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State v. International Business Machines Corp.

Supreme Court of Indiana

March 22, 2016

STATE OF INDIANA, Acting on Behalf of the Indiana Family & Social Services Administration, Appellant/Cross-Appellee (Plaintiff/Cross-Defendant below),
INTERNATIONAL BUSINESS MACHINES CORPORATION, Appellee/Cross-Appellant (Defendant/Cross-Plaintiff below)

          Appeal from the Marion Superior Court, No. 49D10-1005-PL-021451. The Honorable David J. Dreyer, Judge.

         On Petition to Transfer from the Indiana Court of Appeals, No. 49A02-1211-PL-00875.


         ATTORNEYS FOR APPELLEE/CROSS-APPELLANT, INTERNATIONAL BUSINESS MACHINES CORPORATION: Jay P. Leftkowitz, Steven J. Menashi, Kirkland & Ellis LLP, New York, New York; Steven D. McCormick, Jonathan C. Bunge, Daniel R. Lombard, Kirkland & Ellis LLP, Chicago, Illinois; Andrew W. Hull, Daniel K. Burke, Hoover Hull LLP, Indianapolis, Indiana.

         David, Justice. Rush, C.J., Dickson and Rucker, J.J., concur. Massa, J., not participating.


         David, Justice.

         This case involves a $1.3 billion Master Services Agreement (" MSA" ) entered into between the State of Indiana, acting on behalf of the Family and Social Services Administration, (" State" ) and International Business Machines, Corp. (" IBM" ) to modernize and improve Indiana's welfare eligibility system. Although the MSA was supposed to last ten years, the State terminated it less than three years in, citing performance issues on the part of IBM. Both parties sued each other for breach of contract.

         At issue is whether IBM's breach of the MSA was " material." The trial court found that the State failed to prove the breach was material, looking at the MSA as a whole, and in light of the benefits received by the State. The Court of Appeals majority reversed the trial court on this issue, finding that IBM's breach went to the " heart of the contract" which the Court of Appeals majority determined was defined by the policy objectives of the MSA. Both the trial court and the Court of Appeals majority cite to the common law Restatement (Second) of Contracts § 241 factors for analyzing the materiality of a breach. However, here, the MSA itself sets forth the standard for assessing the materiality of a breach. The MSA also provides performance standards and indicators to measure IBM's performance. The policy objectives of the MSA are incorporated into those performance standards. Consistent with Indiana's long tradition of recognizing the freedom to contract, we hold that when a contract sets forth a standard for assessing the materiality of a breach, that standard governs. Only in the absence of such a contract provision does the common law, including the Restatement, apply.

         In this case, the contract provides that in order to terminate the MSA for cause, the State had to prove a breach or a series of breaches by IBM that were " material considering this Agreement as a whole[.]" (MSA § 16.3.1(1)(A), (C).) We hold that under the facts and circumstances of this case, looking at the performance standards and indicators provided in the MSA, IBM's collective breaches were material in light of the MSA as a whole. With the exception of its material breach analysis, we summarily affirm the Court of Appeals on all other issues. Indiana Appellate Rule 58(A)(2)[1]. We reverse the trial court's finding that IBM did not materially breach the MSA and we remand to the trial court for calculation of the parties' damages consistent with this opinion, including any appropriate offsets.

         Facts and Procedural History

         During his first term, Governor Mitch Daniels announced that Indiana's welfare system was " broken" and " plagued by high error rates, fraud, wasted dollars, poor conditions for its employees, and very poor service to its clients." (Appellant's App. at 166.) Governor Daniels called it " America's worst welfare system." (Appellant's App. at 167.) Thus, beginning in late 2004, the Governor and senior officials began to plan a modernized system based on a " remote eligibility" model previously implemented in Texas. (Id.) This new system would allow Indiana citizens to apply for welfare benefits " via web and call center" without the need for face-to-face meetings with a case worker, and eligibility determinations would be done on a centralized, statewide basis rather than in local county welfare offices. (Id.) The State sought vendors for this project and ultimately awarded it to IBM and a group of coalition companies (collectively " IBM" ).

         On December 27, 2006, the State and IBM executed a 10-year, $1.3 billion Master Services Agreement (" MSA" ) in an effort to modernize and improve Indiana's welfare eligibility system. The MSA contains more than 160 pages plus extensive attachments, including 10 exhibits, 24 schedules and 10 appendices, which encompasses all aspects of the parties' working relationship. Generally, the MSA aimed to establish centralized service and call centers for the processing of welfare applications, enable remote electronic access to the system, provide the State a paperless document system, create systems to combat fraud and improve Indiana's poor welfare-to-work record and lower administrative costs.

         To tat end, the MSA set forth the various " Policy Objectives" for the modernization effort, which include, in pertinent part:

(1) (i) to provide efficient, accurate and timely eligibility determinations for individuals and families who qualify for public assistance, (ii) to improve the availability, quality and reliability of the services being provided to Clients by expanding access to such services, decreasing inconvenience and improving response times, among other improvements, (iii) to assist and support Clients through programs that foster personal responsibility, independence and social and economic self-sufficiency, (iv) to assure compliance with all relevant Laws, (v) to assure the protection and integrity of Personal Information gathered in connection with eligibility determination, and (vi) to foster the development of policies and procedures that underscore the importance of accuracy in eligibility determinations, caseload integrity across all areas of public assistance and work and work-related experience for Clients in the Programs.

(Appellant's App. at 567.) The MSA also provides that when construing and interpreting provisions and terms of the MSA, " [i]n the event of any uncertainties" or in the event of any " ambiguity, vagueness, or inconsistency" the " provisions and terms shall be read in a manner consistent with the Policy Objectives." (MSA § 1.4.) However, the MSA also provides that:

[n]otwithstanding the foregoing, in no event shall the Policy Objectives change or expand [IBM]'s obligations hereunder unless expressly agreed to by the Parties pursuant to a Change.

(MSA § 1.4(5).)

         Pursuant to the MSA, IBM's first obligation was to assist the State in processing social service applications under the State's existing procedures in all Indiana counties. Then, the modernized system was to be rolled out in phases on a region-by-region basis according to a " preliminary," " initial Transition Timeline." (MSA § 3.2.1(2).) Finally, once the modernized system was in place in all counties, the project would reach the final stage, " Steady State." (MSA § 3.2.1(1).)

         The MSA sets forth various standards and measurements in order to assess IBM's performance. It provides that IBM's satisfactory performance will be measured by the following eight standards:

1) Adherence to all the terms of this Agreement, including all covenants, obligations, representations and warranties;
2) Performance in accordance with and compliance with the Modernization Project work plans, schedules, and milestones agreed to by the Parties;
3) Performance of the Services in accordance with all applicable requirements of this Agreement, including the Performance Standards set forth in Schedule 10 [Performance Standards];
4) Satisfactory results of Audits by the State, its representatives, or other authorized Persons in accordance with Article 9 (with all results of such Audits being addressed in accordance with the Governance Plan);
5) Attendance at and participation in the DFR financial review and other meetings conducted from time to time by FSSA (both internally and with the public);
6) Timeliness, completeness, and accuracy of required reports;
7) Determination by the State of (i) [IBM]'s satisfactory performance of the Services and the Delegated Activities; and (ii) [IBM]'s satisfactory oversight and management of the Subcontractors; and
8) [IBM]'s efforts to assist the State in achieving the Policy Objectives.

(MSA § 3.8.2.)

         The MSA also provides four categories of performance standards that are associated with specific monetary consequences (liquidated damages) in the event they are not met:

1) Service Levels: the performance metrics, and associated penalties and incentives, that focus on [IBM]'s processing accuracy in administering the Programs and which impose more stringent measurements of the error rates than those currently applied.
2) Key Performance Indicators (" KPI" or " KPIs" ): performance metrics, and associated penalties, designed to provide incentive to [IBM] to focus on other key metrics related to the Service components that are important to the State and its Clients.
3) Critical Transition Milestones: penalties imposed if [IBM] does not achieve the Critical Transition Milestones identified by the State that are critical to the successful transition of the Services.
4) Federal Penalties: penalties imposed by the Federal government, as set forth in Section 15.2.6 of the Master Services Agreement.

(MSA Schedule 10.) However, some of these metrics, for example, the Service Levels Metrics, were not applicable until Steady State, which never went into effect. Alternatively, some of the KPIs were accelerated by agreement of the parties in a Change Order.

         Article 16 of the MSA provides that the State had the right to terminate the MSA for its own convenience or for cause. With regard to for cause termination, the State could terminate the MSA for cause in the case that there is a breach that is " material considering [the MSA] as a whole." (MSA § 16.3.1(1)(A).) The State could also terminate the MSA for cause when there is:

a series of breaches of [IBM]'s obligations, none of which individually, constitutes a breach of this Agreement which is material considering this Agreement as a whole, but which, in view of [IBM]'s history of breaches, whether or not cured, collectively constitute a breach of this Agreement which is material when considering this Agreement as a whole . . .

(MSA § 16.3.1(1)(C).) The State could also terminate the MSA for any reason, if it determined that such termination was in its best interest.

         Once IBM began to roll out the modernized system to the twelve-county pilot area, the parties saw implementation issues immediately. These included call center issues, untimely processing of applications and redeterminations for benefits and a failure to follow proper procedures. Despite these challenges, the State approved rolling out the project to additional Indiana counties. In total, the modernized system was rolled out in fifty-nine (59) of the ninety-two (92) counties.

         IBM cites, and the trial court found, two factors that contributed to the initial difficulties with the modernization project. First, after the rollout to the pilot region, Indiana was faced with the " Great Recession," and the State unemployment rate more than doubled. Because of this, benefit applications increased dramatically. Second, Indiana was hit with a series of natural disasters (flooding) beginning in 2008. These disasters also impacted rollout of the modernization project. The parties mutually agreed to suspend rollout of the modernization project in order to accommodate disaster relief efforts.

         The MSA contains provisions which address economic downturn and natural disasters. Schedule 11 of the MSA provides Material Assumptions applicable during the term of the MSA and includes the assumption that " there will be no . . . material economic downturn in the State of Indiana." (MSA Schedule 11.) It further provides that " an inaccuracy or error in any of the Material Assumptions shall not automatically entitle [IBM] to any Change which it may request" but that IBM could request changes be made " solely pursuant to the Change Order Process." (MSA § 4.1.3.) As for the natural disasters, the MSA defines a " Force Majeure Event" as: " fire, flood, earthquake, other act of God or nature . . . beyond the reasonable control of the affected party that delay or prevent the Party, directly or indirectly, from performing its obligations under the Agreement." (MSA Appendix I.) Also, the MSA provides that in the case of a Force Majeure Event, if " [IBM] is unable to perform any of its obligations under this Agreement or such performance is rendered impractical, [IBM] shall provide notice to the State. . . ." (MSA § 21.22.) IBM did not submit a Change Order regarding the recession nor did it provide notice to the State regarding a Force Majeure Event.

         The State expanded the scope of IBM's work eleven (11) times during the course of the project, which led to additional strain on the modernized system. For instance, in 2007, the State added a Healthy Indiana Plan (" HIP" ) to provide insurance to uninsured Hoosiers below a certain income level. The volume of HIP applications far exceeded the State's initial projections, causing IBM to fall further behind in application processing.

         During the rollout, the State conducted a series of project assessments. IBM received positive feedback from State officials. For instance, in May of 2008, FSSA Secretary Roob reported to the Indiana General Assembly that with regard to the modernization project, the State was " serving more people statewide and in a timelier manner than we ever have before." (Appellant's App. at 189.) In October of 2008, the director of FSSA's Division of Family Resources gave IBM primarily " 9s and 10s out of 10" in IBM's annual customer satisfaction survey. (Id.) In December 2008, Governor Daniels said that the new system ...

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