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Flow Downs: Cloud or Otherwise

Posted 23rd June 2011 by Jagvinder Kang, Director

Introduction

A lot of 'buzz' and issues continue with Cloud computing, however, although the arrangements give rise to certain new considerations, a lot of the issues remain the same from an IT contracting perspective — including on the topic of `flow-downs.'

Flow-downs are of course the contractual arrangements which an IT supplier will be looking to 'flow-down' from its contract with its customer to its subcontractor. Sometimes these flow-downs are expressed as mandatory flow-downs, namely, those which a customer will expressly state in a contract are required to be flowed-down to its subcontractor, for the customer to ensure that there is a 'chain of protection' for the customer.

However, flow-downs are not limited in scope to these. As there can be other flow-downs, which although not expressed to be required to be reflected in a subcontract, would still need to be reflected in such an arrangement, in order to prevent the supplier being in breach of its arrangements with its customer - eg intellectual property right assignment provisions, security obligations or accreditation requirements.

Flow-down Arrangements

The question which often arises, is to what extent do these flow-downs need to be reflected in the subcontracting arrangements. In order to ensure true 'back-to-back' arrangements, the simple answer would be pretty much all of those provisions which impose any obligations and liabilities which are relevant to the subcontractor.

The reality though, is that a subcontractor is rarely likely to mirror 'wholesale' the provisions which are in the prime customer contract, unless the subcontracting arrangement is akin to taking the bulk of the service obligations under the prime contract.

Parties therefore need to be realistic and pragmatic in this situation, and understand that risk and reward go hand in hand. If a subcontractor is not taking on the lion's share of profit, why should it be exposed to the lion's share of liability? Likewise, a subcontractor can not in such circumstances justify expending a large amount of management and legal time and cost, on negotiating a contract which contains large numbers of provisions which are either not relevant, or where it has not 'built in' any risk premium in its pricing to accept those obligations.

Businesses therefore need to be alive to the fact that an intact contractual flow-down chain is not something which is always realistically possible, and pursuing such an arrangement in such circumstances is likely to be a waste of time, resource and nothing more than a relationship straining position.

Parties therefore need to identify the key flow-down requirements, and determine how to 'plug the gap' on the other ones without being in breach of the prime contract.

This approach must be tailored though in the context of such considerations as:

  • The value of the contract;
  • The types of parties involved/industry sector (eg public sector —v- private sector; operators in highly regulated industries); and
  • The mission-criticality of the contract to the business of the customer.

Certain of these types of dynamics can lean the flow-down requirements more towards a mirroring approach — however, if this approach is to be taken, then the parties need to ensure that they have factored enough time on both sides to give the contract proper consideration by not only the legal team, but also by the management, delivery, commercial and risk teams operating within the respective organisations.

Factoring in a realistic timeline, and negotiating the subcontract arrangements in parallel to the prime contract, can also provide the opportunity to attempt to address or raise any true subcontractor `showstopper' issues in the prime contract negotiations.

In situations where subcontracts are entered into after the prime contract is already executed (far from ideal, but it is something which sometimes happens depending upon the circumstances), then where important flow-downs can not be agreed for genuinely justifiable reasons, it is prudent to raise these with the customer — this allows an opportunity to see if a 'waiver' can be obtained in the context of the particular subcontractor in question, by possibly providing an alternative approach which can be adopted in the subcontracting arrangements, which still provides the requisite level of comfort to the customer. This again means that time is required, hence why the contractual negotiation timeline needs to be realistic, to allow the best opportunity for such conciliatory discussions.

Final Thoughts

Prime contract and subcontracting arrangements have been working for decades in the IT industry, and they will continue to do so in the 'Cloud era', but the underlying principles of pragmatism and timing still apply.

The most contentious issue on flow-downs though, is usually that of liability. Compromises are always discussed (and usually reached), but when it comes to this, parties need to also factor in internal business continuity, disaster recovery, insurance and other internal risk management measures, rather than simply attempting to use a contract to completely outsource one's risk.

All of this, therefore, requires building in time not only into the project delivery, but also into the contractual negotiation timeline.