Appeals court: IBM materially breached contract with state

The Indiana Court of Appeals has reversed a Marion County judge’s finding that IBM did not materially breach the contract it had with the state to modernize its welfare system. As a result, the appeals court ordered a determination of damages to the state.

The state and IBM entered into a billion-dollar contract to update and modernize Indiana’s welfare system in December 2006. But the process was plagued with problems and the state ended the 10-year contract in October 2009 “for cause,” in part because of IBM’s “numerous and repeated quality and timeliness failures.”

When the contract was terminated, Indiana had paid IBM nearly $437 million, plus $4.4 million for disengagement services.

The state and IBM sued each other – the state sought $170 million; IBM wanted at least $52 million. Marion Superior Judge David Dreyer in July 2012 awarded IBM $52 million, plus $10 million in prejudgment interest. He found that IBM did not materially breach the contract.

But two of the three judges on the appeals panel found this was an error, that he should have considered IBM’s failures to meet federal program targets in determining whether to terminate the contract for cause. They also held that the economic downturn and flooding that hit Indiana in 2008 should not have been considered as reasons to excuse IBM’s performance because the contract provided IBM with a remedy in the event of these issues.

“We find that the heart of this contract was to provide services to the poor in a way that complied with federal law,” Chief Judge Nancy Vaidik wrote in State of Indiana, acting on behalf of the Indiana Family & Social Services Administration v. International Business Machines Corporation, 49A02-1211-PL-875. “In this respect IBM’s performance, as the trial court explained, ‘consistently missed the mark.’ This substandard performance by IBM, $437 million and 36 months later, went to the essence of this contract.”

The COA upheld that IBM is entitled to the $40 million in assignment fees, despite the material breach because these fees represent value to the state in the ability to assume certain subcontracts, as well as that deferred fees are not payable to IBM in the event the contract was terminated for cause.

The state no longer has to pay the $2.5 million in early termination close out payments because of IBM’s breach, but it must pay the $9.5 million for the equipment it kept after cancelling the contract.

IBM is not entitled to $10.6 million prejudgment interest, the court held. The judges remanded for a determination of the amount of fees IBM is entitled to for change orders 119 and 133 and to determine the state’s damage and offset any damages awarded to IBM as a result of its material breach.  

Judge Ezra Friedlander dissented in part, believing that IBM did not materially breach the contract and that IBM can recover transition fees.