Performance IncentivesBy Philip D. Porter | Posted 2011-10-03 Print
Before entering into a cloud computing transaction, evaluate the service provider’s obligations to ensure availability and utility, and determine its incentives to meet those obligations.
Customers should seek contract provisions that create meaningful incentives for the cloud service provider to meet agreed- upon service levels. The most common of these incentives are service credits, technology escrows and, for extreme circumstances, termination rights.
Service Credits: Service credits can take the form of amounts of money that customers could apply to subsequent payment obligations to a service provider, or refunds of amounts already paid to which a customer becomes entitled if service levels are not achieved. They typically do not exceed 20 percent of the total fees charged by the service provider. This at-risk amount is then allocated among the various service levels. Service credits are most effective when they reduce a service provider’s profits. They should not cause a service provider to incur operating losses that could force the vendor to cut its operating costs and impair its ability to deliver functional and reliable services.
When charges for services are payable monthly, customers should be entitled to apply service credits to payments for the following month. When payments are annual or service credits are attributable to service-level failures during the final month of a contract, the service provider should issue a refund in the amount of the service credits to which the customer is entitled.
Technology Escrows: Technology escrows are used most frequently in software as a service (SaaS) cloud computing transactions. These transactions require two separate escrow accounts—one for object code and another for source code, with overlapping, but not identical, events that trigger release of the deposit.
An escrow agreement for object code provides for release of the deposit to a customer in the event of a service provider bankruptcy, cessation of business, discontinuation of services or a specified failure by the service provider to meet an agreed-upon availability standard. Upon a release of the deposit, the customer can duplicate the cloud-based service in its own computing environment or in the computing environment of a third-party hosting-services provider.
An escrow agreement for source code provides for release of the deposit to a customer in the event of a service-provider bankruptcy, cessation of business, discontinuation of services or a specified failure by the service provider to meet an agreed-upon issue-resolution standard, which might be inability to resolve a single high-severity-level issue or repeated failures to resolve high- or moderate-severity issues in multiple consecutive months. Escrow provisions should be evaluated for enforceability under applicable bankruptcy laws.
Termination: Finally, if the service provider’s nonperformance of its obligations—including nonperformance attributable to a force majeure occurrence (an unforeseen event beyond the service provider’s control)—affects a customer’s operations so seriously that it must seek an alternative technology solution, a cloud computing agreement must permit the customer to terminate the agreement without a termination fee, with an entitlement to a pro rata refund of service fees that the customer has prepaid for any period following the effective date of such a termination, and without a cure period.
When offering or availing themselves of the often-substantial cost and scalability benefits of cloud computing services, service providers and customers must recognize that these services are delivered with technology assets that are neither in the customers’ possession nor under their control.
It is in the interest of both parties to structure contracts for these transactions in a manner that gives customers a reasonable expectation that the cloud-based services will be reliable. Each party to a cloud computing transaction is responsible for making sure that the agreement satisfies this interest.
Philip D. Porter is a partner in the Northern Virginia office of Hogan Lovells. He's a member of the firm's Intellectual Property Practice and leads the technology transactions and outsourcing practice groups in the United States.
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