Material Breach In Outsourcing Contracts

Keywords: outsourcing, agreement, material breach,

A well-negotiated outsourcing agreement typically grants a customer the ability to terminate the arrangement without payment of any penalties in the event of a "material breach." However, unless the agreement names specific events that constitute a material breach, that determination will be left to a court. While there are no "bright line" rules to assist a court in making its decision, some case law exists that offers customers guidance in navigating these murky waters.

In particular, the primary focus of a recent case, State of Indiana v. IBM,1 was whether or not the State of Indiana was properly entitled to terminate its agreement with IBM for material breach.

This article will explore some of the key points that can be gleaned from cases where material breach was a focus of the litigation and will culminate in some concepts and best practices that customers can implement to provide more predictability when evaluating whether a supplier materially breached an agreement.

What Constitutes a Material Breach?

When is a supplier in "material breach" for its failure to perform in an agreement? Law treatises offer some guidance to assist with that determination. For example, a material breach has been explained as a breach that "is so fundamental to a contract that the failure to perform ... defeats the essential purpose of the contract," "go[es] to the 'root' or 'essence' of the agreement," or "touches the fundamental purpose of the contract and defeats the object of the parties in entering into the contract."2 One authority, The Restatement (Second) of Contracts, recommends a multi-factor test that courts can invoke to determine whether a breach is material. Specifically, the court should consider the following factors:

The extent to which the injured party will be deprived of the benefit that he or she reasonably expected The extent to which the injured party can be adequately compensated for the part of that benefit of which he or she will be deprived The extent to which the party failing to perform or to offer to perform will suffer forfeiture The likelihood that the party failing to perform or to offer to perform will cure his or her failure, taking account of all the circumstances, including any reasonable assurances The extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.3 Another view on materiality offers this insight: "Ordinarily the issue of materiality is a mixed question of law and fact, involving the application of a legal standard to a particular set of facts. However, if reasonable minds cannot differ on the issue of materiality, the issue may be resolved as a matter of law."4

How have state courts interpreted the issue of material breach? In Illinois, a material breach is one that is "so substantial and fundamental as to defeat the objects of the parties in making the agreement, or whether the failure to perform renders performance of the rest of the contract different in substance from the original agreement."5 Case law in Illinois further opines that a "breach must be so material and important to justify the injured party in regarding the whole transaction at an end."6

In applying these concepts, Illinois courts have stated that "[t]he determination of materiality must turn on the facts of each case" and that, "to properly consider whether [a] defendant's breach was material, it is necessary to begin by placing that breach in context."7 An Illinois court will most likely apply the multi-factor test cited above...