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State, IBM contest $62 million award for canceled welfare contract

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Indiana Court of Appeals judges spent the better part of a 90-minute oral argument Nov. 25 focused on whether a trial judge’s order applied the proper legal standards in awarding $62 million to IBM after the state canceled its $1.3 billion contract to overhaul Indiana’s welfare administration.

Marion Superior Judge David Dreyer in July 2012 awarded IBM $52 million plus about $10 million in prejudgment interest after the state negated the 10-year deal involving the Family and Social Services Agency after just three years.

apb-il-ibm03-15col.jpg Arguing for the state, Peter Rusthoven tells the Court of Appeals a $62 million judgment for IBM should be vacated. (IL Photo/Aaron P. Bernstein)

In State of Indiana v. IBM, 49D10-1005-PL-021451, Barnes & Thornburg LLP partner Peter Rusthoven argued for the state – to the sometimes skeptical appellate judges – that the record was replete with evidence that the contract was canceled for cause.

“The trial court ruling was clearly erroneous,” Rusthoven said. He argued that IBM officials promised more than they could deliver in promoting an advanced, totally computerized welfare-intake system, then later claimed, “We’re just the Geek Squad from Best Buy” taking orders from the state.

Before the trial court, the state sought the maximum it could recover from IBM – $125 million of the $437 million it paid during the first three years of its contract. IBM sought more than $100 million – claims it restated to the appeals panel during oral arguments.

“During the early part of the contract, IBM was being underpaid,” said IBM attorney Jay

Lefkowitz of the New York firm Kirkland & Ellis LLP. “… Our costs were going to be significantly more than $10 million a month” that the state was paying at the outset.

IBM’s efforts to upgrade the state’s computer systems for screening and processing claims for welfare, food stamps and Medicaid was “plagued with problems from the start,” Rusthoven told the Court of Appeals panel. He argued the judges would have to determine whether Dreyer’s opinion was “infected from top to bottom with legal errors,” beginning with the ruling that IBM was not in material breach.

Judge Nancy Vaidik countered Rusthoven’s assessment of IBM’s performance. The trial court made particular findings of fact, for instance, that “IBM was curing these problems” at the time the contract was nixed, Vaidik said.

Rusthoven said that was among the clear errors in the trial court ruling. He pointed to language in the IBM contract saying the state had to be satisfied with the company’s overall performance. He said the court had to look at IBM’s performance under the contract in totality. “The state was not satisfied in 2009,” he said.

apb-il-ibm02-15col.jpg Company attorney Jay Lefkowitz argues the state should pay more than $100 million for canceling its contract to upgrade Indiana’s welfare system. (IL Photo/Aaron P. Bernstein)

“You paid $437 million for something,” Judge Ezra Friedlander interjected. “You had to be satisfied with something.” Presiding Judge John Baker also pointed to the amount the state paid before canceling the contract and arguing breach.

Rusthoven said the state never argued that IBM did nothing, but rather that the company wasn’t hitting performance goals. And just because the state continued paying IBM roughly $10 million a month under the contract, “That doesn’t give (IBM) a blank ‘no-material-breach’ check,” he said.

Rusthoven answered Vaidik’s query of what he would have the court do by urging the panel to vacate the awards.

He also told the panel key IBM witnesses and the company’s internal documents showed that some of the claimed damages IBM sought under the contract were “arbitrary” and unenforceable.

But Lefkowitz dismissed testimony of “arbitrary” claims as coming from “a much more junior member of the team.” He said his client was entitled to sums in addition to those awarded by the trial court. Lefkowitz pushed for total damages of about $106.6 million.

That increased amount would include an additional $43 million in deferred fees – a “true-up” or “make-whole payment” reflecting the greater amount of upfront work IBM performed at the outset of the contract, plus compensation for lost revenue.

The trial court ruled the state failed to show IBM in material breach despite evidence of poor performance under the contract. The state also received benefits including improved FSSA performance as a result of the contract, a ruling the trial court also found precluded a determination of material breach.

The court’s $52 million in damages includes $40 million in assignment fees Indiana owes IBM because the state retained the company’s subcontractors after it dropped IBM. Another $9.5 million in equipment expenses was awarded to pay for computers, monitors, furniture and other assets procured under the contract, and an additional $2.5 million was awarded in early termination close-out payments. That includes actual costs to IBM that were incurred as a result of the state’s cancellation of the contract.

apb-il-ibm01-15col.jpg Presiding Court of Appeals Judge John Baker addresses a question to counsel in State v. IBM during oral arguments Nov. 25. Panelists flanking Baker are Judges Ezra Friedlander and Nancy Vaidik. (IL Photo/Aaron P. Bernstein)

Lefkowitz said the state received clear benefits from hiring the same subcontractors IBM lined up to do the work, and that when Gov. Mitch Daniels canceled the contract, IBM experienced a tangible loss that can only be compensated by the additional $43 million award. “We were going to make $4.7 million a year just from one of the subcontractors,” Lefkowitz told the panel.

The state is still using equipment provided under the IBM contract, according to Lefkowitz. “It makes perfect sense you’ve got to buy this equipment if you want to use it.”

Rusthoven countered to the panel that the argument for deferred fees would set a dangerous precedent. “IBM is claiming it had a right to make a loan to the state which the state now has to repay.”

While Rusthoven also argued the state has sovereign immunity from paying prejudgment interest, Lefkowitz disagreed, claiming “the state stands on the same footing as any other party.”

A day after oral arguments in State v. IBM, a separate appeals court panel affirmed Dreyer’s rulings in a suit IBM filed against a subcontractor, ACS Human Services Inc. That appeals panel upheld a ruling that IBM owed ACS $709,398.95 in costs related to discovery and costs of production of documents as a nonparty in the state suit. Also affirmed was the trial court’s grant to IBM of $425,178.85 in sanctions against ACS.

The Court of Appeals will rule in State v. IBM at a later date.•

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