Include penalty clauses for assured service level

Penalty clauses in a service contract not only act as deterrents but also help in ensuring vendor accountability. These clauses help in pulling up the vendors in case of service failures through a scheme of penalties.

Dhiren SavlaDhiren Savla

Service level agreement (SLA) between concerned parties is an obvious first step taken by companies today. But, what happens if the SLA is dishonored and the company suffers losses due to lack of vendor accountability? Hence, including penalty clauses while drafting an SLA is a very good idea, as the penalty clauses would help pull up the vendor in such cases.

Drawing from personal experience, for one of my international projects, due to an intermittent drop in service availability, the expected level of performance was not assured by a telecom vendor. The vendor had failed on both parameters of network availability and performance guarantee (latency). However, inclusion of a penalty clause in the SLA not only helped us get sufficient credit but also forced the vendor to provide an additional connectivity option for redundancy.

While drafting penalty clauses, the following parameters should be taken care of:

Availability of services: This would mainly involve factors such as network uptime, data center resources, or even database availability. Including penalty clauses is a must in case of network downtime for a long time, which could affect the business function.

Quality of services: This includes performance guarantee, number of defects in a particular software, gaps in the processes, and others. A more forward looking approach in this case could be a penalty against every failure to meet business objectives. Penalty clauses for the quality of services are not to hurt the vendor or to save money, but to keep a check on the deliverables and set the right expectations.

Penalty clauses can be of several types. Some of the penalty clauses may include:

1) Financial penalty: Clauses specifying a financial penalty is a popular practice. In this, the vendor has to pay back the customer a portion of the damages as agreed by both parties in the SLA. However, this penalty clause may not assure full compensation for damage to the business due to service failure.

2) Service credits: When the previously agreed level of service is not maintained, this penalty clause calls for the vendor to offer credit to its client for a duration mentioned in the SLA.

3) Extension of license or support: According to this penalty clause, if an SLA is dishonored, the vendor has to extend the term of the license or support provided to the customer. As per such penalty clauses, the vendors may be forced to grant additional time for application, development and maintenance.

Impact analysis

With an increasing number of chief information officers (CIOs) insisting on the inclusion of various penalty clauses in an SLA, even the vendors have started taking them seriously. Since the penalties are directly linked to the key performance indicators (KPIs), a vendor ends up losing money when the agreed performance standards are not met with.

However, a CIO should not always be perceived by vendors as the cop with a cudgel. He should, therefore, also consider including a scheme of rewards for fulfilling or exceeding the expected levels of service in an SLA. As opposed to a penalty clause, a reward clause could positively motivate the vendor to perform even better.

About the author: Dhiren Savla is a director - Technology at CRISIL Limited, a Standard & Poor's Company. He has more than 20 years of experience across verticals including BFSI, travel, BPO, real estate, and infrastructure.

(As told to Anuradha Ramamirtham)

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