Bankers often grouse about the quality of the computer services they buy from outsourcers, but rarely do such tensions escalate into lawsuits.

Perhaps that's why a suit filed in 1992 by a South Texas community bank against Electronic Data Systems Corp. attracted so much attention.

Texas State Bank of McAllen accused the data processing giant of fraud and breach of contract for allegedly failing to convert two smaller banks owned by the same holding company, Texas Regional Bancshares, to the EDS system.

A 12-member jury disagreed, deciding last June that EDS did not violate the contract. EDS, in fact, was awarded $500,000 on a countersuit - the amount it would have received if the two affiliates had been converted.

Ultimately, that award was never paid. The parties settled in October 1994, apparently to avoid further litigation, and Texas State Bank took its data processing in-house.

While both parties are prohibited from talking about the specifics of the case, George R. Carruthers Jr., chief financial officer at Texas State Bank, said the experience taught him a big lesson.

"The real issue here is if I was ever to do it again, I would want heavyweight, well-seasoned computer programmers who were well versed in financial institution data processing to assist in the evaluation" of the system, he said. "I think that maybe a third party doing a detailed analysis of a system that you are attempting to go to is well worth the time and effort."

Mr. Carruthers is not alone in coming to that view. While few outsourcing relationships end so bitterly - indeed, many continue happily for years - industry experts say that bankers have become much more sophisticated in their choosing of outsourcers and negotiating of contracts.

To protect themselves in case things go wrong, banks are increasingly looking to technology consultants and lawyers to choose outsourcers and help negotiate contracts.

"The first bank outsourcing deal we did was in the mid-1980s, so you're looking at 10 years of knowledge accumulated," said John Halvey, a partner at Milbank, Tweed, Hadley & McCloy, the New York law firm that advised American Express Bank on its recent $350 million outsourcing deal with EDS.

When Onbancorp of Syracuse, N.Y., was negotiating its outsourcing agreement Systematics Financial Services Inc., now called Alltel Information Services, the bank called in consultants from KPMG Peat Marwick. Robert J. Bennett, chief executive, told the American Banker that he believed Onbancorp needed more expertise than it had in-house.

"One of the things you have to be careful about is performance standards," Mr. Bennett said. "It was worth the $10,000 to $12,000 we paid to make sure that contract had ironclad performance standards."

He recalled that the first version of the contract did not include the kind of performance standards the bank wanted. "If (they) can get away with it, and you're crazy enough to sign it, well, that's what contracts are supposed to do."

Not surprisingly, industry experts agree.

"Service level problems are very common. You absolutely, unequivocally have to have" performance standards in the contract, said Mr. Halvey. "They can't be objectives. They have to be hard. Too many contracts get written that say, 'The service level objective is this.' It's not an objective. It's a contractual obligation to perform that way."

Mr. Halvey, whose firm has worked on about 20 such deals for banks, said he also insists that contracts call for liquidated damages, or penalties, if the outsourcer fails to achieve standards such as the amount of time a mainframe computer is available.

Still, he said those damages are designed more to capture the attention of the vendor than compensate the bank for the performance problems. "Liquidated damages are Pyrrhic victories. They are victories - and you want to have them," he said. "But if you are relying on them, you are in a lot of trouble. You want enough money in there to make it painful to the vendor."

But Clyde H. Wilson Jr., an attorney with Wilson, Johnson & Jaffer, a Sarasota, Fla., firm that specializes in computer and technology cases, said vendors typically won't allow for such penalties in their contracts, especially if the potential customer is not a very large bank.

"If you're big, you can get big concessions," he said. "A community bank is not going to go to (AT&T Global Information Solutions) and get them to remove their warranty limitations. You're not going to get them to throw out their disclaimer of consequential damages."

But there are some attractive provisions that smaller institutions can negotiate, Mr. Wilson said.

He referred to one of them as the "fly the guy in from Japan" clause, meaning that the contract would require a high-level executive to handle any big problems that may occur.

And if the standard contract calls for arbitration - an increasingly popular approach to resolving disputes - Mr. Wilson said he pushes to have that arbitrator be a lawyer, and not someone from the software industry who may be more inclined to side with the vendor.

Mr. Wilson also noted one of the reasons arbitration is cheaper than litigation is that there is no lengthy process of discovery. But waiving discovery, he said, makes it harder for a bank to prove that the vendor was the source of the problem.

In negotiations, Mr. Wilson tells vendors, "I'll give you arbitration but you've got to give me my discovery."

"You have to go in there looking from the point of view of function and what we need it to do," he said. "What is going to happen to us if we have problems? What performance deficiencies can we tolerate? What can we not tolerate? And this takes quite a bit of soul searching."

Mr. Halvey of Milbank Tweed said contracts should also include provisions requiring the outsourcer to perform a root-cause analysis to determine the cause of any problem.

But Mr. Halvey also noted that performance issues are ultimately linked to how much a bank is willing to pay. Banks that want to guarantee very high performance levels can expect to pay a higher price for the service, he said.

"If your focus is on low price, you are typically going to have to be a little more flexible on the service levels," he said.

Mr. Wilson also offered another compelling reason to negotiate a favorable deal. "It's a lot cheaper to have a good contract than it is to have a good litigator," he said. "I make a hell of a lot less money off somebody doing the contract right the first time."

He added that signing an outsourcing agreement is extremely important because of the logistics of a major conversion. "There is something about being with a particular vendor in the computer category that is almost like a marriage," he said. "Once your bank gets totally set up on a particular system - hardware and software" - it is extremely difficult to change.

Even if a deal never gets to litigation or arbitration, an outsourcing agreement that fails to live up to a bank's expectations can prove costly. When Stephen A. Hansel took over as chief executive of Hibernia Corp. in New Orleans in 1992, it was losing money and operating under regulator- imposed restrictions (See cover story).

Among the costs that needed to be reined in, Mr. Hansel rapidly concluded, were those in the back office. Previous management, he said, had signed a contract with Integrated Systems Solutions Corp. (ISSC), International Business Machines Corp.'s outsourcing unit, that would "sell the future short."

He said the costs of the contract were "backloaded," or certain to rise even as the asset base was shrinking. Hibernia paid IBM $12 million to get out of the deal and, near the end of 1993, signed an outsourcing agreement with Systematics. The conversion was completed in January. Mr. Hansel said the bank will save at least $40 million over eight years.

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