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Service levels and service credits: a tale as old as time

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The Roman empire dominated the Mediterranean with their fearsome fleet of ships. One of their secrets? They apparently outsourced the crewing of some ships to private merchants. Some merchants would agree to ensure the ships reached their destination by a particular date, and for every day they were late, they agreed a fixed amount would be deducted from their fee. 2000 years later, service levels and service credits are still an effective tool to align supplier and customer incentives.

Nervous customers have a large toolkit to draw on when they want to build in contractual protections. Think service obligations, rectification plans, intervention rights and termination rights, to name a few. One of the most effective of these are service levels and service credits – particularly in agreements for ongoing services where ‘performance’ is not clear cut. Service levels remove that ambiguity, while service levels help align a customer’s and supplier’s incentives.  

However, although they appear simple, there are potential pitfalls to avoid. Remember these key points when drafting service level and service credit regimes:

  • Are they an exclusive remedy? This is often fiercely negotiated. A compromise may be agreeing they are exclusive financial remedies, or only exclusive remedies in respect of the less critical service failures.
  • Should they be accompanied by a customer termination right? Customers are frequently able to terminate for the supplier’s ‘material breach’. This threshold is often unclear. However, where parties agree precise service levels, materiality is suddenly more quantifiable, and customers may argue it makes sense to agree a termination right by reference to service level failures.
  • Should service credits be capped? Suppliers who agree service credits may wish to reduce their exposure by imposing a cap on the credits they pay out. Caps between 5% and 20% of annual fees are common. 
  • What tracking obligations apply? Customers often have limited visibility on the performance actually being achieved. As such, customers will often want to impose an obligation on the supplier to implement monitoring processes, that track and report performance, at a level of detail to determine compliance with service levels. 
  • What are an appropriate number of service levels? A sliding scale of levels will provide a smoother incentive structure, but too many levels may overburden a supplier with administrative monitoring obligations.