AMS Sues National Union Over Mississippi Troubles

By Steve LeSueur, EditorOn April 29, 1999, one week after his state had filed a $984 million lawsuit against American Management Systems Inc. for breach of contract, Mississippi Commissioner of Revenue Ed Buelow met with representatives from AMS to try resolving the dispute out of court.Buelow, who had terminated an AMS contract to build an automated tax system for his state, offered to settle for a mere $14 million."I wasn't interested in bankrupting the company," he recalled in an interview with Washington Technology. "I originally was interested only in getting the money back I was entitled to."The requested settlement primarily included the amount of the AMS contract, which was $11.2 million, and $2 million for year 2000 expenses caused by project delays."I just wanted enough money to build our own tax system and pay our Y2K expenses and legal fees," Buelow said.AMS officials mulled the offer for about a week, during which time they issued a press release calling the huge lawsuit "inexplicable" and staunchly maintained they could have delivered the promised tax system. AMS of Fairfax, Va., then informed Buelow that the company would be willing to settle the case for just under $2 million.Insulted by the low offer, Buelow withdrew his own and then issued a statement blasting the AMS release as misleading and incorrect. After that, lawyers on both sides went to work.The eventual outcome of the case is well known. On Aug. 23, a jury ruled in favor of Mississippi and ordered AMS to pay $474.5 million in actual and punitive damages.After considering an appeal, AMS reached an out-of-court settlement with Mississippi, agreeing to pay $185 million over 13 years ? an amount 10 times Buelow's original settlement offer. Most damaging to AMS was the fact that its liability insurance did not cover the entire amount, forcing the company to pay $35 million out of its own pocket.What is not well known, however, is that AMS is now suing National Union Fire Insurance Co. of Pittsburgh, Pa., one of its two insurance providers, claiming that National Union's intractable stance prevented AMS from reaching a pre-trial settlement with Mississippi.Not only did AMS pass up the opportunity to settle for $14 million, but the company rejected or ignored other settlement offers from Buelow as well, including one for $35 million just one week before the trial.The lawsuit against National Union, filed Sept. 11 in federal court in Jackson, Miss., contends that AMS officials would have seized upon these opportunities, but because National Union was responsible for paying up to $50 million in damages, AMS needed its approval to settle. In essence, National Union had veto power over any settlement offers.The lawsuit asserts that National Union failed to pursue "reasonable settlement demands," instead choosing to "gamble with the funds and resources of AMS" by forcing a trial.The lawsuit does not specify an amount of damages. But AMS Chairman Paul Brands, in comments made Oct. 10 in New York, said the company would seek $38 million to recoup settlement costs and legal fees and would seek other damages, such as damage to the company's reputation and credit standing.AMS' share price plunged 31 percent from $21.81 to $15 the day the jury award was announced, but has since climbed to about $19.AMS' other insurance company, Federal Insurance Co. of Warren, N.J., has joined AMS in the complaint against National Union, which has since filed a motion to have the case dismissed or transferred to the U.S. District Court for the Eastern District of Virginia.Officials with AMS, Federal Insurance and National Union would not comment on the case, but each has filed court documents with details regarding the dispute. For AMS to win its case, the company must do more than argue that National Union is guilty of poor decision making. AMS must prove that National Union's actions were unreasonable based upon the available evidence at that time, and that the insurance company ignored the interests of its client."National Union failed to make an honest, intelligent and knowledgeable evaluation on the merits of the settlement opportunities presented prior to the jury verdict," the AMS complaint said. Had National Union done so, AMS contends it could have reached a pre-trial settlement well within the policy limits.XXXSPLITXXX-AMS in December 1993 signed what would become an $11.2 million contract to design and build an automated computer system for the Mississippi State Tax Commission. The project, which was expected to take three years, would create an integrated system for collecting, recording and maintaining 38 different categories of state taxes. In a bid presentation to tax commission officials, AMS said that its proposed system would generate $36 million annually in additional revenue for the state, Buelow said.The tax system, however, never got built. State officials said they tried to go live with the first of the 38 tax systems in 1997 and 1998, failing both attempts, and that a third version of that single tax system provided by AMS in January 1999 was so fraught with defects, they could not even complete testing.On April 22, 1999, nearly five and one-half years into the project, Buelow terminated the contract. That same day, the state filed a lawsuit against AMS seeking $234 million in actual damages and $750 million in punitive damages.Because the amount of damages sought by Mississippi appeared to be so out of proportion to the $11.2 million contract, many observers dismissed the huge claim as a ploy to win a quick settlement rather than a true assessment of damages to the state. But Armin Moeller, a partner at Phelps Dunbar LLP of Jackson and one of the attorneys representing Mississippi, contends that the figures are solidly grounded.The $234 million in actual damages included $18 million for staff support for the project, $32 million to hire a new contractor and $184 million in lost savings and revenue that would have been generated by the new system. The AMS tax system, after all, was supposed to have increased revenue collection by $36 million annually beginning in 1997 or 1998, and now the state probably wouldn't have a system in place until 2003 or 2004.The punitive damages were calculated on a 3-to-1 ratio of punitive to actual damages, which is commonly accepted by the courts, Moeller said."We didn't pull the numbers out of thin air. We had concrete evidence, things in writing, smoking guns from their own documents," he said.Nevertheless, Buelow wanted to avoid a trial if he could. A state legislator from 1976 until 1992, when he became head of the tax commission, he had taken a lot of heat from some of his former colleagues for wasting state funds on the failed tax system. He would have been satisfied just getting back enough money to get started on a new one."I never wanted to be in this thing at all," he said. "Lawyers and I don't get along very well. It was a very stressful situation."XXXSPLITXXX-Buelow made three pre-trial offers to settle the case, according to Buelow and Moeller. The first was the $14 million offer made in April 1999, one week after the lawsuit against AMS was filed. Mississippi withdrew this offer May 11 after AMS countered with a $2 million offer, Moeller said.There were no settlement discussions again until April 2000, when AMS said it began urging National Union to participate more actively in the lawsuit. AMS officials also asked that mediation be arranged to help work out a settlement.AMS had $102 million in liability insurance. Its coverage was structured such that Federal Insurance had the first $2 million in coverage, an amount that would largely pay legal fees. National Union had the next $50 million in coverage and then, if that amount was exhausted, Federal Insurance was responsible for $50 million. The mediation occurred June 6. Participating on one side were Buelow and other state officials and their lawyers. On the other side were AMS officials and lawyers and representatives from the two insurance companies. Mississippi offered to settle for just under $52 million, said Moeller.Moeller said the offer had increased significantly from the original $14 million offer for a number of reasons. First, during the year that Mississippi and its lawyers were preparing the case, they discovered that the cost to build their own tax system was much higher than they had originally estimated. In addition, legal costs had mounted, as had the lost revenue for the state. Most significantly, however, they had found the "smoking-gun evidence" that AMS knew that there were problems with the Mississippi system and chose to ignore or hide them rather than correct them, said Moeller. According to Moeller, AMS promised Mississippi a custom-built tax system, but when the company received more lucrative contracts for tax systems in Kansas and other states, AMS diverted its experienced and skilled employees to these other projects. He also said that AMS tried to steer Mississippi away from a custom system to one like the company was building in Kansas, which wouldn't work in Mississippi because the two states use different types of software for key applications.AMS officials, of course, argued that they had done nothing wrong and were fully capable of delivering the promised system. Even before going into mediation, Mississippi's lawyers believed they had a strong case, Moeller said. They already had conducted two shadow juries, or focus groups, in which they presented the strongest evidence they had for both AMS and the state. In both instances, the shadow juries ruled in favor of Mississippi, with the second jury awarding damages that were similar to those eventually awarded in the actual trial, Moeller said. The $52 million settlement offer proposed at mediation would have exhausted Federal Insurance's $2 million policy and nearly all of National Union's $50 million coverage. Federal agreed, but National Union would not, according to court documents filed by AMS and Federal Insurance. In fact, National Union essentially refused to talk to the Mississippi delegation or make a counter offer, according to Moeller and Buelow."We found it to be a surprisingly arrogant and in-your-face position, considering what AMS and its insurers knew at the time regarding the claims in the lawsuit and what we had learned in discovery," said Moeller.But AMS was apparently anxious to settle, and shortly after mediation, Paul Brands, AMS chairman and then-chief executive officer, called Buelow and asked to meet with him, Buelow said. "Mr. Brands asked what it would take to settle the lawsuit," Buelow recalled. Moeller said he advised Buelow that there was no reason to reduce the settlement offer based on the merits of the case, which he was confident Mississippi would win in court. Nevertheless, Buelow in mid-July dropped the offer to $35 million, and Brands told him he would take it to the insurance companies. But National Union again refused to pay, according to AMS and Federal Insurance court documents. Instead, on July 31, AMS and National Union countered with an offer of $6.1 million, approximately the amount Mississippi had paid to AMS for the tax system, according to Moeller.Mississippi rejected the offer and one week later, Aug. 7, the two sides met in court. But even during the trial, which lasted until Aug. 23, AMS officials were hoping to settle, according their complaint.Shortly before the trial ended, Charles Stauber, a senior vice president at American International Group Inc., which owns National Union, met with Buelow in the courthouse witness room. In an affidavit filed Nov. 13, Stauber said he offered Mississippi $11.9 million and tax system software and suggested that he might go as high as $15 million. Buelow said he does not recall hearing the $15 million figure, although that, too, would have been insufficient. "I told him [Stauber] that we weren't interested in getting any software. We had already tried AMS software, and it didn't work. I was only interested in a cash settlement," he said. The meeting lasted only 30 minutes.So there was no settlement. The jury, after deliberating only 90 minutes, returned a verdict awarding Mississippi $474.5 million in damages, an amount that far exceeded AMS' insurance coverage and potentially threatened to bankrupt the company, which last year had revenue just over $1.2 billion.AMS officials considered appealing the verdict, but this would have required the company to post a bond in excess of $600 million during the appeal. So AMS and its insurance companies reached a settlement with Mississippi to pay $185 million over 13 years. In today's dollars, or present value terms, the settlement reportedly cost the three companies about $137 million. National Union paid about $50 million, Federal Insurance $52 million, and AMS $35 million.AMS combined its portion of the fine with its legal fees to take a one-time, before-tax charge of $38 million in this year's third quarter.So why did Mississippi settle for $185 million instead of taking the jury's $474.5 million award?"This was not a vendetta or vengeance lawsuit," Moeller said. "Mississippi's objective was to get an automated, integrated tax system that would serve the citizens."An appeal would have prevented the state from getting money to build the system for at least two years while the case was tied up in court, with no assurance that, even if Mississippi won the appeal, AMS could swallow the huge penalty. "It was never in the interest of the state to bankrupt AMS. If the company went belly up, Mississippi wouldn't have gotten its money," Moeller said.XXXSPLITXXX-It's easy to get lost in the plethora of numbers in this case, but the simple fact is that AMS could have settled the lawsuit for an amount well within its insurance coverage. Had AMS and its insurance providers, for example, accepted Mississippi's last offer of $35 million, Federal Insurance would have paid only $2 million and AMS nothing at all.It is important to note, however, that the settlement would have cost National Union $33 million. Whether this consideration motivated National Union's decision not to settle could be a key focus of its dispute with AMS, because AMS is alleging National Union acted in bad faith by putting its own interests above those of AMS.Buelow and Moeller are uncertain what role National Union played when AMS rejected Buelow's first settlement offer of $14 million, but Moeller said that National Union was in charge when the two sides were talking in the spring and summer of 2000. Moeller said that National Union was aloof, even arrogant, in its dealings with his law firm, and "was not very interested in a dialogue or discussing settlement." But Mississippi Revenue Commissioner Buelow recalls receiving similar treatment from AMS officials. "I didn't get the impression that AMS was more anxious to settle than National Union," he said.In its court filing, National Union points to statements made by AMS that the Mississippi lawsuit was "without merit" and that the jury verdict likely would be overturned on appeal."Throughout the proceedings," Stauber said in his affidavit, "AMS officials maintained in discussions with officials of National Union, Federal and others that the [Mississippi] claim was baseless."XXXSPLITXXX-Mississippi's lawsuit against American Management Systems Inc. didn't garner much attention outside the state before the trial, but the large jury award and subsequent $185 million settlement brought swift notoriety to the dispute.The immediate reaction of many industry officials was similar to that of Bill Loomis, a Legg Mason Wood Walker Inc. analyst who declared the jury's verdict "outlandish." But officials said that, outlandish or not, the Mississippi case already is making systems integrators more careful in signing up for large-scale IT projects, and not just in Mississippi."I've already found that systems integrators are more cautious everywhere," said John Kost, a vice president with Siebel Systems Inc. of San Mateo, Calif.Kost, in fact, said he knew of one instance in which a large integrator in another state pulled back from bidding on a complicated state health-care system because of what happened in Mississippi. "Their lawyers said not to even think about it," he said.In the wake of the Mississippi case, information technology companies are reviewing more closely new state IT projects, evaluating risk and whether to bid, said Tom Davies, a senior vice president with Current Analysis Inc., a Sterling, Va., market research and intelligence company. Companies will want to know, for example, whether a potential state customer resolves contract disputes through an administrative process or through the courts, with a jury trial waiting at the end, he said.Davies also predicted that companies will avoid some design and implementation projects as too risky."The projects that run into trouble are usually the ones where you're developing a system from the ground up to fit custom requirements," he said, noting that Mississippi's automated tax system was this type of project."Systems integrators go into this business knowing that complex projects involve risk and possible failure, and that's why they have liability insurance," he said.The jury's $474.5 million judgment against AMS was the largest in the recollection of industry and government officials interviewed for this article.Other high-dollar disputes between state governments and IT contractors in the last decade have included Electronic Data Systems Corp., Plano, Texas, and the state of Florida; and Lockheed Martin Corp., Bethesda, Md., and the state of California. As these cases show, the state doesn't always come out on top. The Orlando Sentinel reported that in 1989, Florida's Department of Health and Rehabilitative Services purchased an automated welfare system from EDS with an initial value of $179 million. After it was installed two years later, the system repeatedly broke down, causing long lines at welfare offices and overpayments. By that time, the cost of the system had climbed to $240 million. In 1992, EDS sued the state when it stopped payment on the system. Florida's attorney general filed a countersuit seeking $60 million in damages and attempting to ban the company from future business in the state. Florida lost its case in 1995 when a circuit court judge, following an arbiter's ruling, dismissed it and ordered the state to pay EDS $50 million. Although the arbiter found that EDS failed to disclose critical information about the system's ability to perform its mission, he said it worked adequately when the state took it over. The Sacramento Bee reported that in 1992 Lockheed Martin was starting work on an automated child welfare system for the California Department of Social Services. The five-year contract was initially valued at $99 million but skyrocketed to $304 million. After years of legal wrangling, a judge presiding over a non-jury trial ruled in favor of Lockheed Martin and ordered the state pay the company $58 million. In his ruling, the judge said the state officials did not perform the preliminary work they agreed to do as part of the contract, and the state failed to ensure the cooperation of the counties involved in the project. Government officials understand that even competent vendors can run into trouble."These are big, substantial companies with long track records of success," said Steve Kolodney, chief information officer in the state of Washington. "Just because they had a problem in one state, it would be wrong to assume they would have problems elsewhere."Rich Varn, Iowa's CIO, said his state will look cautiously at any company that has had problems in another state, but added, "You can't find any company that hasn't had a big failure." ? Steve LeSueur and William Welsh