For lawyers outsourcing presents a hybrid transaction, usually involving a transfer of assets, both on commencement and on termination, combined with an agreement for the supply of services. Performance management of those services is typically a critical issue for both supplier and customer. In addition to rapid growth over this period, understanding of the benefits and nature of outsourcing has developed to accommodate a variety of influences; this is reflected in a continuing evolution of the form and content of outsourcing agreements.
Then and Now
Table 1 illustrates typical provisions or approaches that might have been present in an outsourcing contract in the mid-nineties compared with those that one might find in the same contract today.
|
Then |
Now |
|
Qualitative outputs |
Service level agreements |
|
Post contract benchline B |
Pre-contract due diligence |
|
Stable state with price escalation |
Continuous improvement with price reductions |
|
Stable infrastructure |
Technology refreshment |
|
Disputes litigated |
Alternative dispute resolution |
Table 1
Knowledge through Experience
A number of the illustrated changes reflect knowledge acquired through experience – ‘learning by doing’. The passage of time means that many first generation contracts have ended, and the learning gained in the first generation exercise can be incorporated within the second generation contract.
‘Agreements to agree’
For example, in the nineties it was not unusual to find that there was no existing regime with quantified service levels. The decision to outsource might be driven by a desire to save cost but also by a desire to access the perceived expertise of suppliers, and to gain the disciplines that come with the outsourcing process.
Establishing a quantified service level regime was part of the desired process. This was often done by allowing the supplier to assess and quantify the existing service levels in the period immediately following contract signature, accompanied by an ‘agreement to agree’ the service level regime that would be contractually binding. Such a regime might take effect six months or a year after contract signature, and carried obvious risks for both parties but principally for the customer.
This frequently encountered practice in part reflected naivety on the part of customers, but also the fact that customers did not have established output-based systems governing the basis upon which the relevant services were supplied by IT departments to their internal customers. A regime of this kind can be established prior to entering an outsourcing arrangement but this step was often sacrificed in the rush to outsource. This is far less prevalent today.
‘Exit management’
As first generation contracts have ended many customers have acquired first hand experience of exit management. Exit management was often given scant attention in first generation contracts. Again it is typically the customer for whom the learning process has been most painful. The customer might find that the contract does not give it protection in transition in a number of ways. It might find that the pool of people used by a supplier to provide the service is ‘managed’ by the supplier so that some of the best people are diverted elsewhere and do not transfer back to the customer or to a new supplier. It might find that there are no obligations on the supplier to provide the information which is needed by competing suppliers in a re-tendering situation in order to assess the costs associated with the labour pool.
In a similar vein, the customer might find that it does not own intellectual property rights vital to the continued provision of the services, whether provided by itself or by a new supplier. Significant unexpected costs might attach to the continued availability of such rights either via the first generation supplier or via a third party, or some combination of the two. Dealing with this adequately is not just a matter of incorporating appropriate transition provisions, but also of being aware of these risks in dealing with the ownership of IPRs created during the life of the contract, and providing appropriately for these. It also means that, at the lowest, customers seek to gain visibility of any dependencies, such as dependence on third-party software, that exist in the provision of services by the supplier and, at the highest, that customers seek to control this process by requiring that their consent be given before any third-party dependency is created.
|
Business Model |
Legal Mode |
Anticipated change |
|
Commodity |
Terms and conditions |
Low |
|
Developmental – build and run |
Add specifications and acceptance procedures |
Medium |
|
Transformational |
Add consultancy |
High |
Table 2
Rates of change and the Requirement for Flexibility
Dynamic environments
A second major area of influence is an increasing realisation of the extent and nature of the changes that will be an inevitable part of many outsourcing arrangements. Rather than fixing services for the duration of the contract with change control provisions inserted to deal with occasional changes in services, in many cases continuous change is at the heart of the outsourcing process. Such requirements necessitate very different contracts.
Business models for outsourcing
This in turn reflects the wider ambit of the subject matter of outsourcing, and indeed the frequent use of outsourcing as a vehicle to achieve change in an enterprise. Table 2 illustrates three business models that might drive outsourcing. ‘Commodity’ outsourcing refers to the outsourcing of a basic business process, for example payroll administration, which is mature and stable in nature. ‘Build and run’ refers to the need for the supplier to create new systems or build new applications on behalf of the customer and then to run and manage these as part of the day-to-day arrangements.
Finally, in ‘transformational’ outsourcing the supplier is given the task of managing and controlling a specified range of business processes. The intention might be to give the supplier a high degree of control as to the engineering and design of the processes required to achieve the required outputs, and in this way the customer intends to gain the maximum benefit of creative thinking by expert suppliers as to the reengineering of what are often business critical systems. The objectives might be, for example, much closer alignment of the customers’ products and services with the needs of its own customers, or the achievement of major cost savings by the adoption of new technology.
The degree of change anticipated during the life of these three different arrangements is very different. If, as it should, the relationship is to drive the contract rather than vice-versa, the contracts required by these three different scenarios will be very different. As outsourcing as a business process has matured, the number of projects or activities in the second and third categories has increased rapidly.
This evolution of approach and thinking has influenced the thinking of management and the consultants advising them. A number of the most influential consultants conceptualise the outsourcing process as part of a wider process known as ‘sourcing’ as shown in Diagram 1.
Lawyers will recognise ‘evaluation and selection’ and ‘contract design and negotiation’ as core to the advice they provide on a day-to-day basis. Around this are added, at the front-end, the development of a ‘sourcing strategy’, which might or might not involve outsourcing, and then, following the contract negotiation and signature, the task of ‘sourcing management’. This latter element reflects the realisation that, in outsourcing contracts above all others, the contract cannot be put in a drawer and forgotten. It must provide the mechanism for documenting all the changes required over the life of the contract.
Continuous improvement
In transformational outsourcing, the sourcing management element will often require more than reliance on consensual change control mechanisms. Customers will demand a real commitment to continuous improvements in outputs or prices, or both, over the life of the contract. This is given life in the contract not only by a qualitative commitment by the supplier, but also by a commitment to quantified targets and by a commitment to associated activities such as benchmarking, or by a commitment to open book accounting, with mechanisms such as ‘gain share’ (whereby any savings realised by the supplier are to be shared on an agreed basis).
Partnering
The notion that continual, and possibly continuous, change is at the heart of an outsourcing arrangement often gives rise to the notion of a contract reflecting a partnership between supplier and customer rather than a traditional supply arrangement. In many cases, the warm glow attached to the word ‘partnership’ evaporates just as soon as the parties attempt any serious exploration of what it is they are attempting to capture in such an arrangement – one thing is certain, it is never joint and several liability!
The desire for a partnering approach sometimes gives rise to proposals for the creation of joint venture or special purpose vehicles (SPVs) as a means of achieving the intended philosophy of approach. SPVs are frequently used in public sector PFI schemes, but they are not unknown in the private sector. An example of a relatively complex arrangement is shown in Diagram 2.
In this example physical assets are held in one special purpose vehicle, while an operational company to which the staff are transferred and from which the services are provided, forms another. Charges for use of the assets are made by SPV1 and for the provision of services by SPV2. In the proposal from which this example is taken, the shares in the principal SPV are held 50:50. The services company might be named in such a way that use is made of part of the customer’s main business name, and by this means as well as by the shareholding, at least psychologically, the transferred staff will have a strong sense of continued involvement with and loyalty to the customer. From the service provider’s point of view, the customer retains ‘some skin in the game’, which is intended to encourage a genuine sense of partnership and co-partnering. However if things do go wrong, or if a transfer is involved upon re-tendering of the contract, the process is simplified by the corporate structure, which facilitates share transfers in the various vehicles rather than more complicated asset transfers.
The set-up costs of a relatively complex corporate structuring of this kind are obviously higher – the parties will need to investigate these and any related issues carefully in order to decide whether the higher set-up costs justify the intended benefits.
The Influence of the Public and Regulated Sectors
A third major influence bringing change to outsourcing agreements both commercially and in the way they are documented arises through the specific requirements of the public sector, both central and local government, and through the requirements of regulated sectors such as financial services.
The Public Sector – An enormous amount of effort has been expended by government agencies to develop methodologies for activities, which include outsourcing, principally in the PFI arena. In July 1999 the first edition of the Standardisation of PFI contracts was published with the aim of providing guidance on key issues in PFI in order to achieve commercially balanced contracts, and to assist with the delivery of best value for money. A second edition drawing on experience in and after 1999 was published in [2002]. Specific Standardisation Guidance for the IT sector was published as an annex to the general guidance in March 2000.
In April 2000 the Office of Government Commerce (“OGC”) assumed responsibility for this guidance from the Treasury Taskforce and the Treasury Taskforces projects activity transferred to Partnerships UK plc (“PUK”). PUK was appointed by OGC to lead a review of the Second Edition, and following a consultation exercise with interested parties, a Revision to the Second Edition was published in 2002.
It is beyond the scope of this paper to provide a detailed review of this extensive body of guidance, but its influence has been felt well beyond the confines of the public sector. There is evidence suggesting that the approaches and policies experienced in public sector projects are subject to a process of knowledge transfer, which is carrying elements over into private sector projects.
At a general level there is now much better understanding of how the design and negotiation of contracts operates as a process for risk identification, allocation and transfer. There can be no doubt however that this means a tougher regime for suppliers.
Risk in the technical solution – For example at one time it was common for the parties to develop an output specification that combined within a single document a statement as to what was required by the customer and as to the technical solution to be provided by the supplier. The public sector customer is now advised to insist on a separate statement of its service requirement to which the supplier responds by the provision of a technical solution. The technical solution is not approved as such by the customer. It will be evaluated by the customer in choosing between competing suppliers, but it is the supplier’s principal obligation to provide the services requirements. The aim of this arrangement in the eyes of the customer is that the risk of the technical solution not meeting the customer’s service requirement remains with the supplier.
Risk in the legacy systems – Increasingly suppliers are asked to take the risk in legacy systems. Public authorities are unwilling to provide warranties in respect of existing systems and the supplier must rely on its due diligence to assess them. The risks here can be significant; for example any IT system might contain material latent defects which will not be disclosed by even the most assiduous pre-contract enquiries and investigations.
Limited rights to sue the customer or to terminate the agreement – Another example is provided by the way in which the supplier’s ability to claim for breach and its right to terminate an agreement has been narrowed to a significant degree. In many projects the supplier’s right to raise a claim against the customer is limited (with certain limited exceptions) to a right to sue for non-payment of the charges where there is no bona fide dispute in respect of them. The only right for the supplier to terminate is in respect of such non-payment.
No service: no fee – at the heart of PFI philosophy is the notion that in the event of no service no fee is to be received by the Supplier. In private sector contracts it is quite common for the amount at risk in service credit regimes to be a proportion only of the service charges. There is therefore a fundamental difference of quantum if not of principle between the two sectors.
Compensation, relief and force majeure events – in public sector contracts the definition of force majeure events are now much narrower than has been the case historically, and than is still typically the case in private sector agreements. For example, force majeure might be restricted to war, armed conflict and limited examples of similar catastrophic circumstances.
Two other categories of event are often encountered. First, relief events are those which prevent the supplier from fulfilling its obligations, but which because of their nature give the supplier the right to apply for relief from the right the customer would otherwise have to terminate the Agreement or to claim liquidated damages. Such events (for example, fire, explosion, storms, floods, strikes and lock outs) are those which formerly would have been within the traditional definition of force majeure.
Second, compensation events are those which prevent the supplier from fulfilling its obligations, but which give the supplier the right not only to apply for relief from its obligations but also to apply for compensation from the customer. These will typically include default by the customer in performing its obligations where this default prevents the supplier from meeting its own specified obligations.
Regulated sectors – Similar approaches are increasingly encountered in highly regulated sectors such as financial services and utilities. Banks and utilities companies rely on their respective regulatory licences in order to operate. Regulators have recently taken increased interest in the risks inherent in outsourcing[1]. Banks and utilities therefore bring particular considerations to an outsourcing negotiation. Although they wish to avail themselves of the benefits of outsourcing, they perceive a real need to maintain control of their destiny by means of extensive rights of “non-fault” termination in a wide range of circumstances, and by extensive rights of “step-in” on short notice in circumstances where a regulator might require it or there might be any threat to their licence, or indeed to any of their business critical systems or processes.
International and Offshore Outsourcing
Over the last several years considerable momentum has built up in connection with international and offshore outsourcing. The drivers for such activity are various. The cost savings offered by overseas jurisdictions such as
Risk assessment
Any jurisdiction must be assessed for the political and economic risks associated with trading there.
Choice of law and jurisdiction
Lawyers will be asked to advise on appropriate choice of law and jurisdiction, and dispute resolution clauses. This will lead in turn to an assessment of the financial strength of the contracting parties, and also analysis as to whether a judgement by a court in one jurisdiction would be enforceable in the jurisdiction of the other contracting party. This in turn might lead to consideration of arbitration as a means of dispute resolution even in businesses which do not normally favour it.
Contractual structure and mechanics
The model for an international outsourcing arrangement discussed in an earlier section of this paper demonstrates the potential for complex corporate and contractual structuring. At a simpler level there is a need for clarity and understanding of language. Reference is often made to ‘global’ agreements or to ‘framework’ agreements supported by ‘local’ agreements in relevant jurisdictions. However experience suggests that ‘global’ and ‘framework’ can be used interchangeably and in different senses in different organisations. Similarly commercial managers may not properly understand the distinction between a party acting as ‘principal’ as opposed to as ‘agent’. Such issues require early exploration to avoid misunderstandings and wasted effort and time.
Project management
Local law and local customs must be investigated and understood. For example, the role of works councils in
Acquired rights directive
While it might be thought safe to assume that offshore outsourcing to a jurisdiction outside of the European Union will be outside the ambit of the Acquired Rights Directive, there is a need to understand the nature of the commercial arrangements. It is possible that interim and transition arrangements can render a transaction subject to TUPE, to the consternation and surprise of the respective managements of both customer and supplier.
Conclusion
Against the backdrop of continued evolution of business models for outsourcing, it is clear that the legal approach has moved on to a significant degree over the last decade. In part this reflects learning by doing, less reliance on ‘agreements to agree’ and greater focus on the more difficult risks and issues such as exit management. In part it reflects the very considerable effort expended by government and regulated sectors to better understand and cater for the risks involved and to ensure that the recommended legal regimes reflect this. The knowledge gained has not been confined to the public and regulated sectors alone. At the same time, the nature of the legal risks and commercial issues are changing as the international focus of outsourcing gathers pace. The international element will continue to grow in importance. It is clear that lawyers dealing with this area are on a stimulating journey with no very clear point of arrival.
Bill Jones is a Partner in the Technology Group at Wragge & Co. E-mail: bill_jones@wragge.com. All rights reserved. No part of this paper may be reproduced or transmitted in any form or by any means, electronic or mechanical including photocopying, recording or any information storage or retrieval system, without prior permission in writing from the author. First published March 2003.
[1] See for example Financial Services Authority Consultation Paper 142: “Operational risk systems and controls” July 2002
