A great deal of attention is often given to provisions of an outsourcing contract that, while important, may well never be used – and certainly not if all goes according to plan. By way of contrast, far
too little attention is often given to provisions that will definitely be needed, such as those dealing with re-tendering and exit, whether on termination or expiry. Anyone who has negotiated a second or third generation outsourcing, or brought these services back in-house, will appreciate that the process is not always straightforward and can prove very expensive for a customer which has not negotiated sufficient provisions in the original outsourcing agreement.
This article covers different aspects of exit that should be dealt with in an outsourcing agreement to ensure that the customer’s position is as strong as possible and that the process runs smoothly. It also suggests some approaches that can be taken if, when a customer is approaching termination or expiry, it turns out that the contract is not as strong as would have been hoped. The key topics that will be covered are:
• what the customer needs on expiry or termination
• what the contract should cover
• ways to reduce risks associated with exit.
What the Customer Needs
The starting point when drafting exit provisions is to consider what the customer needs on exit. The key requirements that need to be considered in a typical outsourcing are set out below.
Assets
Assets used in an outsourcing project will be split into various categories. For example, there will be real property which could include dedicated data centres, switch rooms and network management centres. There will also be tangible assets, such as the kit used by an in-house department, route and other communications equipment. The customer will need to decide at the outset of the deal whether existing and future assets will be owned by the supplier or the customer (with the supplier having a right of use) – this decision will affect the strength of its position on exit. Important factors to consider when determining who should own a particular asset are whether or not the asset is a commodity and the type of services being provided by the supplier.
It is important for the customer to know precisely what assets are being used by the supplier on a regular basis throughout the term so as to enable it to assess what it needs following exit and to be in a position to give information to a prospective new supplier.
There may of course be discussion over whether or not assets should be transferable to the new supplier or back to the customer on exit – this may be determined by whether or not the assets are used exclusively. If assets are used for more than one customer, the supplier may be able to give the customer access or use of the assets for a particular period of time. If the assets are being transferred, a key issue will be the price payable for the assets – for example, net book value or fair market value. If the supplier proposes net book value, the customer may want the contract to specify how the supplier depreciates its assets (eg does it conform with UK GAAP or US GAAP).
Contracts
The supplier may well be using a variety of contracts to enable it to deliver the services – software licences will be among those. These may be contracts to which the customer was a party prior to the contract or contracts that the supplier enters into itself.
An initial decision will need to be made as to whether the customer’s contracts will be transferred to the supplier. If they are transferred, the customer will need to ensure that the contracts can be transferred back on exit, if it may require them. This can often be addressed with third parties at the time of the outsourcing. The supplier may of course enter into its own contracts, in which case the customer may again want the right to have these contracts transferred to it on exit. Whether or not a customer needs a contract on exit will in part depend upon whether it is a ‘commodity contract’. If transfer is important to the customer, the customer may want to require the supplier to negotiate the ability to transfer the contract as a condition of being an approved subcontractor. A more detailed position may need to be agreed if services are being provided under the contract to the supplier which are not used exclusively for the customer.
Finally, to enable the customer to scope what it will need following exit, the customer will need to know what contracts are being used by the supplier throughout the term (which is separate from any commercial requirement for subcontractors to be approved).
Employees and Contractors
The contract will include detailed provisions dealing with employees, including provisions relating to the employees that transfer to the supplier at the start of the relationship. The customer will need detailed information relating to employees to determine which employees are key following exit and to ensure that it has access to the right people. With employees comes knowledge, so it is often essential for the customer to have the right to require employees to transfer to the customer or new supplier on exit – this is an area where employment regulations (the Transfer of Undertakings (Protection of Employment) Regulations 2006) will determine which employees will transfer.
A detailed analysis of TUPE and employment provisions is outside the scope of this article, but a general point to note is that the recent changes to TUPE in 2006 makes the circumstances in which there will be a transfer of an undertaking (and therefore employees) even clearer. However, this still depends upon the specific type of services that are being provided – for example, in relation to call centre services, an important factor will be the degree to which employees are leveraged ie whether they work from a dedicated call centre or themselves provide services to a number of customers.
If there is a risk that key individuals may not be covered by TUPE, then a customer may want the ability to approach them in any event to give them the opportunity to transfer. This may apply, for example, where certain services are provided by specialists who are temporarily assigned to a project or temporarily take responsibility for certain contractors. A customer will also want to control the degree to which employees can be swapped in and out of provision of the services during a specified period prior to the end of provision of the services (to avoid the supplier ‘cherry picking’ the employees it wishes to keep and transferring those it does not).
Intellectual Property
The outsourcing contract should deal with who owns each element of intellectual property produced in the course of provision of the services. However, while a customer may be content for the supplier to retain ownership of certain intellectual property, (eg relating to its methods of doing business), it may need a licence for itself or the new supplier to enable transition to run smoothly. Indeed, this may extend beyond intellectual property produced during the project to other proprietary tools used by the supplier to provide the services. These may also be sufficiently important for the customer to require them to be placed in escrow at the start of the relationship.
Data
The provisions dealing with data are also of the utmost importance to the customer. One of the reasons why data is so important is that there is no alternative to data being provided by the supplier. The customer should have access to data at appropriate points during the term and particularly on exit. The customer may be able to reduce its risk relating to data by ensuring that it has access during the term to make regular copies.
Land
It may be in the customer’s interest to be able to take over the supplier’s premises to achieve a smooth hand over. An example where this may be appropriate is where dedicated data centres are used by the supplier.
Information and General Assistance
In addition to the detailed requirements above, a customer will need the general right to require the supplier to provide assistance to ensure that the transition is smooth.
The customer will also need a range of information. For example, it may be absolutely essential that the customer understands precisely the technology infrastructure used by the supplier and that the supplier retains a detailed inventory throughout the term. Indeed, the customer may also need a period during which the employees of the new supplier or its own employees are able to work with the supplier to pick up the necessary day-to-day know-how.
There is likely to be a detailed due diligence period during which the customer or new supplier will be able to ask for information, which must then be provided by the supplier. This process can be very time consuming, so the contract will need to deal with who pays for this information or assistance.
How the Contract Should Deal with Exit
Once you have ensured that the customer has sufficient rights on exit, you need to ensure that it can exercise rights at the correct time and that the necessary mechanics are included.
Re-tendering
When drafting exit provisions, it is easy to forget that there are a number of different scenarios, which mean that a customer may require slightly different rights (or indeed the same rights to be exercised at a slightly different time). For example, when a customer is re-tendering its needs are very different from when services are being brought back in-house.
Re-tendering is a significant issue, since it will determine whether the customer has realistic options when it is approaching termination – it needs to assess these to determine whether there are any realistic alternatives to remaining with the supplier. Indeed, if a customer is transferring the services to a new supplier, it is advisable to have entered into the replacement agreement with another supplier before serving a notice of termination, which will require it to have carried out a re-tendering process. Since it can be difficult to predict when a customer may need to re-tender, a customer should ideally be able to seek information and assistance to enable it to re-tender at all points during the term (rather than only during a specified period before expiry or following service or termination). The process of re-tendering would otherwise become much more difficult for a customer if the contractual exit provisions were not yet in operation.
Given the complications that can arise when re-tendering, it is much better if the customer has a rolling deal than a fixed deal as negotiations do not always go according to plan.
Mechanics on Exit
An obvious point (but one that can often be missed) is that the contractual provisions should set out the mechanics to ensure that the interests set out above are covered. The key mechanics that will need to be considered are:
• the delivery of operational information
• the delivery of data
• the right to acquire assets and contracts which are not owned by the customer
• terms which relate to both automatic and non-automatically transferring employees
• terms to give the customer access to important resources, such as employees and contractors
• transitional services – not everything will be caught by the exit management provisions, so it is essential to include some catch-all wording
• the provision of the services following termination to be provided in accordance with the contractual provisions
• flexibility to transition services in a phased manner.
Ways to Reduce Risks Associated with Exit
When decisions are being made in the original deal, there is a balance between the risks to the customer on exit and achieving the full benefits of an outsourcing. Strengthening the customer’s position on exit comes at a cost. For example, the more control that a customer takes, the less it may benefit from the savings that could be made by the supplier. On the other hand, by retaining contracts, the position on exit can be safer and easier. Another benefit may also be that the supplier is prevented from making a profit by achieving a margin on all its sub-contracts, rather than by making its own business more efficient.
With that in mind, some very general rules to minimise a customer’s risks on termination are as follows.
• Control by the customer of key assets and contracts will put the customer in a stronger position, although there will be a number of other relevant factors to determine what position is appropriate.
• If the customer does not control assets and contracts, it is critical for it to have as much knowledge about them as possible throughout the term of the contract.
• The less commoditised an asset or contract, the more important it is likely to be to ensure that the customer is able to take control on exit.
• Knowledge comes with people, so ensuring that employees transfer is crucial. Therefore, to increase the likelihood that TUPE applies, a bespoke service is likely to be better than a leveraged service (although the costs are likely to be higher).
• Access to data at all times is key.
• Information should be accessible throughout the term using a variety of rights, including audit, inventory and reporting rights.
Of course, as exit approaches a customer will need to review the outsourcing contract to assess its position. It is very possible that the contract will not give all rights that a customer will need, since the contract is likely to reflect a range of compromises. Indeed, there may have been all sorts of changes since the contract was signed, which are not reflected in its terms. It may then be difficult for the customer to negotiate the rights it needs, particular if the supplier has a sense that it is approaching an exit situation.
For that reason, it is important for a customer to assess its risks around exit on a regular basis. If it considers that its risks on exit are too great then it should seek to improve the position as early as possible. It may achieve this through pure re-negotiation. Alternatively, it may chose to do so at a point during the term when it has leverage for other reasons – for example, if it becomes entitled to terminate on change of control of the supplier or breach by the supplier.
Conclusion
Exit is usually well covered at a high level in outsourcing contracts. However, far too often the provisions do not drill down into enough detail or sufficiently set out the mechanics on exit or deal sufficiently with when the customer needs to exercise rights in order to re-tender effectively.
While the detailed exit provisions are often to be set out in an exit plan to be produced by the supplier within a specified period of time, this tends not to be at the top of either party’s list of priorities in the initial period after signing, when the focus is on transition and transformation. However, the customer is at significant risk if is not produced and it is an issue that needs to be pursued following signature. Once the exit plan has been produced, it should also be examined closely by the customer to ensure that it is sufficiently focused on the deal rather than just being the supplier’s standard documents and should be reviewed and updated on a regular basis.
Steve Holmes is a Senior Associate at Baker & McKenzie LLP: Steve.Holmes@BAKERNET.com
