What are the most common contract forms for outsourcing arrangements, and what are the advantages and disadvantages of each?
The most common form of outsourcing agreement is a master service agreement (MSA). An MSA typically sets out a framework for the main terms, such as payment terms, IP ownership and service levels, and establishes a base of understanding upon which parties can quickly negotiate the future provision of services (generally via a statement of work). MSAs can be tailored to the specific needs of the industry and the outsourcing party and can also provide for flexibility to change the services provided as business needs evolve. Because an MSA is a key document governing the relationship between the customer and supplier, the process of negotiation can be very time-consuming.
As more service providers offer their software on a cloud basis, agreements governing software as a service (SaaS) products are becoming more common. The same concerns generally apply to SaaS agreements as traditional hosted products. While troubleshooting and updates are easier to facilitate with SaaS solutions, there are also inherent security risks with outsourcing physical control of data, and business continuity risks where the reliability and availability of key services are out of the control of the outsourcing party.
Before entering into an outsourcing contract, what due diligence is advised?
Robust due diligence should be conducted on the service provider and on the company outsourcing services. Below is a non-exhaustive list of some key areas for diligence:
- capacity and experience of the service provider and any known material subcontractor;
- data protection and security practices and certifications;
- service levels guarantees;
- price and charging method;
- flexibility regarding volume and type of service; and
- disaster recovery and business continuity plans.
Duration and renewal
What is the common duration of outsourcing contracts? How does the renewal process commonly play out?
In Canada, there are no statutory restrictions on the duration of an outsourcing agreement. Parties are free to negotiate whatever term seems appropriate to them in light of their specific circumstances. Generally speaking, most agreements have a term of between three and 10 years. Typically, the term that is agreed will take into account the amortisation term of the initial investments as well as the complexity and uniqueness of the arrangement. There is often a provision for automatic annual renewal in the absence of a notice of termination and there is usually a provision for a review and examination of charges prior to any such renewal.
What procedures and criteria are commonly used to select suppliers?
Request for proposalIn a request for proposal (RFP) process, the customer develops a business plan that includes specific objectives, milestones and performance measures relating to the service that is to be outsourced. Depending on the nature of the services and, potentially, internal policies of the customer, the customer may choose to issue RFP variants such as a request for information or a request for quotation. The procurement documents will include a description of the process and the rules that govern it, the contractual terms of the prospective bid, a detailed description of the service requirements and a draft services agreement – basically, all of the information that a service provider would need to make a bid and the customer may need to assess such bid.
In the procurement process, two contracts will be created:
- the bidding contract, which establishes the rules that govern the process itself; and
- the substantive contract between the customer and the winning bidder or bidders.
Outsourcing processes initiated by governments are also informed by trade agreements and guidelines that apply to procurement by governments and quasi-governmental entities.
Invitation to tenderAn invitation to tender is sometimes issued in addition to or in place of an RFP.
How are the service specifications agreed and monitored, and what service terms and parameters are commonly applied? Can any flexibility be provided for in these terms?
Service specifications, a key element of outsourcing agreements, can vary from sector to sector and may also be affected by applicable regulations, the confidentiality of the services in question to the customer and the degree to which they have been customised for the customer. Service specifications may also be used to assess if services have been satisfactorily performed.
The way in which service levels are described and monitored often depends on how objectively they can be measured. Service levels such as timing requirements (eg, time limits to respond to or resolve issues) are typically set out in detail in the agreement. More general service warranties are included for services that are less objectively measurable, but realistically these can sometimes be difficult to enforce. It is generally the practice in Canada to build flexibility into service level requirements.
Other things to consider with respect to service levels include:
- that, in longer-term outsourcings, customers will usually require their suppliers to improve service levels over time, on the assumption that it is reasonable to expect suppliers to actively improve their methods and technologies; and
- that it is common to agree to establish governance committees to assess supplier performance on a periodic basis.
What charging methods are commonly used?
Charging methods will vary with the nature of the services being provided, the exclusivity of the relationship and the manner in which risk has been allocated among the parties. In Canada, as elsewhere, there are a number of standard charging methods, including ‘fixed price’, ‘cost plus’, ‘resource-based charges’ and ‘time and materials’. It is not uncommon for an agreement to use more than one (or even all) of these methods to price distinct elements of the transaction.
‘Fixed price’ means just that – the customer pays a predetermined price. This has the advantage of cost certainty for the customer and revenue certainty for the supplier. It is applicable primarily in outsourcings where the volume of the services provided is predictable and non-volatile.
A ‘cost plus’ method requires the customer to pay the supplier its actual cost of providing the services plus an agreed profit margin. Provisions are generally included to ensure transparency in the assessment and reporting of costs. Indirect costs, such as overhead, are included (typically on an amortised basis) in the actual costs.
Resource-based charges’ require the customer to commit to a fixed recurring charge that is calculated on the basis of a projected service volume. To determine the actual charge, the fixed amount is adjusted according to the actual volume of the relevant resource that was actually used in the most recent period.
Time and materials
The customer pays an agreed-upon unit price for specific items of service (eg, volumes of data processed, the hourly rates of applicable resources or deliveries made). The supplier may want to stipulate a minimum fee. This arrangement is often used in situations where the level and volume of services are not predictable.
Complex long-term outsourcings may include mechanisms to ensure that the price paid remains competitive throughout the existence of the agreement. Examples include index-linked increases that adjust for general increases in business costs (eg, use of a consumer price index), benchmarking the supplier’s charges against those of specified competitors (this is a time-consuming process that requires parties to agree typically in advance the parameters for such comparisons) and agreements about sharing cost savings from the outsourcing. In addition, the customer will often request a ‘disputed fee’ mechanism that suspends any obligation on its part to pay a disputed charge while the dispute is being worked out.
Warranties and indemnities
What warranties and indemnities are commonly stipulated in outsourcing contracts (for both the customer and the supplier)? Are there any mandatory or prohibited provisions in this regard?
WarrantiesThe warranties in a particular outsourcing agreement can depend on the type of transaction, type of services and, realistically, on the relative negotiating positions of the parties. Warranties that are found in most, if not all, Canadian agreements include:
- that the service provider has the capacity to enter into the contract and to perform its obligations;
- that the service provider will fulfil its obligations with reasonable skill and care, in accordance with good industry practice, in a timely and professional manner and in accordance with all applicable laws and regulations;
- that the material information that the service provider provided in the pre-tender and tender stages was and remains complete and accurate; and
- that the service provider has the required permits, licences, certifications and accreditations and operates in a manner consistent with specified quality assurance protocols that apply in the context of the type of services covered by the agreement.
Service providers may also warrant that the services and deliverables do not infringe or violate the IP rights of third parties and that they possess all of the rights that are required to provide the services. However, service providers can sometimes be reluctant to provide this warranty, in which case the customer may still be protected by the indemnity described below if obtained from the supplier.
Several customary warranties are mirrored by customer and supplier, including that they are authorised to enter the agreement and that they will perform their obligations under the agreement.
Sale of goods legislation implies certain conditions and warranties into outsourcing agreements. See, for example, Sections 13 and 15 of Ontario’s Sale of Goods Act (RSO 1990, c S.1) (and equivalents in other Canadian provinces), which may imply conditions or warranties relating to the seller’s right to sell the goods and to their quality and fitness. Corresponding provisions relating to services generally apply only if the recipients of these services are consumers (ie, individuals acting for personal reasons). Warranties and conditions implied by law can be expressly excluded by contract.
Those involved in outsourcing in Canada should also consider the impact of Canada’s treaty obligations. The UN Convention on Contracts for the International Sale of Goods (CISG), for example, pre-empts provincial legislation (other than in Quebec) and may affect certain sales of goods transactions. As a consequence, parties must specifically exclude the applicability of the CISG should they wish:
- the law of a Canadian province to be the governing law of an international sales contract; or
- the specific terms of their agreement to take precedence and govern the transaction involving the sale of goods.
Canadian outsourcing agreements typically contain mutual indemnities with respect to property damage, bodily harm and other losses arising from wilful misconduct or gross negligence, caused by either party. They also typically include certain specific supplier indemnities, under which the customer is indemnified with respect to losses resulting from third-party IP infringement claims, employment-related claims by the supplier’s employees and breaches of applicable law or of confidentiality, privacy or security obligations by the supplier.
Ending the agreement
What are acceptable grounds for terminating an outsourcing contract?
In common law jurisdictions, general common law contractual principles such as frustration and mistake may be invoked to terminate or render void a contractual relationship. However, the grounds for the termination of a contract are primarily a matter for negotiation between the parties. Termination rights as negotiated will typically allow either side to terminate in the following situations and under the conditions noted:
- material breach of the contract (on notice to the other party, if the breach is not remedied within the pre-determined cure period or immediately for certain breaches that are deemed egregious and are not capable of being cured, eg, breach of confidentiality obligations);
- consistent breaches of the contract, even if they are individually minor or not material (the type of breach and number of breaches must be defined in the contract);
- insolvency (as defined in the contract; there is no statutory termination right under Canadian insolvency legislation);
- change of control of the supplier; and
- for convenience, on prior notice.
It is important that these termination rights be described clearly in such a way as to avoid potential disputes on the availability or applicability of such termination rights.
How do contracts commonly address exit from the outsourcing contract?
Once an exit is contemplated, contractual provisions providing for termination or post-termination services will generally apply. Such provisions will generally address issues such as IP rights, confidential information and transition support.
Is there a common or mandatory notice period for non-renewal of a contract?
The parties will generally negotiate and agree on notice periods, which are not mandated by Canadian federal or provincial law. Negotiated notice periods tend to be situation-dependent; in cases of egregious breaches (at least where it is possible to do so from a practical perspective), termination without notice is often provided for.
In general, a customer will require an extended notice period in order to repatriate the services or to transition them to another service provider. In such cases, to ensure a smooth transition, the contract would typically contain transition assistance obligations of the supplier that continue either after the notice of termination has been provided or after the termination of the agreement.
What can customers do to make their outsourcing contract more successful?
To improve outcomes for outsourcing contracts, customers can take a number of steps, including:
- performing internal diligence – this allows the customer to understand its capacity and needs, helping it set clear parameters and specifications for the outsourcing project;
- understanding the business case for the outsourcing – this allows customers to better direct the process and focus on the value drivers of the outsourcing decision in the first place;
- plan internal resource use accordingly – successful outsourcing agreements require the customer to make significant resource commitments internally to monitor and ensure the outsourcing agreement is effectively performing its function; and
- clear governance structure – outsourcing agreements are more likely to succeed if the key personnel within the customer’s organisation have a clear understanding of the reporting structure so that decisions can be made quickly.