For those of us who’ve been doing outsourcing for some time (and well before it became trendy in the UK and US markets, never mind the Middle East and Africa), it is cause for mild satisfaction that we’ve gone mainstream. But it’s getting crowded out there. As with any other legal service, a firm needs to be able to distinguish itself from its competitors in delivering that service. In the early years, this was relatively straightforward. Most people hadn’t seen an outsourcing contract much less negotiated a decent one. The ‘front end’ terms and conditions, crafted on behalf of clients, were the ‘value added’ — not anymore. Lawyers, being slaves to precedent and probably the greatest proponents of the fair use defence when it comes to ‘endorsing’ each other’s work product, have ensured that front end terms and conditions for outsourcing are now, effectively, standardised in the market place.
Shifting Up a Gear
So, this standardisation must have resulted in the improvement in the overall quality of the deals being done, right? Wrong. Just as many ‘bad’ deals continue to be done in the marketplace, even though we are, no doubt, certain that they all have beautifully crafted terms and conditions, which the lawyers can stand back and justly be proud of as ultimately protecting their clients’ interests.
The lawyer’s traditional approach of never straying far from the ‘security blanket’ of the terms and conditions is simply not good enough in the context of major, complex outsourcing transactions where each party’s responsibilities can become so intertwined that major litigation is a rare event. Corporate clients are now spending billions on outsourcing, which has become key to their strategic focus. They are setting up dedicated sourcing functions to manage their multi-sourcing initiatives. They expect these ‘über-procurement’ functions to deliver. In turn, as the market for acquiring outsourcing services becomes more sophisticated, clients are demanding more from their external outsourcing advisers.
An outsourcing deal is, essentially, a commercial transaction that creates the basis for a relationship, which in turn requires a framework for governance (or read ‘partnership’) that may last anywhere between three and ten years. Ultimately, as lawyers, we take responsibility for the overall construct of that relationship in contractual form. It is, therefore, incumbent on us to take a greater interest in ensuring that construct is actually workable in practice.
But, what gets lawyers to a level of comfort on the day of execution of the agreement is a very different focus to what will drive the relationship between the parties over the next three or more years. This is where most outsourcing transactions go awry. Not in the inability of one party to enforce an indemnity, or rely on a warranty, but poorly constructed commercial foundations and insufficient focus upfront on the on-going governance of that relationship.
Let’s be frank. As terms and conditions in outsourcing become more commoditised, we are rapidly reaching the point where there are acceptable and known ranges of negotiating positions each party can take in any deal. This is not to say that the legal terms and conditions in the outsourcing agreement can now be treated with any less importance, far from it. It is obviously vital that the client has a strong robust contract in place with clearly defined and enforceable terms. However, what we are saying is that an unbalanced focus by the lawyers on the potential impact of an extreme breakdown in the relationship, to the exclusion of effort in defining how the relationship will actually be governed on a day-to-day basis, is not a good thing when it comes to achieving best practice in outsourcing agreements.
Clients experienced in outsourcing will tell you that their primary focus is maintaining effective governance of these relationships in the face of change that occurs over the life of these deals. And, if they had their time again in the negotiation room, this is where they would have exerted greater effort to understand how the parties would manage this effectively. This is where outsourcing lawyers who are experienced in negotiating these deals (and we emphasise the word ‘experienced’) should be ‘adding value’ above and beyond the watertight legal framework they should be expected to construct as a matter of course.
The Only Certainty is Change
As an outsourcing lawyer, the only certain fact that you know when any agreement is signed is that the services will change over the term. As the primary tool for governing the relationship between the parties, the agreement must be able to accommodate and deal with that change.
Changes may occur as a result of multiple causes. The most likely and predictable change is a volume change to the amount of services that the client requires. A certain level of change in this area can be accommodated through various pricing mechanisms, giving predictable pricing within defined bands. So, for example, you could agree a unit price for the provision of support for a standard desktop. The client would then be able to understand and budget for an increase or decrease in its desktop estate driven by business changes. These mechanisms therefore take certain elements of volume change out of the realm of change management. The client has a predictable price without the need to constantly negotiate a minor change to the agreement on an ‘agreement to agree’ basis.
The problem usually occurs with unpredictable change. What happens if the budget is withdrawn for planned infrastructure changes within the client’s IT environment? The supplier’s price (enshrined in the agreement) was based on such infrastructure being in place to support provision of the services. This is clearly a much harder change to predict: you can’t legislate for every change to the environment. Many changes will be driven by sound business decisions made by the client. There are, of course, more sophisticated change management mechanisms that take change management to a better level than just an ‘agreement to agree’ between the parties, which ultimately ends up in a dispute resolution process. Such mechanisms are discussed in greater detail below.
The role of lawyers in an outsourcing transaction should, therefore, be to place more importance on the issue of governance of the on-going relationship of the parties as part of the negotiating agenda. Lawyers have the ideal skills to structure this relationship in a more realistic way and to seek to provide their clients with practical, pragmatic mechanisms to deal with these issues.
There’s a school of thought that says once the outsourcing agreement is signed, it should be ‘put in the bottom draw’ and only taken out if things go badly wrong in the relationship (for example, when litigation is commenced by either party). The theory goes that the parties should be able to forge better ‘commercial’ relationships without the formal contract wording acting as a ‘dead hand’ on the blossoming relationship.
This is an extremely misguided theory for two reasons. If the parties adopt this behaviour, they will rapidly find that they have both moved away from the letter of the agreement to such an extent that when either party is unhappy with the direction of the relationship and wishes to exercise one of its rights in the agreement, the other party is likely to point to the fact that the party seeking to rely on the mechanisms in the contract has not been performing its part of the contractual ‘bargain’. The contract, therefore, becomes irrelevant to the reality of the practice established by both parties in the course of dealing with each other. This is very commonly seen as an issue which arises when either party raises the prospect of re-negotiating an agreement before the end of the term.
The other reason for not adopting this practice is that the client will invariably have fought tooth and nail, expending a large amount of management effort and cost to include key protective mechanisms in the agreement prior to it being signed. These ‘deal breaker’ points are then to be squandered post signature of the contract as they gather dust in the bottom draw.
So, how can the agreement help structure the relationship between the parties after it’s signed?
Dealing With Change
A good outsourcing agreement should be sufficiently flexible to accommodate the changes that will occur throughout the life of the deal and it should provide practical, pragmatic mechanisms to govern the relationship between the parties and the outcomes of changes, which are predictable and a methodology for resolving changes that may not be so easily predicted.
Thus there are many tried and tested mechanisms to deal with volume changes in the services, which do not rely on ‘agreement to agree’. ARC/RRC and PxQ pricing mechanisms, for example, give predictable automatic pricing adjustments for a limited volume change to the services.
There are less well-known mechanisms to deal with changes that, although foreseeable, the outcomes of which may not be so readily predicted. One example is a change to the client’s policies that might alter the costs of the supplier providing the services. Clearly, it will not be beneficial for a client to have the supplier ‘price in’ the potential risk of any such change to the policies throughout the term.
The key in this instance could be for the client to understand how the supplier’s cost drivers have changed as a result of the change in policy. The client, especially in the financial services area, will firstly require the supplier to comply with the new policy. The question is then whether such compliance has had a material effect on the supplier’s costs. The supplier should be obliged to demonstrate (with supporting evidence) that its costs have been materially increased by the new requirement and that it has evidence of having reviewed alternative solutions to accommodate the change without an increase in the price, for example, diverting resource from other tasks or lowering a service level. It should always be the client’s choice whether it wishes to take the lower service/cost option.
Another way of trying to predict the outcome of such changes is to define ‘materiality criteria’ against the outcomes of such changes. Therefore, you may agree that the cost of the supplier complying with a change must be demonstrated to reach a certain threshold before the price is adjusted. This principal can be extended to classify some changes as minor changes and, therefore, ‘business as usual’ changes that must be accommodated within the price and some changes as material changes that might require the price to be adjusted.
In the latter case, the supplier should be able to demonstrate the increase in the level of effort required to deliver the change. This is where transparent pricing can be useful, where the client requires the supplier to report on a regular basis on how many FTEs (full time equivalents) or resources the supplier is using to provide the services. The aim of this mechanism is not for the client to direct resource to be used in a particular way on its account or to crucify the supplier by not allowing it to make a reasonable profit. This would be counter-productive in an outsourcing relationship — where the supplier must be incentivised to drive out inefficiency in the delivery of the services. It is merely to give the client some management information by which it is able to judge a proposed cost increase or decrease from the supplier.
Lawyers advising on outsourcing transactions are uniquely placed to be able to drive better governance mechanisms in such agreements. Increasingly, in-house lawyers are being asked to take a more active part in the retained organisation of the client in the on-going management of these complex outsourcing relationships. Lawyers should see the increasing focus on supplier management and governance in the field of outsourcing as an opportunity to make a real difference to the way in which the agreement is treated after it is signed. It is in neither party’s interests to put it in the bottom draw. An agreement that becomes a practical tool to manage the relationship will lessen the chance of costly disputes during the life of the agreement or the ultimate failure of the relationship and that has to be a good thing.
First published in Legal Business magazine.