This article examines how to use outsourcing contracts to drive performance and reduce the chance of corporate failure.
Long recessions place unusual stresses on all areas of corporate life, as commercial drivers reflect and adapt to changing financial circumstances. Outsourcing arrangements and other ongoing contractual relationships are just one area that sees fresh significance as a result of these changes.
As the economy worsens and litigators spend increasing proportions of their time poring over contracts which go off track, clients may well reflect that appropriate drafting at the outset of any outsourcing - the legal framework for the outsource being imbued with adequate flexibility - may have saved time and money and, ultimately, prevented the relationship ‘going bad’.
This article first considers the effect of recession on the current stock of outsourcing contracts and relationships and suggests ways in which those contracts and relationships can be amended to fit better the needs of today and the immediate future. It then focuses on the contract clauses in standard outsource contracts that have been brought into relief by the recession and the lessons that can be learned by draftsmen so that their future contracting drafting may perform better when faced with significant changes in the commercial environment. Finally, it considers the key aspects of outsourcing in a recession from a litigation perspective, so as to flag up matters that commonly go wrong (by way of a shopping list for the drafters of the future to have in mind).
The Recession - How is it for You?
The fact that this recession is expected to be long term and comes hot on the heels of a significant period of boom time has identified a trend for the contracts entered into during the boom to reflect the fat times.
Over the past three to five years, businesses have systematically procured goods and services with a focus on securing the best available services under agreements that have allowed for growth. The present turbulence in the global economy has pushed many business sectors and associated suppliers of goods and services into uncharted waters. The recent months have seen mergers, acquisitions and insolvencies in almost all sectors. Significant head count losses have already occurred and seem set to continue. The drivers by reference to which goods and services are now required have moved on significantly from when relevant contracts were first put in place.
The impact of this is that many of the affected institutions are operating under contractual arrangements that are no longer relevant to their immediate requirements: the volumes by which pricing structures were set may no longer be appropriate; the service levels and the administrative costs of managing agreements may well be wholly out of kilter with the true needs of the institution; and consolidation and corporate reorganisations may have left certain arrangements entirely redundant.
The circumstances present an opportunity to scrutinise existing arrangements to identify (1) whether they remain appropriate and relevant to present business needs and (2) to identify where costs can be saved and how payment profiles can be adjusted to meet immediate demands to reduce cost.
The following three-step plan is a suggested logical basis to review and, where appropriate, rebase existing outsourcing arrangements:
Part one - a contractual review
The starting point should be an expedited review of existing contractual arrangements to identify areas of oversupply, contract overlap and, most importantly, costs saving opportunities within the existing contractual arrangements.
- Particular focus should be paid to:
- Pricing mechanisms and index-based price review clauses.
- Volume-based adjustment provisions.
- Benchmarking and service adjustment clauses.
- Technological advance clauses.
- Savings clauses.
- Contract review and change control provisions.
- Service levels - to identify whether all contracted service levels are needed and whether the levels set can be adjusted down in return for a price reduction while still securing performance at an appropriate level.
- Management reporting - to identify if the weight of management information can be reduced to focus on the data actually required for management purposes in return for a price reduction.
Part two - an operational review
Working with your commercial leads for the contractual arrangements identified in part one, you need to work through the business demands as they relate to those arrangements. This process should address:
- How the procurement of services and groups can be optimised in terms of consolidating arrangements.
- Whether consolidation can unlock volume discounts.
- Whether payment profiles can be adjusted to achieve price discounts.
- Whether terms and scope can be extended to reduce price.
Part three - putting the contractual and operational reviews to work
The actions to be taken in part three are likely to include:
- The operation of existing contract provisions or highlighting to the supplier dormant contract provisions which need to be activated.
- The renegotiation of contracts.
- The termination and consolidation of contracts.
‘Recession-proofing’ Future Outsourcing Contracts
Flexibility and balance are key characteristics that promote the chances of an outsourcing agreement lasting the course. Many of the contracts in play at the moment have been restrictively drafted, often reflecting the inexperience of draftsmen and over-enthusiastic exploitation of an imbalance of bargaining power. Those contracts are now showing strain as they fail to allow the contractual relationship to adapt to the unforeseen degree of change necessitated by the impact of recession.
To learn from the effects of this recession, dealmakers and draftsmen should be seeking to build as much flexibility into new outsource agreements as possible. The contract clauses in focus are largely those set out in part one of the review process recommended above.
Pricing clauses and volume based adjustment provisions
Cost and price are invariably the villains of the piece when it comes to failure in outsource agreements. The common gripes in this recession are principally from customers complaining that they feel they are not getting value for money compared with the offers being made by competitor suppliers and/or that they are not receiving the savings they were promised at the outset.
Recessionary markets always give rise to keen pricing and aggressive sales activity and the siren call of competitors with significant undercutting pricing proposals. In the circumstances, it is extremely easy to forget that the pricing in the agreement in question may be reflective of the fact that the agreement may be in its fourth year of five and that during the boom times the pricing was keenly in the customer’s favour. A sense of balance, a realisation of the historic relationship and fairness of approach should be maintained.
The pricing provisions should be reviewed to determine what provision, if any, has been made for market fluctuations. Commonly there may be index-based price review provisions. These should be checked to see if the relevant index has dropped and whether the customer might be entitled to a deduction in charges. Equally it is sometimes that case that contracts contain variations on a ‘best pricing’ or ‘most favoured nations’ clause. These generally offer a customer some undertaking that the supplier will offer its keenest pricing in the market to that customer. If such a clause exists then it makes sense to check its effect now.
Volume-based adjustments clauses are valuable to allow flex in the face of market changes. Generally the contracts with such clauses in drafted to date allow for a relatively small band of fluctuation. Nevertheless, these clauses should be considered in detail now. They usually offer a prescribed method for adjusting price in accordance with movement in volumes against a baseline. Often there is a band up and down where there is no price adjustment but beyond that band the provision will generally reflect a stepped increase in price in the event of additional volume being added to the contract and a stepped decrease in the event of reduction. Sometimes the stepped increase is designed to encourage more volume to be added by showing keener pricing to reflect the increased scope of work being made available to the supplier. In the present circumstances, the availability of an increased volume incentive is clearly of interest if consolidation of agreements is possible to allow the customer to tip in extra volume thereby depressing the overall cost. Equally, the opportunity to reduce volume and benefit from reduced pricing will also be of interest if headcount or overall demand for the services in question has dropped.
In future drafting, draftsmen should devise pricing methodologies that are realistic but which can also adjust within prescribed parameters to market fluctuation. While ‘most favoured nations’ clauses at their most aggressive are unfair to the supplier, an adjusted clause where the obligation is not to offer keenest pricing but to track the median pricing offered may be valuable and not be a complete non-starter with the supplier.
Volume-based adjustment clauses are often just what the doctor ordered, where appropriate to the services in question. Such clauses are often the obvious way to build controlled flexibility in the face of market change. When considering the present state of such clauses, parties should consider extending the up and down boundaries so that, where presently such clauses can generally accommodate swings of plus or minus 20%, the pre-planned fluctuation should be pushed out further.
Benchmarking clauses are the hot topic at the moment. Following on from the comments made above on pricing and most favoured nations clauses, it is no surprise that customers are looking to take advantage of the ability to benchmark pricing where the expectation is that market forces have driven down prices offered by suppliers.
Clearly the benchmarking clauses in question need to be considered with great care and, in particular, the provisions for what happens in the event of a poor benchmark report need to be closely scrutinised. An analysis should then be carried out to determine on a rough basis the cost and disruption that a benchmark might cause against the likely outcome of the benchmark in terms of pricing. A benchmark service provider should be willing to provide non-binding and usually free guidance at this scoping stage to assist such an analysis to be carried out.
The value of a benchmark - beyond just the blunt and obvious price reduction potential - is in an assurance to the customer that the price being paid is fair and reasonable, both in the context of the contract as well as the competition in the marketplace.
Often, the mere threat of invoking benchmarking clauses can achieve an offer of significant pricing discounts. Sometimes these discounts are offered in return for the customer undertaking to waive rights to benchmark for agreed periods of time.
In short, when appropriately drafted, benchmarking clauses can add flexibility and a comfort blanket for the customer. Suppliers are generally averse to the inclusion of benchmarking clauses as history dictates that they never operate in the supplier’s favour. However, the newer style of drafting of benchmarking clauses appears to be more acceptable - generally because they address some of the suppliers’ concerns. For example, the newer form of such clauses often provides that the benchmarking is a tripartite arrangement including the supplier. This gives the supplier a seat at the table and creates a nexus and a duty of care between the benchmarker and the supplier. The newer form of clause also generally includes detailed process provisions to involve the supplier in scoping the instruction to the benchmarker and providing the right for the supplier to receive the benchmark report in draft and make representations before the report is finalised.
Benchmark clauses are also becoming more realistic in how a poor report is to be responded to. They now often allow the supplier a sensible period of time to seek to adjust pricing and performance to adhere to the median identified by the benchmark, followed by a termination right for the customer if the supplier does not, or is not able to, make such adjustment within the prescribed time limit.
Technological advance clauses and savings clauses
Technological advance clauses are intended to provide the customer with confidence that the contract will keep pace with advances in technology and that price benefits are passed through. Often these clauses are considered to have little enforceable value but that is simply a matter of how the clause is drafted.
In the circumstances of recession, these clauses are being considered in the general review of contractual arrangements and customers are taking them into account in their discussions with suppliers. Often on inspection the clauses are found to be enforceable but have not been operated. With the exponential improvement in technology, the passing of only a few years can throw up a significant opportunity in terms of performance and price.
Savings clauses are often problematic, especially when found in combination with benchmarking clauses and volume adjustment provisions. With the other clauses operative, there is little room left for the supplier to find additional room for savings. The customer should also be keeping a wary eye on their suppliers’ margins. If the aggregated effect of benchmarking, most favoured nations, volume adjustment, technological advance and savings clauses cut too deeply into the suppliers’ margins, then it should be a matter of concern for the customer as well as the supplier. If a deal looks too good to be true, as the maxim goes, it often is - a suppliers’ natural reaction to their margins being cut too deeply will be to look to reduce service to redress the balance. Inevitably, reduced margin will be unpopular with suppliers and where the agreed pricing was originally appropriate (with the supplier making a reasonable margin in line with the relevant industry sector) cutting into that margin can seriously threaten relationships and ultimately threaten the outsource.
Accordingly, we advocate the inclusion of technological advance clauses. Care must be given to ensuring that they are enforceable and that their application is reasonable. What works is ensuring that the net benefit of technological advance is shared between supplier and customer and making the adherence to the technological advance provision specifically part of the benchmarking clause to ensure compliance can be policed. Savings clauses and service improvement plans may be useful but customers should be realistic and fair and should always have a weather eye on the overall effect of such clauses alongside the other similar provisions in their agreements.
Change control provisions
If the overall theme of this section of the article is that draftsmen need to inject flexibility into their outsourcing agreements, then it will come as no surprise that change control is a key subject. That said, it is and should be a simple but controlled process.
All contracts need a process to allow change to the provisions of the contract and to the scope; clauses which cater for this should be as simple and transparent as possible. The danger of labyrinthine change control clauses of extraordinary complexity - quite aside from being difficult for lawyers to fathom - is that they are simply not used by the respective contract managers, as they do not understand them and find them unworkable in practice. Involving contract managers in the drafting of these essential clauses can go some considerable way to ensuring that they are of practical application.
As a general rule of thumb, the change control clause needs to identify a process by which a change can be called for, assessed and approved or denied and, if approved, cater for pricing adjustment and the treatment of consequential effects on the rest of the contract.
Contract management provisions
Contract management provisions have changed in profile from being considered as tree-hugging frippery to an essential tool in keeping the contract on track, on budget, and in step with change - all of which must be music to the ears of any company battling the realities of a deep recession. If there is one clear message coming from the effect of the recession on outsource arrangements, it is that the parties need to talk openly to inform each other of the stresses that the market change is bringing on each party and specifically on the outsource agreement.
Where contract management works well, most of the contractual cudgels can remain in their box and the fluctuations in the market can be identified in advance and addressed in a consensual manner. If this happens, the relationship is more capable of avoiding crisis.
There is not room in this already long article to discuss the specifics of contract management clauses and in reality each contract management clause should be made bespoke to the relationship it is seeking to govern. In this respect, as with change control provisions, this is an area of drafting that works best when contract managers themselves are involved in the drafting process with a right of veto over the lawyers.
Suffice it to say, practical contract management clauses form an essential part of an outsource agreement. This leads, inevitably, to a brief discussion of where the contract management provisions do not do the trick and more formal dispute resolution comes into play.
Where Did it all Go Wrong?
Even before heading into the eye of the recessionary storm, statistics relating to the performance of outsourcing deals have traditionally not made happy reading - a sizeable number fail in the short term, with reasons given centring on a failure to understand at the outset what was required, poor service (or at least performance not meeting what was expected) and - predictably - cost.
It is these broad areas, which arguably generate the greatest number of ‘outsourcing disputes’, ‘hot spots’ (in litigation terms) serve to flag up matters that commonly go wrong and which the drafters of the future should note. The discussions above in relation to recession-proofing outsourcing contracts should help to inform such drafting.
Dispute resolution clauses - one size does not fit all
Dispute resolution clauses themselves should be flexible and designed to ensure that everything can be done to keep the parties on track and talking commercially to each other as long as they want to be. Avoiding the ‘go nuclear early’ option and keeping the litigators out, for at least a prescribed period of time, can give CEOs the opportunity to have productive business-to-business discussions. All of these options can be built into a good dispute resolution clause.
Consideration should be given to prescribing alternatives to court litigation - arbitration, if circumstances are right (for example, if confidentiality is an issue, one or more of the parties to the outsourcing is located outside England and Wales, or parties want to limit rights of appeal). Equally, expert determination can often provide parties with a route to a speedy and effective resolution to a particular business-critical issue, which may otherwise prove a roadblock to performance of the outsourcing contract more generally. Often, the parties simply want someone who is an expert in their business area to make a (binding or non-binding) judgement call on what is or is not correct, without the need for more formal (and expensive) recourse to the courts.
The inclusion of mediation in a dispute resolution clause should always be given proper consideration, as it sits alongside other routes to resolution (i.e. does not preclude litigation or arbitration, etc) but can also represent an early, relatively quick and cost effective means of getting the parties together for facilitated negotiations - through which the solutions available can often be more imaginative business solutions rather than simply the payment of cash sums.
What is commonly called a ‘step clause’ can provide for a number of these alternatives. It is important to ensure that timeframes for these alternative means of dispute resolution are included, so that in the event a particular avenue does not prompt a deal, the parties can easily move on to more formal court proceedings/ arbitration. The dispute resolution clause requires both careful thought and tailoring to a particular set of circumstances, if it is to work for you at the relevant time. One size definitely does not fit all, and time spent at the outset in getting the drafting right can give you many more useful options further down the line.
Outsourcing offers both benefits and risk - dive in blind and be prepared to take a bath. Prepare, identify your goals, arm yourself with legal advisers experienced in both what works and what can go wrong, ensure there is flexibility in the contractual provisions and focus on sound contract management from the beginning of the relationship, right up to and including the resolution of any disputes. The company that does all this - and achieves the right balance between benefit and risk - can reap significant reward.
This article was published on 14 July 2009 on gtnews.com, the treasury and finance network.