What are the most common contract forms for outsourcing arrangements, and what are the advantages and disadvantages of each?
The most common contract form used in outsourcing transactions is a master service agreement (MSA) that governs one or more subsidiary statements of work (SOWs). SOWs are typically organised by categories or groups of related services called ‘service towers’.
The MSA contains terms and conditions of more general applicability, dealing with issues such as intellectual property, termination, indemnification, representations and warranties, as well as limitations of liability. SOWs contain a detailed description of the services and each party’s functions and responsibilities relating to a service tower. Most of the operational and commercial terms and conditions (eg, transition, pricing and service levels) are detailed in exhibits and subsidiary attachments to the MSA (if the terms in the exhibit apply across all SOWs) or an SOW (if the terms in the exhibit apply only to that particular SOW).
This structure provides the customer the ability to add new services under an existing MSA with the service provider without having to renegotiate the general terms for each engagement.
If an alternative legal vehicle is used for the relationship (eg, a joint venture), then other forms of contracting may be used (eg, an operating agreement).
Before entering into an outsourcing contract, what due diligence is advised?
Due diligence should be conducted internally within the customer organisation to ensure that the customer thoroughly understands and can articulate its requirements.
Customer base case
A base case of the current cost of performing services internally should be developed. The base case is used to determine whether outsourcing is the appropriate strategy and serves as a baseline for evaluation of service provider proposals.
Business requirements of the functions being outsourced should be documented in order to create the scope and service levels for the outsourcing engagement.
Human resources issues The impact that outsourcing will have on employees and contractors should be evaluated, including the extent to which the customer will require or allow the service provider to hire the customer’s personnel. A plan for communicating the transition to customer personnel should also be developed.
Third-party products and services being used by the function that will be outsourced should be evaluated to determine whether the service provider will assume the contract or use the products and services under the customer’s agreement. Whether the consent of, or notice to, the third-party vendor is required must be determined.
In addition to the service provider selection process described below, customers should conduct due diligence on their potential service providers, including by:
- soliciting references from other customers;
- reviewing service provider financials and performance history; and
- performing service provider demos and site visits.
Duration and renewal
What is the common duration of outsourcing contracts? How does the renewal process commonly play out?
Given the significant amount of time and effort required to establish a relationship and transition the outsourced services and functions to a new service provider, outsourcing relationships typically have initial terms ranging from three to five years. Customers typically require the unilateral right to renew the contact for one or more renewal period.
What procedures and criteria are commonly used to select suppliers?
Customers will either employ a single bidding or multiple bidding process, issuing a request for proposal to one or several potential service providers respectively. A multiple bidding process affords the customer greater leverage because the process is competitive in nature.
The criteria for selecting a service provider vary depending on the customer’s goals and objectives. However, the most common factors are the proposed solution (ie, scope, technology, quality and resources), pricing, responses to the terms and conditions, as well as customer culture fit. Customers will often use a scorecard to compare the service providers in a multiple bidder process.
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 are typically agreed in the SOW. Where certain details cannot be obtained until after the signing of the contract, the parties may agree to a baselining period during which the service provider will verify the actual services against certain assumptions.
Compliance with the service commitments is monitored through meaningful service levels measuring the services, robust audit rights and a detailed governance process.
What charging methods are commonly used?
The most common charging methodology in smaller outsourcing arrangements is a periodic service fee, which may include a variable component that reflects the volume of service provided. Charging methodologies tend to grow in complexity with the overall transaction. Large outsourcing transactions commonly feature charges composed of some combination of a fixed-fee component, pass-through charges and a variable fee based on agreed rates and a resource unit that reflects the volume of services provided. Where transactions include a resource unit-based fee, the charging methodology often includes a band in which actual usage may fluctuate without affecting charges, as well as additional resource charges and reduced resource credits, which are used to determine the price impact of usage outside of the band.
Fixed price, time and materials, and cost-plus pricing are less common, but may be used as the primary mechanism in project-based outsourcing, outsourced manufacturing and facilities management engagements, or as a component of a complex pricing structure.
Customers secure the benefits of favourable pricing through contract terms that fix the fees during the initial term and cap subsequent increases, commit the service provider to giving the customer its ‘most favoured customer’ pricing going forward, and allow the customer to periodically benchmark fees against the fees paid by similarly situated customers of similar services.
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?
No representations, warranties or indemnities are mandatory or prohibited.
Representations and warranties
Each party customarily warrants its organisation and authority to enter into the contract. Any additional customer warranties are likely to address specific preconditions to the transaction or unusual risks for the vendor in doing business with the specific customer.
Service provider representations and warranties are more extensive, reflecting the complex nature of outsourced services. Service providers typically warrant that services and deliverables will satisfy general standards (eg, performance in a professional manner), specific requirements set forth in the agreement or statement of work and external standards (eg, standards promulgated by an industry group or international organisation for standardisation). In addition, service providers often warrant that they will provide services of at least the standard and quality of those received by the customer before transition.
Other common service provider representations and warranties include:
- compliance with laws, conformance to changes in those laws and performing in a way that does not put the customer in violation of the laws;
- compliance with applicable third-party contracts; and
- protecting the customer against computer viruses.
Service providers often agree to defend against the following types of claim and indemnify the customer against related losses:
- third-party claims for infringement;
- third-party claims alleging the service provider’s breach of a third-party contract;
- claims by the service provider’s employees, agents and subcontractors;
- claims arising from violations of law;
- claims arising from the service provider’s failure to obtain or maintain required consents, permits or government approvals;
- third-party claims for taxes that were the service provider’s responsibility;
- third-party claims for personal injury, death, loss or damage to real or personal property; and
- third-party claims arising from the service provider’s gross negligence or wilful misconduct.
The customer may seek additional indemnities depending on the nature of the services and the risks involved. The customer will also want to ensure that the scope of losses covered by the indemnity is sufficiently broad and that indemnified losses are not limited by the general damages cap.
The customer may offer a more limited set of indemnities, typically focusing on customer actions or customer-provided resources that are potential sources of third-party claims against the service provider.
Ending the agreement
What are acceptable grounds for terminating an outsourcing contract?
Outsourcing agreements generally allow the customer to terminate for the service provider’s uncured material breach. Given the difficulty of proving the materiality of a breach or the insufficiency of cure efforts, customers often seek rights to terminate if:
- transition or implementation is not completed on time;
- the service provider commits numerous breaches that in the aggregate are material, even if individual breaches are cured; or
- numerous or repeated service level violations occur or aggregate performance credits exceed a threshold.
Customers may also wish to include a right to terminate following the service provider’s breach of certain critical obligations (eg, data security requirements or compliance with specific legal requirements) or on a change in control of the service provider. In addition, a right to terminate for convenience (possibly on payment of a termination fee or reimbursement of wind-down expenses) can help protect the customer in the event of a change of strategic direction, a change of management or general dissatisfaction with the service provider that does not rise to the level to support termination for cause.
Is there a common or mandatory notice period for non-renewal of a contract?
There is no mandatory notice period generally applicable to the termination of an outsourcing agreement, but specific circumstances may implicate legal requirements. For example, if termination entails the closing of a facility in the United States, notice periods under the Worker Adjustment and Retraining Notification Act 1988 (which requires employers to provide employees and authorities with 60 days’ prior written notice of certain plant closings and mass layoffs) may apply.
Notice periods are rarely shorter than 30 days, while 90 days is more common. In a complex outsourcing, the parties may negotiate a renewal process with timelines for the delivery and evaluation of renewal proposals.