What is the extent of outsourcing in your jurisdiction, including the most common sectors for outsourcing activities?
Outsourcing is common across many industries and sectors in the United States. The most common types of outsourcing include:
- outsourcing of financial or other business processes (eg, accounting, call centres, retail and human resources);
- outsourcing of IT functions (eg, network management, application development and cloud computing); and
- outsourcing of professional functions (eg, legal, accounting, procurement and administrative support).
Sectors such as financial services and healthcare tend to be large consumers of outsourced services. In addition, outsourced manufacturing remains a common solution for US-based producers. Outsourcing by government entities is increasingly common, although it continues to lag behind other sectors, due in part to laws and regulations regarding government procurement.
How would you describe the government’s approaching to outsourcing arrangements? Are there any government-sponsored incentives for outsourcing, or restrictions on outsourcing abroad?
There are no federal programmes expressly aimed at encouraging or discouraging offshore outsourcing. Proposals for such programmes tend to garner significant attention, but no such proposal appears likely to be passed into law in the coming year. Some US states have implemented outsourcing prohibitions, but these generally apply only to contracts to provide services to that state or its agencies.
Is there any overarching domestic legislation governing outsourcing?
There is no overarching US federal law that specifically governs outsourcing transactions. These transactions are generally governed by the contract laws of each state and any applicable state or federal laws that relate to important issues affecting outsourcing transactions (eg, data protection and privacy, employment, export controls and IP rights).
Are there any sector-specific laws or industry guidelines on outsourcing?
The healthcare industry is subject to the Health Insurance Portability and Accountability Act 1996 (HIPAA) and the Health Information Technology for Economic and Clinical Health Act 2009, which regulate the privacy and security of protected health information. Many service providers and contractors that provide services involving protected health information to covered entities (eg, healthcare providers) are required to enter into a business associate agreement with the covered entities and are subject to the HIPAA Privacy and Security Rules.
Financial institutions are required to take steps to protect the privacy of consumers’ finances under federal and state laws, such as the Gramm-Leach-Bliley Act and its implementing regulations relating to financial institutions’ privacy policies, information sharing policies and data safeguarding. Other federal statutes (eg, the Bank Secrecy Act and the Bank Service Company Act) impose disclosure, reporting and anti-money laundering requirements that may apply to outsourcing transactions.
In addition, the Office of the Controller of the Currency (OCC) and the Federal Reserve Board (FRB) issued guidance on how financial institutions should manage third-party risks, with a particular focus on outsourcing transactions. Both the OCC and FRB guidance touch on issues that often arise in outsourcing transactions and are used by financial institutions when negotiating related provisions with service providers.
Government contracts are highly regulated at both state and federal level and often include contract terms that differ substantially from private sector contracts. For example, government contracts contain mandatory clauses which afford government entities special rights, including the right to unilaterally change contract terms or terminate the contract. In addition, government contracts typically include provisions mandated by the Federal Acquisition Regulation (FAR) or the Department of Defence’s FAR Supplement, which must flow down to subcontractors.
Licences, permits and approvals
What licences, permits and/or approvals are required for outsourcing activities, if any? What are the penalties for non-compliance with these requirements?
No licences, permits or approvals are specifically required for outsourcing activities. However, it is likely that third-party vendors of software and services will require consent or approval in order for the service provider to access, use or manage the software or services on the customer’s behalf. In addition, to the extent that it is necessary for performance or receipt of services, each party will typically license its intellectual property to the other.
Are any legislative or regulatory reforms envisaged or underway which will affect outsourcing arrangements?
Numerous outsourcing bills have been introduced at federal level, which if passed would restrict offshoring or provide incentives for companies to keep jobs in the United States. For example, the federal No Tax Breaks for Outsourcing Act would ensure that multinational corporations pay the same tax rate on profits earned abroad as those earned in the United States.
What legal vehicles/structures are available for outsourcing arrangements, and what are the advantages and disadvantages of each?
Outsource services to third-party service providers
Structure When outsourcing services to a third-party service provider, that party performs services using its own resources and employees, or resources and employees transitioned (or ‘re-badged’) from the customer. This is the most commonly used structure for outsourcing.
Outsourcing services to a third-party service provider is the easiest structure to establish, since the service provider will have many of the requirements in place. Start-up costs during the creation of the outsourcing arrangement are lower and there is greater operational flexibility to re-allocate resources in response to market changes.
When outsourcing services to a third-party service provider there is less control over managing those services, bringing a greater risk of loss of customer data or intellectual property, poor service quality or even abandonment of services. If operational efficiencies achieved by the service provider do not outweigh its profit, the recurring costs over the life of the arrangement will be higher. Outsourcing in this way can bring benefits as a result of the service provider’s flexibility to respond to market changes, but may require renegotiation of the outsourcing agreement.
Outsource services to wholly owned or controlled subsidiaries
The customer creates a wholly owned or customer-controlled (also known as ‘captive’) subsidiary to provide services.
Outsourcing services to a wholly owned or controlled subsidiary brings the greatest control over the service provider, making it easier to renegotiate the outsourcing agreement or adjust management. It also provides the greatest level of control over the customer’s data and intellectual property. If the captive subsidiary can achieve efficiencies that are reasonably similar to a third-party service provider, there will be a significant reduction in recurring costs.
Outsourcing services to a wholly owned or controlled subsidiary can be difficult and costly to establish, since the customer must set up the legal entity and any necessary outsourcing processes. Limited depth of experience and resources of the captive subsidiary may result in higher costs or service issues for the customer, especially in response to market changes.
Outsource services to joint ventures
Several customers establish a joint venture to jointly manage an outsourcing arrangement. Stakeholders often have similar governance and ownership rights.
Outsourcing services to a joint venture means reduced start-up costs compared to a captive subsidiary; however, the costs of responding to market changes are shared by the stakeholders. When compared to a third-party service provider structure, there is greater control over the direction of the services and greater flexibility in renegotiating the outsourcing agreement, and when compared to a captive subsidiary structure, there is a reduced risk of changes to the market or regulatory regime.
Outsourcing services to a joint venture is the most difficult regime to establish, because of the establishment of a subsidiary entity and involvement of multiple customer parties. When compared to a captive subsidiary structure, there is reduced control over the direction of the services and reduced flexibility in renegotiating the outsourcing agreement and responding to market changes; however, when compared to a third-party service provider structure, there is an increased risk of changes to the market or regulatory regime.
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.
Remedies and protections
What legal remedies are available to the parties to an outsourcing contract in the event of contractual breach or unjust termination?
Breach or unjust termination of an outsourcing agreement is most likely to lead to a claim for damages for breach of contract. Equitable remedies (eg, specific performance or injunctive relief) may be available when the plaintiff can show that money damages will be inadequate. A common use of injunctive relief is to prevent the disclosure of trade secrets or other confidential information.
US laws provide parties with substantial leeway to modify or waive the availability of legal remedies by contract (eg, by requiring arbitration or mediation in lieu of the courts, waiving or reserving the right to equitable relief, or waiving the right to a jury trial). Thus, a party’s legal remedies should always be assessed in light of the contract terms.
What other remedies are available (eg, contractual)?
In addition to termination, a customer may seek:
- to audit the service provider to verify compliance with the agreement;
- to withhold charges for defective products or services;
- indemnity and defence against claims arising from certain breaches;
- service level credits based on the service provider’s failure to achieve performance targets;
- milestone credits when the service provider fails to satisfy key milestone due dates; and
- step-in rights that allow the customer to take over performance of the services when the service provider fails to perform critical services.
How can the parties to an outsourcing agreement limit or exclude their liability?
Outsourcing agreements often include terms capping the amount of direct damages payable by each party and waiving the ability to recover indirect, consequential and certain other types of damages. US courts generally give effect to such limits in commercial contracts between sophisticated parties, although doctrines in some US states can lead to a court disregarding contractual limits on liability. For example, courts in many US states will not allow exclusion of liability for gross negligence or wilful misconduct.
Liability limits are often subject to negotiated exceptions. Many of these exceptions focus on indemnity, harm that is likely to include substantial indirect or consequential damages (eg, losses stemming from breach of confidentiality provisions), circumstances where a party’s culpability should preclude the protection of the liability limits (eg, cases of fraud, violations of law or intentional acts, such as violating specific negative covenants) and breaches that concern matters of particular sensitivity for one or the other party. Customers should carefully consider the nature of the outsourced service, likely breaches by the service provider and the damages that flow from such breaches. Reliance on form provisions is likely to leave the customer exposed to risks without adequate remedies.
Asset transfer and assignment
Movable and immovable property
What rules, standards and procedures govern the transfer and assignment of movable and immovable property in the context of an outsourcing arrangement?
Immovable property (ie, real estate) is rarely transferred except in ‘build to operate’ transactions, in which the service provider builds and operates a facility for eventual transfer to the customer. The customer should perform title searches, comply with recordation requirements and obtain contractual commitments that the property will be transferred free of liens and encumbrances. Immovable property leases in an outsourcing transaction are usually documented in a separate lease agreement entered into by the parties.
Movable property (eg, equipment and computer systems) can be sold or leased in the outsourcing agreement without the need for a separate document, although sometimes a separate bill of sale may be used. The movable property to be transferred should be clearly identified in a schedule.
Property transfers may take place at the beginning of the outsourcing relationship or at the end, when the customer resumes responsibility for the outsourced services or transfers them to another service provider. The contract should provide a procedure for effecting end-of-term transfers.
What rules, standards and procedures govern the transfer and assignment of intellectual property in the context of an outsourcing arrangement?
Intellectual property – including patents, trademarks, copyrights and know-how – may be assigned or licensed pursuant to an outsourcing transaction.
The parties should carefully consider the scope of licences given by the service provider, including:
- the duration of the licence;
- whether the licence is exclusive or non-exclusive;
- whether the licence is transferable or sub-licensable; and
- the purposes for which the licensee may use the intellectual property.
The licence should also specify which party owns modifications to or works derived from licensed intellectual property. Continued use of service provider intellectual property after termination may be critical to in-sourcing or re-sourcing the services without disruption; if so, the licence grant should include post-termination rights. The customer may grant licences to allow the service provider to use customer or third-party intellectual property solely for the purpose of performing the services.
If know-how or trade secrets are licensed, appropriate confidentiality and security obligations must be included in the agreement to ensure that the owner’s rights are protected.
In addition, customers may use the work for hire doctrine under federal copyright law to ensure that copyright in developed works vests in the customer. The doctrine applies only to certain categories of works enumerated in the US Copyright Act that are specifically commissioned for the customer and which are described as ‘work for hire’ in the contract.
How can a customer’s rights and obligations under another contract be transferred/assigned to the supplier?
A customer’s rights and obligations under third-party contracts can be assigned to the service provider. Alternatively, the customer can appoint the service provider as its agent for purposes of managing the contract on the customer’s behalf. Either way, the parties must determine whether the counterparty to the contract is entitled to give consent. If consent is required, the outsourcing agreement should address each party’s responsibility for obtaining the consent and how a failure to obtain consent will impact on service scope, fees and other terms of the arrangement.
If the service provider manages the third-party contract on the customer’s behalf, the outsourcing agreement should address the process for designating the service provider as the customer’s agent, and provide a clear description of the scope of the agency, as well as covenants requiring the service provider to comply with the terms and conditions of the third-party contract and to indemnify the customer against losses arising from a breach.
What rules, standards and procedures govern the protection and transfer of data in the context of an outsourcing arrangement? Are there any sector-specific regulations in this regard? What are the penalties for non-compliance?
The United States lacks a unified governing data protection framework like the EU General Data Protection Regulation. Subject to some sector-specific exceptions, US privacy and security jurisprudence is primarily focused on the privacy and security of consumer personal information. For example, highly regulated industries such as healthcare and financial services are governed by distinct sets of laws and regulations at federal and state level. Companies in other industries are governed by a patchwork of federal and state privacy and security-related laws of general applicability. Notably, the United States does not restrict transfer of consumer data to other jurisdictions (in contrast with the European Union, which places strict requirements relating to transfer of consumer data to certain other jurisdictions).
Publicly posted privacy policies create self-imposed obligations for companies with respect to their collection, use and disclosure of personal information.
Employment and labour
What rules, obligations and liabilities apply to the transfer of employees to and from the customer and supplier (including with regard to offshoring arrangements and termination of the outsourcing contract)?
Employment laws at the federal and state levels may be implicated in the outsourcing context when an employee is hired, terminated, transferred or re-badged, including laws relating to pensions, notice requirements, benefits and welfare, collective bargaining, anti-discrimination and other unfair practices. If the outsourcing results in a plant closure or mass layoff, prior notice to employees, certain agencies and local officials may be required under the Worker Adjustment and Retraining Notification (WARN) Act 1988 and its state equivalents. In addition, if the outsourcing crosses national borders, customers and service providers may be subject to the laws of foreign jurisdictions (eg, the EU Acquired Rights Directive), which safeguards employees’ rights and transfers contractual and statutory rights of a transferred employee from the customer to the service provider (or vice versa when employees are transferred back at the end of the term).
Consequences for violations of such employment laws vary depending on which laws have been violated. In general, penalties are limited to monetary damages and potentially job reinstatement to affected employees.
Definition of ‘employer’
How is ‘employer’ defined in the context of an outsourcing arrangement, and how does this affect the parties’ responsibilities and liabilities?
Outsourcing can result in transfers of employment, as well as the employees of one party taking direction from the other party. Generally, common law determines when an employment relationship exists in the United States, so it is important for the agreement to clearly state each party’s roles and responsibilities relating to employees (which may include terms dealing with compensation and benefits, security measures, employee training, any existing employment contracts and protection of employee data). The agreement should also incorporate safeguards against joint employer liability, which could result in one party being held responsible for the other party’s employment liabilities. In addition, state and federal laws may define ‘employer’ differently for specific purposes. For example, the WARN Act contains its own definition of ‘employer.’ As with any arrangement involving employees, myriad employment laws must be considered when structuring an outsourcing arrangement. The parties should look at the specifics of each deal and obtain counsel on what employment risks need to be addressed.
Organised labour issues
To what extent are labour unions and works councils involved in outsourcing arrangements?
Labor unions and works councils are not often involved in the planning or negotiation of most IT or business process outsourcing arrangements in the United States, although a unionised workforce is more likely in outsourced manufacturing. Outsourcing agreements should address the parties’ responsibilities relating to collective bargaining agreements. From the customer’s perspective, the contract should require the service provider to make the customer aware of any collective bargaining agreements with unionised service provider personnel if the expiration of such an agreement or any resulting labour dispute could potentially interfere with the outsourced services or adversely affect the customer’s rights under the agreement.
What immigration schemes and rules are pertinent in the context of outsourcing arrangements?
US companies that will be hiring or using foreign workers to deliver services must comply with and obtain H-1B or L-1B visas, as applicable. Customers should be aware of, and require service providers to comply with, guidance published by US Citizenship and Immigration Services. Further, the outsourcing agreement should clearly allocate responsibility for obtaining required visas or work permits. Finally, customers often require service providers to use E-Verify – a Department of Homeland Security website – to confirm the eligibility of employees to work in the United States.
What tax liabilities arise in the context of an outsourcing arrangement? Can these be mitigated in any way?
The federal government does not impose value added, sales, use or service tax, but several states do collect them, including on outsourcing services. The scope of services covered by state laws varies by jurisdiction.
Parties can manage their exposure by clearly stating in the contract which party is liable for each type of tax, including any caps on tax exposure and agreements on how changes to tax law will be addressed by the parties. Customers who take on liability for service tax should require the service provider to specify any applicable tax in advance in the agreement or a statement of work and to include such taxes as separate line items on each invoice. In addition, the contract should also entitle the customer to any tax refunds or rebates received by the service provider for taxes paid by the customer.
Property and employment tax issues may arise in an outsourcing transaction. As with service tax, responsibility should be clearly defined in the contract.
The parties’ overall tax liability may be affected by how the contract allocates payments to taxable and non-taxable categories of services and the parties’ agreement on whether specific exemptions or resale certificates apply. Therefore, outsourcing agreements should require both parties to cooperate to minimise tax liability after signature.
How are outsourcing disputes commonly resolved? Is alternative dispute resolution (ADR) common and effective?
Governance procedures provide the first opportunity to identify and resolve problems that could lead to disputes.
Unresolved disputes may be addressed by litigation or by ADR. The most common form of ADR in outsourcing is arbitration, although some parties opt to include mediation as the final step in dispute resolution or as a non-binding intermediate step prior to litigation or arbitration. For arbitration, the agreement should address the number, selection and minimum qualification of the arbitrators, the procedural rules that will apply, how much discovery is permissible, whether the arbitrator can rule on dispositive motions and in what manner, and the timeframe for completing the arbitration and rendering the arbitrator’s decision.
Both litigation and arbitration have advantages. One party (often the service provider) or both may prefer the added confidentiality of arbitration. Despite a common perception that arbitration is faster and less expensive than litigation, it is often difficult to predict which method will be costlier. Arbitration proceedings provide the parties more flexibility in terms of the duration and rules. For example, the parties can agree to dispute resolution via expedited procedures. But an arbitrator does not have a court’s power to compel compliance, so arbitration can drag out if one or both parties are uncooperative. Moreover, an arbitration award is not appealable. Litigation allows for joinder of third parties, while arbitration rules may require separate resolutions for multi-party disputes.
Recent case law
Has there been any notable recent case law which may affect the resolution of outsourcing disputes in future?
In 2010 the state of Indiana sued IBM for breach of a $1.6 billion agreement to outsource the state’s welfare processing system. IBM countersued. The resulting battle illustrates the cost and complexity of outsourcing disputes and the risk of mutual liability. A 2012 ruling found fault on both sides, with the court stating that “neither party deserves to win this case” before awarding damages to IBM. On appeal in 2016, the Indiana Supreme Court reversed the decision and remanded it to the trial court, which awarded the state $128 million in damages.
The rulings highlight the need for contractual clarity on key issues, including:
- service definitions and measurable results (eg, service levels for key elements of the outsourced service);
- specific remedies for the service provider’s failure to meet its performance targets and whether such remedies are exclusive of other customer rights;
- termination rights, including events other than material breach that should allow the customer to terminate the contract (eg, implementation failures, chronic service level failures or a pattern of breaches, whether cured or otherwise); and
- the consequences of termination.
Additional Proposed Questions
What are the most common types of disputes arising from an Outsourcing Agreement?
The most common disputes relate to the scope of work, and specifically whether a particular task or service is part of the services. Gaps in the parties’ understanding of the services arise for a variety of reasons. First, it is difficult and time-consuming to identify all tasks included in the services and all desired results. This is particularly true for newer types of service or services that are not frequently outsourced. Second, even when outside advisers have fairly refined template descriptions of the services, many customers have unique or customised requirements. Third, discussions about the scope of the services suffer from the same issues as other types of negotiation:
- negotiators may be unclear about what they want;
- negotiators may think that they have reached resolution without an actual meeting of minds; or
- negotiators may not have considered all potential possibilities.
These communication failures are often exacerbated by differences in language or culture.
The parties can minimise the risk of a scope dispute in a number of ways. Customers can include a ‘sweeps’ clause in the master service agreement (MSA). Sweeps clauses come in a number of guises, but the most common provide that even if specific tasks are not specifically described in a subsidiary statement of work (SOW), they are included in the services if they are included in a financial model of the transaction or if they were performed by the customer’s employees or contractors affected by the transaction. Finally, the parties can plan upfront so that they have adequate time to prepare the SOW and have it reviewed by all relevant parties.
Pricing is another common source of dispute. Pricing disputes often relate to questions of scope, but they also arise because pricing formulas are unclear or events occur that were not contemplated by the parties. The best way to avoid such disputes is to pressure test the pricing formulas.
What can customers do to make their outsourcing contract more successful?
The MSA cannot simply be shelved once it has been negotiated. Unfortunately, the hard work is only beginning. Customers should actively manage their service provider and the agreement to realise the anticipated benefits of the deal. Active management includes an investment in the governance process. Customers should:
- meet frequently with the service provider, particularly during transition;
- monitor performance;
- not allow issues to fester;
- listen to the service provider and understand where the customer is impeding performance; and
- document agreed-on deviations from the agreement.
Customers should also consider exercising their audit rights at least once during the life of the deal. Audits often reveal overcharging or underperformance. Either can arise for a variety of reasons, including honest mistakes, turnover of customers or service provider personnel, incompetence or malfeasance. Even if it reveals no issues, the audit tells the service provider that it is being actively monitored.
How do contracts address exit from the outsourcing contract?
The MSA should address exit from the relationship in a comprehensive manner. At a high level, this means that the customer should consider how long it will take to transition to a new service provider and what it will need from the incumbent service provider to accomplish a smooth transition. Issues to consider include the following:
- How long can the customer continue to receive services after termination? A period of six to 24 months is typical, depending on the nature of the services.
- Will key service provider personnel remain committed to the deal during the wind-down period?
- Will service levels and other quality standards remain in effect?
- What rights will the customer have to recruit service provider employees who are providing services?
- What assets used to perform the services can the customer acquire from the service provider?
- What intellectual property of the service provider can the customer use?