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Considering Outsourcing? Four Critical Risks to Navigate

PRACTICE AREA GROUP: Technology and Commercial Contracts
DATE: 20.06.2011

In the current economic climate more and more business organisations, including public authorities, are considering the benefits of outsourcing non-core or non-income generating business processes and functions in order to find new efficiencies, to reduce costs, to increase shareholder value or to gain a competitive advantage. Almost all organisations have external service providers facilitating their business and outsourcing arrangements can cover the provision of a broad range of services from the provision of IT functions, call centres, HR and payroll, accounting, treasury and finance, administration, claims management and supply chains to logistics support.

Outsourcing does however involve certain risks and in particular organisations should be aware of the need to form a robust yet flexible contractual relationship which mitigates the inherent risks associated with transferring responsibility of a particular service or function to a third party. This article highlights four of the more common practical risks confronting organisations planning to outsource and discusses some of the ways such risks can be mitigated effectively.

Liquidity

In the current global financial crisis, it is particularly critical that prior to a customer entering into an outsourcing arrangement the customer considers the possibility of the outsourced service provider facing financial difficulties and the impact this would have on the customer’s business. Prior to contracting it is essential that the customer carries out extensive diligence on the proposed service provider in order to investigate their credit worthiness, subsisting insurance cover, and capacity to perform the outsourced service. In the event that the customer considers the outsourcing to be commercially viable the customer should then seek to build protective provisions into the outsourcing agreement which would provide adequate protection for the customer in the event that the service provider becomes insolvent. This would include an express right to terminate in the event of the service provider’s insolvency, possibly requiring a parent company guarantee or performance bond, requiring the service provider to take out sufficient insurance cover and to enter the customer as the beneficiary of such insurance and ensuring that business continuity plans cover the possibility of service provider insolvency.

If the customer becomes aware that the service provider is likely to become insolvent, it should consider whether it would be preferable to terminate the agreement or whether it would be more advantageous to proactively renegotiate terms or even offer the service provider financial support, taking into account the significance of the outsourced service to the customer’s business and the customer’s dependence on the struggling service provider to perform.

Pricing Competitiveness and the Cost of Change

One of the main commercial issues for an outsourced service customer is maintenance of price competitiveness over the duration of the contract. The service provider’s input costs will be high at the beginning of the service provision but will decrease over time, the service fees are generally fixed over the term of the contract and the service provider therefore makes a higher profit margin once the initial set up phase has ended. Benchmarking and other forms of market testing, indexation and gain-sharing are often used although there is no one-size-fits-all solution. While long term arrangements are likely to yield more attractive pricing they also involve a greater necessity for changes to be made to the service description, service levels and technology platform throughout the term of the contract, this in turn increases the risk of an uneconomical service due to scope creep. As a result, customers typically seek to ensure that the process of agreeing and implementing changes to the services is clear and systematic and that pre-agreed controls govern the cost of any agreed changes. This is equally important for the service provider so that they can provide additional services without losing their profit margin. Public authorities should include a change procedure to deal with changes that are within the scope of the original procurement but be mindful that changes outside such scope may involve a re-tendering process as public procurement rules generally do not permit an authority to depart from the parameters set out in the original procurement exercise. An appropriate balance will also need to be achieved between customer and service provider regarding the cost of changes required as a result of changes in law and regulation.

Termination and step-in rights

Service providers are generally concerned that customers will seek to terminate the agreement before the service provider has recovered its investment in the project and once existing problems with the services have been resolved or re-structured. From the customer’s perspective, it is critical to ensure that there is no deterioration in service and service levels during the term of the contract and it may also want to consider termination on a change of ownership or control of the service provider. It is therefore important that there are clear and objective termination rights. The customer may also seek a right to terminate for convenience at any time which will usually mean a discussion and agreement regarding compensation that might in such circumstances be payable to the service provider. The customer may also request step in rights so that it can temporarily take control itself or through a third party if the service performance is inadequate but this is difficult to implement in practice.

Consequences of termination/Exit Management

The question of how the services are migrated back to the customer or to an alternative service provider upon expiry or termination of the agreement is critical in all outsourcing transactions. The exit rights will need to be carefully designed to balance the competing needs of the customer and service provider. Post-termination assistance, use of intellectual property and equipment, recruitment of staff, assignment or novation of sub-contracts, and return of data and records will all need to be addressed. The service provider will be concerned to cover the cost of its investment, to retain control of its intellectual property rights and that it receives fair compensation for providing any termination assistance.

Conclusion

It is clear that organisations are increasingly pursuing commercially viable structural alternatives to combat the global economic downturn and outsourcing is becoming an increasingly popular strategic option. The benefits of an outsourced model do however come at the price of having to manage certain associated risks and it is therefore important that outsourced arrangements are reflected accurately in bespoke contracts which detail the customer’s unique requirements, allocate responsibility and mitigate the scope of the risks involved.

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