What every business lawyer needs to know about outsourcing

By Dana H. Shultz
©2004

As outsourcing becomes more widespread, lawyers are increasingly likely to find themselves enmeshed in preparing, reviewing or negotiating – or resolving disputes regarding – outsourcing agreements. Here are the basics that every business lawyer should know about outsourcing agreements.

Let’s start with some definitions. “Outsourcing” means having a third party perform business functions that ordinarily would be performed within a company. For years, companies have outsourced information technology operations (“IT outsourcing”). More recently, companies have outsourced other operations, such as human resources, accounting or procurement (“business process outsourcing”).

“Offshoring” or “offshore outsourcing” means outsourcing business functions to an overseas location. Manufacturing often is offshored to China, while IT, call centers and other back-office services frequently are offshored to India.

Big picture

There are three characteristics that, together, make outsourcing unique among commercial transactions, and often quite interesting for lawyers.

First, outsourcing tends to be a multidisciplinary practice area. Depending on the transaction, one might require knowledge of commercial contracting, business formation, asset transfers, intellectual property, substantive business operations, taxation and international law. No individual lawyer is likely to be an expert in all of these areas, but familiarity with the issues and access to colleagues with the necessary expertise are required.

Second, outsourcing requires a long-term perspective. Because the services to be outsourced are important to the customer’s business operations, outsourcing relationships are expected to last years. No one wants to go through the cost, effort and disruption of changing suppliers every 12 or 18 months. Accordingly, lawyers and their clients need to enter negotiations with the perspective that each party must profit on a sustained, continuing basis; this is not the time to gouge or be adversarial. Most importantly, the agreement must be drafted so each party has strong incentives to carry out its obligations faithfully. Neither party can afford the time, cost or damage to reputation of a major dispute.

Third, while outsourcing usually is characterized as a way to save money, it is most valuable when it helps businesses make their operations more effective.

Bob Di Giovanni, a partner in the Los Angeles office of Shaw Pittman LLP (www.shawpittman.com), has found that outsourcing often is “designed to be an engine of transformation.” He notes that this characteristic makes outsourcing transactions “some of [his] more interesting deals.”

Supplier-customer relationships

Well before the first draft of the agreement is prepared, the outsourcing customer and its lawyer need to evaluate which type of supplier to select. Business and legal concerns will be paramount, but (especially for publicly held companies) political considerations may arise, as well.

There are many supplier options nowadays, especially as regards offshore outsourcing. For example, the customer might work with:

• A domestic supplier that will provide services in the U.S. or at an overseas division;
• The domestic operation of an overseas supplier;
• An overseas supplier directly; or
• A joint venture between the supplier and the customer created specifically for one or more outsourcing transactions

Once the supplier is selected, the outsourcing agreement will establish a framework for their relationship. That framework will be defined largely in terms of ongoing communication obligations. The parties will identify their respective relationship managers and executive sponsors; provide, review and respond to written reports; hold regularly scheduled status meetings; and establish procedures for solving problems and resolving crises.

Business issues

Much of the outsourcing agreement will address day-to-day business issues. While the client has primary responsibility for identifying those issues, an experienced lawyer often can provide valuable input. If the customer selected the outsourcing supplier pursuant to a Request for Proposal (RFP) process, most of the business requirements already should have been documented for easy incorporation into the agreement.

The first business consideration is the scope of work: Which services (and products) will the supplier provide to the customer? How can the customer request additional services? If a change to the agreed upon scope is appropriate, how should one party raise this issue to the other? And how must the change be approved?

Once the scope is established, service levels — the objective criteria by which the supplier can be held accountable — are essential. The parties must make sure, however, that each service level measures the right thing. For example, customers often require a certain level of system availability every month, with excessive down time resulting in financial penalties.

The right approach is to express the service level directly in terms of the percentage of time that the system is available — rather than, for instance, specifying the type and amount of the supplier’s investment in resources that are expected to keep the system running.

Pricing is a central business term from each party’s perspective. The price may be as simple as one monthly fee that covers everything, or the price may have many different service and product components. Either way, prices and payment terms must be specified clearly.

Sometimes an outsourcing agreement gives the customer the right to review pricing annually against industry benchmarks and to renegotiate pricing if it is out of line relative to those benchmarks. Bench-marking is particularly appropriate in industries, such as telecommunications, where costs are expected to decline significantly over time.

The customer almost certainly will require that the supplier comply with the customer’s information security procedures. These procedures typically cover such issues as who in the customer organization must authorize use or disclosure of specified data; how such use or disclosure must be documented; and how to report exceptions to the procedures.

Disaster recovery obligations should be spelled out and may depend on where outsourcing services will be provided. For example, it often is considered adequate to make a full backup of data at a computer center every night and store the backups at an off-site location. When tensions between India and Pakistan were at their highest, however, some customers considered it more prudent to have data transmitted real-time via telecommunications from India to a location outside that country.

Among the most important business issues are those related to entering into and unwinding the outsourcing relationship, such as transferring assets and personnel, where applicable.

Legal issues

Most of the legal issues that arise in outsourcing are similar to those that arise in other commercial transactions, but with some variations that are specific to outsourcing.

Intellectual property always is important. Even if the outsourced services are not designed specifically to create IP such as software, the agreement must clearly account for ownership of all IP that the parties will contribute to or create in the business relationship.

Each party will want provisions protecting its confidential information against disclosure by the other party — though the stakes are likely to be higher than in the typical commercial transaction. For instance, the supplier may control all of the customer’s IT assets or all of its human resources data. The parties thus must pay particularly careful attention to how confidential information is defined and how that information may be used and disclosed. The customer may require that each member of the supplier’s staff sign an individual confidentiality agreement specifically for the customer’s benefit.

In a similar vein, depending on the nature of the transaction, privacy considerations may arise. For example, while the Gramm-Leach-Bailey Act protects consumers’ personal financial information held by U.S. financial institutions and the European Data Directive regulates the collection, use and disclosure of personal data within the EU, both of these laws have implications outside their home jurisdictions.

Even if specific compliance requirements are set forth in the agreement, it is always appropriate to add a provision that each party will comply with all applicable laws and regulations.

While defining breach of the agreement may be straightforward, it may be more difficult to specify remedies. The reason: Immediate or quick termination of the relationship is not likely to be a realistic option, because that likely would leave the customer with a major hole in its business operations. As a result, the agreement’s termination provisions may combine unwinding of the agreement’s start-up provisions with transfer of customer assets to a replacement outsourcing supplier.

Dispute resolution is always a huge issue in commercial transactions, and especially so in offshoring. Ideally each party would like to have local jurisdiction, venue and choice of law, but the other party will almost certainly push back — after all, its mirror-image perspective is just as valid.

A particularly helpful approach is offered by the International Chamber of Commerce, which provides international dispute resolution services (www.iccwbo.org/index_court.asp). ICC arbitration can be contractually mandated using the following model sentence: “All disputes arising out of or in connection with the present contract shall be finally settled under the Rules of Arbitration of the International Chamber of Commerce by one or more arbitrators appointed in accordance with the said rules.” As in other commercial transactions, however, the parties should allow for court issuance of injunctions against breach of confidentiality provisions or unauthorized use of intellectual property.

Finally, the agreement should include all the usual legal boilerplate — warranties and representations, limitations of liability and damages, indemnification, force majeure, integration, survival and the like. But all of these need to be thought out extra carefully in the outsourcing context.

In summary, outsourcing is similar to other major commercial transactions yet has its unique characteristics, especially in offshoring. For lawyers with the right background, outsourcing can be an interesting and fulfilling practice area.

• Dana Shultz (www.danashultz.com) is a Bay Area licensing, intellectual property and technology contracting attorney who is experienced in outsourcing software development and related services.