By March 1, 1999 Read More →

Flexibility in Service Contracts: How to Build It and Keep It | Article

meeting at tableFlexibility in legal contracts bears striking similarities to a team of professional athletes under the tutelage of a watchful coach. The coach (like the user in an outsourcing agreement), studies and selects athletes (a service provider), based on their aptitudes for flexibility and coachability, as well as their existing skills and past performances. Part of the coach’s job is to design limbering exercises to build stamina, enable bursts of strength and ensure flexibility. Over time, the team and coach build trust in each other and are able to use that trust in responding flexibly to zig-zags and challenges that even the coach had not foreseen.

In contracting for long-term services agreements, a user must design and implement its own strategies that will support such limbering exercises. Typically, this requires three stages — planning, contracting and post-contract management — and these determine the success both parties will have in dealing with change. The spirit of teamwork enables contracting parties to be flexible and able to get over bumps in their path, but the importance of the contracting and management stages cannot be overemphasized. Flexibility and legal enforceability of contract do not need to be mutually exclusive.

The Planning Stage

Selection of the “right” vendor involves an evaluation not merely of price and capability, but also of “culture.” Like “experience,” a vendor’s culture reflects its business philosophy in action. The selection process should involve due diligence by the customer regarding the vendor’s record and attitudes toward rigidity; structure; adaptation; bureaucracy; change and, most importantly, the vendor’s attitudes toward building the customer’s shareholder value.

The Contracting Stage

Services, Duration and Environment:

Contracts are made to allocate risks. Typical contracts allocate known risks and provide some opportunity to each party to obtain a commercially reasonable outcome for risks that are unlikely but nonetheless possible.

Ten contractual provisions affect flexibility in resolution of new situations. The first is a change in the scope of services. This will likely affect staffing commitments, technology investment, pricing and service level commitments, among other things. In defining the scope of contracted services, the customer should establish a method for integrating the vendor’s services into the customer’s other service infrastructures, both internal and external, both current and planned.

Duration of the contract, and possible termination, greatly affects flexibility. The legal right to insist on changes during the term of a contract relates, in part, to provisions enabling termination if such changes are not made. Termination by the customer without cause is, therefore, an essential requirement of any outsourcing deal. In return, however, the customer may need to accommodate the measurable and foreseeable financial and technological consequences of any such termination.

The third contractual provision is alignment of service levels with the customer’s business objectives. Service level commitments should be geared toward measurable predictors of customer shareholder value. To the extent that service commitments reflect purely technical specifications and not business drivers, tensions will persist between technical performance and long-term “partnership.” Customers should be aware of such inherent tensions and plan to protect their right legally to realign the services contract with their evolving management plans for maximizing shareholder value.

Changes in the business environment also affects flexibility. In a rapidly globalizing economic environment, unforeseeable changes to the business environment are predictable. Such changes could result in a dramatic surge, or equally dramatic decline, in the customer’s utilization of the vendor’s services. The contract should contemplate the impact on pricing and service level commitments and, indeed, all commitments in the face of such dramatic changes.

The fifth factor is changes in the legal environment. Laws, rules and regulations change, often unpredictably. For example, a customer’s international business might be brought to a halt if the vendor could not accommodate new privacy rules imposed by the European Union’s directives. A contract that did not foresee such changes then must be construed to allocate the cost of compliance with such new directives — even if they do not have the force of law in the United States. Accordingly, contracts should require the vendor to comply with changes in the laws, and costs of compliance should be addressed as well; otherwise, the vendor would be exculpated from having to comply by arguing that an act of state, act of God or other force majeure exonerates the vendor’s non-compliance.

Strategies, Technology and Decisions: Sometimes, a customer’s business strategy changes sharply, necessitating another need for flexibility. There are a variety of causes for such strategy changes, such as a new senior manager taking control; a hostile takeover in a leveraged buyout strategy and subsequent initial public offering; or a merger with a competitor that has incompatible technologies. It may be a divestiture of a division that was a major consumer of the external service provider’s volume of services; it may be unionization or de-certification of a union; or it may be antitrust enforcement forcing a divestiture. To be able to respond to such changes, the contract must plan for an allocation of risks, responsibilities and procedures.

The seventh contractual provision affecting flexibility is changes in technology. For long-term contracts, the vendor should assume certain predictable risks of technology changes. Vendors (and customers) should have done their homework on the impact of Moore’s Law on the transaction (on the rapidity and cost impact of changes in processing speed and capacity), historical relationships between price and performance in the sectors relating to the scope of work, and an educated guess about the future path. As to the future, one may predict (and contractually agree on) certain refreshment cycles. Beyond a certain point, such as three to five years, changes in technology are speculative; both sides must provide contractual leeway to benefit from such changes without incurring material adverse consequences if those changes should radically alter the contractual balance.

Virtually all well-drafted, long-term service agreements contemplate procedures for the adoption and implementation of decisions by both customer and vendor. A set of procedures for “co-sourcing” or “joint sourcing” of decisions will facilitate effective communications, planning and implementation of changes. However, no amount of joint decision making should relieve a vendor from responsibility for its core services commitments. Concomitantly, such procedures cannot be used by the customer to impose a unilateral change in scope. In short, effective working procedures can facilitate changes and smooth transitions to a new balance of risk and reward, but not beyond the bounds of the scope, service levels and pricing commitments.

The ninth provision is change control. Most long-term service agreements require “change orders” to memorialize contractual agreement on changes affecting the responsibilities of the parties. Change-control procedures should be effectively monitored and implemented by the vendor’s “project office.” They should also be managed for easy reference and identification of emerging larger problems, to avoid the use of short-term solutions to confront larger, long-term problems that require systemic change, such as renegotiation.

A final contractual provision affecting flexibility is repricing. The pricing schedules should reflect a band of services at varying, foreseeable levels in order to facilitate financial planning for both parties. At the outer limit, unbundled and transparent pricing — particularly for commodity-type services — should be considered. Pricing algorithms and strategies should be studied separately, since pricing flexibility reflects a constellation of business terms.

The Management Stage

Post-Contract Management. As the saying goes, work only begins once the contract is signed. No amount of contractual boilerplate can protect against ill will spawned by neglect, poor communications or failure to identify and plan one’s business. Effective contract management requires skills that differ from effective management of in-house staff. So, in planning the transition, as well as the post-contract management, the customer must maintain trusted, technologically savvy managers to supervise and plan with the vendor’s account managers. Senior management should ensure that the team managing the vendor has these skills.

Change Management. Outsourcing involves fundamental changes to the infrastructures that deliver support services to the business enterprise. Managing change requires careful planning and ongoing management of technology, pricing, service, corporate culture and skills. As part of this process, the parties’ goal should be to determine how to give the customer “market-driven” flexibility; this would enable the customer to respond to changes in the marketplace for its core products and services through changes in the outsourced infrastructures that support such core products and services.

In financial markets, planning for unforeseeable change is done by trading in futures and options; in the information technology sector, planning can be achieved by transparent pricing models that define future service levels against market-based benchmarks. This is most easily achievable in “commodity” markets, such as data center operations, certain applications development, desktop maintenance and other cases where industry specialists offer competitive service offerings outside the box of monolithic outsourcing.

Planning should also restrict changes that are foreseeable. How often will the vendor change the personnel engaged on the account? For what reasons, and how often, will the technology be refreshed? Who will assume the risk of such change? Contractual restrictions on certain changes can achieve predictability and, therefore, reduced risk for both parties.

Still other changes must be mandated. Some of the most vociferous complaints about the failures of outsourcing arise from a lack of flexibility in continuous process improvement and continuous improvement in the price-performance ratio. Typically, this occurs after several years of a long-term contract. Unless the vendor is financially motivated to provide market-driven improvements, the customer will only get those service levels that were initially contracted. Creative pricing solutions and joint venture approaches may achieve this result.

Renegotiation

When all else fails, renegotiate or move on. As with the relationship between the athlete and the coach, the future depends on both parties’ willingness to show good faith and revise the terms as new challenges are confronted by each. In time, they may stretch beyond the original deal into a new contract through renegotiation reflecting a constellation of new environments.

All in all, legal flexibility boils down to selecting the right team player at the beginning and working through the foreseeable and “drastic” unforeseeable risks in the contracting stage.


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