Emerging Trends in Outsourcing: A Legal Perspective | Article

IT outsourcingOutsourcing is not a new phenomenon, but it continues to evolve. Some notable trends are emerging. One is simply increased activity. Mary Lacity and Leslie Wilcocks estimated that the global IT outsourcing market alone will be worth US $150 billion by 2004 in their book, “Global Information Technology Outsourcing: In Search of Business Advantage.”1 There are more subtle trends as well. For example:

  • Outsourcing increasingly involves more than one country – “single country” outsourcing is giving way to “multi-country” outsourcing, as clients seek arrangements that cover their global operations;
  • Outsourcing increasingly encompasses “strategic” activities – while vendors continue to outsource “operational” functions, “strategic sourcing” is steadily moving beyond manufacturing, assembly, and development into more “customer facing” activities;
  • Outsourcing now more often involves a significant development component – while most outsource providers offer “commoditized” services, many clients are pressing for “customized ” solutions that can require significant “bespoke” efforts; and
  • Outsourcing partners increasingly endeavor to embed procedures in their contractual arrangements to deal with both anticipated and unanticipated issues – codified “service level” commitments are supplemented with various “relationship management” processes.

Each of these trends raises a number of interesting challenges for the business, technical and legal teams that are tasked with closing the deal. This article highlights some of the more interesting challenges from a legal perspective.

Single versus Multi-Country Outsourcing

Negotiating a good single country outsourcing relationship is not a trivial task. The agreement obviously must address service level issues. It usually must address what, how and when personnel, assets and intellectual property rights will be transitioned from the client to the provider. It also should address how the outsourced function may eventually be transitioned back to the client in the event that the parties terminate their relationship. Outsourcing should be viewed as a marriage; do not underestimate the importance of negotiating a good pre-nuptial agreement.

Negotiating a good multi-country outsourcing relationship multiplies the challenges. Multi-country relationships introduce a new layer of tax considerations. If the relationship involves the transfer of employees, the parties will find that foreign labor laws may give rise to various hurdles that do not exist here in the United States. In Europe, for example, the “transition in” and “transition out” may be tantamount to a “transfer of going concern,” which raises a plethora of employment issues. Similarly, a multi-country relationship may raise thorny privacy issues. And cultural differences can present an array of practical issues.

The legal advisor should provide a workable structure for negotiating, implementing and potentially unwinding a multi-country outsourcing arrangement. In practice, this often results in two levels of agreements – a “framework” agreement between the “top” principals; and local agreements between affiliates of each principal in the relevant countries. To the extent possible, this structure should discourage needless re-negotiation at the local level. However, local applicable regulations or “mandatory” law may make certain country-by-country customization necessary or advisable. Overall tax planning or antitrust concerns may constrain the principals’ ability to super-impose obligations on local affiliates. And, of course, it should not be assumed that local country management always ascribes to home office dictates.

“Operational Outsourcing” versus “Strategic Sourcing”

“Operational outsourcing” occurs across many different functions of an organization – information technology, human resources, facilities management, and a multitude of other back-office functions. Much has been written about the relative success of “selective outsourcing,” as compared to “total outsourcing.” In the IT arena, commentators speculate that “outsourcing” will soon move to “e-sourcing” – utility-style, scalable access to shared, standardized applications on a “pay-as-you-go” basis.2 Whatever the future brings, such arrangements must address service level issues and what, how and when personnel, assets and intellectual property rights will be transitioned to the provider, and then potentially back again to the client.

“Strategic sourcing” is not new. Outsourcing product manufacturing, assembly, and logistics activities, in whole or in part, has a long and rich history. Many vendors have outsourced development activities offshore. Now, however, vendors also increasingly outsource warranty, help desk and other customer relationship functions. In these situations, rather than being buried in the supply chain, the outsource provider interacts directly with its client’s ultimate customers. The provider’s presence and identity may be disclosed, or not. Irrespective of this issue, when outsourcing such “customer facing” activities, the client must take steps to ensure that its outsource provider continually enhances the client’s “good will” in the marketplace. This concern is less pronounced in traditional “operational outsourcing.”

Additional challenges arise where, for example, a vendor offers a service in the marketplace and opts to outsource a key component of this offering. The component may not be “core” to the vendor’s business, but often is “mission critical” in terms of ultimate customer satisfaction. Consider the software company that offers an ASP solution and decides to outsource the hosting function to an IT infrastructure provider. In addition to negotiating service level and transition issues, the parties may seek to create a marketing alliance around the now “co-branded” ASP offering. They may want to negotiate a “shared risk” revenue-splitting arrangement, as compared to utilizing more traditional “fixed fee” pricing models. Such “strategic sourcing” arrangements give rise to legal issues that are not present in traditional “operational outsourcing.”

Customized Solutions

Many companies have spent – and, in some cases, misspent – millions of dollars building in-house IT systems to support their business. Today, outsourcing is sometimes viewed as a way of avoiding such expensive and time-consuming internal projects. Instead of building or assembling an in-house system, the company sets out to purchase the required functionality as a service from an outsource provider. In many instances, this functionality will be available on the market as a standard “commoditized” solution. This is, however, not always true. The company then finds itself negotiating with the outsource provider for a “customized” solution.

When negotiating for a customized outsourced solution, the legal advisor should not ignore the many lessons offered by failed system development projects. For example, beyond addressing service level, transition and other issues that belong to outsourcing, the parties may want to establish a process that generates detailed architecture, functionality and performance specifications for the customized solution before any serious building commences. And, if the client will invest significant dollars in creating the customized solution, it may be appropriate to consider whether the client should be entitled to a “return on investment” if and when the provider re-deploys the solution, in whole or in part, for other clients.

“Relationship Management” Processes

Negotiating a good outsourcing agreement presents many challenges, not the least of which is reaching common ground on disclaimers of consequential damages and limitations of liability. The client usually wants the outsource provider exposed to all, or a substantial portion, of the damages and liabilities that the may be suffered or incurred in the event of service failure. Even where the provider lacks “deep pockets,” the client frequently views this potential exposure as creating leverage that ensures performance. In contrast, the provider obviously will seek to limit this exposure. Protracted and difficult negotiation often ensues.

The legal advisor should be prepared to offer creative solutions that overcome this impasse. These solutions usually involve focusing the parties on creating processes that will be triggered in the event that service performance falls below pre-defined thresholds. The objective is to identify “early warning” signals and specify effective remedial actions to be take to minimize the risk of service failure and avoid resulting damages and liabilities. Again, outsourcing is like a marriage. Pre-nuptial agreements deal with how to unwind the relationship. A divorce, however, may be altogether avoided if the parties agree in advance to submit to marriage counseling in the event that tensions develop in the relationship.

Lessons from the Outsourcing Journal:

  • Multi-country outsourcing introduces many complexities that usually are best handled with two levels of agreements – a “framework” agreement between the “top” principals, and local agreements between affiliates of each principal in the relevant countries.
  • As “strategic sourcing” arrangements move into more “customer facing” activities, the client should ensure that its “good will” is continually enhanced in the marketplace, and the parties may need to consider various legal issues that do not arise in traditional “operational outsourcing.”
  • When an outsourcing arrangement involves custom development, the parties should consider using processes and mechanisms typically included in system development arrangements in order to better ensure success and achieve balance.
  • Outsourcing agreements should include “early warning” signals and specify effective remedial actions that are triggered in the event of deficient performance, so as to minimize the risk of service failure and resulting damages and liabilities.

1 Global Information Technology Outsourcing: In Search of Business Advantage, Mary C. Lacity & Leslie P. Wilcocks, John Wiley & Sons, Ltd. 2001 at 2 and 5-11.

2 John Hagel III and John Seely Brown, “Your Next IT Strategy” Harvard Business Review (Oct. 2001).

Michael S. Mensik is a Partner at Baker & McKenzie (Chicago office) and is the Co-Coordinator of the firm’s Global Information Technology Law Practice. He can be reached at [email protected]. Peter R. George is an associate in the firm’s Global Information Technology Law Practice. He can be reached at [email protected].

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