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Avoiding Outsourcing Pitfalls

A leading technology company in Silicon Valley is facing a tight deadline to launch its latest product. Short of staff and worried about costs, it outsources the project to a software development company in India. The outsourcing arrangement is vague. Their top developer, who also serves as adjunct faculty at a nearby university, hires some of his graduate students to assist with the creation of the lines of code. 

Just as the new product is about to launch, the CEO gets a call from the Indian supplier. The university is claiming ownership rights to the code because several of the graduate students did the work utilizing university offices and computers.

The annals of outsourcing relationships are filled with nightmare scenarios like the hypothetical one described above, threatening not only the success of your company, but potentially exposing it to unexpected costs and even liability.

While the stakes are obviously higher when a company outsources crucial business functions offshore, even outsourcing non-core business functions, like customer service call centers, can create problems for a company when the outsourcing arrangement turns sour.

So how does a company protect itself from pitfalls when it outsources one or more of its business functions offshore? Of course, nothing replaces careful, diligent investigation and discussion at the management level before deciding if, what, and where to outsource. But since even the most carefully drawn plans can falter, a well-drafted outsourcing agreement can help soften the blow when things go bad.

Below are six key provisions that any outsourcing arrangement should have to help mitigate unavoidable problems when they occur.

1. Protect Your IP

As the example above illustrates, any outsourcing arrangement that involves sharing or developing proprietary software is vulnerable to dispute and even outright theft. Moreover, unlike the US, not all countries recognize intellectual property rights. For example, while countries such as China, Russia, and Mexico are among the most popular countries for outsourcing, they also have among the weakest intellectual property laws.

Before entering into an outsourcing arrangement, first determine the extent to which local law protects your IP. Armed with this information, make sure your outsourcing arrangement has a well-drafted, bullet-proof intellectual property provision that

  1. clearly establishes ownership of IP in existence at the time the outsourcing arrangement is entered into
  2. clearly establishes ownership of IP that is developed or improved during the course of the outsourcing relationship
  3. restricts the supplier, in the strongest terms, from disclosing any of your proprietary software or other information.

    The following checklist will help you draft an IP provision that meets all three requirements:

    • Clearly define the intellectual property to be protected.
    • After determining what legal protections the laws of the host country provide, include an affirmative representation and warranty of the supplier to adhere to those laws. (However, don’t limit yourself to only the protections afforded under local law; be as broad as applicable law will allow.)
    • Clearly define the parties that will be subject to a non-disclosure agreement.
    • Clearly define what activities are prohibited under the non-disclosure agreement. Include strong penalties for breach of the IP provisions.

2. Ensure Data Privacy

The protection of customer or employee data, particularly when it comes to transferring personally identifiable information internationally, such as a customer’s or an employee’s name, social security number, or home address has emerged as a major challenge for those interested in outsourcing HR functions or customer service capabilities due to a growing number of cross-border restrictions. At best, disclosure of private information by your supplier can be embarrassing for you. In the worst case scenario, it can expose you to liability.

Even the most routine cross-border transfers can cause problems for an enterprise. Therefore, make sure your outsourcing arrangement requires the supplier to adhere to the data privacy laws of the host country. If the host country does not have sophisticated data protection laws, consider requiring the supplier to adhere to the laws of another, more developed jurisdiction, such as the European Union.

Finally, the most widely accepted basis for permitting the transfer of information, regardless of jurisdiction, is obtaining the data subject’s consent. Therefore, obtain written consent from the data subject prior to transferring information to a third-party supplier.

3. Require Consent for Subcontracting

One matter that often gets overlooked when drafting outsourcing agreements is subcontracting rights. While it’s not unusual for suppliers to turn to subcontractors to assist with a project, it’s also not unusual for the supplier to subcontract one or more functions without notifying you.

Again as in the case of the Indian developer who hired his graduate students to help with coding illustrates, you may often learn that a supplier has subcontracted one or more business functions only when trouble arises.

To protect yourself, always be sure that your agreement includes a section on subcontracting rights that carefully spells out when and where the supplier can subcontract. Be sure to include the following provisions:

  • Make sure the supplier can only subcontract with your written consent.
  • Retain the right to review the terms of a subcontracting arrangement before it is entered into.
  • Require the supplier to remain contractually liable for the functions that are subcontracted.
  • Require that, at the very least, the subcontractor’s level of service, systems, and control must be on par with that of the supplier.
  • Retain the right to establish specific parameters or prerequisites for any subcontractor, such as those you might create if you were to hire the subcontractor yourself.
  • Require the subcontractor to be subject to the terms and conditions of the IP provisions of the outsourcing arrangement.
  • Require that the subcontractor hold you harmless and indemnify you for any acts or omissions of the subcontractor.

Finally, while most companies contract the right to periodically oversee the supplier into the terms of the outsourcing arrangement, most never consider requiring oversight of a subcontractor as a condition to subcontracting. However, oversight of the subcontractor should be a condition to subcontracting and should be drafted into the outsourcing arrangement if you want to best protect your interests.

4. Include an Exit Strategy

One reason why outsourcing has become so popular is that it enables a company to respond quickly to changing market needs. However, a change in the geopolitical climate or change in the company’s focus or profitability could necessitate the need to terminate an outsourcing relationship. Moreover, a well-established supplier could suddenly fold or otherwise become unable to perform, forcing you to change suppliers at a moment’s notice.

Be sure, therefore, to develop an adequate exit strategy that takes into account how long it will take you to transition the outsourced business functions back to your home office or to another local supplier. Give yourself the right to terminate the outsourcing agreement early in case things go awry. Also, require the supplier to cooperate with you (and the new supplier) during the transition phase leading up to and following termination of the outsourcing agreement. Finally, consider giving yourself the option to acquire key resources of the supplier to ensure a smooth transition process and retention of key assets.

5. Properly Address Dispute Resolution

Litigation of disputes with a supplier can prove to be your most costly expense when outsourcing. Take, for example, a large US pharmaceutical company that has a dispute with its offshore supplier in Prague. The company decides to bring a lawsuit against the supplier near its Austin, Texas corporate headquarters. However, the company soon learns that under Czech law, all disputes involving Czech companies must be litigated in The Czech Republic absent express agreement otherwise by the contracting parties. Suddenly, the company is forced to find Czech counsel to handle the lawsuit and budget an expensive overseas litigation.

To avoid this type of situation, ensure that your outsourcing arrangement properly addresses how you will resolve disputes. Consider which laws should govern the contract and where disputes will be adjudicated. Also consider requiring all disputes to be arbitrated by a local or international arbitration firm, thereby avoiding courts.

6. Indemnification

Unfortunately, not all suppliers are always as keen to comply with local law as you. In order to ensure that you aren’t left paying for your supplier’s liability as a result of negligent or willful conduct, include an indemnity provision in your outsourcing arrangement.

Such a provision should achieve two purposes. First, it should clearly establish that you are not liable for the acts or omissions of the supplier. Second, it should provide for a broad indemnity provision to insulate your company in case an aggrieved third-party decides to include you in any civil or criminal actions.

Outsourcing has rapidly become an effective management tool to reduce costs, control outcomes, and focus on core business practices. However, because your success is often dependent on foreign cultures, laws, and business customs, it can be replete with pitfalls. A well-drafted outsourcing arrangement can help minimize those pitfalls and soften the blow when unavoidable ones arise.

Jon F. Doyle is a partner in White & Case’s Global Equity Compensation and Financial Services Group in San Francisco. Doyle advises multinational companies and financial institutions on various legal issues related to doing business overseas, including issues related to outsourcing, offshoring, joint ventures, and other means of international expansion. His email address is [email protected].

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