Article by Brad Peterson (Chicago), Mark Prinsley (London), and Michael Kalachman (Chicago)

Switching from one outsourcing supplier to another involves the effort and risk of both terminating and entering into an outsourcing engagement. This article highlights some of the key issues for a customer in deciding whether to switch suppliers, in preparing to switch suppliers, and in making the transition from the incumbent supplier to the new supplier. For this article, we assume that the customer outsourced a mission-critical information technology function or business process to a supplier some years ago and is now considering obtaining those services from a different supplier.

DECIDING TO SWITCH SUPPLIERS

Switching suppliers can be both costly (including employee time and effort and legal and consulting fees) and disruptive for the customer and its business operations. Accordingly, the decision to switch suppliers should not be made lightly. The customer should evaluate (1) the additional value that the new supplier could provide, (2) the additional risks in changing suppliers, and (3) the cost of exiting the current outsourcing contract.

Additional Value

The first question to is how much more value a new supplier is expected to create for the customer than the current supplier is expected to create. This is a key to success both because that expected value must outweigh the additional charges and risks described below and because the negotiation team will need to capture that value in the contract with the new supplier. There may be added value because of:

  • Changes at the Customer. The customer may be ready to move to another stage. For example, the customer may see an opportunity for a new supplier to transform the out-sourced function, take on a different scope or provide offshore resources.
  • Changes in Supplier Market. Other suppliers may have developed superior offerings, technologies, methods or processes.
  • Customer Dissatisfaction. In some cases, the supplier may have breached the contract, lost financial stability or otherwise failed in an objective way. In other cases, the supplier may be delivering on contractual commitments but the customer subjectively sees less value than expected. In those cases, the customer needs to determine how much of the fault lies with the supplier—often change is required within the customer.

Each of these, of course, only indicate the possibility of added value. Estimating the level of added value requires analysis and judgment.

Risks in Switching Suppliers

Switching suppliers has nearly all the risks of outsourcing, plus significant additional risks. These additional risks flow from the fact that the function to be re-sourced is no longer internally performed by the customer. These additional risks can include:

  • Lack of Knowledge about the Outsourced Function. Because the customer does not have the internal function under its control, the customer will have more difficulty describing the services in its Request for Proposals ("RFP") or Statement of Work ("SOW"). The incumbent supplier may not be inclined to fully cooperate in providing this information. It’s not enough to turn to the SOW in the existing agreement as that is likely out-of-date or, possibly, includes limits on the scope of services that are part of the problems that led to switching suppliers.
  • Lack of Transferable Function. In outsourcing, the customer has an existing function to sell. By the time a customer is leaving an outsourcing relationship, the incumbent supplier has likely folded the customer’s internal function into a shared service environment that the customer cannot provide to the new supplier. Thus, the new supplier will need to build the function from the ground up, with a greater chance of performance failures that could hurt both the customer and the new supplier.
  • Lack of Time Flexibility. When outsourcing, despite what the executive sponsor may say, it is generally no catastrophe if the start date for the outsourcing is a week or even a few months later than the target date. The customer’s employees and subcontractors simply remain on the job a bit longer as employees or subcontractors of the customer. When the existing contract ends, the customer might find itself without a supplier.
  • Difficulties in Knowledge Transfer. In outsourcing, the key knowledge regarding the out-sourced function is in the hands and heads of customer employees. When changing sup-pliers, the key knowledge is in the hands of the ousted supplier, who tends to see it as competitively sensitive information that cannot be disclosed to third parties, particularly its competitors.
  • Need to Terminate an Existing Relationship. Because outsourcing is a complex, multi-faceted interaction between companies, terminating an outsourcing arrangement often requires considerable negotiation and may involve considerable cost and risk of degradation in service.

Termination Charges and Rights

The customer should also identify potential charges from the current supplier in connections with the outsourcing and the risks posed by the limitations of its termination-related rights under its current outsourcing contract. This is primarily a legal analysis. Termination Charges. The first goal of the legal analysis is to identify the exit alternative with the lowest termination fee. Outsourcing contracts generally allow the customer to exit the relationship for various reasons, each at a different cost. Typically, exit is possible with no termination fee at the contract expiration date or upon a material uncured breach by the supplier. The customer may also have the right to terminate if it pays a termination for convenience fee. However, the termination for convenience fee may be daunting. Exit from the contract may also be possible at a lower termination fee in connection with certain defined events, such as a change in control of a party or a change in laws that has a substantial effect on the outsourcing arrangement. In addition, a partial exit may be possible through a right to de-scope or a right to use third parties, and may allow the customer to retain the best part of the current outsourcing arrangement while terminating other parts.

Termination fees are often negotiable. For example, the facts and legal analysis might indicate, though not conclusively, that the supplier has breached the outsourcing contract in a manner sufficient to justify a termination. If so, the customer and supplier may negotiate a termination fee lower than the specified termination for convenience fee. Similarly, the supplier may be willing to waive the termination for convenience fee if the supplier retains some portion of the work, if the customer agrees to keep the termination and the reasons for termination confidential, or if the decision to terminate the relationship is mutual.

There may also be tactical opportunities for the customer to reduce the termination fees. If, for example, the customer has a right to institute a benchmarking, the result of which is likely to lead to a reduction in the charges, the supplier may be willing to terminate to avoid being locked into the contract at the reduced fees that result from the benchmarking.

Termination Transfer Rights. The second goal of the legal analysis is to identify any rights or obligations to transfer the current supplier’s capabilities to the new supplier. The right to obtain the current supplier’s capabilities might include rights to purchase assets used to provide the services, take assignment of contracts used to provide the services, or to solicit or employ supplier personnel currently providing the services. In addition to the termination rights specified in the contract, the customer may have termination-related rights under law. For example in the European Union countries, the incumbent supplier’s in-scope personnel may transfer automatically to the customer or to the new supplier under the Acquired Rights Directive where the transfer is, in effect, a transfer of an economic entity.

Termination Assistance Services. The existing contract may allow the customer to require the supplier to assist in the smooth transition to a successor provider. These termination assistance services might include documenting customer requirements in connection with the preparation of a request for proposal, writing and executing transition plans, assisting in the novation of material subcontracts, or transferring knowledge to the customer or its new supplier.

The legal analysis may find no termination transfer rights or rights to termination assistance services. However, these rights may be negotiable based on the current supplier’s desire to develop or retain a customer relationship or a reputation for treating former clients well. Obviously, letting a customer fail in an expensive and public way would adversely affect the supplier’s ability to gain new business (though it might help in customer retention). If the customer does need to negotiate for these rights, the customer should consider starting a negotiation quickly, while the current supplier retains a high level of interest in the customer’s good opinion.

Contractual dispute resolution alternatives. The legal analysis should always review the dispute resolution and escalation processes specified in the contract. It may be that there is form of escalation that may provide a route to address the customer’s concerns about the incumbent supplier. Also, this contractual analysis might also reveal other ways to solidify an argument by the customer that it is entitled to terminate for cause.

CHARTING THE TRANSITION COURSE

Once the customer decides to switch suppliers, proper planning helps to capture potential value and mitigate risk in switching suppliers. The planning required includes almost all the planning required for an outsourcing. In addition, it involves the following issues:

  • Commencement Date. The customer should determine, as a critical date instead of an objective, the date on which the new supplier will take over responsibility for the services from the current supplier. Generally, customers need at least six months, and more likely nine months, between the time that they decide to seek other suppliers to the transition date under the new contract.
  • Overlap Period. The customer should plan on a period of time during which the current and new suppliers will both be performing services to allow for knowledge transfer and to minimize risk. During the initial portion of this overlap period, the current supplier should remain primarily responsible for the performance of the services, while the new supplier performs transition activities, including ensuring that its employees receive the requisite know-how and information from the current supplier and the customer. Later, the customer may wish to have the two suppliers run parallel operations to ensure that the new supplier is performing in the same manner as the old supplier, possibly even after the transition date of the new arrangement.
  • Termination Notice. Outsourcing contracts generally prescribe minimum notice periods for termination. In some cases, there is a minimum notice period to avoid an automatic renewal. Once the customer has determined the transition date and the required overlap period, the customer’s legal staff should analyze when to give the notice. For example, in a termination for convenience, it is common to require the customer to provide notice to the supplier between 90 days and six months prior to termination. Giving effective notice in accordance with the current agreement within the required time period is critical to being able to terminate the existing arrangement as expected. Note, however, that it may be worth informally notifying the existing supplier to begin to obtain transition assistance services.
  • Disclosure of Information. The more information the customer can provide to the new supplier regarding the services and the customer’s environment in connection with the RFP and during due diligence, the more meaningful the supplier’s response and the smoother the transition will be. However, suppliers often consider this information to be confidential and obtain contractual protections against disclosure to competitors. Thus, the customer, with the assistance of its legal advisors, should review the existing contract to determine if there are any confidentiality restrictions that may limit the information related to the outsourcing relationship (including the contract itself) that can be disclosed to the prospective suppliers. Where the Acquired Rights Directive applies in Europe and employees will transfer, there may be arguments about the amount of data about those employees that the incumbent supplier may disclose to the customer or the potential new supplier because of data protection/privacy concerns. These concerns can usually be overcome but they do give ammunition to the uncooperative incumbent supplier.
  • Select and Notify Bidders. The customer should identify, based on its comparative benefit and risk analyses, the suppliers that it would like to invite to bid. Those suppliers should be contacted to determine if they are interested in responding to the re-sourcing RFP. As far in advance of the Transition Date as possible, the customer should distribute the RFP to all interested prospective suppliers and commence negotiations with one or more suppliers.
  • Transition Plan. The transfer of an outsourced function to a new supplier is a precarious and intricate exercise that can be accomplished with greater ease and less disruption with proper and timely planning. As part of the termination assistance services, the customer should have the current supplier prepare a detailed plan for the timely transition of knowledge and the services to the new supplier. The transition plan should include the tasks to be performed by the current supplier, the new supplier, and the customer, and applicable milestones and completion dates.
  • Governance. The ability of all three parties to work together effectively and efficiently during the overlap period will be instrumental in achieving a smooth transfer of the services. The customer should consider how the relationship among the customer and both suppliers will be governed and consider formally negotiating a three-way governance arrangement.
  • Assets and Contracts. For operational continuity and/or economic reasons, the customer may want the new supplier to utilize some or all of the equipment and/or contracts used by the current supplier to provide the services. Whether or not the customer has necessary termination transfer rights, the customer should, with the help of the current supplier and the new supplier, identify which equipment it wants to purchase from the current supplier and determine pricing. In addition, the customer should identify any leases, licenses, and other contracts that it wants the current supplier to assign to the new supplier. It’s also worth asking whether there are contracts that the former supplier would pay money to be able to assign—some suppliers enter into long-term contracts that can be a significant burden in a termination.
  • Subcontracts. The customer should consider whether it wants the new supplier to continue to use the services of any subcontractor currently performing services under the outsourcing agreement. In making this determination, the customer should assess the importance of the subcontracted function and the level of the subcontractor’s knowledge regarding the customer’s environment and the services. As with other contracts, it’s worth determining whether accepting assignment of a contract from the current supplier would provide value to the current supplier.
  • Current Supplier Personnel. The success of the re-sourcing may, in large part, depend on the continuity of key personnel resources throughout the transition to facilitate the transfer of knowledge from the outgoing supplier to the new supplier. Accordingly, the customer should determine if there are any employees of the current supplier (or its subcontractors) that it would like the new supplier to hire. Any no-hire and right-to-solicit clauses should be reviewed. Together with the current supplier and new supplier, the customer should determine when and how the designated supplier personnel will be notified of the employment opportunity with the new supplier. The customer should also cause the new supplier to initiate any internal processes necessary to hire any former-supplier employees that accept its offer of employment. Where the outsource operates in any part of the European Union, the Acquired Rights Directive means that, as a matter of law, employees will move across with the transfer of the economic entity. The legal analysis will need to establish the extent to which the Directive bites on the proposed re-sourcing and what protections the customer has against the incumbent supplier swapping in less able staff onto the account so that when the transfer takes place, the new supplier does not get the most skilled staff.
  • Projects in Progress. The customer should consider how to allocate responsibility for any projects that the current supplier may be working on when its contract terminates. With respect to any given project, the customer may opt to (1) complete the project itself, (2) terminate the project, (3) transition the project to the new supplier, or (4) have the cur-rent supplier complete the project on an accelerated schedule as part of the termination assistance services. The determination regarding how the projects in progress will be handled should be reflected in the transition plan described above.

IMPLEMENTING THE TRANSITION

After a new supplier is selected and signs a contract with the customer, the customer will need to implement the transition. The tasks include:

  • Transferring Knowledge. As stated above, the key to a successful re-sourcing transition is the timely, effective, and complete transfer of knowledge from the current supplier to the new supplier. The transition plan should detail how the parties intend to accomplish this knowledge transfer, provide for numerous checkpoints during the overlap period, and identify objective criteria to measure the adequacy of knowledge transfer at each checkpoint.
  • Obtaining Documentation. The customer should seek to obtain copies of all documents used by the current supplier in providing its services (to the extent possible under the current agreement). These documents may include (1) a policy and procedures manual, (2) any manuals prepared by the current supplier regarding the customer’s systems, equipment, software, or any materials developed by the current supplier under the outsourcing contract, (3) any documented architecture standards for the customer’s environment, or (4) any documents related to equipment purchased or software transferred from the current supplier to the customer or the new supplier.
  • Hiring Current Supplier Personnel. In addition to transferring knowledge from the current supplier workforce to the new supplier workforce, as discussed above, the customer may want to retain certain key members of the current supplier’s team on its account and in the European Union, will have obligations to take staff with the transfer of the business. The customer should arrange to interview, make offers to, and hire (or have the new supplier make offers to and hire) those individuals identified during the planning process.
  • Entering into Subcontracts. The new supplier should enter into subcontracts with the vendors identified by the customer during the planning process. The current supplier may be required (or, if not required, willing) to assist the customer and the new supplier in negotiating a new subcontract with the vendor on terms similar to the terms in the current supplier’s existing subcontract.
  • Purchasing Equipment. If, during the planning process, the customer decided to purchase (or have the new supplier purchase) any equipment used by the current supplier, the bill of sale or other transfer document should be completed and signed prior to the transition date. The customer should take care to obtain from the current supplier all documentation, licenses to microcode and other software provided with the equipment and, to the extent possible, any manufacturer warranties.
  • Transferring Leases, Licenses, and Other Contracts. The parties should work together to transfer or assign from the current supplier to the new supplier any equipment leases, software licenses, or other contracts that are to be assigned to the customer. The customer should take care to ensure that appropriate consents are obtained and that the third party states that the contract is in full force and effect, with no defaults and no amounts outstanding. It is also valuable to obtain a waiver of any past claims from the third party unless the dying agreement includes an indemnity for claims arising prior to the assignment. (This issue is often not addressed in outsourcing agreements, meaning that the liability for supplier’s defaults could be transferred to the customer.)
  • Notifying Managed Third Parties. The customer should terminate all letters of agency and similar documents granting rights to the current supplier as of the transition date. New letters of agency or similar documents should be provided, giving the new supplier managerial responsibility for the contract.
  • Obtaining Customer Data. The provisions of the current agreement related to customer data are worth reviewing in detail. Some suppliers claim that they own data about their customer’s business that they gather, create, or derive under outsourcing agreements. The customer should obtain copies of its data to the maximum extent permitted by the outsourcing agreement. Customer data may include data related to the current supplier’s performance of the services (e.g., service level data) or data related to the customer’s business (e.g., employee information, customer lists, financial data, etc.). Following the completion of its termination assistance services obligations, the customer should ask the current supplier to return or destroy any customer data in its possession for confidentiality reasons.
  • Obtaining Developed Materials. The customer should request that, prior to the Transition Date, the current supplier provide to the customer or the new supplier copies of all materials developed by the current supplier under the outsourcing agreement that have not been provided previously. In addition, the current supplier should provide the source code for these developed materials to the extent the customer is entitled to receive source code under the outsourcing contract.
  • Arrange Access to Current Supplier Facilities. The customer should arrange for the new supplier to have access to the current supplier’s facilities during the overlap period if such access is required to conduct knowledge transfer activities or perform the other tasks specified in the transition plan. The customer’s outsourcing contract with the current supplier may provide the necessary facility access rights.

These are only the core tasks. Every change of suppliers is different, with unique and vexing issues arising from the unique aspects of the current outsourcing contract, the scope, the technology, and the business. However, by following this basic roadmap, along with good sourcing practices, a customer can significantly increase the value and reduce the risk of a change in suppliers.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Mayer Brown is a combination of two limited liability partnerships: one named Mayer Brown LLP, established in Illinois, USA; and one named Mayer Brown International LLP, incorporated in England.