United States: Key Issues In Outsourcing: A Supplier’s Perspective

Last Updated: October 12 2005

By Stuart Pergament and Linda L. Rhodes (Washington D.C.)

In most, if not all, outsourcing transactions, suppliers find themselves in a competitive environment. This environment often involves the issuance by a prospective customer to several suppliers of a request for proposal that likely contains business and legal terms and conditions and requires suppliers to indicate their willingness to accept them. In addition, many prospective customers use advisors, both business and legal, who use solicitation/ negotiation procedures designed to elicit the best pricing and legal terms and conditions for their clients. Most suppliers recognize that the leverage lies with customers, but the more recognized and proficient suppliers have contracting policies that, while flexible and subject to reconsideration on a case-by-case basis, limit the degree of financial and legal risk that they are willing to undertake. While this article does not purport to represent the views of all outsourcing suppliers, it attempts to express the high-level perspective of some of such suppliers with respect to certain key outsourcing issues based on the experience of Mayer, Brown, Rowe & Maw LLP.

The fundamental tension between customers and suppliers is (1) the desire of customers to obtain all of the services that they are receiving during a period prior to contract signing under terms and conditions that require ongoing improvements to such services, as well as to avoid unexpected increases in cost due to changes, including changes to the services that may be dictated by events that are not within the control of either of the parties, and (2) the desire of suppliers to perform the services on the basis desired by customers and to realize a reasonable and predictable profit. The increasing sophistication of customers, as well as their use of advisors, has resulted in a tightening of profit margins. Accordingly, suppliers increasingly focus on the pricing adjustment and liability-related provisions of the outsourcing agreement, in part, to reduce the likelihood that their profit margins will be further eroded.

This article discusses the perspective of customers and suppliers with respect to the definition of the services, but its principal focus is several of the critical price adjustment and liability- related issues that are encountered in standard outsourcing agreements.

Scope of Services. While many commentators customarily state that a well-defined scope of services will prove to be beneficial to both the customer and the supplier, this perspective may not be shared by all customers. The benefit to the customer that is most often cited is that a welldefined scope of services will not require a supplier to build into its pricing a "risk premium" that will diminish the size of the cost savings the customer is looking to attain. However, customer advisors have an excellent sense of the costs associated with outsourcing and the competitive supplier selection process will result in, at a minimum, the diminution of any such risk premium. Accordingly, customers may not only use broad wording to describe the services, but also may use so-called dragnet provisions (e.g., all services, functions and responsibilities that are required for the proper performance of the services; all services that were provided in the last 12 months) to limit the ability of the supplier to seek an adjustment in pricing or other contract terms. Asupplier may reduce its risk through extensive due diligence, but suppliers are often not provided with adequate access or time to conduct it, and suppliers must weigh the substantial costs of such due diligence against the likelihood of selection.

Suppliers generally attempt to use the following approach to define the scope of the services:

  • A description that describes each category and each major sub-category of the services. This will generally be augmented by a matrix that covers the tasks for such categories and sub-categories and allocates the related responsibilities to supplier, customer or both.
  • A provision that acknowledges that all subtasks necessary to perform the services are included in the services.
  • A provision that acknowledges responsibility for those services within such categories and sub-categories that were performed in the last 12 months, to the extent that such services were confirmed during due diligence, the supplier is hiring the customer employees that were performing such services and the supplier has built in a reasonable risk premium to cover any potential gaps in the foregoing.

Notwithstanding this approach, suppliers will not generally forego contract change language in the outsourcing agreement. This language typically requires the parties to meet to discuss the schedule and fees in the event there is a change in the service needs or requirements of the customer due to (a) the customer’s request for new services or changes in services that are different from prior services, (b) certain performance failures by the customer (e.g., the failure to provide adequate or accurate information, the failure to perform timely any of its responsibilities) and/or its other service providers, (c) certain events that are not within the control of the parties (e.g., force majeure events experienced by the customer) or (d) a failure of assumptions in a statement of work not being realized in any material respect.

Grant of Exclusivity to Supplier. Suppliers desire the outsourcing agreement to contain an exclusivity provision with respect to the services and, perhaps, new (but related) services. This provides the supplier with a reliable revenue stream, control over the outsourced function and an opportunity to provide additional services at attractive rates. The customer will typically resist complete exclusivity because it locks the customer into a single supplier that may not turn out to be the best choice for all functions or geographies, especially in later years. The lack of an exclusivity provision also enables the customer to maintain competitive pressures on the supplier’s pricing and performance.

Suppliers will generally accept a limited form of exclusivity or an equivalent protection, including minimum volume or preferred provider protections. These protections might include the following: tiered pricing that requires higher unit costs if anticipated volume is not achieved, minimum volume commitments, percentage of the customer’s requirements, exclusivity for a limited time period, exclusivity limited to supplier’s core competence and right of first refusal or right of first offer on new services.

Most Favored Customer. A typical most favored customer provision requires the supplier to provide the services at the lowest charges that it applies to other commercial customers for the "same or substantially similar" services. This formulation and, indeed, most others that are used, are ambiguous (e.g., substantially the "same" vs. substantially "similar") and do not address the complexities of pricing. These complexities include whether the provision applies to all of the services (or may be considered by each category of services), the volume of the services (and the effect of reducing the volume of the services) and the various risk factors associated with the services (e.g., the service level and service level credit formulations and the other liability-related provisions).

Accordingly, suppliers generally attempt to have these types of considerations incorporated into the most favored customer formulation. However, given the reasonable changes that will likely be suggested by a supplier and accepted by most reasonable and sophisticated customers and their advisors, the likely continuing lack of objectivity in any formulation and weighing the benefits of such a provision against the likelihood that it will be used meaningfully by the customer, some customers and suppliers ultimately agree to delete such a provision from the outsourcing agreement. This still leaves the customer with the benchmarking provision to obtain fair pricing.

Compliance with Laws. An outsourcing agreement will typically require that, with respect to the provision of services and the performance of its other contractual obligations, the supplier will comply with all applicable laws and may also require that software, equipment, systems and materials owned, provided or used by the supplier in providing the services are in compliance with all applicable laws. The supplier will typically counter with a provision that attempts to make clear that, while the supplier may have extensive experience in information technology or the other special areas being outsourced, the supplier is not providing legal service and cannot accept responsibility for the customer’s legal obligations. Notwithstanding this difference in contractual outlook, suppliers will not generally bear the risk of compliance with undisclosed legal requirements that are specific to the customer. Accordingly, the following approach will generally be considered by suppliers:

  • Supplier will be responsible for identifying and notifying the customer of laws and changes in laws applicable to the supplier’s performance, and the customer’s receipt of the services.
  • Customer will identify and notify supplier of any laws and changes in laws applicable specifically to the business of the customer or its use of the services.
  • Supplier will be responsible for all of such laws and changes in laws, subject to the following:
    • Supplier will bear the cost of compliance with changes in laws applicable to its provision of the services.
    • Customer will bear the cost of changes in laws specifically applicable to the business of the customer or its use of the services.

However, certain laws require special note, including data privacy laws and Sarbanes- Oxley. Data privacy laws, in most cases, impose obligations directly on the customer, whether or not the customer uses service providers to process or otherwise have responsibilities with respect to customer data. Customers customarily try to require suppliers to provide back-up liability for their acts or omissions that result in violations by the customer of data privacy laws. In addition, customers generally require suppliers to enter into additional agreements to assist customer with its compliance obligations (e.g., model clauses acknowledged to create a safe harbor under data privacy laws). Supplier will, as a practical matter, be willing to provide such back-up liability and to enter into such additional agreements. However, such model and other contractual clauses impose broadly stated security and other obligations on suppliers and must be carefully reviewed by suppliers to determine whether their current policies and procedures, and technology, will enable compliance without substantial additional cost or legal risk.

The obligation for interpreting the requirements of Sarbanes-Oxley and determining the control objectives necessary for compliance therewith also will remain with the customer. Customers may deal very broadly with Sarbanes-Oxley by use of a general statement to the effect that supplier will comply with all obligations imposed on customer under Sarbanes- Oxley. Suppliers will generally attempt to limit any such compliance obligation to shared implementation responsibility with respect to the requirements of Sarbanes-Oxley that are implicated by the particular services being performed by the supplier. In addition, consistent with a well-defined scope of services, the suppliers will generally attempt to limit this aspect of the services to those tasks that customer has determined are necessary for customer to achieve compliance with its obligations under Sarbanes-Oxley. Such tasks should be set forth in an exhibit to the outsourcing agreement.

Scope of Indemnity. The typical indemnities requested by customers range from the very broad (e.g., a breach of any warranty or covenant under the outsourcing agreement) to the very narrow (e.g., the introduction of viruses into customer systems). In addition, there may be mid-range indemnity requests (e.g., a breach of security-related obligations). The scope of indemnities is of critical importance to suppliers because a supplier’s indemnification obligations are customarily outside of the limitation on liability protections afforded the supplier (i.e., a monetary cap and no consequential or similar damages). Accordingly, while each of the requested indemnities warrants scrutiny, and likely narrowing by suppliers, the focus here is on the broad to mid-range indemnities.

Before considering the subject matter of specific indemnities, it is worthwhile to focus on the indemnification formulation. In many cases the supplier is requested to indemnify for any and all claims and losses. While indemnity is generally thought to provide protection with respect to third-party claims, the foregoing could be construed to cover direct claims by the customer and any and all losses incurred by the customer, whether direct or consequential. Accordingly, such a formulation, when combined with broad indemnification obligations, could render the limitation on liability provisions in the outsourcing agreement meaningless. Asupplier will generally attempt, with limited exceptions (e.g., personal injury), to limit indemnity to only third-party claims and for losses equal to the amounts payable to the third-party claimant and, if the supplier fails to defend, the legal expenses incurred by customer in defense of the claim.

In considering the scope of the indemnities, suppliers typically resist a general indemnity for a breach of service-related warranties and covenants. Such an indemnity would, at a minimum, subject the supplier to open-ended liability for third-party claims, and, in the event the supplier fails to limit its indemnity obligations to third-party claims, would subject the supplier to open-ended liability for claims by the customer. Suppliers strive to limit the indemnities to enumerated and circumstantial obligations under the outsourcing agreement and to not provide indemnity for any services-related obligations.

Service Levels. In many cases, the customer will not have sufficient data for setting performance standards for the service levels at the commencement date. In such cases, the outsourcing agreement will typically include a monitoring period during with the supplier will measure its performance of the services previously performed by customer to determine repeated performance standards, and based upon such measurements, the parties will set the performance standards to which the supplier will be responsible thereafter. A similar monitoring period will apply when a new service level is added.

The customer will typically request an over-allocation of the service level credits. Suppliers will generally attempt to limit such over-allocation to all service levels, but not also within categories of service levels. Such multiple over-allocations can substantially increase the likelihood that the supplier will have to pay service level credits. Further, the supplier will generally require that there be caps on the allocation of service level credits so that no one service level will be allocated more than an agreed-upon percentage of the at-risk amount. If a single incident results in the failure of the supplier to meet more than one service level, the customer will typically have the right to select any one of such multiple service level defaults for which it will be entitled to receive a service level credit; however, the customer will not be entitled to a service level credit for more than one of such service level defaults.

Finally, suppliers strive to require that all or part of the service level credits be counted against the monetary cap on liability.

Limitations on Liability and Exclusions. Outsourcing agreements generally contain a monetary cap on liability and an exclusion of consequential, incidental and other indirect damages and punitive damages. The discussion about the monetary cap on liability usually revolves around the number of months of charges that the supplier will have at risk and how such monetary cap will be calculated before such number of months transpire (e.g., a number of months times the estimated monthly charges or a fixed dollar amount that is supposed to approximate such amount of charges). This number of months is transaction-specific but typically is in the mid-range between nine (9) and fifteen (15) months. In addition, significant negotiation often occurs around what items will be excluded from such limitations on liability. The typical customer requested exceptions from the foregoing limitations of liability include bodily injury (including death), damage to tangible personal property, violations of laws, the indemnities, wrongful termination of the outsourcing agreement or supplier’s refusal to provide termination assistance, willful misconduct and gross negligence. These exclusions mean that the applicable party will remain liable without limitation for the excluded claims, despite the limitations on liability.

The exclusions for bodily injury (including death), physical damage to tangible personal property, violations of law, the indemnities (provided that the exclusion from consequential, etc., damages are limited to those payable to the third-party claimant), wrongful termination/failure to provide transition services and willful misconduct, will more often than not be accepted by a supplier. Suppliers are generally concerned about excluding from the limitation of liability loss or damage of software and data, and therefore typically seek to avoid such exclusions.

Before agreeing to such a carve-out for gross negligence, the supplier will generally consider which laws apply to the agreement and the definition of "gross negligence" under such laws. An exception for gross negligence may be appropriate where, under the applicable law, gross negligence requires some form of wanton or reckless conduct, but it might not be appropriate if, under the applicable law, gross negligence is defined or interpreted to be more akin to mere negligence.

The customer may ask that losses occasioned by any breach of a party’s representations and warranties be excluded from the limitations of liability. The same principle applied to the indemnification provisions, as described above, should apply to the exceptions to the limitations of liability—the supplier will generally be careful to limit which representations and warranties are excluded to be sure that they do not include service-related representations and warranties.

Termination. Suppliers often incur large initial costs in transitioning the outsourced function from the customer’s environment and processes to the supplier’s environment and processes. In some cases, suppliers also incur large costs in transforming the customer’s operation with substantially better technology or processes.

Customers often prefer not to pay for these transition and transformation costs as incurred. Instead, they want to pay the same amount each year, allowing them to stay within their original budget and possibly begin to save money even in the first year of the agreement.

As a result, in outsourcing, suppliers often accept losses in the first year(s) of the contract to gain high profits in the later years. However, the prospect of those high margins is subject to many risks, such as termination for convenience, termination for cause, customer insolvency and reductions in scope.

Most customers will require a termination for convenience provision in the outsourcing agreement. The supplier may agree to such a provision but only after an initial period during which it has recouped some of its initial costs and/or include termination for convenience fees that protect it against losses related to those upfront costs.

If a customer has a right to reduce the scope of the services being outsourced, such a right is, in essence, a termination for convenience right. Accordingly, a supplier will generally resist granting to the customer such a right unless the customer is obligated to continue to pay for the terminated services or pay termination for convenience charges. At a minimum, the foregoing should hold if the customer terminates certain of the services, perhaps above a threshold amount.

One of the most troublesome termination for cause provisions is multiple or repeated breaches which, while not individually material, are in the aggregate material. This provision sometimes comes without a cure right. Accordingly, a supplier may not be on notice of the less than material breaches or, whether or not on notice of such breaches, may have cured each of them promptly or within the cure period prescribed for material breaches, and still be subject to termination. Suppliers generally attempt to limit this provision to multiple or a fixed number of breaches of substantially similar obligations and to require customers to provide notice of these breaches and to provide a shorter cure period, vis-à-vis the cure period for material breaches, for the last of such breaches that would otherwise trigger a termination right.

Intellectual Property Rights. The customer will generally turn over control of substantial amounts of its intellectual property to the supplier. The customer will desire to continue ownership of intellectual property provided by the customer, including ownership by the customer of intellectual property created by the supplier under the outsourcing agreement in the performance of the services.

The supplier may also provide to the customer access to some of its intellectual property or use such intellectual property in the performance of the services. Customers often attempt to require supplier to provide to customer and its other service providers a broad license in supplier’s intellectual property that is used in the performance of the services. Supplier will generally permit use of its intellectual property by customer only to receive or use the supplier’s services and deliverables. Supplier will generally strive to retain rights in all derivative works of its own intellectual property.

The supplier will typically be willing to grant the customer ownership to deliverables (and sometimes other work product, other than that created for, or usable to provide services to, customers generally) developed by supplier in the services. Notwithstanding the foregoing, the supplier generally retains ownership of any of its intellectual property, including methodologies, processes and the like incorporated into those deliverables and grant to the customer a limited license to its intellectual property incorporated into the deliverables (i.e., as incorporated into such deliverable and only for customer’s internal purposes).

The above sets forth critical outsourcing issues from the supplier’s perspective. Of course, the parties may negotiate many other important issues in the contract formation process, and a full legal and business review of the issues is always essential.

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.

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