Once an outsourcing project has received the necessary business case approval and the high-level commercial terms are agreed with the supplier, there is often pressure on the project team to “get the deal done.” However, there are a number of critical issues that need to be considered before an outsourcing contract can be signed. Failing to spend enough time on the detail of the agreements at the outset can lead to costly problems in the long run.
Particularly in business process outsourcing, the customer often becomes heavily dependent on the supplier. If the supplier fails to perform for any reason, it will likely have a serious detrimental impact on the customer’s ability to carry out its day-to-day business. It is therefore worth investing time at the outset to get the terms of the agreement right.
Some of the most critical questions a customer will want to ask when drafting an outsourcing agreement are:
- Are we happy with the definition of the scope of work/services to be provided?
- How will change be dealt with?
- Does the Service Level Agreement do what we need it to?
- How can we monitor and proactively address risks so that they don’t turn into problems?
- What are our termination rights? How can we exit the relationship while still ensuring business continuity?
When it comes to the scope of work, both clarity and flexibility are key.
It is important that an outsourcing agreement is clear on what the supplier is obliged to provide. However, too narrow a definition of the scope of work limits the customer’s flexibility. It also increases the risk that the supplier claims “scope creep” and extra remuneration if the customer seeks to deviate, in any way, from the narrow definition.
One way to ensure a balance between the need for clarity and flexibility is to not be too prescriptive on how the work is to be carried out. Instead, the parties should focus on the functions that are to be outsourced and the expected outcomes.
Where there is an overlap in the customer and supplier’s areas of responsibility, the supplier should assume broad responsibility for entire functions, except for specific, enumerated tasks for which the customer retains responsibility. That way, nothing falls through the gaps. The customer’s obligations are clearly delineated, and all other actions that are necessary to fulfill the named function fall within the supplier’s scope of work.
Anticipating and dealing with change
Technology, industry and regulatory changes can impact both the customer’s needs and the supplier’s costs. One critical issue to address at the outset, particularly for indefinite or multi-year contracts, is how the parties will deal with change. When changes do occur, there may be a need to renegotiate the price or other terms of the contract. However, renegotiations can be time-consuming and distract management on both sides from their core activities. To avoid this, certain principles can be agreed upfront such as:
Agreeing that non-material changes will not give rise to a change in price.
Setting out pricing algorithms based on the customer’s consumption of the services. These can provide both parties with certainty if the customer’s consumption varies for whatever reason.
Joint governance procedures to manage change with specific timelines for raising and pricing changes.
Swift dispute resolution measures. Parties can quickly get into an argument about whether something actually constitutes a change and, if so, how much that change costs. For a customer, protracted negotiations can delay the implementation of important processes. Parties should, therefore, consider including a specific dispute resolution mechanism in the contract to deal with change. Such measures might include a binding expert opinion or arbitration to determine whether something constitutes a change and, if so, what a fair price would be to implement that change. Such mechanisms help break the deadlock if the parties have reached an impasse. In addition, sometimes, the mere threat of third party involvement is enough to focus the parties’ minds and help them reach a deal on change faster.
Defining and monitoring Service Levels
The service level agreement (the “SLA”) is often a side agreement signed at the same time as the outsourcing agreement. It is, however, equally important to the parties’ effective relationship and deserves proper attention in order to get the terms right.
The SLA should define the standards to which the supplier is expected to adhere. It should do so in unambiguous language, by reference to clearly defined metrics and robust measurement systems.
The number of service level objectives (“SLOs”) required by the SLA, and the penalties for non-compliance, will depend on the complexity and criticality of the processes being outsourced. However, the main guiding principles when setting SLOs include:
They should be focused on what is really important to the client. They do not need to measure every aspect of the service. Measuring and monitoring too many peripheral issues is not only a waste of resources, both within the customer and the supplier, but it also runs the risk that management will not be able to “see the forest for the trees.”
They should be realistic. SLOs should be set by reference to industry benchmarks and/or realistic forecasts. Unrealistic targets run the risk of costs spiraling, which is not in the interest of either party.
They should be explicit about what is measured, how it is measured, and over what period. The reporting requirements should also be clearly set out. Typically, weekly reporting with a monthly, joint review is sufficient. However, the failure to meet certain critical SLOs may trigger immediate reporting.
While failure to meet SLOs may bring with it a penalty, such as a deduction or withholding of payment, a service bonus or credit model should also be considered to drive good behavior within the supplier and encourage them to go beyond the minimum standards set in the SLA. However, service bonuses will often only be value for money if the over-achievement of the SLAs has a significant, positive impact on the customer’s business or bottom line.
Proactively address problems through shared governance.
In many contracts, when one party fails to comply with its obligations, the remedies for breach are termination and suing for damages. However, the customer will usually have to ensure that it can show default on the part of the supplier before it terminates the agreement. Otherwise, it runs the risk of being accused of wrongful termination and being sued by the supplier for damages. For example, a recent arbitration ruling found that the UK Government had wrongfully terminated an IT project, and that the supplier was entitled to £185 million (US$309 million) in damages and other monetary relief.
Even when things do go wrong, and a breach can be proved, it may not be in the injured party’s commercial interests to terminate the contract and exit the relationship. For this reason, it is important to manage issues proactively, before the breach becomes so serious that termination is the only option. Putting in place joint governance and risk management procedures at the outset helps the parties to do this.
Proactive management of issues might include the following measures:
Setting out a list of events that trigger the reporting requirements and joint governance procedure. In addition to service breaches, the procedure should be triggered by any event that might impact the relationship or the customer’s business in a significant way. These may include reputational issues impacting the supplier, disputes between the supplier and key subcontractors; strikes or issues with key personnel; or downward trends in customer satisfaction surveys.
Depending on the risk associated with the trigger event, the response could range from increased reporting and monitoring (for lower level risks) to third party audit of the supplier or step-in rights for the customer (for higher level risks). These risk management procedures are aimed at helping the parties to address issues before they reach such a critical state that the only viable option is termination.
Termination and Exit
Even with proactive management of risks and issues, the parties will still want termination rights in certain circumstances. The customer should seek a broad right to terminate the outsourcing agreement if the supplier “materially” breaches the agreement, and the customer may want other rights to terminate, including for convenience. The supplier should also have a right to terminate for non-payment by the customer of significant undisputed amounts. In certain circumstances, the supplier may also want to terminate for the customer’s material breaches of any terms that protect the supplier’s intellectual property.
When drafting the agreement, it is very important that the parties plan for termination or expiration. The agreement should require the supplier to provide such assistance as the customer may reasonably require to transition the services back to the customer or to another third party supplier, regardless of the reason for termination. The parties should consider at the outset a non-exhaustive list of the kinds of termination/expiration assistance services required, and set these out in a schedule to the agreement.
These may include:
Requiring the supplier to provide a procedures manual, basically a “how to” guide to allow the customer or another supplier to take over the outsourced processes or services. The agreement should make clear that the customer owns the manual and is free to use as it wishes.
Rigorous requirements regarding the documentation that the supplier is required to create and maintain during the term, which should be handed over at termination/expiration. The customer should have unrestricted access to such documentation during the term of the agreement as well.
A list of what assets are to be transferred to the customer upon termination, and what assets will remain with the supplier. Or, failing that, a clear mechanism for determining which assets will transfer upon termination/expiration.
The above list provides a high-level outline of the kinds of things parties will want to consider when drafting an outsourcing agreement. It is merely a starting point. Every outsourcing agreement will be different and will have its own unique sets of issues. Contract drafters do not have a crystal ball and do not know how the relationship between the parties will evolve. As such, they need to take the time at the outset to ensure that they think through how the relationship will work in practice, and what could go wrong, and include contractual mechanisms to deal with such matters. Taking the time to work through and document these things at the outset can save a lot of headaches further down the line.