Outsourcing A partnership - working together to achieve common business goals

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1 Outsourcing A partnership - working together to achieve common business goals Over the next five years, the global market for outsourcing is anticipated to be anywhere between 10 billion and 3,000 billion. However the market size is calculated, two factors remain outsourcing is a huge industry and it is growing. For many years outsourcing was viewed as a purely operational matter, focused on cost reduction and quality issues. Increasingly, it is considered in terms of corporate strategy and generating shareholder value.

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3 What is outsourcing? Outsourcing has become the term of art to cover the supply by a third party of a service previously carried on by a customer (or a previous supplier) which often (but not always) involves the transfer to the Service Provider of certain of the business functions of the customer. CMS Cameron McKenna has substantial experience in assisting clients to identify and anticipate commercial and legal issues when outsourcing services The reason why a business decides to outsource will be critical to the success of the outsourcing activity. Typically, reasons given for outsourcing include: focus on core business cost savings (opex or capex) improve the quality of service and encourage innovation reduce headcount free up capital locked into nonproductive assets The key to a successful outsourcing transaction is to identify at the outset the objectives of the outsourcing and the risks that will arise from the loss of direct control over the performance of the outsourced operations, and then to strike the right balance between the interests of the customer and its supplier. has substantial experience in assisting clients to identify and anticipate commercial and legal issues when outsourcing services. We can work with your procurement and operational teams to identify your key requirements, including the services to be outsourced, the most appropriate structure for outsourcing (including the transfer of employees) and the level of service required and price controls. We see our role as being more than that of drafting the contracts. We add value by helping to facilitate the transaction and act as project managers. CMS Cameron McKenna is a member of the National Outsourcing Association and is a regular attendee and speaker at other industry events this enables us to keep abreast of developments and trends in outsourcing. We welcome the opportunity to become involved as early as possible in an outsourcing transaction so that we can understand the reasons for the project, the business issues and objectives, the internal resources available and to identify the role and responsibilities to be undertaken by us, thereby assisting us to help you assess the issues and the risks involved in the transaction. What is being outsourced? Historically, businesses have tended to outsource activities such as IT provision, including data centres, call centres, facilities management and payroll non-core Outsourcing 3

4 The key to a successful outsourcing transaction is to identify at the outset the objectives of the outsourcing and the risks that will arise from the loss of direct control functions which can be delivered effectively by other, more specialist, service providers. The success of these activities has encouraged many businesses to reconsider the boundaries of what they consider to be strategic core business functions with the consequence that outsourcing is increasingly seen as applicable to a host of additional business processes. For example, we recently advised an international hotel company on the outsourcing of its catering operation, and the Royal Mail on outsourcing its employee health services. Business process outsourcing or BPO can extend to a whole range of other functions such as human resources, finance and accounting, first and second line maintenance, supply chain management and research and development. Offshoring? Businesses are increasingly outsourcing functions offshore, primarily to benefit from lower labour costs and flexible working practices. That said, a variety of factors need to be considered in choosing an offshore location such as language, government support, infrastructure, labour pool, political stability and data/ip security. Preferred countries or regions have varied over the years and include India, a favoured location for IT outsourcing and IT based BPO, as well as Eastern Europe, The Philippines and China. Outsourcing offshore raises a number of additional legal and commercial issues for a business. Additional consideration needs to be given to issues such as: regulatory authorisations and compliance in the home country of the client business and the location of the service provider; employment considerations on migration; exit mechanisms at the end of the term; offshore benchmarking; taxation consequences; multinational dispute resolution; and multicontracts where the client business outsources group functions based in a number of jurisdictions. We have experience in managing offshore outsourcings in conjunction with local lawyers in other jurisdictions where appropriate (and whether part of the CMS network or independent law firms). Recently, for example, we have advised a manufacturer on the outsourcing of its accounting function from a number of European jurisdictions to service centres in the Czech Republic and Mauritius. Outsourcing 4

5 The outsourcing process Planning and implementation Outsourcing should be treated no differently to any other business opportunity. It should be properly planned and clear objectives and priorities should be set. We see our role as being more than that of drafting contracts. We add value by helping to facilitate the transaction and act as project managers. A priority may be to save costs. The level of cost savings should therefore be identified, as should all the associated risks which may arise out of such cost savings. An objective may also be to achieve a better level of service, therefore the service specification and objective and measurable service levels should be identified early on and weighed up against the potential for increased costs. The outsourcing Service Agreement subsequently drafted by us would reflect the choices made. At the outset of the transaction, we can assist you in the following areas: Identifying due diligence requirements We would consult with you to identify what preparatory work has been undertaken to date, to review your documentation and to advise on any other work required before and during the tender process. For example, we will advise about the information that is likely to be required by the bidders regarding the scope of the project, the importance of identifying current service levels in order to establish benchmarks for the future standard of service to be provided and any applicable procurement regime. Review of existing documentation and advice on impact of the outsourcing on other operations We would also review the scope of your existing arrangements and documentation to assess the impact these might have on the project. In another recent project, we were required to work directly with the client s internal IT team to assist them in identifying all the IT and telecoms requirements for their service agreement. We worked with the client in identifying the way in which the provision of these services affected other business units outside the outsourcing process. Our understanding of telecoms and IT standards also helped our client to prepare a comprehensive technical schedule for the invitation to tender. Advice on structuring options We will advise you about the optimum legal and commercial structures for the services. For example, businesses have been transferred to a new SPV in which the customer takes a stake, akin to a joint venture. This structure has been used where the supplier and customer Outsourcing 5

6 We will work with you in advance to identify the assets to be transferred and the rights to be granted to the outsourcing partner in respect of retained assets which are required for the provision of services. We are also able to advise you on structuring the transaction in a tax efficient manner. believe that the SPV may be able to provide services to third parties as well with the supplier and customer sharing in the profits. It has also been used for mitigating tax in certain sectors. This structure offers the benefits of ring-fencing assets and enables those assets to be easily transferred back to the customer or a substitute supplier through a transfer of shares in the SPV. On the other hand this model may not offer the managerial clean break required by the customer. Conflicts can arise between the supplier and customer when the joint venture is trying to exploit new business opportunities. The joint venture model may also prevent the supplier realising economies of scale that greater integration into its organisation might achieve, resulting in higher fees. Factors affecting the legal structure to be adopted will also include whether the outsourcing is single or multi-site, single or multi-jurisdictional in scope, and amount and timing of the capital investment required from the supplier. Invitation to tender ( ITT) If you are planning to outsource services, CMS Cameron McKenna can help you plan and structure an ITT so that it achieves its purpose. We will work with you in advance to identify the assets to be transferred and the rights to be granted to the outsourcing partner in respect of retained assets which are required for the provision of services. We are also able to advise you on structuring the transaction in a tax efficient manner. For example, pricing of any legacy assets which are to move across to the supplier or joint venture and pricing of services would be considered from a tax and accounting viewpoint. We would also offer the benefit of our experience on leasing (operating and finance), if third party finance were considered appropriate. We are experienced in preparing the contractual documentation required for an effective tender in order to elicit full responses from suppliers. We can advise you on the preparation of the tender documentation so as to ensure that all relevant information is included. We can also advise and assist you in preparing the supporting schedules and draft contract to be included in the ITT. For example, we were involved in an outsourcing where there was a particular requirement that an IT supplier should develop a program to effect an upgrade that would fulfil Outsourcing 6

7 We can assist clients in the proper use of change control procedures and the appropriate way of documenting such changes. both the customer s existing and future needs. This meant that the tender documentation had to include information about both existing and future requirements. We worked with the client s procurement team to prepare the tender documentation, including contractual documentation and service level agreements. We then assisted the client in assessing the suitability of the submissions and measuring the responses. We can also provide assistance in assembling the contents of the data room. This can involve anything from assisting in the early identification of data protection issues or advising what is and what is not material, in the context of the proposed transaction, to running the data room. In dealing with due diligence enquiries we typically liaise closely with clients to provide a central control point for handling information requests smoothly and without unnecessary duplication. Once bids have been received, we can help you evaluate them to choose the correct service provider for you. from those tasked with negotiating the agreement and their advisers but also involving representatives of the team that will be responsible for implementing the project. The transition Clients are, invariably, concerned about business interruption during the period when the assets, employees, hardware or software are being transferred over to the Service Provider. We can help identify and negotiate transitional services arrangements specifying all the steps required for a smooth transition. This may involve assessing any ongoing projects and determining if these should continue or be suspended during this transitional period. We understand the importance of maintaining service levels during this period and we can assist in planning for this. Implementation We do not regard our role as completed on signing of the transaction. We believe that outsourcing differs fundamentally from a corporate disposal. The essence of the continuing transaction is the receipt of service after signing the contract. We have extensive experience of assisting clients in the transition phase, implementing the provision of the service and managing the ongoing relationship. Over the period of the contract, changes are an inevitable, and desirable, part of any outsourcing. We can assist clients in the proper use of change control procedures and the appropriate way of documenting such changes. Contractual arrangements The production of all the relevant legal documentation, including the Asset Transfer Agreement, the main Services Agreement, and all ancillary documentation is a key part of the lawyers role. We would work closely with you to develop the service levels to be incorporated in the main agreement or in a separate Service Level Agreement. The aim of the process is the negotiation of a robust and workable agreement. This requires a combined effort not only Outsourcing 7

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9 Specific issues Services It is imperative that the services to be outsourced are clearly identified, including any part of the services the customer wishes to retain. This may not be so straightforward. We have found that clear, defined and measurable performance standards are key to ensuring that the customer gets what they want and that the service provider understands what it is required to deliver. We can help clients define the service boundaries, both in terms of the business units (including associated employees) and the physical and technical infrastructure. We will seek to ensure that the services definition is sufficiently fluid to allow for changing service requirements during the course of the outsourcing agreement. For example, when acting for a client in the outsourcing of its financial systems and services, we had to plan and organise the services on a pan-european basis, taking into account the additional tax, employee, privacy and cultural differences as well as legal differences. We liaised with foreign lawyers appointed by our client, as well as other members of our CMS European network, to ensure that the client received a consistent level of service. Performance standards We have experience in assisting clients in developing services descriptions for a wide range of technology and business process outsourcing arrangements. The assignments have ranged from health related services to different types of transaction processing, call centres, catering and hotel reservation systems. We have found that clear, defined and measurable performance standards are key to ensuring that the customer gets what they want and that the service provider understands what it is required to deliver. These obligations should include as a minimum: the nature of the performance standards (for instance, legislative compliance, quality of services, financial performance) how compliance is measured (e.g. customer satisfaction, service availability etc) who measures the machinery and procedure of measurement dealing with change At the outset, therefore, one needs to break down all the key components of the service being outsourced and to apply specific benchmarks and measurement processes to each particular aspect of that service. This can be a difficult and time consuming process as often these services have never been analysed or broken down before. Outsourcing 9

10 it is essential to insert provisions to allow for changes in the nature of the relationship and any unexpected developments or increased costs. We have worked with clients to devise a range of commercial solutions to the key performance issues and to incorporate service credit mechanisms focused on the clients business. In one of our projects, we had to put together an unusual scheme in respect of service credits for a nationwide system of health services. This involved identifying and grading the customer s requirements so that they were defined for the purposes of both charging and service levels. We were required to define the consequence of an aggregate number of combined defaults as well as what would happen in respect of persistent breaches. We also had to devise a mechanism to address exceptions to the general rules, for example, to take into account the fact that the supplier s performance might be affected by the remoteness or quality of certain of the customer s sites. Change control Where the agreement is long term or deals with the delivery of complex services, it is essential to insert provisions to allow for changes in the nature of the relationship and any unexpected developments or increased costs. The Service Agreement should provide for a change procedure to allow for either technological developments or changes in styles or requirements going forward. It should be made clear how changes in law and operations should be dealt with by both parties, and how increased costs associated with such changes are to be borne. Charges The most appropriate methods of charging will vary depending on the nature of the service being outsourced. Options include fixed/variable fees, profit share, costs plus and volume related fees. Whatever method is chosen, the customer will wish to impose incentives and protections to ensure that the services are being delivered to the appropriate standard and that the service is in fact providing the expected savings. How is this achieved? Measuring quality against service level standards Transparency of costs Benchmarking charges against the charges of comparable services available in the market and against objective indicators such as specific industry indices Outsourcing 10

11 In our experience, HR related issues can be among the most problematic of the many that have to be dealt with during the course of any outsourcing proposal. Where the customer is paying a variable charge dependent on the provider s or third party s costs, (e.g. of procuring items) a right to audit is essential, along with a requirement of transparency of pricing (within the limits of the provider s confidentiality arrangements with suppliers) to enable forward planning as to how to budget for the most efficient delivery of services, and to ensure that the costs benefits of outsourcing are being achieved. Assets Additional issues need to be addressed when assets (and/or personnel) are transferred as part of an outsourcing arrangement. Examples of such issues include the following: the transfer back of assets and/or replacement of assets on termination of the outsourcing arrangements whether warranties should be given in respect of the assets whether the assets to be retained should be licensed whether the customer should own IP rights generated by the service provider for the purposes of providing the services who should bear the costs of replacing (and disposing of) old equipment HR issues For any company contemplating outsourcing, employment issues need to be considered at the start of the planning process. In our experience, HR related issues can be among the most problematic of the many that have to be dealt with during the course of any outsourcing proposal. It is, of course, well established and understood that TUPE will generally apply where a service is outsourced or where there is a change of service provider. However, the issues that this gives rise to can be complex and we have frequently found that the HR issues have not been given sufficient attention in the planning of the outsourcing process. For example: identifying the relevant employees who will pass across under TUPE this is frequently not as straightforward as it Outsourcing 11

12 A fundamental part of the transaction may be the value of any existing pension fund that is to be transferred. sounds, given that employees, often key ones, may straddle business areas. There may also be employees on secondment to the business being outsourced ascertaining the supplier s intentions regarding employees; customers may seek to impose conditions regarding job security and terms and conditions for the existing workforce the need to conduct an inform and consult exercise with representatives of all affected employees in conjunction with the supplier; this will necessitate an election of representatives where there is no recognised trade union or pre-existing elected committee if a number of the affected employees are members of a trade union, the need to handle the labour relations aspects of the transaction sensitively the need to deal with the difficulties of the timing of a TUPE consultation exercise, particularly if a bidding process is being conducted. This can also give rise to difficult confidentiality issues especially if one or more of the prospective suppliers is a listed company data protection issues regarding making employee information available to bidders the position of employees on termination of the agreement Similarly, pensions issues need to be considered early in the process. A fundamental part of the transaction may be the value of any existing pension fund that is to be transferred. Consider whether the customer may want bidders to provide broadly comparable pension benefits to transferring employees. In addition, a customer may want to negotiate, with a supplier, the option to enable transferring employees to transfer out of their existing scheme into the potential bidder s scheme and to fix the value that would be transferred from the customer s existing pension fund to the supplier, in order to provide these benefits. Whilst occupational pension schemes are excluded from TUPE, the preservation of enhanced redundancy rights, for example, will also need to be reviewed. Many occupational pension schemes provide early retirement benefits which are triggered by redundancy after a particular age, but before the retirement age. In the light of a recent court decision, it will be necessary for both customer and supplier to identify that part of the final pension scheme which relates to the benefits payable before retirement. Outsourcing 12

13 Our employment and pensions team has extensive experience of guiding clients through HR issues from the inception of the outsourcing process to completion. Tax Tax issues will also play an important part in considering and pricing outsourcing. VAT will be an issue for exempt, partially exempt and non-private sector businesses. If such a business outsources work, it may well find that the provider has to charge irrecoverable VAT at 17.5% to costs that would otherwise have been VAT free in the hands of the business e.g. staff, rent, insurance and other overheads. It is necessary to carefully review what is being outsourced to see whether it falls within one of the categories of exempt supplies. There is a continuing series of court cases that may affect the treatment of some services as taxable or exempt in their own right. To ensure that the argument is presented as strongly as possible, care will need to be taken when drafting the outsourcing agreement, and it may be necessary to outsource more, to ensure that the factors at the heart of the exemption remain an essential part of the services bought-in. Also, if assets are being transferred then a capital allowance allocation may need to be agreed. Further, if the customer is not a taxpayer, transferring assets as part of the outsourcing process to a service provider who may benefit from capital allowances could give rise to an overall tax saving which can be factored into the pricing. The customer will need to identify whether the outsourcing arrangements have any direct tax effect in changing his trade resulting in the non availability of any carry forward losses. Depending on the nature and complexity of the outsourcing, other tax issues may arise. Our tax team has a breadth and depth of experience of dealing with such issues. There is a continuing series of court cases that may affect the treatment of some services as taxable or exempt in their own right. To ensure that the argument is presented as strongly as possible, care will need to be taken when drafting the outsourcing agreement. Risk and liability There may well be circumstances where damage to the customer s business (and/or the brand under which it operates) and its loss of profit caused by a breach by the service provider of its contractual obligations may substantially exceed the value of the contract to the service provider. The liability provisions of the Service Agreement should be strictly and clearly drafted to ensure that both parties are certain as to who bears the risk (and to what extent) in the event of breaches of the agreement or tortious acts. How is this achieved? Limit/exclude liability for loss of profit and indirect loss Insert caps where liability remains for different heads of loss Appropriate insurance cover This is often the most contentious area, particularly in relation to outsourcing customer-facing services. The damage that can be created by a poor service provider ruining the goodwill of the customer can probably never in practice be fully compensated for by financial penalties. Therefore, due diligence on the prospective supplier, adopting a true partnering approach, strong and effective measurement and remedial action rights are essential. Outsourcing 13

14 careful consideration should be given to defining appropriate forums for settling different types of disputes, be it an independent expert, mediation and/or arbitration Dispute resolution and remedial action It is essential to provide a mechanism to resolve disputes through co-operation and agreed action between local representatives on the ground. Strong remedial action provisions in the Service Agreement will provide the customer with the assurance that they can step in or direct remedial action immediately upon a problem being identified, which is particularly important where strategic functions are being outsourced. The focus should be on resolving the issue quickly and with the minimum disruption to the proper provision of the services. A clear and workable dispute resolution procedure is also required, preferably focused on co-operative resolution with escalation internally within the parties own organisations. While referral to third parties may ultimately be the only way of breaking deadlock, careful consideration should be given to defining appropriate forums for settling different types of disputes, be it an independent expert, mediation and/or arbitration, with an onus on speedy resolution of operational issues. Outsourcing 14

15 How we can make life easier for you has acted not only for businesses that have a programme of outsourcing but also for those embarking on this activity for the first time. We use our experience to provide the appropriate level of support the client requires to meet its objectives. We are happy to work with in-house legal counsel or directly with your management and business functions as required. We can lead negotiations or provide a supporting role as advisers to you in your negotiations. We can provide examples of the assignments we have worked on for a range of clients. Contact point If you would like to find out more about outsourcing please contact the following members of our Outsourcing Group: T +44 (O) F +44 (0) John Armstrong E john.armstrong@cmck.com David Day E david.day@cmck.com Paul Edmondson E paul.edmondson@cmck.com David Roberts E david.roberts@cmck.com Sandra Rafferty E sandra.rafferty@cmck.com Louise Wallace E louise.wallace@cmck.com For more information on outsourcing and to receive updates on new developments as they arise, register to Law-Now, our free information service. This commentary is not a full review of the topic it covers and does not purport to give legal advice. If you would like to receive specific legal advice please speak to your usual contact at or the persons detailed above. Outsourcing 15

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