Outsourcing Contracts - Are they worth the paper they're written on?

04 August 2006

Gill Andrews

One complaint we sometimes hear about outsourcings, is – Outsourcing contracts are out-of-date the moment they’re signed. And they become more and more out-of-date as time goes on. Rather than spending time on some increasingly irrelevant contract, business people should focus on the underlying customer/supplier relationship. Can this be true?

Anyone who works on outsourcing contracts will know the heavy costs involved - in terms of time, manpower, professional fees, etc. Perhaps unsurprisingly, I am firmly of the view that this is money well spent. But I also think businesses deserve a clear explanation of why a good outsourcing contract is essential, and how businesses can ensure that their outsourcing contracts remain relevant and useful throughout the contract term.

Why have a contract at all?

I think it’s useful to consider this fundamental question at the outset.

Imagine making a presentation to your Board – you’ve found the perfect supplier to meet your businesses’ needs; they’ve got a great track record and the price is right. When the Board asks you about the contract arrangements, you say – Don’t worry about that; I’ve decided not to use a contract on this one. Chances are you’d be looking for a new job before the end of the day. But why?

Of course, there are some legal and regulatory reasons for an outsourcing contract: for example, some regulators require this; and some assets cannot be transferred without a written document. But what about business reasons?

Three key business reasons for an outsourcing contract -

1. Remedies: To provide an appropriate level of remedy, if things go wrong. If your supplier, or customer, does not perform as promised, your business might suffer. Without a good contract, it can be difficult to claim compensation, or to terminate, for failures by the other party. Equally, businesses generally wish to limit their liability for losses incurred in connection with the outsourcing relationship. This cannot be done without a contract.

2. Clearly establishing each party’s responsibilities: Many outsourcing disputes are over which party has responsibility to do, and (usually more importantly) pay for, particular aspects of the service. The disputes usually relate to occurrences that were not anticipated when the contract was first put in place. For example –

· Who procures replacement services if a subcontractor becomes insolvent?

· What information must be given to other bidders, if the customer wishes to put the service out to tender towards the end of the contract term?

· Which party has the right to use valuable information generated in connection with the outsourcing relationship?

The discipline of drafting a contract forces people really to focus on these types of matters. These matters can of course be agreed by way of non-contractual documents. However, in our experience, this generally produces a less rigorous analysis than where a contract must actually be signed off by key decision makers.

3. Regulating the legal consequences of the parties’ actions: For example - should email agreements between contract managers be capable of varying the parties’ rights and responsibilities? What is the legal consequence if the customer’s contract manager repeatedly allows the supplier to perform at below contract standard?

The real point I wish to make is that these key reasons (and more) are all just as important, a couple of years into the outsourcing relationship, as they were on the day the contract was signed. The challenge therefore is to make sure the outsourcing contract remains fit for purpose, and does what it is meant to do, throughout the entire contract term.

Ten Steps to Success – Keeping the outsourcing contract fit for purpose, throughout the contract term

All outsourcing relationships evolve throughout their term – the services change, the market changes, the customer’s organisation changes. Unless the outsourcing contract evolves with the relationship, the contract will become less and less useful as time goes on. It will also become less and less legally effective, the more its provisions differ from the ‘live’ outsourcing relationship.

Actively use the outsourcing contract

The signed outsourcing contract will reflect compromises and agreements made at sometimes the highest levels of the supplier’s and customer’s businesses. But we find that those actually operating the service often do not use the contract. Why is that? Often because they do not know what the contract says on the key issues that affect their work.

1. Make it easy: Most lawyers now use plain English drafting. But an outsourcing contract is still an unwieldy and difficult document to read. Also, an outsourcing contract is not a service manual; its primary purpose is as a legal document, designed to be capable of being used – if need be – in a court of law. Serious thought should be given to the best way of ensuring that the people running the outsourcing relationship really understand how the contract should affect their roles. This is likely, at least, to include -

· Contract summaries: Someone with a detailed knowledge of the outsourcing contract should produce simple, and relatively short, summaries of the contract. These are not designed for the lawyers; they are for those operating the service on the ground.

· Contract management workshops: Explaining how the outsourcing contract works; introducing the Contract Summaries; and addressing peoples’ questions about how particular issues are addressed in the contract, and should be addressed in practice.

2. Keep the contract team in place: Too often, the key individuals who develop and negotiate the outsourcing contract have no ongoing involvement after the contract is signed. Where this happens, there can be a mismatch between the negotiating team’s view of the world, and that of the employees on the ground. The most obvious way to address this is to make sure that at least some of the people who will operate the outsourcing relationship are involved in developing and negotiating the service descriptions, service level schedules, implementation plans etc.

3. Don’t make your outsourcing contract more complex than it needs to be: People actually operating outsourcing relationships often complain that their contracts are too complex. In many cases, this is simply the nature of the legal document, and their concerns can be met by well drafted Contract Summaries. In other cases, these people are right. This is a particular problem with service credit regimes - the contract negotiating team often devises a finely calibrated service credit mechanism, with appropriate weightings given to all relevant criteria. But when the mechanism is handed over to those actually working on the ground, they find it too complex, it takes too much time to administer and sometimes they are unable actually to measure the inputs that need measuring. The operational parts of the contract should always be sanity-checked with the people who will actually be running the relationship. If those people buy into the agreed mechanisms, they are much likely to be used in practice.

Don’t accidentally modify the contract

The negotiating team that agreed the original outsourcing contract will have worked carefully to allocate responsibilities to the parties, and to create the right risk/reward balance and allocation of responsibilities. Without good contract management, and good levels of awareness amongst the outsourcing teams, it is easy to unintentionally modify that balance, and to throw away hard-won rights.

4. Be careful about ‘scope creep’ ‘Scope creep’ occurs when the scope of work entrusted to the supplier gradually increases without anyone really realising this is happening. This is a particular risk where a great deal of service definition work remains to be done when the contract is signed. Without strong relationship management, it can be tempting for the customer’s personnel to request additional functionality; often resulting in escalating costs, and delays as development time is side-lined on ‘nice-to-have’s.’ It can also result in the supplier doing work that is not properly reflected in agreed contract wording, leaving the parties in an uncertain situation if things go wrong.

5. Don’t inadvertently take on extra responsibilities This situation typically arises where the new services are being discussed. It can be tempting for a customer to specify not only what services the supplier must deliver and the related service levels, but also to dictate the method the supplier must use. If that method turns out to be flawed, the customer may find itself without a remedy (as the supplier can argue that it was simply following the customer’s instructions, and the customer had effectively taken on responsibility for selecting the working methodology). Collaborative working can be highly beneficial to outsourcing projects, but it is important to be clear as to which party takes ultimate responsibility for the output of the collaboration.

6. Don’t inadvertently waive your rights Most outsourcing contracts allow the customer to claim service credits, liquidated damages and other remedies for poor performance, missed deadlines etc. In practice (and for good operational reasons), customers often decide not to enforce these rights. However, unless this situation is handled properly, non-enforcement of the agreed contractual rights can result in them being waived, and therefore unenforceable in future.

We certainly do not advocate that service credits, or other remedies, should invariably be claimed. But it is important to develop a legally-effective strategy for responding to failures by the other party, to make sure you do not inadvertently give away your rights.

7. Be aware of the impact of informal communications The supplier’s and customer’s staff will inevitably be in regular contact, by email, on the phone, in person and in workshops, etc. Depending on the circumstances, statements and agreements made in those meetings may be legally binding. These statements and agreements might, for example, have the effect of varying the outsourcing agreement, or of creating a new, collateral contract between the parties. Good contract drafting, and effective training of those involved in the outsourcing relationship, are both key to minimising the risk of this happening.

Good contract management

8. Properly document all contract changes: Often, changes are agreed in emails and in meetings, without any clear record being kept of what was agreed. We see contract disputes where there is absolutely no consensus as to what changes have and have not been agreed. If the outsourcing contract is to remain a useful legal document throughout the contract term, it is vital that contract changes are properly documented. Consideration should also be given to updating Contract Summaries and Manuals, etc.

Where we are asked to advise on a dispute, we are also often handed a pile of Contract Amendment documents, which would seem to have been prepared without any real understanding of what the outsourcing contract itself says. So we are faced with a series of documents that say very different things as to, for example, which party should own particular intellectual property rights developed in connection with the services.

Be sure that contract changes are approved by someone with a good knowledge of the underlying outsourcing contract (ideally someone in your legal or contracting team). In that way, the changes can be made to ‘fit’ with the agreed contract.

9. Periodic contract management workshops: The team operating an outsourcing relationship will change with time. Periodic workshops are useful in keeping everyone up to speed, and are also an ideal forum for discussing possible changes. An outsourcing relationship is complex and multi-facetted. What would work well from a cost profile perspective may be disastrous from an HR perspective – it is important that all members of the team have the opportunity to provide input on possible changes to the relationship.

10. Allocate adequate resources – Recognise that keeping an outsourcing contract up-to-date, and following these Ten Steps, requires work, and the allocation of adequate resources.

The question of relationship

The quotation at the start of this article draws a contrast between the effort spent on the outsourcing contract, and the effort spent on the outsourcing relationship.

We see that as a false distinction. Good outsourcing contract management certainly involves investing time and effort into the relationship itself, as well as following our Ten Steps. But the face-to-face relationship and the contract relationship are both essential to a solid outsourcing. Both are needed, if the relationship is to succeed in a way that properly reflects both parties’ reasonable expectations.

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This article was published in the Report "The Outsourcing Project - Achieving Competitive Advantage Through Collaborative Partnerships" published by CxO Europe.

Gill Andrews is a Senior Consultant in Bird & Bird’s International Outsourcing Group. She advised on her first outsourcing in 1992, and has continued to focus on the area as it has evolved. She has worked on a wide variety of outsourcing transactions, from “straight” domestic IT and communications outsourcings, to innovative business process outsourcings, insourcings and offshorings. She has substantial experience of advising on multinational outsourcings.