Articles Posted in Legal and Contracting Issues

Background on Economic Pricing Adjustments

Outsourcing contracts often include mechanisms to adjust prices for inflation. Among the factors of production, the cost of labor is the most critical and is often subject to these adjustments.

To account for rising production costs in a particular market,** service providers will typically ask for an annual price increase that is pegged to a standard cost of living benchmark, such as a public consumer price index (CPI). Some onshoring and offshoring examples:

Making the decision to terminate an outsourcing agreement is often very difficult and is usually only pursued if enforcing existing rights is not sufficient to address a customer’s major concerns or renegotiating the agreement can’t achieve the desired outcome.

If a customer begins to think about terminating an agreement, it is useful for customers at that juncture to undertake a complete review of the agreement in relation to termination options and consequences to help inform the decision. What should such a review entail?

Can you terminate? And what are you terminating?

In the wake of some extreme weather during 2011 (earthquakes, tsunamis, tornadoes, hurricanes, and mudslides), what better time to review your disaster recovery and business continuity (DR/BC) solution and planning processes?

In some cases, DR/BC planning is a legal or regulatory requirement, but even where it is not, common sense argues for a sound DR/BC plan for any business. Why?

• For most businesses, the dependency on computer systems, applications, databases, networks and electronic delivery systems increases daily – to the point where the efficiency and productivity of the business would drop precipitously if these tools are not available.

A group of health clinics representing dozens of health care providers recently decided to migrate to an electronic health record (EHR) solution. The clinics selected a system that others in the area had recently adopted and negotiated a software license and hosting agreement with the vendor. When the negotiations were completed they asked us to take a look at the contract. The result was a little startling.

The benefits of EHR technology are manifest: less chart pulling, improved billing, reduced costs, remote access to records for point-of-care decision support, improved communication between health care providers (such as the primary care physician and the pharmacist), easier compliance with regulations, improved disaster recovery capabilities (it’s easier to backup a database than copy voluminous paper charts), etc. It also doesn’t hurt that the US government has committed – in the Health Information Technology for Economic and Clinical Health Act (HITECH Act), enacted as part of the American Recovery and Reinvestment Act of 2009 – to spend more than $19 billion through 2014 to encourage adoption of EHR solutions. Needless to say, the rush is on to secure this technology.

It is a common scenario for health IT professionals to involve their legal counsel at the eleventh hour or not at all in EHR procurement, in most cases because they become so focused on the technical and operational aspects of the procurement that they do not appreciate the risks inherent in contract provisions that look like typical “boilerplate.” The rush to finalize an EHR procurement effort can overshadow the need to assess the potential future hidden costs of onerous contract provisions that, for example, limit the vendor’s liability and impose undue obligations on the customer. The EHR vendors have the benefit of years of experience in negotiating procurements, which gives them real bargaining leverage in contract negotiations. Many IT professionals have learned to their chagrin that addressing these provisions at the end of negotiations leaves them with little leverage and a “take it or leave it” response from the vendor, because the vendor recognizes that it’s too late for the customer to start over with another vendor.

Current economic conditions require companies to realize cost savings quickly, and existing outsourcing relationships are a popular target. In most cases it should be faster and cheaper to re-negotiate an existing deal than it is to engage in a traditional competitive procurement. This approach allows a company to leverage the existing contract instead of spending resources to identify and transition to a new supplier.

A typical outsourcing engagement lasts anywhere between three and seven years, and, naturally, issues are bound to arise in that time. Re-negotiation provides an opportunity to address these issues, be they pricing, solution, governance or something different entirely. However, if the answer to whether to renegotiate were this simple, everyone would do it. Several key issues drive whether re-negotiating your existing contract is the way to go, or if the possibility of quick savings is more hope than reality.

Some contracts are better candidates for re-negotiation than others. It can be difficult for a company to determine if a particular contract is suitable for a re-negotiation. Naturally, re-negotiation may become more attractive as the expiration date draws nearer, and service providers are more willing to cut a deal late in the contract life cycle. In practice, most customers consider re-negotiation before that time. If you are wondering if your contract is a good candidate for early renegotiation, here are some points to consider:

In Part 1, addressed managing and mitigating risks during the supplier selection process and in Part 2, I addressed the risks associated with contract negotiations. In this Part 3, I will discuss relationship management as a key component of successful outsourcings.

Successful outsourcing requires effective contract management. While you can mitigate the risks associated with outsourcing through having a robust outsourcing contract, it is the day-to-day management of the relationship with your supplier which is critical to the overall success of the deal. Problems will always arise in long term services arrangements: an inadequate agreement on requirements or specifications, delays, cost overruns and poor performance are not uncommon. Underlying most of these issues is a single recurrent theme – poor management and communication between the parties. If an effective management framework is established early and applied consistently throughout the deal, then the risk of an outsourcing deal failing is significantly reduced.

To assist in the creation of a culture of trust and partnership, you should foster the development of key individual relationships with your supplier so as to facilitate a constructive relationship. Strong relationships will benefit you just as much as your supplier and play a very significant role in ensuring the overall success of the deal and facilitating the development of institutional trust.

In Part 1 of Managing Risks in Outsourcing, I focused on managing and mitigating risks during the supplier selection process. I will now look at the risks associated with contract negotiations.

If poorly planned and executed, the negotiation of an outsourcing contract can be a long, tiring and frustrating affair. Over-populated meetings which continue for days with little progress being made on commercial points, over zealous legal advisers who focus on points which have no real impact on the deal fundamentals, costly delays and significant frustration are sadly a common experience. Negotiation of an outsourcing contract can also expose a customer to a variety of different types of risks which are all too often overlooked.

Common risks which you face during negotiations include an outsourcing contract which does not support your business needs and objectives, costly delays in the timetable and the realization of benefits from the outsourcing, and long term damage to the relationship with your supplier due to an adversarial approach being taken to negotiations.

Outsourcings can offer organizations significant commercial benefits but they also present challenges and risks throughout the outsourcing life-cycle for the outsourcing organization whether during the supplier selection process, in the course of contract negotiations, during the implementation and day to day operation of the outsourced services, and on exit from the outsourcing contract. Here are some practical tips for organizations who propose to outsource on how to manage and mitigate some of these risks. In Part 1, I will focus on supplier selection. In Part 2, I will cover the negotiation process. In Part 3, I will address relationship management.

Supplier selection is an important step in the outsourcing process which can give rise to a wide range of risks. These include a procurement outcome which does not support your needs and objectives, delays leading to increases in the overall deal costs, discontinuity in the supply of essential goods and services, loss of influence in relationships with your existing essential suppliers, damage to your reputation, exposure of your directors and officers to prosecution and litigation, unauthorized disclosures of your confidential information or confidential information belonging to a third party, and ‘misrepresentation type’ claims brought by the selected supplier or unsuccessful bidders arising from incorrect, misleading or deceptive statements or information provided or made during the selection process.

The success of a selection process in outsourcing deals is dependent upon undertaking sufficient due diligence, preparation and planning. You should conduct a baseline review to identify and assess your current services and systems and the current costs of providing those services and systems. The quality and depth of this analysis is key. Not only will it form benchmarks for performance and service levels but it can also be used to confirm that the outsourcing business case is economically viable.

Suppliers of IT outsourcing services limit their responsibility for paying damages arising from the loss of customers’ sensitive data (whether or not intentionally lost by the supplier). Only a few years ago, it was commonplace in an IT outsourcing agreement for a supplier to agree to be responsible for any losses of customer confidential information caused by the supplier. Today, however, due to the widespread increase of data breaches and the higher potential for large amounts of liability that can result from such breaches (see Zurich Insurance fine) suppliers are much less likely to agree to open-ended liability.

IT outsourcing suppliers have taken various approaches to capping their exposure to damages resulting from data breaches, both for amounts owed directly to the supplier’s outsourcing customer as well as the amounts owed to the customer’s clients.

Some suppliers will accept “enhanced” liability for some amount of money that is larger than the general limitation on damages recoverable for standard breaches of the contract; this enhanced amount of money is often set aside as a separate pool of money that cannot be replenished once it is “used up” to pay for the data losses. Some differentiate the amount of exposure they have to these breaches based upon whether the data in question is or should have been encrypted. Still others vary the amounts of exposure based upon whether data was merely lost or whether the data was actually misappropriated by the supplier.

Once the ink is dry on a signed outsourcing contract, the real work begins for the customer and the service provider. Before the customer can start to realize any savings, efficiencies or service improvements, the parties must first complete the critical task of transitioning from the customer to the service provider the day to day responsibility for performing in-scope functions. This transition process can take several weeks or even months.

Each party has a strong incentive to complete the transition on time. Ordinarily, the customer wants to start reaping the benefits of the outsourcing as quickly as possible. Likewise, the service provider wants be in a position to start charging full freight fees for steady-state services as soon as the transition is complete. In addition, appropriately structured contracts often include an additional incentive for timely performance by the service provider: monetary credits to the customer if transition milestones are not completed on time.

Competing with this need for speed (or, at the very least, on time completion) is the customer’s desire to mitigate the operational risks associated with any transition. Complexities abound, especially if the transition involves multiple service towers and geographies, a transfer of personnel and assets, and a physical change in the location from which services are performed. The stakes are high for both parties. In the worse case scenario for the customer, a hasty transition can result in an interruption or degradation of a critical business activity.