EM Law are experts in advising on outsourcing arrangements. This note considers the issues that arise in relation to outsourcing, both from a customer and a supplier’s perspective, including a review of the outsourcing process and the contractual arrangements involved.
What does outsourcing involve?
Outsourcing involves a transfer by a business (the customer) to a third party (the supplier) of the operational responsibility for the provision of a distinct business function, process or service. Given the inherent transfer of responsibility, many outsourcing arrangements involve a transfer to the supplier of those employees who were engaged by the customer in the activity that is being outsourced.
For outsourcing to work, an appropriate contractual structure needs to be adopted. The contract needs to identify the requirements of the customer and contain:
Key issues such as migration, escalating remedies for poor service and post-termination transfer arrangements must also be carefully considered to ensure that:
The Transfer of Undertakings (Protection of Employment) Regulations 2006 (SI 2006/246) (TUPE) set out when TUPE will apply to outsourcing, both on the initial outsourcing and on any subsequent or second-generation outsourcing.
The main effect of TUPE is to transfer the contracts of employment of employees involved in the outsourced function to the supplier. However, many questions arise during the process as a result of TUPE, including which employees are employed in the undertaking, what happens to those who choose not to transfer and what liabilities are actually transferred.
The key point in considering employment-related issues at the outset of the outsourcing process is for the customer to identify those employees who are or may be in the pool of transferring employees at the time of the transfer. These should be identified by the customer early in the due diligence process and ultimately may be included in a list of transferring employees in the outsourcing agreement. This information will also form part of the obligations upon the customer or existing supplier under TUPE to provide specified “employee liability information” at least 28 days before the outsourcing takes place.
Structuring outsourcing transactions
The simplest form of outsourcing transaction structure is an outsourcing agreement between the customer directly with the supplier for the services. If a transfer of assets is also anticipated, a separate transfer agreement may be negotiated or the transfer arrangements may be covered in the services agreement itself. If a separate transfer agreement will be used, it is advisable to ensure that any provisions that apply to the parties’ ongoing relationship do not appear in the transfer agreement but are covered in the outsourcing agreement.
If the supplier intends to use subcontractors, the customer should require prior notification of the subcontractor as a minimum, and preferably should retain a right of veto over the use of particular subcontractors. The supplier should remain liable for the acts and omissions of its subcontractors as if they were its own. The customer may seek a contractual right to pay key subcontractors directly or to seek the assignment of key subcontracts to the customer if the supplier suffers a certain level of financial distress, often linked to a decline in the credit-rating of the supplier.
It is fundamental to the success of an outsourcing that the contractual arrangements work to create a flexible, long-term relationship which sets out detailed rules but can deal with the pace of change and problems when they arise.
Services, service levels and service credits
The services description is the lynchpin of any outsourcing contract, as it describes how the services provided by the supplier will satisfy the customer’s requirements.
The service description must make it clear what the supplier will provide and what the customer expects to receive. Therefore, it should comprise a detailed description of the services in question and clearly set out the divisions of responsibility between the supplier and the customer. It should also be drafted as a legally enforceable document, with the obligations of the supplier clearly identified.
In some cases, particularly where the specification will be negotiated during a public procurement process, the agreement also attaches the customer’s requirements as a separate schedule. There will usually be an obligation on the supplier to ensure that the service description or specification is developed to reflect the customer’s requirements, which usually take precedence over the subsequently developed service description. However, it is still necessary to ensure that the service description is as detailed as possible at the outset and does not conflict with the customer’s requirements set out in the agreement.
In addition, all outsourcing agreements should require the supplier to perform the services in accordance with a set of service levels (sometimes referred to as key performance indicators). The service levels should be incorporated into the main contract and should use terminology consistent with the main contract.
The service level arrangement should address the monitoring of the service levels and contain the structuring of a set of service credits to address the possible failure on the part of the supplier to achieve the required service levels. This should enable the customer to seek redress for poor service without the need to pursue legal action or terminate the agreement. Accordingly, for the customer, service credits provide a way of focusing the supplier’s management on avoiding sub-standard service delivery.
If the supply of service drops below a certain level of performance, the customer should be entitled to seek damages in addition to service credits and, should the service levels be breached on a persistent basis, trigger the customer’s right to terminate the agreement.
Changes and change management
The outsourcing agreement will need to:
The outsourcing agreement should try to anticipate the consequences of particular changes, for example, which changes in the law should be paid for by the customer and which by the supplier. While it will not be possible or indeed desirable to prescribe for every conceivable change, the outsourcing agreement should set out a framework on how changes are to be managed as well as setting out the consequences of the more obvious changes, such as changes in volumes or service levels, or both.
Charges and charge adjustments
The charging regime is often one of the most complex areas of the outsourcing arrangements and there are different methods for calculating the charges:
Benchmarking will usually involve a comparison of the supplier’s charges or service levels against other suppliers in the marketplace. This may be done at different stages throughout the contract term although it will often be restricted to no more than once every 12 months. The parties will also need to agree where the findings of the benchmarking review will result in an adjustment to the supplier’s charges or service levels.
Human resources: TUPE and pensions
The people issues surrounding an outsourcing arrangement are complex. The outsourcing agreement (or the transfer agreement, if this is where some of the provisions will be covered) will need to deal with:
Unless there is a fundamental change in the nature of the work or how it will be undertaken, TUPE will usually apply to outsourcing, both on the initial outsourcing and on any subsequent or second-generation outsourcing. This will mean that the contracts of employment of those employees engaged in the undertaking will transfer from the customer or an existing supplier to the new supplier (or its sub-contractor) at the outset of the outsourcing arrangement, and from the supplier back to the customer or to a replacement supplier (depending on whether the services are taken back in-house or terminated and the contract granted to a new supplier) at the end of the contract term.
Both the customer and the supplier will need to ensure that their obligations in relation to TUPE are met. For example, they will need to comply with their respective duties to inform and, in some cases, consult with appropriate representatives of any of their employees who may be affected by the transfer, whether or not these employees are to be included in the transfer. Customers should also note that, in addition to providing the new supplier with information about employees, TUPE requires disclosure of “suitable information” relating to the customer’s use of agency workers.
The outsourcing agreement will need to deal with the following employment issues:
Intellectual property rights
The outsourcing agreement will need to deal with:
At the outset, where the customer owns intellectual property rights used to provide the services, it may decide to sell them or to license them to the supplier. During the life of the contract, consideration must be given as to how any new intellectual property rights are to be dealt with and whether, for example, the customer will be given a right to use the intellectual property rights or have them assigned to it. Much of this will depend on negotiation, the price paid for the services and the extent to which the services provide a bespoke solution for the customer.
Specific warranties are usually negotiated in place of the general warranties that are implied by law. The customer should require the supplier to warrant the quality of the services. Commonly, suppliers warrant that the services will be provided with reasonable skill and care, but customers should consider whether further warranties are appropriate. In addition, the supplier should consider what warranties it wishes to obtain from the customer. In particular, warranties should be sought by the supplier in relation to the assets, employees and third party contracts being transferred.
Liability and limitation of liability
In relation to the recovery of losses under the contract, both parties will need to consider the types of losses that may be recovered and the cap on liability.
Where services are critical to the operation of the business of the customer, the losses which the customer may suffer if the supplier fails to provide the service may be significant. It is important, however, not to impose contractual liabilities that are disproportionate to the value of the contract. As a result, consideration is often given to setting limits on the supplier’s liability that relate to payments due under the outsourcing agreement (possibly on a multiple basis) or the insurable level of loss on a project-specific basis.
It is also important to identify any areas where the supplier’s liability should not be subject to a cap. For example, the supplier’s indemnity in relation to intellectual property rights is often unlimited because it represents the customer’s protection for unquantifiable third party liabilities which the supplier is able to prevent or control.
Customers may also want to limit their liability in damages to the supplier. The supplier should take care that the drafting of the limitation clause does not restrict the supplier’s right to recover for non-payment of charges that are properly due.
Audit rights are an important element of any outsourcing arrangement, allowing the customer to review the supplier’s performance and charges. The audits will be required for contractual and regulatory reasons as well as to ensure the supplier’s staff are complying with their obligations under the outsourcing agreement.
The outsourcing agreement will also need to contain detailed provisions for termination and exit management. Rights of partial termination should also be considered if the services are capable of separation.
The parties should be able to terminate for fundamental or persistent breaches of the agreement. It is important that termination provisions are carefully drafted if the parties wish to have a right to terminate for a breach other than a repudiatory breach.
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