A service level agreement (SLA) is a critical part of any outsourcing contract. SLA defines the boundaries of outsourcing project in terms of the functions and services that the service provider will deliver and identifies the service standards that the service provider must meet. A well-drafted SLA accurately sets expectations for both parties and provides guidance for measuring performance to the defined targets.

Although there is no hard and fast rule governing how many measurements the parties should include in each SLA, it only makes sense to measure what matters to customer. Customer may tend to think that the more measurements the SLA contains, the more control it will have over service providers. This approach rarely works in practice. Customer should choose the measurements with information that can be simply analyzed, digested and used to manage the project.

SLA also needs to specify the consequences for failure to meet one or more of service levels. The consequences may include service level credit or termination right by customer. Service level credit often does not adequately compensate actual lost suffered by customer as a result of service provider’s failure to meet the service standards. If the outsourced function is business critical, it is important to identify additional consequences for failing to achieve the service standards, such as designating the critical functions as key service levels and identifying the termination triggers.

Each service measurement service provider is required to meet add additional cost which will be passed on to customer. While it may be nice to have system availability 100% on a 7/24 basis, it adds significant cost to guarantee 100% availability. Customer needs to understand what it needs, why it needs certain performance standards and weigh expectations and set reasonable and attainable performance standards. The goal is to achieve customer’s business objectives at a lesser cost while the service provider is motivated to meet the achievable performance standards.

In certain cases, SLA may also include bonus to be given to service provider for exceeding the performance standards. While some customers may be of the view that SLA sets out the minimum standards and they expect the service provider to exceed the service levels without special compensation, there are benefits to structure the SLA to provide real incentives for outstanding performance by the service provider. If the service provider can add significant value to customer’s business, customer should be willing to share the extra value gained. Outsourcing is a partnership arrangement in that the service provider delivers business critical services to customer to enable customer to execute on its business objectives. It is important to have a winning contract for everybody.

Market conditions, business requirements and technology improvements continue to occur during the term of an outsourcing contract. A SLA needs to be adaptable to emergence of new technology and improvements. There should be periodic review and adjustments to reflect the industry standards.

SLA plays a very important role to guide the service provider to understand customer’s business requirements and to monitor their performance. Designing a comprehensive, fair and effective SLA is a key to a successful outsourcing relationship.

Recent research published by industry analyst Gartner shows that the business process outsourcing sector will expand by 5 per cent in 2012, with multinational companies leading the charge. Business process outsourcing is seen by many companies as a means of reducing costs. Companies have been engaging in outsourcing (both information technology and business process services) for many years. Use of foreign-based third party service providers is also not new. While many of the issues are not unique to offshore outsourcing engagements, offshoring highlights the importance of some of the challenges.

Companies have been outsourcing various types of business processes to offshore service providers, including employee benefit administration, payroll processing, customer support, insurance claim review, credit card processing, mortgage servicing, or tax return administration. Sometimes outsourcing arrangements involve disclosing large volumes of personal or sensitive information to service providers. There have been incidents where employees of offshore suppliers misused the personal or sensitive information entrusted to them as part of the outsourcing arrangement. While data privacy incident may occur anywhere, customers have less control when service providers are located in another country. Privacy and security requirements are key consideration in any offshore outsourcing arrangements. It is important for customers to include provisions that require service providers to implement and maintain security measures that are designed to safeguard customer information.

Offshore outsourcing also involves the risk of potential applicability of foreign jurisdictional law to the outsourced activities. A company located in Canada may decide to outsource its back office processing function to a service provider at an offshore location. The arrangement may involve sending personal information of Canadian customers to the service provider’s data centre in the United States. The data may be backed up in Europe and processed by the service provider in Asia. Since different countries have different approaches to privacy, the requirements of each jurisdiction must be considered. Companies that engage in offshore outsourcing should consider how foreign data privacy laws or regulatory requirements may interact with the domestic privacy laws and regulations and how any possible conflicts can be managed.

There are also country risks (social, economic and political instability) involved in doing business in certain countries. For example, escalation of the India/Pakistan conflict, potential terrorist attacks, civilian unrest, acts of war which could prevent the offshore service provider from delivering the services. If the outsourced function involves critical business operation, customer needs to develop plans to actively monitor the country risk, develop its own contingency or resource backup plan, and build in mechanism in the outsourcing contract to deal with the contingency plans and exit strategies. While service providers always have business continuity plan, customer needs to examine the plan to determine how it works with customer’s continuity planning and to assess the likelihood that the service provider will be able to implement its plan when required. For example, a contingency plan that moves workers from one region to another (or even from one country to another) may be difficult to implement. The contingency plan needs to be tailored according to the nature and criticality of the work being performed at the offshore location, the complexity of the work, and the onsite/offshore staffing ratio.

Exit provisions are one of the most important contractual protections for a customer in an outsourcing relationship. The provisions provide the framework to allow a customer to continue its business during transition and provide leverage for the customer in renegotiating the contractual terms. It is important to carefully draft the exit provisions because they will be used when the relationship between customer and service provider is not at its best.

A well-drafted outsourcing contract enables either party to terminate the arrangement prior to the agreed-to end date in a fair and reasonable manner. This is not to say that the termination provisions should be mutual between the customer and the service provider because the risk two parties undertake in an outsourcing arrangement is very different. If an outsourcing contract is terminated, the service provider will lose revenue. On the other hand, the risk for the customer is substantially higher if an outsourcing contract is terminated. For example, the customer losing services for its call centre or IT infrastructure management or its business process (such as reconciliation or payment processing) translates into losing operational time, revenue and reputation. The difference in risk between customer and service provider means that the two parties need to have different termination right in an outsourcing contract.

One of the termination rights in an outsourcing contract is termination for material breach. While some may argue that such termination right should be reciprocal such that if there are material breaches by one party, the other party should be able to terminate. There are certain circumstances where a service provider should be able to terminate for breach by a customer but such termination right should be restricted to very few cases. For example, if there is a sustained failure by the customer to pay undisputed amounts or if there is an infringement on the intellectual property rights of the service provider by the customer. Some may argue that the service provider should also be allowed to terminate in the situation where the customer has failed to perform its obligation which hinders the service provider’s ability to perform its contractual obligations. This type of breach by a customer can usually be remedied by monetary damages and termination is not an appropriate remedy.

The other termination right is termination for convenience or termination without cause. This termination right is usually exercised when a party decides that the outsourcing arrangement no longer aligns with its business direction. Transitioning from a service provider involves considerable cost, risk and disruption to customer. Giving a service provider the right to terminate for convenience means the customer may be forced to migrate to another service provider at a time dictated by the service provider. This is highly disruptive for a customer. This will also force the customer to incur transition cost that it is not budgeted for.

Some service providers still argue the necessity of having a reciprocal termination for convenience provision on the ground that the outsourcing relationship may not work as planned and the service provider should be allowed to exit. It is for this reason that the customer should resist the reciprocity of this provision. If it turns out that the outsourcing contract is not as profitable as the service provider has originally anticipated, this termination right provides the service provider significant leverage in renegotiate the terms (including pricing) and the service provider will be able to extort higher pricing from the customer simply because the customer heavily relies on the service provider to keep its operation running. Unless the customer misled the service provider in the due diligence phase, it is the responsibility of the service provider in conducting proper due diligence and preparing an accurate cost model. The risk of not performing proper due diligence or preparing an accurate cost model should not be shifted to the customer through the leverage the service provider may have in threatening to terminate the outsourcing contract for convenience.

Regardless of the function being outsourced (whether it is data centre networking services, business process outsourcing, call centre services, application development and programming), performing a detailed and thorough due diligence is the first step in cementing a successful and healthy relationship for both supplier and customer. The objectives of performing due diligence are to allow both parties to understand customer’s business requirements and objectives, to evaluate the supplier’s capabilities, to understand the cost components, to ascertain the risks to both parties, and to establish the level of cultural fit of both organizations. The extent to which the parties can minimize the assumptions and dependencies will depend on the amount and quality of information available. With the right amount of quality data, the parties can have more certainty in the solution and pricing proposal. This will in turn facilitate an effective negotiation.

There are different types of due diligence that the parties will need to undertake. First of all, before any decision to outsource is made, customer will need to perform due diligence on its own business. Customer will need to identify the objectives it wishes to achieve, determine the scope fit for outsourcing, assess the current delivery model and service levels, identify the future requirements for the services, and forecast the return on investment.

Customer also needs to perform due diligence on types of service offerings available in the marketplace, the capabilities of various suppliers, and to assess potential supplier’s ability to deliver the services, their approach to service delivery, determine whether there are any current or anticipated resourcing pressures which may impact the delivery of the services by supplier, and to assess the level of cultural fit between the customer and supplier organizations.

It is also very important for customer to provide sufficient opportunities and data for suppliers to perform due diligence on the business or functions being outsourced. Supplier needs to be provided with an opportunity to fully understand customer’s business, to confirm the business requirements, to understand whether and how the service levels are being achieved by the customer, and to validate any assumptions. Where customer organization is currently performing the services in-house, it is not unusual that customer may not necessarily have all the service level data documented. Supplier usually insists upon a post-contract verification period to assess whether the service level requirements are achievable. This means customer will not have certainty on every component of the contract on signing. Pricing and/or service levels may be subject to change depending on the data gathered during the verification period. This uncertainty can be avoided if the customer is able to provide quality and reliable historical data on the service levels.

According to a survey conducted by the Outsourcing Centre, almost 50 percent of the ITO and HRO deals were renewed. Companies often instinctively renew outsourcing contracts, especially if the existing relationship has no major issues. While it may be tempting to renew the deal because negotiating a new deal requires both parties to invest significant energy, time and money, customer must decide whether or not renewal is the best option. Renewal is not always the right choice. 

The survey conducted by the Outsourcing Centre also shows that about 30 percent of the customers renewed the deals for a better pricing model. While pricing is an important factor in deciding whether or not to renew, there are a number of other factors that are equally important to customers. These factors include supplier’s performance over the current contract term, the strength of the relationship with the supplier, the alignment of the current outsourcing model with customer’s strategies and objectives, any change in customer’s operating model, strategy or requirement since the initial contract was executed, whether the customer expects that its operating model, strategy or requirement may change during the renewal term, the capability of supplier to support customer future growth, supplier’s innovation and flexibility, the cost of transition, the ability of customer to manage the transition, the level of risk during transition given other initiatives, the availability of other service providers, changes in appetite for risk, changes in the outsourcing industry, changes in the legal and regulatory environment.

Regardless of whether the customer decides to renew the existing outsourcing contract or to enter into a negotiation for a new one, it requires careful and detailed planning. Renewal presents a very good opportunity for customers to adjust the terms and scope of the outsourcing contract to align with its operations, requirements and business expectations and to ensure that the deal remains competitive. 

The time and effort required for renewing, renegotiating or rebidding cannot be underestimated. Many outsourcing contracts contain boilerplate clauses which require service provider to remind customer of pending expiry about six to nine months prior to the expiry date. In reality, customer should start thinking about the renewal at least eighteen months prior to the expiry date. For example, on average it takes about six months for customer to evaluate the existing outsourcing relationship, consider all the factors discussed above, and make a determination whether or not to renew an existing outsourcing contract. If the customer decides not to renew the existing contract, the customer will need to decide whether or not it wants to renegotiate the agreement with the existing service provider or whether it wants to issue the RFP for rebidding the services. If it decides to proceed with the RFP option, it will take about six months to gather information to develop and issue the RFP, evaluate the bidders, perform due diligence, and make the down select decision. Therefore, in order to have proper planning and to retain leverage in the negotiation, it is important for customer to start thinking about any potential renewal early.

For nearly 20 years, organizations that outsourced part of their functions to service providers have relied on SAS 70 reports to gain assurance that proper controls relevant to user entities internal control over financial reporting are in place at service organizations. With the globalization of outsourcing services and changes in regulatory landscape, the American Institute of Certified Public Accountants Auditing Standards Board issued Statement on Standards for Attestation Engagements (SSAE) No. 16 in January 2010. SSAE No. 16 is effective for reporting periods ending on or after June 15, 2011 which means that the new standards could affect organizations as early as June 2010.

SSAE No. 16 is substantially similar to SAS 70. One of the key difference is in the portion of the report where the service organization describes its controls and systems. Under SSAE No. 16, service organization will need to provide a description of its system (as opposed to description of its controls under SAS 70). Description of system is more expansive and detailed when compared to that of the SAS 70 description of controls. Controls are only one aspect of a system. The new standards require service organizations to provide more information on their systems, processes and procedures.

The other key difference is that SSAE No. 16 requires service organizations to provide management assertion regarding management’s responsibility for the description of the system and the related controls designed to achieve the stated control objective. The new standards also require service organizations to identify risks that threaten the achievement of the control objectives.

While many of the descriptions contained in the SAS 70 reports provided by service organizations meet most of the criteria under the new standards, service organizations who currently only meet the minimum requirements of SAS 70 will need to put in more efforts under the new model. The new standard represents more work for service organizations because they are now required to provide a more elaborate description on the system and also to provide a management attestation. The new model may or may not have been contemplated when the outsourcing contract was negotiated. If the additional work was not contemplated when the outsourcing contract was prepared, this represents additional effort and cost on service organizations which could mean some of the service organizations may remove topics that were previously included in their SAS 70 reports. User entities need to understand what they expect the scope of the audit to include and the type of audit rights required under the new model.

Both service organizations and user entities need to review existing outsourcing contracts to determine the type of audit and reports required under the existing contracts, whether the existing contractual language is broad enough to cover SSE No. 16, and whether revisions are necessary to transition to the new standards.

Multi-country outsourcing means customer engages supplier to deliver outsourcing services to its affiliated entities in various jurisdictions. Structuring and negotiating a long-lasting outsourcing relationship require the parties to effectively manage many risks. Multi-country outsourcing deals multiple the challenges.

There are different ways to structure a multi-country outsourcing relationship. The most commonly used approach is to have a framework agreement between the two principal entities and local agreement between local entities of the two organizations. The terms and conditions in the framework agreement will flow to the local entities except to the extent they have been modified in the local agreement. The local agreement will take into account any specific local requiremens (which may include specific local law requirements or unique service requirements for the local entities). The benefits of this structure is that it can avoid the need of re-negotiating all the legal terms and conditions in various regions and ensure consistency. In addition, customer may also be able to take advantage of volume discount while supplier may be able to get the benefit of economies of scale. The downside of this approach is that it may be perceived by local entities as having been forced to accept pre-negotiated terms and conditions. Depending on the specific circumstances, there may also be concerns of anti-trust regarding principal’s ability to impose obligations on its affiliates.

Even though the parties may have the terms and conditions negotiated in the framework agreement, the work at the local level is far from being completed. Aside from the usual local requirements, such as any employment legislation, dispute resolution requirement or governing law (for example where the services will be delivered in both common law and civil law jurisdictions), there are other issues that must be reviewed in preparing local agreements. For example, there has been an increased focus on on any privacy and security issues in any outsourcing relationship. There has not been any unified approach in dealing with these issues. Depending on the type of the data and the jurisdictions involved, certain data may not be able to flow freely across various countries. The parties will need to review the local requirement and address the local differences in privacy, security, data protection and cross-border data flow issues.

Aside from the privacy and data protection requirement, the parties also need to decide the appropriate service levels for various regions taking into consideration the criticality of the service in the region, the currency of the infrastructure, the availability of the resources in the region. There are also many other issues that will need to be discussed, including the performance measurement approach, reporting approach, the credit approach, and termination (for example, whether the termination triggers termination of the framework agreement or whether the termination operates on a country-by-country basis).

Also, if customer operates in a highly-regulated environment, local regulatory requirement must be looked at. For example, if the customer is a financial institution, there are guidelines published by regulators in various countries (such as Canada, Singapore, Japan,….) on the regulator’s expecation of some of the key terms and conditions in a material outsourcing arrangment entered into by a financial institution.

It is important to remember even if we use the framework agreement in multi-country outsourcing deals, one size does not necesary fit all and there are too many local variations to be ignored.

Many times clients start outsourcing process before they are ready. Premature outsourcing decisions sometimes are driven by executive decision that the outsourcing function will need to be completed by certain deadlines. This can cause lots of problem. Effective negotiation of any outsourcing deals requires clients to perform proper due diligence and gather necessary internal data before the outsourcing process starts. Such data could include scope of services required, current mode of operation, desired future mode of operation, historical service level performance, extent of employees impacted, third party contracts and current cost base. 

Defining service requirements based on client’s own internal need is critical to any successful outsourcing relationship. Without reliable data, it will be very difficult to structure an outsourcing deal that will last. Surprisingly, many clients rush to issuing the RFP without having gone through internal due diligence or to gather the necessary data. Some clients rely on the service requirements proposed by suppliers which may not necessarily meet client’s need. When the internal data is not available or the quality of which is questionable, suppliers will be unwilling to commit and very often, the parties will be left with an agreement to agree in the outsourcing agreement. While an agreement to agree may be able to satisfy the imminent need of both parties to get the contract done, it offers very little protection to either party. It is certainly a no win situation from the client perspective. The transition is underway and if the parties could not agree on the undefined items, the parties will be in a dispute situation. This usually means that the parties will invoke dispute resolution mechanism and engage in lengthy negotiation which usually translates into project overtime and over budget. This is also a no win situation from the supplier perspective because recasting the solution is a costly exercise. Engaging in a dispute at such early stage is also very damaging from the relationship standpoint. 

Having comprehensive service requirements at the very start of the process will minimize the chances that the service requirements will need to be renegotiated or recast at the eleventh hour due to insufficient or questionable data. Recasting or revising the service requirements usually means there will be a revision to the bid price. In order to have a meaningful comparison of various bids from different suppliers, client will need to articulate its requirements so that suppliers can price its solution based on a defined set of service requirements.

It is not an easy task for clients to gather internal data because the IT or operational processes of many client organizations may not be at the same standard as the top tier IT suppliers. While the internal due diligence may require lots of time and effort for clients, the result of the due diligence provides more extensive and reliable data upon which both client and supplier can rely to structure an outsourcing deal that will meet the need of both parties and produce a deal that will last.

Many outsourcing contract negotiations start with customer’s paper. While this may not necessarily be objectionable, both parties must understand and remember what the objectives of the deal are. The problem in using a party’s standard template agreement is that those standard clauses may have little relevance to the outsourcing deal. While some customers may believe it is always “better” to get the supplier to agree to “more favourable” terms and conditions in the contract, the reality is that the customer is always the one who ends up paying for such additions.

For example, it is not unusual to see extensive provisions in outsourcing contracts addressing audit rights. The problem is that those provisions are sometimes drafted by legal team who may have little understanding as to what their technical and management teams are expecting from the supplier. An example that I often see is that the customer’s legal representative always insists on a very broad audit right which would include a standard SAS-70 Type II report and a custom SAS-70 report on an annual basis. Since customers in an outsourcing relationship are more interested in “controlling” cost, they would ask suppliers to build those necessary costs into their cost model. SAS-70 audits are not cheap, and depending on the scope, it may very well be hundreds of thousands of dollars per report. While the cost of a custom SAS-70 would not be determined until the scope is determined at the time the audit is performed, the supplier may have to do a best estimate on what the potential cost will be and include the cost in the pricing. The issue is that if the customer is performing a custom SAS-70, chances are a standard SAS-70 audit report may not be needed. To ask for all the audit reports for no additional cost in the outsourcing contract means supplier will have to factor in those costs in building the cost model. This means that the customer may be paying for something it does not need.

Another example is to ask for extensive performance measurements and corresponding service level credits for failing to achieve the performance targets. Customers sometimes may be under an impression that it is better to ask for performance measurements that cover a broad range of activities. To monitor every aspect of performance not only increases the cost of managing the project, but also require the supplier to build additional cost into its cost model as a contingency for having to pay service level credits. The measurement should be focusing on the ones that would have significant impact on the customer’s operation if supplier fails to perform, because a certain percentage of the service level credits the supplier is asked to pay will be included as part of the service fee. Once again, customer should not be asking for something it does not need. 

We need to understand what the objective of the outsourcing deal is, what the solution is, and what the needs of the parties are. There will need to be collaboration among cross-functional teams in any outsourcing contract negotiation. The business and technical requirements will need to be translated into the legal contract. We need to step back and consider whether it is something that the client really needs and whether the deal supports our position. Don’t forget there is no such thing as a free lunch. Supplier always charges the customer for what they ask. Clients do not want to pay for something that ends up being a waste and they certainly do not want to prolong contract negotiation on issues that are not even relevant.

Outsourcing deals usually involve very intense and lengthy negotiation between supplier and customer team members. They spend months or year(s) together in planning, drafting and negotiating the agreement before the deal gets implemented or executed. There are at least two review processes that should take place shortly after an outsourcing deal is finalized. The first one is the contract handover process which provides an opportunity for the deal team to pass on the knowledge to the delivery and implementation team so that they can run with the project. The second review is the deal review or lesson learned session to make sure that organization can build on the experience gained from each deal and add it to the institutional knowledge. While many organizations perform contract review or handover process after the deal is finalized, organizations always miss the opportunity to capitalize the knowledge the team gained from each deal.

Invaluable lessons can be gained at each stage of the deal. For example, there may be suggestions on how the internal process could be improved to support future deals and to minimize bottleneck. The review could lead to improvements on internal approval process, resource engagement process, communication strategy, alignment with industry practice on key issues, and better understanding of its own requirements as well as the other side’s requirements. The discussion may also reinforce the importance of conducting proper due diligence which can minimize the need of the parties to engage in a very expensive re-solutioning process post-contract signing.

The review should include not only things that the organization could improve on, but also things that worked well. While most likely the lessons learned by individual team members will be reflected in the way each team member will handle the next outsourcing deal, it is also important for organizations to formalize the lesson learned process so that the knowledge can stay at the institutional level.

It is important to conduct the review shortly after the project is completed when the deal is still fresh in everyone’s mind. After gathering the thoughts from various team members, it will be useful to follow up on those ideas and examine the ones which warrant further review. While many people would agree on the usefulness of conducting lessons learned session, the reality is that as soon as a deal is completed, the deal team members are usually dispersed to pursue other projects. Deal review sessions may not necessarily be conducted as often as we would expect due to limited resources. Where resources permit, organizations could consider expanding the lesson learned process to include regular deal review. It will be beneficial to perform a root cause analysis on deals that have failed to achieve the intended objectives. By performing a root cause analysis, organizations may realize that those deals have a common theme. Identifying those areas can minimize costly repeated mistakes and increase efficiency. For example, the analysis may reveal a poorly performed due diligence or a poorly defined statement of requirement. Organization may proactively minimize similar problem by offering training or by adjusting the composition of the deal team. Conducting deal review can expand cross-team learning and assist organizations to identify areas where it could continuously improve. 

The natural objective of companies entering into outsourcing contracts is to get the best possible terms. The parties assemble working teams which include legal, technical, business and operational personnel. The teams spend weeks, if not months, in negotiating the terms and conditions. While the negotiation team members are very familiar with the end result, the rest of the team members may have very little knowledge of what has been negotiated. With the exception of the operational team members who will stay on to deliver the services or to manage the account, most of the negotiating team will disperse after the contract is finalized. Regardless of how good the contractual terms are, the team may not even be aware of what is in the contract. If the operation team does not fully understand the terms in the contract, this could mean supplier may end up delivering more than the scope of the contract or the customer may end up receiving less (or paying more) than what they bargained for, or the implementation schedule may be delayed and both parties will get frustrated.

Having an effective legal knowledge transfer to the operational team in an outsourcing arrangement is crucial to the success of the outsourcing relationship. For example, the parties may have already negotiated the mechanism to deal with changes in laws, but if the working teams are not aware of such terms, they may negotiate the changes on a case by case basis and sometimes to the detriment of the parties. This is especially the case if some of the working team members have been previously involved in other similar deals but with different contractual terms. They may tend to address the situation in a way similar to what they did in the last deal without much understanding of what has been negotiated in the contract.

Companies can maximize the effectiveness of the contractual terms they have negotiated by designing and implementing a knowledge transfer process from the negotiation team to the operational team. This is not to say, however, that every time an issue comes up, the parties should resolve the issue by resorting to the legal terms. Knowing each party’s rights and obligations can avoid many unnecessary disputes.

The right individuals should be part of the knowledge transfer process. It is important to include not only the individuals who will be managing the outsourcing relationship, but also those who will be running the services or account on a daily basis, including individuals from the technical, finance, service level management and governance areas. Ideally, if it is an important outsourcing engagement, the knowledge transfer should be more than just a legal memo to the team. I find the dialogue format to be very useful. For big outsourcing arrangement, this legal knowledge transfer process could take a couple of days depending on the complexity of the arrangement and may involve one or more seminars.

It will be useful to provide the team with the business context within which the deal was negotiated. This will provide the team with a better appreciation of the key objectives of the parties in entering into the outsourcing arrangement. Some of the items that should be addressed in the knowledge transfer process include the scope of the services, the milestones, the service levels, the fee structure and invoicing, the governance model and reporting requirements. The idea is to equip the operation team with as much background information and contractual knowledge as possible so that they fully appreciate the context that governed the negotiation and the objectives sought. 

In outsourcing agreements, customers usually request the so-called most favoured customer (MFC) clause from their service providers. The MFC clause is a promise from the service provider to treat the customer not less favourably than its customers. The clause can take various forms but invariably it requires the service provider who offers lower charges to any other customers for the same or substantially similar services to reduce the charge of the customers. Some customers like the clause because it provides them with comfort that the charges under its outsourcing agreement will be competitive during the term of the contract. This is important for customers in a long-term outsourcing arrangement relationship, because customers do not need to wait to the end of the term or pay early termination fees if the charges are no longer competitive. Should the service provider fail to deliver on this promise, it may be subject to a claim for damages.

We need to pause and reflect on the usefulness of this clause. While MFC clause may be useful in certain cases (for example, where customer becomes the first client of the Supplier in a new geographic market), the value this clause will need to be assessed on a case-by-case basis. The MFC clause is problematic for both service provider and customer. From the service provider’s perspective, the clause poses an administrative problem. It is very difficult for service provider to police its compliance with this provision, not only because of the number of clients and contracts involved, but also because of the unique nature of outsourcing services. Many of the outsourcing solutions are customized and therefore, no two deals are alike. The like-for-like comparison is very difficult to implement. In addition, some of the MFC clauses include retroactive price adjustment to the date the lower charges were first offered to other customers. This raises a revenue recognition concern for service providers, in that the MFC clause violates the price fixed or determinable revenue recognition criteria. This means the revenue (not the cost) from the arrangement will need to be deferred. Moreover, the MFN clause will also pose difficulty to the service provider in offering a “better” deal to other customers for strategic reason. 

From the customer’s perspective, the clause is also problematic. All of the outsourcing agreements are covered by confidentiality provisions. This means that the terms of the agreement cannot be shared with any third parties. Customers realize this restriction and sometimes we see wordings in the MFC provisions which provide the right to a customer’s auditor to verify supplier’s agreements with its third party customers. This audit wording fails to recognize the fact that the customer’s auditor will also be subject to the same confidentiality restrictions as the customer itself. Very often, customers will need to just rely on the statements from the service provider’s officer. Customers cannot have an independent verification of service provider’s compliance with the MFC clause. The other big issue lies in the difficulties in its measurement. It is very difficult to normalize different sets of services and different customers. The MFC clause often includes language to take into account deals of similar nature, size, scope, term, locations, delivery model, service levels, technical complexity, pricing components, etc. The more qualifiers included in the normalization process, the less likely that there will be another deal that is alike and the less meaningful the clause becomes. The MFC clause does not provide protection to customers that the pricing offered by a service provider is competitive to the competitors’ pricing. The MFC clause does not take into account the price in the marketplace. 

In addition to the measurement, enforcement, and revenue recognition issues we mentioned above, the MFC clause does not serve an incentive for service providers to renegotiate pricing with individual customers because the MFC clause could increase the cost of such negotiation by requiring service providers to pay the renegotiated pricing to all customers who have such MFC clause in the contracts. One could also potentially raise an argument under the anti-competition legislation.

Benchmarking can offer a more objective assessment of the competitiveness of the charges. Benchmarking provides a better assurance to customers that the price is fair and reasonable in the marketplace. Very often, the mere threat by the customer of invoking the benchmarking clause can result in pricing concession or discount from the service provider in return for customers waiving the right to perform benchmarking for a certain period of time. Although there will also be issues in finding like-for-like comparators, at least there is a prescribed process and conditions.