Plus Ça Change

One of the most complicated things to address as part of a long term outsourcing is the implications of change. Gartner Group recognized this when it released the results of a survey in which it found:

• 55% of enterprises have renegotiated their outsourcing agreement terms within the lifetime of the contract;
• 15% of such renegotiations occurred within the first 12 months;
• only 23% of enterprises did not expect to enter into renegotiations; and
• nearly 8 in 10 outsourcings will go through renegotiations at some stage.

According to Gartner’s survey, one of the biggest issues leading to contract renegotiation was a lack of flexibility in the outsourcing contract sufficient to accommodate unforeseen changes (fully 50% of survey respondents identified this as the cause of their renegotiation).

To my mind, these survey results are a clarion call for the importance of taking care to anticipate the impact of changes on an outsourcing — the longer the outsourcing transaction term, the greater the necessity for such forethought. This is the first in a series of posts that will look at some of the types of events that can occur during the life of an outsourcing agreement and the mechanisms that can be built into an agreement to handle these changes in manner predictable to both customer and vendor.

1. Unanticipated Impact on M & A Activity

It is obvious that an enterprise’s entering into of an outsourcing agreement does not result in a stoppage of that enterprise’s other mergers and acquisitions activities. However, outsourcing agreements often fail to address the nexus between M&A activity and the outsourcing itself. If an enterprise has entered into an outsourcing, what happens if it wants to sell an affiliate where that affiliate is also a beneficiary of the same outsourcing? Has the outsourcing made the affiliate unsalable in the sense that the running of its business is dependent on the outsourcing for some important business function? What happens if the enterprise acquires a new affiliate which the parent enterprise desires to have extended the benefit of the outsourcing? These are questions best raised at the start of the outsourcing (when a customer’s bargaining power is greatest), rather than in the middle of an M&A deal when these issues tend to rise to the surface.

(i) Acquisitions

If an enterprise acquires a new affiliate, and as part of the integration of that affiliate with the enterprise’s corporate environment, desires to extend the benefit of its existing outsourcing to that affiliate, there are some contractual mechanisms which will help facilitate that outcome.

The “Affiliate Clause”. The first is an affiliate clause which states that at the customer’s request, the vendor will provide services to the affiliates of the customer, as though these parties were the customer itself. The effect of a clause such as this is to negate the need for a re-negotiation of the outsourcing deal documentation. Instead, the services are provided through the parent enterprise to the affiliate, with the parent becoming responsible for the affiliate. More specifically, managing this M&A circumstance through an affiliate clause means there is no direct contractual relationship (known as ‘privity of contract’) between the affiliate and the vendor, which in turn means that neither can enforce the contract terms against the other. Accordingly, the clause must provide on the one hand that the parent enterprise will enforce the contract on behalf of the affiliate, and on the other, that the parent enterprise will be responsible for the affiliate’s breaches. In this way, the contractual relationship stays directly between the parent enterprise and the vendor, but accommodates the addition of the affiliate. With the introduction of a new affiliate in the mix, volumes under the outsourcing may well increase along with the associated fees under the deal — these changes would typically be addressed as part of the change control process (the controls on which are important and will be explored another post). 

Participation Agreement. Another way to handle this circumstance would be through the introduction of a participation agreement. Unlike an “affiliate clause”, a participation agreement is entered into directly between each of the vendor, the parent enterprise and the affiliate and functions, by incorporating the outsourcing agreement’s terms and conditions by reference, so as to extend those terms directly to the affiliate. The difference between the affiliate clause and the participation agreement is the lack of a direct contractual relationship between vendor and affiliate (or lack of privity of contract) in the foregoing example and its maintenance in the latter. The effect of this difference means that in the latter example, a vendor may could make a claim for damages directly against the affiliate under the participation agreement and vice versa. In this way, the allocation of risk between the parent company and its affiliates viz-a-viz the vendor is handled differently in the two models. Different customers may prefer one approach over the other. Another difference is the requirement for administration on the part of the customer and vendor — the affiliate clause requires no subsequent contract documentation to be entered into, although both approaches likely result in the necessity for change order documentation to be settled. There is one more important thing to consider in the case of the participation agreement and that is how do cross-defaults work? The participation should specifically address circumstances in which the parent enterprise terminates its agreement with the vendor — is the effect of such a termination likewise a termination of the participation agreement? The opposite should be considered as well — if an affiliate terminates the participation agreement, should that result in a termination of the parent company’s outsourcing agreement? Different customer and circumstances will dictate different answers to these questions, but it is important to address this point.

(ii) Divestitures

The approach with divestitures should be managed in a similar fashion. The parent enterprise’s outsourcing agreement should include a divestiture clause. Such a clause would state that if an affiliate is sold to a third party and thereby ceases to be an affiliate of the parent enterprise, then such affiliate could continue to obtain the benefit of the outsourcing by entering into an agreement for such services directly with the vendor. This approach would create a directly contractual relationship between the former affiliate and vendor, with the result that breaches under the new outsourcing agreement and associated liability would flow directly between the vendor and the former affiliate. The rationale for this approach (as opposed to an approach that was strictly the opposite of the affiliate clause) is that the parent company no longer has control over its former affiliate, and accordingly, would no longer desire to be deemed to be responsible for its breaches or to act to on its behalf with respect to its claims against the vendor. What is critical on this approach is to settle the terms and conditions of the agreement to be entered into by the vendor and the former affiliate. It’s not enough to simply say, as is often done, that the parties will enter into an outsourcing agreement. Leaving it at that results in an unenforceable ‘agreement to agree’. Instead, definitive terms and conditions (including pricing) must be set. One approach is to state that it would be on the vendor’s standard terms and conditions (including pricing), and annex a copy to the main agreement. Another approach would be to duplicate the terms and conditions of the parent company’s agreement. Whatever is ultimately negotiated, bringing certainty as to the term, scope of services, service levels and pricing for such services is desireable in that it aids in the M&A divestiture activity by creating operational and pricing certainty which can be factored into the M&A deal. 

More generally, with respect to be both acquisitions and divestitures, by accounting for M&A activity ahead of time in a long-term outsourcing agreement, the acquisition or sale of an affiliate can play out through the outsourcing agreement in a predicable manner, thereby limiting financial and contractual uncertainty.