Mandatory Change in an Outsourcing Relationship

Although it is now customary for outsourcing agreements to include extensive change management provisions, not all of them include “Mandatory Change” or “Directive” provisions. These are provisions that entitle a Customer to require its Service Provider to start work on a particular change on a priority basis and without compliance with the often extensive provisions that have been inserted into the outsourcing agreement specifically to ensure that the Service Provider does not start work on a change until there is a written agreement around all of the terms and conditions. The need for Mandatory Change provisions can arise, for example, in a government outsourcing where the government intends to introduce legislative changes impacting systems as part of its budget but needs the changes to be in production the moment they are announced. In such circumstances, the government customer may not have the time to issue a Change Request, evaluate the Service Provider’s Change Response and then negotiate the Change Order: it needs the Service Provider to start work immediately to ensure the changes are ready at the moment they are required.

The challenge in dealing with Mandatory Change provisions is how to balance the interests of the parties. The Customer’s interest is in having the Service Provider start work immediately. The Service Provider’s interest (or one of them) is in getting paid: how should the Service Provider be compensated for implementing the Mandatory Change? The answer is not obvious. How do the parties, at the time an outsourcing agreement is signed, establish a fee that will compensate the Service Provider for costs it will incur in providing services in the future and take account of any cost impacts on the other services provided by the Service Provider?

In thinking about this issue, as (former) Service Provider’s counsel, there are two principles that are important:

(i) once the Service Provider is obligated to provide the services, as it is required to do under any Mandatory Change or Directive provision, the Service Provider loses whatever negotiating power it may possess; and

(ii) any solution that requires the Service Provider to refer a dispute to the contract’s dispute resolution process is a bad solution. Never mind that the costs of going through dispute resolution can exceed the Service Provider’s fees to complete the Mandatory Change. Putting an issue into dispute resolution changes the tone of an outsourcing relationship and undermines whatever trust and good will exists between the parties. Service Providers may absorb costs for which they should rightfully be compensated if the costs can only be recovered by making a claim under the outsourcing agreement’s dispute resolution procedures: the damage to the outsourcing relationship is too high a price to pay. Therefore if the procedure to compensate the Service Provider for its efforts in implementing a Mandatory Change is to require the Service Provider to refer the issue to dispute resolution, this is not a very good solution.

There are a number of options for dealing with these issues. These include:

(i) Time and Materials: The Service Provider is compensated on a time and materials basis at rates set out in the outsourcing agreement. If the parties wish to rely on a time and materials based solution, it should only be as a fall back solution, after the parties have attempted to negotiate agreement around price, say by escalating the pricing dispute through the internal steps of the dispute resolution process and as a condition of the Service Provider starting to perform the services. Alternatively, time and materials pricing can be used on an interim basis while one of the other options is exercised.

(ii) Pricing Threshold: As part of negotiating the Mandatory Change provisions in the outsourcing agreement, the parties agree to a pricing threshold e.g. five hundred thousand dollars. When circumstances requiring a Mandatory Change arise, the Service Provider is required under the outsourcing agreement to start to perform services immediately. At the same time however, the Service Provider prepares a Change Proposal including pricing for the Customer. The parties attempt to negotiate a resolution based on the Change Proposal provided by the Service provider. If they are not successful, the Customer is required to refer the dispute to dispute resolution. While the matter is in dispute, once the Service Provider has incurred costs in excess of the pricing threshold, the Customer is required to compensate the Service Provider on a time and materials basis for additional costs in excess the pricing threshold.

(iii) Baseball Arbitration: This approach is most effective in outsourcing agreements that include provisions for expedited dispute resolution. Under this approach, the Service Provider is required to start to deliver services in response to notice of a Mandatory Change from the Customer. However, as with the approach set out above, the Service Provider provides the Customer with a Change Proposal that includes pricing. If the Service Provider’s proposal is not acceptable to the Customer, the Customer responds with its own Change Proposal including pricing. If the Customer’s proposal is not acceptable to the Service Provider, then the issue is resolved by “baseball arbitration”, i.e. the dispute is referred to a single arbitrator who chooses one of the two proposals as the basis for compensating the Service Provider.

It is in the Customer’s interest that Mandatory Change or Directive provisions be part of contemporary outsourcing agreements. However such provisions must also recognize the interests of the Service Provider and strike an appropriate balance.