Outsourcing - expert tips on iron-clad protection

How to avoid a messy divorce

Breaking up is always hard to do, especially when you and your partner are knee-deep in a multimillion-pound deal to transform back-office processes.

But these messy divorces are not inevitable, with a bit of forethought and good contract discipline, outsourcing specialists at law firm DLA Piper say it is possible to avoid acrimonious staff custody battles and costly termination payments.

Duncan Pithouse, partner for the technology, sourcing and commercial group at DLA Piper said that spelling out your expectations when drawing up the contract is the key to a happy outsourcing relationship.

"Getting the balance right at the outset is the key for long term success," he said, adding that by the time there are serious problems with service delivery it is "almost too late to put it right".

To avoid this customers are increasingly looking for ways to spot early signs of financial distress at suppliers, Pithouse said.

Here are Pithouse's tips on the clauses and checks at the heart of a cast-iron outsourcing contract:

Due diligence
When choosing a supplier it is no longer sufficient to rely on audited accounts, owing to time lags such accounts can be out of date as soon as they are published.

Companies need to seek extra reassurance by asking for unaudited/management accounts and testimonies on the liquidity of the supplier, such as opinion letters from auditors, comfort letters from banks and affidavits from CFOs.

Multi-sourcing
By choosing multiple suppliers to fulfil a single business function, say finance and accounting, companies avoid putting all their eggs in one basket.

This way if a single supplier goes under, the worst that can happen is the temporary loss of one part of the process rather than the entire chain.

It can also make it easier to swap in an alternative supplier from this group of outsourcers to take the place of the failed one.

Performance bonds and guarantees
Both can help provide an insurance policy against the supplier failing to deliver.

Performance bonds are money that is put to one side by the supplier that can be claimed by the customer in the event that the supplier defaults on a contract.

A guarantee is a contractual obligation that the parent company of a supplier will step in to deliver a service or pay damages if its subsidiary becomes unable to do so.

Notification obligations
Building notification obligations into a contract provides transparency as to the financial health of key suppliers.

Notifications can be set up for events such as staff attrition rates hitting a certain level, a suppliers' unrestricted cash dropping below a set level, breaches of banking covenants or when there are changes to the company board.

This insight can flag up problems at an early stage, for instance a high attrition rate usually does not indicate that a company is a happy place to work.

Softer obligations can be fixing regular meetings with CxOs to discuss the supplier strategy going forward.

Renewing these obligations every 12 months can help create a greater focus in the supplier.

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Rights of step in
This allows the customer to step in and take over the supplier's facilities and staff being used to deliver services. These are triggered by certain events, usually consistent or significant failure to deliver the agreed service.

It is important to agree the right trigger events and how much continuing assistance the customer will want from the supplier after stepping in and taking over.

These are unpopular with suppliers because of their reputation, with many suppliers often preferring to terminate a contract rather than allow a step-in-right to be exercised by the customer.

Anticipating termination rights
These clauses allow customers to exit a contract before a supplier's financial difficulties get out of hand, with the idea being to get out of a contract while a managed withdrawal is still possible.

These can be set to be invoked when a solvency/liquidity ratio exceeds a set threshold, the supplier experiences a decline in standing with a credit rating agency or where there is a breach of a banking covenant.

Novation rights/collateral contracts
Novation rights allow for a service subcontractor to take over from the main supplier if the main contractor becomes insolvent or has their contract terminated.

A collateral contract is a parallel agreement where the customer has a contract with a subcontractor to run the service from the beginning but it doesn't come into effect until the departure of the main contractor.

Acquisition of assets
When setting out what assets belonging to the supplier can be taken over by the customer in the event of supplier insolvency, there are several questions to ask.

How will the value of the supplier assets be set, will it be fair market or net book value?

Is the acquisition of assets an option or an obligation for the customer?

Are the assets that can be acquired by a customer limited to those that are wholly used to deliver a service to that customer?

Who will bear the cost of the removal of the assets?

Staff transfer and solicitation
Getting hold of supplier staff and expertise used to deliver a service will be a pressing concern for a customer in the event of supplier insolvency.

Ways that a customer can smooth the takeover of supplier staff are by requiring supplier staff secondments, setting out the right for the customer to pay supplier staff in extreme circumstances and imposing restrictions on staff movements within service delivery team.

Benchmarking and market testing
Ensure that confidentiality agreements allow for benchmarking to allow price and the level of service delivery to be compared against the wider market.

If benchmarking reveals that the customer is paying above the odds then it can lead to contract renegotiation that allows for a better deal.

A gainshare agreement can also allow the customer to share in the cost benefits, for instance where a supplier has made a service more efficient and it costs a supplier less to deliver that service.

Similarly a service level improvement agreement allows for the supplier and the customer to agree an automatic increase in the level of performance to be achieved by the supplier each year.