Negotiating and Preparing Outsourcing Contracts, by George A. LaMarca
It is not unusual for businesses seeking to improve operations and reduce costs to utilize outsourcing of entire segments of their operation. There are advantages and disadvantages of this type of business model. LaMarca & Landry, P.C. recently completed a litigated matter concerning an outsourcing contract. The case was referred by the general counsel for an out-of-state firm who contracted for substantial work to be performed by an Iowa company.
The parties had a written contract; however, it was a mere outline of what was in reality the formation of a much more complicated relationship. The uncertainties were bound to lead to confusion, disruption and litigation. While all contracts should contain clear and concise terms, in an outsourcing contract both the type and the content of those terms become vital to the relationship.
As a result of our experience in this case, we can offer you the following general insights and elements to be considered in any outsourcing relationship your business considers implementing:
Preliminary Due Diligence
1. Determine whether the company is adequately insured to cover the risk of its operations and, in particular, damage caused to your customers as a result of the outsource service company (OSC) breach of the contract.
2. If at possible, have the OSC share financial information with you showing at least two things: a) does it have sufficient net income from its operations to meet its day-to-day obligations; b) is it sufficiently capitalized to continue an operation if it has any significant disruption in revenues.
3. Have confidentiality and nondisclosure agreements in place before beginning negotiations. This agreement should include the same protection of your company’s trade secrets and intellectual property that will also be in your company’s contract with the OSC.
4. You should insist that the OSC become licensed to do business and maintain a registered agent in your state.
5. Insist that the OSC share financial information with you showing at least two things: a) does it have sufficient net income from its operation to meet its day-to-day obligations; b) is it sufficiently capitalized to complete your contract if it has any significant disruptions in revenues.
6. You should conduct a civil background check on the company and its principals to see if they have been the subject of any litigation.
7. You should also conduct a criminal background and SEC complaint check on the OSC principals to see if they have been the subject of any criminal investigation or securities violation charges.
8. Ask for past/current customer references and banking references. References on key OSC principals should be requested and completely followed up on.
9. Request (and then verify) the employment resumes of the key employees who will be directly responsible for the OSC’s performance of your contract. Require updates when new employees become responsible for the OSC’s performance of your contract.
10. Both any need to engage and the identity of all key subcontractors the OSC will utilize for your project must be identified. The same due diligence check you need to do on the OSC should also be undertaken for these entities as well.
Key Contract Terms
11. Have a defined plan that includes specific procedures to ensure the quality of services, products or work provided by the OSC.
12. Be careful about agreeing to the law of the OSC state as being applicable to the interpretation or construction of the contract. While the law may not be substantially different from the law of your state of incorporation, oftentimes there is a legal advantage motive behind the selection of one state’s law over the other.
13. The OSC should have a specific obligation to ensure the security of your company’s data in its hands.
14. If the OSC’s services, work or product is not in conformity, then the goods or services can be rejected as non-conforming.
15. Obtain representations and warranties that the OSC will provide work applicable with industry standards and governmental regulations, and then provide for a periodic verification process at stages of the work.
16. Require the OSC to have a disaster plan in place to ensure its ability to remain operational despite a catastrophic casualty, and also to protect your company’s information and products in its control or possession.
17. The OSC should adequately insure against and bear the risk of loss to your company’s product until delivery and acceptance by your company.
18. The time, terms and method of payment should be clearly delineated. If there are no incentive arrangements or other forms of compensation, they should be expressly denied and excluded.
19. The clearer and broader the scope of the OSC’s services, the better.
20. The OSC should designate a project manager responsible for your company’s work and that all notices and other contract-required communications will be sent to him and from him to your company. Similarly, your company should have a designated project manager.
21. Deadlines and notices for communication of key information, progress reports, deadlines and payment dates should be clearly set out.
22. The contract should clearly state that unless expressly set forth, there will be no additional charges, and that the OSC can complete the contract without any “add-on” services or charges.
23. If the OSC is a subsidiary or close affiliate of another company, seek the guarantee of that company for the OSC’s obligation to your company.
24. Be clear that all right, title and interest to your company’s intellectual property is fully protected. If related copyrights or patents are in any way generated by the OSC as a result of its working on your company’s time and project, they should be immediately disclosed and belong to your company.
25. Both parties should limit their liabilities on the outsourced work. A limitation not only on the amount of damages, but also on indirect damages should be employed.
A scope of work should be drafted with extreme attention to detail. A beginning to end delineation of the entire process and the work to be performed should be clearly spelled out. The scope of work guides the entire contract. If it is not properly defined, all other terms become impacted and typically ineffective.
Is the company adequately insured to cover the risk of its operations and, in particular, damage caused to your customers as a result of the OSC’s breach of the contract?
As is true in all transactions, care must be taken to identify key contractual requirements, vulnerabilities, and an appropriate exit strategy if things go wrong.
First, it is critical that you select the right OSC (the due diligence). Second, the contract should be set up in such a way that both parties benefit from the relationship (the key contract terms). Successfully completing these two steps will ensure that the OSC can deliver as needed and also that both parties have sufficient incentives to guarantee the success of the relationship.
Because even the best of written contracts sometimes result in litigation, spend sufficient time with the principals of the OSC to determine if they are the type of people you feel comfortable working with. Be wary of unrealistic promises, or unfounded, self-promoting representations contrary to your due diligence results.
Outsourcing with a foreign OSC is beyond the scope of this memorandum. But, at the very least, you should consider language barriers, the stability of the foreign government, its system of laws, taxation issues, its protection of intellectual property of U.S. companies, and international trade agreements that may interfere with the smooth operation or enforcement of the contract.
The above information is intended to provide general guidelines and recognition of basic issues. It is not a substitute and should not be considered legal advice for any specific transaction.