Offshore Outsourcing: 8 Contract Tactics That Protect Against New Threats

CIO — In the wake of events such as the admission of fraud by Satyam's CEO and recent terrorist attacks, sourcing professionals have been forced to consider whether they really enjoy the protections they thought they had already established contractually with their providers.

In revisiting the suitability of contractual protections, sourcing teams also should revisit existing approaches adopt new strategies for emerging threats. These dangers include:

1. The current economic conditions, which are pushing sourcing pros to focus almost exclusively on cost, to the potential detriment of risk management;.

2. Geographic instability, which has caused disruptions in offshore locations.

3. Vendor instability, such as Satyams fall from grace and the more recent Chapter 11 bankruptcy filing of BearingPoint, which highlights how much business risk is associated with work done by outsourcers.

Forestalling every conceivable threat is an impossible goal. Rather, the purpose should be to adopt prudent practices that anticipate as much as possible and protect the enterprise against unforeseen events. Here are eight tips to help you negotiate or re-negotiate your next contract:

1. Modify common clauses like force majeure to encompass other threats. Conventional outsourcing protections focus primarily on natural disasters. A French phrase meaning "superior or greater force," a force majeure provision typically frees both parties from liability when an event happens that is beyond the control of either party, like an earthquake. However, in establishing such protections, clients must be careful not to forgive a lack of responsible precaution.

2. Extend criteria for eligibility for termination for cause. Now that clients have experienced at least the prospect of a sudden, unforeseeable threat to their supplier's viability, they should rethink their approach to termination provisions. Change of control is adequate upon acquisition, but sourcing teams can't afford to wait for the culmination of legal proceedings in a case of fraud. Consequently, buyers should include termination provisions that provide an early, rapid response to changing supplier conditions, linked to visible triggers such as a sudden reduction in a supplier's credit rating, admission of fraud, or misleading financial statements.

3. Extend change of ownership provisions to address potential supplier breakup. Although it's a time-honored strategy, allowing for termination based on change of control, precipitated by either the buyer or the supplier, takes on new significance amid increasing market instability. For example, the recent experience of Satyam clients included not just the threat of acquisition but breakup of the company and the prospect of it selling off specific units. Outsourcing clients should make sure that change of control provisions addresses these potential scenarios.

4. Establish clear ownership of assets and documentation. Outsourcing contracts are usually strong on the disposition of hard assets, but not necessarily on "soft" assets such as software, documentation, and other intellectual property artifacts. Spend more time defining and claiming such intellectual property in contracts.

5. Add Clauses And Terms That Address Emergent Concerns. Clauses addressing transition-out requirements, audit provisions and termination costs are all advisable. Used sparingly today, sourcing teams should become more aggressive in securing transition assistance in a contract with adequate discussion of timeframes and payment provisions. Requesting additional audits of a vendor's conformance with specific industry regulations, service provisioning, pricing or even financials is an increasingly frequent response of outsourcing clients. Finally, vendors are becoming less enthusiastic about funding equipment costs and "pass-through" expenses given today's credit crunch, so minimizing these aspects can simplify transition and make it less contentious.

6. Take advantage of recent lessons learned. Recent events allow buyers with new perspectives and requirements to reevaluate their contractual foundations. Make sure you consider any necessary audit provisions up front. Provisions for transition to alternative suppliers, long established on the infrastructure side, are becoming more prevalent on the applications side as well, in some cases complicating multi-vendor scenarios. Remember that any costs the supplier incurs will likely enter into the supplier's calculations of costs to recover upon termination for convenience, including selling and general administrative expenses.

7. Seek concessions if re-negotiating a contract. Renegotiate existing contracts with an eye toward clarifying responsibility for termination charges, as well as transition assistance. Given today's marketplace, it's a good time to extend categories of potential termination for cause, as well as introduce audit provisions. Suppliers are in many cases readily conceding these provisions. Of course, renegotiating rates is part of this discussion. In such cases, it's valuable to put a price on perceived comfort factors such as access to domestic US-based development centers in the case of offshore applications work, which customers tend to appreciate in the abstract but struggle to use in practice, particularly given additional facilities-related costs.

8. Make sure you secure adequate legal advice. The suggestions in this report are intended as guidelines only and are not intended to substitute for legal counsel. As many of the new scenarios and contingencies in contracting bring additional legal risk and complexity, sourcing teams should ensure that their legal counsel reviews contracts with particular care.

Bill Martorelli is a Principal Analyst at Forrester Research, where he serves Sourcing & Vendor Management professionals. His primary research focus is application sourcing strategies. Bill will present on sourcing models at Forrester's IT Forum, May 19-22, in Las Vegas.