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Death of Captive Paradigm? Business Transformation of a Shared Services Captive: Legal and Business Issues in Conversion from SSO to Independent BPO Service Provider

October 9, 2009 by Bierce & Kenerson, P.C.

General Electric Company’s announcement on November 8, 2004, that it has agreed to sell 60% of its Indian captive services company GE Capital Information Services (“GECIS”) marks a turning point in the trend towards establishment of offshore captive services companies.  This article considers the legal and business issues in a conversion of a foreign captive shared services organization (“SSO”) to an independent business process outsourcing (“BPO”) service provider.   It is a lesson in management strategy, risk analysis and, most importantly, return on investment for shareholders.

Disclaimer: The author has not seen the documentation among the parties on this transaction.

GECIS as Captive SSO.

GECIS was established to provide specialized talent and resources to GE’s affiliates globally.  Most recently, it has been providing Six Sigma productivity improvement methodology and training, cost savings advisory services and back-office business process support to GE’s affiliates.  The legacy of GECIS as a captive organization demonstrates GE’s success in managing services as a core competency across the world.  GE’s press release noted:

As a captive, GECIS probably had reached the limit of its ability to scale the processes and generate business value. Even GE globally has limited capacity to absorb shared services.

The Business Transformation to BPO Services Provider.

Sale of Shares.
GE converted the SSO to a BPO service provider by selling a majority share to two private equity firms, General Atlantic Partners and Oak Hill Capital Partners.  After the sale, GE will own 40%, with each of the other two shareholders owning 30%.

Recapitalization.
The GECIS company will also be recapitalized.  Recapitalization of a healthy, growing company in a booming services economy suggests that the new investors will be contributing new capital.   The pricing of the share sale, as well the relative contributions to capital, may depend on an “earn-out” based on on post-sale performance of the company.

Allocation of Shareholdings; Impact on Corporate Governance.
GE could have chosen to sell to one other shareholder.  By selling to two investment groups, it dilutes the individual power of the other shareholders and retains an opportunity, by persuasion or other alignment of interests, to potentially share majority control with one of the two investors.  Thus, for accounting and regulatory purposes, GE ceases to own control.  For corporate governance purposes, it may retain an option (explicit or in a shareholders agreement) to share voting control with one of the two investors.

Expansion of Markets.
GE’s Press Release announced an expansion of into new markets, which will be generate new value for the new private equity investors.  GECIS “will accelerate its third-party sales, marketing and delivery capability to significantly expand its client base, especially in China and Eastern Europe, where it began operating two years ago.”

Management.
As announced, Mr. Pramod Bhasin will remain as president and chief executive officer, supported by the current Gecis global management team.

Board of Directors.
Thee new board, comprising four representatives from GE and six from the new investors, will be constituted by the end of 2004.

GE as Customer.
As announced, Gecis will continue to serve GE under a multiyear contract. That contract undoubtedly gives GE a priority claim on some of Gecis’s resources, most-favored-nation pricing and other preferences afforded to the best customers.

International Capital Structure.
The admission of new investors requires an appropriate capital structure.  Capital structures are driven by considerations of corporate law, taxation, effectiveness of controls and predictability of the rule of law.  Generally, international investments are structured to interpose an offshore holding company so that sales of the portfolio company are sheltered from income tax on disposition.

Corporate Governance.
Selection of the jurisdiction for the holding company, that will be co-owned by the investors, has an important bearing upon the corporate governance.   Corporate governance involves the rights to elect and terminate the board of directors, to approve important business decisions that might affect corporate operations, policies, financing, growth, mergers, acquisitions, dispositions, recapitalizations, joint ventures and liquidation.

Each of these corporate governance elements depends on the voting rights established under the applicable corporation or company law, the shareholders’ agreement, if any, the by-laws and resolutions of the board of directors.  Every country has its own corporation law, and nomenclature and rights vary across the world.  “Offshore” jurisdictions specialize in attracting foreign investment by offering highly flexible corporate structures, with minimal protections for minority shareholders.

Minority Holder’s Statutory Rights.
The right of a minority shareholder to block a major corporate action — such as an acquisition, major divestiture or restructuring — may be greater in some countries than others.  In India, the holder of a 25% ownership interest in a limited company are entitled to block such major corporate actions.  In Delaware and New York, for example, the minority has no such right, and the holder of a majority of the voting rights can effectively dictate major corporate actions.  As a result, when a 100% owner of an Indian shared services captive wishes to recapitalize the Indian company, it will normally choose a jurisdiction that allows absolute control by the majority owners, subject to fiduciary duties to minorities.

Recapitalization vs. Sale of Shares.
For sole owner of an operating company like an Indian captive services provider, sale of shares could trigger a capital gains tax.  By having the operating company (or a holding company) issue new shares, the funding of new investment capital into the business can be achieved without capital gains tax because capital contributions are not taxable events.

Classes of Shares.
Frequently, new capital contributions are paid in consideration of the issuance of a new class of common shares.  A capital structure with multiple classes of shares has several implications.  The same results can be achieved without multiple classes of shares, but to do so would require extensive negotiation and drafting of a complex shareholders’ agreement.

First, by statute, each class may have the right to approve or disapprove certain corporate actions.  Thus, if one shareholder has all shares in a class, that shareholder may effectively veto major changes that require the consent of all classes of shares.

Second, if there are three shareholders in any class of shares, it ownership can be structured so that none has a majority control of that class.  By loading up the number of minority shareholders in one class of shares, none has any control.  Such a structure strengthens the de facto control of the holders of a majority of any other class of shares.

Third, each class of shares can have different rights of voting, dividends and liquidation preferences.  This feature can allow different investors to design a plan for their own particular investment parameters, including cash flow and the timing and conditions of exit from the investment.

Impact on GE.

Strategic Redirection.
GE’s sale of the 60% stake in the GECIS subsidiary does not mark any withdrawal from the Indian market.  GE’s businesses in India represent annual revenues of $1 billion and 22,000 employees.  Rather, the sale suggests a change in strategic direction.

• The competitive advantage of having a captive BPO service provider appears to have already been achieved.  GE will continue to be a customer, with preferential benefits, of the restructured GECIS.  But there appeared no compelling competitive reason not to expand the clientele of the BPO service provider across global markets.
• The sale of the 60% stake will support expansion of GECIS’s business.  GECIS will accelerate its efforts in marketing, sales and delivery to “underserved” areas that have not experienced productivity improvements, such as China and Eastern Europe.  Opportunities for expansion into new markets will take additional capital investment, which will be provided by the new investors as part of the recapitalization.   It was not clear whether GE would make an additional investment, but it would be normal to do so if the expansion were to require a staging of capital expenditures.

Human Resources.
The transfer of ownership control can have significant effects upon an entity’s employees.

• New Management.
  The recapitalization using private equity investment may be accompanied by a change in management.  In the GECIS case, the operating management will continue in place, but the board of directors will be controlled by the investors in proportion to their respective ownership percentages.  This approach contrasts with the clash that occurs when a strategic acquirer seeks to impose its own management structures and approach upon a new acquisition.  In the GECIS situation, the employees and customers have some assurance that, despite the change in control of the board of directors, the new management will do “more of the same” and seek to expand operations rather than integrate them with a strategic acquirer.
• Pension Plans.
  Rules governing employment law, taxation of deferred compensation and pension rights tend to be territorial in nature.  Under the U.S. pension law (“ERISA”), an employer is not required to cover foreign-based employees, whether directly or employed by foreign subsidiaries or affiliates, include in its U.S. profit sharing, pension, retirement and medical insurance plans.  In this situation, GECIS probably has its own Indian-based pension plans, and there will probably be no impact on any U.S. ERISA plans.  A few exceptions might apply for certain senior executives, and as to them the recapitalization to include new majority ownership will likely result in some special price adjustments over time..
• Exit Strategies.
  With new capital, the company should grow.  But the new investors have predictable time horizons for realizing the return on their investment.  Employees and suppliers should anticipate a strategic sale or initial public offering in five to seven years.  At that time, a change in control may be expected.

Intellectual Property Rights.
Private equity investments do not normally come with significant intellectual property that can be licensed to the newly acquired portfolio company or can be exploited as part of commercial services to customers.  In this case, there might be some cross-licensing of intellectual property rights of the private equity portfolio companies owned by the private investors.  Press reports were silent on this issue.  In each new private equity investment, the integration and cross-licensing of technologies across portfolio companies of private equity funds merits further exploration.

“Captive of Multiple Unrelated Owners.”

Private equity investors may bring synergies and, like Internet Capital in the late 1990’s, even develop a strategy of assembling service companies that can support each other in the classic conglomerate or Daibatsu intercompany strategic relationships.  In this case, the private equity investors will clearly be acquiring a crown jewel that can not only grow by expanding to new markets, but which can develop new synergies, efficiencies and productivity improvements for other portfolio companies.  To the extent that other portfolio companies of General Atlantic and Oak Hill Partners can benefit from the GECIS productivity improvement services, the purchase price will yield multiples of value.   This intrinsic portfolio enhancement consideration might have been an important factor in pushing up the purchase price.

Local Ownership and Selection of Business Partners.
The BPO market is not protected by local restrictions on foreign ownership.  Accordingly, it is entirely normal for foreign investors to share in foreign ownership.    One may inquire why GE did not consider a local Indian private equity fund instead of two American-owned funds. This can probably be explained by an affinity of culture and a long-standing relationship among the parties in the American market.  Also, the Indian private equity funds are not as liquid and highly developed as American private equity funds.

Conclusion

The transformation of a captive services organization to a BPO service provider presages increased reluctance of global organizations to own their shared services operations, at least where the “first-mover” advantages of having in-house resources have been achieved.   Senior managements of global organizations will now face ever so starkly the question whether their shared services organizations are part of the aligned vision of the global enterprise.  If the SSO is not efficient, it should be replaced by an efficient paradigm.  If the SSO is efficient, it can be used as a launchpad for growing a “sideline” business, generating additional return on shareholder equity.

Conversion from captive to BPO provider requires extensive strategic planning.  It involves substantial degree of complexity in execution.  Time will tell whether other companies will follow in GE’s footsteps.

Forensic Investigations: Distinguishing Ordinary Outsourced Investigation from Privileged Investigation

October 9, 2009 by Bierce & Kenerson, P.C.

Many providers of finance and accounting (“F&A”) services cover a broad array of managed services.  The functions of internal audit, pre-litigation claims and, more specifically, insurance claims processing deserve special attention from a legal standpoint.  This article addresses distinctions between ordinary managed services (subject to pre-trial discovery) and “privileged” investigations that are not disclosable to adversaries in litigation.  The analysis applies across all forms of business process outsourcing (“BPO”), but is particularly appropriate for F&A, HR specialty outsourcing and Sarbanes-Oxley “Internal” Audit.

Normal Rules of Discovery or Disclosure.

Under American rules of civil procedure, litigants are required to disclose to their adversaries information that could be used as evidence, or that could reasonably be expected to lead to the disclosure of evidence.  Ordinary conduct of business, including managed services (or “outsourcing”) is subject to the normal rule.

This rule (sometimes called pre-trial discovery, sometimes called pre-trial disclosure) has several purposes:

• to force each party to identify “reality” and not make any claims or defenses unless justified by the facts.
• to enable a party to discover and use the facts to challenge claims or defenses of its adversary.
• to promote settlements, and thereby reduce the burden of litigation on the court system.
• in criminal cases, to give the accused access to “Due Process” under U.S. Constitutional norms.

Work Product Exception.

Investigations by attorneys or persons under the control of attorneys may be entitled to escape the normal rules of disclosure.  Such investigations are conducted in anticipation of litigation. Businesses at risk of liability to third parties, employers and insurance companies investigating claims are entitled to assert the legal privilege to avoid having their investigators be required to testify in pre-trial depositions and otherwise disclose evidence before trial.

As a matter of public policy, such investigations are confidential and privileged, and the investigators are not subject to depositions during the pre-trial discovery process in order to preserve attorney-client communications and to enable to develop attorney work product free of intrusion.  The confidentiality and privilege enable clients to obtain legal advice free of risk of disclosure.  The attorney-client privilege and attorney work-product privilege to do not, however, protect a client from the duty to testify as to facts witnessed directly by the client outside any attorney-client communication.

A string of recent court decisions has examined the conditions under which an insurance company’s examination of a claim crosses the line from being an investigation performed in the ordinary course of the insurer’s business (and thus not eligible for the legal privilege) or work performed in anticipation of litigation.  Travelers Casualty & Surety Co. v. J.D. Elliot & Co. P.C., ____ F.3d ___, NYLJ Oct. 25, 2004, p. 25, cols. 3-4 (S.D.N.Y. 2004), Judge Pitman; Weber v. Paduano, 02 Civ. 3392 (GEL), 2003 WL 161340 (S.D.N.Y. Jan. 22, 2003); Mt. Vernon Fire Ins. Co. v. Try 3 Bldg. Svces., Inc., 96 iv. 5590 (MJL) (HBP), 199998 WL 729735 (S.D.N.Y. Oct. 16, 1998); Am. Ins. Co. v. Elgot Sales Corp., 97 Civ. 1327 (RLC) (NRB), 1998 WL 647206 (S.D.N.Y. Sept. 21, 1998); see also United States v. Adlman, 134 F.3d 1194, 1199 (2d Cir. 1998).

Burden of Proof.
The party asserting the work product protection bears the burden of establishing the applicability of the work product exception.   If that party seeks to deny all testimony by an investigator, it must prove the availability of the work product exception at all stages of the investigation, from beginning to end.

Standard for Determining When Work Product Exception Applies.
In the Travelers decision, the court noted that there is no “bright line” test for determining when an insurance company’s investigative work is not privileged (i.e., it is merely performed in the ordinary course of business) and when it is privileged as an investigation done in anticipation of litigation.  The court rejected the use of a line based on investigation done prior to the filing of any insurance claim.

A first factor is whether the investigator was retained before any decision was made whether the insurance carrier would reimburse its policyholder for an insured loss.  If the investigation is conducted before there is any reason to expect litigation from either the policyholder or against potential third party sources of reimbursement (under the principle of subrogation), the investigation does not qualify for the work product privilege.

A second factor is whether there was any actual threat of litigation at the time when the investigator was retained to conduct the investigation.  If there is nothing in the file to indicate that litigation is on the horizon, or perceived to be “on the horizon,” the privilege will not apply.

A third factor is whether the investigator is hired by an attorney or merely by the business, employer or insurance company.  There should be some showing that litigation counsel has been retained in order to justify work product privilege.

Impact on Outsourcing.

Internal investigations by providers of outsourced services are normally not eligible for work product privilege.  Enterprises and their F&A outsourcing service providers should adopt certain “best practices” to preserve work product privilege.

• Identify that Litigation is Anticipated.
  If the enterprise customer or the service provider does anticipate any litigation, whether between the two parties or in relation to a third party whose rights might have been injured by an act or omission of the enterprise customer or the service provider, then litigation counsel should be consulted.
• Records Management.
  The parties should establish a log of “anticipated litigation” and maintain it under the management of lawyers.  The records should be clearly marked so that there is no doubt that the investigations are conducted with some specific fear or threat of identifiable litigation “on the horizon.”
• Separate the “Ordinary Work” from the “Work in Anticipation of Litigation.”
  The enterprise customer and the F&A outsourcing service provider should clearly define the scope (statement of work) to include separate categories of “ordinary work” (the usual managed services) and “work in anticipation of litigation” that could be identified and administered separately.   This segregation would insulate the validly privileged internal audit from the non-privileged ordinary operations.

Class Action Litigation in Outsourcing: Managing Consumer Litigation Risk after Class Action Fairness Act of 2005

October 9, 2009 by Bierce & Kenerson, P.C.

The enactment of U.S. federal legislation forcing litigants to argue large class-action claims in federal court will help business generally.  If class actions are basically about violations of consumer rights, what impact will it have on outsourcing, and why?  This article applies to all those who manage call centers, credit cards, employment and payroll, HR administration, finance and accounting and other consumer-facing business functions.

I.    The Public Policy and Public Impact of Class Actions

Rule 23 of the Federal Rules of Civil Procedure allows federal courts to aggregate the claims of multiple injured parties – “plaintiffs” – against one or more common defendants. The claims may be joined into one massive complaint so long as (1) the class is so numerous that joinder of all members is impracticable, (2) there are questions of law or fact common to the class, (3) the claims or defenses of the representative parties are typical of the claims or defenses of the class, and (4) the representative parties will fairly and adequately protect the interests of the class.

Rule 23 serves many societal purposes.

A.    What is a Class: Size of Claims and Impact on Access to Judicial Redress.

1. Small Claims.
For small claims, it allows the aggregation of multiple claims that would not otherwise have been litigated.  It thereby serves to protect the small consumer against the corporate tortfeasor where the damages per plaintiff are very small and the aggregate damages are substantial.

2. Large Claims.
For large claims, Rule 23 economizes judicial resources by avoiding litigation on the fundamental facts affecting perhaps a small or “finite” number of injured parties each of whom has suffered substantial damages.  If the facts are the same or substantially the same, class actions provide judicial efficiency.

B. What is a Class: Technical Requirements.
Following extensive analysis by lawyers and judges that resulted in a multi-thousand page report dated May 1, 1997, on March 27, 2003, the U.S. Supreme Court amended Rule 23 of the Federal Rules of Civil Procedure.  See http://www.uscourts.gov/rules/congress0303/CV-Letters.pdf and http://www.uscourts.gov/rules/WorkingPapers-Vol1.pdf As noted above, a class has to have sufficient “numerosity” to bundle a lot of claims, and sufficient “commonality” to justify treating the same facts or legal circumstances to the members of the class.

C. Socially Engineered Remedies.
Remedies in class actions cover several types of damages.

1.    Compensatory Damages.
Each injured party could receive an appropriate amount of compensation for the loss suffered.

2.    Disgorgement.
Beyond compensating the victims, class  actions can serve as a socially engineered tool for promoting equitable remedies where it is not possible to locate or compensate every member of the class.  In such cases, class actions can force a wrongdoer (or group of wrongdoers with liability allocated by market share, for example) to disgorge ill-gotten gains from consumer fraud and deceit.

3.    Equitable Remedies.
Equitable remedies are applied in order to prevent an injustice.  They can include contempt of court, but most often are structured as injunctions.   An injunction can be issued to prohibit future violations of individual plaintiffs’ rights.

D.  Emerging Growth of Class Actions in an Automated Process-Driven Society.
Based on a federal court procedural rule initially adopted in 1966, class actions have burgeoned since the 1990’s.

1.   Automation of Injury-Causing Commercial Activity.
There has been a shift from individual litigation to representational litigation, as a more “efficient” and effective method of recovering damages from wrongdoing defendants.  Such litigation seeks to recover damages from torts and other repetitious effects inherent in a mechanized, if not automated, Cyber Age.  What started as a basis for supporting consumer product safety and civil rights cases became a weapon for extorting settlements, often of trivial financial value to the injured class, for mass torts and, increasingly, “mass actions” of all types.

2.    Impact on Business Process Outsourcing (“BPO”) and Internal Business Process Management (“BPM”).
Class actions have become the tool of choice for effectuating social change, by shifting money to victims, and for redress of torts involving such diverse problems as securities laws violations, consumer product safety, banking and insurance billing methods and debt collection procedures.

The glorious scalability of business process automation (whether outsourced or not) can become an infamous scalability of mass torts.  Mass torts occur when many people suffer the same consequences of the same (or similar acts) of the defendant(s). Since BPO and BPM can automate injury-causing interactions with consumers, class actions become everyone’s business.  Accordingly, every business that performs, or hires someone to perform, such functions should be aware of the impact of the new Class Action Fairness Act of 2005 upon their business.

II. Consumer Litigation Risks in Outsourcing.

A.    Customer Relationship Management.
Call centers contact customers and prospective customers in outbound calls.  Such contacts may violate applicable consumer protection laws and rules of the Federal Communications Commission, the Federal Trade Commission or the various states.  Fines and penalties may be imposed by the regulators.  In addition, individuals may be able to recover damages for violations of their rights under state or federal law, depending on the type of violation.  In short, by allowing the aggregation of clams common to a class of persons that are “similarly situated,” class actions for violations of laws could become a call center’s worst nightmare.

B.    Privacy Violations.
Virtually any outsourced business process may involve privacy violations arising from mistakes or negligence in the receipt, custody, processing, storage, access, encryption and transmission of confidential records of individuals in a class could form the basis of a mass tort.  records maintenance.   Such violations may apply to health information, personally identifiable information (such as Social Security Numbers), and financial and other personal information submitted to financial institutions or others for valid commercial purposes.  Violations of privacy may result in fines and liability under the Health Insurance Portability and Accountability Act (HIPAA), the Graham-Leach-Bliley Act and the Fair Credit Reporting Act, as amended.

C.    Racketeering and Corrupt Organizations Act (Treble Damages and Attorneys’ Fees).
Outsourcing that is performed remotely usually involves the use of interstate means of communication.  Under RICO, two violations of predicate crimes within a ten year period using such means of communication are subject to triple damages and attorneys’ fees.  Virtually any type of outsourcing could be theoretically subject to a RICO claim.

D.    Antitrust Violations (Treble Damages ).
Antitrust laws provide for triple damages and attorneys’ fees as well.  Where two competitors, each with significant market share in a relevant market, collude to fix prices or allocate territories, the participants will be violating the Sherman Antitrust Act.  Such laws are not likely to apply to outsourcing due to the vertical nature of the relationship arising from business process outsourcing.  Indeed, consumers rarely assert antitrust violations.  Consequently class actions for antitrust violations appear to be a remote possibility.

E.    Civil Rights Violations.
In human resources outsourcing, the service provider may be called upon to engaged in a series of important steps that, if mismanaged, could result in a claim of civil rights violations.  Civil rights generally include discrimination on the basis of sex, race, religion, national origin and even sexual preference.   Specific statutes protecting against age discrimination in employment also come into play in HR outsourcing.

III.    Changes Introduced by the Class Action Fairness Act of 2005

Class actions have affected banks, insurance companies, asbestos manufacturers, tobacco sellers and pharmaceutical manufacturers.   A consortium of business leaders lobbied Congress to change the rules so that interstate commerce can not suffer the burdens of favoritism or arbitrariness that are perceived by many to be part of the state court system.  They also wanted to make the rules uniform across the country, which cannot happen but remains a reasonable ideal in a federal system.

Consequently, the new Act will reduce personal benefits to plaintiffs’ class action lawyers unless the benefits are more aligned with a large segment of the class members.  This involves resetting the rules governing contingency legal fees and transferring cases to the federal district court if any defendant requests it.

A.    Restructuring of Attorney Fee Incentives for Plaintiffs’ Class Action Lawyers.

Rebalancing the Uses (and Abuses) of Coupons in Class Action Settlements.
Any enterprise sued in a class action for violation of consumer protection laws might concede defeat, issue “coupons” for injured parties that force them to use “free” additional services in lieu of cash payments, and pay the attorneys’ fees of the plaintiffs’ lawyers.   The Act will cut back on the ability of plaintiffs’ lawyers to collect cash based on the gross value of the coupons offered by limiting their fees to a percentage of the coupons actually used.  28 U.S.C. 1712(a), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a). If any portion of such attorneys’ fees is not based on the gross value of the coupons, then hourly rates will apply.  Traditionally, hourly rates are not enough to create a wealthy plaintiff’s lawyer.

In the past, coupons issued in class actions have notoriously have had low redemption rates due to the restrictions on duration of use, blackout dates limiting the scheduled use and other unpalatable coupon redemption rules.   This “coupon” strategy will force plaintiffs’ lawyers to seek to maximize the market value of the coupons, thereby aligning the interest of the injured class with those of their lawyers.

Where the class action results in any injunctive or other equitable remedies against the defendant’s), the court may apply a “lodestar” computation with a multiplier method to award attorneys’ fees.

To punish defendants but not allow attorneys to benefit, the financial value of unused coupons could be donated to charity or to government as agreed to by the parties.  28 U.S.C. 1712(e), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).   This would benefit society generally but not benefit the plaintiffs’ attorneys, whose fees could not be based on any such donation.

Net Losses to Lead Plaintiffs.
In some cases, a named plaintiff or other individual plaintiff must pay “sums” to class action attorneys that would make a net loss to that plaintiff.  The new law permits such arrangements only if judicially approved in a determination that the non-monetary benefits bestowed substantially outweigh the monetary loss.  28 U.S.C. 1713, as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

B.    When Must the Mass Action be Transferred to Federal Courts.

1. The General Rile Requiring Transfer of Mass Actions to Federal Courts.
The new law will transfer to federal courts all class actions that are “mass actions,” subject to certain exceptions, upon the demand by any defendant.   Litigation in state courts must be transferred to federal courts where the amount in controversy, as an aggregate of all claims of all individual plaintiffs, does not exceed the “sum or value” of $5 million, exclusive of interest and costs.  28 U.S.C. 1332(d)(6), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a); 28 U.S.C. 1453(b), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec. 5.

A “mass action” means “any civil action (except a class action filed in or removed to a federal district court under Rule 23 of the F.R.Civ.P. “in which monetary relief claims of 100 or more persons are proposed to be tried jointly on the ground that the plaintiffs’ claims involve common questions of law or fact, except that jurisdiction shall exist only over those plaintiffs whose claims in a mass action satisfy the jurisdictional amount requirements” of $75,000 per claim.   28 U.S.C. 1332(d)(11)(B)(i), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

2.    The Exceptions to Mandatory Transfer.

(a)    Judicial Evaluation based on Balancing of Factors.
The Act authorizes the district courts to decline to exercise jurisdiction over a class action where between one third and two-thirds of the members of all proposed plaintiff classes in the aggregate and the primary defendants are citizens of the state where the action was originally filed.  In such cases, the court may take into consideration various enumerated public policy and procedural considerations listed in the Act.  28 U.S.C. 1332(d)(3), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

(b) Prohibition on Mandatory Transfers in Cases of Local-Impact Class Actions.
Congress chose not to require the mandatory transfer to federal district court of class actions that have a distinctly local character.  Local character applies where several conditions all apply.  In each case, the plaintiffs and at least one major defendant must be local.   In each formulation, more than “two-thirds of the members of all proposed plaintiff classes in the aggregate are citizens of the State in which the action was originally filed.”   Also, in each “localization” situation, there must be at least 100 members of the proposed plaintiff class.    28 U.S.C. 1332(d)(5)(B), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

(i) One Defendant’s Conduct.
Under one formulation of this principle,” at least one defendant is a defendant from whom significant relief is sought by members of the plaintiff class,” and “whose alleged conduct forms a significant basis for the claims asserted by the proposed plaintiff class is a citizen of the State in which the action was originally filed.”   Such cases must be transferred to federal district court where the “principal injuries resulting from the alleged conduct or any related conduct of each defendant were incurred in the State in which the action was originally filed.”  28 U.S.C. 1332(d)(4)(A)(i), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

As to such situations, Congress chose not to require the mandatory transfer to federal district court of class actions that are not bunched in time with other similar class actions.    Thus, in such situations, there is no mandatory transfer where, ” during the 3-year period preceding the filing of that class action , no other class action has been filed asserting the same or similar factual allegations against any of the defendants on behalf of the same or other persons.”  Id.

(ii)    The Primary Defendants.
Under another formulation of this principle, the “primary defendants” are citizens of the local state.   The statute does not define the term “primary,” so legislative history must be consulted on the legislative intent.  This formulation of “local” damages does not consider whether the principal injuries resulting from the alleged conduct or any related conduct of each defendant were incurred in the State in which the action was originally filed.

(c)    Excluded Transactions.
Congress denied federal courts any jurisdiction for mass actions involving two types of claims for which local courts are well suited to class actions or that relate essentially to local law, and are already covered by Rule 23.1 (Derivative Actions by Shareholders) and Rule 23.2 (Actions Related to Unincorporated Associations):

• Securities Law Violations: a “covered security” (under the federal securities law, Section 16(f)(3) of the Securities Act of 1933 and Section 28(f)(5)(E) of the Securities Exchange Act of 1934) or rights, duties and obligations (inclining fiduciary duties) relating to any “security” (under federal securities laws, Section 2(a) of the Securities Act of 1933); and
• Shareholder Claims: shareholder class actions that relate to the “internal affairs or governance” of a corporate entity are not covered if the class action is filed in the state court of the state of incorporation.

IV.    Impact of the Class Action Fairness Act of 2005.

This new law requires the transfer to federal courts of all class action litigations that involve interstate or international commerce (which Congress has the constitutional power to regulate) and the claims are at least $5 million in the aggregate, exclusive of interest and costs.

A.    Benefits to Businesses that Might be Defendants.
For businesses (including both outsourcers and their enterprise customers), the benefits derive from:

• Less Pandering:
  a federal judiciary that is appointed for life, and therefore under no personal compulsion to seek election or re-election by pandering to consumer groups;
• Tighter Rules of Civil Procedure:
  a body of federal rules of civil procedure that impose the risk of severe sanctions if pleadings and practices are contemptuous or otherwise non-compliant with the rules, including personal sanctions and civil fines on the litigant, the litigant’s executives (if it is an entity) and the attorneys litigating engaging in sanctionable procedural misdeeds.
• Allocation of Discovery Costs to Plaintiffs:
  an emerging body of cost-allocating and risk-allocating procedural rules that may impose on the plaintiffs significant costs of imposing demands that the defendant (usually a business) deliver myriads of documents and records during the pre-trial discovery process.
• Elimination of Geographical Favoritism:
  the new prohibition on class action settlements that provide for favoritism in disproportionate payments to some class members simply by reason of closer geographical proximity to the court.  28 U.S.C. 1714, as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.3.
• Comments by Regulators of FDIC-Insured Depository Institutions:
  state and federal regulators of depository institutions whose deposits are insured or regulated by the Federal Deposit Insurance Corporation will be notified of any proposed settlement and will have 90 days to comment on it.  28 U.S.C. 1715, as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec. 3.
• Judicial Conference Study Recommendations on Best Practices:
  the requirement of a new judicial study to contain “best practice”  recommendations for (i) the fees and expenses awarded to counsel in connection with a class action settlement appropriately reflect the extent to which counsel succeeded in obtaining full redress for the injuries alleged and the time, expense, and risk that counsel devoted to the litigation; and (ii) the class members on whose behalf the settlement is proposed are the primary beneficiaries of the settlement.  Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec. 6.  This will further focus on alignment of fee incentives for plaintiffs’ counsel with the rewards obtained for the class members.
• Neutralization of the Coercive Effect of Class Actions:
  a regime that removes financial incentives for plaintiffs’ class attorneys to inflate claims, delay settlement or otherwise impose punishing burdens on defendants solely because the aggregation of claims to huge financial levels creates its own substantive rule that settlement is cheaper at all costs than the risk of astronomical liability.  The new Act overcomes part of the substantive effect of class actions that are independent of the underlying claims of the plaintiffs.

B.    Greater Segmentation of Smaller Classes in Narrower Geographic Scope.
This law might encourage the plaintiff’s attorneys to file separate class actions in multiple states, with narrowly defined classes limited to individuals or other victims within a limited geographical territory.

C.    Cost Reduction for Businesses with Possible Sharing with Consumers.
The new law specifically addresses the costs of doing business, with an expressed intention of reducing such costs.   In practice, the reduction in the number of class actions may be expected to reduce insurance premiums for general liability, thereby enabling businesses (whether service providers or enterprise customers) to increase their coverages, retain a higher self-insured deductible or cut insurance premiums.  Such savings could generate chain-reaction benefits of additional capital available for capital investment, research and development, dividends to shareholders and/or reduced prices to consumers.

D.    Promotion of Innovation.
The law seeks to “benefit society by encouraging innovation and lowering consumer prices.”   Act, Sec. 2(b).   This theme will likely be the mantra of the second administration of President George W. Bush (January 20, 2005-Jan. 19, 2009).  The Act does not specifically encourage innovation, but if insurance premiums are reduced, the risk of unacceptably high damages is more manageable because federal judges will be deciding class action procedures, then entrepreneurs and businesses could justify taking slightly greater risks.

V.    Impact on Outsourcing.

The Act reduces the burden of class action defense by correcting some historic abuses.   The Act impacts outsourcing by making reducing litigation risks for both enterprise customers and their service providers.  Such risks exist in every BPO relationship, since third parties — who could be consumers, patients, loan applicants, customers, technology users, family members — could conceivably be injured by the acts or omissions of the service provider, the enterprise customer or both.

For suggestions on how to minimize your risks of a class action, with particular reference to diverse services such as call centers and multifarious BPO performed in foreign back offices, engineering, design, manufacturing, distribution and logistics, please consult our White Paper, “Are You Ready for Class Action Litigation in Outsourcing?”.

Finance & Accounting Outsourcing: Does Outsourcing Reduce Risk?

October 9, 2009 by Bierce & Kenerson, P.C.

When enterprises look to outsource in-house responsibilities, finance and accounting functions are usually not the first ones farmed out. Executives might expect to read headlines like, “Aon Negotiating to Outsource Most of its U.S. IT Infrastructure to Computer Sciences Corporation,” a development Aon and CSC touted in a 2004 press release. Sophisticated business process outsourcing (“BPO”) such as finance and accounting is not as widespread as IT outsourcing.

As enterprise firms seek to enhance their competitive advantage and minimize risks in the Sarbanes-Oxley environment, more and more businesses are looking to outsource parts of their finance and accounting functions. Determination of the right fit with a service provider and the right mix of services is essential.

This article addresses some key business and legal issues in whether F&A outsourcing reduces risks.

What F&A functions are candidates to be outsourced?

Not all F&A functions are created equal. Each F&A function has its own risk profile and potential suitability for outsourcing. Risk profiles reflect the nature of the business functions, size and character of the enterprise, since publicly trade companies must deal with the vagaries and criminalization of accounting practices under Sarbanes-Oxley, and other considerations.

Transactional vs. Judgmental Operations.
Transactional functions, especially payroll and accounts payable and receivable, are the most commonly outsourced functions. Financial reporting and more advanced functions can also be outsourced, though the more interaction required for a function—say, for instance, budgeting—the less likely it is to be outsourced. But today, F&A outsourcers are taking on responsibilities once executed by entire in-house F&A departments.

Enterprise Maturity.
F&A outsourcing depends on enterprise maturity.

Public Companies and “Wannabe’s.”
Mature enterprises — public companies and those considering going public — must, or will have to, establish and certify, on a quarterly basis, the adequacy of their accounting reporting and control systems. Compliance with the Sarbanes-Oxley Act has generated new software and service offerings by information technology service providers and consultants. Such technology might be maintained in-house, a hosting service provider or by a managing service provider.

For public companies, the challenge is to identify those F&A functions that can be “safely” outsourced with minimal risk that a failure will result in civil or criminal liability for the CEO and the CFO. Once such “safe” functions have been identified, the lawyers can deal with “reasonable” allocations of risk between the service provider and the enterprise.

Startups and Emerging Companies.
Startups may outsource more of a function. Outsourcing helps startups avoid misestimating their own needs. Two scenarios are common among startups: they underestimate their F&A needs, or they overestimate them.

Startups will often hire a bookkeeper, for instance, and may get the basic transactional aspects of the business right. But without an accountant, they can’t optimize their F&A strategy. This mistake can often require a startup to sink far more capital in F&A and litigation down the road than they would have had to invest up front.

Alternatively, some firms will bring on a CFO or Comptroller when their F&A needs do not demand that those positions be filled by a full-time employee.

Governance Considerations.
Entire F&A departments can be outsourced, all the way up to the CFO level. We interviewed two F&A outsourcing firms on the desirability of outsourcing CFO and Comptroller functions. Ephinay will take over all F&A responsibilities from a customer except CFO and Comptroller, which Ephinay believes must be retained by the customer for governance purposes. Other outsourcers, like Geller & Co., are more willing to absorb even the responsibilities of CFO and Comptroller, eliminating the need for any F&A functions to be retained by the customer. In contrast, Ephinay believes that is rarely optimal except when the customer’s business is highly specialized. Perhaps the distinction is not so important for small business, but for larger and growing businesses, retention of key internal executives helps ensure controls are retained as well.

When is F&A outsourcing a better solution than in-sourcing?

Business Process Analysis.
As in all other types of outsourcing, F&A outsourcing starts with an analysis of the business processes of an enterprise. This analysis must cover virtually all essential elements of the business processes under consideration. Thus, an “end-to-end” approach will identify functionality, interaction with third parties (such as suppliers, customers and regulators), the degree of human expertise required for each process and the degree to which human expertise can be captured in a scalable information technology solution that includes hardware, software, telecommunications and technology managers.

Business Processes Considered for F&A Outsourcing.
Having dissected the business processes from end-to-end, the enterprise then considers how the classic types of rationales for outsourcing might fit into each F&A process. Many firms find outsourcing F&A business process functions preferable to retaining them. Here are some common reasons why.

Shifting functions plays to core competencies.
F&A outsourcers exist for one reason and one reason alone: to take over the F&A functions of other businesses. If F&A outsourcers fail to do a good job of F&A in a competitive marketplace, they will fail entirely. F&A is an F&A outsourcing firm’s core competency, by definition. Of course, this is an agreement to “trust me.”)

In-house functions are always secondary to the fundamental premise of the company.
In a semiconductor business, for example, making and selling semiconductors is the lifeblood of the business; F&A functions are necessarily secondary because they do not create business. This is no less true of large corporations than it is of startups or enterprise businesses. Top talent is routed to revenue-generating departments; being an accounting whiz, for example, is unlikely to take you to the top of GM. F&A outsourcers, unlike their customers and prospective customers, are structured to reward those who perform F&A functions well.

F&A outsourcing optimizes functions of non-F&A businesses.
F&A outsourcers allow businesses to focus on revenue generation instead of worrying about F&A matters, which are integral to their operations but do not actually create revenue for their business.

Outsourcing optimizes the function of the CFO and other senior-level employees.
When transactional functions are outsourced, the CFO can focus on F&A strategy rather than minutiae. The CFO can be a CFO, the Comptroller can be a Comptroller.

Cost Substitution.
Outsourcing enables businesses to implement more advanced technology solutions more cheaply. Take, for example, a firm with an antiquated IT system that costs them $10 million dollars a year to run. They want to upgrade, but the upgrade will require a capital investment of $15 million; the outsourcer, on the other hand, can provide the service for $8 million. The customer may prefer to go with the outsourcer, who can provide the improved technology for less than the cost of the customer’s obsolete technology and for substantially less than the cost of an in-house upgrade.

Economies of scale.
F&A service providers such as Ephinay and Geller claim they can give the customer “more F&A bang for the buck.” An outsourcing provider (or a CPA firm) could enable a company outsource its needs to F&A experts who work part-time for the company. When ’re hiring a part-time F&A provider, the enterprise can afford to tap a deeper bench for the same money. For the same costs as for a CFO, the enterprise might get a CFO, a Comptroller, and a bookkeeper. The customer can take advantage of the fact that the outsourcer likely has a much larger and more specialized staff than the customer’s in-house F&A department. A customer could afford to have a small army of outsourced accountants, for example, working on its projects at crucial times, which it could never do in-house.

Peaks and Valleys.
Outsourcing may also help smooth peaks and valleys in the monthly, quarterly and annual financial and accounting cycles. Variability in service volumes enables companies to budget for their in-house baselines and manage the pricing and costs — on a variable pricing method — of outsourced staffing for peak loads. In contrast to staff augmentation as a business model, though, outsourcing involves minimum purchase commitments by the enterprise customer, thereby allowing an efficient outsourcer to engage in resource management planning and delivery of lower per-unit resource costs.

Process Complexity.
Certain F&A processes are so inherently complex, or judgmental, that the entire process is outsourced before the enterprise even considers hiring and supporting its own staff. Such areas include employee retirement planning, ERISA fund investment and pension administration. (These processes overlap with HR functions, making them even more complex.)

Why F&A outsourcing minimizes risk

Outsourcing in F&A is often a way to increase competitiveness and minimize a firm’s risk. Outsourcing can improve competitiveness by cutting costs, but it can also improve the capabilities of the customer’s firm beyond freeing up intellectual and financial capital. Here’s what the sales pitch sounds like:

• Shifting functions is shifting risks.
  Shifting functions to an outsourcer can be a way of shifting risk to that provider. When a customer contracts with an outsourcer to execute a function, the customer then looks to the outsourcer for results; it becomes the responsibility of the outsourcer rather than the customer to deliver. This improves efficiency for the customer; if an employee calls in sick and can’t deliver before an important deadline, for instance, that now becomes the outsourcer’s problem rather than the customer’s.
• F&A outsourcers are better structured to catch many kinds of errors.
  Many outsourcers have multiple levels of review built into the F&A process and are therefore more likely to catch errors before they become catastrophes. These errors could range from the occasional arithmetic mistake to faulty accounting and the attendant potential for civil liability. Many customers cannot afford to hire in-house the quantity or quality of people required to match an F&A outsourcer’s product. F&A outsourcers also often have more detailed or more up-to-date knowledge of arcane tax regulations that can be leveraged to the customer’s advantage. This is, of course, more important in the Sarbanes-Oxley world, where accounting errors can embroil firms in heftier fines and more serious litigation than before. In addition, unauthorized expenditures by outsourcers are impossible—whether the result of a mistake by the outsourcer or criminal embezzlement—when the contract between the customer and the outsourcer spells out precisely what expenditures are authorized and what responsibilities will be retained by the customer.
• F&A outsourcers are less likely to make mistakes because it undermines their entire business.
  F&A outsourcers’ livelihood comes from their contractual work. At a minimum, outsourcing in general does not increase risk. Problems presented by the risks of mathematical errors, incompleteness of records, lost records, and inappropriate classification of transactions for accounting purposes, for example, are at least as likely to occur among F&A departments of businesses that retain F&A functions as they are among F&A outsourcers. But in general, F&A outsourcers minimize these risks because F&A is their exclusive function; if they make these kinds of mistakes routinely, their business stands to pay a substantial material price. (In response, the enterprise needs to consider who is better at assuming the risk of making and making good on the typical types of errors associated with a particular business process.)

Questions that enterprise customers want answered

The prospective customer is considering handing over his business’ finances to another business. That is an inherently delicate process, especially if the prospective customer is not already acquainted with the outsourcer. Customers expect answers to the following questions:

• Why should I outsource when I can retain control by insourcing?
• for what functions is the outsourcer responsible?
• Is the outsourcer reachable, or do I have to call between 9 a.m. and 5 p.m. to get in touch with a responsible person?
• What attitudes and cultures should I look for in a “good” service provider?
• How will outsourcing my F&A functions increase my firm’s competitiveness?
• Will outsourcing allow the CFO to be more effective and act more strategically?
• Will outsourcing increase our risk? Even if outsourcing can increase quality and reduce cost, the customer wants to know what the risks of outsourcing are, and whether and how they can be managed, before he closes a deal.
• How do I assure that the outsourcer will track what we need to track, including possible fraud in its own operations?
• What alternatives exist to outsourcing this function? Would an investment in software “solve the problem” of managing the particular F&A function?

Friction points

In outsourcing arrangements as in any transaction, friction points arise particularly when responsibilities are poorly defined. As in other types of outsourcing, F&A outsourcing involves classic issues that need resolution in planning and contracting.

• Scope of services must be defined. If the scope of services to be performed by the outsourcer is left vague by the parties in their contract, serious problems can arise. The customer must know what responsibilities he is contracting to the outsourcer and what functions he retains. Likewise, if the number of hours or amount to be billed by the outsourcer is left open-ended, opportunity for customer-outsourcer friction increases.
• Due dates for projects must be spelled out in advance by contract where appropriate. Outsourcers cannot be expected to respect informal internal agreements customers may have been accustomed to when F&A functions were in-house (“Frank always got me the numbers on Fridays—I don’t see what the problem is”) unless they are specified up front. But this is a problem inherent in any transaction, in outsourcing and insourcing.
• Software compatibility is generally not an issue.
  This is a major concern for customers—how much of my standard operating procedure will I have to change to accommodate the outsourcer?, they frequently ask. The answer can be “none.” Generally F&A outsourcing firms do not impose tech solutions on their clients when transactions are light. Platform compatibility can become an issue, however, as the complexity of the mathematics increases. Some outsourcers are “platform agnostic” regardless of the volume of transactions involved, while others may require their high-volume customers to use Solomon or SAP.

Transitional Issues

A business’ decision about whether to outsource any function, F&A or otherwise, often hinges on the cost of transitioning responsibilities to the outsourcer. The slope of the customer’s learning curve and the amount of time required to make the transition depends on the number and importance of the outsourced functions. It also depends on the particular outsourcing firm.

Timing.
Some firms require four to six weeks to take over bookkeeping responsibilities from their customers; others do it in as little as two weeks. Outsourcing a whole F&A department could take as long as a year, or as little as a month

Transition Planning Toolkit.
Firms will often require their customers to fill out a questionnaire detailing business expenses to help acquaint the outsourcer with the customer’s regular expenses. This helps accelerate the transition. However, some pain occurs when the enterprise of the customer has to modify its process to accommodate the new outsourced business process.

Comparison with In-sourcing.
Some F&A outsourcers assert that transition costs entailed in a switch to outsourcing are not necessarily higher than those of hiring a new person in-house, and can often be recouped much more quickly. However, in a larger organization, the degree of change management is much greater when transitioning to an outsourced process.

Conclusion.

F&A outsourcing contracts may still represent a small minority of total outsourcing arrangements. Yet businesses are increasingly looking to F&A outsourcers to take over certain high volume, low risk, F&A functions with a modest degree of discretion or judgment. The trend in outsourcing towards allowing smaller and smaller businesses to outsource has taken hold in the F&A area as well. Small and mid-sized businesses (“SMB’s”) and startups can often find it profitable to outsource a variety of different F&A functions that would only have been profitable for major corporations to do just a few years ago. F&A outsourcing is becoming increasingly common among businesses that want to reduce risk and optimize their competitiveness and are willing to invest in strategic sourcing plans and skilled contract lawyers.

Effective risk management requires effective legal contracting. Given to complexity of F&A outsourcing, careful contracting is required.

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