How to Achieve Innovation through Outsourcing: Shifting the Paradigm
March 19, 2010 by Bierce & Kenerson, P.C.
Can an enterprise customer get real innovation through outsourcing? It depends. After looking at a case study in contract manufacturing and finance and accounting outsourcing, we can draw some lessons on the squeaky wheel that will need lubrication beyond effective governance.
New Product Development. Recently, Bierce & Kenerson, P.C. was engaged by a global enterprise to assist in a two-phase deal with a supplier. In phase one, the parties entered into an agreement for the joint development of a new type of product to retrofit an old product using new energy-efficient technology. In phase two, the enterprise customer agreed to either buy the new product from the supplier or to pay a royalty for the value of the supplier’s intellectual property and development efforts. The risk of failure was essentially nil, since the enterprise customer could have developed the product alone. Yet it chose to work in tandem with the supplier to achieve a speedier path to market for a hot product with a big potential demand in order to avoid loss of market share to well-financed agile competitors.
The contract development process took much longer than the product development process for several reasons.
o Market Positioning. First, the customer and supplier had not really reached agreement on issues of exclusivity, market positioning and branding. Having already committed resources for joint development of a new innovative product offering to the enterprise’s customers, the enterprise customer lost some of its bargaining power (and actually lost some goodwill in the marketplace) until these issues were resolved in the master supply agreement.
o Financial Viability and Contingency Planning. Second, the supplier was a new entrant into the market, with venture funding but no strong ongoing revenue stream. Financial viability issues challenged the paradigm, requiring careful scenario analysis and negotiation of step-in rights using various sources of goods, services and intellectual property rights. Both parties had different compliance issues arising from separate provisions of securities disclosure laws, including the Sarbanes-Oxley Act of 2002.
o Publicity. Third, the supplier was a publicly traded company for which the new deal would require public disclosure under investor protection laws. The enterprise customer had not focused on managing the public message that might be presented by the supplier. Initially, the supplier was considering issuing messages – through its Marketing Department – that suggested that the enterprise customer could not develop the new product through its own skill, ingenuity, foresight and initiative. The supplier wanted to build its own goodwill on the back of its customer, while the customer wanted an OEM relationship. Modifications of the supply agreement were negotiated so that it would not constitute a “material” relationship for disclosure to investors. This delayed disclosure and thus enabled the enterprise customer to pursue the OEM strategy until after its entry into the new market under its own name.
o Teamwork and Leadership. Fourth, initially, the enterprise customer’s internal teams lacked a management leader to pull together all the participants in a pre-deal analysis of the entire impact. The Sales Department wanted new product to compete with new customers. The R&D Department responded to the Sales Department’s push by offering innovation through joint development with a potential competitor. The Finance Department did not kill the deal even though it lacked a strong business continuity plan. The Legal Department was told that it did not need to bind the parties in one master relationship agreement because deal terms were still being worked out for phase two (production and delivery). As the relationship evolved, the team coalesced and aligned their common interests for achieving, selling and supporting the innovative new product.
New Service Development. Use of third parties to assist in development of new lines of service face similar issues.
o Continuous Process Improvement. It is a best practice in outsourcing deals for service providers to deliver “continuous process improvement.” In designing the outsourcing relationship, the parties need to distinguish between incremental process improvements that come from learning how to be more efficient at a given process, on one hand, and major shifts in business process design that can yield dramatic cost savings. To overcome the hurdle, some dealmakers simply accept that, if there is no measurable “process improvement,” the service provider will drop the price over time in lieu of real process improvement. This is no substitute for true innovation through joint design.
o Intellectual Property. It is a best practice in outsourcing deals to allocate rights in existing and future intellectual property. In advance of a master services agreement, the parties must therefore distinguish between ordinary intellectual property that comes from continuous process improvement and that which flows from some form of capital investment by either party or both parties. Neither party wants to be foreclosed from using improvements or new breakthroughs. The challenge is to agree in advance on scenarios for each case and to provide rewards and governance criteria to minimize disputes on governance as the “innovation” unfolds during the course of the relationship.
o Competition by Service Providers. It is also a best practice for service providers to use “state of the art” service delivery platform – people, process, technology and business processes — to deliver competitive services. In designing their business relationship, the parties to an outsourcing need to distinguish between the service provider’s competitive service delivery platform and the enterprise customer’s unique brand and goodwill in the marketplace. Management of the business reputation and goodwill of each party to a joint innovation project thus becomes a critical contract and business element for negotiation. It requires careful scenario analysis involving business opportunities in new markets and existing markets, capital investment and ROI hurdle rates as well as contractual provisions consistent with applicable antitrust and competition laws.
o Joint Venture. It is a best practice in outsourcing for the parties to expressly disclaim they are in a joint venture. In effect, this eliminates a fiduciary duty to account for profits from the joint efforts. This clause could defeat joint efforts in innovation, since it segregates benefits and promotes potential competition.
Designing Relationships for Innovation. These examples underscore that outsourcing and OEM contract manufacturing cannot be relied upon to achieve “innovation” without a clear business plan. That plan must include the key factors that are considered in any joint venture. Each party needs to focus on its investment, the proprietary nature of its investment and the ultimate uses of those innovations. Ultimately these impact innovation’s on marketing, branding, sales, customer relationships, goodwill, competitive positioning and new product development. The parties need effective communication on evolution of the innovation and how to share future benefits and ongoing investment, if any, in maintenance.
In short, without an innovation strategy, outsourcing is unlikely to yield much other than some cost savings and some gain sharing. In any event, even such a narrow goal risks an inability to reach agreement. The parties must first reach agreement on allocating ownership of any resulting intellectual property rights and understanding the impact on each party’s competitive positioning.
Most importantly, implementing an innovation strategy will require a governance plan for managing collaboration and competition. A governance plan will identify conflicts of interest and principles for collaboratively resolving conflicts.
Case Study for Legal Risk Management for “Cloud Computing”: Data Loss for T-Mobile Sidekick® Customers
October 29, 2009 by Bierce & Kenerson, P.C.
Telecom providers are increasingly outsourcing IT functions for “cloud computing.” A widespread data loss in mid-October 2009 by an IT outsourcer to a mobile telephony provider underscores the practical limitations of using the Internet as a data storage platform.
In this episode, subscribers to T-Mobile Sidekick® mobile devices were informed that their personal data – contact information, calendars, notes, photographs, notes, to-do lists, high scores in video games and other data – had almost certainly been lost. T-Mobile (a service of Deutsche Telekom AG) had outsourced the management of the “cloud computing” function for the Sidekick® devices to Microsoft’s subsidiary, Danger, Inc. While T-Mobile has offered a $100 freebie in lieu of financial compensation and some data was recovered, the case invites legal analysis of the liability of the any service provider – whether for mobile telephony or enterprise backup and remote storage – for “software as a service” (“SaaS”) or “cloud computing.”
Technological Framework for “Cloud Computing. “ “Cloud computing” means simply that data are processed and stored at a remote location on a service provider’s network, not on the enterprise’s network or a consumer’s home computer. Such data could be any form of digital information, ranging from e-mail messages (such as those stored by Google and Yahoo!) to databases, customer records, personal health information, employee information, company financial information, customer contracts and logistics information.
“Clouds” come in two flavors: public and private.
- In a public cloud, the general principles of the Internet apply, and data transmissions can flow between many different third-party computers before reaching the service provider’s servers. Amazon offers hardware in variable computing capacities in its “Elastic Compute Clouds” (or “EC2”) services. Similarly, Google offers an “Apps Engine.”
- In a private cloud, one service provider (alone or with its subcontractors) controls the entire end-to-end transport, processing, storage and retrieval of data.
Cloud computing exposes users to some key vulnerabilities and added costs:
- The user depends on a high-performance Internet connection. Service level performance cannot be guaranteed except in private clouds.
- ‘Single points of failure” (“SPOC”) in data transmission, processing and storage, for which special security measures and redundancy may be required. Heightened security risks require extra resources.
- Loss of control over the public portion of a “public cloud” can impair performance through delays and data loss resulting from uncontrolled environments.
- Delays in data restoration may occur due to interruptions in data transmissions.
- Business continuity, resumption and data protection require special solutions.
- Passwords could be guessed at using social networking tools, but if the user accounts are maintained internally in a controlled network, the systems could use techniques to detect and eradicate misuses and abuses from users based on aberrational access profiles and unauthorized territorial access. In a public cloud, security tools such as data leak prevention (“DLP”) software, data fingerprinting, data audit trail software and other tools might not be effective.
Such vulnerabilities explain why “cloud computing” needs special controls if used as a platform for providing outsourced services.
In the October 2009 T-Mobile debacle, users relied on the telecom service provider to store and backup the data. Mobile telephony devices (other than laptops) were seen as tools for creating but not storing, significant volumes of data. Remote data storage was a unique selling proposition, or so one thought.
T-Mobile’s Technological Failure. In its website, T-Mobile exposed the technological sources of the failure of its “cloud computing” for mobile devices. It explained:
We have determined that the outage was caused by a system failure that created data loss in the core database and the back-up. We rebuilt the system component by component, recovering data along the way. This careful process has taken a significant amount of time, but was necessary to preserve the integrity of the data. SOURCE: T-Mobile Forums, Oct. 15, 2009 update.
Mitigating Damages: Public Relations Strategy for Restoring Customer Confidence and Maintaining Brand Goodwill. After some delay, without admitting any liability or damages, T-Mobile adopted a “damage control” strategy adopted from the usual “disaster recovery” process models:
Compensation. It offered any affected customers a $100 gift card for their troubles in addition to a free month of service.
Communication Outbound. It created and updated a Web forum for Sidekick users to get information about the nature of the problems, whether the data loss was irretrievable and the time to resume operations.
Communication Inbound. It provided an e-mail contact address so that it could respond to inquiries and thus identify and counteract rumors that might have been spreading.
Compliance. T-Mobile notified the public media since the “disaster” exposed it to the possibility that more than 5,000 consumers in any particular state might have had their personally identifiable information (“PII”) exposed to unauthorized persons such as hackers. Such notifications (along with other notices to individual customers and designated government officials) are mandated by state law in over 40 states.
Corrections and Control. It focused on remediation first, deferring problem resolution with any claims against its service provider Microsoft’s subsidiary Danger, Inc..
Confidentiality. It kept its communications with its failing provider confidential and focused on remediation.
Escaping Liability for Damages. Generally, telecom service providers disclaim liability in excess of a small amount. Further, service contracts contain exclusions of liability for consequential damages as well as force majeure clauses. Generally, such disclaimers and exclusions are enforceable. However, various legal theories might prevent a service provider from escaping liability for failed service delivery.
Legal Risks for Providers of “Cloud Computing” Services. T-Mobile consumers might assert various legal theories against T-Mobile for damages if their data are not fully restored, or if T-Mobile fails to act promptly and reasonably to mitigate damages to consumers.
False Advertising; Unfair and Deceptive Practices. State and federal laws prohibit false or deceptive advertising and unfair and deceptive practices. Enforcement of these laws is generally restricted to governmental agencies such as the Federal Trade Commission, the Federal Department of Justice and the state Attorneys General. Deception is a term of art and depends on the facts. In this case, the question is how solidly did T-Mobile portray the benefits of “cloud computing,” and did it warn against loss of data. If T-Mobile can show that it warned users of potential data loss and recommended that they back up their own data, such a warning might relieve it from liability. If T-Mobile represented that it would use reasonable security, backup and business continuity services, subscribers with lost data might have a claim of negligence or gross negligence.
Consumer Fraud. Under common law and state consumer protection laws, generally, a fraud occurs when the seller knowingly misleads or makes a false statement of fact to induce the consumer to make a purchase.A massive fraud is subject to a class-action claim in Federal court under Federal Rules of Civil Procedure.
Magnuson-Moss Warranty Act. Normally, an outsourcing services contract is not one that is associated with the maintenance of a product such as a telephone or a computer. If the service provider were also selling any equipment to the customer, and the customer were a “consumer,” and the service provider’s agreed to maintain or repair the consumer product, then the Magnuson-Moss Warranty Act, 15 U.S.C. § 2301 et seq. would apply. This risk explains why sellers of consumer products (mobile telephones) offer only limited warranties. The Magnuson-Moss Warranty Act is probably not a source of potential liability for T-Mobile, but that depends on the customer contracts.
Privacy Violations. Cloud computing providers may become liable to consumers or enterprise customers for failure to comply with applicable privacy statutes. Such statutes protect personal health information (under HIPAA), personal financial information (under the Gramm-Leach-Bliley Act), personally identifiable information (state and federal laws), financial information of a plan fiduciary under ERISA or other or simply confidential information that could be a trade secret or potentially patentable idea of an enterprise or its customers, suppliers or licensors. Export control laws and regulations governing trade in arms and “defense articles” are thus not good candidates for “cloud computing” except for “private clouds.”
Enterprises hiring third-parties to remotely process and manage their operational data are liable to third parties if any protected data is mishandled, depending on the exact wording of the law. Allocation of liability for privacy and security violations is typically a negotiated element of any outsourcing agreement.
Protecting Consumers in Cloud Computing. The legal framework for “cloud computing” needs to be well defined before it can become a reliable business model replacing networks or local workstations. Regardless of disclaimers in consumer contracts, providers of “cloud computing” services will need to adopt reliable, resilient storage backups, disaster recovery and business continuity services. Moreover, when hiring a “cloud computing” service provider (as T-Mobile did when it hired Microsoft/Danger, Inc.), the seller must ensure high standards by its subcontractors. Telecom outsourcing to IT providers requires special technical and legal controls to protect the consumer and the telecom carrier.
Proctor & Gamble Highlights New Legal and Business Issues in Multi-Sourcing
October 16, 2009 by Bierce & Kenerson, P.C.
Background
This case study examines some extraordinary circumstances involving competitive sourcing of services. It is not typical of the normal competitive sourcing, but it highlights some emerging business and legal issues in managed competitive sourcing of global services.
During the late 1990’s, Proctor & Gamble Co. (“P&G”), maker of soaps, toiletries and personal care consumer goods, created a “shared services” unit to provide a common suite of administrative and operational services to its lines of business. The shared services unit delivers such services as information technology, finance and accounting, logistics support and other administrative functions.
During the spring and summer of 2002, newspapers reported that P&G was in lengthy competitive negotiations with two outsourcing services providers to sell P&G’s shared services unit for $1 billion and hire the winning services provider for an 8 year, $8 billion outsourcing contract covering information technology, human resources and other major administrative functions.
In August 2002, it looked like Affiliated Computer Services, Inc. (“ACS”), of Dallas, Texas, was going to win the bidding, due to the reported withdrawal by Electronic Data Systems Corporation (“EDS”), of Plano, Texas. EDS had reportedly withdrawn from negotiations in June or early July because of pricing.
On September 17, 2002, ACS announced its withdrawal from negotiations with P&G. In an ACS press release, ACS’s President Jeff Rich noted, “While the size of this opportunity was historic and would have been accretive to earnings, we believe the financial, operational and cultural risks were too high.” In other words, the risks were disproportionate tot he profit potential.
At about the same time in mid-September 2002, EDS reported disappointing financial results, causing a one third drop in its share price in one day, due in part to increased costs because of “heavy investment in attempts to obtain new business.” Then, on September 24, 2002, EDS’s stock price plunged roughly another 30% after being downgraded by a Merrill Lynch stock analyst, who concluded that EDS’s free cash flow for the 2002 year could be wiped out by stock repurchase operations necessary to settle derivative instrument exposures. The EDS stock price decline was symbolic of a more general stock market decline on September 24, 2002, to the lowest point in four years (even lower than the post-9/11 trauma in 2001), based on the Dow Jones Industrial Average index.
EDS’s stock price plunge left P&G with a weakened sole bidder. With ACS having publicly withdrawn after EDS had publicly withdrawn, P&G might have been lucky to have any bidder. Or P&G might reevaluate and restructure its strategy.
This case study was completed on September 26, 2002, and is subject to clarification and further consideration.
Business Issues
This scenario underscores the dangers of hyper-aggressive competitive bidding that combines both outsourcing and a sale of significant assets by the customer to the vendor in a glutted market. In this case, the customer was apparently so aggressive on the pricing of its assets that one of two finalist bidders concluded that the deal was uneconomical. When the customer apparently continued to push the second bidder for the same deal as if the competitive bidding process had continued, the second bidder withdrew. This left the customer the prospect of having no bidders despite completion of an arduous, detailed and highly disciplined and managed competitive procurement process.
Further, the publicity surrounding the prospective outsourcing of the customer’s shared services unit, involving approximately 5,700 employees, raised questions about the viability of the outsourcing process and the impact of a possible failure upon the customer’s staff, its customers and its shareholders.
Accordingly, this case study evokes questions about circumstances affecting competitive procurement of long-term services.
Transfer of Customer’s Shared Services Center to the Vendor
Reportedly P&G had bundled its shared services unit — including multiple “back office” functions — into a cost-efficient self-standing business.
Factors in the Competitive Viability of the Transferred Shared Services Unit.
To our knowledge, the press did not comment on the degree to which the P&G shared services unit was ready to become a competitive unit of an outsourcing services provider. To be viable in the new role, the acquired unit would not only have to serve P&G as the customer, but also demonstrate the ability to generate cash flow that justified the price of the unit. The reported $1 billion asking price received no comments on whether the shared services unit had the corporate culture, the business plan, the competitive bidding experience, the inurement to the vicissitudes of competition, the personal accountability and internal leadership necessary to pay off the $1 billion price tag.
Valuation and Accounting Factors.
As with any acquisition of a going business, the questions of valuation, goodwill and other internal accounting practices of the P&G shared services unit have not been publicly defined. However, it is clear that the bidders examined them closely. ACS withdrew, in part, because it could not justify the return on investment. While ACS’s announcement of its withdrawal observed that the cash flow would be “accretive” to ACS’s income statement, it is perfectly conceivable that the successful bidder would have to write off goodwill under financial accounting principles. This might explain why EDS withdrew in August 2002 and ACS withdrew in September 2002.
Negative Market Environment.
Declining financial and stock markets in 2000 through 2002 resulted in the loss of significant shareholder value between the time for planning and execution of the proposed outsourcing. P&G established its Global Services group in 1998. Probably in late 2001, P&G decided to sell it in a massive outsourcing.
By the time for conclusion of contract negotiations in anticipated for August – September 2002, several adverse market conditions had occurred. The stock markets had fallen. And the information technology and telecommunications sectors swooned, with sharp declines in corporate purchasing of IT goods and services. Globally, throughout 2002 major IT outsourcers had terminated the employment of tens of thousands of IT workers. Consequently, the business prospects for a new IT services facility would be introduced into the market at a time of grossly excessive capacity for IT services both in the U.S. and worldwide.
The Impact of Corporate Governance and Accountability on Valuation.
President George W. Bush signed the Sarbanes Oxley Act of 2002 designed to root out misfeasance and malfeasance in the executive suites of publicly traded companies. In August 2002, senior executives of publicly traded U.S. companies had to sign and file certifications that the financial statements were not materially misleading. Enron, Tyco International and Adelphia Communications executives were indicted for looting. In late September 2002, the Securities and Exchange Commission indicted Tyco’s former CEO L. Dennis Koslowski, claiming that he should disgorge his personal bonus for having entered into an acquisition with a flagging company (Flag Telecom) at an inflated price, allegedly for the purpose of artificially inflating his personal compensation. Clearly, the regulatory environment counseled extreme caution on valuations of assets in an acquisition.
The “Stalking Horse” in the Bidding
A bidder that has no chance of winning is a “stalking horse”. This case study evokes the question whether ACS ever became a stalking horse, or whether P&G “over reached” on both finalist bidders.
Absolute Ability to Deliver the Full “Program.”
A bidder must determine whether it realistically has the resources to win in a convincing fashion. Otherwise, the competition is a gamble for the bidder. This self-assessment is essential in the “no-bid” decision as well as in the negotiations as the customer’s business rationale and expectations are revealed at the bargaining table.
Comparative Advantage.
If the bidder does not know the identity of its competitor, then it can only guess and rely upon its own self-assessment of capabilities. Once the names of the two finalist bidders became public, some commentators observed that ACS’s bid had not been as strong as EDS’s because ACS, while capable, would have had to “stretch” to satisfy P&G’s contractual expectations.
Rigged Bidding.
Typically, bidders that are not in the “top tier” should ask themselves whether the “rules of engagement” have been “rigged” in favor of a competitor. If this is true, then the competitive procurement process is a sham, and, as a legal matter, the stalking horse may have a legal claim for fraud.
Remedies for the Stalking Horse.
The rational bidder, when it realizes that is has become a stalking horse, should evaluate its possible remedies.
- Litigation for Fraud.
The ethical, savvy service provider is not likely to sue its prospective customer for fraud. Business reputation through avoidance of litigation is generally the customary business policy of outsourcing vendors. However, the benefits of a lawsuit might be achievable through other means (see below) or through non-public dispute resolution mechanisms. Bidders might be entitled to certain legal rights under pre-bidding agreements with the customer that define the rules of the procurement. - Unilateral Direct Boycott.
If it feels that it has been “used” as a stalking horse, it can elect not to participate in future “rigged” bidding wars managed by the same specialized outsourcing advisors. - Complain to the Customer.
A complaint might not necessarily result in compensation. It might, however, restructure the negotiations and re-admit the bidder into the realm of a “viable possibility” instead of a stalking horse. In government contracts, formal contests and appeals can result in substantial delays in the award of the contract. In private transactions, a more informal approach might be productive. The customer might have a self-interest in being responsive. - Request Compensation.
The stalking horse bidder has lost not only its out-of-pocket expenses, but also its prospective profit from alternative application of the same resources to other prospective pursuits. - Sell a Service.
Rather than just demand compensation for its out-of-pocket expenses, the stalking horse bidder might offer to sell some deliverable that resulted from the aborted competitive bidding procedure. This could include:- data discovered during the due diligence phase that could be useful to the implementation of the eventual outsourcing, or to its restructuring during the negotiation phase;
- recommendations of an advisory or consultative nature from a service provider’s perspective (to facilitate negotiations with the remaining bidder(s)); or
- other services or deliverables.
When a Service Provider Should Withdraw from Negotiations
In competitive procurement and auctions, each bidder must analyze the value of the transaction and draw its own conclusions as to circumstances that might make its bid no longer commercially reasonable. Experience suggests that a bidder should withdraw under any of the following conditions:
- Overpriced.
The combination of the costs of acquisition and the reward for future services rendered does not meet the financial hurdles imposed by senior management. The financial hurdles could be imposed either individually on each segment of the operation or globally on the combination of the operations. - Inability to Integrate Personnel.
In this case, ACS alluded to “culture” as a factor. In essence, an observer might conclude that each of the finalist bidders, in its own time, concluded that there were insurmountable cultural differences with the P&G employees who would be in scope and who would become the winning bidder’s employees. - Unsuitability of the Bundle as a Deal or as a Deal Structure.
If both finalist bidders were willing to withdraw, then each must have concluded that the “package” was unsuitable for economic reasons. Suitability might have meant that the post-transaction commitments to be assumed by the winning bidder were excessive. Customers and their specialized consultants may take note of the fact that EDS was invited back into the bidding at a time when ACS was still the sole bidder, and that in order to entice EDS to come back to the negotiating table P&G and its specialized consultant must have acquiesced in some of their demands about the deal structure. - Risk Allocation.
Certain news reports suggested the transaction would have an estimated value (excluding the acquisition of the shared services unit) of $8 billion for an 8-year term. Another article estimated the overall value of services at between $4 billion and $10 billion over an estimated 10-year term. If the winning bidder has no means of projecting actual revenues, it cannot determine whether the risk of the initial investment — in the acquisition, transition and post-transition commitments relating to the acquisition and transition — was outweighed by the prospective profit. In short, the profitability was not sufficiently clear. - Mismatch of Expectations and Post-Effective Corporate Culture of the Customer.
Having lived with an outsourced “back office” environment already for two or three years, P&G’s end users should probably adapt to the hiring of an external outsourced services provider. However, one might wonder why P&G wanted to outsource the environment to an external services provider. The press reports do not suggest that P&G was unhappy with its shared services unit. But certainly a bidder should ask whether there was any reason for the customer to be unhappy. And if the customer were actually unhappy with the quality of the service, the customer might have unreasonable expectations about the level of responsiveness, service or alignment of its shared services unit. Conversely, if the customer were very happy with the shared services unit, the only reason for outsourcing might have been to generate cash flow from asset divestiture. At that point, the service provider becomes a venture capitalist, hoping that the acquisition will be accretive to the cash flow. In either case, the bidders must analyze the suitability and cultural fit of the bidder with the customer’s expectations.
Lessons Learned from the Customer’s Perspective
Flexibility.
This extraordinary case study suggests that, in complex transactions with multiple functions being outsourced, the customer’s self-assessment and preparation for negotiations should include some flexibility and fall-back positions. Where both finalists are cornered and see no alternative but to walk away from negotiations, clearly the customer has played the game of “corporate chicken” and run both the bidders off the road. Such an outcome would be a serious lost opportunity, not to mention unrecoverable expense, for all involved. What guiding principles should inspire the customer?
True Competition.
The key requirement for a competitive procurement is that it remain truly competitive. If a scoring factor becomes clearly overwhelming for or against one of the finalist bidders, then the continuing bidding war is a farce between the guaranteed winner and the stalking horse.
Why should the customer want true competition? Without a viable final competitor, the guaranteed winner will normally revert to some of the more costly behaviors and tactics evident in a sole-source procurement – delays, quibbling, attempts to apply unfair pressure. Such behaviors normally deprive the customer of the best competitive price, terms and conditions.
Disclosure of Ongoing Negotiations.
Despite corporate policy statements, non-disclosure agreements with employees, contractors, bidders and others, the news of this outsourcing transaction became publicized. Information leaks by disgruntled in-scope employees can have an impact on decision-making and strategy by the prospective service providers, since the employees can identify the other bidders. Every bidder can be expected to want, and get, this information. The bidding could become transparent, not only to the customer and its employees, but also to the bidders.
Acceleration of Benefits.
An accelerated contract yields benefits earlier. Acceleration also facilitates commitments in the transition phase, encouraging in-scope personnel to remain and support the outsourcing, and avoids the risk that the entire project will be abandoned. Abandoned projects, like failed deals, can easily cause loss and disruption, not to mention litigation and continuing distraction.
Ethics in Competitive Procurement.
Competitive procurement has been a fundamental precept of modern capitalism. But when it degrades into stalking horse disguise, one may question whether conduct is ethical and fair. Every customer has an interest in being known for its ethical conduct, and indeed must question its own conduct internally if skewed procurement practices violate stated corporate governance principles. In an era of renewed governmental and shareholder needs for trust and confidence, and to avoid certifying financial statements that do not accurately reflect in all material respects the risks of claims from stalking horses, senior management of major enterprises should ensure that the customer’s stated business ethics are implemented in its competitive procurement practices. See Corporate Governance in Outsourcing
Initial Definition of the “Rules of the Game.”
The customer normally defines the rules of engagement with prospective vendors. The customer must determine the degree to which it wishes to address the legal, business and ethical issues presented in this case study.
Lessons for Multinational Alliances or Teams
Experts in the outsourcing process may wish to rethink their methodologies as a result of this potential fiasco
No Teams for P&G.
The P&G case was limited to single enterprises bidding to take ownership if the shared services business and provide outsourced services in their place. This case differed from the decision by J.P. Morgan, in the famous “Pinnacle Alliance” outsourcing, to hire four vendors to manage complex IT infrastructures, software and other back office operations. P&G insisted on a single point of accountability and single owner of all transferred IT infrastructures.
Subcontractors in the Bidding Process.
Many outsourcing transactions, particularly large and complex ones, may involve foreign subcontractors, such as software developers and maintenance services providers in Asia. Teaming alliances can fall apart if the customer engages in pitting a team against a globally integrated company.
Self-Interest in Competitive Bidding.
In adopting “stalking horse” tactics for a massive outsourcing across multiple functions and countries, the multinational enterprise customer risks alienating the best services providers. It also risks losing the benefits of outsourcing by so narrowly defining the transaction as to prevent the entry of competent competing teams.
Inside Job: Bank One’s Decision to Insource Bank’s IT Operations
October 16, 2009 by Bierce & Kenerson, P.C.
Bank One, the sixth largest bank holding company in the United States with $270 billion in assets, has been conscientiously in-sourcing its technology, managing the integration of bank acquisitions through its own internal teams. In November 2002, the bank announced the completion of a major systems conversion in Illinois to consolidate its information technologies on “one” platform. This represents the fourth conversion in the last 17 months.
Chairman Jamie Dimon said that the bank had “invested $500 million in improving and consolidating our systems, moving to an upgraded platform that provides our customers with easier access and convenience and our bankers with better and faster information.” The bank estimates that the conversions will save $200 million in annual operating costs. The bank eliminated 600 software applications, including a number of home-grown ones.
“The conversions are key milestones in building a company that leverages technology to help meet our customers’ needs,” Dimon said. “At the same time, we have in-sourced many technology functions so we now control our own destiny. We are now operating as one company with one brand,” he said. “Our focus is on investing in systems that will give Bank One a competitive advantage by improving customer service, reducing costs and accelerating innovation.”
Different points of view make a market in ideas, and in services.
2005 Footnote: Mr. Dimon became Co-Chairman of JP Morgan Chase in the BankOne merger. As a result, the IBM – JP Morgan Chase Summary agreement was terminated to return to insourcing of IT services.
Business Intelligence and Industrial Espionage in Outsourcing
October 9, 2009 by Bierce & Kenerson, P.C.
Boeing Loses $1 Billion in Transactions as Punishment, Escapes Debarment
Summary.
“Business intelligence” refers to the practice of collecting and analyzing competitive information in the marketplace to assist an enterprise in self analysis and redirection of its resources to maintain and improve competitiveness. “Industrial espionage” refers to the clandestine methods of obtaining competitive information that is not publicly available. As a legal matter, this distinction can have serious consequences. This case study offers some suggestions for staying on the right side of the law not only in business intelligence but also for internal audit controls and business ethics.
Boeing Punished.
In July 2003, the U.S. Air Force hit Boeing Company with the harshest punishment on any major U.S. military contractor in decades. Boeing was found to have stolen thousands of pages of confidential technical documents of its archrival, Lockheed Martin Corp. Boeing reportedly used such industrial secrets in submitting proposals to the Air Force in 1998 to provide satellite launching services. As a result, the Air Force transferred to Lockheed the services of providing seven launches previously awarded to Boeing, and in addition awarded three more launches to Lockheed.
Boeing Escaped Debarment: “Too Big to Punish”?
Many commentators on the Boeing punishment have asserted that Boeing escaped debarment under the Federal Acquisition Regulations simply because it was too big to punish. The losses by other agencies would have been considerable. Instead, the punishment related to the Boeing business segment that had allegedly violated the law, rather than to all other Boeing divisions. This punishment reflects the difficulty of the Government’s use of the debarment process to protect Government interests when the supplier community is highly concentrated and consolidated.
The Economics of Business Intelligence.
Business intelligence serves a valid competitive purpose in the marketplace. Gathering publicly available information:
- sharpens the competition and increases opportunities for consumer and customer choice;
- enables competitors to restructure their offerings of services and goods, often by restructuring key business processes for improved efficiency, reduced cost, better quality, a more attractive suite of services and goods and a broader appeal to a wider range of customers;
- and improves the efficiency of markets, accelerating improvements in customer service and thereby improving the customer’s quality of life, integration of external services with in house services and other external services.
The Law of Business Intelligence.
The law of business intelligence is limited by common law and statutes that protect proprietary rights, privacy rights and intellectual property.
Debarment under the Federal Acquisition Regulations.
Causes of Debarment.
Debarment can occur based on conviction, violation of law or a serious or compelling cause. Debarment is a remedy available to the U.S. Federal Government under the Federal Acquisition Regulations. The purpose is to exclude “ineligible” contracts from new bidding.
Violations. The debarring official may debar a contractor for a conviction of or civil judgment for:
(1) Commission of fraud or a criminal offense in connection with-
(i) Obtaining;
(ii) Attempting to obtain; or
(iii) Performing a public contract or subcontract.
(2) Violation of Federal or State antitrust statutes relating to the submission of offers;
(3) Commission of embezzlement, theft, forgery, bribery, falsification or destruction of records, making false statements, tax evasion, or receiving stolen property;
(4) Intentionally affixing a label bearing a “Made in America” inscription (or any inscription having the same meaning) to a product sold in or shipped to the United States or its outlying areas, when the product was not made in the United States or its outlying areas (see Section 202 of the Defense Production Act (Public Law 102-558)); or
(5) Commission of any other offense indicating a lack of business integrity or business honesty that seriously and directly affects the present responsibility of a Government contractor or subcontractor.
Nonperformance; Violations of Public Policy.
In addition, a debarring officer my debar a contractor, based upon a preponderance of the evidence, for:
(i) Violation of the terms of a Government contract or subcontract so serious as to justify debarment, such as-
(A) Willful failure to perform in accordance with the terms of one or more contracts; or
(B) A history of failure to perform, or of unsatisfactory performance of, one or more contracts.
(ii) Violations of the Drug-Free Workplace Act of 1988 (Pub. L. 100-690
(iii) Intentionally affixing a label bearing a “Made in America” inscription (or any inscription having the same meaning) to a product sold in or shipped to the United States or its outlying areas, when the product was not made in the United States or its outlying areas (see Section 202 of the Defense Production Act (Public Law 102-558)).
(iv) Commission of an unfair trade practice as defined in 9.403 (see Section 201 of the Defense Production Act (Pub. L. 102-558))
Violation of Immigration Laws.
Additionally, debarment is available as a remedy against a contractor, based on a determination by the Attorney General of the United States, or designee, that the contractor is not in compliance with Immigration and Nationality Act employment provisions (see Executive Order 12989). The Attorney General’s determination is not reviewable in the debarment proceedings.
Lack of Present Responsibility.
Finally, debarment may be imposed against a contractor or subcontractor based on any other cause of so serious or compelling a nature that it affects the present responsibility of the contractor or subcontractor. Such a determination is more subjective than other reasons, and may include abuse of confidential information through industrial espionage or as suggested below, failure to maintain internal accounting records and a history of unethical business conduct.
Consequences of Debarment.
Debarment prevents an entity from being an eligible bidder on new contracts but does not terminate existing contracts. Contractors debarred, suspended or proposed for debarment are also excluded from conducting business with the Government as agents or representatives of other contractors, from acting as subcontractors and from acting as individual sureties. Exceptionally, an agency head or a designee determines that there is a compelling reason for contracting with the debarred supplier. This exception leaves open the choice of sanctions for misconduct, and leaves the affected agencies free to decide to ignore the debarment for their own internal purposes. FAR 9.404.
Non-Procurement Common Rule.
Also, under the “non-procurement common rule,” debarred contractors may be ineligible for nonprocurement transactions such as grants, cooperation agreements, scholarships, fellowships, contracts of assistance, subsidies, insurance and other government benefits.
Existing Contracts Not Abrogated.
Notwithstanding the debarment, suspension, or proposed debarment of a contractor, federal agencies may continue contracts or subcontracts in existence at the time the contractor was debarred, suspended, or proposed for debarment unless the agency head or a designee directs otherwise. In addition, the Governmental agencies may continue to order goods or services under purchase orders against existing contracts, including indefinite delivery contracts, in the absence of a termination. However, agencies may not renew or otherwise extend the duration of current contracts, or consent to subcontracts, with contractors debarred, suspended, or proposed for debarment, unless the agency head or a designee authorized representative states, in writing, the compelling reasons for renewal or extension.
Business Judgment and Evaluation of Factors in the Decision to Debar.
Under the Federal Acquisitions Regulations (Section 9-406(a)), before arriving at any debarment decision, the debarring official should consider a range of business judgment considerations and an assessment of the impact on the government factors. The list includes:
(1) Whether the contractor had effective standards of conduct and internal control systems in place at the time of the activity which constitutes cause for debarment or had adopted such procedures prior to any Government investigation of the activity cited as a cause for debarment.
(2) Whether the contractor brought the activity cited as a cause for debarment to the attention of the appropriate Government agency in a timely manner.
(3) Whether the contractor has fully investigated the circumstances surrounding the cause for debarment and, if so, made the result of the investigation available to the debarring official.
(4) Whether the contractor cooperated fully with Government agencies during the investigation and any court or administrative action.
(5) Whether the contractor has paid or has agreed to pay all criminal, civil, and administrative liability for the improper activity, including any investigative or administrative costs incurred by the Government, and has made or agreed to make full restitution.
(6) Whether the contractor has taken appropriate disciplinary action against the individuals responsible for the activity which constitutes cause for debarment.
(7) Whether the contractor has implemented or agreed to implement remedial measures, including any identified by the Government.
(8) Whether the contractor has instituted or agreed to institute new or revised review and control procedures and ethics training programs.
(9) Whether the contractor has had adequate time to eliminate the circumstances within the contractor’s organization that led to the cause for debarment.
(10) Whether the contractor’s management recognizes and understands the seriousness of the misconduct giving rise to the cause for debarment and has implemented programs to prevent recurrence
Proposed Debarment of MCI WorldCom.
Debarment may also be asserted for lack of adherence to internal controls over accounting and reporting systems and business ethics. This argument was asserted against MCI (formerly WorldCom) on July 31, 2003, subject to administrative determination.
The argument is based on the contractor not being “presently responsible” because in this case, the contractor was alleged to have been previously involved in one of the biggest shareholder frauds in U.S. history and still suffered ten “material weaknesses” in the company’s internal controls. In the case of the General Services Administration’s notification letter to MCI WorldCom assorting the proposed debarment, “A material weakness is a weakness found to be pervasive throughout an encore organization. Each individual weakness is considered to be a significant control deficiency. The acceptable standard is for a company to have no material weaknesses or of one is found for it to be promptly corrected.”
In MCI’s case, the GSA alleged that the company needed to implement “procedures and controls to review, monitor and maintain general ledger accounts. Implementing adequate controls on the general ledger is significant because that is where all of the company’s financial transactions are summarized for all of its accounts.” MCI has promised to comply with Sarbanes-Oxley Act of 2003 by June 30, 2004 one year earlier than the statute requires. MCI noted it is aware of the deficiencies and is cooperating with the GSA and investigating agencies.
What a Customer Should Know about an Outsourcer’s Key Personnel.
Concentration of Sellers in an Industry.
Ordinarily an enterprise customer should not have many concerns about the prior employment history of a major outsourcing services provider. After all, the services provider’s business is to maintain the confidentiality of its customers’ confidential data. Without the customer’s trust that its data will be protected, the customer will not engage in outsourcing. If the outsourcing service provider is engaged in a tightly competitive environment with only a few competitors, the customer could become concerned that its confidential information might float around the industry and become known to multiple outsourcing service providers, particularly those who service the customer’s competitors. Thus, the customer should be concerned about the normal employment and privacy protection polices practices and enforcement methods that the external services provider has adopted.
Employment Practices.
Employment practices are probably the most frequently abused methods of collecting competitive information in an illegal or wrongful manner. Hiring an experienced person from a key competitor has long been a method of gathering competitive information. If the person was in a position of trust and confidence, having had access to key competitive policy, strategy and tactical information, the newly hired employee is in a position to damage his or her former employer’s business. Outsourcing customers may properly inquire about a proposed contractor’s hiring process.
Replacing a Service Provider in Midstream: Case Study on Equifax Spin-off, Certegy’s Cancellation of EDS Contract and Hiring of IBM
October 9, 2009 by Bierce & Kenerson, P.C.
Summary:
The termination of a long-term outsourcing contract in midstream, before the normal expiration, requires careful legal and business planning. It may also require payment of a large termination fee. In this case study, we analyze such a case involving the termination of an existing EDS contract and the transitioning to IBM as a new services provider.
Certegy’s Deal with EDS.
Certegy Inc. [NYSE: CEY] is a publicly traded company that provides credit and debit processing, check risk management and check cashing services, and merchant credit processing services to over 6,000 financial institutions, 117,000 retailers and 100 million consumers worldwide. Its 2002 revenue exceeded $1 billion. It was formerly known as Equifax PS, Inc., a subsidiary of Equifax, Inc., which spun off its payment services businesses into what is now called Certegy, as of June 30, 2001.
Under the terms of an agreement apparently entered into before the spin-off, Certegy’s former parent (or Certegy) entered into an agreement with EDS for IT services that was scheduled to expire in 2009. The agreement evidently provided for a termination fee if the customer wished to terminate for convenience.
The Spin-off
As part of the spin-off, Equifax, Inc. agreed to deliver Certegy certain information technology services. But that agreement expressly disclaimed any commitment to deliver any contractual service levels. Rather, Equifax agreed only to provide services in a commercially reasonable manner in accordance with any service levels specified on a particular exhibit. The indemnification provisions protected Equifax from claims by Certegy except in case of willful misconduct. The spin-off company had no leverage.
The Fee for Termination for Convenience: Investor’s Perspective
As announced by Certegy on March 21, 2003, Certegy was to record a pre-tax provision of up to $10 million in the first quarter of 2003 for early exit costs associated with severing its existing services agreement with EDS. Certegy’s Chairman, President and CEO, Lee Kennedy, reported that the termination fee was a good investment:
“IBM offers best-in-class computer operations support and has a proven track record with Certegy as a trustworthy business partner. The early exit costs to be recognized in connection with terminating the EDS agreement represent an investment in our future that is projected to generate an internal rate of return of more than 20% over the next ten years.” [Emphasis added.]
Certegy did not announce how it might achieve that 20% internal rate of return or whether that rate applied to the $10 million termination fee or the projected $150 million to be paid to IBM over ten years.
By identifying a projected internal rate of return, Certegy may have begun a dialogue with its investors as to the structure of the deal and the rationale for the midstream change. Materiality of disclosure might become an issue of the projected 20% IRR relating to the $150 million.
Certegy’s Deal with IBM.
In March 2003, Certegy announced a 10-year deal with IBM, with an estimated value of $150 million.
Essentially, Certegy’s focus on the IBM “on demand” services model must have represented a change in one or more essential elements of the scope, pricing, or service delivery methodology. One may speculate that there were material differences between EDS’s and IBM’s deal structures, such as delivery platform, the territorial scope, the pricing structure of the services to be provided by EDS, a change in the actual volumes of services, a change in the bandwidth of upper and lower levels of baseline services volumes for pricing, or all of these circumstances.
Certegy had an existing relationship with IBM. IBM was already providing IT services to Certegy’s United Kingdom and Australia operations. The new deal reportedly “can provide” Certegy with “significant cost savings and future operational flexibility” through IBM’s “on-demand” technology services.
EDS’s Perspective.
EDS’s spokesman characterized this situation as not a “win” by IBM over EDS, but rather a decision by the customer to extend an existing relationship with IBM to additional territorial scope when EDS signed a deal with one of Certegy’s competitors. The new deal allows Certegy to save money by standardizing on IBM as the sole provider across the world. But the $10 million termination fee is probably not an adequate compensation for EDS’s lost profit remaining during the remaining unexpired term of approximately six years of the contract.
Best Practices.
Collaboration with a Competitor.
In its first Form 10-K filing with the Securities and Exchange Commission, Certegy identified EDS as one of its competitors: “The markets for card transaction processing and check risk management services are highly competitive. Our principal competitors include third-party credit and debit card processors, including First Data, TSYS, EDS, and Payment Systems for Credit Unions, third-party software providers, which license their card processing systems to financial institutions and third party processors.” Certegy, Inc. Form 10-K, Fiscal Year ended December 31, 2001.
Termination for Conflict of Interest as a Termination for Convenience.
Customer’s normally do not get any right to terminate an outsourcing services contract merely because the service provider also provides services to a competitor of the customer or because the services provider is, or becomes, a competitor of the customer in any line of business As a general rule, no major service provider will agree to grant any exclusivity rights to its customers. Exceptions do occur, and we would be pleased to consult on the types and circumstances of such exceptions.
Potential Conflicts of Interest as a Factor in Defining Scope.
Indeed, one challenge in identifying the proper scope of services to be outsourced lies in the risk that the outsourcing services provider could become a competitor of the customer’s prime business. Certegy faced this challenge because its core business of credit and check processing approvals requires extensive investment in automation. Similarly, large outsourcing service providers, such as EDS, IBM and CSC, enable such businesses as Certegy to piggyback on the outsourcer’s deep knowledge of the customer’s vertical industry and the outsourcer’s extensive ongoing investment in technology.
Consequently, the enterprise customer’s sole remedy is generally to ensure an exit strategy that defines conditions where the service provider might be considered to have a conflict of interest or special relationship with a competitor. This issue merits careful attention and frank discussions in all phases of outsourcing, including scope definition, selection of the service provider and contracting.
Single Provider vs. Competing Providers.
In this situation, Certegy had adopted a strategy of having two providers of IT services. One argument in favor of such a strategy might be that actual competition is a better than the fictitious competition of the benchmarking process. More likely, this situation probably evolved without such a “grand strategy.”
Hidden Costs to the New Company in a Spin-off: The Vendor’s Renegotiation Dilemma.
An outsourcing service provider in EDS’ position must identify the potential for an unhappy customer to terminate early an existing profitable long-term relationship. In this case, EDS chose not to complain publicly about the loss in service volumes due to the Equifax spin-off of Certegy. One may speculate that the spin-off disrupted the efficiency of a well-established EDS service delivery. The relevant press releases are silent on the disruption of services and the strain on a previously negotiated pricing model that the spin-off caused to EDS. If the contract were being negotiated from scratch today, spin-off transition changes might have been the subject of negotiations.
In theory, the costs of severing the EDS deal and transitioning to IBM could have been paid by Equifax prior to the spin-off. But the availability of EDS services was probably viewed as a benefit, giving Certegy time to operate independently after the spin-off, at least for a time.
Impact of a Spin-off on Design of Outsourcing Contracts.
The termination of the EDS deal appears to reflect a number of changes in the customer’s management perspective.
First, EDS’s loss of 75% of its share value over a 12 month period before March 2003 certainly caught the customer’s attention. This elicited concerns about EDS’s ability to deliver the services as contracted, but really only addresses EDS’s ability to make large acquisitions.
Second, before and shortly after the spin-off, the customer engaged in a program of acquisitions. As a result, outsourcing with a single outsourcer might have become more effective than having multiple sources of services, and the pre-existing pricing structure and scope became rapidly outdated.
Third, the contracts probably did not contemplate how the two service providers might collaborate, if necessary. There is no mention in the press reports of this issue. The customer probably did not have a plan for this possibility, so the customer had little choice but to move from one vendor to another.