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:
Established in 1997 to provide internal business support for GE, Gecis has built global operating capabilities supporting nearly 1,000 business processes across each of GE’s 11 business units, including critical finance and accounting, supply-chain management, customer-service support, software development, data modeling and analytics activities. Gecis’ sophisticated IT-enabled operations include fully staffed facilities in North America, Europe, India, and China. Bhasin said Gecis provides its services in 19 languages and is highly experienced in recruiting talent and managing operations in each of these markets.
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.
Income Tax Considerations.
An offshore holding company structure might also reduce the rate of withholding tax in the portfolio company’s country of operations. That reduction typically depends on selection of a jurisdiction with a mature income tax treaty that does not have a provision limiting its benefits if the holding company is not majority owned by residents of one of the two countries. Further, a mature income tax treaty may exonerate from “secondary” withholding tax any distribution of dividends by the holding company to its shareholders.
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.
Impact of Sarbanes-Oxley Upon Outsourcing
October 9, 2009 by Bierce & Kenerson, P.C.
Corporate Governance and Accountability under Sarbanes-Oxley Act of 2002.
On July 30, 2002, President George W. Bush signed the Sarbanes-Oxley Act of 2002. The bill establishes new rules of corporate governance and accountability for accounting for U.S. and foreign publicly owned companies whose shares are registered with the U.S. Securities and Exchange Commission. If you work for such a company, you have some immediate actions for timely compliance, some by August 30, 2002.
This legislation has potential importance to both outsourcers and their customers, as well as their accountants, executives, investment bankers, employees and attorneys.
Scope of the Law.
Enacted in the wake of a series of corporate accounting scandals, this vast and sweeping legislation establishes a public accounting oversight board, adopts certain minimal measures to preserve auditor independence, amends federal security laws to hold insiders and corporate executives and directors to higher standards of care in trading securities (including blackout periods during which such trading is prohibited), increases and extends corporate disclosures of accounting matters, sets standards for “corporate and criminal fraud accountability” and hardens the penalties for “white collar crime.” For particular provisions on corporate responsibility for financial reports and the accuracy of financial reports (including “off balance sheet transactions”), see our copy of the law at Sarbanes-Oxley_Legislative_Text.
Study on Manipulative Accounting.
Investment bankers will now become the subject of a new SEC study. But the study will go further, covering topics that affect virtually every publicly traded outsourcing services provider and its methods of operation. The study will review, among other issues relating to Enron and Global Crossing’s bankruptcies, the role of investment bankers and other advisors:
in creating and marketing transactions which may have been designed solely to enable companies to manipulate revenue streams, obtain loans, or move liabilities off balance sheets without altering the economic and business risks faced by the companies or any other mechanism to obscure a company’s financial picture.
Impact of Sarbanes-Oxley Act of 2002 on Outsourcing Service Providers.
For outsourcing service providers, the new law creates the risk that the SEC might seek to impose penalties for failure to adopt conservative accounting principles. We think that this law could create challenges for outsourcers that adopt the percentage of completion method of accounting, which may be appropriate but nonetheless perhaps not as credible or conservative as the “as collected” basis. Take our Survey on related accounting issues.
Impact of Sarbanes-Oxley Act of 2002 on Employees.
The Sarbanes-Oxley Act of 2002 protects employees from termination or other major adverse effect if they report alleged violations of the accounting rules or corporate governance requirements of that law. For a copy of the act as it applies to employees, please refer to our copy of the law at Sarbanes_Oxley_legislative_text
Please note that this gives new protections to whisteblowers who are employees, but also to non-employees as well. Please refer to our copy of the law at /Sarbanes_Oxley_ACT_2002_legislative_text
Impact of Sarbanes-Oxley Act of 2002 on the Role of Attorneys in Outsourcing.
The Sarbanes-Oxley Act of 2002 on corporate governance and accountability requires attorneys to take their concerns about accounting treatment to in-house lawyers and ultimately to the Board of Directors. Law firms assisting parties to an outsourcing transaction should consult with their clients concerning the accounting treatment implicit in the transactional structures.
Impact of Sarbanes-Oxley Act of 2002 on Venture Capitalists.
The Act will give pause to venture capitalists who fund start-up outsourcing services providers. It raises the legal liability of VC’s who serve on boards of directors, particularly if the portfolio company is targeting an IPO and board membership remains an important component of the VC relationship, compensation, “protection” of VC-organized investor interests and generally investment management.
Impact of Sarbanes-Oxley Act of 2002 on International Outsourcing Services Providers.
Being incorporated outside the United States may have its advantages as well as its disadvantages. Under the Sarbanes-Oxley Act of 2002, foreign companies whose shares are traded on U.S. stock exchanges must comply with new obligations on financial reporting, audit and corporate governance. Foreign services providers such as Accenture Ltd., of Bermuda, that were organized outside the United States prior to relevant “cutoff” dates are likely not to suffer the consequences of U.S. governmental retaliation for foreign “inversion” operations. Unless their securities are listed on a U.S. securities exchange, such foreign services providers may enjoy regulatory freedoms, but such freedoms may elicit suspicion by investors and prospective customers due to the lower level of corporate governance discipline and public disclosure of material information. If you have any question about this process, please contact one of our attorneys.
International Outsourcing: Business Judgment Factors
October 9, 2009 by Bierce & Kenerson, P.C.
Summary.
Why do you need an international outsourcing strategy? You might be negligent if you don’t have one.
Fiduciary Duty.
Directors are legally responsible for managing their companies. They have a duty to exercise their own business judgment for the best interests of the company and its shareholders. Offshore outsourcing has matured in many industries to the point where it could arguably be a breach of that fiduciary duty not to send some work offshore.
The benefits to the company and shareholders of offshore outsourcing could include cheaper supplies, more competitive services by service providers or suppliers, lower cost of capital, speedier entry into the market and other reasons.
Against such benefits the directors must consider the commercial, legal, reputational, foreign currency, security, intellectual property, human resources and other risks involved in any outsourcing, particularly an international outsourcing.
Negligence.
Any lawyer will tell you what negligence is: you owe a duty to follow a standard of care, and when you fail to follow that standard of care, your failure proximately (predictably) causes the damage that actually results.
Business Judgment Rule.
One of the first principles of corporate governance is that the board of directors has a duty to exercise its business judgment in managing the affairs of a company. This rule requires active decisions, not neglect. Given the globalization of economy and the potential significant benefits of offshore outsourcing, it could be argued that every board of directors must consider international outsourcing.
Sarbanes-Oxley Act of 2002: Is Insourcing a Material Risk?
SEC regulations under the Sarbanes-Oxley Act requires disclosure of material contingencies. See Sarbanes Oxley and Outsourcing. Is it material not to seize business opportunities that could cut costs materially?
Investor Interest.
If your company’s shares are publicly traded, you need to consider the effect of your outsourcing strategy upon investors, particularly mutual fund managers and hedge fund managers.
Fund Manager’s Perspective.
In an interview published in The Wall Street Journal on January 28, 2003, Richard Lane, co-manager of a $650 million FMI Focus Fund, concluded that he would not invest his fund’s money in shares of companies that lack a “good outsourcing strategy to China.” His rationale: “The companies that are faster at outsourcing either products or components … will get a leg up on the competition.”Investment Banker’s Perspective.
Investment bankers advise on capital structures of companies. A management tool that harnesses low-cost suppliers effectively frees capital for spending on core business opportunities.
“Join the Bandwagon” into Foreign Sourcing.
In February 2003, Foote Partners reported as many as 35 percent to 45 percent of U.S. and Canadian Information Technology workers will be outsourced – replaced by contractors, consultants, offshore technicians and part-time workers – by 2005. The survey, based on discussions with 1,880 private sector and government employers, found American companies “can’t afford to do application development in the U.S. anymore (because) the nature of the business has changed.” Similarly, Forrester Research estimated in 2003 that the $4 billion in U.S. wages that floated offshore in 2000 will become a tidal wave of $136 billion – and 3.3 million IT-related jobs – by 2015. One reason: It’s now easier to contract maintenance and support via Web-based collaborative tools, high-speed data networks, cost-effective bandwidth and standardized business applications. U.S. IT workers facing displacement are encouraged to retrain in project management or technologies, such as IT security and wireless networking.
Caveat.
Outsourcing can involve considerable risk. For example, the existence of foreign legislation for protection of intellectual property or data protection might be clear, but the local government’s enforcement policy and judicial experience might not be favorable. Certain countries have a reputation for disregard of misappropriation of intellectual property rights despite laws protecting such rights. Depending on the type of functions or operations that can be outsourced, such risks might be mitigated by special strategies. Bierce & Kenerson, P.C. has advised multinational clients on such strategies.