Change Mismanagement

January 13, 2012 by Bierce & Kenerson, P.C.

“Change happens.” Sometimes it happens elegantly, with all parties agreeing. But change can be mismanaged, resulting in legal disputes on pricing, service level performance, duty to perform and impact on performance milestones Change mismanagement happens too.

Change as a Matter of Choreography. Contracts for business services resemble complex choreography for artistic dance, where each dancer minimizes effort and intertwines and exits from the scene according to a musical score. “Work flows,” “flow charts” and “algorithms” define the dance steps, the dancers and the music.

In business process management (BPM), “change management” choreographs the changes in the scope of work, pricing, scheduling, service levels and other essential commercial terms of the outsourced services. By contract, the parties can establish a predictable process for permitting such changes to ongoing contracts, without resulting in breach or termination.

Change Mismanagement. Sourcing and procurement procedures must define procedures for managing changes that will not break the contract. Experience shows that both the enterprise customer and the service provider are capable of mismanaging the change process. Such mismanagement results in litigation, waste (investment in the procurement process, startup costs and unwinding costs that may compensate the other party for unamortized profit).

Change Management Mistakes by the Enterprise Customer. Customers can make mistakes in planning that impact eventual operations:

Inadequate financial analysis of the anticipated impact of the sourcing upon the operation, including neglect of costs of contract administration, price changes in the spot market over time.
Inadequate “base case” that overestimates baseline demand, underestimates volatility in demand or fails to require internal procedures for governance of internal demand (such as charge-back pricing methodology for transparent allocation of costs of the services and contract administration).

Mistakes can occur in customer’s change management as well. For example, when the customer’s own clientele or consumers witness a severe decline in demand or transaction volume, the minimum monthly fees paid to the outsourcer might weigh heavily on costs. Of course, scalability in such volumes should have been anticipated, and the customer might have decided that the “price” of such minimum monthly fees was a safe bet in avoiding other capital investment that would otherwise have been necessary for continuing to offer the “services” in-house.

Severe volatility in such demand or transaction volumes can be very costly to the enterprise customer in a major outsourcing. For example, a supplier of mobile military equipment hired an IT service provider to ensure a high level of service that anticipated the government customer would be well-served. Then the military procurement strategists decided that the particular mobile equipment was not suitable for the next phase in the war. They wanted more mobility, less protection. So they canceled further purchases and continued only in “repair” mode for the existing fleet of such equipment. When the equipment supplier approached the IT service provider to reduce or redeploy the resources implied in the minimum monthly fees, the IT service provider refused, saying that such a change was too drastic and that the contractual termination fee was therefore due and payable upon presentation of an invoice. When the customer refused, the IT service provider sued. The matter was quickly settled with a substantial payment to the IT services provider and the customer’s loss of its upfront investment in the procurement process (lawyers, accountants, operations personnel and startup transition costs).

Change Management Mistakes by Service Providers. The biggest sin for a service provider is to invest additional time, effort and expense in providing services that are not paid for. Such change mismanagement can easily occur:

Failure to notify the customer in advance of the need to change pricing due to customer requests for different services, different methods for service delivery or reduced or increased volumes of services.
Failure to maintain records of changes in the services.
Failure to obtain customer approval to changes in prices or pricing methodology.
Failure to obtain customer approval for certain types of changes that have an impact on the smooth internal workflow of the customer’s in-house operations or the customer’s other service providers, and thus hamper the productivity of the enterprise customer.

For example, in 2005, Phoenix Signal and Electric entered into a contract with the New York State Thruway Authority to install cameras and signs along a toll highway. The contractor performed “extra work,” or “extras,” and claimed additional compensation. It claimed the extra work was justified because of the mutually unforeseen difficulty of performance, requiring an additional stage of work to provide sufficient cement foundations for the cameras and signs. Upon judicial review of the contractor’s claim for payment, the Court of Claims and the appellate court found that the additional stage was not an “extra” but was part of the base charges. Further, the courts rejected the contractor’s demands for payment of additional monies because the contractor had failed to meet two conditions precedent to payment: notice to the customer and adequate recordkeeping to enable the customer to audit the need and scope for the additional work. Phoenix Signal and Elect. Corp. v. N.Y.S. Thruway Auth., ___ N.Y.S. 3d ____, Dkt 512433 (Dec. 22, 2011, 3^rd Dept App. Div.), NYLJ Jan. 3, 2012, dec.nylj.com/1202536924950. In short, depending on how the contract is written, the customer may refuse payment when the service provider mismanages the “change management” process.

Best Practices. All services agreements should define the parameters, processes and conditions for permitting changes. When the parties fail to plan, they plan to fail, and disputes will arise. A well-drafted Change Management procedure, implemented by regular reviews of performance against the contract terms, can avoid such mistakes.

Filed under: Newsletter Article
Tagged: Best practices, Chanage mismanagement, contract management, enterprise customer, service provider, sourcing and procurement procedures.

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.

Filed under: Case Study, Newsletter Article
Tagged: Case Study, contract development, contract manufacturing, enterprise customer, innovation, new product development, supplier

When is a Contractual Limitation of Liability Invalid and Unenforceable? American Public Policy Exceptions to Exculpatory Clauses in Telecommunications

December 21, 2009 by Bierce & Kenerson, P.C.

An essential element of risk management in any commercial contract for the sale of services or goods is the clause limiting the vendor’s liability.

In the sale of goods, the policy limitations are set forth in the Uniform Commercial Code, which invalidates clauses that deprive the customer of an “essential remedy” or the clause is part of an abuse of a consumer under a contract of adhesion, and under the federal Magnuson-Moss Warranty Act and similar state laws. In the sale of services, the policy limitations reflect common law, which may include a judicial analysis of regulations and the fundamental nature of the relationship between the service provider and the enterprise customer.

A decision by a New York State Supreme Court judge in November 2009 highlights the limits on exculpatory clauses under American jurisprudence under principles of gross negligence, willful misconduct, “special duty,” breach of the implied covenants of good faith and fair dealing and prima facie tort. In addition, other legal theories – such as fraud, intentional interference with business relationship, negligent misrepresentation, breach of the implied duty of good faith and fair dealing and prima facie tort – might not be available to enterprise customers for a simple failure by the service provider to deliver proper accounting information relating to its services. So the “special relationship” theory (described below) merits special attention.

This court decision is a stark reminder that the autonomy of contracting parties is always limited by public policy. Enforceability of contracts thus must include contract planning and negotiation, express limitations on remedies and conformity to public policy exclusions that invalidate certain exculpatory clauses. This interplay sets the framework for risk allocation, contract pricing, performance standards, dispute resolution and competitive strategy for the enterprise customer and the service provider.

I. The “Special Relationship” among Telecom Carriers

The Duty of Connected Telecommunications Carriers to Each Other. In this case, Empire One Telecommunications Inc. v. Verizon New York Inc. (__ N.Y.S.3d ____, Nov. 2, 2009 NYLJ, p. 21, cols. 3-4), Justice Carolyn E. Demarest ruled that one service provider cannot rely upon its exculpatory clause when it has a special duty due to a special relationship with its customer. The decision goes beyond a simple analysis of claims that include gross negligence and willful misconduct, which have long been judicially viewed as exceptions to the normal rule that contractual limitations of liability are enforceable.

Historical Monopoly, Regulated for Competition. The Empire case reflects special character of telecommunications services as a regulated utility. In the Empire One case, Verizon and Empire One were competitors. By virtue of the historical breakup of the prior monopoly held by AT&T over a decade before, Verizon controlled the transmission equipment and lines that carried the telecommunications for Empire’s customers. Under the Telecommunications Act of 1996, 47 U.S.C. 151 et seq.), Verizon had a statutory duty to provide certain telecommunications services to competitors like Empire. Empire was a reseller of Verizon services. Empire was allowed by federal law to interconnect its own network (and other networks) with the Verizon network.

Implied Duties. Under the Telecommunications Act of 1996, Empire was entitled to control the business relationship with the ultimate consumer because Empire enrolled them as its customers and Empire’s own equipment delivered the final connection to the customer. Verizon was carrying calls that were originated with other carriers (such as but not limited to Verizon) that terminated using Empire equipment. Under the Telecommunications Act of 1996, as terminating carrier, Empire is entitled to bill the customer for the service and make a profit by charging the interconnecting carriers that originated the calls for using Empire equipment to deliver the “last mile” termination services. All calls are logged into the billing system of Verizon, since it acts as traffic controller. Verizon equipment, as the glue of the telecom system, is capable of providing information on date, time, origination and destination and the duration of calls as well as codes (LATA identifiers, a valid settlement code, a valid originating local routing number and other validation codes used in billing) that enables interconnecting carriers to bill each other for services.

Failure to Provide Billing Records. Empire complained that Verizon had manipulated the call records that it delivered to Empire by stripping essential information needed for Empire to bill other carriers. Empire alleged that Verizon rendered the call records “useless for the very purpose for which they are intended”. Empire complained that such omissions prevented Empire from determining the originating jurisdiction or the types of telephone calls (mobile, land-line), thus depriving Empire of the ability to charge the originating carrier for the termination services by Empire.

Damages. Empire alleged its losses from 2004 to 2008 were approximately $2,500,000 in lost revenue plus approximately $160,000 in payments to Verizon for unusable billing records covering over 15 million telephone calls. The Empire court provided a refresher course in the liability that a breaching party is deemed to assume. A breaching party “is liable for those risks foreseen or which should have been foreseen at the time the contract was made.” Ashland Mgt. v. Janien, 82 NY2d 395, 403 (1993), quoted at Empire, page 22, col. 1.

Elements of a “Special Relationship.” The decision focused on the conditions that established a “special relationship” between one telecom carrier to another that used its telecom transport facilities (the equipment and the lines) for a fee. The decision focused on the statutory structure regulating public utilities for the public benefit, which, the court held, supports a finding of a “special relationship” between the service provider with a monopoly over the billing records and the service provider that needed the billing records to bill other carriers. “Public policy as reflected in the regulatory structure would also mitigate against enforcement” of the exculpatory clause. The concept of “special relationship” has precedents under prior New York judicial decisions where a public utility fails to perform its duty to furnish reliable service.

Unequal Bargaining Power. Verizon argued that there is no “special relationship,” and therefore the exculpatory clause is valid, where the service contract was negotiated by two sophisticated parties who negotiated in a commercial setting. Rejecting this argument, the court ruled there was clearly an inequality in bargaining power between the two public utilities since, in this case, the terms were not actually negotiated. To promote the public interest under the Telecommunications Act of 1996, the court said, Empire as customer should be afforded the “protection generally due a consumer when dealing with a utility with monopolistic control of the desired service.”

Published Tariff Filing. The general public policy against exculpation of gross negligence and willful misconduct was also written into the particular tariff that Verizon had filed with the public utilities commission.

Service Provider’s Termination of Service following Unresolved Billing Dispute. Other precedents under New York law dealing with Verizon’s wrongful refusal to provision telecom services have ruled that Verizon is liable for consequential damages to a reseller of telephone services over lines provided by Verizon where (i) Verizon had billed and actually been paid for a telephone feature that it had not actually provided (a “billing error”), (ii) the customer stopped paying for the feature allegedly not provided, and (iii) Verizon cut off the reseller from its network for non-payment. The court allowed the reseller to pursue lost profits as consequential tort damages for gross negligence or willful misconduct.

II. Other Classic Causes of Action when the Service Provider Fails to Perform Proper Accounting Services for its Services Performed

Gross Negligence. Under New York precedents, “gross negligence” must “smack of intentional wrongdoing.” Kalisch-Jarcho, Inc. v. Cit of New York, 58 NY2d 77, 385 (NY 1983). Gross negligence evinces a “reckless indifference to the rights of others.”

Fraud. Fraud involves (i) a false misrepresentation as to a material fact, (ii) an intention by the defendant to deceive the plaintiff by such false misrepresentation, (iii) justifiable reliance by the plaintiff on the misrepresentation, and (iv) damages caused by plaintiff’s reliance. Empire claimed each of these elements but the court dismissed the fraud claim since fraud claims cannot be used to duplicate the same elements of a breach of contract, where the fraud claim was “collateral to the contract” and not based on the same facts alleged as to the breach of contract. A fraud claim is insufficient if it merely alleges that a misrepresentation of an intention to perform services under the contract.

Implied Duty of Good Faith and Fair Dealing. Under common law, there is an implied duty of good faith and fair dealing in the performance of contractual obligations. Here, Empire’s claim that Verizon breached this duty was dismissed since it was equivalent to a claim for breach of contract.

Tortious Interference with Business Relations. In the Empire case, Empire as CLEC customer claimed that Verizon as service provider had interfered with Empire’s business relations by its failure to provide the call data needed to enable Empire to bill its interconnect customers. This legal theory requires the injured party to allege and prove (i) the existence of the actual or prospective business relationship with a third party, (ii) the defendant, having actual knowledge of that relationship, intentionally interfered with it; and (iii) the defendant either acted with the sole purpose of harming the plaintiff or used means that were dishonest, unfair or improper, and (iv) the defendant’s conduct thus injured the plaintiff’s business relationship.

In the Empire case, this legal theory was unsupported. Empire was unable to validly claim that Verizon’s failure to provide interconnect customer billing information was directed to harm Empire’s customers, not merely to harm Empire. The court noted that Empire merely alleged that it was unable to invoice interconnect carriers for transiting its network due to the invalid and inadequate call records that Verizon sells to it. “Empire’s inability to bill these third–party carriers, however, would not induce these carriers not to do business with Empire.” Hence, Empire was unable to sustain a claim of intentional interference with business relationship.

Negligent Misrepresentation. Empire also claimed that Verizon was liable for consequential damages due to Verizon’s negligent misrepresentation. Such a claim depends on alleging and proving three requirements: (i) the existence of a special relationship or privity-like relationship that imposes a duty on the defendant to impart correct information to the plaintiff, (ii) the fact that the information was incorrect, and (iii) the plaintiff reasonably relied on the information to its detriment. It is a question of fact whether there exists a “special relationship” sufficient to justify plaintiff’s legitimate expectation that the information would be true and accurate. In this case, the tariff and the contract were worded in a manner that denied this type of special relationship to Empire.

Prima Facie Tort. Empire unsuccessfully alleged that Verizon was liable for “prima facie” tort, a unique common law tort theory under New York law. The requirements for alleging and proving such a cause of action include (i) the intentional infliction of harm, (ii) which causes special damages, (iii) without any excuse or justification, (iv) by an act or series of acts that would otherwise be lawful, and (v) that the disinterested malevolence was the sole motivator for the defendant’s harm-causing conduct. Empire failed to allege the last point, which it probably could not prove since reaping unfair profits is not an act of malevolence but rather an act of greed.

III. Lessons for Everyone

The Empire One decision was framed in the area of telecommunications and invoicing. Separate from the area of regulated public utilities, it offers nonetheless several practical lessons for structuring an outsourcing agreement:

Exculpation is Limited. Public policy exceptions for gross negligence and willful misconduct are implied in every contract, whether or not included contractually.
Mutually Agreed “Special Relationship.” A “special relationship” may exist, and the service provider’s exculpation might not be valid or enforceable, where the enterprise customer depends on the service provider to provision the service,
Mutually Agreed Consequences. As a contracting matter, the parties should identify the consequences if the service provider suspends service while there is a dispute over adequacy of its provisioning of services, over billing for past services and for the customer’s inability to obtain alternative services in the spot market without consequential damages.
F&A Services: Special Negotiating and Drafting Issues. Legal theories of fraud, intentional interference with business relationship, negligent misrepresentation, breach of the implied duty of good faith and fair dealing and prima facie tort do not give any remedy to the enterprise customer that loses revenue from an inability to use the service provider’s billing records to invoice its own interconnect customers. For “finance and accounting” outsourcing, this lesson means that inaccurate or insufficient accounting services need to be identified as a breach, and the quantum and conditions of “damages” for “direct damages”.

Filed under: Case Study, Newsletter Article
Tagged: contracting, Contracts, dispute resolution, enterprise customer, Gross Negligence, management, risk management, Special Relationship, telecommunications

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.

Filed under: Case Study
Tagged: Case Study, competitive sourcing, enterprise customer, ethical, Sarbanes Oxley Act of 2002, services providers, shared services

Patents in Outsourcing: Strategy and Practice for Business Process Patents and International Trade in Services

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

Should a service provider develop a patent portfolio? In performing outsourced services, the service provider performs certain business processes that range from information technology to office procedures. Since U.S. courts have interpreted patent laws to make business processes eligible for patent protection, the patent law has played a small but growing role in business process outsourcing. This article addresses some key issues in patent law in outsourcing, including validity, infringement, extraterritoriality and the role of patents in outsourcing.

What is a Patent?

A patent is a statutory monopoly that allows the inventor to practice an invention, to allow others to use the invention under terms and conditions that the inventor considers acceptable and to prevent unlicensed persons from using the invention. Under U.S. law, an invention must be novel, useful and non-obvious to one skilled in the existing “art” (science). It is the specific claims in the specification of the invention that are entitled to the statutory monopoly. In patent applications, claims are written as independent (and therefore unrelated to any other claim) or dependent (and therefore viable only if the related independent claim is valid).

Impact on Competition.
Quite simply, patents stifle competition. For this reason, courts and regulators have adopted limitations on abuses of patents, such as tying the use of non-patented goods or services to patented goods or processes.

The Specification.
The patent application must set forth the “specification” that describes the exact scope of an invention and its method of “manufacture” in sufficient detail that it describes what is left to the public outside the scope.   Markman v. Westview Instruments, Inc., 116 S. Ct. 1384, 517 U.S. 370, 373 (1996).   The specification consists of two parts:

a detailed “written description of the invention and of the manner and process of making and using it, in such full, clear and concise, and exact terms as to enable any person skilled in the art … to make and use the same.”   35 U.S.C. 112, para. 1.

a conclusion “with one or more claims particularly pointing out and distinctly claiming the subject matter which the applicant regards as his invention.” 35 U.S.C. 112, para. 2.

General Definition of Patentable Processes.
Patentable process “inventions” must involve a “process, art or method, and include… a new use of a known process, machine, manufacture, composition of matter, or material.” 35 USC 100(b).   “Whoever invents or discovers any new and useful process, machine, manufacture or composition of matter, or any new and useful improvement thereof, may obtain a patent therefore,” subject to the patent law’s other provisions. 35 U.S.C. 101.

Software Patents.
Software patents have been issued in the United States since 1982, when Merrill Lynch patented a financial transaction software application that links securities brokerage accounts with” cash management accounts.”  U.S. Patent No. 4,346,442. While early judicial decisions quibbled that the processing of data was not an eligible process, the courts and the U.S. Patent and Trademark Office have generally accepted the patentability of software.

Business Process Patents.
Business methods are the sequence of steps that are undertaken to engaged in a specific business activity. Until 1998, a business method was considered to be an idea, and business methods as ideas were not patentable. In July, 1998, the U.S. Court of Appeals for the Federal Circuit did away with that interpretation of the U.S. patent law. The case, State Street v. Signature Financial, legitimized the patentability of software that Signature had written to enable it to administer mutual funds more efficiently. The software merely embodied a business process.   The court’s language was broad enough to embrace any business process (as long as it was new and “nonobvious” and had a “useful, concrete, and tangible result”). Congress has done nothing to restrict this judicial interpretation.

Validity.

Once issued by the U.S. Patent and Trademark Office, a patent is presumed valid. 35 U.S.C. 282. The party who seeks to invalidate a patent or any individual claims has the burden of establishing invalidity. To meet this burden of proof, the party seeking to invalidate must prove the invalidity by “clear and convincing evidence,” a standard that is very high. Helifix Ltd. v. Blok-Lok Ltd., 208 F.3d 1339, 1346 (Fed. Cir. 2000). In making its proof, the party seeking to invalidate may rely upon a variety of arguments. Such arguments may include an assertion that the patent holder engaged in “fraud on the patent office” by failing to disclose relevant “prior art” that would have prevented the issuance of the patent in the first place.

In litigation seeking to invalidate a patent, the first issue is one to be decided by the judge: what is the scope of the claims in the patent? The second issue is one for the jury: has infringement occurred? Markman v. Westview Instruments, Inc., 116 S. Ct. 1384, 517 U.S. 370, 384-391 (1996).

Enforcement of Patent Rights.

Enforcement of patent rights presents problems both for the patent holder and for the alleged infringer. The patent holder risks invalidation of the patent, thereby losing the right to claim royalties from all licensees. The alleged infringer (who may include an unhappy licensee unwilling to pay future royalties) may risk heavy damages.

Doctrine of Equivalents.
Judicial interpretation of patent claims adopt two approaches: literal and interpretive. Under historical case law, the monopoly of a patent claim extents beyond the literal description and covers “equivalents” as well.  Applying some judicial discretion in the interpretation of the literal scope, the doctrine thus allows an infringement claim where the differences between the accused device or process and the patent claim are “insubstantial” and represent only “trivial changes.”

Prosecution History Estoppel.
Affirming this principle, the U.S. Supreme Court has restricted it by noting that the patent applicant’s modifications to its application forms a “prosecution history” that can serve as estoppel for any purpose under the patent law, not merely relating to eligibility (by narrowing it to deal with prior art).   Festo Corp. v. Shoketsu Kinzogo Kogyo Kabushiki Co., Ltd., 535 U.S.722 (2002).   At common law, the equitable principle of estoppel serves as an enforceable bar to assertion of a right or claim of right. The Festo decision permits alleged infringers to review the file history and rely upon any concessions or limitations made by the patent applicant as a basis for limiting the scope of the patent claims. Prosecution history estoppel under Festo thus opens the flood gates for competition who read the file history and look for concessions made by the applicant.

In Honeywell Int’l Inc. v. Hamilton Sundstrand Corp., 2004 WL 1202997 (Fed. Cir. June 2, 2004), the Court of Appeals for the Federal Circuit ruled that, in the patent prosecution process, the applicant is deemed to have waived the full breadth of a broad independent claim when it re-writes the claim to be more specific.   Historically, patent prosecution involves the normal process of writing a “stand-alone” (independent) claim followed by a subsequent dependent claim (relying on the “stand-alone” claim’s basic premise).   When the patent examiner rejects the stand-alone claim and asks the applicant to rewrite it to convert the dependent claim into a new stand-alone claim, the applicant may do so. In doing so, the applicant is deemed to abandon the full scope of the original stand-alone claim, and to rely only on the dependent claim.

Under the Festo decision as interpreted in Honeywell, rewriting the dependent claim into an independent claim form, accompanied by abandonment of the original broad independent claim, creates a presumption of “prosecution history estoppel” that nullifies the “abandoned” claim. As a result, patent applicants will probably be more prudent and narrowly focused when considering use of broad independent claims.

For outsourcing, this means that only narrowly defined claims will pass muster. Outsourcing services providers hoping to rely on patent protections will therefore be exposed to greater risks of competition due to lack of broad patent monopoly.

Defenses by Alleged Infringers.
The alleged infringer may allege various defenses, such as:

non-infringement

absence of liability for infringement

inenforceability.

invalidity of the patent or any claim for substantive or procedural reasons. 35 U.S.C. 282

Extraterritoriality in Patent Law.

Patent law is a creature of the national law. Each country applies its own rules. U.S. patents do not cover the business processes or manufacturing process used in another country. John Mohr & Sons v. Vacudyne Corp., 354 F. Supp. 1113 (N.D. Ill. 1973).

However, goods made abroad using processes patented in the United States are subject to exclusion, upon importation, unless licensed by the U.S. patent holder. Exclusion requires registration of the patent with customs services. Enforcement of exclusion is hardly 100% effective.

Services performed abroad that result in delivery of information in the United States are generally not subject to U.S. patent protection. In that case, where a portion of the services are rendered in the United States, a U.S. business process patent will cover the U.S. portion of the services.

Patent Conventions.
A number of international conventions, beginning with the Paris Convention of 1886, accords certain procedural rights in countries that adhere to them. The World Trade Organization’s Agreement on Trade-Related Intellectual Property requires participating countries to comply with the Paris Convention and certain other intellectual property conventions. WTO members must treat foreign nationals on a non-discriminatory basis in respect of the patent laws. The Patent Cooperation Treaty provides a mechanism by which an applicant can file a single application that, when certain requirements have been fulfilled, is equivalent to a regular national filing in each designated Contracting State. There are currently over 112 PCT Contracting States.

Relevance to Outsourcing.

Patent protection — or the lack of it — can affect the service provider’s ability to perform the scope of work under the outsourcing services agreement. Patents may be relevant to outsourcing, but not necessarily.

Comparative Advantage.
In the field of business process outsourcing, the service provider can achieve competitive advantage by having a patented process, since it allows that provider to perform that process without paying royalties and without patent infringement claims or litigation.

Defensive Strategy.
Having a pool of patents can be useful to avoid having to pay costs of infringement litigation and infringement damages.   Without any patents, the service provider has nothing to barter in a cross-licensing transaction that could be proposed as a settlement.

Branding Strategy.
One service provider uses part of the title to a U.S. patent as the phrase that defines its service brand: “On Demand Process….” [U.S. Patent No. 6,370,676]    Public relations consultants and business developers might review the service provider’s patent portfolio for similar defining clues to brand development. Conversely, branding strategists should be consulted for strategic nomenclature of patent applications.

Termination for Cause.
Ordinarily, the enterprise customer relies upon the service provider’s indemnity against infringement in lieu of adopting a right to terminate for cause in the event of infringement. Such indemnities are customary.   Enterprise customers might wish to consider whether reliance on such indemnification is sufficient as a remedy in case the service provider’s business process is determined to be infringing on some third party’s rights.   Similarly, service providers should engage in appropriate research to determine whether their method of performing or delivering the services infringes, or risks infringing, a valid U.S. patent.   In either event, the issuance of new patents to cover existing processes could be problematic for the business relationship.

BPO Patent Strategy in Practice: Who Actually Patents What?

We conducted a search of U.S. patents issued to leading outsourcing service providers in information technology, human resources and manufacturing. The results were not surprising.

ITO and Consulting.
Outsourcers that specialize in managing IT and in consulting services do not hold many patents. Such service providers generally engage in “ordinary” and “well known” business processes that are ineligible for patenting, such as installing, configuring, fine-tuning, hosting and maintaining current versions of some commercial “off-the-shelf” software. Where the customer requires extensive customization, the work product normally belongs to the customer as a special project for a separate fee. Alternatively, the parties agree that the service provider will own and market the work product under agreed financial and operating conditions.

To the extent that ITO service providers do apply for patents, the patents tend to be in:
- a niche area (e.g., a system for cashing checks for persons without bank accounts where the customer must engage in some self-service task, U.S. Patent No. 6,038,553), or
- a generic function (e.g., data processing apparatus and corresponding methods for the retrieval of data stored in a database or as computer files, notably, methods and systems to facilitate refinement of queries intended to specify data to be retrieved from a target data collection, U.S. Patent No. 6,678,679).
HRO.
Outsourcers that specialize in human resources management generally do not hold any patents. For example, a search of two HRO industry leaders showed that neither owns any U.S. patent.

Business Process Outsourcing.
Business process outsourcing that relies upon software may be a good candidate for patent protection, but only for patenting the software. At this stage, the difference between a software developer and a service provider gets murky. Generally, BPO outsourcers do not pursue patent strategies but use other methods for protecting intellectual property and competitive advantage. Exceptionally, they may patent their software to defend against third party software developers.
Original Equipment Manufacturing.
Outsourcers that serve as contract manufacturers logically focus energy on preserving their rights to conduct “contract manufacturing” in the United States and other countries. Companies such as Celestica, Jabil Circuit, Sanmina-SCI and Solectron have each developed some patents that relate to generic operations, not to specific product designs or manufacturing processes unique to their customers. As to the latter, the contract manufacturers require their customers to license any customer technology used in the manufacturing process, or at least refrain from suing over the contract manufacturer’s use of such process or any equivalents.

Factors Affecting an Outsourcer’s Patent Strategy.

Limitations of a Patent Strategy in Outsourcing.

Patent strategies depend on obtaining global monopoly through global patenting. The limitations on patenting of business methods in a global digital economy suggest that patenting is not the solution for protecting a service providers proprietary processes.

Costs of Global Patenting.
Assuming that a service provider wished to achieve global exclusivity, it would have to file patent applications in at least the 112 countries that are members of the Patent Cooperation Treaty, in addition to dozens more. The cost of prosecuting and maintaining patents is high, and could be worthless if “copycat” service providers were to infringe virtually all claims except for a few.

Costs of Prosecuting Patent Infringers.
A “plain vanilla” patent infringement lawsuit costs an estimated $750,000 as a minimum. To such out-of-pocket costs, the patent holder must add the opportunity cost of the executive and technical personnel whose time is diverted towards the litigation process, the portion of their salaries, benefits and overhead allocable to the litigation process, and the costs of enforcing a judgment.

Uncertainties of Patent Scope and Validity.
The patent application process contains many uncertainties. As to scope, under the Festo doctrine, any concession made by the applicant can be used as an “admission against interest” by a defendant. Patent holders making a concession to the patent examiner in any country may be deemed to have made the same concession in all other countries. Alleged infringers will scour the patent prosecution files in all relevant countries and look for such concessions. As to validity, any prior art (including customary usages of the trade, the technical literature and other pre-existing patents) that is not disclosed to the patent office could jeopardize the entire patent.

Risks of Counterclaims of Patent Abuse.
In any litigation, the plaintiff risks counterclaims by the defendant. In patent cases, the counterclaims could include antitrust violations subject to triple damages under U.S. law or for simple damages as “abuse of dominant market position” under European Union law. For market leaders, the costs of defending counterclaims can be greater than the costs of pursuing a basic infringement claim. Also, where patent applications fail to disclose substantial prior art the use of the patents to monopolize a field of business activity could arguably constitute patent abuse.

Inconsistencies of Law, Legal Systems and Results.
Given the exclusive right of each country to adopt its own patent rules, service providers considering a patent strategy must accept the fact that what is patentable in one country might not be patentable in another country. “Whipsaw” in application of legal principles leads to unpredictability and inequity.

Loss of Secrecy.
Because patents must be published to be enforceable, the inventor immediately loses all secrecy. (Exceptionally, a few patents are not published where interests of “national defense” apply.) Thus, pure “software” or pure “business method” might not be patentable in countries where competitors could use the software or method to perform the same service and export the results to the country that grants patent protection. Given the availability (and advisability) of encryption technologies and privacy methods, the foreign use of the software or method would likely go undetected, with no resulting enforcement of patent rights.

Gambling with “Best Embodiment” Rules.
Sophisticated businesses -whether service providers or enterprise customers – engage in a game of hiding trade secrets and patenting a business process. The rules of this game are limited by the principle that the patent application must disclose the “best embodiment” of the full process.

The Business Process Paradox in the Outsourcing Life Cycle.
Both parties in an outsourcing contract should understand the implications of what we call “the business process patent paradox.” Patents owned by the service provider make it stronger against competition and may enable the enterprise customer to enjoy the benefits of the service provider’s innovation investments. Yet, upon termination the customer would need to be converted to a non-infringing process or be given an evergreen patent license usable by the customer or its successor service provider. Perversely, this patent paradox may inhibit the basic efficiencies of outsourcing, namely, scalability, portability, transparency, audit ability and periodic renewal or replacement. One exception applies. In contract manufacturing, the customer might wish to patent its processes in the countries where infringement is most likely, such as by the contract manufacturer at the end of the OEM manufacturing agreement.

Advantages of Trade Secrecy.
Many outsourcing service providers prefer to retain their comparative advantage by using trade secrets. Trade secret protection does not protect against patent infringement. Trade secrets do not provide adequate protection where the trade secret becomes generally known. This risk is high in a digital global economy where information can be copied and stored in many ways that are not traceable to the authorized recipient of the trade secret. Optimally, the service provider will develop and use proprietary software covered by patents. Even then, the patents might not disclose the full process.

Best Practices.

Patents could play a pivotal role in the competitiveness, viability and continuity of services provided by a service provider.

Enterprise Customers.

Enterprise’s Own Proprietary Processes.
An enterprise customer that wants its service provider to perform “proprietary” business processes will need to consider the impact of that contractual requirement on its own risk profile, its willingness to indemnify the service provider appropriately and its ability to do, or hire others to do, alternative processes that are not infringing. Hiring a service provider to perform such processes might contradict other commercial policies, such as not outsourcing “core” business processes and maintaining certain processes confidential as a competitive advantage, even though such confidentiality is customarily protectible under a non-disclosure agreement.
Due Diligence and Selection Process.
Enterprise customers should ask the service provider for a description and list of all patents that the service provider owns or has pending.
Indemnification.
The customary solution to patent infringement is to require the service provider to indemnify the enterprise customer in case of any alleged or actual infringement by the service provider of third-party patents and other intellectual property rights.
Termination of Contract.
Historically, intellectual property infringement is not an event of default in outsourcing contracts. This situation will probably continue. Other contractual solutions exist that may allow the customer to enjoy the benefit of the contract or to terminate.

Service Providers.

Due Diligence.
The service provider should ask the enterprise customer about any patents and other protect able intellectual property that the customer would require the service provider to use (or that might be needed to perform the agreed services). As a defensive measure, the service provider should understand the applicability of any customer-owned patents and its impact on its own intellectual property strategies.

Contract Provisions.
The infringement indemnity may extend to the interaction between the customer and the service provider’s business methods and processes. Appropriate allocation of liability and indemnification should be considered to avoid extending the infringement indemnity beyond processes that the service provider controls.

Filed under: White Paper
Tagged: alleged infringer, Business Process Outsourcing, contract manufacturing, enterprise customer, patent, Patent Cooperation Treaty, patent portfolio, service provider, services infringes, services providers, statutory monopoly, World Trade Organization

Document Mismanagement: When the Customer Miscommunicates a Court Order to the Document Managing Outsourcer

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

Summary.

For corporations that have outsourced any process of document storage or management, electronic discovery procedures in litigation can be a nightmare. The lessons of multiple mistakes by both the enterprise customer and the service provider leads us to suggest some “best practices” in relation to litigation management and document management for inclusion in the policies and procedure manuals that accompany sophisticated outsourcing transactions. Ambiguity and confusion will reign as the “supreme law of the land” if there is no clarity in relation to processing special requests by the enterprise customer for special preservation or management of electronically stored documents.

Background.

UnumProvident Corp. hired IBM to manage certain electronic records. In a subsequent lawsuit by an employee of UnumProvident, a New York court ordered UnumProvident that it and its “agents” “shall not alter, destroy, or permit the destruction of, or in any fashion change any ‘document’ in the actual or constructive care, custody or control of such person, wherever such document is physically located.” The order provided for the preservation of a variety of documents, including claims files, policy and procedure manuals, medical files and e-mails for a six-day period.

Miscommunication by Client to Outsourcer.

In reviewing whether UnumProvident had complied with the protective order, a New York trial court determined that UnumProvident had failed to give clear instructions to IBM to preserve the necessary documents. The court identified a number of problems:

The UnumProvident litigator had discussed with the Court the extension of the expiration of the parameters for the backup tapes, but “UnumProvident did not explore that option with IBM in any meaningful way.” UnumProvident failed to identify technological means of transferring documents from backup tapes having specified expiration dates to backup tapes (or a hard drive or other electronic media) without any expiration date.

Both the enterprise customer and the outsourcing service provider were criticized for not having the necessary understanding of the technical steps necessary to preserve the protected documents. “Neither [the customer’s enterprise security architect” nor the service provider’s Delivery Project Executive] had sufficient expertise to discuss the [document] preservation project in a meaningful way. Neither of them took the steps that they needed to take to get sufficiently informed advice on the issues involved.”

UnumProvident failed to supervise the efforts of its enterprise security architect who had been delegated the task of preserving the electronic documents. The UnumProvident enterprise security architect “was allowed to make critical decisions about how much and what email should be preserved pursuant to UnumProvident’s legal obligations. In the end, [he] made his decision based on inaccurate information. As a result, [one particular day’s] data was not preserved except to the extent that it still remained in an employee’s computer mailbox or had only been deleted within 14 days of the date of the snapshot.”

Outsourcer’s Errors in Compliance. IBM made only one mistake. Once it realized the mistake, IBM quickly avoided further damage by excellent responsiveness. The mistake was unintentional:

In creating the December snapshot [to preserve the records as requested by UnumProvident], IBM had unwittingly taken steps that caused the back-up tapes to re-enter the [rotating tape back-up] system prematurely, and as a result many [documents] already had been overwritten [when IBM did the first recovery test].

In this mistake, IBM “inadvertently reset the [rotating tape] settings so that the [rotating tape] retention protocols for the back-up tapes in off-site storage tapes so that the tapes expired before their scheduled time.” As a result, the backup tapes were either recalled, reused and overwritten before they should have been, with a loss of data. Neither UnumProvident nor IBM realized this had occurred, nor did they expect it.

After the failed restoration test, “IBM realized for the first time what had happened. IBM immediately identified all server back-up tapes and preserved them. It had already extended the [backup plan] expiration date protocol to 365 days as a result of its discussions” with the enterprise customer.

Thus, while IBM made a mistake, it appears that the loss was minimal, or, at least impossible to assess as of the time when the court rendered its decision.

Losses.

As of the court’s decision in September 2003, it was not clear whether the plaintiff had been injured by reason of the loss of protected data. Other backups were located. Other methods of proof might have been available to prove the same information. Accordingly, the case is instructive for what happened, not for the legal consequences.

Best Practices in Document Management.

This case highlights some simple truths about document management in outsourcing.

Tape Rotation Period.
It is a false savings for a company to have a short period for the rotation of its backup tapes. For any enterprise that is the subject of litigation, a short rotation period will increase the risk of inadvertent loss of data due to expiration or overwriting of data under normal data preservation and destruction policies and procedures.

Trap for the Unwary: Why every contract (or related policy and procedure manual) should address data management.
When the loss of data violates a court order, the loss becomes willful and subjects the enterprise customer to unpredictable losses that might arise from being foreclosed to present evidence that might have been supported (or rebutted) by the lost data.

Service Providers Should Warn Customers about Litigation Issues.
In this situation, both the service provider’s delivery executive and the customer’s executive failed to understand the requirements of the court order protecting documents. This confusion could have been avoided by establishing a “role and responsibility” matrix on third party demands for access to documentation.

Customer’s Duty to Warn the Service Provider.
Ultimately, as a litigant, the customer enterprise is subject to the severe penalties under court rules that may arise out of a willful noncompliance with procedural rules on pre-trial discovery and disclosure of evidence to the opposing party. The customer has the burden of insisting on clear procedures. The customer should take the initiative to warn the service provider of the need to make due investigation and implement appropriate protections of the documents and data covered by a protective court order.

Litigator’s Duty to Identify Potential Compliance Risk.
If an attorney’s client becomes subject to a protective order, the attorney should probably investigate promptly who is the custodian of the protected information and find a solution for compliance. In this situation, the attorney seems to have passed the task off to an in-house attorney, who passed it off to a systems administrator, and no one verified the immediate compliance. IMMEDIATE COMPLIANCE is what is required by the court order, so all attorneys involved in such situations should take an interest in not merely asking for compliance, but verifying it. Of course, this notion would convert the trial lawyer to a project manager, but that should be not too difficult in view of the availability of e-mails and scheduling technology, as well as disaster recovery procedures, to implement a mini-disaster recovery plan.

Service Provider’s Sales Pitch.
Outsourcing will no longer serve as a reliable and safe business for the customer if the service provider makes mistakes in anticipating and responding to specific protective orders. In this case, the service provider was unaware of the problem of overwriting of backup tapes until protected data had already been lost.

Relationship of the Enterprise Customer’s Adversary with the Enterprise Customer’s Service Provider.
In this case, the protective court order was addressed to the defendants and their respective “officers, agents, servants, employees and attorneys.” One may question whether the attorneys for the enterprise customer’s adversary failed to obtain identification of who was custodian of the protected data. There had been plenty of time to do so, since the process of getting to agreement on what documents would be protected (and not just a fishing expedition for any documents whatsoever) had taken time and was supervised by the court. One may ask whether the plaintiffs’ outside legal counsel was not negligent in failing to try to identify such custodians so that the custodians could be notified, or even subject to court order, before protected documents had been overwritten.

Reference:
Keir v. UnumProvident Corp., __ F.3d __, NYLJ Sept. 4, 2003, p. 23, cols. 4-6, p. 24, cols. 1-5 (S.D.N.Y. 2003), Judge Cote.

Filed under: White Paper
Tagged: document management, document storage, electronic discovery, enterprise customer, litigation management, service provider

Legal Compliance in Outsourcing

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

When is the Service Provider Liable for its Customer’s Compliance with Laws, including Payment of Fines and Penalties for Non-Compliance?

When is the service provider liable for its customer’s compliance with laws, including payment of fines and penalties for non-compliance? Most outsourcing agreements require each party to comply with applicable laws. However, as business process outsourcing (“BPO”) services move up the value chain, legal compliance obligations can get somewhat tricky. Consider the scenario where the service provider’s services substitute for the enterprise customer’s normal compliance with laws governing the enterprise customer’s operations. If you are a candidate for public office, your consultant might just be liable for your compliance, fines and penalties. If you stay out of politics, you can still learn about a critical BPO contracting issue that played out in a New York City election campaign.

Context: Compliance with Election Laws.

If you are a candidate for public office, your consultant might just be liable for your compliance, fines and penalties. While laws vary, it is instructive to consider the liability of a political consultant. The consultant’s client, a New York City political candidate, failed to timely respond to the Campaign Finance Board’s draft audit report and filed late four disclosure statements. The consultant acknowledged its office failures. It offered two excuses. First, its failures were due to its own disorganization (and not its client’s). Second, the candidate’s records were on a computer affected by a computer virus. This is hardly a case involving the usual due diligence, site visits and other critical infrastructure offered by the usual “big ticket” outsourcing. But the case illustrates what happens in case of “worst practices.”

Statutory Liability.

The particular statute imposes liability on “agents” as well as the political candidates. Under the New York City Administrative Code, §3-711(1), an “agent” includes individuals and entities who have undertaken the responsibility for campaign law compliance.

The Service Agreement.

The political consultant claimed that it had developed computerized systems designed to keep its clients’ political campaigns in compliance with the campaign finance regulations. The agreement provided that the service provider would complete all filings with the regulatory agency and explain to the candidate and monitor all rules and regulations applicable to the political campaign.

The Course of Dealing.

The political consultant actually performed as promised, at least to the degree sufficient to be designated as an “agent” liable under the regulations for compliance. The candidate’s Candidate Certification listed the service provider as the mailing address for notices from the regulatory agency. The service provider’s employee represented to the regulatory agency that she represented the committee for the candidate’s election with respect to compliance. The candidate’s disclosure statements were generally delivered by hand by the service provider’s messenger. The service provider’s contacts with the regulators outnumbered those of other representatives of the candidate’s election committee.

Implications for Enforcement of Other Types of Regulatory Legislation.
This decision represents an enforcement action by the governmental agency responsible for administering a regulatory law. The regulators targeted enforcement action directly against the “BPO service provider” by reason of its contractual undertakings, its actions for compliance and its direct communications with the agency. The same analysis might not apply to non-delegable compliance duties, such as these of the CEO and the CFO under the Sarbanes-Oxley Act of 2002.

Equitable Estoppel.

In this case, the court, without setting forth a theory of law, concluded that it would be inappropriate to allow a service provider to act as agent and not have the liability of an agent.

To allow any entity, that has agreed to fulfill the compliance requirements of behalf of a candidate to shoulder the blame for a candidate’s non-compliance, and then to allow that same entity to escape liability because it claims it is not an “agent” of the candidate, would not serve the purpose of the Campaign Finance Act. To accept [the service provider’s] argument would defeat the policy behind the Campaign Finance Act.

As a result, the court found that it was not “arbitrary and capricious” to impose the candidate’s penalty on the consultant, and that such an imposition did not lack a rational basis.

Lessons Learned.

By assuring compliance with laws, the service provider agrees to guarantee the result. Unlike a commitment to use “best efforts” or some other type of “efforts,” a BPO service provider’s guarantee of results implies an agreement to shoulder the fines and penalties imposed on the service provider’s customer by reason of any failure to comply.

Matter of The Advance Group v. New York City Campaign Finance Board, __ N.Y.S.__, NYLJ (Feb. 3, 2004), p. 18, cols. 3-4 (N.Y. Co. Sup. Ct. 2004), per Justice Shafer.

Filed under: White Paper
Tagged: Business Process Outsourcing, compliance, enterprise customer, Equitable Estoppel, service provider

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.

Filed under: White Paper
Tagged: attorney-client privilege, Business Process Outsourcing, discovery, enterprise customer, ordinary managed services, pre-trial discovery, privileged investigations, service providers, work product

Failed Deals, Bankruptcy and Class Action Securities Fraud in Global Outsourcing: In re Alcatel Securities Litigation

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

In a pre-Sarbanes-Oxley time, the hypergrowth Dot.Com era disintegrated into “Dot.bomb” implosions. Reciprocal deal-making in speculative ventures was almost the norm, particularly in telecommunications transport. The litigation aftermath of failed deals, bankruptcy and class actions for securities fraud is reaching resolution. This short case study provides a synopsis of some key points of failure in reciprocal transactions, with a focus on telecom.

Background.

Alcatel is a French technology corporation. On October 20, 2000, the company issued a U.S. initial public offering (IPO) for its Class O shares. This class was 100% owned by Alcatel, but served as a “tracking” stock for the company’s Optronics Division. The IPO raised approximately $1.2 Billion and created additional shares that could be used as currency in mergers and acquisitions.

The Reciprocal Deal.

Soon after the IPO, Alcatel announced that it had invested $700 million in its customer, 360networks Corporation. In turn, the customer agreed to purchase over $1 billion in equipment from Alcatel to create a proposed trans-Pacific fiber-optic network.

Announcements to Investors.

When Alcatel’s proposed merger with Lucent fell through, Alcatel issued an unexpected announcement to investors that warned of a projected $2.6 billion loss for the second quarter of 2001. The loss included charges associated with a write-down of goodwill for two acquisitions (Xylan and Packet Engines), a full write-down of the $700 million invested in 360networks and various inventory write-downs. Allegedly, the announcement downgraded its Optronics Division in light of that unit’s “high exposure to the submarine market and the increased lack of visibility and potential delays in large projects, as well as inventory build-ups.” In re Alcatel Sec. Litig, __ F.3d __, NYLJ Mar. 11, 2005, p. 23, cols. 1-4, p. 24, cols. 1-4, at p. 24, col. 3 (S.D.N.Y. Mar. 11, 2005) (Judge Casey) [“In Re Alcatel Sec. Litig.”].

Violations Alleged.

The Alcatel investors claimed securities fraud. Most of the claims were dismissed because of late filing. The case is a cautionary tale and reminds us of the interests of investors as key stakeholders in outsourcing, whether as shareholders in global enterprises or as shareholders or bondholders in service providers.

Recommendations.

The story of Romeo and Juliet brings to mind the aphorism “‘T’is better to have lived and loved than to never loved at all.”

In securities fraud litigation, the love has turned to hate. So we posit the modern aphorism, “‘T’is better to have solicited investment and warned than to have never solicited investment at all.”

In short, participants in outsourcing should each refocus on the specificity of their warnings surrounding the risks of outsourcing and other strategic relationships, the nature and risks of the issuing company’s supply chain of suppliers and customers, and the particular risks in the industry. The generic warnings might not be sufficient, so constant updating may be appropriate, even without considering the special certification, audit and control issues presented under the Sarbanes-Oxley Act of 2002.

Service Providers.

Reciprocal Dealings and Joint Ventures Pose Special Securities Risks.
Typically, the service provider’s investors are the ones with a securities fraud claim. To be put on notice to inquire further, the service provider’s investors need to receive a storm warning of the seriousness of a material problem that could affect an ordinary investor’s decision to buy, sell or hold the securities of the service provider. In the case of reciprocal business dealings and joint ventures between service providers and their enterprise customers, the standards of disclosure are heightened because the materiality is heightened: a bankruptcy by the enterprise customer (as in the case of WorldCom for EDS or in the case of 360networks for Alcatel).

Designing and Planning for Investor Notification.

Service providers should therefore consider the following prudent business practices:

Interdependencies:
warnings to investors whenever they enter into reciprocal business dealings or joint ventures with customers, to identify the mutuality of commitments and dependencies for success, particularly specific risks of such dependencies.
Material Changes:
warnings to investors whenever such dealings or ventures give rise to material losses or other material risks of liability.
Keeping the Risks Small:
keeping the size and financial value at risk below the “materiality threshold” so that any failure to disclose would not trigger a claim of material securities fraud (or, in cases of a consortium contract with leading enterprise customers in an industry vertical, a claim that the contract restrains trade or otherwise violates competition laws).

Enterprise Customers.

Enterprise customers face questions, as securities issuers, surrounding the viability of their key suppliers. Best practices to avoid securities fraud claims should be considered.

General Warnings about Dependency on Suppliers.
It is customary to identify that the issuer is dependent on its suppliers for continuity of business operations.
Specific Warnings about Limitations on Liability of Suppliers.
It is customary for commercial enterprises to negotiate limitations of liability. Enterprise customers seek such limitations when they are sellers, and they customarily allow certain limitations of liability to their service providers, subject to unlimited liability for certain key failures by the service provider. The enterprise customer should provide specific warnings of the risks of outsourcing. Any disclosure of mitigation measures taken would be in the nature of “comfort” to the investor, which could backfire and render the warning useless.
Consider Investing in Your Service Providers and Suppliers.
Enterprise customers may have more leverage over a publicly traded service provider if the customer is also a shareholder. The amount of the shareholding is not as significant as the fact that the enterprise customer can have access to company information for a valid corporate purpose in relation to its decision whether to buy, sell or hold the shares. Being a shareholder gives the enterprise customer a seat at the table in the judicial selection of the most representative shareholder to prosecute any shareholder class action. And it permits the shareholder to opt in or opt out of the securities litigation, which could be useful in governing the personal and corporate relationships as customer.
Negotiate a Good Contract.
A solid outsourcing contract, accompanied by effective contract administration and relationship governance, makes a difference. In-house counsel not experienced in the art of outsourcing should hire specialized lawyers. Reliance on consultants to process legal issues may be courting investor inquiry.

Filed under: Case Study
Tagged: enterprise customer, initial public offering, merger, Sarbanes Oxley Act of 2002, securities fraud claims, service providers, shareholders in global enterprises

Deal Structure: Countertrade – Transformational Outsourcing — Call Centers — Customer Care

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

Outsourcing Service Provider as Distributor for Customer’s Core Services

In early February 2004, IBM and Sprint Corp. prepared to announce a major outsourcing agreement for IBM to assume the responsibility for customer services for Sprint wireless PCS telecom services. The deal affects 5,000 to 6,000 jobs at Sprint. According to news reports, the value of the deal is estimated at $2 billion to $3 billion, which equals the total amount that Sprint forecasts in its own savings.

Scope; Metrics.

The arrangement appears designed to restructure existing call center operations, some of which had already been outsourced, to integrate call centers with technology-enabled data management on customer demand, customer satisfaction and market conditions in real time. IBM will be seeking to dramatically improve Sprint’s customer satisfaction through better customer segmentation, more efficient call routing, reduced average call handle times and a higher rate of first call resolution. IBM will provide customer self-service tools via the Internet and web-based services. IBM will also provide ongoing consulting services to Sprint to continually improve customer satisfaction. IBM will take over management of Sprint’s existing vendor-operated call centers (moving from one outsourcer to another) as well as a Sprint-owned call center in Nashville, Tennessee. IBM claims that in such outsourcing arrangements, “IBM is transforming, integrating and managing key business processes for [its customers] to become more flexible in adapting to market and customer variables in real-time.”

Countertrade: “Counter-Distribution Services.”

The transaction makes IBM one of Sprint’s largest distributors. In the joint press release, the two companies said the relationship will include “a long-term business alliance that designates Sprint as a key IBM vendor for wireless and wireline services and enables IBM to incorporate Sprint’s national PCS wireless services and its IT and data products and services into customized on-demand solutions for IBM’s customers.” Thus, IBM is expected to market Sprint’s core services — wireless and land-line voice and data services — to IBM’s other customers.

By appointing the outsourcing services provider as a distributor, this multinational outsourcing customer barters its purchasing power for marketing and sales, particularly with a global sales organization with easy access to the technical procurement executives in multinational enterprises. And as service provider IBM incurs risks of the failure of its customer Sprint to deliver promised services to IBM’s other customers. That results in a common effort that could be called a joint venture, but the parties did not call it more than a “business alliance.”

Countertrade: “Counter-purchase Agreements.”

The counter-distribution agreement has substantially lower risk of failure for the services provider than a simple counter-purchase by the service provider of its customer’s goods and services. When WorldCom went bankrupt in 2002, EDS took a substantial charge to its revenues, since the balance of trade was negative. EDS owed money to WorldCom for WorldCom’s services, but WorldCom was able to reduce its payments to EDS by reason of the bankruptcy protection for WorldCom’s operations. (Later, WorldCom changed its name to MCI). But if Sprint fails to deliver its services to IBM’s customers, IBM’s reputation will be tarnished, which could cause greater harm to IBM.

Outsourcing as a Tool for Business Process Transformation.

This deal contemplates the transitioning of Sprint from delivering classic telephony services in a “stand-alone wireless and wireline network.” Reading between the lines, IBM will probably help Sprint convert to Internet telephony, or “voice over Internet protocol” (“VOIP”). Telephony will integrate into the desktop and computer network environments.

The press release suggested initially that the deal looked like simply a transfer of Sprint’s existing call center operations from its existing service providers (and some insourced call centers) to a new service provider. IBM’s commitment to improved service level agreements was heralded as a means of “dramatically” improving customer satisfaction.

But the joint press release suggested, without saying clearly, that the deal has much more strategic impact, by asking IBM to convert Sprint’s wireless and wireline telephone service to a network capable of Internet telephony (called “voice over Internet Protocol,” or “VOIP”) for IBM’s other corporate customers. To cushion the shock of cannibalizing its own classic telephony services, Sprint probably enlisted IBM to bundle Sprint’s services into IBM’s other IT-enabled outsourcing services. IBM became a reseller of Sprint telecom services. More significantly, Sprint’s business was to be transformed into an Internet-based service provider to IBM’s other customers.

The deal has the potential, therefore, to transform Sprint’s customer base, its method of service delivery, its revenue profile, and its marketing alliances in addition to hiring a service provider to improve service levels in call centers.

Lessons Learned.

The counter-distribution model offers substantial flexibility for both the service provider and its customer.

Service Provider’s Perspective.
For the service provider, credit risks (from a prospective bankruptcy of the customer) may be managed by financial management of the delivery of the customer’s goods or services. Similarly, the service provider might not need to make any financial commitments to secure and retain the right to resell the customer’s goods or services.
Enterprise Customer’s Perspective.
For the enterprise customer, access to a global sales organization may serve as a scorecard criterion for selection of prospective service providers. The customer might rightly conclude that a bigger, more global, more diversified service provider would assure a wider channel for the distribution of the customer’s own core business services. For telecom companies, using an IT services provider to distribute telecom services is a logical extension of the service proposition in response to the convergence of the Internet, telephony and digital communications. Reportedly, IBM will be selling Sprint services to large corporations so that employees of Sprint customers may transfer data from their networked desktop or laptop computers to wireless devices such cell phones, Blackberry® and Palm® handheld mobile devices.
Mutual Dependency, Mutual Risk.
For each party in a countertrade transaction, however, the lessons of the past invite caution. Once two parties are interdependent as customers or as marketers, the relationship requires a more complex management interaction. The risks for each are increased. If the customer wanted to fire the service provider for a breach of service level agreements, for example, the service provider might have the right to cancel the distribution rights (if unprofitable) or might seek to retain the distribution rights free of any “cross-default” clause. The stakes are higher for potential “win-win” or potential “lose-lose” outcomes.
Long-Term Impact.
If a Sprint-IBM countertrade model for distribution of the customer’s services were to become the model for a long-term outsourcing contract, securities law and antitrust laws might come into play.
- Securities Regulation.
  As to securities laws, the impact might be so important that investors might consider it “material” to decisions whether to buy, sell or hold the enterprise customer’s corporate securities. Initially, such a distribution model does not appear likely to generate any “material” revenue streams for the enterprise customer. Over time, the impact might grow particularly if the outsourcing has the goal or potential of restructuring the enterprise customer’s business model.
  
  At some stage, the disclosure required under applicable securities laws might become problematic, as information publicly disclosed could be used by competitors. As a result, both enterprise customer and the services provider have some incentive not to enter into transactions that are not so important and material as to require disclosure under applicable securities laws.
  
  In reviewing the press release, one may question whether investors are adequately informed of the true nature of the risks of this transformation of the customer’s business, not from the standpoint of the risk of IBM’s nonperformance, but from the standpoint of Sprint’s ability to successfully transform its own service model by the counter-trade structure with IBM promoting VOIP to IBM’s other customers.
- Competition Policy and Antitrust Laws.
  As to antitrust laws, reciprocal dealings by organizations in the same competitive arena could be unlawful as anti-competitive under U.S. federal antitrust laws and European Union competition policy. Before entering into a countertrade transaction, the parties should consider the likely impact of the distribution or counterpurchase operations as to exclusivity, market size, concentration of suppliers and customers in the relevant market, and other factors that define structural anticompetitive activities. As global customers hire global service providers to provide distribution services, the impact in any single country’s marketplace may be small compared to a similar business relationship between parties located only in one country or regional market. Consequently, the antitrust risks are relatively small at the global level.
- If IBM were to repeat this paradigm in other industries, though, IBM might gain market power in an important array of global non-IT services. Further anti-trust reviews might be appropriate in such a scenario.

Filed under: White Paper
Tagged: business processes, Call centers, Distributor, enterprise customer, service level agreements, service provider

Background

Business Issues

Transfer of Customer’s Shared Services Center to the Vendor

Factors in the Competitive Viability of the Transferred Shared Services Unit.

Valuation and Accounting Factors.

Negative Market Environment.

The Impact of Corporate Governance and Accountability on Valuation.

The “Stalking Horse” in the Bidding

Absolute Ability to Deliver the Full “Program.”

Comparative Advantage.

Rigged Bidding.

Remedies for the Stalking Horse.

When a Service Provider Should Withdraw from Negotiations

Lessons Learned from the Customer’s Perspective

Lessons for Multinational Alliances or Teams

What is a Patent?

Validity.

Enforcement of Patent Rights.

Extraterritoriality in Patent Law.

Relevance to Outsourcing.

BPO Patent Strategy in Practice: Who Actually Patents What?

Factors Affecting an Outsourcer’s Patent Strategy.

Limitations of a Patent Strategy in Outsourcing.

Best Practices.

Summary.

Background.

Miscommunication by Client to Outsourcer.

Losses.

Best Practices in Document Management.

When is the Service Provider Liable for its Customer’s Compliance with Laws, including Payment of Fines and Penalties for Non-Compliance?

Context: Compliance with Election Laws.

Statutory Liability.

The Service Agreement.

The Course of Dealing.

Equitable Estoppel.

Lessons Learned.

Normal Rules of Discovery or Disclosure.

Work Product Exception.

Impact on Outsourcing.

Background.

The Reciprocal Deal.

Announcements to Investors.

Violations Alleged.

Recommendations.

Service Providers.

Designing and Planning for Investor Notification.

Enterprise Customers.

Outsourcing Service Provider as Distributor for Customer’s Core Services

Scope; Metrics.

Countertrade: “Counter-Distribution Services.”

Countertrade: “Counter-purchase Agreements.”

Outsourcing as a Tool for Business Process Transformation.

Lessons Learned.

Publisher’s Blog