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Outsourcing Law & Business Journal – May 2011

June 1, 2011 by Bierce & Kenerson, P.C.

OUTSOURCING LAW & BUSINESS JOURNAL™ : Strategies and rules for adding value and improving legal and regulation compliance through business process management techniques in strategic alliances, joint ventures, shared services and cost-effective, durable and flexible sourcing of services.  www.outsourcing-law.com.  Visit our blog at http://blog.outsourcing-law.com.

Insights by Bierce & Kenerson, P.C. Editor. www.biercekenerson.com.

Vol. 11, No. 4, May 2011

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1.  Legal Issues in Using Performance Metrics for Innovation.

Such real-time vendor governance tools can be used for more than just benchmarking actual performance against contractual obligations.   They can also be used to:

• identify process improvements in the outsourcing services delivery process for “better outsourcing”; and
• innovate across the entire customer organization and customer supply chain.

This article takes the leap from just governing an outsourced function (through dashboards and performance metric reporting) to re-structuring the entire enterprise based on “big data.”  By applying “business analytics” to such “big data,” organizations can improve the quality of their procurement organization (and their internal resource commitments) by looking for innovation.   In short, organizations that outsource can tap into governance data to help innovate processes for efficiency and higher revenue per Dollar of expense.

This article explores key attributes of business analytics in outsourcing and the challenges for integrating analytics in outsourcing contracts and a shared-services SLA-based services environment.   It also sheds light on why innovation never comes from outsourcing, unless the parties plan for it and adopt appropriate legal protections.  For more on the “next step” from “vendor governance” to “organizational transformation,” click here .

September 20-22, 2011, SSON presents Finance Transformation 2011, Dallas, Texas. This conference is targeted to owners, controllers, procurement leads, sourcing strategists, shared services and global finance leads who want a complete view of transformation, incorporating holistic vision and operating strategy, end-to-end process optimizations, technology enablement, business performance management and sourcing strategy, whether that strategy is shared services, outsourcing or a combination of the two.    Click here to get more information.

September 26-27, 2011, IQPC presents e-Discovery Oil & Gas, Houston, Texas. IQPC’s Third e-Discovery for Oil and Gas program is specifically tailored to address eDiscovery issues in the energy industry.  The program features detailed case studies from Oil & Gas ProducersService Companies that have implemented eDiscovery practices that have lowered the cost and increased the efficiency of producing ESI.  Panel presentations will discuss critical issues in eDiscovery from leading experts in the legal, information technology and records management sectors.  For more information, click here.

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FEEDBACK:  This newsletter addresses legal issues in sourcing IT, HR, finance and accounting, procurement, logistics, manufacturing, customer relationship management including outsourcing, shared services, BOT and strategic acquisitions for sourcing.  Send us your suggestions for article topics, or report a broken link at wbierce@biercekenerson.com.  The information provided herein does not necessarily constitute the opinon of Bierce & Kenerson, P.C. or any author or its clients.  This newsletter is not legal advice and does not create an attorney-client relationship.  Reproductions must include our copyright notice.  For reprint permission, please contact:  wbierce@biercekenerson.com.  Edited by Bierce & Kenerson, P.C.  Copyright (c) 2010, Outsourcing Law Global, LLC.  All rights reserved.  Editor-in-Chief:  William Bierce of Bierce & Kenerson, P.C., located at 420 Lexington Avenue, Suite 2920, New York, NY 10170, 212-840-0080

Legal Issues in Using Performance Metrics for Innovation

May 26, 2011 by Bierce & Kenerson, P.C.

Today, several software developers offer comprehensive software suites for governance of IT and business process outsourcing (BPO) services.  Such software enables outsourcing customers to see real-time data, presented on “dashboards,” of vendor performance metrics, including service catalog offerings, demand and supply volumes, service level management (measuring and reporting on SLA’s), incident and problem management (identifying outages) and change management data bases (CMDB’s) and computations of billing adjustments to reflect gaps between actual performance and contractual obligations.  Such software reports on “what is happening.”

Such real-time vendor governance tools can be used for more than just benchmarking actual performance against contractual obligations.   They can also be used to:

• identify process improvements in the outsourcing services delivery process for “better outsourcing”; and
• innovate across the entire customer organization and customer supply chain.

This article takes the leap from just governing an outsourced function (through dashboards and performance metric reporting) to re-structuring the entire enterprise based on “big data.”  By applying “business analytics” to such “big data,” organizations can improve the quality of their procurement organization (and their internal resource commitments) by looking for innovation.   In short, organizations that outsource can tap into governance data to help innovate processes for efficiency and higher revenue per Dollar of expense.

This article explores key attributes of business analytics in outsourcing and the challenges for integrating analytics in outsourcing contracts and a shared-services SLA-based services environment.   It also sheds light on why innovation never comes from outsourcing, unless the parties plan for it and adopt appropriate legal protections.

BUSINESS PROCESS MODELING FROM GOVERNANCE DATA

Sourcing activities that are governed by SLA’s generate huge databases.   The data can be assembled in a data warehouse that collects metadata about the operations (such as time of day, capacity and load management parameters, and quality parameters) from multiple sources for information retrieval and decision support.

Supply chain management requires continuous attention to performance management by external and internal service providers.  Business intelligence refers to the management tools for identifying, analyzing and acting on operational performance metrics for a business enterprise.  Such tools can include software, IT and telecom infrastructure and databases of “best practices” to help optimize operations and continuous process improvement.

Based on BI metrics of operations, finance and marketing, business process modeling involves taking big operational datasets from multiple business processes (“silos”), deconstructing and parsing them into value chains and optimizing the value chains for the bottom line.  Such modeling yields financial and operational efficiencies through business process re-engineering, productivity and growth.  In addition, such modeling improves transparency for process governance and operational risk management purposes.  In short, BI is a core tool for “governance, risk management and compliance” (GRC).

Beyond more efficient current operations, BI metrics enable predictive modeling for future demand management.  Exploring the relationship of different operating conditions based on historical data, predictive modeling extracts meaningful patterns, trends and anomalies from huge datasets, pointing the way towards future operational requirements and contingencies.  Predictive modeling can be used to refine and reduce the scope of outsourcing services, revise the “base case” for sourcing initiatives and thereby narrow the “flux” and uncertainty in performance-based pricing models.   Predictive modeling can answer business questions such as what transactions are likely to require special human problem solving and how to redesign marketing, product development, manufacturing and customer services to improve sales and reduce waste.  In short, SLAs can be analyzed to improve top and bottom lines.

STRATEGY

What are business analytics? Business analytics measure the business value of a business process.  Unlike SLA’s, analytics define the business benefits of an operating function.  While SLA’s measure how well a function is being performed, business analytics measure how effectively a business function generates business value.  At the “machine” level, they measure availability, transaction volumes and “speeds and feeds.”  At the BPO level, they measure quality, throughput, error rates, re-work cost, customer satisfaction and service delivery at specified times of day and week.  At the KPO level,metrics are a work in progress.

Insights. Business analytics can expose deep insights into business process and transform existing operations for higher performance, business value, proximity to the customer, market share and customer loyalty.  Business analytics represents an iterative improvement to the management of vendors, surpassing service level agreements in strategic value.

Causality. To be meaningful, metrics used in business analytics must correlate directly and proportionately with business success.  Indeed, the analytics process involves identification and quantification of such correlations.  For example, reliability data (system uptime, availability, mean time between failure, mean time to repair) correlate directly with productivity of workers, throughput in the manufacturing process, outbound sales calls by a call center and customer trust and repeat purchasing (or, conversely, churn ratio).  The analytics process establishes such causal connection, allowing insights in to pain points and opportunities for increasing revenues, reducing costs and eliminating waste.

Baseline for Developing Business Analytics. Contractual SLA’s establish a methodology for quantifying the outputs of delivered services.  Business analytics depend upon a rock-solid foundation for measurement of such outputs.  Unless core SLA’s are delivered, there can be no hope of identifying business benefits, inspecting such metrics for business insights and transforming the business to achieve the opportunities afforded by such analysis.  Since outsourcing is only an extension of the enterprise’s internal functions, effective business analysis of outsourcing requires corresponding metrics for internally managed processes and functions.  Already certain business consultants have developed, and some leading companies are implementing, software that identifies the same metrics across internal and external providers, including across multiple providers.

Building Analytics into the Business Process. The key to successful implementation of business analytics is to gather metrics and adapt them to shareholder value.  It is the responsibility of the CEO and the CFO to set forth the business metrics, which can be as simple as financial accounting reports, to the individual processes.  Extending the reach of activity-based costing, business analytics can show real-time SLA measurement and real-time impact on finance, sales, resource utilization, cost of goods sold, capacity utilization, resource efficiency and other income-statement metrics.

Delivering Analytics to Senior Management. Delivering analytics requires asking senior management to define what  they want to measure and how they wish to have it measured.  In a manufacturing environment, such metrics involve production line uptime, reject rate, production throughput, waste ratio, etc.  In a services environment, such metrics involve similar quantification of uptime, reliability, error rate, customer call abandonment rate, performance latency (response time) and accuracy (such as the re-work rate).  Senior executives need to define what they want, with help from the operations department.

ARCHITECTURE AND TOOLS

Pilot Projects at the Top, Implementation at the Mid-Level. To get started, small projects are used as pilots.  They serve to elicit questions for analysis and demonstrate proof of concept.   BI projects normally involve senior management at the strategic level, with implementation and ongoing reporting by middle management.

Harmonization of Conflicting Metrics. Pilot projects are helpful for standardization.  If different departments use different metrics, the pilot will show the differences, either by wildly divergent outcomes (inviting analysis of definitions and assumptions) or direct statement of conflicting assumptions. For example, “uptime” might include scheduled maintenance periods for one group, but omits such periods for another group.   Harmonization will help the organization adopt standard metrics and prevent under-reporting and over-reporting of the same data.

IDENTIFYING AND ACTING ON OUTCOMES

Pricing: Linking Performance Metrics to Business Value. Incentive compensation structures typically link payments to creation of shareholder value.  Similarly, “shared risk” and “shared reward” pricing structures also link performance to business value.  In each case, BI / BA tools can improve the value generated by measuring.   But identifying effective metrics is an iterative process.

In sourcing, what pricing metrics and methods are best linked to performance?  A license royalty offers a simple solution, since it is based on sales and gross revenues.

Innovation. The enterprise customer of outsourced services can use the “big data” generated from monitoring vendor performance over long periods as the inputs for analysis to enable organizational transformation.   Innovation occurs when the BI tools are structures to

• eliminate  processes that have high error rates or high consumption of resources;
• identify high-value relationships (and functions) and cutting out (or outsourcing) low-value relationships and functions;
• redeploy back office personnel into centers of excellence for shared services organizations;
• compare performance between vendors and between internal and external teams; and
• create value chains across the supply chain.

Contract Compliance. In short, the retained team that manages contract compliance for outsourcing engagements should interface with organizational designers (whether in-house or external consultants) to mine the “dashboard data.”  Contract compliance thus feeds innovation, but only if BI tools and strategies are separately adopted.

LEGAL, REGULATORY AND COMPLIANCE ISSUES

Legal Issues in Business Intelligence and Business Analytics. Several legal issues must be addressed to implement and manage an effective BI / BA program across the organization’s internal and external supply chains.  Corporate policies should be designed (or at least audited and revised periodically) with a view towards capturing the innovation opportunities that come from analyzing contractual compliance and other operational and performance data.

SLA Design and Management. Service level agreements (SLA’s) should be designed for achieving multiple goals:

• quality services for reliability, predictability, scalabilty and cost management;
• metrics tied to the returns on investment (and equity) for operations that are considered “core” or “prime value drivers” for the internal organization.

Thus, paradoxically, outsourcing can be used to shed light on insourced functions to improve ROI, ROE and overall shareholder value.

Data Rights Management for BI Processing. Most BI software applications process data from different sources and different data types.   The enterprise needs to ensure that it has legal rights to access and use all data that it wishes to analyze.

• The enterprise should specify, in its third-party supply chain and service contracts, that performance data obtained from evaluating the services of the service provider belong to the customer and may be used for any internal purposes.
• Service providers, of course, may wish to prevent the publication of performance outcomes through the use of appropriate confidentiality agreements.
• The question of data rights management can become a contentious issue in case of a disputed termination for cause, so the outsourcing contract should address how to handle performance metrics and their disclosure in any dispute resolution process.
• Since most enterprises are also service providers and may be subject to similar vendor management, they need to ensure that they can use the “big data” from vendor management tools for their own internal process improvement and innovation strategies.  In short, every customer is also a vendor, and everyone needs to have access to use “supply chain data” across internal and external supply chains.

Software Rights Management. Both service providers and enterprise customers need to ensure they have the licensed right to use the BI / BA tools.   This requires a software license audit for both parties whenever vendor governance tools and BI/ BA tools are used.

Business Method Patents, Trade Secrets and “Proprietary Rights”: Ownership and Licensing. The insights derived from BI analysis of outsourced (and insourced) operations can create new business methods.   Such methods may include patentable processes.  Organizations investing in SLA management, performance metrics analysis and BI need to protect their rights to own exclusively the insights and new business models developed using the data fees from internal sources and outsourcing service providers.   The organization should take all appropriate measures to ensure it will own the trade secrets (and any related business method patents).   Such considerations need to be addressed in non-disclosure agreements, confidentiality clauses in outsourcing contracts, subcontracts (at all levels in the sub-supply chain), employment documentation (employment offer letters, manuals, stock option plans (particularly in California) and termination procedures).

The waters are a bit murky as to ownership of improvements developed by the service provider.   Most outsourcing agreements mandate that the service provider deliver better service without being specially compensated for “continuous process improvements.”   Such clauses are  treated as standard “gimme’s” without cost or inconvenience by the customer, and many vendors ignore such clauses or swap them for a price concession over time.

Rather than swim in such murky waters, service providers and enterprise customers may benefit from a frank discussion on the opportunity to specify who owns those improvements and whether there is any license rights in them.  At this point, the customer is thinking that all improvements should enure to its benefit, but such thinking vitiates any incentive for the provider to deliver any real value for no additional compensation.  Hence, most service providers sell “consulting services” for “business process transformation” or “organizational redesign” and try to keep “innovation” out of the outsourcing contract.  At the very least, by independent BI analysis (“continuous process improvement”), the service provider can conduct its own BI analysis and own its own rights in trade secrets (and any related business method patents).

Confidentiality. Outsourcing contracts should include BI-type data and insights in the definition of “confidential information.”  Of course, whose “confidential information” it is should be defined as well.

Trade Secrets: Protection and Survival. The insights and process changes derived from BI / BA analysis should be protected as trade secrets.  Non-disclosure agreements should segregate “confidential information” from “trade secrets” so that “trade secrets” can survive the expiration of the non-disclosure period.

Competitive Advantage and Innovation. Sometimes BI will yield some crucial insights that the organization does not want to reveal to its service providers (or business management consultants), who might recycle such processes to benefit the organization’s competitors.  The BI governance model should help managers identify the competitive impact of sharing improved processes with outsourcing service providers.  If there is a significant innovative competitive advantage, then the process becomes “core” and thereby ineligible for further outsourcing until it is “best practice” widely known among competitors.  This example underscores the tension between outsourcing for operational excellence and outsourcing as a tool for “innovation.”  Recently, savvy service providers have begun developing and deploying their own proprietary business models for generic industry operations, thereby reducing this tension and making it easier to sell “best of breed” BPO.

Value Creation Process:  Training. Generally, outsourcing customers and their service providers do not compete for the same pools of talent.  In the field of business analytics, this generalization does not apply.  Service providers hire talent from the customer’s industry (and potentially from customers) to acquire process expertise, regulatory and risk-management expertise and build service delivery models.  The outsourcing contract should address matters of permitted and prohibited employment practices relating not only to operational personnel, but also to GRC and BI initiatives.

Regulatory Compliance Issues in BI.

Unwanted Industry Standards. Transparency of process has become the mantra of health regulators since HIPAA in 1995, securities regulators since the Sarbanes-Oxley Act of 2002, and financial regulators since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.  Innovation strategies that data-mine outsourcing performance data can improve transparency.  But such successes can risk inducing the regulators to require other regulated enterprises to adopt one company’s “trade secrets” (which generate comparative advantage and shareholder value) as generic “industry best practices.”  Hence, disclosures to regulators should be couched in terms of proprietary information.

Auditor’s Checklists. Auditors conducting SAS-70, Type II audits (and their successor ISAE audits) have their own checklists.  Enterprises (and service providers) should require auditors to preserve the confidentiality of BI-generated process improvements.  But how can the auditors be prevented from using such “intelligence” in auditing competitors?

Corporate Governance Meets Vendor Governance.

Governance. Governance defines who is managing the BI/BA process, their reporting and accountability, and their incentives for finding, championing and achieving process improvement and enhanced shareholder value.  BI initiatives require careful attention to access controls and use of the inputs and outputs of the BI applications.   Polices and procedures for governance of BI / BA should address the rules for adopting changes in business processes (with supporting explanations and BI reports).   Internally, organizations will want to identify the roles of Finance, IT and Operations in BI / BA governance as applied to outsourced services.

Segregation of Operations from Management (and Innovation). For optimal outcomes, should enterprises seeking innovation segregate corporate governance (and innovation) from vendor management?   Probably not.  Segregation facilitates protection of trade secrets.  However, as a matter of career path for some individuals, some vendor managers from the procurement group might move to the BI analytics group.

Integration of BI into Operations Management. Conversely, the BI team should serve as internal consultants to the outsourcing vendor management group.  Such consulting (and training in BI concepts) can improve the design of service level management protocols, adjustment of SLA’s as processes changes (such as with mergers, acquisitions, divestitures and regulatory mandates).

CONCLUSION

Outsourcing engagements have spawned “big data” that can be analyzed for improvements to core processes (such as brand management, customer satisfaction, product design and development).   The legal framework for BI should be carefully planned and implemented to ensure that the enterprise retains flexibility, legal rights and avoids potential infringement in pursuing its mission and innovating its core processes.

Outsourcing Law & Business Journal™: Feb/March 2010

March 20, 2010 by Bierce & Kenerson, P.C.

OUTSOURCING LAW & BUSINESS JOURNAL (™) : Strategies and rules for adding value and improving legal and regulation compliance through business process management techniques in strategic alliances, joint ventures, shared services and cost-effective, durable and flexible sourcing of services.  www.outsourcing-law.com. Visit our blog at http://blog.outsourcing-law.com for commentary on current events.

Insights by Bierce & Kenerson, P.C., Editors.  www.biercekenerson.com

Editor’s Note: Back by popular demand, we are repeating  our Webinar on Sourcing of Global Talent on Tuesday, March 23, 2010.  If you missed this event last November, you can register for it now by clicking here.   This webinar will discuss the human capital management for the contingent workforce in our current economic climate. The speakers will address issues in designing a contingent workforce strategy, managing this contingent workforce, effective governance and the managing risks and legal issues that arise with the implementation of such a workforce using internal and external resources.

Managing Knowledge, Compliance and Legal Risks in Sourcing of Global Talent
A webinar, Tuesday, March 23, 2010, 11 AM Eastern Daylight Time U.S. (45 minutes)
Speakers:
· William B. Bierce, Esq., Bierce & Kenerson, P.C. – outsourcing lawyer
· Chris Nuttall, PA Consulting, Member of PA’s Management Group
· Larry Scinto, PA Consulting, Managing Consultant

Vol. 10, No. 2 (Feb/March 2010)
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1.  How to Achieve Innovation Through Outsourcing: Shifting the Paradigm.

2. U.S.-India Bilateral Cooperation on Trade and Investment:  Impact of Joint “Framework” upon Global Services Industries.

3. Humor.

4. Conferences
_______________________________

1.    How to Achieve Innovation Through Outsourcing: Shifting the Paradigm. 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 the complete article, please click here.

2. U.S.-India Bilateral Cooperation on Trade and Investment:  Impact of Joint “Framework” upon Global Services Industries. On March 17, 2010, the U.S. and India signed a “Framework for Cooperation on Trade and Investment” to strengthen bilateral economic cooperation.  The three-page agreement is short on details and relies upon inter-ministerial meetings and “Focus Groups” to identify and overcome impediments to bilateral l trade and investment.   Five Focus Groups cover agriculture, innovation and creativity, investment, service industries and tariff and non-tariff barriers to bilateral trade in goods.   The Framework agreement responds to a number of complaints by American businesses about the Indian legal framework governing intellectual property protections.  For the complete article, click here.

3.  Humor.

Innovation, n. (1) an improvement that is clearly better than mere continuous improvement; (2) any cost saving that merits a special reward; (3) a joint venture in “process management” clothing.

Framework agreement, n.  (1) a house with wall-size windows and no roof; (2) statement of work for unspecified deliverables; (3) a milestone with no end in sight.

Investor, n. (1) someone willing to give up a sure thing in the hope for a better sure thing; (2) hostage to hope; (3) optimist.

Investor protection, n. (1) shield for avoiding an instant capital loss; (2) a one-handed wind-shifter.

Publicity, n.  (1) good news, even if it’s bad news; (2) bad news when it’s not good news; (3) what a public figure craves but a private individual avoids.

4.  Conferences.

March 22-26, 2010, SSON presents the 14th Annual North American Shared Services & Outsourcing Week, Orlando, FL.  This event goes above and beyond the typical conference, with 8 tracks, 13 workshops/site tour, 1 Master Class, the Shared Services Excellence Awards and 7+ hours of networking!  This year, the platform has been completely revitalized and revamped, featuring raw and honest onstage interviews to the “no personal agendas” G8 Panel discussions.  The expert speaker faculty comes from leading companies including Coca-Cola, NASA, General Motors, Unilever, AstraZeneca, Schering-Plough, CA, Microsoft, Orbitz Worldwide and more!  View the complete agenda on http://www.sharedservicesweek.com/brochure.php.

Receive an exclusive 20% discount with special code SSW-MP10.  Contact Kim Vigilia at kim.vigilia@iqpc.com.

March 25-26, 2010, American Conference Institute’s 4th National Forum on Reducing Legal Costs, Dallas, Texas.  This essential cross-industry benchmarking forum gathers together more than 30 senior corporate counsel and legal sourcing managers responsible for cost-reduction success stories, as well as leaders from law firms who are pioneers in the alternative fee world, to guide those in attendance on the complexities of keeping legal department costs in check. Now in its fourth installment, this event also offers unique networking opportunities with senior practitioners in the field, includingin-house counsel across a wide spectrum of companies and industries. For more information, visit their website.

April 26-28, 2010, Legal IQ and IQPC present its 9th Annual eDiscovery Conference, San Francisco, California, bringing industry leaders together to explore eDiscovery project management, best practices for preserving and producing ESI, defending keyword searches, and protecting privileged ESI.  Topics include:

• Cloud Computing and eDiscovery – What’s in it for you?
• Emerging Technologies and Social Networking: Ethics and New Challenges
• New Models and Structures for Managing eDiscovery
• Statistical Validation and Data Analytics in eDiscovery
• Protecting Privileged Communications and Rule 502
• Vendor Partnership and What Happens After the End of Litigation
• ESI Preservation and Collections

Outsourcing-law.com subscribers receive a 20% discount off All-Access conference pricing using code IUS_OSL_#5.  Click here to get more information.

May 10-12, IQPC’s 7th Annual HR Shared Services and Outsourcing Summit, Chicago, Illinois. This event will be a gathering for corporate HR & shared services executives from companies across North America to exchange ideas, develop new partnerships and discuss the latest tools, technologies and strategies being employed in the profession to enhance departmental efficiencies and propel corporate growth.  The event will focus on the most current topics in the HR shared services industry including metrics, automation, outsourcing, globalization, compensation & rewards, benefits and an overall focus on the new strategic role of HR shared services.how to tackle change management, analyze current and future projects and further develop the instrumental key areas within HR shared services.  Visit their website to register and get more information.

May 17-19, IQPC presents its Information Retention & E-Disclosure Management Summit, London, UK. This is Europe’s premier event in this field, designed to help you steer your organisation successfully through lawsuits and regulatory inquiries.  Topics include:

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FEEDBACK: This newsletter addresses legal issues in sourcing of IT, HR, finance and accounting, procurement, logistics, manufacturing, customer relationship management including outsourcing, shared services, BOT and strategic acquisitions for sourcing. Send us your suggestions for article topics, or report a broken link at: webmaster@outsourcing-law.comThe information provided herein does not necessarily constitute the opinion of Bierce & Kenerson, P.C. or any author or its clients. This newsletter is not legal advice and does not create an attorney-client relationship. Reproductions must include our copyright notice. For reprint permission, please contact: publisher@outsourcing-law.com. Edited by Bierce & Kenerson, P.C. Copyright (c) 2010, Outsourcing Law Global LLC. All rights reserved. Editor in Chief: William Bierce of Bierce & Kenerson, P.C. located at 420 Lexington Avenue, Suite 2920, New York, NY 10170, 212-840-0080.

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.

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