Replacing a Service Provider in Midstream: Case Study on Equifax Spin-off, Certegy’s Cancellation of EDS Contract and Hiring of IBM
October 9, 2009 by Bierce & Kenerson, P.C.
Summary:
The termination of a long-term outsourcing contract in midstream, before the normal expiration, requires careful legal and business planning. It may also require payment of a large termination fee. In this case study, we analyze such a case involving the termination of an existing EDS contract and the transitioning to IBM as a new services provider.
Certegy’s Deal with EDS.
Certegy Inc. [NYSE: CEY] is a publicly traded company that provides credit and debit processing, check risk management and check cashing services, and merchant credit processing services to over 6,000 financial institutions, 117,000 retailers and 100 million consumers worldwide. Its 2002 revenue exceeded $1 billion. It was formerly known as Equifax PS, Inc., a subsidiary of Equifax, Inc., which spun off its payment services businesses into what is now called Certegy, as of June 30, 2001.
Under the terms of an agreement apparently entered into before the spin-off, Certegy’s former parent (or Certegy) entered into an agreement with EDS for IT services that was scheduled to expire in 2009. The agreement evidently provided for a termination fee if the customer wished to terminate for convenience.
The Spin-off
As part of the spin-off, Equifax, Inc. agreed to deliver Certegy certain information technology services. But that agreement expressly disclaimed any commitment to deliver any contractual service levels. Rather, Equifax agreed only to provide services in a commercially reasonable manner in accordance with any service levels specified on a particular exhibit. The indemnification provisions protected Equifax from claims by Certegy except in case of willful misconduct. The spin-off company had no leverage.
The Fee for Termination for Convenience: Investor’s Perspective
As announced by Certegy on March 21, 2003, Certegy was to record a pre-tax provision of up to $10 million in the first quarter of 2003 for early exit costs associated with severing its existing services agreement with EDS. Certegy’s Chairman, President and CEO, Lee Kennedy, reported that the termination fee was a good investment:
“IBM offers best-in-class computer operations support and has a proven track record with Certegy as a trustworthy business partner. The early exit costs to be recognized in connection with terminating the EDS agreement represent an investment in our future that is projected to generate an internal rate of return of more than 20% over the next ten years.” [Emphasis added.]
Certegy did not announce how it might achieve that 20% internal rate of return or whether that rate applied to the $10 million termination fee or the projected $150 million to be paid to IBM over ten years.
By identifying a projected internal rate of return, Certegy may have begun a dialogue with its investors as to the structure of the deal and the rationale for the midstream change. Materiality of disclosure might become an issue of the projected 20% IRR relating to the $150 million.
Certegy’s Deal with IBM.
In March 2003, Certegy announced a 10-year deal with IBM, with an estimated value of $150 million.
Essentially, Certegy’s focus on the IBM “on demand” services model must have represented a change in one or more essential elements of the scope, pricing, or service delivery methodology. One may speculate that there were material differences between EDS’s and IBM’s deal structures, such as delivery platform, the territorial scope, the pricing structure of the services to be provided by EDS, a change in the actual volumes of services, a change in the bandwidth of upper and lower levels of baseline services volumes for pricing, or all of these circumstances.
Certegy had an existing relationship with IBM. IBM was already providing IT services to Certegy’s United Kingdom and Australia operations. The new deal reportedly “can provide” Certegy with “significant cost savings and future operational flexibility” through IBM’s “on-demand” technology services.
EDS’s Perspective.
EDS’s spokesman characterized this situation as not a “win” by IBM over EDS, but rather a decision by the customer to extend an existing relationship with IBM to additional territorial scope when EDS signed a deal with one of Certegy’s competitors. The new deal allows Certegy to save money by standardizing on IBM as the sole provider across the world. But the $10 million termination fee is probably not an adequate compensation for EDS’s lost profit remaining during the remaining unexpired term of approximately six years of the contract.
Best Practices.
Collaboration with a Competitor.
In its first Form 10-K filing with the Securities and Exchange Commission, Certegy identified EDS as one of its competitors: “The markets for card transaction processing and check risk management services are highly competitive. Our principal competitors include third-party credit and debit card processors, including First Data, TSYS, EDS, and Payment Systems for Credit Unions, third-party software providers, which license their card processing systems to financial institutions and third party processors.” Certegy, Inc. Form 10-K, Fiscal Year ended December 31, 2001.
Termination for Conflict of Interest as a Termination for Convenience.
Customer’s normally do not get any right to terminate an outsourcing services contract merely because the service provider also provides services to a competitor of the customer or because the services provider is, or becomes, a competitor of the customer in any line of business As a general rule, no major service provider will agree to grant any exclusivity rights to its customers. Exceptions do occur, and we would be pleased to consult on the types and circumstances of such exceptions.
Potential Conflicts of Interest as a Factor in Defining Scope.
Indeed, one challenge in identifying the proper scope of services to be outsourced lies in the risk that the outsourcing services provider could become a competitor of the customer’s prime business. Certegy faced this challenge because its core business of credit and check processing approvals requires extensive investment in automation. Similarly, large outsourcing service providers, such as EDS, IBM and CSC, enable such businesses as Certegy to piggyback on the outsourcer’s deep knowledge of the customer’s vertical industry and the outsourcer’s extensive ongoing investment in technology.
Consequently, the enterprise customer’s sole remedy is generally to ensure an exit strategy that defines conditions where the service provider might be considered to have a conflict of interest or special relationship with a competitor. This issue merits careful attention and frank discussions in all phases of outsourcing, including scope definition, selection of the service provider and contracting.
Single Provider vs. Competing Providers.
In this situation, Certegy had adopted a strategy of having two providers of IT services. One argument in favor of such a strategy might be that actual competition is a better than the fictitious competition of the benchmarking process. More likely, this situation probably evolved without such a “grand strategy.”
Hidden Costs to the New Company in a Spin-off: The Vendor’s Renegotiation Dilemma.
An outsourcing service provider in EDS’ position must identify the potential for an unhappy customer to terminate early an existing profitable long-term relationship. In this case, EDS chose not to complain publicly about the loss in service volumes due to the Equifax spin-off of Certegy. One may speculate that the spin-off disrupted the efficiency of a well-established EDS service delivery. The relevant press releases are silent on the disruption of services and the strain on a previously negotiated pricing model that the spin-off caused to EDS. If the contract were being negotiated from scratch today, spin-off transition changes might have been the subject of negotiations.
In theory, the costs of severing the EDS deal and transitioning to IBM could have been paid by Equifax prior to the spin-off. But the availability of EDS services was probably viewed as a benefit, giving Certegy time to operate independently after the spin-off, at least for a time.
Impact of a Spin-off on Design of Outsourcing Contracts.
The termination of the EDS deal appears to reflect a number of changes in the customer’s management perspective.
First, EDS’s loss of 75% of its share value over a 12 month period before March 2003 certainly caught the customer’s attention. This elicited concerns about EDS’s ability to deliver the services as contracted, but really only addresses EDS’s ability to make large acquisitions.
Second, before and shortly after the spin-off, the customer engaged in a program of acquisitions. As a result, outsourcing with a single outsourcer might have become more effective than having multiple sources of services, and the pre-existing pricing structure and scope became rapidly outdated.
Third, the contracts probably did not contemplate how the two service providers might collaborate, if necessary. There is no mention in the press reports of this issue. The customer probably did not have a plan for this possibility, so the customer had little choice but to move from one vendor to another.
Finance & Accounting Outsourcing: Does Outsourcing Reduce Risk?
October 9, 2009 by Bierce & Kenerson, P.C.
When enterprises look to outsource in-house responsibilities, finance and accounting functions are usually not the first ones farmed out. Executives might expect to read headlines like, “Aon Negotiating to Outsource Most of its U.S. IT Infrastructure to Computer Sciences Corporation,” a development Aon and CSC touted in a 2004 press release. Sophisticated business process outsourcing (“BPO”) such as finance and accounting is not as widespread as IT outsourcing.
As enterprise firms seek to enhance their competitive advantage and minimize risks in the Sarbanes-Oxley environment, more and more businesses are looking to outsource parts of their finance and accounting functions. Determination of the right fit with a service provider and the right mix of services is essential.
This article addresses some key business and legal issues in whether F&A outsourcing reduces risks.
What F&A functions are candidates to be outsourced?
Not all F&A functions are created equal. Each F&A function has its own risk profile and potential suitability for outsourcing. Risk profiles reflect the nature of the business functions, size and character of the enterprise, since publicly trade companies must deal with the vagaries and criminalization of accounting practices under Sarbanes-Oxley, and other considerations.
Transactional vs. Judgmental Operations.
Transactional functions, especially payroll and accounts payable and receivable, are the most commonly outsourced functions. Financial reporting and more advanced functions can also be outsourced, though the more interaction required for a function—say, for instance, budgeting—the less likely it is to be outsourced. But today, F&A outsourcers are taking on responsibilities once executed by entire in-house F&A departments.
Enterprise Maturity.
F&A outsourcing depends on enterprise maturity.
Public Companies and “Wannabe’s.”
Mature enterprises — public companies and those considering going public — must, or will have to, establish and certify, on a quarterly basis, the adequacy of their accounting reporting and control systems. Compliance with the Sarbanes-Oxley Act has generated new software and service offerings by information technology service providers and consultants. Such technology might be maintained in-house, a hosting service provider or by a managing service provider.
For public companies, the challenge is to identify those F&A functions that can be “safely” outsourced with minimal risk that a failure will result in civil or criminal liability for the CEO and the CFO. Once such “safe” functions have been identified, the lawyers can deal with “reasonable” allocations of risk between the service provider and the enterprise.
Startups and Emerging Companies.
Startups may outsource more of a function. Outsourcing helps startups avoid misestimating their own needs. Two scenarios are common among startups: they underestimate their F&A needs, or they overestimate them.
Startups will often hire a bookkeeper, for instance, and may get the basic transactional aspects of the business right. But without an accountant, they can’t optimize their F&A strategy. This mistake can often require a startup to sink far more capital in F&A and litigation down the road than they would have had to invest up front.
Alternatively, some firms will bring on a CFO or Comptroller when their F&A needs do not demand that those positions be filled by a full-time employee.
Governance Considerations.
Entire F&A departments can be outsourced, all the way up to the CFO level. We interviewed two F&A outsourcing firms on the desirability of outsourcing CFO and Comptroller functions. Ephinay will take over all F&A responsibilities from a customer except CFO and Comptroller, which Ephinay believes must be retained by the customer for governance purposes. Other outsourcers, like Geller & Co., are more willing to absorb even the responsibilities of CFO and Comptroller, eliminating the need for any F&A functions to be retained by the customer. In contrast, Ephinay believes that is rarely optimal except when the customer’s business is highly specialized. Perhaps the distinction is not so important for small business, but for larger and growing businesses, retention of key internal executives helps ensure controls are retained as well.
When is F&A outsourcing a better solution than in-sourcing?
Business Process Analysis.
As in all other types of outsourcing, F&A outsourcing starts with an analysis of the business processes of an enterprise. This analysis must cover virtually all essential elements of the business processes under consideration. Thus, an “end-to-end” approach will identify functionality, interaction with third parties (such as suppliers, customers and regulators), the degree of human expertise required for each process and the degree to which human expertise can be captured in a scalable information technology solution that includes hardware, software, telecommunications and technology managers.
Business Processes Considered for F&A Outsourcing.
Having dissected the business processes from end-to-end, the enterprise then considers how the classic types of rationales for outsourcing might fit into each F&A process. Many firms find outsourcing F&A business process functions preferable to retaining them. Here are some common reasons why.
Shifting functions plays to core competencies.
F&A outsourcers exist for one reason and one reason alone: to take over the F&A functions of other businesses. If F&A outsourcers fail to do a good job of F&A in a competitive marketplace, they will fail entirely. F&A is an F&A outsourcing firm’s core competency, by definition. Of course, this is an agreement to “trust me.”)
In-house functions are always secondary to the fundamental premise of the company.
In a semiconductor business, for example, making and selling semiconductors is the lifeblood of the business; F&A functions are necessarily secondary because they do not create business. This is no less true of large corporations than it is of startups or enterprise businesses. Top talent is routed to revenue-generating departments; being an accounting whiz, for example, is unlikely to take you to the top of GM. F&A outsourcers, unlike their customers and prospective customers, are structured to reward those who perform F&A functions well.
F&A outsourcing optimizes functions of non-F&A businesses.
F&A outsourcers allow businesses to focus on revenue generation instead of worrying about F&A matters, which are integral to their operations but do not actually create revenue for their business.
Outsourcing optimizes the function of the CFO and other senior-level employees.
When transactional functions are outsourced, the CFO can focus on F&A strategy rather than minutiae. The CFO can be a CFO, the Comptroller can be a Comptroller.
Cost Substitution.
Outsourcing enables businesses to implement more advanced technology solutions more cheaply. Take, for example, a firm with an antiquated IT system that costs them $10 million dollars a year to run. They want to upgrade, but the upgrade will require a capital investment of $15 million; the outsourcer, on the other hand, can provide the service for $8 million. The customer may prefer to go with the outsourcer, who can provide the improved technology for less than the cost of the customer’s obsolete technology and for substantially less than the cost of an in-house upgrade.
Economies of scale.
F&A service providers such as Ephinay and Geller claim they can give the customer “more F&A bang for the buck.” An outsourcing provider (or a CPA firm) could enable a company outsource its needs to F&A experts who work part-time for the company. When ’re hiring a part-time F&A provider, the enterprise can afford to tap a deeper bench for the same money. For the same costs as for a CFO, the enterprise might get a CFO, a Comptroller, and a bookkeeper. The customer can take advantage of the fact that the outsourcer likely has a much larger and more specialized staff than the customer’s in-house F&A department. A customer could afford to have a small army of outsourced accountants, for example, working on its projects at crucial times, which it could never do in-house.
Peaks and Valleys.
Outsourcing may also help smooth peaks and valleys in the monthly, quarterly and annual financial and accounting cycles. Variability in service volumes enables companies to budget for their in-house baselines and manage the pricing and costs — on a variable pricing method — of outsourced staffing for peak loads. In contrast to staff augmentation as a business model, though, outsourcing involves minimum purchase commitments by the enterprise customer, thereby allowing an efficient outsourcer to engage in resource management planning and delivery of lower per-unit resource costs.
Process Complexity.
Certain F&A processes are so inherently complex, or judgmental, that the entire process is outsourced before the enterprise even considers hiring and supporting its own staff. Such areas include employee retirement planning, ERISA fund investment and pension administration. (These processes overlap with HR functions, making them even more complex.)
Why F&A outsourcing minimizes risk
Outsourcing in F&A is often a way to increase competitiveness and minimize a firm’s risk. Outsourcing can improve competitiveness by cutting costs, but it can also improve the capabilities of the customer’s firm beyond freeing up intellectual and financial capital. Here’s what the sales pitch sounds like:
- Shifting functions is shifting risks.
Shifting functions to an outsourcer can be a way of shifting risk to that provider. When a customer contracts with an outsourcer to execute a function, the customer then looks to the outsourcer for results; it becomes the responsibility of the outsourcer rather than the customer to deliver. This improves efficiency for the customer; if an employee calls in sick and can’t deliver before an important deadline, for instance, that now becomes the outsourcer’s problem rather than the customer’s. - F&A outsourcers are better structured to catch many kinds of errors.
Many outsourcers have multiple levels of review built into the F&A process and are therefore more likely to catch errors before they become catastrophes. These errors could range from the occasional arithmetic mistake to faulty accounting and the attendant potential for civil liability. Many customers cannot afford to hire in-house the quantity or quality of people required to match an F&A outsourcer’s product. F&A outsourcers also often have more detailed or more up-to-date knowledge of arcane tax regulations that can be leveraged to the customer’s advantage. This is, of course, more important in the Sarbanes-Oxley world, where accounting errors can embroil firms in heftier fines and more serious litigation than before. In addition, unauthorized expenditures by outsourcers are impossible—whether the result of a mistake by the outsourcer or criminal embezzlement—when the contract between the customer and the outsourcer spells out precisely what expenditures are authorized and what responsibilities will be retained by the customer. - F&A outsourcers are less likely to make mistakes because it undermines their entire business.
F&A outsourcers’ livelihood comes from their contractual work. At a minimum, outsourcing in general does not increase risk. Problems presented by the risks of mathematical errors, incompleteness of records, lost records, and inappropriate classification of transactions for accounting purposes, for example, are at least as likely to occur among F&A departments of businesses that retain F&A functions as they are among F&A outsourcers. But in general, F&A outsourcers minimize these risks because F&A is their exclusive function; if they make these kinds of mistakes routinely, their business stands to pay a substantial material price. (In response, the enterprise needs to consider who is better at assuming the risk of making and making good on the typical types of errors associated with a particular business process.)
Questions that enterprise customers want answered
The prospective customer is considering handing over his business’ finances to another business. That is an inherently delicate process, especially if the prospective customer is not already acquainted with the outsourcer. Customers expect answers to the following questions:
- Why should I outsource when I can retain control by insourcing?
- for what functions is the outsourcer responsible?
- Is the outsourcer reachable, or do I have to call between 9 a.m. and 5 p.m. to get in touch with a responsible person?
- What attitudes and cultures should I look for in a “good” service provider?
- How will outsourcing my F&A functions increase my firm’s competitiveness?
- Will outsourcing allow the CFO to be more effective and act more strategically?
- Will outsourcing increase our risk? Even if outsourcing can increase quality and reduce cost, the customer wants to know what the risks of outsourcing are, and whether and how they can be managed, before he closes a deal.
- How do I assure that the outsourcer will track what we need to track, including possible fraud in its own operations?
- What alternatives exist to outsourcing this function? Would an investment in software “solve the problem” of managing the particular F&A function?
Friction points
In outsourcing arrangements as in any transaction, friction points arise particularly when responsibilities are poorly defined. As in other types of outsourcing, F&A outsourcing involves classic issues that need resolution in planning and contracting.
- Scope of services must be defined. If the scope of services to be performed by the outsourcer is left vague by the parties in their contract, serious problems can arise. The customer must know what responsibilities he is contracting to the outsourcer and what functions he retains. Likewise, if the number of hours or amount to be billed by the outsourcer is left open-ended, opportunity for customer-outsourcer friction increases.
- Due dates for projects must be spelled out in advance by contract where appropriate. Outsourcers cannot be expected to respect informal internal agreements customers may have been accustomed to when F&A functions were in-house (“Frank always got me the numbers on Fridays—I don’t see what the problem is”) unless they are specified up front. But this is a problem inherent in any transaction, in outsourcing and insourcing.
- Software compatibility is generally not an issue.
This is a major concern for customers—how much of my standard operating procedure will I have to change to accommodate the outsourcer?, they frequently ask. The answer can be “none.” Generally F&A outsourcing firms do not impose tech solutions on their clients when transactions are light. Platform compatibility can become an issue, however, as the complexity of the mathematics increases. Some outsourcers are “platform agnostic” regardless of the volume of transactions involved, while others may require their high-volume customers to use Solomon or SAP.
Transitional Issues
A business’ decision about whether to outsource any function, F&A or otherwise, often hinges on the cost of transitioning responsibilities to the outsourcer. The slope of the customer’s learning curve and the amount of time required to make the transition depends on the number and importance of the outsourced functions. It also depends on the particular outsourcing firm.
Timing.
Some firms require four to six weeks to take over bookkeeping responsibilities from their customers; others do it in as little as two weeks. Outsourcing a whole F&A department could take as long as a year, or as little as a month
Transition Planning Toolkit.
Firms will often require their customers to fill out a questionnaire detailing business expenses to help acquaint the outsourcer with the customer’s regular expenses. This helps accelerate the transition. However, some pain occurs when the enterprise of the customer has to modify its process to accommodate the new outsourced business process.
Comparison with In-sourcing.
Some F&A outsourcers assert that transition costs entailed in a switch to outsourcing are not necessarily higher than those of hiring a new person in-house, and can often be recouped much more quickly. However, in a larger organization, the degree of change management is much greater when transitioning to an outsourced process.
Conclusion.
F&A outsourcing contracts may still represent a small minority of total outsourcing arrangements. Yet businesses are increasingly looking to F&A outsourcers to take over certain high volume, low risk, F&A functions with a modest degree of discretion or judgment. The trend in outsourcing towards allowing smaller and smaller businesses to outsource has taken hold in the F&A area as well. Small and mid-sized businesses (“SMB’s”) and startups can often find it profitable to outsource a variety of different F&A functions that would only have been profitable for major corporations to do just a few years ago. F&A outsourcing is becoming increasingly common among businesses that want to reduce risk and optimize their competitiveness and are willing to invest in strategic sourcing plans and skilled contract lawyers.
Effective risk management requires effective legal contracting. Given to complexity of F&A outsourcing, careful contracting is required.