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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 EDS had reportedly withdrawn from negotiations in June or early July because of pricing.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.

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.

Privacy in Outsourcing of Health Information

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

The general Privacy Rule under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) requires anyone to obtain a patient’s prior consent in order to use “individually identifiable health information” for non-medical purposes, such as employer evaluations.   For medical treatment and payment purposes, however, using or sharing medical information “for incidental use or disclosure” is permitted.   For marketing purposes, a pharmacist may use a patient’s medical information to make recommendations to the patient to switch medications.

The final Privacy Rule, published August 14, 2002, preserves the role of outsourcers of medical information.  Certain prior draft provisions were softened.

Prior Draft Regulations.

Prior draft regulations, issued by the administration of former President Bill Clinton, would have prevented hospitals and clinics from  scheduling medical tests or surgery until the patient had read and signed a long, legalistic “privacy notice.”

Impact of Regulations on Outsourcing of Medical Information Processing Services.

The prior draft HIPAA Privacy Rule raised several concerns for those involved in outsourcing of medical information processing services.

Continuation of Outsourcing of Records Management and Photocopying.
The prior draft would have had a negative impact on outsourcing of records management and photocopying activities.   It could have effectively eliminated any economic benefits to outsourcing services providers of the cost-based copying fees allowed to be charged to individuals who request a copy of their medical record under the right of access provided by the Privacy Rule. See 45 CFR Section 164.524.  There was a risk of driving the outsourcers out of business.

In acknowledging this, the Department of Health and Human Services made a special clarification to accommodate outsourcing.  Many hospitals and other covered entities currently outsource their records reproduction function for fees that often include administrative costs over and above the costs of copying. In some cases, the fees may be set in accordance with State law. The Privacy Rule, at Sec. 164.524(c)(4), however, permits only reasonable, cost-based copying fees to be charged to individuals seeking to obtain a copy of their medical record under their right of access.   In response to comments that persons seeking copies of all or part of the medical record, such as payers, attorneys, or entities that have the individual’s authorization, would try to claim the limited copying fees provided in Sec. 164.524(c)(4), the final Privacy Rule makes clear that the fee structure in Sec. 164.524(c)(4) applies only to individuals exercising their right of access.

However, the Department of Health and Human Services acknowledged that even this accommodation could put a strain on covered medical-related entities, and that the regulation forced subsidized access to medical records by the individual patients.   HHS argued:

While perhaps onerous on covered entities, the rule does allow outsourcers and their customers to recover more than their costs on non-patients in order to subsidize patients’ access to medical records.

Outsourcing Continues to Require Contracts.
The Department of Health and Human Services final Privacy Rule requires that any relationship between a “covered entity” and a “business associate” (also known as an outsourcer or services provider) must be established and managed by contract.  Some service providers tried, unsuccessfully, to be authorized to “self-certify” their compliance, or have a neutral certification authority.  “With respect to certification by a third party, it is unclear whether such a process would allow for any meaningful enforcement (such as termination of a contract) for the actions of a business associate,” the HHS concluded.

Minimum Standards, not Exclusive Standards.

The final Privacy Rule does not supersede any more stringent privacy protections of any state laws.   The “best practices” approach, therefore, may be to obtain the patient’s consent for certain uses of the medical information, particularly for patients who are likely to change residences from one state to another and the new state of residence has stricter provisions.

Outsourcing Contract Terms.

The final Privacy Rule adopted in August 2002 sets forth specific requirements for contracts between “covered entities” and “business associates” (outsourcers).   For the minimum terms of such a contract, our subscribers can view the terms at hipaa privacy data use contract terms

Definitions.
Key definitions under the final Privacy Rule can be reviewed at hipaa_privacy_definitions

Consumer Protection in Outsourcing and Out-Tasking: Statutory Rules Governing Document Preparation (Bankruptcy Petition Preparers)

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

The federal Bankruptcy Abuse Prevention and Consumer Protection Act, signed by President Bush on April 20, 2005, establishes a new outsourcing (or “out-tasking”) business for “bankruptcy petition preparers.” Such businesses (which could be in corporate or sole proprietorship format) would assist persons in the preparation and filing of bankruptcy petitions. While other laws relate to similar preparers of documents for filing with the federal government (such as for income tax return preparers), this law defines the practice of law by delineating what non-lawyers may do without being supervised by a lawyer.

Coming after an unsuccessful attempt in 2002 by the American Bar Association to use a definition of the practice of law to exclude non-lawyers from many document preparation services, the 2005 bankruptcy reform legislation sets a congressional imprimatur on permissible non-lawyer services. Anyone engaged in document preparation services (including procurement and sourcing consultancies) should consider how this legislation would establish new federal policy on document preparation services and, implicitly, the practice of law.

Anti-Abuse Policy.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, S. 256, 109th Cong., 1st Sess, amending 11 U.S.C. 110, establishes and regulates a new regulated profession of “bankruptcy petition preparer.” The law identifies a public policy of avoiding abusive filings of fraudulent bankruptcy petitions and preventing “fraudulent, unfair or deceptive practices” by bankruptcy petition preparers. The regulatory regime establishes maximum reasonable fees and, for violations of regulations or assisting in fraudulent bankruptcy petitions, impose civil fines and even forfeiture of all document preparation services fees.

The Services Agreement.

A bankruptcy petition preparer must provide a written notice describing the scope of bankruptcy petition preparation services, along with a contrasting provision that specifies what types of services would constitute the practice of law that the preparer is not legally permitted to provide. Accordingly, to avoid abuse of “consumers” of these services, the definition of “practice of law” becomes critical.

Definition of the Practice of Law.

The new law would include (without limitation) the following services as being within the scope of practicing law:

The legal advice referred to in subparagraph (A) includes advising the debtor–

`(i) whether–

`(I) to file a petition under this title; or
`(II) commencing a case under chapter 7, 11, 12, or 13 is appropriate;

`(ii) whether the debtor’s debts will be discharged in a case under [the Bankruptcy Code];

`(iii) whether the debtor will be able to retain the debtor’s home, car, or other property after commencing a case under this title;

`(iv) concerning–

(I) the tax consequences of a case brought under this title; or

(II) the dischargeability of tax claims;

(v) whether the debtor may or should promise to repay debts to a creditor or enter into a reaffirmation agreement with a creditor to reaffirm a debt;

(vi) concerning how to characterize the nature of the debtor’s interests in property or the debtor’s debts; or
(vii) concerning bankruptcy procedures and rights.’;….

Analogy for Other Services Providers.

Management consultants, brokers, investment bankers, turnaround specialists and other service providers can get some comfort from the text of this reform law. While narrowly applicable to the protection of consumers, the law does express a congressional policy of permitting but regulating the performance of certain functions that might, in a prior era, have been considered the practice of law.

To review these areas by analogy in a more generic approach, one might rewrite this law for all document preparation services under the following “rewritten” version. The author takes the liberty of making this analogy only for comparative purposes and does not recommend that it should be sufficient to prevent the document preparer from withstanding a cease-and-desist order or other demand by a competent government authority for other document preparers:

Legal advice that a document preparer shall be prohibited from providing unless performed by a licensed lawyer includes advising any client–

`(i) whether–

`(I) to prepare any document that will be used to comply with any procedure that is governed by a law; or

`(II) commencing a case before any court, tribunal or arbitral authority is appropriate;

`(ii) whether the client’s obligations will be discharged in a case commenced using any document prepared by the document preparer;

`(iii) whether the client will be able to retain certain specific rights in property (including choses in action) after commencing a case using any document prepared by the document preparer;

`(iv) concerning–

`(I) the tax consequences of a case brought using any document prepared by the document preparer; or

`(II) the dischargeability of tax claims;

‘(III) the preservation of any rights against any third party that the document, prepared by the document preparer, is intended to assure; or

‘(IV) the limitation of any liability of the client in respect of any third party or the compliance by the client with any law, rule or regulation affecting the client.

`(v) whether the client may or should make any decision that affects its rights or remedies, including any election to promise to undertake future performance to any third party or enter into any agreement with a third party to reaffirm or clarify any obligation, right or remedy;

`(vi) concerning how to characterize the nature of the client’s interests in property or the client’s obligations for any compliance or reporting purposes; or

`(vii) concerning legal procedures and rights.’.

Caveat Emptor.

In granting this statutory exemption to the monopoly of lawyers, this new law will nonetheless require informed consent by the “client.” The nature of such informed consent in the context of outsourcing contract drafting is a matter of judgment under the circumstances.

Uncertainty Prevails.

Any “document preparers” should obtain legal counsel on whether their services constitute the unauthorized practice of law or an unfair trade practice that might be regulated by the Federal Trade Commission or other regulatory body.

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