• Home
• Jurisdictions
  • Countries
  • Multinational Organizations
• Services Outsourced
  • Finance/ Accounting
  • Legal
  • Human Resources
  • Information Technology
  • Customer Care
  • Other
• Industries
• Sourcing Models
  • Shared Services – Captives
  • Alternative Structures
  • Pricing
  • Financial Engineering
  • Innovation
• Resources
  • Software Tools
  • Definitions
  • Outsourcing 101 – Basics
  • Sourcing Advisors
  • Benchmarkers
• Events
  • Press
  • Past Events / Webinars
  • Upcoming Events
• Archives
  • Newsletter Article Archives
  • Newsletter Archives

Knowledge Management in Strategic Alliances and Outsourcing

December 21, 2012 by Bierce & Kenerson, P.C.

Knowledge management has become a key driver in the design and sustainability of competitive global enterprises today.  In knowledge management (“KM”), organizations define the purpose and meaning of information for the corporate mission, create, store and share information and establish tools and rules for internal and external use (and repurposing) in commerce.  KM presents structural and contractual challenges for enterprise customers and their outsourcing service providers.

Uses of KM.   Knowledge management is a basic tool for business process management (“BPM”).  KM may include training tools (webinars, questionnaires, checklists, algorithms).   KM can enable effective post-merger integration to two organizations by providing transparency into each other’s operations.  KM can also be used to capture the implicit, contextual knowledge of a retiring generation of experienced workers.  KM is applied in outsourcing, supply chain management (“SCM”) and business process management (“BPM”).  Other applications include business continuity planning (“BCP”), disaster recovery (“DR”), audit and control for corporate governances and regulatory reporting.

What is Knowledge Management?    Knowledge management (“KM”) represents the institutionalization of business knowledge derived from personal experience, and the continuous process improvement “on the shoulders of giants” by process designers.  KM applies scenario analysis to predict the suitability for applying a pre-determined process.   It is not ad hoc, but responds ad hoc to situational triggers.  Components to any KM process or system include:

• Scenario Triggers: precursor avenues leading to and funneling a work flow;
• Inputs: the collection of relevant data needed to provide either the context for a work flow (such as criteria for initiating the work flow) or the actual processing of inputs;
• Business Rules: the business rules (and regulatory requirements), or algorithm, processing inputs and delivering outputs as the intended results of the required operation;
• Data Processing: the process of applying the business rules to the inputs after the scenario is triggered and delivering the outputs;
• Records Management: the process of storing information in searchable formats, which may include a thesaurus, searchable links, and clusters of key topics and multiple documents (“records”).

Technologies Used in KM.  Virtually any digital technology can be used for KM.  This includes databases, repositories, intranets (open wikis or closed), extranets, decision support systems, project management tools, time billing and accounting software, web conferencing and online and offline storage systems.   With increasing mobility of computing devices and the use of social networks that can be used to diffuse information, and global cyber threats, KM poses cybersecurity risks to the enterprise.

Legal Issues in KM.    Several fields of law govern KM at different phases of creation, sharing, storage, use and reuse.  These legal fields cover issues in employment, intellectual property rights, trade secrets, corporate fiduciary duty, contractual restraints on competitive activities and related antitrust or competition law, privacy law, contractual rights on warranties and indemnification, and mergers and acquisitions.   In international business, the laws of multiple countries or multiple legal systems can apply, creating conflicts of law that require careful analysis and design for implementing a KM system or KM-based relationships.  Finally, governmental regulations can mandate the form of a KM system.

Employment Law.  Employees and contractors are sources of knowledge, as they take their experience and adapt it to specific problems for resolution.  Human resources departments must ensure that employees do not share knowledge that is subject to a non-disclosure agreement with a former employer or a customer.

Intellectual Property and Trade Secrets.   In the field of business services, a service provider uses work flows that could infringe the patent of a competitor.  Or it might use a trade secret for a purpose not permitted under a non-disclosure agreement.  Or it might present the work product in a form that is confusingly similar to the work product of a competitor under the Lanham Act or principles of “trade dress.”  KM tools and rules should include information about the sources and permitted uses of “knowledge” to avoid infringement litigation and to expand the scope of the organization’s proprietary (and thus competitive) operations.  In strategic alliances (such as teaming agreements and joint ventures) and outsourcing, both parties need to protect their own “KM” so that neither the outsourcer nor the enterprise customer can enjoy unfair competitive advantage after the end of the alliance or outsourcing contract.

Governmental Regulation.  KM has become a prime mandate of governments.  The Enron bankruptcy spawned the Sarbanes-Oxley Act of 2002, forcing public companies to maintain “audit and control” procedures beyond the general “best practices” previously adopted under generally accepted accounting principles (“GAAP”).  Under GAAP, Statement of Auditing Standards (“SAS”) No. 70 established procedures for auditors to verify that companies actually followed the procedures and work flows that they claimed to follow.  SAS 70 has since morphed into another auditing principle (SSAE 16), with a reduced standard of care and risk of liability for the auditors.   The Securities and Exchange Commission requires public companies to identify their vulnerabilities including risks of business continuity and processes for disaster recovery.  The Dodd-Frank Consumer Financial Protection law requires covered banks and financial services companies to adopt hundreds of specific processes, under over 300 regulations, to protect against risks of structural damage to the economy.

Getting Value from KM.   Managers can build enterprise value through KM tools and policies that promote increased efficiency, competitive positioning, transparency and accountability.  For efficiency, a “capability maturity” model may be limited in focus by addressing only constant improvements through analysis of “lessons learned” and proactive process redesign.   For competitive positioning, innovative, entrepreneurial managers can cast aside “inefficient” or complicated business models for new models based on new technologies.

Contract Clauses.  Virtually every business exchange involves the sale of some knowledge.  It can be embedded in a product, or it can be expressed as a means for using a product or consuming services.   Every contract for services (including “managed services” / outsourcing) needs effective analysis, planning and implementation of rules governing knowledge management.

Thinking Ahead.   KM principles are essential for any business.  KM contract clauses help ensure that the business will survive, thrive and adapt.

Outsourcing: Evolution From Single Supplier to Best of Breed

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

In a globalizing, services-based economy, outsourcing has rapidly grown in the last decade. Once confined to “low-value,” low-technology services such as a company’s in-house photocopy machines, messengers, food services and janitorial operations, outsourcing has moved “up the value chain.” At the same time, changes in the nature of outsourcing have led to a variety of other management tools such as multiple outsourcings for “best of breed,” greater internal discipline through “insourcing” under a “managed scorecard” and “shared services” subsidiaries. Roles and identities of service users are merging with those of service providers in a continuum of services.

This article focuses on the evolution of outsourcing in the last ten years and how new models have developed.

“Outsourcing” vs. “Out-Tasking.”

Outsourcing is the process of transferring to an external services provider (the “outsourcer”) the day-to-day responsibility for operating a business process of the corporate enterprise (the “user”). Typically, this involves a transfer of the personnel then employed by the user to the outsourcer’s payroll. Frequently, other assets are transferred as well.

In contrast, “out-tasking” is a more limited approach involving “contracting out” or “subcontracting” a task to a “consultant” or other service provider. This can run the gamut from individual projects for product development to a string of projects that are interdependent and require a certain workflow.

Types of Outsourced Services Today.

Currently, external services providers offer virtually any type of ongoing support for business processes. These range from human resources management, tax compliance, internal audit and real estate asset management to product design, manufacture, design, testing, marketing, logistics, distribution of goods and services worldwide. Given the right mix, one can “outsource” an entire enterprise. Indeed, some new businesses are based exclusively on Internet sales with outsourced support.

Deciding When to Outsource.

Outsourcing is suitable for many different situations. For publicly held companies seeking “efficient” and favorable share pricing, the earnings multiples generated by many capital-intensive assets might fail to support management’s high targets for ROI and ROE from “core business.” For such businesses, outsourcing allows liberation of capital from the constraints of price-earnings ratios and promote management focus on essential determinants of shareholder value. “Do the best, outsource the rest.”

For rapidly changing industries, outsourcing may be the tool of choice for obtaining rapid access to scalable production or to new technologies, a “partnership” with a recognized leader for transitional and long-term technology planning and marginal cost pricing for business processes requiring heavy capital investment.

In the context of mergers and acquisitions, divested companies need operational support from the day of a spin-off or split-off. Outsourced facilities can span the gap and give new management the necessary “breathing room” and allow focus on the core business. Outsourcing can also expedite integration of two merged companies with incompatible technical infrastructures.

Deciding What to Outsource.

In making any “buy” vs. “build” decision, as in outsourcing, financial considerations are critical. But the key driver is to distinguish between functions that are “core” (non-delegable) and those that are merely “essential.” Many “essential” functions are ripe for outsourcing under suitable conditions. For some enterprises, the “hard” decision is deciding what not to outsource.

The classic example of outsourcing revolves around information technology. Today, this field includes the converging technologies of data processing (especially using “enterprise resource planning” (ERP) and “supply-chain management” (SCM) software), telecommunications, Internet “e-commerce,” and remote processing through Internet service providers. In business and industry, this can involve both “back office” and “front office.” In financial services, it can even include the “middle office,” for compliance with financial reporting and securities laws.

At the “back office” level, this business function can be divided into a number of discrete elements. Customers rely upon, but rarely see

1. the operation of a data center with mainframe computers running “legacy” applications,
2. certain applications development and maintenance for custom programs,
3. network administration for local area networks, wide area networks (including telecommunications) and now even “storage area networks” of storage devices for the burgeoning volumes of archival data and
4. “help desk” services for employees with problems using the company’s information technology infrastructures.

At the “front office” level interfacing directly with the customer, outsourcers can provide “private label” services that allow a company to offer a host of resources that it does not own. In doing so, the company can specify in advance what it wants to do, how it wants to do it, and what it is willing to pay. By combining such services as customer relationship management, remote electric meter reading, electronic billing and the like, some new companies can sprout up to compete directly with “bricks and mortar” companies on a cost-effective basis without loss of service quality.

Evolution of Deal Structures.

In the early 1990’s, data services providers such as EDS, IBM, CSC, Perot Systems made their fortunes on long-term, monolithic packages of services covering a broad scope. The trend today is to find niche players to provide specialty services, but this requires significant supervisory and planning skills for the user enterprise. Sometimes one supplier acts as general contractor, or “first among equals,” and manages a consortium. Occasionally, joint ventures supplant the supplier-customer relationship, providing added incentives and risks for both sides. Current methodologies for competitive procurement of outsourcing services reflect the learning of former (or current) long-term deals. Renegotiation occurs regularly, but can only be effective if the necessary tools have been crafted into the deal in the first place.

Making It Work.

Senior management needs to be committed. After the deal is signed, in-house managers need to monitor and manage the supplier’s performance.

Done wrong, however, outsourcing can be a catastrophe. Multiple business risks are inherent in the outsourcing process.

If mismanaged, an outsourcing process could retard growth and result in unintended losses of momentum and key personnel. In such cases, the resulting disenchantment may swing the business process back to “insourcing.” However, “re-sourcing” to another vendor might prove more effective.

“Genetic Mutations” on Outsourcing: Shared Services, Insourcing, Managed Scorecard.

In the last five years, responses to outsourcing deals have generated the quest for “better” deal structures.

“Insourcing” is the process of bringing in-house a business function that was, or was at risk of, being transferred to an external service provider. “Shared services” subsidiaries provide common administrative functions for a group of affiliated companies.

To improve performance and forestall being outsourced, some in-house staffs are focusing on process improvement, sometimes agreeing to be managed as if they were external providers. In some cases, this reaction can produce self-management by “managed scorecard” techniques or in the establishment of “shared services” subsidiaries for cost efficiency. In either case, the “threatened” personnel then become external services providers of their own specialized, albeit generic, processes in the market.

The Independent Lawyer and the “Two Hat” Client.

Virtually every corporate user has the capacity to wear the two “hats” of “user” (in one outsourced business process) and supplier (in another). In major procurements, the assistance of knowledgeable “infrastructure services” lawyers can accelerate the process, reduce risk and facilitate future adjustments. For users-turned-suppliers, knowledgeable legal and business advisers can expedite the “go-to-market” strategy and achieve valuable payoffs in the selection, due diligence and negotiations phases.

Independent legal counsel with experience in both sides of these strategies can expedite and facilitate the process of determining the scope, selecting the outsourcer, negotiating the contract and ensuring implementation.

Sponsors of www.outsourcinglaw.com provide legal and practical business advice on the structuring and implementation of various strategies discussed in this article. For further information, contact one of our sponsors or Bill Bierce (author).

Death of Captive Paradigm? Business Transformation of a Shared Services Captive: Legal and Business Issues in Conversion from SSO to Independent BPO Service Provider

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

General Electric Company’s announcement on November 8, 2004, that it has agreed to sell 60% of its Indian captive services company GE Capital Information Services (“GECIS”) marks a turning point in the trend towards establishment of offshore captive services companies.  This article considers the legal and business issues in a conversion of a foreign captive shared services organization (“SSO”) to an independent business process outsourcing (“BPO”) service provider.   It is a lesson in management strategy, risk analysis and, most importantly, return on investment for shareholders.

Disclaimer: The author has not seen the documentation among the parties on this transaction.

GECIS as Captive SSO.

GECIS was established to provide specialized talent and resources to GE’s affiliates globally.  Most recently, it has been providing Six Sigma productivity improvement methodology and training, cost savings advisory services and back-office business process support to GE’s affiliates.  The legacy of GECIS as a captive organization demonstrates GE’s success in managing services as a core competency across the world.  GE’s press release noted:

As a captive, GECIS probably had reached the limit of its ability to scale the processes and generate business value. Even GE globally has limited capacity to absorb shared services.

The Business Transformation to BPO Services Provider.

Sale of Shares.
GE converted the SSO to a BPO service provider by selling a majority share to two private equity firms, General Atlantic Partners and Oak Hill Capital Partners.  After the sale, GE will own 40%, with each of the other two shareholders owning 30%.

Recapitalization.
The GECIS company will also be recapitalized.  Recapitalization of a healthy, growing company in a booming services economy suggests that the new investors will be contributing new capital.   The pricing of the share sale, as well the relative contributions to capital, may depend on an “earn-out” based on on post-sale performance of the company.

Allocation of Shareholdings; Impact on Corporate Governance.
GE could have chosen to sell to one other shareholder.  By selling to two investment groups, it dilutes the individual power of the other shareholders and retains an opportunity, by persuasion or other alignment of interests, to potentially share majority control with one of the two investors.  Thus, for accounting and regulatory purposes, GE ceases to own control.  For corporate governance purposes, it may retain an option (explicit or in a shareholders agreement) to share voting control with one of the two investors.

Expansion of Markets.
GE’s Press Release announced an expansion of into new markets, which will be generate new value for the new private equity investors.  GECIS “will accelerate its third-party sales, marketing and delivery capability to significantly expand its client base, especially in China and Eastern Europe, where it began operating two years ago.”

Management.
As announced, Mr. Pramod Bhasin will remain as president and chief executive officer, supported by the current Gecis global management team.

Board of Directors.
Thee new board, comprising four representatives from GE and six from the new investors, will be constituted by the end of 2004.

GE as Customer.
As announced, Gecis will continue to serve GE under a multiyear contract. That contract undoubtedly gives GE a priority claim on some of Gecis’s resources, most-favored-nation pricing and other preferences afforded to the best customers.

International Capital Structure.
The admission of new investors requires an appropriate capital structure.  Capital structures are driven by considerations of corporate law, taxation, effectiveness of controls and predictability of the rule of law.  Generally, international investments are structured to interpose an offshore holding company so that sales of the portfolio company are sheltered from income tax on disposition.

Corporate Governance.
Selection of the jurisdiction for the holding company, that will be co-owned by the investors, has an important bearing upon the corporate governance.   Corporate governance involves the rights to elect and terminate the board of directors, to approve important business decisions that might affect corporate operations, policies, financing, growth, mergers, acquisitions, dispositions, recapitalizations, joint ventures and liquidation.

Each of these corporate governance elements depends on the voting rights established under the applicable corporation or company law, the shareholders’ agreement, if any, the by-laws and resolutions of the board of directors.  Every country has its own corporation law, and nomenclature and rights vary across the world.  “Offshore” jurisdictions specialize in attracting foreign investment by offering highly flexible corporate structures, with minimal protections for minority shareholders.

Minority Holder’s Statutory Rights.
The right of a minority shareholder to block a major corporate action — such as an acquisition, major divestiture or restructuring — may be greater in some countries than others.  In India, the holder of a 25% ownership interest in a limited company are entitled to block such major corporate actions.  In Delaware and New York, for example, the minority has no such right, and the holder of a majority of the voting rights can effectively dictate major corporate actions.  As a result, when a 100% owner of an Indian shared services captive wishes to recapitalize the Indian company, it will normally choose a jurisdiction that allows absolute control by the majority owners, subject to fiduciary duties to minorities.

Recapitalization vs. Sale of Shares.
For sole owner of an operating company like an Indian captive services provider, sale of shares could trigger a capital gains tax.  By having the operating company (or a holding company) issue new shares, the funding of new investment capital into the business can be achieved without capital gains tax because capital contributions are not taxable events.

Classes of Shares.
Frequently, new capital contributions are paid in consideration of the issuance of a new class of common shares.  A capital structure with multiple classes of shares has several implications.  The same results can be achieved without multiple classes of shares, but to do so would require extensive negotiation and drafting of a complex shareholders’ agreement.

First, by statute, each class may have the right to approve or disapprove certain corporate actions.  Thus, if one shareholder has all shares in a class, that shareholder may effectively veto major changes that require the consent of all classes of shares.

Second, if there are three shareholders in any class of shares, it ownership can be structured so that none has a majority control of that class.  By loading up the number of minority shareholders in one class of shares, none has any control.  Such a structure strengthens the de facto control of the holders of a majority of any other class of shares.

Third, each class of shares can have different rights of voting, dividends and liquidation preferences.  This feature can allow different investors to design a plan for their own particular investment parameters, including cash flow and the timing and conditions of exit from the investment.

Impact on GE.

Strategic Redirection.
GE’s sale of the 60% stake in the GECIS subsidiary does not mark any withdrawal from the Indian market.  GE’s businesses in India represent annual revenues of $1 billion and 22,000 employees.  Rather, the sale suggests a change in strategic direction.

• The competitive advantage of having a captive BPO service provider appears to have already been achieved.  GE will continue to be a customer, with preferential benefits, of the restructured GECIS.  But there appeared no compelling competitive reason not to expand the clientele of the BPO service provider across global markets.
• The sale of the 60% stake will support expansion of GECIS’s business.  GECIS will accelerate its efforts in marketing, sales and delivery to “underserved” areas that have not experienced productivity improvements, such as China and Eastern Europe.  Opportunities for expansion into new markets will take additional capital investment, which will be provided by the new investors as part of the recapitalization.   It was not clear whether GE would make an additional investment, but it would be normal to do so if the expansion were to require a staging of capital expenditures.

Human Resources.
The transfer of ownership control can have significant effects upon an entity’s employees.

• New Management.
  The recapitalization using private equity investment may be accompanied by a change in management.  In the GECIS case, the operating management will continue in place, but the board of directors will be controlled by the investors in proportion to their respective ownership percentages.  This approach contrasts with the clash that occurs when a strategic acquirer seeks to impose its own management structures and approach upon a new acquisition.  In the GECIS situation, the employees and customers have some assurance that, despite the change in control of the board of directors, the new management will do “more of the same” and seek to expand operations rather than integrate them with a strategic acquirer.
• Pension Plans.
  Rules governing employment law, taxation of deferred compensation and pension rights tend to be territorial in nature.  Under the U.S. pension law (“ERISA”), an employer is not required to cover foreign-based employees, whether directly or employed by foreign subsidiaries or affiliates, include in its U.S. profit sharing, pension, retirement and medical insurance plans.  In this situation, GECIS probably has its own Indian-based pension plans, and there will probably be no impact on any U.S. ERISA plans.  A few exceptions might apply for certain senior executives, and as to them the recapitalization to include new majority ownership will likely result in some special price adjustments over time..
• Exit Strategies.
  With new capital, the company should grow.  But the new investors have predictable time horizons for realizing the return on their investment.  Employees and suppliers should anticipate a strategic sale or initial public offering in five to seven years.  At that time, a change in control may be expected.

Intellectual Property Rights.
Private equity investments do not normally come with significant intellectual property that can be licensed to the newly acquired portfolio company or can be exploited as part of commercial services to customers.  In this case, there might be some cross-licensing of intellectual property rights of the private equity portfolio companies owned by the private investors.  Press reports were silent on this issue.  In each new private equity investment, the integration and cross-licensing of technologies across portfolio companies of private equity funds merits further exploration.

“Captive of Multiple Unrelated Owners.”

Private equity investors may bring synergies and, like Internet Capital in the late 1990’s, even develop a strategy of assembling service companies that can support each other in the classic conglomerate or Daibatsu intercompany strategic relationships.  In this case, the private equity investors will clearly be acquiring a crown jewel that can not only grow by expanding to new markets, but which can develop new synergies, efficiencies and productivity improvements for other portfolio companies.  To the extent that other portfolio companies of General Atlantic and Oak Hill Partners can benefit from the GECIS productivity improvement services, the purchase price will yield multiples of value.   This intrinsic portfolio enhancement consideration might have been an important factor in pushing up the purchase price.

Local Ownership and Selection of Business Partners.
The BPO market is not protected by local restrictions on foreign ownership.  Accordingly, it is entirely normal for foreign investors to share in foreign ownership.    One may inquire why GE did not consider a local Indian private equity fund instead of two American-owned funds. This can probably be explained by an affinity of culture and a long-standing relationship among the parties in the American market.  Also, the Indian private equity funds are not as liquid and highly developed as American private equity funds.

Conclusion

The transformation of a captive services organization to a BPO service provider presages increased reluctance of global organizations to own their shared services operations, at least where the “first-mover” advantages of having in-house resources have been achieved.   Senior managements of global organizations will now face ever so starkly the question whether their shared services organizations are part of the aligned vision of the global enterprise.  If the SSO is not efficient, it should be replaced by an efficient paradigm.  If the SSO is efficient, it can be used as a launchpad for growing a “sideline” business, generating additional return on shareholder equity.

Conversion from captive to BPO provider requires extensive strategic planning.  It involves substantial degree of complexity in execution.  Time will tell whether other companies will follow in GE’s footsteps.

Hewlett Packard and NEC, 2002 Joint Ventures in Outsourcing

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

Overview.

On December 12, 2002, Hewlett Packard and NEC announced a joint venture (“JV” or “alliance” for our discussion) with NEC to deliver managed information technology outsourcing services in Asia, the United States and Europe.   The legal structure of the joint venture was not fully disclosed, but some guesses may be made.   This case study explores business and legal issues frequently arising in joint ventures.   We trace some of the prior relationship and the resulting economic, cultural and operational fit of the venturers.

Joint Venture as a Business Model in a Depressed Global Economy.

The joint venture starts with the realization that the resources of each joint venturer are insufficient to meet a particular market need. ( In a sense, a shared services center is a joint venture of the department or lines of business of a large enterprise.) This particular JV targets a need to serve global companies engaging in mergers and acquisitions. This view of the world suggests that increasingly, for the foreseeable future, consolidation and concentration of multinational enterprises will continue.  In essence, the HP-NEC joint venture targets this wave of global consolidations across industries.

Prediction for Future Restructuring of the Joint Venture.

Business analysis suggests that, after NEC completes a spin-off of its semiconductor business, the new joint venture will be a candidate for merger into HP, provided that the joint venture achieves satisfactory performance goals.  NEC’s Chairman and CEO, Koji Nishigaki, observed at the December 2002 news conference that “we have laid the foundations [for a merger], so the potential is there.   Part of the companies could be merged.   We will see many dynamic changes.”

Ultimately, like any joint venture, the potential for any merger and the success of the joint venture will depend on the joint performance of the JV partners, raising the issue of what commitments each is making to compete successfully in an increasingly competitive, increasingly concentrated market for outsourced international services in information technology management.

The joint venture presents a number of legal issues that are common to any international joint venture in information technology, hardware, software and managed services.

Geographical Scope.

The alliance will market to multinational companies that have offices in one or more territories.  Initially, these territories are limited to China, Japan and the United States.  As of 2004, the joint venture will expand the territory to South East Asia and Europe.   The phased introduction of jointly-provided services into targeted territories should enable the parties to manage the inevitable transitional kinks in their relationship before taking the relationship to distant markets.

Service Scope.

The JV includes marketing, systems integration and customer support services.

Target Customers.

The JV partners intend to create a new market for IT outsourcing for customers that are not dependent on mainframes.   They admit that IBM dominates the mainframe computer market.  Rather, the JV will be targeting large global customers in the “post-mainframe-era market,” particularly the integration of computer systems after mergers of large global corporations that have disparate IT infrastructures.   In Japan, the two have already worked on an integrated system for Sumitomo Mitsui Banking, which is the product of a recent merger of two banks.   That deal not only inspired the joint venture, but probably will also serve as the “sweet spot,” template and benchmark for future joint venture service offerings.

Legal Structure.

The two alliance partners indicated that they will establish one or more joint ventures to provide a range of information technology services.   The HP-NEC announcement did not elaborate on the terms or structure of the JV, so we will speculate.

Under a joint venture, there are basically two methods of developing a “joint venture”

• Contractual Joint Venture:
  In a “contractual” joint venture, the two partners establish a business operation that is based solely on a contract.  No new legal entity is formed.  Such joint ventures were popular in East-West trade during the Soviet era.  At that time, contractual joint ventures had several ideological and legal advantages for the Soviets.   No one had to establish a legal entity that would have an existence independent of the joint venturers.  The Soviets did not have to implement a capitalist tool of an entity owned by someone other than the State (the Fatherland).   Accounting could be defined in the contract, leaving everything to negotiation and nothing to the application of capitalist legal systems.  (Did you hear of Hollywood Accounting?  It spawned many lawsuits.  The Soviets had their own style of contractual accounting, too!).   And termination could be achieved by contract termination, without transfer of any assets from an entity.   We doubt that the HP-NEC deal was inspired by a contractual JV structure.
• Entity Joint Venture:
  In an “entity” joint venture, the joint venturers agree to form a new entity (the “JVCo”), which then serves as the focal point for the business operations.  In an outsourcing JV, the joint venturers typically contribute cash to the JV Co. to conduct certain defined operations (such as its officers and key employees in administration and marketing).   But, the JV partners rarely transfer ownership of intellectual property, operating employees, real estate or technology systems to JVCo.   Instead, the JVCo takes licenses and leases from its JV partners, who also agree to provide defined services to the JVCo so that JVCo can, in turn, deliver the outsourcing package to the JVCo customers.   A JVCo need not have much capital: any transitioning of customer employees and other resources under management could be made to either, or both, of the JV partners instead of to the JVCo.   In fact, JVCo might have no assets at all, assuming that the JV partners each make available, on a “secondment” basis, its own employees performing functions in the name of the JVCo.   Maybe the Soviets had a smarter idea, since at least the third parties dealing with the JV under a contractual JV could make a claim against some deep pockets!

Scope of the JVCo’s Operations.

Under corporate law, the JV partners must carefully define the scope of the JV’s operations.  Like lines in the sand, the scope defines the realm of business opportunities that each JV partner must bring to the JV, rather than perform on its own.  Anything outside the defined scope does not involve any fiduciary duty of a JV partner to bring the corporate opportunity to the JV and to avoid competing with the JVCo for the opportunity.

Scope of Contributions in Kind.

In the HP-NEC deal, the announcement failed to mention anticipated financial contributions.  This suggests that the two parties will minimize invested capital by allocating functions in a complementary, non-competitive, fashion.    Such an allocation justifies a joint venture since the two companies might not have been able to offer or compete in the marketplace alone.   See Antitrust in Joint Ventures in Outsourcing.

In the press conference, HP’s President, Carly Fiorina, said that HP “focuses on capability, invention and innovation,” while NEC “brings important capabilities in open mission-critical systems.”   This suggests that NEC would be providing managed services for data centers operating legacy systems under Unix (or variants), and HP would be providing customer solutions design, project management and custom services in software development, product design, technology improvement plans and strategic consulting.

HP’s Contribution.
HP is already a leading outsourcing company in North America and Europe.  In September 2002, Canadian Imperial Bank of Commerce awarded HP with a seven-year, $1.5 billion contract for the provision of IT services.

NEC’s Contribution.

Technology Solutions.
NEC’s Solutions group offers custom consulting and systems integration services that could be used to provide back-office support in Japan.   NEC Solutions offers highly reliable computing solutions to enterprise, government, and individual customers by providing software, hardware, and services necessary to design, integrate, and operate these elements.  NEC Solutions focuses on customized solutions packages for new technology deployments for customers.

In addition, NEC’s Systems Integration services group, which has approximately 13,000 systems engineers, provides end-to-end systems design, development, deployment, and systems operation solutions.  System integration is provided directly and through NEC Soft, Ltd. and other subsidiaries. SI services consist of (a) systems design, development, and deployment services, (b) operational support services, including system problem diagnosis and correction, and (c) consulting services on systems architecture design and technology planning, including the evaluation and selection of technologies and platforms.

In software, NEC develops and provides software products primarily for use in its computers. Software products include operating systems, middleware for managing large-scale distributed data processing systems, and application software. NEC continues to further develop its capabilities in middleware to enable the more rapid, cost-effective integration of different systems, protocols, and software.

Rationale for a Joint Venture in Outsourcing.

Several key factors brought this joint venture into being:

Prior Collaborative Relationship over Many Years.
Since at least 1995, HP and NEC have been collaborating on technology other than services.   They share mutual competitors, including Microsoft and IBM.    Prior to the merger of Compaq into HP, HP had already established a series of joint activities in research and development, design, manufacture and distribution of computers and their components.  The past relationship focused on combining mainframe technology expertise of NEC and, in at least one case, Hitachi, Ltd., with HP’s operating systems and computers.

In 1995, the two companies partnered in the Unix server arena, allowing NEC to purchase large-scale servers and related technology from HP on an OEM basis for resale in Japan.   As a result, the NEC NX7000 product line is based on HP technology.

In 1997, HP became an OEM supplier to NEC and Hitachi, Ltd. of entry-level models in the HP 9000 D-class Enterprise Server family.    Also, HP signed a multi-year software development agreement with NEC and Hitachi to integrate Japanese mainframe expertise into HP-UX operating system for grater modularity, scalability, performance, reliability and management by self-healing enhancements to detect and repair unexpected software problems in the HP-UX kernel.  Incidentally, in 1989, HP and Hitachi signed a broad alliance including the joint development of HP’s Precision Architecture RISK CPU chips and the design and construction of HP’s PA-RISC systems.   The two companies established a technical support center in Japan (the “HP-NEC Enterprise Solution Integration Center,” or “HP-NEC ESIC”).

In 1998, HP and NEC signed a development agreement to optimize HP’s HP-UX operating system to run on systems using the upcoming Merced 64-bit processor.    As of 2002, the Merced processor has not generated widespread market demand.

In 1999, HP and NEC agreed to collaborate on what they called was the next generation of Japan’s Internet Protocol (IP) network.   Under the 1999 agreement, NEC distributed IP servers using HP-UX (HP’s Unix-like operating system) and HP OpenCall (HP’s middleware) together with NEC’s application software and IP network equipment.   On the R&D level, the two companies agreed to combine their computer and telecom technologies to provide real-time high performance for telecom carriers.

In May 2002, HP and NEC announced a strategic collaboration to deliver large-scale, open mission-critical solutions for targeted industries.    They noted that, together, they had already jointly delivered several complex mission-critical solutions in the financial and telecommunications industries.   This collaboration expressed an intention to target a number of U.S. financial services companies and a range of global Japanese companies.   They intended to explore broader market opportunities worldwide, common systems integration and solutions, to leverage each other’s enabling technologies such as NEC’s OpenDiosa middleware for high-availability applications on non-mainframe servers and HP’s Utility Data Center and Integrated Service Management.  The allocated roles for HP to provide IT infrastructure services and outsourcing capabilities and NEC’s systems integration and support technologies.

Common Technology Architectural Orientation.
While each of the JV partners has developed thousands of patents, every patent is subject to challenge and invalidation.

Concentration and Vertical Integration in the International Markets for Information Technology Outsourcing.
In 1997, Computer Associates reportedly offered to acquire Computer Sciences Corporation so to support distribution of CA’s software products.   CSC successfully rebuffed the offer.  But the dialogue raised the question of the viability of a future IT outsourcing business where the Service Delivery group was merely the distribution channel for proprietary software of Computer Associates and its favored channel partners.

Restructuring of NEC.
NEC has been hard hit by a combination of a decline in global demand for computers (and the computer components that NEC manufactures), falling prices for IT hardware, excess capacity in broadband telecommunications (and consequential decline in optical networking), and a general economic decline in Japan during the 1990’s and early 2000’s.  As a result, NEC has restructured for cost-cutting, redirection of capital investment and supply-chain management to improve manufacturing efficiency.   The restructuring includes closing of aging factories, layoffs, transfer of semiconductor business (including system LSIs, integrated circuits and discrete devices and compound semiconductor devices but not DRAM’s) to a new subsidiary that NEC intends to spin off in a public offering.  Since 2000, NEC has also separated its plasma display panel division and merged several similar units at group companies.

In short, NEC has decided to slim down from its “giant” size into a series of separate companies, each with its own business plan.   Development of an outsourcing business suggests a new business plan.  In announcing the JV, NEC’s President and CEO Koji Nishigaki admitted that NEC had no experience in the full-scope type of outsourcing business, and hoped to learn from HP’s business model.

Restructuring of HP.
HP is the fish that swallowed the second fish that swallowed the third fish.  HP merged with Compaq Corporation, a computer manufacturer and outsourcing services provider, after Compaq had acquired Digital Equipment Corporation, a computer manufacturer and outsourcing services provider especially for distributed networks of computers.   As part of the post-merger integration, HP has shed thousands of workers and sought economies of scale and new channels for leveraging core competencies — including outsourcing — into new geographical markets.

Coopetition: Competition and Collaboration amongst Outsourcers.

“Coopetition” refers to the anomaly of companies that compete in one sector cooperating closely in another sector.

IBM.
In this case, HP, NEC and Hitachi, who have all worked closely to compete with IBM and other computer manufacturers, have joined IBM in the promotion of “open source” computing, to be supported by a non-profit Open Source Development Lab in Portland, Oregon, to test enterprise-class Linux.

Microsoft.
Microsoft licenses eHome technology to NEC and HP.

HP and NEC.
Each of HP and NEC sell computers, personal digital assistants / Windows CE devices and other technologies that perform similar functions.

Securities Law Disclosures for Joint Ventures.

Joint ventures involve significant risk to the business and reputation of each party.   Formation and operation of a joint venture could require disclosure under securities laws, since a significant venture could have a material impact on the financial performance of either party.   Each of HP and NEC has annual revenue in the neighborhood of about $35 billion to $40 billion.   A venture that does put at risk 1% or 2% of that revenue stream (consisting of $350 million to $700 million) probably is not “material.”

On the other hand, such information might be disclosed generally in the issuer’s “management discussion and analysis.”   This disclosure is much more general in nature.

As NEC said in such discussion in its Form 20-K filed in August 2002:

As part of our strategy, we have entered into a number of long-term strategic alliances with leading industry participants, both to develop new  technologies and products and to manufacture existing and new products. If our strategic partners encounter financial or other business difficulties, if their strategic objectives change or if they perceive us no longer to be an attractive alliance partner, they may no longer desire or be able to participate in our alliances. Our business could be hurt if we were unable to continue one or more of our alliances.

Under the Sarbanes-Oxley Act of 2002, joint venturers such as NEC and HP will probably need to disclose more information relating to joint venture operations.  While that law generally does not change the definition of materiality, it does require disclosure of information the previously was ignored under former financial accounting principles.   The act does require closer attention to disclosure of “off-balance-sheet” transactions.   The SEC has issued a proposed rule on such disclosures.

Outsourcing Tools for Insourcing

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

Outsourcing Tools for Insourcing.

The typical outsourcer also provides a spectrum of support and consulting services compatible with a totally insourced environment. Thus, outsourcing is only one of the core service offerings. Enterprise customers now ask the question: why outsource when I can insource using the right tools? While there may be many reasons to outsource, there are equally many reasons not to outsource. The reasons relate to ERP, SCM, CRM and DRM solutions that can be used to keep customers loyal and flexibly prepared for a future outsourcing. Emerging BPM / business process management tools and software as a “service,” can likewise create opportunities for retention of functions in house.

Does your “outsourcer” also sell tools that facilitate insourcing? In this article, we take a quick look at one particular tool offered by the king of outsourcers for its enterprise customers’ data centers.

Panoply of Insourcing Tools.

Insourcing tools help a customer manage its technology and service delivery to its internal customers without dependence on a third party for design, maintenance and support. Let’s consider a few:

• Web-Enabled Self Service and the ASP Model.
  Under the “Applications Service Provider” model, the external services provider hosts its own proprietary software solution. The customer enters data into the provider’s software by remote control, either using web-enabled services or high-speed link.
• Web-Enablement of Customer’s Proprietary Software.
  Companies such as Citrix have developed tools to allow a customer to place its own proprietary software on a secure Intranet, thereby reducing access costs, particularly for end-users who are traveling, home-based employees, or in a large complex organization with multiple offices worldwide.
• Software Licensing Model.
  Software that helps customers perform their own “managed services” has developed over time. In the “early days,” data base software such as Oracle and DB2 organized data. More recently, enterprise resource planning software (“ERP”), supply-chain management (“SCM”), customer relationship (“CRM”) and device-relationship management (“DRM”) software have enabled enterprise customers to harness a uniform set of business process tools across large organizations. Such more robust software serve as tools for reducing complexity, enforcing business process rules and showing transparency of data. Such software also can plan, identify and manage for business continuity in case of disasters. As an emerging insourcing or outsourcing tool, new software tools facilitate provisioning of resources.
• External Benchmarking and Performance Metering Tools.
  Service level agreements (“SLA’s”) define the various performance parameters that define the essential services under any outsourcing agreement. Enterprise customers have tools that measure the same operational data that the external service providers see at the service provider’s facilities. Customers now are demanding access to benchmarking and performance metering tools.

Why Outsourcers Might Offer Insourcing Tools.

There are many reasons why outsourcing might not be a proper solution for a client. Currently, IBM, Hewlett-Packard and Sun Microsystems all offer some form of tool to enable an enterprise customer to automatically provision server workloads based on supply and demand and network traffic. The same “silicon switch” that enables a customer to manage insourced IT resources could thus be used to transform to a hybrid insourced-outsourced combination or externalize the business process virtually.

Transitional Tools for Eventual Outsourcing of Process or Infrastructure, or for Provisioning of Services “On Demand.”

In such cases, the outsourcer should consider providing tools that retain customer loyalty and, like a Trojan horse, enable the customer to become an outsourcing customer “on demand.” The customer becomes trained in the service provider’s software, and such training might inspire confidence that, by using such tools, the customer can place more trust in an outsourced solution, either temporarily or on a continuous outsourced basis. These tools face the challenge of maintaining user control and limiting access to software applications while demand surges or subsides across a network of servers and data centers.

Infrastructure Support.

In fact, among others, IBM has adopted this strategy to service customers who might need hosted infrastructure and rapidly deployable additional server capacity. Its Tivoli “Intelligent Orchestrator” software will allow customers to convert a data center into an IT utility, where provisioning of network capacity (bandwidth), server processing capacity, storage and other computing resources are allocated dynamically in response to defined parameters of supply and demand. This resembles a “utility” because the “grid” operator may now anticipate demand and plan for allocation and reallocation of resources. In emergencies, the “grid” (data center with Intelligent Orchestrator (or competitive equivalent) could redistribute computing resources globally. But the challenge of dynamic global provisioning will remain daunting.

Pricing Challenges.

Tools for insourcing present challenges for the vendor. If the price of the tool is too attractive, the tool will sell and the services will not. If the tool is too expensive, outsourced services might be preferred, but only where the customer has no alternative. And by promoting tools, the vendor might cannibalize revenue from services, and vice versa. Pricing could be in the form of per-seat, per user, global site license, or site license by some other “line of business” demarcation.

Legal Issues in Dynamic Provisioning of Computing and Telecom Resources.
When we look at dynamic, rules-based provisioning of resources across international boundaries, we must remember that data transfers across borders remain subject to local legal controls. These include:

• data protection laws.
• privacy laws.
• export controls on military data or “dual use” civilian-military processes.
• license restrictions on authorized use.
• infringement indemnifications that may be territorially restricted.
• force majeure risks.

Transitioning from Software Licensing to Outsourcing.

Generally, a contract for a software license does not change when the parties enter into an outsourcing relationship. But customers should consider what changes should be made when this occurs, and what risks and assumptions have changed by virtue of the transition. By gaining the customer’s trust through a software tool, the vendor can thereby convert the customer to an outsourcing customer quickly, almost immediately. “Just sign here.”

We believe, in such cases, there could be significant business issues that need to be reflected in an appropriate contractual document. We recommend that an outsourcing lawyer be consulted in such circumstances.

More Information.

Bierce & Kenerson, P.C. does not provide any of the tools described above. However, we may be able to identify or comment on legal and practical issues of tools that may be of interest to the IT and technology-enabled services community. Please let us know if you have any questions about our experiences with particular vendors.

• Publisher’s Blog

  Visit our publisher's blog, Bierce on Business, for commentary on current events.
  
  Registered Users
  We are currently not accepting new registrations, but existing users can still log in.