Canada: Outsourcing: from a Legal Perspective

Last Updated: July 26 2002
Article by Christopher Koressis
14 CANADIAN Treasurer FEBRUARY / MARCH 2002

In the August/September 2001 issue of Canadian Treasurer, the author looked at the reasons why companies outsource their information technology functions and how to solicit bids from organizations interested in supplying services. This article takes a further look at the outsourcing question.

Many companies look at outsourcing a business or technology function as an alternative way to provide the service. The company contracts with an outside supplier to provide the same results as it formerly provided in-house.

However, from a legal perspective, it may be best to look at outsourcing as being much like selling off a part of an organization - with the option to buy it back in future. Seeing outsourcing in this way helps to clarify some of the legal and practical issues involved.

In this article, we will look primarily at outsourcing an Information Technology function that involves computer equipment and software. This is one of the areas that companies most commonly outsource. However, the principles discussed in this article can apply equally well to outsourcing areas such as pension-plan administration, in-vestment management and other elements of cash and treasury management.

Consider the similarities between a conventional sale and an outsourcing arrangement for two companies, Able Manufacturing Co. and Baker IT Services Inc.:

  • In both a sale and an outsourcing agreement, Able takes a standalone function (in this case, IT services) that was previously administered in-house and transfers the performance of the function to a third party.
  • Both generally involve the transfer of Able’s assets such as computers, peripherals, networks and supplies to Baker. They may also involve transfer of employees to Baker.

However, there are also differences:

  • In an outsourcing relationship, the sale is generally only temporary and lasts only for the term of the agreement. At the end of that time, Able may either decide to take the division back (i.e. not renew the agreement), sell it to another company (i.e. find another outsourcing partner) or re-sell it to Baker (i.e. continue the outsourcing agreement). Of course, Baker may also want to make some changes to the relation-ship when it comes up for renewal.
  • There is a much closer ongoing relationship between Able and Baker than there would be between Able and an outright purchaser of the division. The two companies must work closely together, and they share an interest in making Able’s IT functions work smoothly. However, in almost every other respect there is the potential for a win/lose, zero-sum dynamic.

Given this potential for conflict in an outsourcing agreement, the participants can resemble a married couple sharing a bed, with both spouses wanting all the covers.

The potential for conflict begins right from the start of negotiations, regarding the duration of the contract. Baker will likely want a long-term agreement, because it will likely lose money in the first part as it learns how to work with Able, and it will want as long a time as possible in which it can achieve profitability on the contract.

For its part, Able will likely want to keep Baker on a short leash. Partly, this is because Able knows that, at the end of the outsourcing agreement, it may be difficult to re-start its own in-house IT division. Having a short agreement will make this more feasible, increasing its bargaining leverage with Baker.

Another issue at the start of the agreement is Able’s computer equipment. Able may want Baker to buy some of its assets for a healthy sum, while Baker’s aim may be to avoid taking any of Able’s equipment, so it can do the work on its own equipment, set up to meet its specifications and procedures. It may consider Able’s equipment to be obsolete and question the compatibility of Able’s equipment with its own. Moreover, Baker may use this issue as a bargaining lever to get better terms from Able.

Along with the hardware comes software. Often, a company such as Able will have perpetual or multi-year licences with software vendors, which specify the number of users and how the software is to be used. The software provider may not be enthusiastic about transferring the software to Baker, because it will likely lose revenue from on-going support and maintenance fees payable by Able. Moreover, Baker may already have an enterprise licence to use the vendor’s software as an outsourcer. In that case, the software vendor loses Able as a customer and gets little or no incremental revenue from Baker. Baker may not even use the vendor’s software and will not want to pick up the licences even if it could. As a result, the software licences that Able paid for may become useless, and Able will not receive full benefit from its investment in them.

In addition to computer equipment and software, Able and Baker also have to consider the issue of personnel. Able’s people carry with them an invaluable inside perspective on how Able works. They can be vital to the success of the outsourcing project, particularly in its early stages, when Baker is still learning the ropes. For this reason Baker may be as motivated as Able for at least some of Able’s employees to receive a soft landing at Baker – with good jobs, at comparable seniority and benefits.

However, here, too, there is potential for conflict. Baker may be willing to take some Able employees, but at a lower rate of pay (which may be part of the reason they can offer the service cheaper than Able could do it in-house) and only if they pass a probationary period. Baker will almost certainly not want to take all of Able’s IT employees, as it has its own workforce to keep productively employed.

As the end of the agreement nears, another staffing issue rears its head. What happens if Able wants to take the function back in-house? How will the former Able employees react, having worked for several years at Baker and perhaps now considering themselves Baker employees? Will they want to come back to Able? And what if Baker offers inducements for them to stay at Baker? The two parties will need to settle this question ahead of time and cover this in the contract.

They will also need to agree in advance on levels of service, another source of potential conflict. Able will want strict covenants regarding reliability of service, and Baker may feel that such requirements are impractical and unnecessary.

Given these potential conflicts, is it possible to turn the dynamic of the out-sourcing relationship around, so it be-comes not win/lose, but win/win?

One way is to have not just penalties for the IT supplier’s failure to meet specified service levels, but incentives for exceeding them. To do this, it is important for Able to benchmark the service levels it can achieve in-house on its own with-out engaging Baker. These service levels can then be compared to the results achieved by Baker, the IT specialist.

A third-party performance auditor may well serve a useful function in this area - a company with credibility on both sides of the agreement, able to measure and report on service levels.

Having a legal framework that discusses issues such as this is also important. This agreement must take note of potential sources of conflict and indicate how to deal with these, ahead of time. This will not only allow both parties to evaluate whether they want to go ahead with the deal, it will also help them solve issues as they occur.

The result of a good outsourced IT function is better service, reassurance for the company receiving the service, and lower costs.

Christopher Koressis, LL.B., is a partner with Fogler, Rubinoff LLP, a Toronto law firm, who specializes in business law, including information technology and outsourcing initiatives. He can be reached at 416-941-8807 or 416-720- 1624 (ckoressis@foglerubinoff.com).

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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