Re-assessing Outsourcing Strategies in a Recession

Duncan Pithouse, Partner, DLA Piper forecasts current trends on contract agreements between customers and suppliers.

SSON: How has the current economic climate impacted sourcing agreements between customers and their suppliers?

Duncan Pithouse: Financial health of suppliers has obviously always been important all the time on the basis that you are making sure that you are contracting with an entity that is obviously going to be around to provide the services to you. Obviously with the difficulties that some of the top suppliers have got into, like Satyam, for example - the sensitivity for the customer has been increased quite significantly. We are building for our customers and talking to our own clients who are the buyers of the services about the additional rights that they can look for in their contracts to protect them a little bit more.

I think also, a lot of buying institutions; you know a lot of financial institutions in particularly, which were big buyers and are big buyers of outsourced services have struggled recently. We have seen the likes of Lehmann Brothers effectively collapse. There has been an increased sensitivity across the market place as to the financial health of all the participants to ensure that everybody is protected. What would be very interesting would be, is to look at some investment banks outsourcing contracts where they allowed the supplier to terminate contracts due to the insolvency of investment banks on the premise, I am sure, that it would never happen! So they thought it was an easy give in the negotiations and I guess for some of them, it is coming back to bite them. And for the likes of the Lehmann Brothers who probably needed to maintain the continuity of some of their outsourced services to give them a chance for selling the business – that was probably a big concern for them in assessing what the situation really was on the ground.

SSON: So what has happened with cases like Lehmann Brothers? How do you think their supplier contract was compensated?

Duncan Pithouse: Well it depends; if the supplier had the right to terminate, which really in an outsourcing contract they have very limited rights to terminate, it is normally limited to non-payment of fees on a system basis. But if the supplier has the right to terminate and can terminate, the supplier has to make the decision of ‘is it better for me to terminate and cut off any revenue stream if I am getting one,’ because of course
you won’t want to spend money, not recover it or is it better to work it through to try an improve its position in negotiation, so as to at least to get some revenue out of the contract.

So if I was the supplier in that situation and had the ability to terminate because the customer was going bust, effectively, then you would have to try and understand,  whether it was worth trying to continue  and was there  any revenue to be had out of the contract. And consider going to the customer and trying to negotiate preferential credit terms or payment terms, payments on account, so that you  as the supplier protected and not going to end up out of pocket because of non-payment of fees.

SSON: So do you think the customer has more leverage to negotiate than say this time last year?

Duncan Pithouse:Yes, I think that is definitely where the market is going. The market is moving towards the customer being more definitive and thorough. I hesitate to use the word aggressive, but not far off it, in terms of the knowledge they want in terms of a supplier’s financial health and the rights they want in a contract to be able to exercise in terms of that health. So, both in terms of requirements as to disclosure in terms of financial information, management reports right the way through to more extensive termination rights linked to what are effectively anticipated events. Not even events that have happened, but if the customer thinks that something is going to happen then it will want to exit the contract before it actually does happen to avoid been embroiled in a mess of supplier insolvency, which is a very difficult situation to manage for a customer.

SSON: Is the customer getting a better deal?

Duncan Pithouse: I think they are beginning to negotiate better protection around their contracts in terms of their ability to exit. That is certainly an increase we have seen and it is something that suppliers are beginning to appreciate as more normal now to ask for. Historically, suppliers have been fairly reticent to look behind the veil, so to speak in terms of what actually goes on behind the scenes, but I think there is now a real understanding on suppliers’ behalves to give some visibility, because it is what all customers are asking for.

SSON: I was surprised to hear that negotiation time-scales are now shorter as a result of the economic crisis between the supplier and the customer; what are your views on that?

Duncan Pithouse: I think the position on that is the decision-making process on the customer side is a little bit longer – there is a lot more thought as to whether it is the right thing to do and whether is going to deliver the benefits the customer wants it to deliver. And that is right, because you are entering into 5 year, 7 year, 10 year deals that you need to get right. But once the decision has been made to outsource, our experience recently has been the time that we are given to negotiate the contract is shorter than it has historically has been. And the reason for that is because the rationale for wanting to enter into the outsourcing contract is to achieve cost savings. So the quicker the customer can get the contract in place and start delivering those cost savings, the better for it, particularly when they are running up against cost-saving targets at year-end or half-year or quarter-end.

SSON: On the other flip of the coin, have you seen some customers stop in their tracks in negotiating a contact with a supplier because of the current economic situation?

Duncan Pithouse: Yes definitely. There is obviously always a constant reappraisal of a business case to enter into an outsourcing arrangement from a customer perspective. And the continuing reassessment of that, whether it is going to achieve what it needs to achieve is an issue that crops all the time throughout the decision making process; the procurement process. And yes we have seen very large contracts/ arrangements canned almost days before signature, because the customer didn’t think it was going to reach the benefits it thought it would.

SSON: Duncan in terms of the supplier relationship with the customer, what do you forecast for the next year?

Duncan Pithouse: I think you will see an increased activity in outsourcing. I think that companies and customers who have never really considered outsourcing as a option will begin to consider it as an option as they as they see it can deliver true cost benefits, which will obviously affect the bottom –line on the reducing of the cost base. I think that you will ultimately see some bigger transactions as well as some customers appreciate that the larger the scale of the project the bigger the savings can be achieved. But I also think that you will see bigger shift in the commercial arrangements as well. You might see a shift towards shorter deals to allow customers greater flexibility. I think you will see a greater focus on customer sensitivity around their suppliers. They will want to be able to exit the contracts more easily. They will want to have more of a direct impact and benefit from the cost savings achieved through suppliers on an ongoing basis.

SSON: So will suppliers be affected in this changing environment?

Duncan Pithouse: I think there are real opportunities for suppliers who are able to flexible. I think there are sore real opportunities for bigger organizations who have that critical mass and the business volume and the business model to be able to sustain the requirements that customers want. I think that there is an appreciation within the supplier community of the concerns that customers have - suppliers have the same concerns to some extent and they are being lot more flexible in terms of some if the requirements they are being asked for. I think suppliers will take a more robust approach to risk going forward. I think that they will argue that some of the recompense under the contract doesn’t justify the risk they are being asked to take on. I think that might lead to greater debates over equalization of risk and outsourcing in contracts.

SSON: Do you think protectionism will have a negative effect on outsourcing?

Duncan Pithouse: No, I don’t think it will, particularly in Europe. And the reason for that is we have European laws that relate to the freedom of movement of services and goods so you effectively can’t discriminate against an overseas provider in favour of a local based provider. I think that people are now are of the view that we are part of a wider Europe and see that there are opportunities to outsource to Europe and further  offshore to India without historical ties to India and the historical market there mean that people are very open to it. I don’t think you will see the same degree of protectionism in the UK that is rearing its head in the US.

Duncan Pithouse specializes in non-contentious technology and sourcing matters and focuses on complex international sourcing arrangemnets. He advises on a wide range of sourcing projects relating to business functions and activities such as IT infrastructure, application design, build and support, finance and accouting, HR, procuremnet, pension admin and actuarial services. Duncan advises on all aspects of the contract from the terms and conditions, through to pricing models and service level and credit mechanisms.