Outsourcing Agreements: the Legal Implications

by Kidd Rapinet on February 29, 2008

Outsourcing is an arrangement by which an organisation in the public or private sector (the “Customer”) contracts out to a third party supplier of services (the “Supplier”) the provision of a business activity or function that typically is ancillary to the Customer’s main operation. The purpose is to reduce costs and to enable the Customer to focus on its core activities.

Typically the process starts with a competitive tendering exercise, in order to obtain the most competitive price and other terms and facilitate comparison of quotations from different suppliers. Legal involvement is advisable from the beginning of the tendering process, in order to ensure that a level playing field is maintained and to help ensure that bids conform to the Customer’s terms so far as possible.

Once a bid has been successful, the legal documentation typically involves an Assets Transfer Agreement, by which the assets and possibly staff that were previously used to provide the outsourced function in-house are transferred to the Supplier, and a Services Agreement, by which the Supplier agrees to supply the outsourced services back to the Customer.

The Assets Transfer Agreement will be similar to the form used on an arms’-length sale of a business to a third party, but, depending on the particular transaction, will not normally be so extensive. The consideration payable may not be substantial and the Customer will be reluctant to give extensive warranties concerning the assets. However, this will depend on the nature of the particular transaction. For example a privatisation of a public service may be approached more along the lines of an acquisition than will an outsourcing of an IT Department. The Supplier will need to consider whether to undertake due diligence.

The document that requires particular care (on the part of the Customer and the Supplier as well as by their solicitors) is the Services Agreement. Key issues to consider here are:

  • Defining a statement of services requirements (“SOSR”) with as much specificity as possible, both in the overall description of the scope of the services and in the detail of how they are to be provided and the levels of service to be achieved. The SOSR should form part of the invitation to tender and will eventually become a schedule to the Services Agreement. It is vital that both parties have as clear an understanding as possible of what is expected, so that tenders can be costed accurately and the scope for disputes minimised.
  • Risk allocation is a key issue in drafting. The first step in dealing with this is to agree the detail in the SOSR as to the levels of service to be provided. It will then be necessary to agree the financial consequences of any failure to meet those levels of service and to agree who bears the risk of events which are under neither party’s control.
  • The Transfer of Undertakings (Protection of Employment) Regulations 2006 (“TUPE”) have a major impact in this area. TUPE provide that on a “relevant transfer” (which includes a service provision change) the contracts of employment of persons employed in that undertaking automatically transfer to the transferee, together with all related liabilities, require consultation with those employees and render any dismissals connected with the transfer automatically unfair unless for an economic, technical or organisational reason unconnected with the transfer. It is not easy to determine how far TUPE will apply to many outsourcing arrangements. The Customer may wish to retain staff previously involved in the outsourced function, or may expect the Supplier to take over responsibility for them. The Supplier will need to factor the implications of TUPE into any bid. TUPE will again be relevant on a future change of Supplier. This is an area where legal advice is particularly needed.
  • Inevitably the nature of the outsourced function, the Customer’s requirements for it and the means of providing it will be liable to change over the expected life of the Agreement. A mechanism needs to be built into the Agreement for managing post-contract change. This will involve an element of co-operation between the parties in negotiating revised terms and pricing that will be impossible to provide for fully in the original Agreement.
  • The procedure for dispute resolution or avoidance also needs to be considered carefully. The parties will be entering into an ongoing business relationship over a period of time, and from the Customer’s point of view it may be entrusting the Supplier with a function that is key to its business. A bitter or protracted dispute could be disastrous. Mechanisms for mediation, expert determination or alternative dispute resolution should therefore be considered in preference to litigation or arbitration.
  • Finally, an exit strategy needs to be considered. The Customer does not want to become so tied in with the Supplier that it cannot re-tender on the expiry of the initial term, or it may decide in future to take the outsourced function back in-house. The Services Agreement may be terminated prematurely due to the breach or insolvency of one party. What then happens to the transferred assets and staff? How is the service to continue to be provided whilst the Customer arranges for a new supplier?

As can be seen, a number of these issues will require close co-operation between both parties and their solicitors during the tendering and drafting process in order to ensure a successful outsourcing arrangement that is profitable for both Customer and Supplier.