Legal Eye: Outsourcing through the credit crunch

As the economy heads into recession, it's time to delve into the legal implications of the downturn on outsourcing contracts. Lawyer Kit Burden offers a primer.

Will the economic crisis act as a blocker or driver of outsourcing activity? So far it's unclear but with many businesses looking to drive economies of scale wherever they can, the issue of how and where IT budgets are spent has never been under closer scrutiny.

While everyone waits for the economy to stabilise, changes to how business is being outsourced and contracted are already in progress. So just what are the immediate legal and contractual implications of the credit crunch and could they well outlast the crisis itself?

The cost of cost-cutting
Obviously, as revenues drop and budgets are squeezed, the overwhelming focus for 2009 will be on cost control, both in relation to existing contracts and new projects.

For existing contracts, customers will be going over their provisions with a fine-toothed comb to see what can be done to reduce or limit costs going forward. The benchmarking provisions commonly found in outsourcing contracts are an obvious example but of equal relevance will be unitary/transaction-based pricing regimes, whereby costs can be reduced if ways can be found to lessen demand.

Key issues

1. Keeping outsourcing effective: short term cost cutting vs long term strategic delivery

2. The IT challenge of rapid mergers and acquisitions

3. Regulatory overload: tackling the bureaucratic legacy of the credit crunch

Similarly, many customers may begin to review their rights of termination, either to prompt an actual move to a lower cost provider, or simply to threaten a move to leverage better pricing from an incumbent supplier.

For new projects, it goes without saying that customers will be looking to strike as solid a deal as possible. On the one hand clients will be more conservative and keen to ensure the solvency and financial status of their partners. We are already seeing increasing demands for front-loaded payments and rights to suspend/terminate in the event of even relatively short periods of non- or late payment.

On the other hand, in their quest for smaller prices now, many clients may risk paying a higher financial and strategic cost in the long term.

Some may be tempted to take on additional contract risk by accepting lower limits of liability or lower service credit caps leaving themselves exposed. There is also a concern that cost-cutting becomes corner-cutting with customers opting for short-term savings only to experience serious project failures further down the line.

The challenge of integration
The major and rapid consolidation of the financial services sector has seen deals consummated in a matter of days, if not hours. This often means integrating IT infrastructure and sourcing strategies are overlooked initially - and only addressed once the deal is sealed.

But this integration is rarely straightforward. For example, if there are different contracts covering the same service for both the acquirer and the acquired, which apply to the entire corporate group? And which one is to be used? Likewise, if there are two contracts now in place for use with the same supplier, which one gets used?

Worst case scenario may well see a recently negotiated, costly contract be superseded by an 'inherited' contract that is found to offer better terms. In those instances, the termination provisions will require careful scrutiny in order to work out whether an early exit is possible as of right, or will need to be negotiated.

Son of Sarbox?
One thing is for certain: once the regulators are able to catch their breath and start to take stock, a change of approach in terms of the degree and aggressiveness of regulation is inevitable. Sarbanes-Oxley may come to be seen as a gentle precursor to 'real' official oversight.

What will this mean for contract drafters and negotiators? Well, the likely influx of new regulation could have far-reaching effects for both current and new contracts. The extent of reporting and audit obligations - already in the spotlight following Sarbanes-Oxley and (for financial services entities) Basel II and MiFID - will clearly be bolstered further, with potential requirements to report on broader issues of risk, whether or not they have yet begun to impact upon the contracted service.

Regulators may also seek additional rights of intervention for themselves and their agents. For contracts signed up before the current crisis took hold, the parties will need to look back at the change control with law provisions to work out which of them will have to bear the cost of first assessing and then implementing the necessary changes.

More generally, companies will have to consider any new regulatory and legislative requirements carefully, and analyse what impact they have on their existing systems and procedures. Even if there appears to be a good fit, there will likely still be a pressure to be seen to be 'doing something', however superficial in practice.

Avoid short-termism
Both directly and indirectly, the credit crunch has already made an indelible impression on outsourcing contracts and while it has certainly helped drive competition and cost-efficiencies there is a danger that rapid consolidation and growing financial pressures breed a short-termist attitude from which we never recover.

At a time when any spend should be made wisely, we can ill afford to make outsourcing contracts less structured and strategically relevant - a collective temptation that clients and contractors alike need to avoid.

Kit Burden is a partner in the technology, media and commercial group at law firm DLA Piper.