Outsourcing Contracting Complexity: Most Challenging Terms and Conditions
Stan Lepeak, Managing Director, EquaTerra Global Research
Thomas Hall, Managing Director, EquaTerra Contract Negotiations Advisory
On March 5, 2010, EquaTerra released the inaugural edition of its legal Pulse survey, the newest iteration of the Pulse survey research program. The legal Pulse is similar to EquaTerra’s long-standing global service provider/advisor Pulse in that it examines trends and futures in the global outsourcing market, but it is more focused on specific topics and themes – including contract complexity, deal terms and conditions and negotiating contentiousness – that are best addressed by legal counsel supporting outsourcing deals.
A prior blog presented study findings on which classes of outsourcing service providers are the most contentious to deal with during the contract negotiation process. This blog will review which legal and commercial contractual terms and conditions the polled lawyers view as the most challenging to negotiate.
Negotiating contracts for large, and not so large, outsourcing efforts is an inherently complicated and complex process. While there are factors that can lessen or limit complexity, such as greater contract terms standardization, there was consensus among survey respondents that contracting is becoming more complex. Fifty-two percent of legal counsel polled indicated they have seen greater contracting complexity over the past few quarters while just four percent have seen less.
Contracting complexity is not necessarily a bad thing, particularly if it is required to address greater complexity introduced into outsourcing efforts such as more comprehensive deals or the increased use of global service deliver y models. The key is for buyers to anticipate the complexity and have the skills and resources to adequately manage it. To this end, it is important to understand which legal and contractual terms are typically more complex to negotiate. The figure below illustrates the top five ranked most challenging legal and commercial contract terms to negotiate, per survey respondents.
The two most challenging legal terms identified are limitation of liability and supplier financial risk. In some cases these terms have become even more onerous to negotiate due to current challenging economic market conditions. While buyers should press for the most favorable conditions in a negotiations effort, they and their negotiating teams must be realistic in what they seek from service providers. Address supplier financial risk is important and can prove contentious but is more straightforward than addressing limitation of liability. Here are some of our thoughts on limitation of liability.
Theoretically, limitation of liability in a commercial context should fall within a range of the service provider’s expected net margin to its expected gross margin. Any less and the service provider can make money despite massive failure; any more and the service provider is insuring the client by putting its own assets at risk.
There are numerous factors and caveats appropriate for limitation of liability negotiations. These include nature of acts (e.g., contract breach, negligence, gross negligence, abandonment, malicious intent and malicious intent of employee), nature of damage (e.g., failure of critical systems, loss of personal information), insurance requirements and standards of conduct. These factors may justify higher or even uncapped limitation of liability under specific circumstances.
Limitation of liability in contracts for outsourced services is typically expressed as a number of months of revenue under the contract. Applying the math to expected margins, and subject to the caveats above, tier one service providers in commercial markets typically limit liability from nine to 18 months of revenue for a five to seven year deal. In the public sector, services were historically provided pursuant to unlimited liability. While this is no longer standard practice, limitation of liability tends to remain higher in the public sector, typically 18 to 24 months revenue for a five to seven year deal. Further, federal and state legal requirements may prohibit limitation of liability in the procurement of some services.
Buyers of outsourced services must balance their business case goals with the practical likelihood of negotiating them into a contract. Buyers must work closely with internal legal counsel and procurement groups experienced with outsourcing, and should bring in third-party legal counsel and commercial sourcing advisors for current market expertise as appropriate. Many great outsourcing ambitions do not make it to fruition because of an inability to contract for them – though in some cases this is just as well.
Leave a Reply