Concluding an HR services agreement poses many timing risks. Let’s call it the “dating game.
Contract development starts with the selection process and ends with the effective date of the contract. This article focuses on the latter. The dating problem arises when businesses enter into outsourcing transactions remotely. Whenever there is no mutually signed agreement, CFOs, CEOs, and LOB managers have potential liability for accounting missteps.
The contract “effective date” is typically defined as the date when the HR services agreement is signed. The “dating game” has many implications for corporate governance, financial accounting, disclosures to shareholders, revenue recognition, taxation, employee relations, and plain-old strategic timing. HRO practitioners need to focus on the clock as well as clock speed. Look-backs, signatures on “the morning after,” and “agreements to agree” can be trouble.
At the end of 2005, several of our clients faced difficulties in the dating game. In two deals, the employer (enterprise customer) signed the HRO deal in December 2005, but the HR services provider signed in January 2006. In each case, the service provider began the transition services in December and was entitled to be paid for those services. One provider invoiced the employer in December, the other submitted its invoice in January.
In a “look-back” situation in January, one of the employers later requested the service provider delay the “effective date” until January, when the employer signed the contract. In this situation, the service provider pushed back and kept the effective date in December.
In a second situation, the “dating game” was more quixotic. Let’s call it the “morning after agreement.” Both signed in January. Executives on each side had exchanged e-mails indicating their intent to enter into the agreement. Implied in this exchange was the understanding that without final approval under internal corporate governance principles, the deal still could be cancelled. In January, the employer advised that the documents had to be reviewed by senior executives responsible for risk management and indemnities. In this case, the enterprise customer booked the deal in December and, in early January, was under extreme pressure from its CFO to sign or cancel. In addition, it had announced the deal to its employees in December, in context of the 60-day window under the WARN Act to enable a smooth transition by March 1. Yet, by early February, there was no internal approval by the risk managers and chief administrative officer.
A third case involves multi-silo outsourcing in which the parties wanted the deal signed in December, but statements of work were not completed until the next year. In this “agreement to agree,” the contract was valid because it specified obligations. These year-end deals presented several questions. Can an accrual-basis employer “book” the expense for financial accounting purposes if neither party had signed the definitive agreements by the end of the calendar (or fiscal) year? What if only the service provider had signed in December, and the employer signed in January? What if neither had signed a clearly definitive agreement?
If a party books a transaction without complying with financial accounting rules, it is subject to claims that it manipulated revenues or expenses. For large enterprises, this isn’t a problem if the size of the HRO contract is not material. However, if some major operational risk is ceded to the service provider, the employer might consider a financial disclosure.
Interpreting financial accounting rules for securities law enforcement, the SEC’s staff deems revenue to be realized or realizable and earned when all the following are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the seller’s price to the buyer is fixed or determinable and (iv) collectibility is reasonably assured. Even with a signed agreement, the deal could be undone by a side deal.
For corporate governance, all necessary corporate approvals need to have been obtained. Officers need to be duly authorized to act in the scope of their authority. All internal and external events necessary to finalize the obligations need to have been satisfied for accrual under financial accounting.
The service provider might want to exclude conditions (walk-away rights) subsequent to protect revenue recognition. The parties should avoid whipsawing potentially inconsistent tax accounting practices. Employees must be notified of layoffs and plant closings at least 60 days beforehand. Most importantly, plain-old strategic timing suggests that parties agree on their goals and pursue and complete the deal so neither has to unwind, backtrack, restate earnings (or net earnings), renegotiate, reopen, or revisit the deal.