Myriad contractual considerations exist when striking up a deal. Here’s a look at items that must be included in the agreement and things to avoid.
As we look forward to a new year of HR outsourcing, it is helpful to take a look at lessons learned from recent experience. In this article, we consider what to look for in an HR service provider, major contract terms and common mistakes in the process of contract development.
Evaluation of prospective service providers starts with the internal assessment of readiness for outsourcing of one or more HR processes. These processes range from simple payroll to recruitment processing, human capital management through tracking and training programs, to medical benefits and tax-sheltered programs such as ERISA plans, life insurance, and tracking of contributions to 529 college investment programs and management of 1099 independent contractors.
The roles and responsibilities for multiple HR functions involve important issues of compliance with regulatory, pension, employment and tax laws, employer liability, and fiduciary duty. Each outsourced process therefore requires special attention to address the particular requirements of applicable laws, regulations, taxes, and retirement and group plans. Here, then, are the attributes of an ideal HRO service provider:
• Cultural fit;
• Value-added relationship;
• Track record;
• Smooth transitioning; and
• Financial stability.
• Cultural Fit. Management gurus refer to a business culture as the unstated assumptions that define the commercial and human capital components of one’s business. In business process outsourcing (BPO), culture serves a vital function that is similar to a country’s constitution. As an unspoken but commonly agreed upon set of grand principles, culture, like a constitution, provides a common reference for filling gaps in the written contract.
Lawyers like to include a clause merging all verbal and written communications into the agreement. As a practical matter, we know that there is a field of what is a “commercially reasonable” interpretation and implementation of contractual wording. By establishing boundaries to this field, “culture” is vital to helping smooth communications, anticipate and resolve relationship problems, and plan for future changes.
Culture clashes can kill a perfectly “normal” outsourcing deal. One type of culture clash occurs where the enterprise customer has a culture of cherry picking its vendors on a best-of-breed basis. This culture clash is predictable where the service provider’s culture is involved in selective engagements with a limited number of customers for sourcing a broad range of HR and related finance and accounting processes.
A second form of culture shock can erupt where the service provider imposes its own methodologies on its customers without preparing the way through executive leadership and training of customer’s end users. As with the implementations of Enterprise Resource Planning (ERP) software, process transformation can be painful and result in abandonment or scaling back of important changes.
A third kind of culture class occurs when the enterprise expects the service provider to do all of the transitional planning and the enterprise does not know about the level of change that will occur. This can arise from inadequate due diligence by either side.
A fourth kind of culture clash can arise from a stressful price negotiation. I have participated in one multinational HR outsourcing deal where the customer squeezed the service provider so tightly the president of the service provider vowed to make sure the customer paid for every minor change.
This leads to the question of whether the culture is one of “partnership” or simple “sourcing.” When I started in this business, service providers always shocked me when they started contract negotiations with a word about “strategic partnership” or “partnering.” My shock comes from the legal rule that partnering involves a fiduciary duty for the service provider to put one’s partner’s interests ahead of one’s own. If there is no mutuality of commitment, if the pricing is lopsided and does not allow for some profit for the provider, if the customer expects the provider to do everything and they have failed to set up a “roles and responsibilities” matrix, the parties will be in constant culture shock and petty clashes until renegotiation time.
• Value-added relationship. Every service provider wants to grow its business with the customer. Customers should try to understand where the service provider’s growth will occur: types of service, territory, etc. By gaining an insight into the service provider’s business plan, the customer can determine whether it will likely enjoy the benefits of such growth as the customer’s business evolves.
• Track Record. The past is generally an indication of the future. A vendor’s track record needs to be reviewed with current and past customers. If the vendor’s list of references is used, it will likely include only favorable clients. The prospective customer should understand from disgruntled or former customers what proclivities might make a particular vendor unsuitable for that customer. In due diligence, the enterprise should review this information with the service provider and achieve agreement on how to avoid “past problems.”
• Smooth Transitioning. An uneven transition from the enterprise customer’s existing operations to the newly outsourced operations can be extremely frustrating. A transition that takes too long can lose valuable savings as well as expose the operation to foot-dragging and, worse, by the in-scope employees. A transition that takes too little time risks inadequacies in testing, process modeling, and training. This assumes that the enterprise customer is not also engaging in some form of business process redesign, which transforms the operations. If so, this should be planned for either before or after the transition to the external services. An essential part of the RFP, due diligence and contract negotiation processes should be devoted to risk management in transitions.
• Financial Stability and Global Risk Management. Every service provider has a financial profile. Its financial condition should be adequate to meet the requirements of the services. Where the service provider is an onshore sales entity dependent on an offshore entity for backup or main transaction processing, the enterprise customer should take a holistic view of risk management across the entire global service delivery platform. Financial risks of the offshore operations should be mitigated through audit, insurance, termination, and guarantee clauses.
FIVE KEY CONTRACTUAL TERMS
When putting together the HRO contract, here are the top five key terms:
• Relationship governance;
• Risk allocation (limitation of liability, indemnification);
• Scope; and
• Compliance with law.
• Relationship Governance. Litigation does happen. In one famous case, a service provider sued the customer in Illinois for breach, claiming the right to sue for an injunction. This took the dispute out of the arbitration procedure. The exception engulfed the rule. The result was an embarrassment to the enterprise customer, though the provider also shared in the negative perception of the public view.
Outsourcing has been compared with a marriage. It could also be compared with the team-building process. Each requires some parameters and sometimes some coaching by committed, disinterested “responsible” professionals to ensure that the team agrees on basic concepts, strategies, and processes. This requires constant monitoring and measurement of performance (a job that can be done by software) as well as expectations and the need to deal with changes in laws or the enterprise customer’s business operations (such as mergers, divestitures, and restructuring).
Establishing rules for dispute resolution is an essential process of “relationship governance.” This includes escalation of disputes to senior managers and arbitration.
But to avoid disputes or channel energies that might derail a dispute resolution, it is more important to set up channels of communication. Some outsourcing consultants even provide software that allows for identifying gaps between expectations and reality, and for resolution of either the expectation (desires) or the reality (failures in performance). The point is that some institutionalization of the relationship is needed to ensure its viability, and relationship governance tools are critical to continuing the “steady state” operations with minimal friction.
Relationship governance starts in contract negotiations. In one HR and finance and accounting outsourcing transaction that was signed in 2006, the enterprise customer’s external law firm used its standard 130-page, 10-point form to elicit a comparison of competitive responses by the two down-selected service providers. The preferred service provider decided to walk away from the deal because the contracting process started out with a boilerplate contract that did not address the particular deal structure that the parties had discussed in the sales phase. The service provider quit before getting out of the starting gate because of the oppressive first draft and its negative prior experience with the customer’s external law firm in getting it to a commercially acceptable allocation of risks.
In that case, the second service provider got the deal. But the result was not as ideal for the enterprise customer because it still had to negotiate away all irrelevant deal terms and the related ancillary text, as well as add special terms that related to the deal. In short, better anticipation of “relationship governance” issues could have secured a commitment from the preferred provider and would have at least avoided wasted negotiations.
• Termination. Termination rights are essential tools for managing the relationship. Termination sets the framework for a renegotiation, transition to a new supplier (“re-sourcing”), or in-sourcing. Termination is always painful because it requires further transition and extra effort.
The threat of termination can be used to obtain a realignment of an old contract to new business conditions. Terminations can occur for cause, for convenience, for changes in control of an enterprise that are likely to impact the relationship, and for other reasons. Since termination affects the service provider’s ROI for its service delivery platform, which reflects a capital commitment, terminations may result in special payments. The costs of unwinding the agreement need to be identified and allocated up front.
• Risk Allocation (Limitation of Liability, Indemnification). Some of the most difficult negotiations relate to the allocation of risks. For each party, there are some risks for which the other party should be liable without limitation. Such risks address core business viability considerations such as confidentiality, legal compliance, fraud, and the like. Other risks—such as force majeure and failure to meet SLAs—will need to be limited. Whenever there is some unlimited liability, the party agreeing to indemnify for a covered loss will need to be very specific about the conditions of payment. In that sense, outsourcing contracts have all the drama of negotiating a unique insurance policy to cover operational losses.
Risks can be poorly allocated by adopting a multiple contract structure with unclear allocation of responsibilities. For example, a global company that delivered liquefied natural gas agreed to use such a structure for the development of new software that would restructure its home-grown operations. The software developer would then host and maintain such software and provide transactional support. The software was late and over budget, and the company terminated the deal. Surprisingly, the service provider claimed that the delays were the customer’s fault. Only after litigation did the customer get its legal reprieve.
• Scope. Most HR outsourcing is done in a best-of-breed manner, with multiple services managed by multiple vendors. This approach can create a web of confusion because each vendor needs to access the customer’s databases for different reasons. For smaller enterprise customers, this approach can result in proliferation of databases and related software programs. ERP software, which centralizes databases on one platform enhanced by perhaps some customization or add-ons, can help bring order out of chaos. Whatever the
strategy, defining the scope of services to be outsourced should be part of an overall institutional plan for data management, data accessing, data mining, and data storage.
• Compliance with Law. The typical outsourcing contract requires each party to comply with all applicable laws. This approach creates confusion in which both parties may be jointly and severally liable, where pricing reflects an existing legal and tax structure that could change overnight, or where non-compliance might be due to a lack of communication or a rogue employee. Changes in law in the jurisdiction where the services are performed could impair the rights of the enterprise customer in its home jurisdiction. All this leads to challenges in drafting a commercially reasonable contract.
SIX COMMON MISTAKES
In the contract development process, companies often make mistakes in the following six areas:
• Knowledge process management;
• Continuous improvement;
• Excessive complexity in SLA management and dispute resolution;
• Insufficient flexibility;
• One-sided deal; and
• Partner selection.
• Knowledge Process Management. HRO has come a long way since simple payroll processing. At the highest levels, HR service providers offer the skills of highly educated individuals, using proprietary and generic software to develop individualized financial planning strategies based on the enterprise customer’s profiles in HR, legal and financial risks, and market factors. At the lowest levels, HR service providers may simply be doing highly repetitive tasks that involve conversion of paper to digital data—testing and processing of data for medical claims, for example.
HRO has the capacity to create a more flexible business enterprise through greater definition of “implicit” knowledge and translation into process and procedure manuals. Process-driven auditors have forced enterprises to make all HR (and other) processes more “auditable.” Failure to require process definition, auditing, and control will land the enterprise in hot water with regulators. The “common mistake” element in such knowledge management matters often comes not from the contract but from the failure to administer the contract.
For example, recruitment process outsourcing (RPO) offers the HR director a chance to offload the repetitive time-consuming work of identifying, qualifying, interviewing, and testing candidates for jobs. The knowledge base associated with recruitment processing might be a valuable asset to the employer because it includes its unique job requirements that, in turn, may contain competitive advantage for optimizing the candidate’s fit into the enterprise. That knowledge base needs to be identified and updated by the employer and used to drive the RPO services of the service provider.
• Continuous Improvement. Another common mistake is a lack of mutual understanding on continuous improvement. Most long-term contracts prevent the enterprise customer from renegotiating the scope and SLAs, except as part of “change management” that involves the service provider’s negotiated consent. Outsourcing lawyers expect the provider to continuously improve the quality of its performance over time without being asked. Such clauses can be difficult to enforce, but they are important to set the framework for later discussions if the provider has made no investment in process improvement and the lack of investment has prevented the customer from getting a better result. Of course, the service provider typically views this from the standpoint of committing capital investment. The parties need to understand and have consensus on the degree to which such capital investment will be required and paid for as part of the pricing.
• Excessive Complexity in SLA Management and Dispute Resolution. Another common mistake involves the design of SLAs and pricing adjustments for insufficient performance. Most major HRO outsourcing contracts have key performance indicators that become service level agreements. To promote ideal performance, the enterprise might set up several SLAs that are either similar or overlapping. If the pricing structure requires adjustments for failures across similar SLAs, the only result is to increase the penalties, not necessarily to increase the quality of service. Careful planning must be done to avoid such problems and perhaps even to create incentives for truly exemplary performance.
• Insufficient Flexibility. Some enterprise customers make mistakes relating to their future needs for flexibility. Outsourcing is based on the notion that repetitive tasks can be performed more cost-effectively and with greater quality when performed by a provider that dedicates capital and ongoing management efforts to those tasks. This notion can conflict with the need of the enterprise customer to gain flexibility in scope, volumes of services, territorial coverage, compliance with changing laws, and business models. Modern outsourcing contracts need to address all these issues, which will be reflected in the pricing structure. Failure to give adequate flexibility can result in needless conflict.
• One-Sided Deal. One of my axioms about “truth in outsourcing” is that the customer sometimes fools itself. The one-sided deal is “too good to be true.” I have seen deals that became one-sided when the customer decided to restructure the pricing mid-stream in negotiations or when the pricing structure was incompatible with the allocation of commercial risks.
For example, one deal based on per-employee charges to cover recruitment, payroll, and benefits processing in several countries originally called for a global pricing structure. But the enterprise customer discovered that local country managers wanted no part of any outsourcing if the pricing was not competitive on a local basis. At the enterprise level, cross-subsidization was important to entice the provider to handle the cats and dogs at a fixed fee, but the local country managers revolted. The resulting one-sided deal gave the provider no profits for two years, and eventually the deal folded because one country manager refused to play in the arena. The deal wound up being unraveled before the end of transition, with the customer paying a substantial termination fee to walk away. This case shows the importance not only of keeping the deal “commercially reasonable,” but also in providing appropriate global incentives and controls to all stakeholders.
• Partner Selection. Dancing with the wrong partner can cause a stumble. Selection of the wrong outsourcing partner—or using a “wrong” partner as a finalist in the down-selection process—can require total overhaul of the deal and a new vendor selection process. One major global enterprise negotiated with two U.S. publicly traded service providers a few years ago for a combination of HRO and finance and accounting. One of the providers faced accounting restatements. The other refused to accept the enterprise customer’s conditions. The outcome was a bifurcation of scope into smaller, more manageable silos serviced by three different providers who were told to work together.
Effective HRO requires careful planning and administration. Common errors can arise from many causes. There might be an insufficient analysis of the management responsibilities for retained functions or retained administrative responsibilities. The contract might not contain sufficient flexibility or clarity to cover future needs. The provider’s culture might not fit with that of the enterprise customer. Global planning and effective communications of needs, requirements, and expectations are an integral part of an effective HRO program.