Replacing a Service Provider in Midstream: Case Study on Equifax Spin-off, Certegy’s Cancellation of EDS Contract and Hiring of IBM
The termination of a long-term outsourcing contract in midstream, before the normal expiration, requires careful legal and business planning. It may also require payment of a large termination fee. In this case study, we analyze such a case involving the termination of an existing EDS contract and the transitioning to IBM as a new services provider.
Certegy’s Deal with EDS.
Certegy Inc. [NYSE: CEY] is a publicly traded company that provides credit and debit processing, check risk management and check cashing services, and merchant credit processing services to over 6,000 financial institutions, 117,000 retailers and 100 million consumers worldwide. Its 2002 revenue exceeded $1 billion. It was formerly known as Equifax PS, Inc., a subsidiary of Equifax, Inc., which spun off its payment services businesses into what is now called Certegy, as of June 30, 2001.
Under the terms of an agreement apparently entered into before the spin-off, Certegy’s former parent (or Certegy) entered into an agreement with EDS for IT services that was scheduled to expire in 2009. The agreement evidently provided for a termination fee if the customer wished to terminate for convenience.
As part of the spin-off, Equifax, Inc. agreed to deliver Certegy certain information technology services. But that agreement expressly disclaimed any commitment to deliver any contractual service levels. Rather, Equifax agreed only to provide services in a commercially reasonable manner in accordance with any service levels specified on a particular exhibit. The indemnification provisions protected Equifax from claims by Certegy except in case of willful misconduct. The spin-off company had no leverage.
The Fee for Termination for Convenience: Investor’s Perspective
As announced by Certegy on March 21, 2003, Certegy was to record a pre-tax provision of up to $10 million in the first quarter of 2003 for early exit costs associated with severing its existing services agreement with EDS. Certegy’s Chairman, President and CEO, Lee Kennedy, reported that the termination fee was a good investment:
“IBM offers best-in-class computer operations support and has a proven track record with Certegy as a trustworthy business partner. The early exit costs to be recognized in connection with terminating the EDS agreement represent an investment in our future that is projected to generate an internal rate of return of more than 20% over the next ten years.” [Emphasis added.]
Certegy did not announce how it might achieve that 20% internal rate of return or whether that rate applied to the $10 million termination fee or the projected $150 million to be paid to IBM over ten years.
By identifying a projected internal rate of return, Certegy may have begun a dialogue with its investors as to the structure of the deal and the rationale for the midstream change. Materiality of disclosure might become an issue of the projected 20% IRR relating to the $150 million.
Certegy’s Deal with IBM.
In March 2003, Certegy announced a 10-year deal with IBM, with an estimated value of $150 million.
Essentially, Certegy’s focus on the IBM “on demand” services model must have represented a change in one or more essential elements of the scope, pricing, or service delivery methodology. One may speculate that there were material differences between EDS’s and IBM’s deal structures, such as delivery platform, the territorial scope, the pricing structure of the services to be provided by EDS, a change in the actual volumes of services, a change in the bandwidth of upper and lower levels of baseline services volumes for pricing, or all of these circumstances.
Certegy had an existing relationship with IBM. IBM was already providing IT services to Certegy’s United Kingdom and Australia operations. The new deal reportedly “can provide” Certegy with “significant cost savings and future operational flexibility” through IBM’s “on-demand” technology services.
EDS’s spokesman characterized this situation as not a “win” by IBM over EDS, but rather a decision by the customer to extend an existing relationship with IBM to additional territorial scope when EDS signed a deal with one of Certegy’s competitors. The new deal allows Certegy to save money by standardizing on IBM as the sole provider across the world. But the $10 million termination fee is probably not an adequate compensation for EDS’s lost profit remaining during the remaining unexpired term of approximately six years of the contract.
Collaboration with a Competitor.
In its first Form 10-K filing with the Securities and Exchange Commission, Certegy identified EDS as one of its competitors: “The markets for card transaction processing and check risk management services are highly competitive. Our principal competitors include third-party credit and debit card processors, including First Data, TSYS, EDS, and Payment Systems for Credit Unions, third-party software providers, which license their card processing systems to financial institutions and third party processors.” Certegy, Inc. Form 10-K, Fiscal Year ended December 31, 2001.
Termination for Conflict of Interest as a Termination for Convenience.
Customer’s normally do not get any right to terminate an outsourcing services contract merely because the service provider also provides services to a competitor of the customer or because the services provider is, or becomes, a competitor of the customer in any line of business As a general rule, no major service provider will agree to grant any exclusivity rights to its customers. Exceptions do occur, and we would be pleased to consult on the types and circumstances of such exceptions.
Potential Conflicts of Interest as a Factor in Defining Scope.
Indeed, one challenge in identifying the proper scope of services to be outsourced lies in the risk that the outsourcing services provider could become a competitor of the customer’s prime business. Certegy faced this challenge because its core business of credit and check processing approvals requires extensive investment in automation. Similarly, large outsourcing service providers, such as EDS, IBM and CSC, enable such businesses as Certegy to piggyback on the outsourcer’s deep knowledge of the customer’s vertical industry and the outsourcer’s extensive ongoing investment in technology.
Consequently, the enterprise customer’s sole remedy is generally to ensure an exit strategy that defines conditions where the service provider might be considered to have a conflict of interest or special relationship with a competitor. This issue merits careful attention and frank discussions in all phases of outsourcing, including scope definition, selection of the service provider and contracting.
Single Provider vs. Competing Providers.
In this situation, Certegy had adopted a strategy of having two providers of IT services. One argument in favor of such a strategy might be that actual competition is a better than the fictitious competition of the benchmarking process. More likely, this situation probably evolved without such a “grand strategy.”
Hidden Costs to the New Company in a Spin-off: The Vendor’s Renegotiation Dilemma.
An outsourcing service provider in EDS’ position must identify the potential for an unhappy customer to terminate early an existing profitable long-term relationship. In this case, EDS chose not to complain publicly about the loss in service volumes due to the Equifax spin-off of Certegy. One may speculate that the spin-off disrupted the efficiency of a well-established EDS service delivery. The relevant press releases are silent on the disruption of services and the strain on a previously negotiated pricing model that the spin-off caused to EDS. If the contract were being negotiated from scratch today, spin-off transition changes might have been the subject of negotiations.
In theory, the costs of severing the EDS deal and transitioning to IBM could have been paid by Equifax prior to the spin-off. But the availability of EDS services was probably viewed as a benefit, giving Certegy time to operate independently after the spin-off, at least for a time.
Impact of a Spin-off on Design of Outsourcing Contracts.
The termination of the EDS deal appears to reflect a number of changes in the customer’s management perspective.
First, EDS’s loss of 75% of its share value over a 12 month period before March 2003 certainly caught the customer’s attention. This elicited concerns about EDS’s ability to deliver the services as contracted, but really only addresses EDS’s ability to make large acquisitions.
Second, before and shortly after the spin-off, the customer engaged in a program of acquisitions. As a result, outsourcing with a single outsourcer might have become more effective than having multiple sources of services, and the pre-existing pricing structure and scope became rapidly outdated.
Third, the contracts probably did not contemplate how the two service providers might collaborate, if necessary. There is no mention in the press reports of this issue. The customer probably did not have a plan for this possibility, so the customer had little choice but to move from one vendor to another.