Ethics in Outsourcing:
The Challenge of Providing Services to Public Enterprises and Their Customers
This article addresses ethical and legal challenges when a service provider assists both a public enterprise and IFs regulated enterprise customers.
Newspapers reported that Perot Systems marketing materials to energy traders suggested that certain holes in the energy trading system could be exploited short-term, but would invite correction long-term. If a child could see the holes, was it a breach of contract for Perot Systems to point out the obvious?
Allegations of Conflict of Interest. Responding to allegations of assisting energy traders abuse of energy trading rules, In a letter dated October 24, 1997, to the President of the California Independent System Operator Inc. (“ISO”), H. Ronald Nash, a Vice President of Perot Systems, stated that he had satisfied himself that
“no inappropriate disclosures of “inside information” have occurred. At no time has Perot Systems offered to assist anyone to exploit “potential weaknesses and shortcomings in the ISO’s system,” or suggested that our involvement in developing the ISO’s system would allow us to exploit any knowledge we have about the ISO’s system. Without discussing this matter further with you, we can only speculate that someone has not distinguished between the ISO’s business protocols and the systems that implement these protocols.”
On March 9, 2000, Perot Systems announced a new $35 million contract with CalPX, the California Power Exchange, that followed the “one-of-a-kind” Cal ISO contract. “CalPX is a private, non-profit, public benefit corporation that was created through state legislation to provide an efficient, competitive auction for energy on an open and nondiscriminatory basis,” according to the announcement. In that CalPX contract, Perot Systems said,
Perot Systems will provide business consulting and applications development services to CalPX for the creation of new products and services, and expansion of its markets. Perot Systems will also assume responsibility for distributed applications maintenance and information technology infrastructure management in order to improve the quality and cost of CalPX services to its market participants.
June 2002, when a California state legislator attacked Perot Systems as having told customers how to “game the system,” Perot Systems disclaimed having disclosed any confidential knowledge.
Vendor Selection.
A customer hiring a sophisticated service provider can rightfully demand that the vendor will not engage in conduct that is intended to deprive the customer of key markets, or abuse confidential information. If the customer expects to impose a duty not to engage in conduct that might be prejudicial to the customer, the parties should specify the scope of such arrangements. The scope might include any one or more of the following:
- a prohibition on the use of any confidential information;
- a non-competition covenant;
- a covenant not to solicit any customers who might be customers of the enterprise;
- a covenant not to explain the vulnerabilities of the enterprise’s operations, even if such vulnerabilities are in the public domain or could be identified by persons who do not have access to confidential information (that is, not to identify paths for investigation by hackers or adverse parties);
- a prior notification before any specified commercial activities may be pursued;
- a covenant not to take any action that might have a material adverse effect on the customer’s business or its relationship with its customers.
Legality of Ethical Constraints.
Ethical and non-competition constraints create legal and moral challenges. As a matter of public policy, non-competition covenants are narrowly construed and enforceable only to the extent reasonably necessary to enable the enterprise customer to get the benefit of its investment in the relationship with the employee or other service provider. Such covenants restrict commerce. The challenge is to balance the government’s interest in promoting the free flow of ideas and trade in the marketplace with the private interests of parties. Under this analysis, government should promote the economic benefits of such free flows in “general skill and knowledge” in any fruitful manner that is not unfair to the customer.
In bargaining for a given contract, the vendor must be careful not to tie up its resources (including its talented people, its infrastructure and its “general skill and knowledge”). To concede a covenant not to compete, therefore, the vendor should price the agreement so as to account for the opportunity cost of foregoing opportunities in the relevant sector that do not involved a customer’s confidential information, either because a “Chinese wall” separating personnel on one client’s projects from those on another client’s projects can be established and maintained, or because the confidential information is sufficiently limited that such a separation would not be necessary in the first place.
Material Adverse Impact.
Any contract provision that is vague may be unenforceable. In Delaware, mergers and acquisitions cases have developed a standard for defining when a “material adverse change” will occur that enables one party or both to terminate an otherwise binding merger or acquisition agreement. In recent decisions, the Delaware Chancery Court has determined that a sudden material drop in a company’s stock price is not a “material adverse change.”
Similarly, in outsourcing contracts, the vendor might agree to do nothing that would cause a “material adverse impact” on the customer’s business. As with the M&A context, this concept should be defined.
Implications for the Future:
There are several likely implications as fallout from the Perot Systems – CalPX political brouhaha.
Declaration of Intent Regarding Conflicts of Interest.
First, in the due diligence and vendor selection, the parties should identify the nature and scope of their respective expectations on conflicts of interest and non-competition.
Costs and Benefits of Management of Conflicts of Interest.
Second, the parties should bargain from the standpoint of the measurable economic costs and benefits of the respective contractual commitments governing “ethics,” “conflicts of interest,” “non-competition covenants,” “fiduciary duty” and confidential information.
Narrowly Defined Restraints.
Third, such restraints should be carefully limited by both parties. If the enterprise customer wants the restraints to be enforceable, it must show that the vendor would not be put out of business by complying with the restraints. In the Perot Systems case, the only restrictions that appear to have been committed are ones that relate to confidential information. As some commentators have said, the “gaming of the rules” adopted by CalPX was open to anyone having access to the published rules. Sophisticated traders, such as Enron, Mirant and Dynegy, could all have reached the same conclusions as Perot Systems merely by studying the published rules.
Payment for Loyalty.
Fourth, if an enterprise customer insists on some duty of loyalty, it should consider special compensation. In the field of employment law, severance compensation that is “over and above” the compensation that a terminated employee might otherwise get, providers sufficient legal consideration to justify enforcing a post-termination non-competition clause. While most states enforce such “non-competes” without additional consideration, the separation of “normal” compensation from “post-termination non-competition covenants” provides an added measure of comfort in predicting enforceability of such covenants. In the case of an independent contractor, policy reasons might suggest that such explicit compensation need not be specified.
Methodologies Supporting Loyalty.
Finally, the parties must define the tools that will be used to implement the conflict of interest policy. These include relevant definitions of conduct that is permitted or not permitted, covenants concerning confidentiality, process management and personnel, and specifications of the procedures in case of alleged breach and the consequences relating to an alleged breach.
If you are interested in a set of sample documents covering such methodologies that could be inserted into your contracts, please contact one of our attorneys.