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.
Outsourcing Tools for Insourcing.
The typical outsourcer also provides a spectrum of support and consulting services compatible with a totally insourced environment. Thus, outsourcing is only one of the core service offerings. Enterprise customers now ask the question: why outsource when I can insource using the right tools? While there may be many reasons to outsource, there are equally many reasons not to outsource. The reasons relate to ERP, SCM, CRM and DRM solutions that can be used to keep customers loyal and flexibly prepared for a future outsourcing. Emerging BPM / business process management tools and software as a “service,” can likewise create opportunities for retention of functions in house.
Does your “outsourcer” also sell tools that facilitate insourcing? In this article, we take a quick look at one particular tool offered by the king of outsourcers for its enterprise customers’ data centers.
Panoply of Insourcing Tools.
Insourcing tools help a customer manage its technology and service delivery to its internal customers without dependence on a third party for design, maintenance and support. Let’s consider a few:
- Web-Enabled Self Service and the ASP Model.
Under the “Applications Service Provider” model, the external services provider hosts its own proprietary software solution. The customer enters data into the provider’s software by remote control, either using web-enabled services or high-speed link.
- Web-Enablement of Customer’s Proprietary Software.
Companies such as Citrix have developed tools to allow a customer to place its own proprietary software on a secure Intranet, thereby reducing access costs, particularly for end-users who are traveling, home-based employees, or in a large complex organization with multiple offices worldwide.
- Software Licensing Model.
Software that helps customers perform their own “managed services” has developed over time. In the “early days,” data base software such as Oracle and DB2 organized data. More recently, enterprise resource planning software (“ERP”), supply-chain management (“SCM”), customer relationship (“CRM”) and device-relationship management (“DRM”) software have enabled enterprise customers to harness a uniform set of business process tools across large organizations. Such more robust software serve as tools for reducing complexity, enforcing business process rules and showing transparency of data. Such software also can plan, identify and manage for business continuity in case of disasters. As an emerging insourcing or outsourcing tool, new software tools facilitate provisioning of resources.
- External Benchmarking and Performance Metering Tools.
Service level agreements (“SLA’s”) define the various performance parameters that define the essential services under any outsourcing agreement. Enterprise customers have tools that measure the same operational data that the external service providers see at the service provider’s facilities. Customers now are demanding access to benchmarking and performance metering tools.
Why Outsourcers Might Offer Insourcing Tools.
There are many reasons why outsourcing might not be a proper solution for a client. Currently, IBM, Hewlett-Packard and Sun Microsystems all offer some form of tool to enable an enterprise customer to automatically provision server workloads based on supply and demand and network traffic. The same “silicon switch” that enables a customer to manage insourced IT resources could thus be used to transform to a hybrid insourced-outsourced combination or externalize the business process virtually.
Transitional Tools for Eventual Outsourcing of Process or Infrastructure, or for Provisioning of Services “On Demand.”
In such cases, the outsourcer should consider providing tools that retain customer loyalty and, like a Trojan horse, enable the customer to become an outsourcing customer “on demand.” The customer becomes trained in the service provider’s software, and such training might inspire confidence that, by using such tools, the customer can place more trust in an outsourced solution, either temporarily or on a continuous outsourced basis. These tools face the challenge of maintaining user control and limiting access to software applications while demand surges or subsides across a network of servers and data centers.
In fact, among others, IBM has adopted this strategy to service customers who might need hosted infrastructure and rapidly deployable additional server capacity. Its Tivoli “Intelligent Orchestrator” software will allow customers to convert a data center into an IT utility, where provisioning of network capacity (bandwidth), server processing capacity, storage and other computing resources are allocated dynamically in response to defined parameters of supply and demand. This resembles a “utility” because the “grid” operator may now anticipate demand and plan for allocation and reallocation of resources. In emergencies, the “grid” (data center with Intelligent Orchestrator (or competitive equivalent) could redistribute computing resources globally. But the challenge of dynamic global provisioning will remain daunting.
Tools for insourcing present challenges for the vendor. If the price of the tool is too attractive, the tool will sell and the services will not. If the tool is too expensive, outsourced services might be preferred, but only where the customer has no alternative. And by promoting tools, the vendor might cannibalize revenue from services, and vice versa. Pricing could be in the form of per-seat, per user, global site license, or site license by some other “line of business” demarcation.
Legal Issues in Dynamic Provisioning of Computing and Telecom Resources.
When we look at dynamic, rules-based provisioning of resources across international boundaries, we must remember that data transfers across borders remain subject to local legal controls. These include:
- data protection laws.
- privacy laws.
- export controls on military data or “dual use” civilian-military processes.
- license restrictions on authorized use.
- infringement indemnifications that may be territorially restricted.
- force majeure risks.
Transitioning from Software Licensing to Outsourcing.
Generally, a contract for a software license does not change when the parties enter into an outsourcing relationship. But customers should consider what changes should be made when this occurs, and what risks and assumptions have changed by virtue of the transition. By gaining the customer’s trust through a software tool, the vendor can thereby convert the customer to an outsourcing customer quickly, almost immediately. “Just sign here.”
We believe, in such cases, there could be significant business issues that need to be reflected in an appropriate contractual document. We recommend that an outsourcing lawyer be consulted in such circumstances.
Bierce & Kenerson, P.C. does not provide any of the tools described above. However, we may be able to identify or comment on legal and practical issues of tools that may be of interest to the IT and technology-enabled services community. Please let us know if you have any questions about our experiences with particular vendors.