Proctor & Gamble Highlights New Legal and Business Issues in Multi-Sourcing
October 16, 2009 by Bierce & Kenerson, P.C.
Background
This case study examines some extraordinary circumstances involving competitive sourcing of services. It is not typical of the normal competitive sourcing, but it highlights some emerging business and legal issues in managed competitive sourcing of global services.
During the late 1990’s, Proctor & Gamble Co. (“P&G”), maker of soaps, toiletries and personal care consumer goods, created a “shared services” unit to provide a common suite of administrative and operational services to its lines of business. The shared services unit delivers such services as information technology, finance and accounting, logistics support and other administrative functions.
During the spring and summer of 2002, newspapers reported that P&G was in lengthy competitive negotiations with two outsourcing services providers to sell P&G’s shared services unit for $1 billion and hire the winning services provider for an 8 year, $8 billion outsourcing contract covering information technology, human resources and other major administrative functions.
In August 2002, it looked like Affiliated Computer Services, Inc. (“ACS”), of Dallas, Texas, was going to win the bidding, due to the reported withdrawal by Electronic Data Systems Corporation (“EDS”), of Plano, Texas. EDS had reportedly withdrawn from negotiations in June or early July because of pricing.
On September 17, 2002, ACS announced its withdrawal from negotiations with P&G. In an ACS press release, ACS’s President Jeff Rich noted, “While the size of this opportunity was historic and would have been accretive to earnings, we believe the financial, operational and cultural risks were too high.” In other words, the risks were disproportionate tot he profit potential.
At about the same time in mid-September 2002, EDS reported disappointing financial results, causing a one third drop in its share price in one day, due in part to increased costs because of “heavy investment in attempts to obtain new business.” Then, on September 24, 2002, EDS’s stock price plunged roughly another 30% after being downgraded by a Merrill Lynch stock analyst, who concluded that EDS’s free cash flow for the 2002 year could be wiped out by stock repurchase operations necessary to settle derivative instrument exposures. The EDS stock price decline was symbolic of a more general stock market decline on September 24, 2002, to the lowest point in four years (even lower than the post-9/11 trauma in 2001), based on the Dow Jones Industrial Average index.
EDS’s stock price plunge left P&G with a weakened sole bidder. With ACS having publicly withdrawn after EDS had publicly withdrawn, P&G might have been lucky to have any bidder. Or P&G might reevaluate and restructure its strategy.
This case study was completed on September 26, 2002, and is subject to clarification and further consideration.
Business Issues
This scenario underscores the dangers of hyper-aggressive competitive bidding that combines both outsourcing and a sale of significant assets by the customer to the vendor in a glutted market. In this case, the customer was apparently so aggressive on the pricing of its assets that one of two finalist bidders concluded that the deal was uneconomical. When the customer apparently continued to push the second bidder for the same deal as if the competitive bidding process had continued, the second bidder withdrew. This left the customer the prospect of having no bidders despite completion of an arduous, detailed and highly disciplined and managed competitive procurement process.
Further, the publicity surrounding the prospective outsourcing of the customer’s shared services unit, involving approximately 5,700 employees, raised questions about the viability of the outsourcing process and the impact of a possible failure upon the customer’s staff, its customers and its shareholders.
Accordingly, this case study evokes questions about circumstances affecting competitive procurement of long-term services.
Transfer of Customer’s Shared Services Center to the Vendor
Reportedly P&G had bundled its shared services unit — including multiple “back office” functions — into a cost-efficient self-standing business.
Factors in the Competitive Viability of the Transferred Shared Services Unit.
To our knowledge, the press did not comment on the degree to which the P&G shared services unit was ready to become a competitive unit of an outsourcing services provider. To be viable in the new role, the acquired unit would not only have to serve P&G as the customer, but also demonstrate the ability to generate cash flow that justified the price of the unit. The reported $1 billion asking price received no comments on whether the shared services unit had the corporate culture, the business plan, the competitive bidding experience, the inurement to the vicissitudes of competition, the personal accountability and internal leadership necessary to pay off the $1 billion price tag.
Valuation and Accounting Factors.
As with any acquisition of a going business, the questions of valuation, goodwill and other internal accounting practices of the P&G shared services unit have not been publicly defined. However, it is clear that the bidders examined them closely. ACS withdrew, in part, because it could not justify the return on investment. While ACS’s announcement of its withdrawal observed that the cash flow would be “accretive” to ACS’s income statement, it is perfectly conceivable that the successful bidder would have to write off goodwill under financial accounting principles. This might explain why EDS withdrew in August 2002 and ACS withdrew in September 2002.
Negative Market Environment.
Declining financial and stock markets in 2000 through 2002 resulted in the loss of significant shareholder value between the time for planning and execution of the proposed outsourcing. P&G established its Global Services group in 1998. Probably in late 2001, P&G decided to sell it in a massive outsourcing.
By the time for conclusion of contract negotiations in anticipated for August – September 2002, several adverse market conditions had occurred. The stock markets had fallen. And the information technology and telecommunications sectors swooned, with sharp declines in corporate purchasing of IT goods and services. Globally, throughout 2002 major IT outsourcers had terminated the employment of tens of thousands of IT workers. Consequently, the business prospects for a new IT services facility would be introduced into the market at a time of grossly excessive capacity for IT services both in the U.S. and worldwide.
The Impact of Corporate Governance and Accountability on Valuation.
President George W. Bush signed the Sarbanes Oxley Act of 2002 designed to root out misfeasance and malfeasance in the executive suites of publicly traded companies. In August 2002, senior executives of publicly traded U.S. companies had to sign and file certifications that the financial statements were not materially misleading. Enron, Tyco International and Adelphia Communications executives were indicted for looting. In late September 2002, the Securities and Exchange Commission indicted Tyco’s former CEO L. Dennis Koslowski, claiming that he should disgorge his personal bonus for having entered into an acquisition with a flagging company (Flag Telecom) at an inflated price, allegedly for the purpose of artificially inflating his personal compensation. Clearly, the regulatory environment counseled extreme caution on valuations of assets in an acquisition.
The “Stalking Horse” in the Bidding
A bidder that has no chance of winning is a “stalking horse”. This case study evokes the question whether ACS ever became a stalking horse, or whether P&G “over reached” on both finalist bidders.
Absolute Ability to Deliver the Full “Program.”
A bidder must determine whether it realistically has the resources to win in a convincing fashion. Otherwise, the competition is a gamble for the bidder. This self-assessment is essential in the “no-bid” decision as well as in the negotiations as the customer’s business rationale and expectations are revealed at the bargaining table.
Comparative Advantage.
If the bidder does not know the identity of its competitor, then it can only guess and rely upon its own self-assessment of capabilities. Once the names of the two finalist bidders became public, some commentators observed that ACS’s bid had not been as strong as EDS’s because ACS, while capable, would have had to “stretch” to satisfy P&G’s contractual expectations.
Rigged Bidding.
Typically, bidders that are not in the “top tier” should ask themselves whether the “rules of engagement” have been “rigged” in favor of a competitor. If this is true, then the competitive procurement process is a sham, and, as a legal matter, the stalking horse may have a legal claim for fraud.
Remedies for the Stalking Horse.
The rational bidder, when it realizes that is has become a stalking horse, should evaluate its possible remedies.
- Litigation for Fraud.
The ethical, savvy service provider is not likely to sue its prospective customer for fraud. Business reputation through avoidance of litigation is generally the customary business policy of outsourcing vendors. However, the benefits of a lawsuit might be achievable through other means (see below) or through non-public dispute resolution mechanisms. Bidders might be entitled to certain legal rights under pre-bidding agreements with the customer that define the rules of the procurement. - Unilateral Direct Boycott.
If it feels that it has been “used” as a stalking horse, it can elect not to participate in future “rigged” bidding wars managed by the same specialized outsourcing advisors. - Complain to the Customer.
A complaint might not necessarily result in compensation. It might, however, restructure the negotiations and re-admit the bidder into the realm of a “viable possibility” instead of a stalking horse. In government contracts, formal contests and appeals can result in substantial delays in the award of the contract. In private transactions, a more informal approach might be productive. The customer might have a self-interest in being responsive. - Request Compensation.
The stalking horse bidder has lost not only its out-of-pocket expenses, but also its prospective profit from alternative application of the same resources to other prospective pursuits. - Sell a Service.
Rather than just demand compensation for its out-of-pocket expenses, the stalking horse bidder might offer to sell some deliverable that resulted from the aborted competitive bidding procedure. This could include:- data discovered during the due diligence phase that could be useful to the implementation of the eventual outsourcing, or to its restructuring during the negotiation phase;
- recommendations of an advisory or consultative nature from a service provider’s perspective (to facilitate negotiations with the remaining bidder(s)); or
- other services or deliverables.
When a Service Provider Should Withdraw from Negotiations
In competitive procurement and auctions, each bidder must analyze the value of the transaction and draw its own conclusions as to circumstances that might make its bid no longer commercially reasonable. Experience suggests that a bidder should withdraw under any of the following conditions:
- Overpriced.
The combination of the costs of acquisition and the reward for future services rendered does not meet the financial hurdles imposed by senior management. The financial hurdles could be imposed either individually on each segment of the operation or globally on the combination of the operations. - Inability to Integrate Personnel.
In this case, ACS alluded to “culture” as a factor. In essence, an observer might conclude that each of the finalist bidders, in its own time, concluded that there were insurmountable cultural differences with the P&G employees who would be in scope and who would become the winning bidder’s employees. - Unsuitability of the Bundle as a Deal or as a Deal Structure.
If both finalist bidders were willing to withdraw, then each must have concluded that the “package” was unsuitable for economic reasons. Suitability might have meant that the post-transaction commitments to be assumed by the winning bidder were excessive. Customers and their specialized consultants may take note of the fact that EDS was invited back into the bidding at a time when ACS was still the sole bidder, and that in order to entice EDS to come back to the negotiating table P&G and its specialized consultant must have acquiesced in some of their demands about the deal structure. - Risk Allocation.
Certain news reports suggested the transaction would have an estimated value (excluding the acquisition of the shared services unit) of $8 billion for an 8-year term. Another article estimated the overall value of services at between $4 billion and $10 billion over an estimated 10-year term. If the winning bidder has no means of projecting actual revenues, it cannot determine whether the risk of the initial investment — in the acquisition, transition and post-transition commitments relating to the acquisition and transition — was outweighed by the prospective profit. In short, the profitability was not sufficiently clear. - Mismatch of Expectations and Post-Effective Corporate Culture of the Customer.
Having lived with an outsourced “back office” environment already for two or three years, P&G’s end users should probably adapt to the hiring of an external outsourced services provider. However, one might wonder why P&G wanted to outsource the environment to an external services provider. The press reports do not suggest that P&G was unhappy with its shared services unit. But certainly a bidder should ask whether there was any reason for the customer to be unhappy. And if the customer were actually unhappy with the quality of the service, the customer might have unreasonable expectations about the level of responsiveness, service or alignment of its shared services unit. Conversely, if the customer were very happy with the shared services unit, the only reason for outsourcing might have been to generate cash flow from asset divestiture. At that point, the service provider becomes a venture capitalist, hoping that the acquisition will be accretive to the cash flow. In either case, the bidders must analyze the suitability and cultural fit of the bidder with the customer’s expectations.
Lessons Learned from the Customer’s Perspective
Flexibility.
This extraordinary case study suggests that, in complex transactions with multiple functions being outsourced, the customer’s self-assessment and preparation for negotiations should include some flexibility and fall-back positions. Where both finalists are cornered and see no alternative but to walk away from negotiations, clearly the customer has played the game of “corporate chicken” and run both the bidders off the road. Such an outcome would be a serious lost opportunity, not to mention unrecoverable expense, for all involved. What guiding principles should inspire the customer?
True Competition.
The key requirement for a competitive procurement is that it remain truly competitive. If a scoring factor becomes clearly overwhelming for or against one of the finalist bidders, then the continuing bidding war is a farce between the guaranteed winner and the stalking horse.
Why should the customer want true competition? Without a viable final competitor, the guaranteed winner will normally revert to some of the more costly behaviors and tactics evident in a sole-source procurement – delays, quibbling, attempts to apply unfair pressure. Such behaviors normally deprive the customer of the best competitive price, terms and conditions.
Disclosure of Ongoing Negotiations.
Despite corporate policy statements, non-disclosure agreements with employees, contractors, bidders and others, the news of this outsourcing transaction became publicized. Information leaks by disgruntled in-scope employees can have an impact on decision-making and strategy by the prospective service providers, since the employees can identify the other bidders. Every bidder can be expected to want, and get, this information. The bidding could become transparent, not only to the customer and its employees, but also to the bidders.
Acceleration of Benefits.
An accelerated contract yields benefits earlier. Acceleration also facilitates commitments in the transition phase, encouraging in-scope personnel to remain and support the outsourcing, and avoids the risk that the entire project will be abandoned. Abandoned projects, like failed deals, can easily cause loss and disruption, not to mention litigation and continuing distraction.
Ethics in Competitive Procurement.
Competitive procurement has been a fundamental precept of modern capitalism. But when it degrades into stalking horse disguise, one may question whether conduct is ethical and fair. Every customer has an interest in being known for its ethical conduct, and indeed must question its own conduct internally if skewed procurement practices violate stated corporate governance principles. In an era of renewed governmental and shareholder needs for trust and confidence, and to avoid certifying financial statements that do not accurately reflect in all material respects the risks of claims from stalking horses, senior management of major enterprises should ensure that the customer’s stated business ethics are implemented in its competitive procurement practices. See Corporate Governance in Outsourcing
Initial Definition of the “Rules of the Game.”
The customer normally defines the rules of engagement with prospective vendors. The customer must determine the degree to which it wishes to address the legal, business and ethical issues presented in this case study.
Lessons for Multinational Alliances or Teams
Experts in the outsourcing process may wish to rethink their methodologies as a result of this potential fiasco
No Teams for P&G.
The P&G case was limited to single enterprises bidding to take ownership if the shared services business and provide outsourced services in their place. This case differed from the decision by J.P. Morgan, in the famous “Pinnacle Alliance” outsourcing, to hire four vendors to manage complex IT infrastructures, software and other back office operations. P&G insisted on a single point of accountability and single owner of all transferred IT infrastructures.
Subcontractors in the Bidding Process.
Many outsourcing transactions, particularly large and complex ones, may involve foreign subcontractors, such as software developers and maintenance services providers in Asia. Teaming alliances can fall apart if the customer engages in pitting a team against a globally integrated company.
Self-Interest in Competitive Bidding.
In adopting “stalking horse” tactics for a massive outsourcing across multiple functions and countries, the multinational enterprise customer risks alienating the best services providers. It also risks losing the benefits of outsourcing by so narrowly defining the transaction as to prevent the entry of competent competing teams.
Sarbanes-Oxley Act of 2002: Retention of Records by Auditors and their Clients relating to Outsourcing
October 9, 2009 by Bierce & Kenerson, P.C.
Summary:
The Sarbanes-Oxley Act of 2002 was intended to prevent future destruction of documents relevant to audits of companies that report their financial information to the U.S. Securities and Exchange Commission. On January 24, 2003, the SEC issued a final rule defining the rules that auditors and issuers and registered investment companies must follow to ensure appropriate document retention procedures.
Significance.
The rule is significant because it affects the trust of investors in the marketplace (including the securities of outsourcing service providers, their customers and their listed advisors). The SEC has estimated that approximately 850 accounting firms audit and review the financial statements of approximately 20,000 public companies and registered investment companies filing financial statements with the Commission.
Rules Applicable to Auditors.
Section 802 of the Sarbanes-Oxley Act of 2002 requires the SEC to promulgate reasonable and necessary regulations regarding the retention of categories of electronic and non-electronic audit records, which contain opinions, conclusions, analysis or financial data, in addition to the actual work papers. The regulations implement this law.
Seven-Year Retention Policy.
The final rule, which is included in Regulation S-X, requires accountants to retain certain records for a period of seven years after the accountant concludes an audit or review of an issuer’s or registered investment company’s financial statements. The proposed rules do not require accounting firms to create any new records. Decisions about the retention of records currently are made as a part of each audit or review.
Documents to Be Retained.
Under the SEC rule, records that auditors must keep for the seven-year period include work papers and other documents that form the basis of the audit or review, and memoranda, correspondence, communications, other documents, and records (including electronic records), which are created, sent or received in connection with the audit or review, and contain conclusions, opinions, analyses, or financial data related to the audit or review.
Effective Date.
Because time may be required to develop systems related to the retention of documents (particularly electronic documents) and to train people to use them, the SEC made the rules effective as of October 31, 2003.
Rules Applicable to Reporting Companies.
Inapplicability to Issuers and Investment Companies.
In issuing the final rule relating to auditors’ obligations of record retention in respect of their audits, the SEC considered “whether issuers and registered investment companies should be required to retain documents that the auditor examines, reviews or otherwise considers during the audit or review but are not made part of the auditor’s records.” Ultimately, the SEC concluded that the rules apply to auditors, and are not intended to cover issuers and registered investment companies.
Under the final rule, reporting companies need not retain the same records or supporting records that are furnished, or made available to, the auditors.
Sarbanes-Oxley Act of 2002: Disclosure of Material Outsourcing Contract Contingencies
October 9, 2009 by Bierce & Kenerson, P.C.
Summary:
Under Section 401(a) of the Sarbanes-Oxley Act of 2002, issuers and registered investment companies reporting to the Securities and Exchange Commission must disclose “off-balance sheet” transactions that may be material. On January 22, 2003, the SEC issued a rule defining the rules governing such disclosures for each annual and quarterly financial report required to be filed with the Commission. This commentary outlines the rule as it applies to both outsourcing service providers and their customers.
Sarbanes-Oxley Act of 2002.
Section 401(a) requires the SEC to issue regulations relating to Section 13(j) of the Securities and Exchange Act of 1934 governing the disclosure of “all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.”
SEC Regulations of January 2003.
The SEC adopted regulations that require a registrant to provide an explanation of its off-balance sheet arrangements in a separately captioned subsection of the “Management’s Discussion and Analysis” (MD&A) section in its disclosure documents. The regulations will require registrants (other than small business issuers) to provide an overview of certain known contractual obligations in a tabular format.
Definition of “Off-Balance Sheet Transactions.”
The regulations include a definition of “off-balance sheet arrangements” that primarily targets the means through which companies typically structure off-balance sheet transactions or otherwise incur risks of loss that are not fully transparent to investors. The SEC advised that its definition of “off-balance sheet arrangements” will employ concepts in accounting literature in order to define the categories of arrangements with precision. Generally, the definition will include the following categories of contractual arrangements:
- certain guarantee contracts;
- retained or contingent interests in assets transferred to an unconsolidated entity;
- derivative instruments that are classified as equity; or
- material variable interests in unconsolidated entities that conduct certain activities.
Materiality.
In order not to leave anything to doubt, the Commission adopted a very broad concept of when the disclosures might be material, and therefore to require disclosure. Consistent with the existing MD&A requirements, the amendments will contain a principles-based requirement that a registrant provide such other information that it believes is necessary for an understanding of its off-balance sheet arrangements and their specified material effects.
Contingency Quantiflication in Table Format.
In addition, the SEC amendments include a requirement for registrants to disclose, in a tabular format, the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligation, for specified time periods. The categories of contractual obligations to be included in the table are defined by reference to the applicable accounting literature.
Impact on Outsourcing.
Outsourcing contracts have been used for a variety of purposes. The complexity of design in the typical outsourcing relationship could generate material contingences. The new SEC regulations affect not only transactions being negotiated, but also existing arrangements.
Effective Date:
This rule applies for all Commission filings that are required tonclude financial statements for the fiscal years ending on or after June 15, 2003. Registrants will be required to comply with the disclosure requirements for the table of contractual obligations in Commission filings that are required to include financial statements for the fiscal years ending on or after Dec. 15, 2003. The SEC asks registrants to voluntarily comply with the new disclosure requirements before the mandatory compliance dates.
Impact of Sarbanes-Oxley Upon Outsourcing
October 9, 2009 by Bierce & Kenerson, P.C.
Corporate Governance and Accountability under Sarbanes-Oxley Act of 2002.
On July 30, 2002, President George W. Bush signed the Sarbanes-Oxley Act of 2002. The bill establishes new rules of corporate governance and accountability for accounting for U.S. and foreign publicly owned companies whose shares are registered with the U.S. Securities and Exchange Commission. If you work for such a company, you have some immediate actions for timely compliance, some by August 30, 2002.
This legislation has potential importance to both outsourcers and their customers, as well as their accountants, executives, investment bankers, employees and attorneys.
Scope of the Law.
Enacted in the wake of a series of corporate accounting scandals, this vast and sweeping legislation establishes a public accounting oversight board, adopts certain minimal measures to preserve auditor independence, amends federal security laws to hold insiders and corporate executives and directors to higher standards of care in trading securities (including blackout periods during which such trading is prohibited), increases and extends corporate disclosures of accounting matters, sets standards for “corporate and criminal fraud accountability” and hardens the penalties for “white collar crime.” For particular provisions on corporate responsibility for financial reports and the accuracy of financial reports (including “off balance sheet transactions”), see our copy of the law at Sarbanes-Oxley_Legislative_Text.
Study on Manipulative Accounting.
Investment bankers will now become the subject of a new SEC study. But the study will go further, covering topics that affect virtually every publicly traded outsourcing services provider and its methods of operation. The study will review, among other issues relating to Enron and Global Crossing’s bankruptcies, the role of investment bankers and other advisors:
in creating and marketing transactions which may have been designed solely to enable companies to manipulate revenue streams, obtain loans, or move liabilities off balance sheets without altering the economic and business risks faced by the companies or any other mechanism to obscure a company’s financial picture.
Impact of Sarbanes-Oxley Act of 2002 on Outsourcing Service Providers.
For outsourcing service providers, the new law creates the risk that the SEC might seek to impose penalties for failure to adopt conservative accounting principles. We think that this law could create challenges for outsourcers that adopt the percentage of completion method of accounting, which may be appropriate but nonetheless perhaps not as credible or conservative as the “as collected” basis. Take our Survey on related accounting issues.
Impact of Sarbanes-Oxley Act of 2002 on Employees.
The Sarbanes-Oxley Act of 2002 protects employees from termination or other major adverse effect if they report alleged violations of the accounting rules or corporate governance requirements of that law. For a copy of the act as it applies to employees, please refer to our copy of the law at Sarbanes_Oxley_legislative_text
Please note that this gives new protections to whisteblowers who are employees, but also to non-employees as well. Please refer to our copy of the law at /Sarbanes_Oxley_ACT_2002_legislative_text
Impact of Sarbanes-Oxley Act of 2002 on the Role of Attorneys in Outsourcing.
The Sarbanes-Oxley Act of 2002 on corporate governance and accountability requires attorneys to take their concerns about accounting treatment to in-house lawyers and ultimately to the Board of Directors. Law firms assisting parties to an outsourcing transaction should consult with their clients concerning the accounting treatment implicit in the transactional structures.
Impact of Sarbanes-Oxley Act of 2002 on Venture Capitalists.
The Act will give pause to venture capitalists who fund start-up outsourcing services providers. It raises the legal liability of VC’s who serve on boards of directors, particularly if the portfolio company is targeting an IPO and board membership remains an important component of the VC relationship, compensation, “protection” of VC-organized investor interests and generally investment management.
Impact of Sarbanes-Oxley Act of 2002 on International Outsourcing Services Providers.
Being incorporated outside the United States may have its advantages as well as its disadvantages. Under the Sarbanes-Oxley Act of 2002, foreign companies whose shares are traded on U.S. stock exchanges must comply with new obligations on financial reporting, audit and corporate governance. Foreign services providers such as Accenture Ltd., of Bermuda, that were organized outside the United States prior to relevant “cutoff” dates are likely not to suffer the consequences of U.S. governmental retaliation for foreign “inversion” operations. Unless their securities are listed on a U.S. securities exchange, such foreign services providers may enjoy regulatory freedoms, but such freedoms may elicit suspicion by investors and prospective customers due to the lower level of corporate governance discipline and public disclosure of material information. If you have any question about this process, please contact one of our attorneys.
Failed Deals, Bankruptcy and Class Action Securities Fraud in Global Outsourcing: In re Alcatel Securities Litigation
October 9, 2009 by Bierce & Kenerson, P.C.
In a pre-Sarbanes-Oxley time, the hypergrowth Dot.Com era disintegrated into “Dot.bomb” implosions. Reciprocal deal-making in speculative ventures was almost the norm, particularly in telecommunications transport. The litigation aftermath of failed deals, bankruptcy and class actions for securities fraud is reaching resolution. This short case study provides a synopsis of some key points of failure in reciprocal transactions, with a focus on telecom.
Background.
Alcatel is a French technology corporation. On October 20, 2000, the company issued a U.S. initial public offering (IPO) for its Class O shares. This class was 100% owned by Alcatel, but served as a “tracking” stock for the company’s Optronics Division. The IPO raised approximately $1.2 Billion and created additional shares that could be used as currency in mergers and acquisitions.
The Reciprocal Deal.
Soon after the IPO, Alcatel announced that it had invested $700 million in its customer, 360networks Corporation. In turn, the customer agreed to purchase over $1 billion in equipment from Alcatel to create a proposed trans-Pacific fiber-optic network.
Announcements to Investors.
When Alcatel’s proposed merger with Lucent fell through, Alcatel issued an unexpected announcement to investors that warned of a projected $2.6 billion loss for the second quarter of 2001. The loss included charges associated with a write-down of goodwill for two acquisitions (Xylan and Packet Engines), a full write-down of the $700 million invested in 360networks and various inventory write-downs. Allegedly, the announcement downgraded its Optronics Division in light of that unit’s “high exposure to the submarine market and the increased lack of visibility and potential delays in large projects, as well as inventory build-ups.” In re Alcatel Sec. Litig, __ F.3d __, NYLJ Mar. 11, 2005, p. 23, cols. 1-4, p. 24, cols. 1-4, at p. 24, col. 3 (S.D.N.Y. Mar. 11, 2005) (Judge Casey) [“In Re Alcatel Sec. Litig.”].
Violations Alleged.
The Alcatel investors claimed securities fraud. Most of the claims were dismissed because of late filing. The case is a cautionary tale and reminds us of the interests of investors as key stakeholders in outsourcing, whether as shareholders in global enterprises or as shareholders or bondholders in service providers.
Recommendations.
The story of Romeo and Juliet brings to mind the aphorism “‘T’is better to have lived and loved than to never loved at all.”
In securities fraud litigation, the love has turned to hate. So we posit the modern aphorism, “‘T’is better to have solicited investment and warned than to have never solicited investment at all.”
In short, participants in outsourcing should each refocus on the specificity of their warnings surrounding the risks of outsourcing and other strategic relationships, the nature and risks of the issuing company’s supply chain of suppliers and customers, and the particular risks in the industry. The generic warnings might not be sufficient, so constant updating may be appropriate, even without considering the special certification, audit and control issues presented under the Sarbanes-Oxley Act of 2002.
Service Providers.
Reciprocal Dealings and Joint Ventures Pose Special Securities Risks.
Typically, the service provider’s investors are the ones with a securities fraud claim. To be put on notice to inquire further, the service provider’s investors need to receive a storm warning of the seriousness of a material problem that could affect an ordinary investor’s decision to buy, sell or hold the securities of the service provider. In the case of reciprocal business dealings and joint ventures between service providers and their enterprise customers, the standards of disclosure are heightened because the materiality is heightened: a bankruptcy by the enterprise customer (as in the case of WorldCom for EDS or in the case of 360networks for Alcatel).
Designing and Planning for Investor Notification.
Service providers should therefore consider the following prudent business practices:
- Interdependencies:
warnings to investors whenever they enter into reciprocal business dealings or joint ventures with customers, to identify the mutuality of commitments and dependencies for success, particularly specific risks of such dependencies. - Material Changes:
warnings to investors whenever such dealings or ventures give rise to material losses or other material risks of liability. - Keeping the Risks Small:
keeping the size and financial value at risk below the “materiality threshold” so that any failure to disclose would not trigger a claim of material securities fraud (or, in cases of a consortium contract with leading enterprise customers in an industry vertical, a claim that the contract restrains trade or otherwise violates competition laws).
Enterprise Customers.
Enterprise customers face questions, as securities issuers, surrounding the viability of their key suppliers. Best practices to avoid securities fraud claims should be considered.
- General Warnings about Dependency on Suppliers.
It is customary to identify that the issuer is dependent on its suppliers for continuity of business operations. - Specific Warnings about Limitations on Liability of Suppliers.
It is customary for commercial enterprises to negotiate limitations of liability. Enterprise customers seek such limitations when they are sellers, and they customarily allow certain limitations of liability to their service providers, subject to unlimited liability for certain key failures by the service provider. The enterprise customer should provide specific warnings of the risks of outsourcing. Any disclosure of mitigation measures taken would be in the nature of “comfort” to the investor, which could backfire and render the warning useless. - Consider Investing in Your Service Providers and Suppliers.
Enterprise customers may have more leverage over a publicly traded service provider if the customer is also a shareholder. The amount of the shareholding is not as significant as the fact that the enterprise customer can have access to company information for a valid corporate purpose in relation to its decision whether to buy, sell or hold the shares. Being a shareholder gives the enterprise customer a seat at the table in the judicial selection of the most representative shareholder to prosecute any shareholder class action. And it permits the shareholder to opt in or opt out of the securities litigation, which could be useful in governing the personal and corporate relationships as customer. - Negotiate a Good Contract.
A solid outsourcing contract, accompanied by effective contract administration and relationship governance, makes a difference. In-house counsel not experienced in the art of outsourcing should hire specialized lawyers. Reliance on consultants to process legal issues may be courting investor inquiry.