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Death of Captive Paradigm? Business Transformation of a Shared Services Captive: Legal and Business Issues in Conversion from SSO to Independent BPO Service Provider

October 9, 2009 by Bierce & Kenerson, P.C.

General Electric Company’s announcement on November 8, 2004, that it has agreed to sell 60% of its Indian captive services company GE Capital Information Services (“GECIS”) marks a turning point in the trend towards establishment of offshore captive services companies.  This article considers the legal and business issues in a conversion of a foreign captive shared services organization (“SSO”) to an independent business process outsourcing (“BPO”) service provider.   It is a lesson in management strategy, risk analysis and, most importantly, return on investment for shareholders.

Disclaimer: The author has not seen the documentation among the parties on this transaction.

GECIS as Captive SSO.

GECIS was established to provide specialized talent and resources to GE’s affiliates globally.  Most recently, it has been providing Six Sigma productivity improvement methodology and training, cost savings advisory services and back-office business process support to GE’s affiliates.  The legacy of GECIS as a captive organization demonstrates GE’s success in managing services as a core competency across the world.  GE’s press release noted:

As a captive, GECIS probably had reached the limit of its ability to scale the processes and generate business value. Even GE globally has limited capacity to absorb shared services.

The Business Transformation to BPO Services Provider.

Sale of Shares.
GE converted the SSO to a BPO service provider by selling a majority share to two private equity firms, General Atlantic Partners and Oak Hill Capital Partners.  After the sale, GE will own 40%, with each of the other two shareholders owning 30%.

Recapitalization.
The GECIS company will also be recapitalized.  Recapitalization of a healthy, growing company in a booming services economy suggests that the new investors will be contributing new capital.   The pricing of the share sale, as well the relative contributions to capital, may depend on an “earn-out” based on on post-sale performance of the company.

Allocation of Shareholdings; Impact on Corporate Governance.
GE could have chosen to sell to one other shareholder.  By selling to two investment groups, it dilutes the individual power of the other shareholders and retains an opportunity, by persuasion or other alignment of interests, to potentially share majority control with one of the two investors.  Thus, for accounting and regulatory purposes, GE ceases to own control.  For corporate governance purposes, it may retain an option (explicit or in a shareholders agreement) to share voting control with one of the two investors.

Expansion of Markets.
GE’s Press Release announced an expansion of into new markets, which will be generate new value for the new private equity investors.  GECIS “will accelerate its third-party sales, marketing and delivery capability to significantly expand its client base, especially in China and Eastern Europe, where it began operating two years ago.”

Management.
As announced, Mr. Pramod Bhasin will remain as president and chief executive officer, supported by the current Gecis global management team.

Board of Directors.
Thee new board, comprising four representatives from GE and six from the new investors, will be constituted by the end of 2004.

GE as Customer.
As announced, Gecis will continue to serve GE under a multiyear contract. That contract undoubtedly gives GE a priority claim on some of Gecis’s resources, most-favored-nation pricing and other preferences afforded to the best customers.

International Capital Structure.
The admission of new investors requires an appropriate capital structure.  Capital structures are driven by considerations of corporate law, taxation, effectiveness of controls and predictability of the rule of law.  Generally, international investments are structured to interpose an offshore holding company so that sales of the portfolio company are sheltered from income tax on disposition.

Corporate Governance.
Selection of the jurisdiction for the holding company, that will be co-owned by the investors, has an important bearing upon the corporate governance.   Corporate governance involves the rights to elect and terminate the board of directors, to approve important business decisions that might affect corporate operations, policies, financing, growth, mergers, acquisitions, dispositions, recapitalizations, joint ventures and liquidation.

Each of these corporate governance elements depends on the voting rights established under the applicable corporation or company law, the shareholders’ agreement, if any, the by-laws and resolutions of the board of directors.  Every country has its own corporation law, and nomenclature and rights vary across the world.  “Offshore” jurisdictions specialize in attracting foreign investment by offering highly flexible corporate structures, with minimal protections for minority shareholders.

Minority Holder’s Statutory Rights.
The right of a minority shareholder to block a major corporate action — such as an acquisition, major divestiture or restructuring — may be greater in some countries than others.  In India, the holder of a 25% ownership interest in a limited company are entitled to block such major corporate actions.  In Delaware and New York, for example, the minority has no such right, and the holder of a majority of the voting rights can effectively dictate major corporate actions.  As a result, when a 100% owner of an Indian shared services captive wishes to recapitalize the Indian company, it will normally choose a jurisdiction that allows absolute control by the majority owners, subject to fiduciary duties to minorities.

Recapitalization vs. Sale of Shares.
For sole owner of an operating company like an Indian captive services provider, sale of shares could trigger a capital gains tax.  By having the operating company (or a holding company) issue new shares, the funding of new investment capital into the business can be achieved without capital gains tax because capital contributions are not taxable events.

Classes of Shares.
Frequently, new capital contributions are paid in consideration of the issuance of a new class of common shares.  A capital structure with multiple classes of shares has several implications.  The same results can be achieved without multiple classes of shares, but to do so would require extensive negotiation and drafting of a complex shareholders’ agreement.

First, by statute, each class may have the right to approve or disapprove certain corporate actions.  Thus, if one shareholder has all shares in a class, that shareholder may effectively veto major changes that require the consent of all classes of shares.

Second, if there are three shareholders in any class of shares, it ownership can be structured so that none has a majority control of that class.  By loading up the number of minority shareholders in one class of shares, none has any control.  Such a structure strengthens the de facto control of the holders of a majority of any other class of shares.

Third, each class of shares can have different rights of voting, dividends and liquidation preferences.  This feature can allow different investors to design a plan for their own particular investment parameters, including cash flow and the timing and conditions of exit from the investment.

Impact on GE.

Strategic Redirection.
GE’s sale of the 60% stake in the GECIS subsidiary does not mark any withdrawal from the Indian market.  GE’s businesses in India represent annual revenues of $1 billion and 22,000 employees.  Rather, the sale suggests a change in strategic direction.

• The competitive advantage of having a captive BPO service provider appears to have already been achieved.  GE will continue to be a customer, with preferential benefits, of the restructured GECIS.  But there appeared no compelling competitive reason not to expand the clientele of the BPO service provider across global markets.
• The sale of the 60% stake will support expansion of GECIS’s business.  GECIS will accelerate its efforts in marketing, sales and delivery to “underserved” areas that have not experienced productivity improvements, such as China and Eastern Europe.  Opportunities for expansion into new markets will take additional capital investment, which will be provided by the new investors as part of the recapitalization.   It was not clear whether GE would make an additional investment, but it would be normal to do so if the expansion were to require a staging of capital expenditures.

Human Resources.
The transfer of ownership control can have significant effects upon an entity’s employees.

• New Management.
  The recapitalization using private equity investment may be accompanied by a change in management.  In the GECIS case, the operating management will continue in place, but the board of directors will be controlled by the investors in proportion to their respective ownership percentages.  This approach contrasts with the clash that occurs when a strategic acquirer seeks to impose its own management structures and approach upon a new acquisition.  In the GECIS situation, the employees and customers have some assurance that, despite the change in control of the board of directors, the new management will do “more of the same” and seek to expand operations rather than integrate them with a strategic acquirer.
• Pension Plans.
  Rules governing employment law, taxation of deferred compensation and pension rights tend to be territorial in nature.  Under the U.S. pension law (“ERISA”), an employer is not required to cover foreign-based employees, whether directly or employed by foreign subsidiaries or affiliates, include in its U.S. profit sharing, pension, retirement and medical insurance plans.  In this situation, GECIS probably has its own Indian-based pension plans, and there will probably be no impact on any U.S. ERISA plans.  A few exceptions might apply for certain senior executives, and as to them the recapitalization to include new majority ownership will likely result in some special price adjustments over time..
• Exit Strategies.
  With new capital, the company should grow.  But the new investors have predictable time horizons for realizing the return on their investment.  Employees and suppliers should anticipate a strategic sale or initial public offering in five to seven years.  At that time, a change in control may be expected.

Intellectual Property Rights.
Private equity investments do not normally come with significant intellectual property that can be licensed to the newly acquired portfolio company or can be exploited as part of commercial services to customers.  In this case, there might be some cross-licensing of intellectual property rights of the private equity portfolio companies owned by the private investors.  Press reports were silent on this issue.  In each new private equity investment, the integration and cross-licensing of technologies across portfolio companies of private equity funds merits further exploration.

“Captive of Multiple Unrelated Owners.”

Private equity investors may bring synergies and, like Internet Capital in the late 1990’s, even develop a strategy of assembling service companies that can support each other in the classic conglomerate or Daibatsu intercompany strategic relationships.  In this case, the private equity investors will clearly be acquiring a crown jewel that can not only grow by expanding to new markets, but which can develop new synergies, efficiencies and productivity improvements for other portfolio companies.  To the extent that other portfolio companies of General Atlantic and Oak Hill Partners can benefit from the GECIS productivity improvement services, the purchase price will yield multiples of value.   This intrinsic portfolio enhancement consideration might have been an important factor in pushing up the purchase price.

Local Ownership and Selection of Business Partners.
The BPO market is not protected by local restrictions on foreign ownership.  Accordingly, it is entirely normal for foreign investors to share in foreign ownership.    One may inquire why GE did not consider a local Indian private equity fund instead of two American-owned funds. This can probably be explained by an affinity of culture and a long-standing relationship among the parties in the American market.  Also, the Indian private equity funds are not as liquid and highly developed as American private equity funds.

Conclusion

The transformation of a captive services organization to a BPO service provider presages increased reluctance of global organizations to own their shared services operations, at least where the “first-mover” advantages of having in-house resources have been achieved.   Senior managements of global organizations will now face ever so starkly the question whether their shared services organizations are part of the aligned vision of the global enterprise.  If the SSO is not efficient, it should be replaced by an efficient paradigm.  If the SSO is efficient, it can be used as a launchpad for growing a “sideline” business, generating additional return on shareholder equity.

Conversion from captive to BPO provider requires extensive strategic planning.  It involves substantial degree of complexity in execution.  Time will tell whether other companies will follow in GE’s footsteps.

Class Action Litigation in Outsourcing: Managing Consumer Litigation Risk after Class Action Fairness Act of 2005

October 9, 2009 by Bierce & Kenerson, P.C.

The enactment of U.S. federal legislation forcing litigants to argue large class-action claims in federal court will help business generally.  If class actions are basically about violations of consumer rights, what impact will it have on outsourcing, and why?  This article applies to all those who manage call centers, credit cards, employment and payroll, HR administration, finance and accounting and other consumer-facing business functions.

I.    The Public Policy and Public Impact of Class Actions

Rule 23 of the Federal Rules of Civil Procedure allows federal courts to aggregate the claims of multiple injured parties – “plaintiffs” – against one or more common defendants. The claims may be joined into one massive complaint so long as (1) the class is so numerous that joinder of all members is impracticable, (2) there are questions of law or fact common to the class, (3) the claims or defenses of the representative parties are typical of the claims or defenses of the class, and (4) the representative parties will fairly and adequately protect the interests of the class.

Rule 23 serves many societal purposes.

A.    What is a Class: Size of Claims and Impact on Access to Judicial Redress.

1. Small Claims.
For small claims, it allows the aggregation of multiple claims that would not otherwise have been litigated.  It thereby serves to protect the small consumer against the corporate tortfeasor where the damages per plaintiff are very small and the aggregate damages are substantial.

2. Large Claims.
For large claims, Rule 23 economizes judicial resources by avoiding litigation on the fundamental facts affecting perhaps a small or “finite” number of injured parties each of whom has suffered substantial damages.  If the facts are the same or substantially the same, class actions provide judicial efficiency.

B. What is a Class: Technical Requirements.
Following extensive analysis by lawyers and judges that resulted in a multi-thousand page report dated May 1, 1997, on March 27, 2003, the U.S. Supreme Court amended Rule 23 of the Federal Rules of Civil Procedure.  See http://www.uscourts.gov/rules/congress0303/CV-Letters.pdf and http://www.uscourts.gov/rules/WorkingPapers-Vol1.pdf As noted above, a class has to have sufficient “numerosity” to bundle a lot of claims, and sufficient “commonality” to justify treating the same facts or legal circumstances to the members of the class.

C. Socially Engineered Remedies.
Remedies in class actions cover several types of damages.

1.    Compensatory Damages.
Each injured party could receive an appropriate amount of compensation for the loss suffered.

2.    Disgorgement.
Beyond compensating the victims, class  actions can serve as a socially engineered tool for promoting equitable remedies where it is not possible to locate or compensate every member of the class.  In such cases, class actions can force a wrongdoer (or group of wrongdoers with liability allocated by market share, for example) to disgorge ill-gotten gains from consumer fraud and deceit.

3.    Equitable Remedies.
Equitable remedies are applied in order to prevent an injustice.  They can include contempt of court, but most often are structured as injunctions.   An injunction can be issued to prohibit future violations of individual plaintiffs’ rights.

D.  Emerging Growth of Class Actions in an Automated Process-Driven Society.
Based on a federal court procedural rule initially adopted in 1966, class actions have burgeoned since the 1990’s.

1.   Automation of Injury-Causing Commercial Activity.
There has been a shift from individual litigation to representational litigation, as a more “efficient” and effective method of recovering damages from wrongdoing defendants.  Such litigation seeks to recover damages from torts and other repetitious effects inherent in a mechanized, if not automated, Cyber Age.  What started as a basis for supporting consumer product safety and civil rights cases became a weapon for extorting settlements, often of trivial financial value to the injured class, for mass torts and, increasingly, “mass actions” of all types.

2.    Impact on Business Process Outsourcing (“BPO”) and Internal Business Process Management (“BPM”).
Class actions have become the tool of choice for effectuating social change, by shifting money to victims, and for redress of torts involving such diverse problems as securities laws violations, consumer product safety, banking and insurance billing methods and debt collection procedures.

The glorious scalability of business process automation (whether outsourced or not) can become an infamous scalability of mass torts.  Mass torts occur when many people suffer the same consequences of the same (or similar acts) of the defendant(s). Since BPO and BPM can automate injury-causing interactions with consumers, class actions become everyone’s business.  Accordingly, every business that performs, or hires someone to perform, such functions should be aware of the impact of the new Class Action Fairness Act of 2005 upon their business.

II. Consumer Litigation Risks in Outsourcing.

A.    Customer Relationship Management.
Call centers contact customers and prospective customers in outbound calls.  Such contacts may violate applicable consumer protection laws and rules of the Federal Communications Commission, the Federal Trade Commission or the various states.  Fines and penalties may be imposed by the regulators.  In addition, individuals may be able to recover damages for violations of their rights under state or federal law, depending on the type of violation.  In short, by allowing the aggregation of clams common to a class of persons that are “similarly situated,” class actions for violations of laws could become a call center’s worst nightmare.

B.    Privacy Violations.
Virtually any outsourced business process may involve privacy violations arising from mistakes or negligence in the receipt, custody, processing, storage, access, encryption and transmission of confidential records of individuals in a class could form the basis of a mass tort.  records maintenance.   Such violations may apply to health information, personally identifiable information (such as Social Security Numbers), and financial and other personal information submitted to financial institutions or others for valid commercial purposes.  Violations of privacy may result in fines and liability under the Health Insurance Portability and Accountability Act (HIPAA), the Graham-Leach-Bliley Act and the Fair Credit Reporting Act, as amended.

C.    Racketeering and Corrupt Organizations Act (Treble Damages and Attorneys’ Fees).
Outsourcing that is performed remotely usually involves the use of interstate means of communication.  Under RICO, two violations of predicate crimes within a ten year period using such means of communication are subject to triple damages and attorneys’ fees.  Virtually any type of outsourcing could be theoretically subject to a RICO claim.

D.    Antitrust Violations (Treble Damages ).
Antitrust laws provide for triple damages and attorneys’ fees as well.  Where two competitors, each with significant market share in a relevant market, collude to fix prices or allocate territories, the participants will be violating the Sherman Antitrust Act.  Such laws are not likely to apply to outsourcing due to the vertical nature of the relationship arising from business process outsourcing.  Indeed, consumers rarely assert antitrust violations.  Consequently class actions for antitrust violations appear to be a remote possibility.

E.    Civil Rights Violations.
In human resources outsourcing, the service provider may be called upon to engaged in a series of important steps that, if mismanaged, could result in a claim of civil rights violations.  Civil rights generally include discrimination on the basis of sex, race, religion, national origin and even sexual preference.   Specific statutes protecting against age discrimination in employment also come into play in HR outsourcing.

III.    Changes Introduced by the Class Action Fairness Act of 2005

Class actions have affected banks, insurance companies, asbestos manufacturers, tobacco sellers and pharmaceutical manufacturers.   A consortium of business leaders lobbied Congress to change the rules so that interstate commerce can not suffer the burdens of favoritism or arbitrariness that are perceived by many to be part of the state court system.  They also wanted to make the rules uniform across the country, which cannot happen but remains a reasonable ideal in a federal system.

Consequently, the new Act will reduce personal benefits to plaintiffs’ class action lawyers unless the benefits are more aligned with a large segment of the class members.  This involves resetting the rules governing contingency legal fees and transferring cases to the federal district court if any defendant requests it.

A.    Restructuring of Attorney Fee Incentives for Plaintiffs’ Class Action Lawyers.

Rebalancing the Uses (and Abuses) of Coupons in Class Action Settlements.
Any enterprise sued in a class action for violation of consumer protection laws might concede defeat, issue “coupons” for injured parties that force them to use “free” additional services in lieu of cash payments, and pay the attorneys’ fees of the plaintiffs’ lawyers.   The Act will cut back on the ability of plaintiffs’ lawyers to collect cash based on the gross value of the coupons offered by limiting their fees to a percentage of the coupons actually used.  28 U.S.C. 1712(a), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a). If any portion of such attorneys’ fees is not based on the gross value of the coupons, then hourly rates will apply.  Traditionally, hourly rates are not enough to create a wealthy plaintiff’s lawyer.

In the past, coupons issued in class actions have notoriously have had low redemption rates due to the restrictions on duration of use, blackout dates limiting the scheduled use and other unpalatable coupon redemption rules.   This “coupon” strategy will force plaintiffs’ lawyers to seek to maximize the market value of the coupons, thereby aligning the interest of the injured class with those of their lawyers.

Where the class action results in any injunctive or other equitable remedies against the defendant’s), the court may apply a “lodestar” computation with a multiplier method to award attorneys’ fees.

To punish defendants but not allow attorneys to benefit, the financial value of unused coupons could be donated to charity or to government as agreed to by the parties.  28 U.S.C. 1712(e), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).   This would benefit society generally but not benefit the plaintiffs’ attorneys, whose fees could not be based on any such donation.

Net Losses to Lead Plaintiffs.
In some cases, a named plaintiff or other individual plaintiff must pay “sums” to class action attorneys that would make a net loss to that plaintiff.  The new law permits such arrangements only if judicially approved in a determination that the non-monetary benefits bestowed substantially outweigh the monetary loss.  28 U.S.C. 1713, as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

B.    When Must the Mass Action be Transferred to Federal Courts.

1. The General Rile Requiring Transfer of Mass Actions to Federal Courts.
The new law will transfer to federal courts all class actions that are “mass actions,” subject to certain exceptions, upon the demand by any defendant.   Litigation in state courts must be transferred to federal courts where the amount in controversy, as an aggregate of all claims of all individual plaintiffs, does not exceed the “sum or value” of $5 million, exclusive of interest and costs.  28 U.S.C. 1332(d)(6), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a); 28 U.S.C. 1453(b), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec. 5.

A “mass action” means “any civil action (except a class action filed in or removed to a federal district court under Rule 23 of the F.R.Civ.P. “in which monetary relief claims of 100 or more persons are proposed to be tried jointly on the ground that the plaintiffs’ claims involve common questions of law or fact, except that jurisdiction shall exist only over those plaintiffs whose claims in a mass action satisfy the jurisdictional amount requirements” of $75,000 per claim.   28 U.S.C. 1332(d)(11)(B)(i), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

2.    The Exceptions to Mandatory Transfer.

(a)    Judicial Evaluation based on Balancing of Factors.
The Act authorizes the district courts to decline to exercise jurisdiction over a class action where between one third and two-thirds of the members of all proposed plaintiff classes in the aggregate and the primary defendants are citizens of the state where the action was originally filed.  In such cases, the court may take into consideration various enumerated public policy and procedural considerations listed in the Act.  28 U.S.C. 1332(d)(3), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

(b) Prohibition on Mandatory Transfers in Cases of Local-Impact Class Actions.
Congress chose not to require the mandatory transfer to federal district court of class actions that have a distinctly local character.  Local character applies where several conditions all apply.  In each case, the plaintiffs and at least one major defendant must be local.   In each formulation, more than “two-thirds of the members of all proposed plaintiff classes in the aggregate are citizens of the State in which the action was originally filed.”   Also, in each “localization” situation, there must be at least 100 members of the proposed plaintiff class.    28 U.S.C. 1332(d)(5)(B), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

(i) One Defendant’s Conduct.
Under one formulation of this principle,” at least one defendant is a defendant from whom significant relief is sought by members of the plaintiff class,” and “whose alleged conduct forms a significant basis for the claims asserted by the proposed plaintiff class is a citizen of the State in which the action was originally filed.”   Such cases must be transferred to federal district court where the “principal injuries resulting from the alleged conduct or any related conduct of each defendant were incurred in the State in which the action was originally filed.”  28 U.S.C. 1332(d)(4)(A)(i), as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.4(a).

As to such situations, Congress chose not to require the mandatory transfer to federal district court of class actions that are not bunched in time with other similar class actions.    Thus, in such situations, there is no mandatory transfer where, ” during the 3-year period preceding the filing of that class action , no other class action has been filed asserting the same or similar factual allegations against any of the defendants on behalf of the same or other persons.”  Id.

(ii)    The Primary Defendants.
Under another formulation of this principle, the “primary defendants” are citizens of the local state.   The statute does not define the term “primary,” so legislative history must be consulted on the legislative intent.  This formulation of “local” damages does not consider whether the principal injuries resulting from the alleged conduct or any related conduct of each defendant were incurred in the State in which the action was originally filed.

(c)    Excluded Transactions.
Congress denied federal courts any jurisdiction for mass actions involving two types of claims for which local courts are well suited to class actions or that relate essentially to local law, and are already covered by Rule 23.1 (Derivative Actions by Shareholders) and Rule 23.2 (Actions Related to Unincorporated Associations):

• Securities Law Violations: a “covered security” (under the federal securities law, Section 16(f)(3) of the Securities Act of 1933 and Section 28(f)(5)(E) of the Securities Exchange Act of 1934) or rights, duties and obligations (inclining fiduciary duties) relating to any “security” (under federal securities laws, Section 2(a) of the Securities Act of 1933); and
• Shareholder Claims: shareholder class actions that relate to the “internal affairs or governance” of a corporate entity are not covered if the class action is filed in the state court of the state of incorporation.

IV.    Impact of the Class Action Fairness Act of 2005.

This new law requires the transfer to federal courts of all class action litigations that involve interstate or international commerce (which Congress has the constitutional power to regulate) and the claims are at least $5 million in the aggregate, exclusive of interest and costs.

A.    Benefits to Businesses that Might be Defendants.
For businesses (including both outsourcers and their enterprise customers), the benefits derive from:

• Less Pandering:
  a federal judiciary that is appointed for life, and therefore under no personal compulsion to seek election or re-election by pandering to consumer groups;
• Tighter Rules of Civil Procedure:
  a body of federal rules of civil procedure that impose the risk of severe sanctions if pleadings and practices are contemptuous or otherwise non-compliant with the rules, including personal sanctions and civil fines on the litigant, the litigant’s executives (if it is an entity) and the attorneys litigating engaging in sanctionable procedural misdeeds.
• Allocation of Discovery Costs to Plaintiffs:
  an emerging body of cost-allocating and risk-allocating procedural rules that may impose on the plaintiffs significant costs of imposing demands that the defendant (usually a business) deliver myriads of documents and records during the pre-trial discovery process.
• Elimination of Geographical Favoritism:
  the new prohibition on class action settlements that provide for favoritism in disproportionate payments to some class members simply by reason of closer geographical proximity to the court.  28 U.S.C. 1714, as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec.3.
• Comments by Regulators of FDIC-Insured Depository Institutions:
  state and federal regulators of depository institutions whose deposits are insured or regulated by the Federal Deposit Insurance Corporation will be notified of any proposed settlement and will have 90 days to comment on it.  28 U.S.C. 1715, as amended by Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec. 3.
• Judicial Conference Study Recommendations on Best Practices:
  the requirement of a new judicial study to contain “best practice”  recommendations for (i) the fees and expenses awarded to counsel in connection with a class action settlement appropriately reflect the extent to which counsel succeeded in obtaining full redress for the injuries alleged and the time, expense, and risk that counsel devoted to the litigation; and (ii) the class members on whose behalf the settlement is proposed are the primary beneficiaries of the settlement.  Class Action Fairness Act of 2005, 109 Cong., 1st Sess., S. 5, Sec. 6.  This will further focus on alignment of fee incentives for plaintiffs’ counsel with the rewards obtained for the class members.
• Neutralization of the Coercive Effect of Class Actions:
  a regime that removes financial incentives for plaintiffs’ class attorneys to inflate claims, delay settlement or otherwise impose punishing burdens on defendants solely because the aggregation of claims to huge financial levels creates its own substantive rule that settlement is cheaper at all costs than the risk of astronomical liability.  The new Act overcomes part of the substantive effect of class actions that are independent of the underlying claims of the plaintiffs.

B.    Greater Segmentation of Smaller Classes in Narrower Geographic Scope.
This law might encourage the plaintiff’s attorneys to file separate class actions in multiple states, with narrowly defined classes limited to individuals or other victims within a limited geographical territory.

C.    Cost Reduction for Businesses with Possible Sharing with Consumers.
The new law specifically addresses the costs of doing business, with an expressed intention of reducing such costs.   In practice, the reduction in the number of class actions may be expected to reduce insurance premiums for general liability, thereby enabling businesses (whether service providers or enterprise customers) to increase their coverages, retain a higher self-insured deductible or cut insurance premiums.  Such savings could generate chain-reaction benefits of additional capital available for capital investment, research and development, dividends to shareholders and/or reduced prices to consumers.

D.    Promotion of Innovation.
The law seeks to “benefit society by encouraging innovation and lowering consumer prices.”   Act, Sec. 2(b).   This theme will likely be the mantra of the second administration of President George W. Bush (January 20, 2005-Jan. 19, 2009).  The Act does not specifically encourage innovation, but if insurance premiums are reduced, the risk of unacceptably high damages is more manageable because federal judges will be deciding class action procedures, then entrepreneurs and businesses could justify taking slightly greater risks.

V.    Impact on Outsourcing.

The Act reduces the burden of class action defense by correcting some historic abuses.   The Act impacts outsourcing by making reducing litigation risks for both enterprise customers and their service providers.  Such risks exist in every BPO relationship, since third parties — who could be consumers, patients, loan applicants, customers, technology users, family members — could conceivably be injured by the acts or omissions of the service provider, the enterprise customer or both.

For suggestions on how to minimize your risks of a class action, with particular reference to diverse services such as call centers and multifarious BPO performed in foreign back offices, engineering, design, manufacturing, distribution and logistics, please consult our White Paper, “Are You Ready for Class Action Litigation in Outsourcing?”.

Litigation in Outsourcing: Liability of Corporate Affiliates, Secured Lenders and Venture Capitalists and their Attorneys under WARN Act for Termination of Employees

October 9, 2009 by Bierce & Kenerson, P.C.

The Worker Adjustment and Retraining Notification Act, 29 USC § 2101, requires employers to give at least 60 day’s notice to their employees before the effective date of a mass layoff or a plant closing. The Act, adopted in the wake of numerous plant closings in the 1970’s and 1980’s, attempts to soften the blow of job loss to workers and their families by providing them with advance notice to allow for transition time to different employment. The WARN Act imposes a financial obligation on the employer that continues after the employer has given notice of termination of employment.

In February 2004, a New York court ruled that the WARN Act interpreted the meaning of “employer” to include venture capitalists and equity portfolio managers. The case is instructive for startup ventures funded by venture capitalists and for mature service providers acquired by a private equity fund for portfolio investment.

Code of Ethics for Auditors: Some Case Studies and Legal Principles in Auditing Standards

October 9, 2009 by Bierce & Kenerson, P.C.

Auditors have their own codes of ethics.   Where there is no code of ethics, or where the code of ethics permits a degree of conflict of intere+/st, the auditors tread at their own risk.  The following case study underscores the traditional common law obligations of auditors as fiduciaries, even before the adoption of the Sarbanes-Oxley Act of 2002.   This section covers some basic issues in auditing standards.

Case Study #1: Cap Gemini and Ernst & Young, Potential Self-Dealing

Responding to SEC criticism of ostensible conflicts of interest, some major accounting firms, such as KPMG and Arthur Andersen, have spun off their consulting arms as independently owned and managed entities. Ernst & Young LLP chose another route. The story of E&Y and its alliance with Cap Gemini leads from a regulatory no-action letter to a court case alleging breach of the accountant’s fiduciary duty. The tale leads to “lessons learned.”

Independence of Auditors: SEC No-Action Letter to Ernst & Young LLP on Alliance with Cap Gemini Ernst & Young LLC.
By no-action letter dated May 25, 2000, the SEC’s Chief Accountant advised Ernst & Young LLP that it would consider E&Y to maintain its independence even though Cap Gemini Ernst & Young were to provide IT services to E&Y audit clients. The no-action letter imposed a number of conditions that ” (1) limit at the outset and within five years end E&Y’s equity interest in Cap Gemini; (2) impose limitations on Cap Gemini’s use of the E&Y name; (3) require a strict separation of E&Y and Cap Gemini’s corporate governance; (4) forbid any revenue sharing between E&Y and Cap Gemini; (5) forbid any joint marketing agreements between E&Y and Cap Gemini; and (6) restrict any shared services between E&Y and Cap Gemini. Letter of Lynn E. Turner, Chief Accountant of SEC, to Kathryn A. Oberly, Esq., Ernst & Young, May 25, 2000. http://www.sec.gov/info/accountants/noaction/lteyltr.php

Litigation Alleging Breach of Accountant’s Fiduciary Duty; Liability for Systems Integrator’s Nonperformance.
Unfortunately, an SEC no-action letter is not a vaccine against client lawsuits. Accountants engaged in management consulting should pay careful attention to a ruling against Ernst & Young, LLP (“E&Y”) and its successor in interest (by sale of consulting business), Cap Gemini Ernst & Young, U.S. LLC (“CGEY”). This case is instructive to anyone in a licensed professional capacity engaged in ancillary or multidisciplinary consulting practice.

Pre-Trial Ruling.
In a pre-trial ruling in early January 2002 on a motion to dismiss, without deciding the final outcome, the court found that E&Y was potentially legally subject to claims of breach of fiduciary duty and punitive damages arising out of a failed software implementation by CGEY, a company in which apparently E&Y is a substantial owner. (The was no allegation or showing of a failure to exercise the skill and care of a reasonably diligent accountant, so the court noted that there were no claims of professional malpractice (whether relating to accounting or computer consulting).

Alleged Misrepresentations by Accountants.
The alleged facts of the case, if true, would be particularly egregious. The following reports are provided according to the court’s pre-trial decision. Whether the allegations will be proven remains to be seen.
In June 2000, E&Y recommended to a client, a medical and nutritional company, to retain CGEY as the vendor to implement a commercial off-the-shelf software package that the client had selected, based on E&Y’s recommendation, for its short and long-term business needs. E&Y made a number of representations to the client to induce the client to hire CGEY, and the court concluded that, without those representations, the client would probably have selected another IT service provider. E&Y reportedly represented that (1) CGEY was competent, experienced and qualified to implement the system selected by E&Y, and (2) CGEY’s performance of services had already been “coordinated” with E&Y.

Existence of Fiduciary Duty.
A fiduciary relationship existed between the accounting firm and its client for several reasons. First, the client had developed a relationship of trusting the accounting firm’s judgment based on prior professional services. Second, the accounting firm offered to provide additional consulting services. Third, the medical and nutritional company was less sophisticated than the accounting firm in the “specialty” for which the accounting firm and the services firm were hired.

Potential Breach of Accountant’s Fiduciary Duty.
Thus, “[w]hen a fiduciary fails to disclose personal interests preliminary to contract, and/or represents the existence of a questionable competence and experience critical to the contract and procures a benefit such as that alleged to E&Y and the newly formed CGEY, the risk of liability for the negligent misrepresentations and a question of fraud is properly alleged.”

Atkins Nutritionals, Inc. v. Ernst & Young, LLP,
NYLJ, Jan. 10, 2002. Accordingly, a fiduciary relationship arose and could have been breached if proven at trial.

Case Study #2: KPMG Canada: Lack of Independence.

In June 2005, the Securities and Exchange Commission entered into a settlement, in an enforcement action, with KPMG LLP (KPMG Canada), a Canadian audit firm, and two of its partners, Gary Bentham, the audit engagement partner, and John Gordon, the concurring and SEC reviewing partner. The SEC asserted that KPMG Canada, Bentham and Gordon lacked independence when they audited the 1999 through 2002 financial statements of Southwestern Water Exploration Co. (Southwestern), a now-bankrupt Colorado corporation.

The SEC claimed that KPMG Canada provided bookkeeping services to Southwestern and then audited its own work. Specifically, after KPMG Canada prepared certain of Southwestern’s basic accounting records and financial statements, it issued purportedly independent audit reports on those financial statements. KPMG Canada’s audit reports were included in Southwestern’s annual reports that were filed with the Commission.

The SEC found that KPMG Canada, Bentham and Gordon engaged in “improper professional conduct” within the meaning of Rule 102(e) of the SEC’s Rules of Practice by virtue of their violations of the auditor independence requirements imposed by the Commission’s rules and guidance and by generally accepted auditing standards in the United States.

Some Rules of Ethics for Auditors

The Sarbanes-Oxley Act sets new standards of independence for auditors.

Public Companies.
Such standards created such friction between public companies and their auditors that decisional gridlock set in.  On May 16, 2005, the Public Company Accounting Oversight Board (established under the Sarbanes-Oxley Act, to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports) issued a policy statement on its Auditing Standard No. 2.  The PCAOB’s Policy Statement sought to give ensure some level of reasonableness and flexibility in the conduct of audits.  As it noted,

In particular, the staff questions and answers seek to correct the misimpression that certain provisions of Auditing Standard No. 2 need to be applied in a rigid manner that discourages auditors from exercising the judgment necessary to conduct an internal control audit in a manner that is both effective and cost-efficient. The Policy Statement expresses the Board’s view that, to properly plan and perform an effective audit under Auditing Standard No. 2, auditors should –

• integrate their audits of internal control with their audits of the client’s financial statements, so that evidence gathered and tests conducted in the context of either audit contribute to completion of both audits;
• exercise judgment to tailor their audit plans to the risks facing individual audit clients, instead of using standardized “checklists” that may not reflect an allocation of audit work weighted toward high-risk areas (and weighted against unnecessary audit focus in low-risk areas);
• use a top-down approach that begins with company-level controls, to identify for further testing only those accounts and processes that are, in fact, relevant to internal control over financial reporting, and use the risk assessment required by the standard to eliminate from further consideration those accounts that have only a remote likelihood of containing a material misstatement;
• take advantage of the significant flexibility that the standard allows to use the work of others; and
• engage in direct and timely communication with audit clients when those clients seek auditors’ views on accounting or internal control issues before those clients make their own decisions on such issues, implement internal control processes under consideration, or finalize financial reports.

Private Companies.
Where the audit client is a privately owned business (such as a private enterprise customer or a private service provider), auditor independence rules still apply.  Reviewing Case Studies #1 and 2, the auditors could probably have avoided the claims of breached fiduciary duty if they had made suitable disclosures and had remedied, or caused their consulting affiliate, to remedy a failed software installation.
In that case, the auditors should:

1. disclose their conflict of interest to the client and obtain waivers (similar to the waivers obtained from medical patients undergoing surgery);
2. remedy the flaws in the selection of off-the-shelf software, the systems integrator, and the systems integrator’s lack of skills to cure the defects impeding software performance; and
3. learn from similar client-relationship mistakes that had been subject to prior, unrelated litigation.

The court’s ruling is based under existing rules governing independence of auditors.

International Outsourcing: Legality of Xenophobia in Outsourcing

October 9, 2009 by Bierce & Kenerson, P.C.

Summary:

In the United States, layoffs during the downward economic cycle following the dot.com bubble and then the 9/11 attack have had a severe impact on the local economies.  In the resulting legislative debate over the impact of outsourcing, some state legislators have proposed a reversion to the “Buy American” principle that conflicts with international trade under the World Trade Organization.  This issue underlines an emerging internal public policy debate on the desirability of international outsourcing.

NOTE: Posted in 2003, this seminal article could be updated for more recent manifestations of xenophobia in outsourcing.

“Buy American” in State Government Contracting.

In March 2002, a New Jersey State Senator, Shirley Turner, introduced a bill that would impose a “Buy American” rule on all purchases in the state.

N.J. Sen. No. 1349, 210th Legislature, intro. Mar. 21, 2002, passed in the Senate (40-0), Dec. 16, 2002.

The bill was inspired by the fact that “Recent published reports have indicated that telephone inquiries by welfare and food stamp clients under New Jersey’s Families First Program were being handled by operators in Bombay, India after the contractor moved its operations outside of the United States as a cost-cutting measure.”  The bill was intended to ensure that State funds are used to employ people residing in the United States and to prevent the loss of jobs to foreign countries.

As a “mini-Buy-American” Act, this legislation does not provide any exception for:

• a determination that a domestic procurement is “not in the public interest,”
• a determination that the cost of a domestic procurement is “unreasonable,” or
• a determination that the particular goods or services being procured are not available in such commercially available quantities or quality as are available abroad.

All of these are exceptions under the federal “Buy American” act.

If enacted, such laws would apply only to government procurement.  But such legislation could have repercussions on the image of offshore outsourcing throughout the United States.

The bill does not address issues of cost, or availability of local American services in the particular procurement.

Legality for Governmental vs. Private Purchases of Foreign Services.

As a matter of law, “Buy American” (or “Buy Local”) laws are illegal under the World Trade Organization’s General Agreement on Trade in Services (“GATS”) when they relate to purchases by private buyers.  But for governmental buyers of services, the GATS allows such favoritism to local service providers.

Impact on International Outsourcing by Private Customers.

Legislation limiting government procurement to local service providers should not have any impact on the right of private companies, as customers, to hire any service provider worldwide to render any service.

• Freedom of Contract.
  In our view, nothing in the various laws of individual states in the United States that currently are in consideration could validly overcome such freedom of contract.
• War.
  In case of a war involving Iraq or other country, the United States federal government could validly adopt rules to safeguard its economy from foreign interests.   As discussed below, this raises risks for contracting parties, but such risks may be surmounted through customary technical means for security, business continuity planning, redundancy and disaster recovery.

Buy American – Revival of the Past.

The “Buy American” legislation was originally adopted by the Federal government as a means of promoting local business.  This legislation, at 41 U.S.C. 10a, is limited to the purchase of goods:

This law has been rendered largely moot by the Government Procurement Agreement adopted at the Uruguay Round of the General Agreement on Tariffs & Trade.  See Agreement Establishing World Trade Organization, Annex 4, Plurilateral Agreements, Government Procurement Agreement.

More recently, state legislatures in the United States have considered imposing some restrictions or prohibitions on the use of foreign service providers for contracts involving payment of  state or local funds.  In New Jersey, State Senator Shirley K. Turner introduced a bill that would prohibit any contracting or subcontracting to foreign service providers where the work could be done by American citizens or lawful permanent resident aliens.  Similar legislation is reportedly under consideration (as of February 2003) in Connecticut, Maryland, Missouri and Wisconsin.

Policy Debate: Validity vs. Wisdom of Xenophobia.

As a matter of public policy, we must distinguish between law and policy.  Would such legislation be lawful?  Under the World Trade Organization (WTO) General Agreement on Trade in Services (“GATS”), it would appear valid for government procurement of services.  As a “beggar-thy-neighbor” policy of keeping jobs at home, such legislation would help generate employment at a time of economic decline, reducing the costs of public welfare and other social costs.

Would such legislation be good public policy?  Such legislation would deprive local governments of purchasing services at the cheapest price.  It would hurt local taxpayers as consumers of government services.

World Trade Organization: No “Non-Tariff Barriers” for Private Trade.

Free trade under the World Trade Organization (formerly known as the General Agreement on Tariffs and Trade, or GATT) is based on certain fundamental principles:

• national treatment of foreign suppliers of goods and services, where each member state must “accord to services and service suppliers of any other Member, in respect of all measures affecting the supply of services, treatment no less favorable than that it accords to its own like services and service suppliers.”   General Agreement on Trade in Services, Art. XVII(1), MTN/FA II-A1B, p.19).
• transparency of the laws and regulations governing international trade (subject to the supervening principle that disclosure is not required where it “would impede law enforcement or otherwise be contrary to the local public interest or would prejudice the legitimate commercial interests of particular enterprises, public or private.”   See, e.g., Agreement on Trade-Related Investment Measures, Art. 6, MTN/FA II-A1A-7, p. 3.)
• non-discrimination.

Market Access to Foreign Services Providers under GATS.

The WTO’s General Agreement on Trade in Services embodies the principle that, in sectors where a member state undertakes to grant market access to service providers from another member state, that market access cannot be restricted either nationally or regionally.    Specifically, it is a violation of GATS for a member state to impose any restriction on market access in any of the following forms:

• Number of Service Providers: limitations on the number of service providers (such as in the form of numerical quotas, monopolies, exclusive services providers or the requirement of a “economic needs” test as a condition of market access).
• Value of Service Transactions: limitations on the total value of service transactions or assets (in the form of numerical quotas or the requirement of an “economic needs” test).
• Quantity of Services Provided or Service Operations: limitations on the total number of service operations or on the total number quantity of service output expressed in terms of designated numerical units, in the form of quotas or the requirement of an “economic needs” test.
• Number of Employees: limitations on the total number of natural persons who may be employed in a particular service sector or that a service provider may employ and who are necessary for, and directly related to, the supply of a specific service in the form of numerical quotas or the requirement of an economic needs test.
• Type of Legal Entity or Joint Venture: measures that restrict or require specific types of legal entity or joint venture through which a service supplier may supply a service.
• limitations on the participation of foreign capital in terms of maximum percentage limit on foreign shareholdings or the total value of individual or aggregate foreign investment.

General Agreement on Trade in Services, Art. XVI(2), MTN/FA II-A1B, p.18.

Exceptions to GATS Protections.

Several exceptions expressly permit a member state to disregard its obligations on trade in services.
Services Supplied in the Exercise of Governmental Authority.

By definition, the GATS does not apply to “services supplied in the exercise of governmental authority.”  General Agreement on Trade in Services, Art. I(3)(c), MTN/FA II-A1B, p.14). In some countries, “governmental authority” involves the performance of functions that are considered commercial or otherwise not “in the exercise of governmental authority.”

In the United States, for example, in November 2000, President George W. Bush’s administration adopted regulations requiring that all governmental functions be evaluated and classified as governmental or non-governmental, and non-governmental functions are to be contracted out to outsourcers (or possibly even privatized).

National Security.
National and international security considerations take precedence over trade in services under GATS. In particular, member states may take actions that they may deem necessary to protect “essential security interests” relating to services for provisioning military establishments, nuclear fuels or their materials, or any other action “taken in time of war or other emergency in international relation.”   As a procedural matter, the member state must notify the WTO’s Council for Trade in Services when such “security exceptions” have been adopted and when they have been terminated.  General Agreement on Trade in Services, Art. XIV bis, MTN/FA II-A1B, pp.16-17.

War.
As a “national security” measure, a member state might impose an embargo on trade in services with one or more other WTO member states during a time of war.  The exception applies “in time of war.”

This “war” exception leaves open a number of vital questions about the legality and viability of discrimination, trade embargos and other acts normally prohibited by GATS.  The “war” exception does not specify that the embargo must only apply to another member state that is at war with the buying member state.  But it is not clear whether the right to impose an embargo applies to a country that is perennially in a “state of emergency” or has never entered into a formal cessation of armed hostilities with a particular other member.

In a sense, this exception could arguably serve as the basis for a member state’s attempt to circumvent the WTO principles of free trade in services.  In our view, such an attempt could invite trade reprisals and dispute resolution before a WTO dispute tribunal.

Deceptive and Fraudulent Practices; Contract Default and Enforcement of Rights.
Under GATS, member states may adopt and enforce measures of a general, non-discriminatory nature relating to “the prevention of deceptive or fraudulent practices or to deal with the effects of a default on service contracts.   Accordingly, laws governing enforcement of rights and remedies under contract breach are not subject to GATS rules, so long as the laws are “not applied in a manner that would constitute a means of arbitrary or unjustifiable discrimination between countries where like conditions prevail, or a disguised restriction on trade in services.”   General Agreement on Trade in Services, Art. XIV(c)(i), MTN/FA II-A1B, p.15.

Data Protection.
Similarly, under GATS, member states may adopt and enforce non-discriminatory laws for “the protection of the privacy of individuals in relation to the processing and dissemination of personal data and the protection of the confidentiality of records and accounts.”  General Agreement on Trade in Services, Art. XIV(c)(ii), MTN/FA II-A1B, p.15).

Safety.
Laws governing safety are also generally exempt from the rules of GATS, except if they are discriminatory or disguised trade restrictions.  General Agreement on Trade in Services, Art. XIV(c)(iii), MTN/FA II-A1B, p.15.

Collection of Taxes.
Laws for the “equitable or effective imposition or collection of direct taxes,” or for the avoidance of double taxation under a tax treaty, may be somewhat discriminatory against foreign service providers.  General Agreement on Trade in Services, Art. XIV(d) and (e), MTN/FA II-A1B, p.15).

Government Procurement.
Exceptionally, under GATS, the WTO principles of most-favored-nation treatment, market access and national treatment do not apply for governmental procurement of services. General Agreement on Trade in Services, Art. XIII(1), MTN/FA II-A1B, p.14). (The other principles, such as the “transparency” duty to publish applicable laws and regulations, remain unaffected.)   The Government Procurement Code, adopted prior to the GATS, relates to trade in goods and does not require any treatment different from GATS.

Safeguard the Balance of Payments.
This exception allows a government to escape from GATS requirements to open its economy to free trade in services in order to safeguard the country’s balance of payments “in the event of serious balance-of-payments and external financial difficulties or threat thereof.”  General Agreement on Trade in Services, Art. XII(1), MTN/FA II-A1B, p.12). This exception is not directed at measuring bilateral trade imbalance between two countries that are trading partners.  Rather it focuses on multilateral trade and generalized imbalances in the balance of payments.

Conclusions for Outsourcing Services Providers.

If you are promoting the sale of your services from a foreign country, you should focus on the practical economic benefits of your service.  This may include:

• abundant labor supply.
• rapid deployment of a large pool of skilled workers for early completion of a complex project.
• high quality standards, such as the Software Engineering Institute Capability Maturity Models for both software and services.
• low cost to the taxpayers whose governments are acting as purchasing agents.
• local presence in the host country, and the role of the host country employee pool for the service provider.

Conclusions for Purchasers of Transborder Services.

There are undoubtedly substantial risks of force majeure in outsourcing.  But the WTO principles of national treatment for private-sector transactions and other fundamental protections of international trade in services are well established.  Legislation by state legislators is not likely to have any impact on your ability to procure services at low cost under a clear outsourcing contract. Despite the risks and problems, using technological methods as well as legal contracts, you can protect your investment in foreign services.

Conclusions for National Governments.

The opening of borders to “free trade” under WTO principles leaves everyone exposed to the risk of loss of value of their knowledge in a rapidly changing information economy.  Governments should focus on building a workforce that is skilled in knowledge tools.

Deal Structure: Countertrade – Transformational Outsourcing — Call Centers — Customer Care

October 9, 2009 by Bierce & Kenerson, P.C.

Outsourcing Service Provider as Distributor for Customer’s Core Services

In early February 2004, IBM and Sprint Corp. prepared to announce a major outsourcing agreement for IBM to assume the responsibility for customer services for Sprint wireless PCS telecom services.   The deal affects 5,000 to 6,000 jobs at Sprint.   According to news reports, the value of the deal is estimated at $2 billion to $3 billion, which equals the total amount that Sprint forecasts in its own savings.

Scope; Metrics.

The arrangement appears designed to restructure existing call center operations, some of which had already been outsourced, to integrate call centers with technology-enabled data management on customer demand, customer satisfaction and market conditions in real time.  IBM will be seeking to dramatically improve Sprint’s customer satisfaction through better customer segmentation, more efficient call routing, reduced average call handle times and a higher rate of first call resolution.   IBM will provide customer self-service tools via the Internet and web-based services.   IBM will also provide ongoing consulting services to Sprint to continually improve customer satisfaction.  IBM will take over management of Sprint’s existing vendor-operated call centers (moving from one outsourcer to another) as well as a Sprint-owned call center in Nashville, Tennessee.  IBM claims that in such outsourcing arrangements, “IBM is transforming, integrating and managing key business processes for [its customers] to become more flexible in adapting to market and customer variables in real-time.”

Countertrade: “Counter-Distribution Services.”

The transaction makes IBM one of Sprint’s largest distributors.   In the joint press release, the two companies said the relationship will include “a long-term business alliance that designates Sprint as a key IBM vendor for wireless and wireline services and enables IBM to incorporate Sprint’s national PCS wireless services and its IT and data products and services into customized on-demand solutions for IBM’s customers.”   Thus, IBM is expected to market Sprint’s core services — wireless and land-line voice and data services — to IBM’s other customers.

By appointing the outsourcing services provider as a distributor, this multinational outsourcing customer barters its purchasing power for marketing and sales, particularly with a global sales organization with easy access to the technical procurement executives in multinational enterprises.   And as service provider IBM incurs risks of the failure of its customer Sprint to deliver promised services to IBM’s other customers.   That results in a common effort that could be called a joint venture, but the parties did not call it more than a “business alliance.”

Countertrade: “Counter-purchase Agreements.”

The counter-distribution agreement has substantially lower risk of failure for the services provider than a simple counter-purchase by the service provider of its customer’s goods and services.   When WorldCom went bankrupt in 2002, EDS took a substantial charge to its revenues, since the balance of trade was negative.  EDS owed money to WorldCom for WorldCom’s services, but WorldCom was able to reduce its payments to EDS by reason of the bankruptcy protection for WorldCom’s operations.  (Later, WorldCom changed its name to MCI).  But if Sprint fails to deliver its services to IBM’s customers, IBM’s reputation will be tarnished, which could cause greater harm to IBM.

Outsourcing as a Tool for Business Process Transformation.

This deal contemplates the transitioning of Sprint from delivering classic telephony services in a “stand-alone wireless and wireline network.”   Reading between the lines, IBM will probably help Sprint convert to Internet telephony, or “voice over Internet protocol” (“VOIP”).    Telephony will integrate into the desktop and computer network environments.

The press release suggested initially that the deal looked like simply a transfer of Sprint’s existing call center operations from its existing service providers (and some insourced call centers) to a new service provider. IBM’s commitment to improved service level agreements was heralded as a means of “dramatically” improving customer satisfaction.

But the joint press release suggested, without saying clearly, that the deal has much more strategic impact, by asking IBM to convert Sprint’s wireless and wireline telephone service to a network capable of Internet telephony (called “voice over Internet Protocol,” or “VOIP”) for IBM’s other corporate customers. To cushion the shock of cannibalizing its own classic telephony services, Sprint probably enlisted IBM to bundle Sprint’s services into IBM’s other IT-enabled outsourcing services. IBM became a reseller of Sprint telecom services. More significantly, Sprint’s business was to be transformed into an Internet-based service provider to IBM’s other customers.

The deal has the potential, therefore, to transform Sprint’s customer base, its method of service delivery, its revenue profile, and its marketing alliances in addition to hiring a service provider to improve service levels in call centers.

Lessons Learned.

The counter-distribution model offers substantial flexibility for both the service provider and its customer.

• Service Provider’s Perspective.
  For the service provider, credit risks (from a prospective bankruptcy of the customer) may be managed by financial management of the delivery of the customer’s goods or services.   Similarly, the service provider might not need to make any financial commitments to secure and retain the right to resell the customer’s goods or services.
• Enterprise Customer’s Perspective.
  For the enterprise customer, access to a global sales organization may serve as a scorecard criterion for selection of prospective service providers.   The customer might rightly conclude that a bigger, more global, more diversified service provider would assure a wider channel for the distribution of the customer’s own core business services.   For telecom companies, using an IT services provider to distribute telecom services is a logical extension of the service proposition in response to the convergence of the Internet, telephony and digital communications.  Reportedly, IBM will be selling Sprint  services to large corporations so that employees of Sprint customers may transfer data from their networked desktop or laptop computers to wireless devices such cell phones, Blackberry® and Palm® handheld mobile devices.
• Mutual Dependency, Mutual Risk.
  For each party in a countertrade transaction, however, the lessons of the past invite caution.   Once two parties are interdependent as customers or as marketers, the relationship requires a more complex management interaction.  The risks for each are increased.  If the customer wanted to fire the service provider for a breach of service level agreements, for example, the service provider might have the right to cancel the distribution rights (if unprofitable) or might seek to retain the distribution rights free of any “cross-default” clause.  The stakes are higher for potential “win-win” or potential “lose-lose” outcomes.
• Long-Term Impact.
  If a Sprint-IBM countertrade model for distribution of the customer’s services were to become the model for a long-term outsourcing contract, securities law and antitrust laws might come into play.
  • Securities Regulation.
    As to securities laws, the impact might be so important that investors might consider it “material” to decisions whether to buy, sell or hold the enterprise customer’s corporate securities.   Initially, such a distribution model does not appear likely to generate any “material” revenue streams for the enterprise customer.  Over time, the impact might grow particularly if the outsourcing has the goal or potential of restructuring the enterprise customer’s business model.

    At some stage, the disclosure required under applicable securities laws might become problematic, as information publicly disclosed could be used by competitors.  As a result, both enterprise customer and the services provider have some incentive not to enter into transactions that are not so important and material as to require disclosure under applicable securities laws.

    In reviewing the press release, one may question whether investors are adequately informed of the true nature of the risks of this transformation of the customer’s business, not from the standpoint of the risk of IBM’s nonperformance, but from the standpoint of Sprint’s ability to successfully transform its own service model by the counter-trade structure with IBM promoting VOIP to IBM’s other customers.

  • Competition Policy and Antitrust Laws.
    As to antitrust laws, reciprocal dealings by organizations in the same competitive arena could be unlawful as anti-competitive under U.S. federal antitrust laws and European Union competition policy.   Before entering into a countertrade transaction, the parties should consider the likely impact of the distribution or counterpurchase operations as to exclusivity, market size, concentration of suppliers and customers in the relevant market, and other factors that define structural anticompetitive activities.  As global customers hire global service providers to provide distribution services, the impact in any single country’s marketplace may be small compared to a similar business relationship between parties located only in one country or regional market.  Consequently, the antitrust risks are relatively small at the global level.
  • If IBM were to repeat this paradigm in other industries, though, IBM might gain market power in an important array of global non-IT services.  Further anti-trust reviews might be appropriate in such a scenario.

Case Study in “On Demand” Computing: American Express Company

October 9, 2009 by Bierce & Kenerson, P.C.

Motivations for an “On Demand” Computing Deal.

American Express Company is the world’s largest issuer of credit cards and provides financial services. Why did American Express Company decide in February 2002 to sign a $4 billion seven-year deal with IBM, the world’s largest information technology company, that the two companies hailed as “on demand” computing? The announcement says little about the structure of the deal, but is clear as to intentions.

American Express Company’s Cost Savings.

American Express calculated that this deal will save them “hundreds” of millions of dollars.

American Express Company’s Internet Initiative.

After 2001, Chairman and CEO Kenneth Chenault began pushing American Express to Web-enable its operations as much as possible. In a Web conference with investors on February 6, 2002, he noted that, “given the compelling economics of online servicing across all our businesses, several initiatives last year focused on shifting customer transactions to the Internet.” He asserted that self-service Web-enabled applications allowed the company to handle 78% of their customer transactions – from payments to disputes — via the Internet, with over 5.5 million U.S. cardmembers enrolled in this program, generating over 83 million logins in 2001, resulting in unit cost reductions of up to 60% for certain transactions, reduced rates of credit problems of credit card fraud (by up to 96% at certain merchants and overall by over 25% in 2001) and of customer disputes (by up to 50%). Other administrative chores have been permanently shifted to the Internet, such as employee and financial advisor processes.

American Express Company’s Restructuring Initiatives.

Due to a sharp decline in travel and in demand for financial services after September 11, 2001, the company accelerated its then current focus on cost cutting and restructuring. In 4Q2001, the company eliminated 5,500 to 6,500 travel-related jobs and took a restructuring charge of $240 to $280 million. In a news release on December 12, 2001, the company note that “reengineering initiatives being implemented or considered by the company include cost management, structural and strategic measures such as vendor, process, facilities and operations consolidation, outsourcing, relocating certain functions to lower cost overseas locations, moving internal and external functions to the internet to save costs, the scale-back of corporate lending in certain regions, and planned staff reductions relating to certain of such reengineering actions.”

Prior and Ongoing Business Relationships.

Announced in February 2002, MarketMile, an e-procurement service provider founded by American Express Company entered into an “e-business on demand” “alliance” with IBM to deliver to American Express’ customers the “benefits of e-procurement” and management of “indirect expense spending via the Internet. This service will be based on IBM’s “Leveraged Procurement Service,” IBM’s program for Web-enablement of a customer’s proprietary applications and supply-chain integration of the customer’s supplier network and customers. In March 2002, IBM and American Express announced an agreement to jointly develop a Web-based expense reporting and reconciliation software tool for reporting travel and miscellaneous business expenses and reconciling corporate purchases, to be marketed by American Express and hosted by IBM.

Interlocking Boards of Directors.

Good friends make good business, it seems. IBM’s Chairman Louis Gerstner from 1993 to March 2002 was formerly Chairman and CEO of American Express Travel Related Services from 1985 to 1989. American Express Company’s Chairman and CEO Kenneth Chenault is a member of IBM’s Board of Directors. This unusual bilateral interlock spanning 15 years of common business experience shows how aligned the interests of the companies have become. Could anyone say that this was the reason why IBM got the deal? (Or was it because of superior acumen, customer service and solid technology?)

IBM’s Investment in Changing Technology.

The selection process for a transaction of this size involves more than board-room and golf-outing relationships. IBM’s position as a manufacturer of computers gives it unique leverage in pricing. IBM’s “Project eLiza,” to deliver self-managing systems technology (including configuration, optimization, fixing and self-protection) across the company’s entire e-server product portfolio by 2007, offers customers the comfort of being with a market leader in hardware that supports e-business.

IBM Global Services: Are they the only game in town?

The promise of “on demand” computing requires a services provider to provide a “total smorgasbord” of services, even for third-party equipment, third-party software and third-party telecommunications. Who else could meet this challenge? Is this a challenge that makes sense for other services providers? Could a meaningful outsourcing contract be drafted that would overcome the inherent limitations of a narrow-scope services provider? Do equipment manufacturers (such as IBM, HP, Compaq and Dell) offer better terms than pure services companies? Or could a narrow-scope services provider compete effectively by becoming a better manager of third-party services than IBM? This deal opens these issues.

Deal Terms.
American Express will pay IBM Global Services about $4 billion over seven years to host its Web site, network servers, data storage, and help-desk support. According to IBM, this contract is IBM Global Services’ largest for utility-based service delivery. Payments are adds are based on actual usage of IT services rather than a flat fee. American Express projects “hundreds of millions of dollars” in IT savings during the life of the contract.

As part of the agreement, American Express will also move about 2,000 employees worldwide to IBM Global Services. The employees will continue to work out of American Express’ data centers in Phoenix and Minneapolis, as well as locations in England and Australia. In March, IBM will begin taking over American Express’ transaction-processing operations.

Utility Computing /On-Demand Computing.

While the concept of on-demand access to IT resources has been in the market for a few years, few large companies such as American Express have committed to it. Essentially, the services provider takes over responsibility for making all purchases, managing the technology and delivering technology as a service “on demand,” when and where needed, in scalable volumes. As a legal contract, however, the degree to which any service can be “on demand” involves prior agreement on the customer’s current and future technology plans, as well as any financial risks that the customer must shoulder to deal with changing customer needs, changes in technology and changing market conditions. The customer still remains responsible for IT strategy, planning and ensuring that it gets what it contracted for.

Finance & Accounting Outsourcing: Does Outsourcing Reduce Risk?

October 9, 2009 by Bierce & Kenerson, P.C.

When enterprises look to outsource in-house responsibilities, finance and accounting functions are usually not the first ones farmed out. Executives might expect to read headlines like, “Aon Negotiating to Outsource Most of its U.S. IT Infrastructure to Computer Sciences Corporation,” a development Aon and CSC touted in a 2004 press release. Sophisticated business process outsourcing (“BPO”) such as finance and accounting is not as widespread as IT outsourcing.

As enterprise firms seek to enhance their competitive advantage and minimize risks in the Sarbanes-Oxley environment, more and more businesses are looking to outsource parts of their finance and accounting functions. Determination of the right fit with a service provider and the right mix of services is essential.

This article addresses some key business and legal issues in whether F&A outsourcing reduces risks.

What F&A functions are candidates to be outsourced?

Not all F&A functions are created equal. Each F&A function has its own risk profile and potential suitability for outsourcing. Risk profiles reflect the nature of the business functions, size and character of the enterprise, since publicly trade companies must deal with the vagaries and criminalization of accounting practices under Sarbanes-Oxley, and other considerations.

Transactional vs. Judgmental Operations.
Transactional functions, especially payroll and accounts payable and receivable, are the most commonly outsourced functions. Financial reporting and more advanced functions can also be outsourced, though the more interaction required for a function—say, for instance, budgeting—the less likely it is to be outsourced. But today, F&A outsourcers are taking on responsibilities once executed by entire in-house F&A departments.

Enterprise Maturity.
F&A outsourcing depends on enterprise maturity.

Public Companies and “Wannabe’s.”
Mature enterprises — public companies and those considering going public — must, or will have to, establish and certify, on a quarterly basis, the adequacy of their accounting reporting and control systems. Compliance with the Sarbanes-Oxley Act has generated new software and service offerings by information technology service providers and consultants. Such technology might be maintained in-house, a hosting service provider or by a managing service provider.

For public companies, the challenge is to identify those F&A functions that can be “safely” outsourced with minimal risk that a failure will result in civil or criminal liability for the CEO and the CFO. Once such “safe” functions have been identified, the lawyers can deal with “reasonable” allocations of risk between the service provider and the enterprise.

Startups and Emerging Companies.
Startups may outsource more of a function. Outsourcing helps startups avoid misestimating their own needs. Two scenarios are common among startups: they underestimate their F&A needs, or they overestimate them.

Startups will often hire a bookkeeper, for instance, and may get the basic transactional aspects of the business right. But without an accountant, they can’t optimize their F&A strategy. This mistake can often require a startup to sink far more capital in F&A and litigation down the road than they would have had to invest up front.

Alternatively, some firms will bring on a CFO or Comptroller when their F&A needs do not demand that those positions be filled by a full-time employee.

Governance Considerations.
Entire F&A departments can be outsourced, all the way up to the CFO level. We interviewed two F&A outsourcing firms on the desirability of outsourcing CFO and Comptroller functions. Ephinay will take over all F&A responsibilities from a customer except CFO and Comptroller, which Ephinay believes must be retained by the customer for governance purposes. Other outsourcers, like Geller & Co., are more willing to absorb even the responsibilities of CFO and Comptroller, eliminating the need for any F&A functions to be retained by the customer. In contrast, Ephinay believes that is rarely optimal except when the customer’s business is highly specialized. Perhaps the distinction is not so important for small business, but for larger and growing businesses, retention of key internal executives helps ensure controls are retained as well.

When is F&A outsourcing a better solution than in-sourcing?

Business Process Analysis.
As in all other types of outsourcing, F&A outsourcing starts with an analysis of the business processes of an enterprise. This analysis must cover virtually all essential elements of the business processes under consideration. Thus, an “end-to-end” approach will identify functionality, interaction with third parties (such as suppliers, customers and regulators), the degree of human expertise required for each process and the degree to which human expertise can be captured in a scalable information technology solution that includes hardware, software, telecommunications and technology managers.

Business Processes Considered for F&A Outsourcing.
Having dissected the business processes from end-to-end, the enterprise then considers how the classic types of rationales for outsourcing might fit into each F&A process. Many firms find outsourcing F&A business process functions preferable to retaining them. Here are some common reasons why.

Shifting functions plays to core competencies.
F&A outsourcers exist for one reason and one reason alone: to take over the F&A functions of other businesses. If F&A outsourcers fail to do a good job of F&A in a competitive marketplace, they will fail entirely. F&A is an F&A outsourcing firm’s core competency, by definition. Of course, this is an agreement to “trust me.”)

In-house functions are always secondary to the fundamental premise of the company.
In a semiconductor business, for example, making and selling semiconductors is the lifeblood of the business; F&A functions are necessarily secondary because they do not create business. This is no less true of large corporations than it is of startups or enterprise businesses. Top talent is routed to revenue-generating departments; being an accounting whiz, for example, is unlikely to take you to the top of GM. F&A outsourcers, unlike their customers and prospective customers, are structured to reward those who perform F&A functions well.

F&A outsourcing optimizes functions of non-F&A businesses.
F&A outsourcers allow businesses to focus on revenue generation instead of worrying about F&A matters, which are integral to their operations but do not actually create revenue for their business.

Outsourcing optimizes the function of the CFO and other senior-level employees.
When transactional functions are outsourced, the CFO can focus on F&A strategy rather than minutiae. The CFO can be a CFO, the Comptroller can be a Comptroller.

Cost Substitution.
Outsourcing enables businesses to implement more advanced technology solutions more cheaply. Take, for example, a firm with an antiquated IT system that costs them $10 million dollars a year to run. They want to upgrade, but the upgrade will require a capital investment of $15 million; the outsourcer, on the other hand, can provide the service for $8 million. The customer may prefer to go with the outsourcer, who can provide the improved technology for less than the cost of the customer’s obsolete technology and for substantially less than the cost of an in-house upgrade.

Economies of scale.
F&A service providers such as Ephinay and Geller claim they can give the customer “more F&A bang for the buck.” An outsourcing provider (or a CPA firm) could enable a company outsource its needs to F&A experts who work part-time for the company. When ’re hiring a part-time F&A provider, the enterprise can afford to tap a deeper bench for the same money. For the same costs as for a CFO, the enterprise might get a CFO, a Comptroller, and a bookkeeper. The customer can take advantage of the fact that the outsourcer likely has a much larger and more specialized staff than the customer’s in-house F&A department. A customer could afford to have a small army of outsourced accountants, for example, working on its projects at crucial times, which it could never do in-house.

Peaks and Valleys.
Outsourcing may also help smooth peaks and valleys in the monthly, quarterly and annual financial and accounting cycles. Variability in service volumes enables companies to budget for their in-house baselines and manage the pricing and costs — on a variable pricing method — of outsourced staffing for peak loads. In contrast to staff augmentation as a business model, though, outsourcing involves minimum purchase commitments by the enterprise customer, thereby allowing an efficient outsourcer to engage in resource management planning and delivery of lower per-unit resource costs.

Process Complexity.
Certain F&A processes are so inherently complex, or judgmental, that the entire process is outsourced before the enterprise even considers hiring and supporting its own staff. Such areas include employee retirement planning, ERISA fund investment and pension administration. (These processes overlap with HR functions, making them even more complex.)

Why F&A outsourcing minimizes risk

Outsourcing in F&A is often a way to increase competitiveness and minimize a firm’s risk. Outsourcing can improve competitiveness by cutting costs, but it can also improve the capabilities of the customer’s firm beyond freeing up intellectual and financial capital. Here’s what the sales pitch sounds like:

• Shifting functions is shifting risks.
  Shifting functions to an outsourcer can be a way of shifting risk to that provider. When a customer contracts with an outsourcer to execute a function, the customer then looks to the outsourcer for results; it becomes the responsibility of the outsourcer rather than the customer to deliver. This improves efficiency for the customer; if an employee calls in sick and can’t deliver before an important deadline, for instance, that now becomes the outsourcer’s problem rather than the customer’s.
• F&A outsourcers are better structured to catch many kinds of errors.
  Many outsourcers have multiple levels of review built into the F&A process and are therefore more likely to catch errors before they become catastrophes. These errors could range from the occasional arithmetic mistake to faulty accounting and the attendant potential for civil liability. Many customers cannot afford to hire in-house the quantity or quality of people required to match an F&A outsourcer’s product. F&A outsourcers also often have more detailed or more up-to-date knowledge of arcane tax regulations that can be leveraged to the customer’s advantage. This is, of course, more important in the Sarbanes-Oxley world, where accounting errors can embroil firms in heftier fines and more serious litigation than before. In addition, unauthorized expenditures by outsourcers are impossible—whether the result of a mistake by the outsourcer or criminal embezzlement—when the contract between the customer and the outsourcer spells out precisely what expenditures are authorized and what responsibilities will be retained by the customer.
• F&A outsourcers are less likely to make mistakes because it undermines their entire business.
  F&A outsourcers’ livelihood comes from their contractual work. At a minimum, outsourcing in general does not increase risk. Problems presented by the risks of mathematical errors, incompleteness of records, lost records, and inappropriate classification of transactions for accounting purposes, for example, are at least as likely to occur among F&A departments of businesses that retain F&A functions as they are among F&A outsourcers. But in general, F&A outsourcers minimize these risks because F&A is their exclusive function; if they make these kinds of mistakes routinely, their business stands to pay a substantial material price. (In response, the enterprise needs to consider who is better at assuming the risk of making and making good on the typical types of errors associated with a particular business process.)

Questions that enterprise customers want answered

The prospective customer is considering handing over his business’ finances to another business. That is an inherently delicate process, especially if the prospective customer is not already acquainted with the outsourcer. Customers expect answers to the following questions:

• Why should I outsource when I can retain control by insourcing?
• for what functions is the outsourcer responsible?
• Is the outsourcer reachable, or do I have to call between 9 a.m. and 5 p.m. to get in touch with a responsible person?
• What attitudes and cultures should I look for in a “good” service provider?
• How will outsourcing my F&A functions increase my firm’s competitiveness?
• Will outsourcing allow the CFO to be more effective and act more strategically?
• Will outsourcing increase our risk? Even if outsourcing can increase quality and reduce cost, the customer wants to know what the risks of outsourcing are, and whether and how they can be managed, before he closes a deal.
• How do I assure that the outsourcer will track what we need to track, including possible fraud in its own operations?
• What alternatives exist to outsourcing this function? Would an investment in software “solve the problem” of managing the particular F&A function?

Friction points

In outsourcing arrangements as in any transaction, friction points arise particularly when responsibilities are poorly defined. As in other types of outsourcing, F&A outsourcing involves classic issues that need resolution in planning and contracting.

• Scope of services must be defined. If the scope of services to be performed by the outsourcer is left vague by the parties in their contract, serious problems can arise. The customer must know what responsibilities he is contracting to the outsourcer and what functions he retains. Likewise, if the number of hours or amount to be billed by the outsourcer is left open-ended, opportunity for customer-outsourcer friction increases.
• Due dates for projects must be spelled out in advance by contract where appropriate. Outsourcers cannot be expected to respect informal internal agreements customers may have been accustomed to when F&A functions were in-house (“Frank always got me the numbers on Fridays—I don’t see what the problem is”) unless they are specified up front. But this is a problem inherent in any transaction, in outsourcing and insourcing.
• Software compatibility is generally not an issue.
  This is a major concern for customers—how much of my standard operating procedure will I have to change to accommodate the outsourcer?, they frequently ask. The answer can be “none.” Generally F&A outsourcing firms do not impose tech solutions on their clients when transactions are light. Platform compatibility can become an issue, however, as the complexity of the mathematics increases. Some outsourcers are “platform agnostic” regardless of the volume of transactions involved, while others may require their high-volume customers to use Solomon or SAP.

Transitional Issues

A business’ decision about whether to outsource any function, F&A or otherwise, often hinges on the cost of transitioning responsibilities to the outsourcer. The slope of the customer’s learning curve and the amount of time required to make the transition depends on the number and importance of the outsourced functions. It also depends on the particular outsourcing firm.

Timing.
Some firms require four to six weeks to take over bookkeeping responsibilities from their customers; others do it in as little as two weeks. Outsourcing a whole F&A department could take as long as a year, or as little as a month

Transition Planning Toolkit.
Firms will often require their customers to fill out a questionnaire detailing business expenses to help acquaint the outsourcer with the customer’s regular expenses. This helps accelerate the transition. However, some pain occurs when the enterprise of the customer has to modify its process to accommodate the new outsourced business process.

Comparison with In-sourcing.
Some F&A outsourcers assert that transition costs entailed in a switch to outsourcing are not necessarily higher than those of hiring a new person in-house, and can often be recouped much more quickly. However, in a larger organization, the degree of change management is much greater when transitioning to an outsourced process.

Conclusion.

F&A outsourcing contracts may still represent a small minority of total outsourcing arrangements. Yet businesses are increasingly looking to F&A outsourcers to take over certain high volume, low risk, F&A functions with a modest degree of discretion or judgment. The trend in outsourcing towards allowing smaller and smaller businesses to outsource has taken hold in the F&A area as well. Small and mid-sized businesses (“SMB’s”) and startups can often find it profitable to outsource a variety of different F&A functions that would only have been profitable for major corporations to do just a few years ago. F&A outsourcing is becoming increasingly common among businesses that want to reduce risk and optimize their competitiveness and are willing to invest in strategic sourcing plans and skilled contract lawyers.

Effective risk management requires effective legal contracting. Given to complexity of F&A outsourcing, careful contracting is required.

Frequently Asked Questions For Employees

October 9, 2009 by Bierce & Kenerson, P.C.

A) “Outsourcing” does not mean the automatic loss of your job.

It may improve an employee’s career opportunities by opening the door to new environments for providing service. Indeed, with the technical training that an outsourcing service provider gives its new employees, being “outsourced” can be a ticket to personal growth, improved opportunities for lifestyle change (e.g., telecommuting, or flex time), and backup to avoid being burned out as the only, “indispensable” employee supporting a business operation. For the employee, the challenges create opportunities. But, because the external service provider will be held accountable for agreed service levels, the employee will also be guided by new measurements and standards of performance.

B) “Outsourcing”: Same Threat to Your Job as in a Merger?

Employees in a company or department that is being targeted for outsourcing normally feel threatened by the uncertainty. This is similar to the fear, uncertainty and doubt experienced by employees in a merger. Yet the outsourcing decision is quite different. Indeed, in an outsourcing, management elects to maintain and effectively deploy all useful resources. External services providers typically do not want to hire someone just to fire them later. By hiring an employee whose job is being outsourced, the outsourcer (external service provider) assumes many responsibilities. Such responsibilities generate high costs in recruitment, training, transitioning in and transitioning out (including outplacement and severance, if applicable), pensions, labor law compliance and other legal and economic obligations. So the outsourcer will normally plan to maintain certain employment levels and efficiently use all personnel whose jobs are being outsourced.

The threat is not the same as in a merger. In a merger, attrition and job terminations are generally one of the compelling reasons to marry the two companies. So your job is more at risk in a merger than in an outsourcing.

C) Can We Avoid Outsourcing?

Yes. When a work group – however large and complex – has been mismanaged through neglect, lack of vision and poor processes, outsourcing might not be the only answer. Improvement of business processes before outsourcing can avoid those outsourcings that occur based solely on “cost savings.” But even good management and leadership cannot escape the compelling advantages of certain types of “strategic outsourcing” that adds a strategic benefit beyond mere cost savings.

D) Should Service Level Agreements Be Used only for Outsourcing?

No. In fact, today’s well-managed businesses often establish “service level” commitments from internal “in-house” staff. Indeed, some information technology departments propose “service level agreements” as a means of setting realistic expectations for business users. Studies have found that frequently, an in-house service department may suffer from criticism by frustrated in-house clients. After going through the process of asking what the in-house clients expect, and showing the costs of fulfilling those expectations, the in-house staff can compare itself to the “best of breed.” The process of defining internal service levels will help harmonize expectations of users and reduce stress by in-house service providers.

E) When Should We Outsource a Function?

Within a globally competitive environment, outsourcing could be useful, or it could unbalance a well-managed organization. The key is to find and maintain one’s balance. Rebalancing involves a candid reassessment of organizational strengths, weaknesses and the threats from the marketplace. Confronting this constant challenge, management must determine what functions fit within the core competencies of the organization, retain those and seek ways to minimize investment and risk in areas that do not add as much value to shareholders – and other stakeholders – as the core competencies.

F) What Alternatives Exist?

Outsourcing is one of a wide range of possible management strategies. Considering “in-house” strategies include:

• Inaction:
  Do nothing. We’re doing a great job already.
• Cuts Projects:
  Eliminate wasteful projects (especially those that require an excessive investment).
• Cut Jobs:
  Eliminate jobs. Load more work onto existing staff.
• Reallocate Resources:
  Shuffle personnel to new, more effective tasks. (Training may be required. Transitions could be bumpy.)
• “Strategic” initiatives include:

• Competitive Departments:
  Make each department into a separate cost-center and allow it to compete for customers both in-house and in the market. General Motors follows this practice.
• Shared Services Subsidiaries:
  Form an alliance of similarly situated customers of the same service, and transfer the “generic” workload to a jointly owned “shared services subsidiary.” (This “shared services” subsidiary might compete in the market as well.) This requires some submission of control and political alliances with outsiders. Experience proves that a jointly managed subsidiary, without independent management of its own, can lose its way and flounder. In this case, outsourcing has been shown as an effective alternative to a failed experiment.
• Joint Ventures with Services Providers:
  A joint venture involves a sharing of risk and rewards. (Outsourcing involves shared responsibilities and possibly shared risks, and rarely involves shared rewards). Joining forces with a services provider can be useful where the functions performed by the joint venture do not require you to promote, directly or indirectly, the cannibalization of your own core business. The services provider, as your joint venturer, will undoubtedly expect a rate of return on its investment by selling the joint services to others – including your competitors – in the marketplace.
• Other Paradigms:
  Organizational management includes a panoply of other paradigms for speed, skill, technological competency and other goals. The authors of this Website would be pleased to explore such other paradigms with you, and to receive your comments on the effectiveness of outsourcing in relation to other possible paradigms.

Mortgage Loan Servicing and Other Outsourcing by TARP-Assisted Entities: Criminalization of Contract Fraud under Government Contracts

September 27, 2009 by Bierce & Kenerson, P.C.

Do you know whether you are a subcontractor receiving payments from an entity assisted under the U.S. Troubled Assets Relief Program or the American Recovery and Reinvestment Act of [February] 2009? You should be aware of the criminalization of contract fraud and the protection of whistleblowers denouncing contract fraud in your operations.

Mortgage and other TARP-Related Fraud Claims. The U.S. federal Fraud Enforcement and Recovery Act of 2009 (“FERA”) identified fraud in mortgage origination as a key systemic risk in the financial system. P.L. 111-10, S. 386, 111th Cong., 1st Sess. So it extended the definition of criminal fraud affecting financial institutions to include frauds by mortgage lending businesses that finance or refinance any debt secured by an interest in real estate, including private mortgage companies, so long as their activities “affect interstate or foreign commerce.” And “major fraud against the Government” was extended to include any fraud involving “any grant, contract, subcontract, subsidy, loan, guarantee, insurance or other form of Federal assistance, including through the Troubled Asset Relief Program [“TARP”], an economic stimulus, recovery or rescue plan, provided by the Government, or in the Government’s purchase of any troubled asset as defined in the Emergency Economic Stabilization Act of 2008.” 18 U.S.C. § 1031(a), as amended by FERA.

Budget for Prosecutions. The presumption is that there are criminal frauds in TARP operations. For the initial year, FERA appropriated $265 million for prosecution of such frauds: $75 million for the FBI to investigate mortgage fraud, $50 million for U.S. Attorneys, $35 million for the Department of Justice (allocated $20 million to the Criminal Division and another $15 million for the Civil Division), $5 million for the Tax Division of the Department of Justice, $30 million to combat postal fraud, $30 million for HUD, $20 million for the Secret Service and $20 million for the SEC.

Liability. FERA imposes triple damages liability (plus fines plus the Government’s costs of prosecution) on an extended scope of frauds under the False Claims Act, 31 U.S.C. § 3729(a), as amended. While an element of “knowing” action is involved in such frauds, it may be hard to distinguish between a knowing intention to complete a record that is vague or incomplete with “knowingly making, using or causing to be made a false record or statement to an obligation to pay or transmit money or property to the Government.” If you find you made this mistake, you can cleanse your sins and pay only double damages by confessing in 30 days.

Scienter. So what level of consciousness is required to have criminal “knowledge?” By definition, the terms “knowing” and “knowingly” means that a person “has actual knowledge of the information; [or] acts in deliberate ignorance of the truth or falsity of the information; or acts in reckless disregard of the truth or falsity of the information.” To prove a “knowing” fraud, the prosecutor does not need to prove a specific intent to defraud. FERA, 31 U.S.C. § 3729(b), as amended.

The Government as Customer. Under FERA, anyone who submits a payment request to “a contractor, grantee or other recipient” is subject to a claim of criminal fraud, provided that the money or property to be spent is to be used “on the Government’s behalf or to advance a government program or interest” where the U.S. Government provides “any portion” of the money or property.

Whistleblower Protection. FERA protects “any employee, contractor or agent” from being “discharged, demoted, suspended, threatened, harassed, or in any other manner discriminated against in the terms of conditions of employment because of lawful acts” to stop violations. Such protection includes 200% of back pay plus interest on back pay, special damages and litigation and attorneys’ costs. 31 U.S.C. § 3730(h) as amended.

Impact on Mortgage Loan Servicers. In companion legislation, the “Helping Families Save Their Homes Act of 2009” defines guidelines for “servicers” of mortgage loans who have conflicting duties of serving the interests of investors and the Governmental interest in limiting needless foreclosures that destabilize property values and damage State and local economies. P.L. 111-22, S. 896, 111th Cong., 1st Sess. (2009). “Servicers” provide the services of collecting and paying over to lenders the principal and interest on mortgage loans. Where the loans are bundled and sold as securities (CDO’s, trusts, special purpose entities, participation certificates) or otherwise bundled as a pool of residential mortgage loans, the “servicers” act on behalf each of the lenders across a spectrum of loans.

In the “Helping Families” act, Congress authorized mortgage loan services to “modify mortgage loans and engage in other loss mitigation activities” consistent with Treasury guidelines and defined a “safe harbor” under the Truth in Lending Act (15 U.S.C. § 1472(h), as amended) to do so. In essence, Congress rewrote the mortgage loan servicing contracts.

First, the servicer has some duty to maximize the net present value of the mortgages. In such case, the Helping Families law redefines that duty as not to maximize the value of any single mortgage, but across all mortgage holders combined.

Second, the service is not liable if it implements a “qualified loss mitigation plan” (for residential loan modification or workout, such as by loan sale, real property disposition, trial modification, pre-foreclosure sale, or deed in lieu of foreclosure). This plan needs to meet three criteria: (i) the borrower has defaulted, or default is imminent or reasonably foreseeable, (ii) the borrower occupies the property as the principal residence, and (iii) the servicer determines (under Treasury guidelines) that the loss mitigation plan is “more likely to provide an anticipated recovery on the outstanding principal debt” than the anticipated recovery through foreclosure. By acting under these “safe harbor” principles, the servicer “that is deemed to be acting in the best interests of all investors” is statutorily exempt from liability to any party and is not subject to equitable remedies such as a stay or injunction.

The Perilous “Safe Harbor.” This is not much of a “safe harbor,” since the law is riddled with the tests of “reasonableness” as to the likelihood of the borrower’s future default and as to whether the “loan mitigation” (restructuring or workout) plan is truly in the best interests of the majority of lenders. In mid-September 2009, the Treasury Department issued new “guidance” tax rules that make it easier for distressed property owners to restructure their loans that were bundled into mortgage pools and sold to investors as securities, since earlier “guidance” prevented delinquent commercial developers from talking to servicers about restructuring, and similar “guidance” applied to residential mortgages. (Note: the “Helping Families” law does not apply to commercial mortgage-backed securities, “CMBS”).

Lessons for Service Providers Exercising Business Judgment, such as Loan Servicers. Loan servicing, particularly for bundled or pools of residential mortgages, constitutes a classic outsourcing transaction for well-defined scope of services. While the Real Estate Settlement Procedures Act has traditionally governed loan servicing, the global recession of 2007 and after has placed loan servicers in a unique conflict of interest beyond the usual need to occasionally restructure a loan under pre-recession conditions. The service remains in the challenging position of having to make judgments about whether loan modification will have a higher yield to investors than loan foreclosure. Their job is to identify and work with financially sound borrowers to pursue alternative “loss mitigation” for those who are not. The servicer remains subject to liability for errors in judgment, even if made in good faith. In short, the economics converted the exception into the rule: most loans now need some “loan mitigation.”

In the case of residential and commercial mortgages, the servicers came under Treasury regulations governing defaulting, or imminently defaulting, loans.

Lessons can be learned for those providing “financial and accounting” services, particularly services where mistakes can be seen as possible frauds:

• Using Tools and Business Process Automation to Support Business Judgments. Where a service provider is hired to deliver services that exercise business judgment, the risks of mistake can be reduced by “automating” those business processes that support the exercise of judgment. In the case of mortgage loan servicers, the use of “net present value” computations (which assumes certain market factors such as interest rates and future payment streams) set the framework for deciding whether loans in the loan portfolio would have a higher value if restructured than if foreclosed. In other services, the use of metrics, software tools and other automation techniques help not only with predictive diagnostics, but also with remediation of errors in judgment or service quality. In all services where regulatory compliance is a part of the provider’s role, the policies and procedures manuals should establish decision trees and work flows that meet the regulatory framework.
• Avoiding Fraud Claims. Fraud claims offer a claimant an easy way to pursue an aggressive litigation strategy. Being inherently based on unique facts, each case of “fraud” defies the usual motion by a defendant for summary judgment. By adopting legally compliant workflows and having more than one person responsible for making business judgments, a service provider has a better chance of avoiding fraud liability for “rogue” decisions. While outsourcing is based on well-defined business processes that can be automated or performed by one person, the exercise of business judgment should be a team sport to avoid risks of weak judgment, bad judgment or bad faith (“scienter”).
• Multiple Customers, Conflicting Duties. When the scope of services includes any services that require the exercise of business judgment, prudence or good faith, the service provider should identify how it can legitimately serve the interests of “multiple masters.” The “Helping Families” act gives some leeway by allowing the servicer to act for the general advantage of all “masters,” even though some masters (lenders) will not be getting pari passu equal treatment with the others. Pari passu does not work for multiple customers in a bundle or pooled service.
• Contractual Safe Harbors. Similarly, when the scope of services requires such business judgment or even fiduciary duty, the service provider and enterprise customer should define contractually what considerations and processes should be adopted to reach a “satisfactory” outcome.
• “Change of Control” + “Force Majeure” = Increased Risk. When collateralized debt obligations became unmarketable as “toxic,” the government stepped in and imposed a new framework. Parties to an outsourcing relationship should carefully consider the possibility of such intervention and changes in risk and reward structures by governmental fiat.

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