Special Issues in Agreements Involving Outsourcing

The trend towards outsourcing will continue to grow as market pressures force corporations to be more tightly focused on core business functions, gaining competitive advantage and reducing costs. Outsourcing is an attractive alternative in good times and bad times. Shifting back end administrative and business functions to an external provider in good times, may be a means for quicker time to market and focusing resources on core business activities to grow the business. In bad times, outsourcing is a means for streamlining the enterprise by eliminating functions, which create a drag on capital and/or do not provide any competitive advantage.

In the current economic environment, concerns over, shrinking margins, liquidity and the
need to reduce operating cost structures is accelerating a trend towards shifting certain
back office administrative functions to outside suppliers. This trend is seen as a major
paradigm shift within enterprises, which have realigned their internal corporate
infrastructure to focus on more strategic areas of their core business.

Although the human resources (HR) function is viewed as critical within corporations,
increasingly, small, medium and even large corporations are moving to outsource this
service.

The case for outsourcing has three basic rationales. First the regulatory
compliance obligations imposed under ERISA, COBRA and IRS regulations, have
become extremely burdensome and expensive for companies. Consequently, avoiding
major legal problems and financial liability requires substantial investment in resources
and capital in an area outside of the core business of most companies. This makes
outsourcing a viable option even if it does not necessarily result in a cost savings in the
near term. Second, the need to upgrade HR systems and invest in new technology is
increasingly difficult when companies are hard pressed to invest in functions aligned with
the core competency of the enterprise. HR outsourcing service providers are better
positioned to invest in new technologies and software more likely to conform to “best
practices” for delivery of the service. Third, for companies with global operations,
employee self-service can substantially reduce costs and improve employee satisfaction
with the service. However, this requires integration of all processes- HRIS, payroll and
benefits administration- across the entire HR operation including its global ones.

Because of the business exigencies driving the shift towards HR outsourcing, the industry
is expected to grow to $37.7 Billion in 2003.
Currently HR outsourcing services fall primarily within three categories: Professional
Employer Organization (PEO), Business Processing Outsourcing (BPO) and Application
Service Providers (ASPs).4
PEOs assume and take full responsibility for the human resources administration,
including the legal liability for the company’s workers. It becomes in essence a coemployer
with final say over, hiring, firing, and compensation decisions. The PEO
becomes a partner, in the non-legal sense, with ownership of the HR function while the
company retains responsibility over all business matters.

BPO refers to all business processes and not just HR. Typically this involves transferring
the entire function to a service provider and is differentiated from PEOs because it
usually involves introducing new technologies and processes to bear in the HR service.
Because of the complexity of HR systems in large corporations, shifting to BPO may be
more expensive in the short term. However, long term it can result in benefits because
large HR outsource providers will invest in systems and technology viewed as
prohibitively expensive within a firm where this function lies outside of its core business.

The BPO services market is growing rapidly with analyst projecting revenues of $128
billion this year and growth to $234 billion by 2005.

Finally, ASPs host software on the web and rent it to users. The most commonly known
of these packages is “People Soft”. The latter application and other packages are used to
manage payroll, benefits, head count and other HR processes.

Each of the HR outsourcing services described has advantages and disadvantages for
particular enterprises depending, on the number of employees, affordability of the
service, type of business and the degree to which an enterprise desires to retain control of
this function in-house.

This paper will briefly cover the legal aspects of HR outsourcing and will discuss some
of the most common contract issues faced in outsourcing relationships, essential items
that ought to be considered by the parties and key provisions within outsourcing service
agreements.

As previously discussed, companies facing pressure to reduce costs or address the
personnel shortages due to corporate down sizing have several different outsourcing
alternatives available to them to delegate back-end administrative functions. Typically,
the first alternative firms look to before looking outside, is to retain control of the
function in-house and reduce employment related costs (taxes, benefits, headcount), by
using contingent staff or (temporary workers) or persons classified as “independent
contractors” (IC) to perform the work. Though this may be an appealing solution for
many firms, given the legal and economic benefits, improper classification of someone as
an IC, consultant or temporary worker, who is later deemed an “employee” carries
serious financial risks.

Friction has developed between the growing use of contract workers in lieu of full time
employees and, the public policy aims of providing workers with protections under
federal labor laws to take the Employment Retirement Income Security Act (“ERISA”)
and state law employee remedial measures. In addition to the tax risk of an IRS audit, the
risks are higher today that workers will bring claims for social security, workman’s
compensation or other actions challenging the misclassification, so that they may
participate in lucrative benefit programs provided by the employer.
The case that brought these issues to the fore was Vizcaino v. Microsoft Corporation
(“Microsoft I”) and its progeny of cases. In Microsoft I, plaintiffs, employees designated
as temporary workers or “free lancers”, brought an action against the corporation to
recover savings benefits under ERISA and for stock option benefits offered through a
stock purchase plan, that were available to regular employees.6 The Court framed the
legal and public policy issues in the opinion’s opening statement:
“Large corporations have increasingly adopted the practice of hiring temporary employees or
independent contractors as a means of avoiding payment of employee benefits, and thereby
increasing their profits. This practice has understandably led to a number of problems, legal and
otherwise. One of the legal issues that sometimes arises is exemplified in this lawsuit. The named
plaintiffs, who were classified by Microsoft as independent contractors seek to strip that label of
its protective covering to obtain for themselves certain benefits that the company provided to all of
its regular or permanent employees.”

The problems for Microsoft arose as a result of an IRS tax audit for tax years 1989 and
1990. The IRS examined the company’s employment records to determine if it was in
compliance with tax laws. Applying the common-law principles defining the employer-employee relationship, the IRS concluded Mircosoft’s “freelancers” were not
independent contractors but employees for withholding and tax purposes.
In reaching this conclusion, the IRS applied the test set out under the common law of
agency, which requires, in determining if a hired party is an “employee”, consideration of
the hiring party’s right to control the manner and means by which the product is
accomplished. The IRS applies a 20 factor “control test” to “assess all of the incidents
of the relationship” with no one factor being determinative of the employment
relationship of the parties.9 The US Supreme Court reached asimilion conclusion in
Nationwide Mutual Insurance Company vs. Darden party not to adopt the IRS factors
and, instead applied a twelve factors that it considered. In assessing the relationship of
the parties the court decided for determining whether an individual qualifies as a
“common law employee”.

Microsoft, on first impression, appeared to have taken the appropriate measures to avoid
stumbling into an employer-employee relationship- the workers were told they were
freelancers and signed various agreements classifying them as independent contractors,
that included provisions that the workers would be responsible for paying their own taxes
and benefits. However, after having taken these steps with respect to the form of the
relationship, the court found that Microsoft had fully integrated these workers into its
workforce, placing them alongside regular employees, sharing the same supervisors,
performing identical functions and working the same core hours. Because Microsoft
required them to work on site, they were given admittance keys, office equipment and
supplies of the company.

Even after the IRS determined that plaintiffs were “common law employees”, Microsoft
attempted to use a temporary agency to “house” these workers as employees of the
agency, so that it could continue to use them in the same manner previously described.
On review in Vizcaino v. U.S. Dist. Court for Western District of Washington, 173 F.3d
713 (9th Cir. 1999) (“Microsoft III”), the Court in striking down the District Court’s
modification of the class of plaintiffs, which it deemed a contravention of its order on
remand, rejected the lower court’s assertion that the eligibility for benefits of these
temporary agency workers turned on whether they were employees of the Company or
the agency. The District Court’s view precluded the possibility that the agency and
Microsoft could jointly employ the plaintiff. The Court held that at common law it was
possible for the plaintiff’s to be employees of both the temporary agency and of the
recipient of their services (Microsoft), if, based on a determination using the Darden
factors, an employee-employer relationship existed. In essence the agency and Microsoft
were joint employers and the triangular relationship that Microsoft created was not
viewed as precluding or as being mutually exclusive of a two- party relationship that
existed between the company and the temporary workers. So what are the lessons gleaned from the Microsoft cases?

o Review the language in the company’s benefit plans to ensure “covered
employees” is properly defined within the plan and not left to statutory or judicial
interpretation.

o The mere classification of workers as independent contractors is not sufficient,
and behavioral, financial and the type of relationship between the hiring party and
the workers must support the classification.

o Users of outsourcing services should apply the 20 IRS factors to conduct a selfassessment
of the relationship between the parties.

o Consider using only ICs that are incorporated so that the relationship is between
entities and not an individual and an entity.

o Ensure that the agreement reflects the 20 factors, so for example: allow the IC to
determine the means and the methods for delivery, limit the agreement to the
project, and ensure the contract calls for the IC to cover its expenses and benefits.

o Require that the IC submit an invoice prior to receiving any payments.

o Avoid placing IC in situations where work is subject to the direct supervision of a
company employee.

o Avoid imposing administrative requirements on the IC, which are applicable to
employees.

o Allow the IC to hire and delegate the work to its employees subject to the
requirements of the project.

In particular, the fact that a worker is employed by a temporary agency, or similar entity
is not a guarantee against misclassification under the joint employer rule applied by the
Ninth Cir. Court in Microsoft III. If a misclassification does occur a firm may qualify for
an IRS Section 530 “safe harbor” exception if it can show the following:

1. Reasonable basis for classification of individuals as ICs based on:

o Reliance on a relevant court case, the advice of a qualified accountant or attorney,
or IRS ruling;

o The IRS did not reclassify the same or similar workers in a previous audit;

o It is standard industry practice to treat the particular workers as ICs.

2. Consistently treated same or similar workers as ICs in the past.

3. Consistently filed federal tax forms 1099 on these same or similar workers.

Outsourcing any critical business function and especially one like HR must be carefully
planned and executed to be an economic and strategic success. HR operations require
trained and specialized personnel to handle complex processes and manage the
compliance responsibilities created under the myriad of federal and state employment
regulations. Outsourcing of this function carries the risk of losing qualified personnel and
a degradation of the function. A firm can ill afford the risk of entering into a relationship
with a vendor whose lack of expertise in payroll and benefit administration causes
disruptions and a loss of efficiency. This may, in the worst case, demoralize the work
force and expose the firm to significant legal liability. Partial success in this area can
mean total failure and the loss of strategic initiative.

Contracting of the outsource service is a process which requires inputs from all of the
stakeholders (HR personnel, users of the service, and the management team) and those
persons within or outside of the organization with expertise in the function. Before talks
are ever initiated with a vendor, the key goal is to define the scope of the service and the
performance metrics, which will be applied to measure success. The use of metrics will
be covered in greater detail below in respect to Service Level Agreements (SLAs).

Important to both parties in the transaction, is defining the kind of relationship, which
must be established for the arrangement to succeed. If the entire HR Dept function is to
be outsourced then it will be in the interest of both parties to enter into a long-term
relationship that will justify the up-front costs and investments that will be required of
each of them. This type of arrangement as previously mentioned is subject to the firms
particular circumstances, and will probably result in selecting either the BPO or PEO
alternative because of the broad scope of the outsourced service. For the buyer this type
of wholesale delegation is expensive, complex and risky. If it doesn’t work out, the
buyers will incur significant costs and, disruption to the business in replacing the vendor
or in bringing the function back in-house.

Typically, total outsourcing of a function is a major undertaking with broad implications
for both the buyer and vendor. In this situation the preferred relationship is one that is
more of a partnership, in the non-legal sense, where the parties view their interests as
mutually benefited by the relationship.

On the other end of the continuum is the outsourcing of processes, like payroll, which is
very specific and straightforward and can be executed on a short-term basis.
Normally, in the HR area, firms will retain part of the function in-house, and delegate
those functions to an ASP or BPO, which require major investments in technology or
software. An outside supplier whose core compency lies within function is better able to
absorb the costs, based on economies of scale. This type of arrangement will generally
result in an intermediate term relationship where the parties will have to develop close
collaboration but will not have to incur the high costs, and investment of resources
required in a long-term relationship.

Partnership arrangements require provisions that maximize the flexibility of the vendor in
performing the service. Typically because such relationships are appropriate in contracts
with long terms of duration, typically five to seven years, and complex service
arrangements, the approach ought to be less prescriptive with respect to the scope and
level of service.
In shorter-term arrangements more typical of supplier/purchaser relationships, contracts
need to be more prescriptive in defining the scope of the services and the client
requirements.

Generally contracts ought to build in some level of flexibility to allow for changes in:

business circumstances,
technology
and the needs of the buyer.

Transfer of Personnel and Assets:

Outsourcing arrangements may require the transfer of assets and personnel to the vendor.
Defining the terms covering the transfer of affected personnel will generally have
important implications for the buyer and its employees with respect to employment or
employment rights. When wholesale outsourcing of groups or functions occur, it is
important for firms to take measures to preserve the general morale, of those remaining
and communicate openly and honestly with those persons transferred under the
outsourcing agreement. Contract terms need to address how the outsourcing of the
function and subsequent transfer will affect benefits, pensions and pay of personnel
moved to the service provider. Consideration should also be given to the rights, if any,
the transferring firm may have to either enforce special terms affecting transferred
employees or the right to retain these employees in the event of contract termination.
With respect to equipment and other assets, terms governing the use by the vendor of any
equipment made available to it by the buyer should specify rights of ownership and other
matters related to the transfer of equipment or other items of value.

Defining the rights to intellectual property (IP) is critical in all outsourcing agreements.
Typically the vendor will want to retain rights in any IP developed by it in the course of
the arrangement. The thought being that it is providing a service and not being paid to
develop IP. The buyer on the other hand will want all rights to IP developed based on the
transfer of proprietary or confidential information to the vendor and any work product
developed in performing the service. This issue will usually be resolved through
negotiation.
Related to this are confidentiality provisions, which provide important contractual
protections with respect to each party’s right’s in and use of IP in the arrangement.

Services
This is will probably be set out in a schedule and negotiated based on the scope of the
services and the functions or processes that will be outsourced. As stated previously, the
nature of the relationship, partnership or supplier/purchaser will determine how detailed
and specific this ought to be.

In any event there should be sufficient clarity and definition for the parties to be able to
set mutual expectations and understand the deliverables that must be produced under the
agreement.
Termination
Defining the terms for exiting an arrangement is one of the most critical issues in an
outsource agreement. Generally, early termination provisions, which set out rights and
applicable penalties due in such event, should be a matter of last resort except in cases, of
material breach or force majeure.

Default provisions should set out escalation clauses and a reasonable cure period to
ensure the parties have procedures for resolving disputes and issues related to the
performance of their respective obligations.
There should also be provisions governing the management of the exit. These should
include the vendor cooperation in facilitating the transfer of the service to another vendor
and the return of any equipment or other items to the buyer, which were used by vendor
during the contract.
Consideration should be given to other provisions, which might help to reduce the level
of disruption to the buyer’s operations as a result of the termination of the agreement.

What is a Service Level Agreement (SLA)?

SLAs in an outsourcing arrangement identify the service levels or performance standards
that the vendor must meet or exceed. The SLA also specifies consequences for failing to
achieve the minimum service level set by the buyer.
SLAs should be applied to the key parts of the outsourced service and not necessarily to
every aspect. The purpose of SLAs is to ensure the buyer has the means to control the
level and the consistency of the service received from the provider.
Generally, the minimum level that ought to be set is that which is required to support the
buyer’s on-going business operations and HR requirements. An important rationale for
outsourcing should be to improve the level and quality of the function that is being
outsourced. Therefore the minimum level of service should be at least equal to the level
that existed before the function was outsourced to the provider.
In the HR area metrics are difficult to establish because much of what is being measured
is intangible. For example if buyer wants to determine the success of a web based
application for benefits, this can only be ascertained by surveying user satisfaction. As
such questionnaires and employee satisfaction surveys become essential tools for
measuring the performance of the vendor.

SLAS must reflect the agreement understanding of the parties as to what constitutes a
good result and with respect to measuring performance, their agreement on the
mechanisms used to measure the result.
The SLA should also cover what constitutes the best and the worst-case level of service.
In this regard the buyer will want to incorporate service credits, which may become
applicable in the event the vendor fails to meet minimum service levels. At the same time
it is also appropriate to consider incentives or bonuses, which the vendor can receive for
achieving the best-case level of service.

The point of any negotiation ought to be that it is in the interest of both parties that the
vendor meet or exceed the service levels set in the SLA. The buyers should not exploit
the use of SLAs, to reduce costs through the application of credits or penalties, because
this will only inject an unnecessary level of contention into the relationship that will
under cut the development of a partnership between the parties.
SLAs should not have a distorting effect on behavior, where the vendor becomes focused
only on those aspects of the service, that are measured, at the expense of other aspects,
which may not be weighted as heavily in the evaluation process. The vendor’s goal
should be to meet, or exceed expectations in every area covered by service.