Special Issues in Agreements Involving Outsourcing

The trend towards outsourcing will continue to				employees.- Allow the IC to hire and delegate
grow as market pressures force corporations to				the work to its employees subject to the
be more tightly focused on core business				requirements of the project.In particular, the fact
functions, gaining competitive advantage and				that a worker is employed by a temporary
reducing costs. Outsourcing is an attractive				agency, or similar entity
alternative in good times and bad times. Shifting				is not a guarantee against misclassification under
back end administrative and business functions to				the joint employer rule applied by the
an external provider in good times, may be a				Ninth Cir. Court in Microsoft III. If a
means for quicker time to market and focusing				misclassification does occur a firm may qualify for
resources on core business activities to grow the				an IRS Section 530 "safe harbor" exception if it
business. In bad times, outsourcing is a means for				can show the following:1. Reasonable basis for
streamlining the enterprise by eliminating functions,				classification of individuals as ICs based on:-
which create a drag on capital and/or do not				Reliance on a relevant court case, the advice of a
provide any competitive advantage.In the current				qualified accountant or attorney,
economic environment, concerns over, shrinking				or IRS ruling;- The IRS did not reclassify the
margins, liquidity and the				same or similar workers in a previous audit;- It is
need to reduce operating cost structures is				standard industry practice to treat the particular
accelerating a trend towards shifting certain				workers as ICs.2. Consistently treated same or
back office administrative functions to outside				similar workers as ICs in the past.3. Consistently
suppliers. This trend is seen as a major				filed federal tax forms 1099 on these same or
paradigm shift within enterprises, which have				similar workers.Outsourcing any critical business
realigned their internal corporate				function and especially one like HR must be
infrastructure to focus on more strategic areas				carefully
of their core business.Although the human				planned and executed to be an economic and
resources (HR) function is viewed as critical within				strategic success. HR operations require
corporations,				trained and specialized personnel to handle
increasingly, small, medium and even large				complex processes and manage the
corporations are moving to outsource this				compliance responsibilities created under the
service.The case for outsourcing has three basic				myriad of federal and state employment
rationales. First the regulatory				regulations. Outsourcing of this function carries
compliance obligations imposed under ERISA,				the risk of losing qualified personnel and
COBRA and IRS regulations, have				a degradation of the function. A firm can ill afford
become extremely burdensome and expensive				the risk of entering into a relationship
for companies. Consequently, avoiding				with a vendor whose lack of expertise in payroll
major legal problems and financial liability requires				and benefit administration causes
substantial investment in resources				disruptions and a loss of efficiency. This may, in
and capital in an area outside of the core				the worst case, demoralize the work
business of most companies. This makes				force and expose the firm to significant legal
outsourcing a viable option even if it does not				liability. Partial success in this area can
necessarily result in a cost savings in the				mean total failure and the loss of strategic
near term. Second, the need to upgrade HR				initiative.Contracting of the outsource service is a
systems and invest in new technology is				process which requires inputs from all of the
increasingly difficult when companies are hard				stakeholders (HR personnel, users of the service,
pressed to invest in functions aligned with				and the management team) and those
the core competency of the enterprise. HR				persons within or outside of the organization with
outsourcing service providers are better				expertise in the function. Before talks
positioned to invest in new technologies and				are ever initiated with a vendor, the key goal is
software more likely to conform to "best				to define the scope of the service and the
practices" for delivery of the service. Third, for				performance metrics, which will be applied to
companies with global operations,				measure success. The use of metrics will
employee self-service can substantially reduce				be covered in greater detail below in respect to
costs and improve employee satisfaction				Service Level Agreements (SLAs).Important to
with the service. However, this requires				both parties in the transaction, is defining the kind
integration of all processes- HRIS, payroll and				of relationship, which
benefits administration- across the entire HR				must be established for the arrangement to
operation including its global ones.Because of the				succeed. If the entire HR Dept function is to
business exigencies driving the shift towards HR				be outsourced then it will be in the interest of
outsourcing, the industry				both parties to enter into a long-term
is expected to grow to $37.7 Billion in 2003.				relationship that will justify the up-front costs and
Currently HR outsourcing services fall primarily				investments that will be required of
within three categories: Professional				each of them. This type of arrangement as
Employer Organization (PEO), Business Processing				previously mentioned is subject to the firms
Outsourcing (BPO) and Application				particular circumstances, and will probably result in
Service Providers (ASPs).4				selecting either the BPO or PEO
PEOs assume and take full responsibility for the				alternative because of the broad scope of the
human resources administration,				outsourced service. For the buyer this type
including the legal liability for the company's				of wholesale delegation is expensive, complex
workers. It becomes in essence a coemployer				and risky. If it doesn't work out, the
with final say over, hiring, firing, and				buyers will incur significant costs and, disruption to
compensation decisions. The PEO				the business in replacing the vendor
becomes a partner, in the non-legal sense, with				or in bringing the function back in-house.Typically,
ownership of the HR function while the				total outsourcing of a function is a major
company retains responsibility over all business				undertaking with broad implications
matters.BPO refers to all business processes and				for both the buyer and vendor. In this situation
not just HR. Typically this involves transferring				the preferred relationship is one that is
the entire function to a service provider and is				more of a partnership, in the non-legal sense,
differentiated from PEOs because it				where the parties view their interests as
usually involves introducing new technologies and				mutually benefited by the relationship.On the
processes to bear in the HR service.				other end of the continuum is the outsourcing of
Because of the complexity of HR systems in				processes, like payroll, which is
large corporations, shifting to BPO may be				very specific and straightforward and can be
more expensive in the short term. However, long				executed on a short-term basis.
term it can result in benefits because				Normally, in the HR area, firms will retain part of
large HR outsource providers will invest in				the function in-house, and delegate
systems and technology viewed as				those functions to an ASP or BPO, which require
prohibitively expensive within a firm where this				major investments in technology or
function lies outside of its core business.The BPO				software. An outside supplier whose core
services market is growing rapidly with analyst				compency lies within function is better able to
projecting revenues of $128				absorb the costs, based on economies of scale.
billion this year and growth to $234 billion by				This type of arrangement will generally
2005.Finally, ASPs host software on the web and				result in an intermediate term relationship where
rent it to users. The most commonly known				the parties will have to develop close
of these packages is "People Soft". The latter				collaboration but will not have to incur the high
application and other packages are used to				costs, and investment of resources
manage payroll, benefits, head count and other				required in a long-term relationship.Partnership
HR processes.Each of the HR outsourcing services				arrangements require provisions that maximize
described has advantages and disadvantages for				the flexibility of the vendor in
particular enterprises depending, on the number				performing the service. Typically because such
of employees, affordability of the				relationships are appropriate in contracts
service, type of business and the degree to				with long terms of duration, typically five to
which an enterprise desires to retain control of				seven years, and complex service
this function in-house.This paper will briefly cover				arrangements, the approach ought to be less
the legal aspects of HR outsourcing and will				prescriptive with respect to the scope and
discuss some				level of service.
of the most common contract issues faced in				In shorter-term arrangements more typical of
outsourcing relationships, essential items				supplier/purchaser relationships, contracts
that ought to be considered by the parties and				need to be more prescriptive in defining the
key provisions within outsourcing service				scope of the services and the client
agreements.As previously discussed, companies				requirements.Generally contracts ought to build in
facing pressure to reduce costs or address the				some level of flexibility to allow for changes
personnel shortages due to corporate down				in:business circumstances,
sizing have several different outsourcing				technology
alternatives available to them to delegate				and the needs of the buyer.Transfer of
back-end administrative functions. Typically,				Personnel and Assets:Outsourcing arrangements
the first alternative firms look to before looking				may require the transfer of assets and personnel
outside, is to retain control of the				to the vendor.
function in-house and reduce employment related				Defining the terms covering the transfer of
costs (taxes, benefits, headcount), by				affected personnel will generally have
using contingent staff or (temporary workers) or				important implications for the buyer and its
persons classified as "independent				employees with respect to employment or
contractors" (IC) to perform the work. Though				employment rights. When wholesale outsourcing
this may be an appealing solution for				of groups or functions occur, it is
many firms, given the legal and economic				important for firms to take measures to
benefits, improper classification of someone as				preserve the general morale, of those remaining
an IC, consultant or temporary worker, who is				and communicate openly and honestly with those
later deemed an "employee" carries				persons transferred under the
serious financial risks.Friction has developed				outsourcing agreement. Contract terms need to
between the growing use of contract workers in				address how the outsourcing of the
lieu of full time				function and subsequent transfer will affect
employees and, the public policy aims of providing				benefits, pensions and pay of personnel
workers with protections under				moved to the service provider. Consideration
federal labor laws to take the Employment				should also be given to the rights, if any,
Retirement Income Security Act ("ERISA")				the transferring firm may have to either enforce
and state law employee remedial measures. In				special terms affecting transferred
addition to the tax risk of an IRS audit, the				employees or the right to retain these
risks are higher today that workers will bring				employees in the event of contract termination.
claims for social security, workman's				With respect to equipment and other assets,
compensation or other actions challenging the				terms governing the use by the vendor of any
misclassification, so that they may				equipment made available to it by the buyer
participate in lucrative benefit programs provided				should specify rights of ownership and other
by the employer.				matters related to the transfer of equipment or
The case that brought these issues to the fore				other items of value.Defining the rights to
was Vizcaino v. Microsoft Corporation				intellectual property (IP) is critical in all outsourcing
("Microsoft I") and its progeny of cases. In				agreements.
Microsoft I, plaintiffs, employees designated				Typically the vendor will want to retain rights in
as temporary workers or "free lancers", brought				any IP developed by it in the course of
an action against the corporation to				the arrangement. The thought being that it is
recover savings benefits under ERISA and for				providing a service and not being paid to
stock option benefits offered through a				develop IP. The buyer on the other hand will
stock purchase plan, that were available to				want all rights to IP developed based on the
regular employees.6 The Court framed the				transfer of proprietary or confidential information
legal and public policy issues in the opinion's				to the vendor and any work product
opening statement:				developed in performing the service. This issue
"Large corporations have increasingly adopted the				will usually be resolved through
practice of hiring temporary employees or				negotiation.
independent contractors as a means of avoiding				Related to this are confidentiality provisions,
payment of employee benefits, and thereby				which provide important contractual
increasing their profits. This practice has				protections with respect to each party's right's in
understandably led to a number of problems, legal				and use of IP in the arrangement.Services
and				This is will probably be set out in a schedule and
otherwise. One of the legal issues that				negotiated based on the scope of the
sometimes arises is exemplified in this lawsuit. The				services and the functions or processes that will
named				be outsourced. As stated previously, the
plaintiffs, who were classified by Microsoft as				nature of the relationship, partnership or supplier
independent contractors seek to strip that label of				purchaser will determine how detailed
its protective covering to obtain for themselves				and specific this ought to be.In any event there
certain benefits that the company provided to all				should be sufficient clarity and definition for the
of				parties to be able to
its regular or permanent employees."The				set mutual expectations and understand the
problems for Microsoft arose as a result of an				deliverables that must be produced under the
IRS tax audit for tax years 1989 and				agreement.
1990. The IRS examined the company's				Termination
employment records to determine if it was in				Defining the terms for exiting an arrangement is
compliance with tax laws. Applying the				one of the most critical issues in an
common-law principles defining the				outsource agreement. Generally, early termination
employer-employee relationship, the IRS concluded				provisions, which set out rights and
Mircosoft's "freelancers" were not				applicable penalties due in such event, should be a
independent contractors but employees for				matter of last resort except in cases, of
withholding and tax purposes.				material breach or force majeure.Default
In reaching this conclusion, the IRS applied the				provisions should set out escalation clauses and a
test set out under the common law of				reasonable cure period to
agency, which requires, in determining if a hired				ensure the parties have procedures for resolving
party is an "employee", consideration of				disputes and issues related to the
the hiring party's right to control the manner and				performance of their respective obligations.
means by which the product is				There should also be provisions governing the
accomplished. The IRS applies a 20 factor				management of the exit. These should
"control test" to "assess all of the incidents				include the vendor cooperation in facilitating the
of the relationship" with no one factor being				transfer of the service to another vendor
determinative of the employment				and the return of any equipment or other items
relationship of the parties.9 The US Supreme				to the buyer, which were used by vendor
Court reached asimilion conclusion in				during the contract.
Nationwide Mutual Insurance Company vs. Darden				Consideration should be given to other provisions,
party not to adopt the IRS factors				which might help to reduce the level
and, instead applied a twelve factors that it				of disruption to the buyer's operations as a result
considered. In assessing the relationship of				of the termination of the agreement.What is a
the parties the court decided for determining				Service Level Agreement (SLA)?SLAs in an
whether an individual qualifies as a				outsourcing arrangement identify the service
"common law employee".Microsoft, on first				levels or performance standards
impression, appeared to have taken the				that the vendor must meet or exceed. The SLA
appropriate measures to avoid				also specifies consequences for failing to
stumbling into an employer-employee relationship-				achieve the minimum service level set by the
the workers were told they were				buyer.
freelancers and signed various agreements				SLAs should be applied to the key parts of the
classifying them as independent contractors,				outsourced service and not necessarily to
that included provisions that the workers would				every aspect. The purpose of SLAs is to ensure
be responsible for paying their own taxes				the buyer has the means to control the
and benefits. However, after having taken these				level and the consistency of the service received
steps with respect to the form of the				from the provider.
relationship, the court found that Microsoft had				Generally, the minimum level that ought to be
fully integrated these workers into its				set is that which is required to support the
workforce, placing them alongside regular				buyer's on-going business operations and HR
employees, sharing the same supervisors,				requirements. An important rationale for
performing identical functions and working the				outsourcing should be to improve the level and
same core hours. Because Microsoft				quality of the function that is being
required them to work on site, they were given				outsourced. Therefore the minimum level of
admittance keys, office equipment and				service should be at least equal to the level
supplies of the company.Even after the IRS				that existed before the function was outsourced
determined that plaintiffs were "common law				to the provider.
employees", Microsoft				In the HR area metrics are difficult to establish
attempted to use a temporary agency to				because much of what is being measured
"house" these workers as employees of the				is intangible. For example if buyer wants to
agency, so that it could continue to use them in				determine the success of a web based
the same manner previously described.				application for benefits, this can only be
On review in Vizcaino v. U.S. Dist. Court for				ascertained by surveying user satisfaction. As
Western District of Washington, 173 F.3d				such questionnaires and employee satisfaction
713 (9th Cir. 1999) ("Microsoft III"), the Court in				surveys become essential tools for
striking down the District Court's				measuring the performance of the vendor.SLAS
modification of the class of plaintiffs, which it				must reflect the agreement understanding of the
deemed a contravention of its order on				parties as to what constitutes a
remand, rejected the lower court's assertion that				good result and with respect to measuring
the eligibility for benefits of these				performance, their agreement on the
temporary agency workers turned on whether				mechanisms used to measure the result.
they were employees of the Company or				The SLA should also cover what constitutes the
the agency. The District Court's view precluded				best and the worst-case level of service.
the possibility that the agency and				In this regard the buyer will want to incorporate
Microsoft could jointly employ the plaintiff. The				service credits, which may become
Court held that at common law it was				applicable in the event the vendor fails to meet
possible for the plaintiff's to be employees of				minimum service levels. At the same time
both the temporary agency and of the				it is also appropriate to consider incentives or
recipient of their services (Microsoft), if, based on				bonuses, which the vendor can receive for
a determination using the Darden				achieving the best-case level of service.The point
factors, an employee-employer relationship				of any negotiation ought to be that it is in the
existed. In essence the agency and Microsoft				interest of both parties that the
were joint employers and the triangular				vendor meet or exceed the service levels set in
relationship that Microsoft created was not				the SLA. The buyers should not exploit
viewed as precluding or as being mutually				the use of SLAs, to reduce costs through the
exclusive of a two- party relationship that				application of credits or penalties, because
existed between the company and the				this will only inject an unnecessary level of
temporary workers. So what are the lessons				contention into the relationship that will
gleaned from the Microsoft cases?- Review the				under cut the development of a partnership
language in the company's benefit plans to ensure				between the parties.
"covered				SLAs should not have a distorting effect on
employees" is properly defined within the plan				behavior, where the vendor becomes focused
and not left to statutory or judicial				only on those aspects of the service, that are
interpretation.- The mere classification of				measured, at the expense of other aspects,
workers as independent contractors is not				which may not be weighted as heavily in the
sufficient,				evaluation process. The vendor's goal
and behavioral, financial and the type of				should be to meet, or exceed expectations in
relationship between the hiring party and				every area covered by service.Born in Havana,
the workers must support the classification.-				Cuba, Mr. Rojas immigrated to the United States
Users of outsourcing services should apply the 20				in 1961 and lived in Ohio and the U.S. Virgin Islands
IRS factors to conduct a selfassessment				before settling in Florida in 1967. He studied
of the relationship between the parties.- Consider				computer programming for three years in a high
using only ICs that are incorporated so that the				school "magnet" program and earned his B.A. in
relationship is between				English and Philosophy from the University of
entities and not an individual and an entity.-				Florida in 1978, with honors in Philosophy. Mr. Rojas
Ensure that the agreement reflects the 20				then attended law school at the University of
factors, so for example: allow the IC to				Miami where he received his J.D., with honors, in
determine the means and the methods for				1981. In law school, Mr. Rojas was an Articles and
delivery, limit the agreement to the				Comments Editor of the school's International Law
project, and ensure the contract calls for the IC				Review and served as a member of the Moot
to cover its expenses and benefits.- Require that				Court Board.Mr. Rojas holds the highest ratings
the IC submit an invoice prior to receiving any				assigned by Martindale-Hubbell, and he is listed in
payments.- Avoid placing IC in situations where				several "Who's Who" publications including Marquis'
work is subject to the direct supervision of a				Who's Who in American Law, Who's Who In
company employee.- Avoid imposing				Florida's Latin Community, Who's Who In
administrative requirements on the IC, which are				Intellectual Property, and Who's Who in
applicable to				International E-Commerce. He is fluent in Spanish.

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Special Issues in Agreements Involving Outsourcing