As the great Zero Mostel (playing Max Bialystock) shouted out in the 1968 film classic The Producers, "if you've got it, flaunt it." The problem in Canada, however, is that top legal talent in outsourcing generally suffer from-and there is really no other way to put this-stage fright. And publicity, as one would expect, is something their American competitors embrace.
Shaw Pittman LLP, the U.S.-based legal giant that has annual outsourcing revenues of US$40 million alone, has "got it" and has no reticence about flaunting it. It has aggressively and successfully branded itself as the "go to" technology transaction firm in the States. It is difficult to think of a Canadian counterpart.
"The challenge of the outsourcing bar in this country is to raise awareness and compete with [American lawyers]," a somewhat rueful Adam Vereshack at McCarthy Tétrault LLP in Toronto acknowledges.
Characteristically, Alison Youngman at Stikeman Elliott, also in Toronto, is more direct. Not one to mince words, Youngman argues that "American lawyers eating our lunch in the outsourcing field is not particularly different from what they're doing in any other field. We need to be thinking of taking our knowledge and selling it globally. We should be fighting back."
The Outsourcing Market
Fighting over what? For the uninitiated, the outsourcing market is huge. Last year it was estimated at $66 billion, double the 1997 estimate. And that's just the Canadian market. For those firms with the skill set and client base to operate internationally, the potential is enormous.
On January 8 of this year, Japan's NEC Corporation and Toronto-based Celestica Inc. jointly announced a massive outsourcing agreement (see "Big Deals" in this issue of Lexpert). The two companies agreed to expand their strategic outsourcing relationship by entering into a supply agreement that would provide Celestica with additional total estimated revenue of approximately US$2.5 billion over its five-year term. Under the agreement, Celestica will acquire two of NEC's advanced manufacturing facilities in Japan, which are engaged in the development and manufacturing of advanced optical transmission systems.
Lead counsel for Celestica on the NEC transaction was Berl Nadler at Davies Ward Phillips & Vineberg LLP in Toronto. Certainly impressive on a stand-alone basis. But it is only when one examines the outsourcing deal sheet for the peripatetic Mr. Nadler and Celestica over the past two years that the breadth and depth of the market becomes apparent:
- Acquisition from Lucent Technologies Inc. of manufacturing operations in Oklahoma City, Oklahoma and Columbus, Ohio (US$170 million) and five-year manufacturing outsourcing agreement anticipated to generate revenue of up to US$10 billion for Celestica during its five-year term (2001);
- Acquisition of Primetech Electronics Inc. of Montreal (approximately $265 million) (2001);
- Acquisition of Avaya Inc.'s manufacturing, repair and supply chain operations in Denver, Colorado and Little Rock, Arkansas (US$200 million) and global strategic alliance with Avaya, including a five-year global manufacturing outsourcing agreement that positions Celestica as Avaya's primary outsourcing partner for telecommunications products (approximately US$4 billion in total expected revenue) (2001);
- Acquisition of Motorola Inc.'s manufacturing assets in Iowa and Ireland (approximately US$70 million) and strategic alliance with Motorola, including manufacturing outsourcing agreement with an estimated value of more than US$1 billion over three years (2001);
- Acquisition of Bull Electronics Inc. from Bull HN Information Systems Inc. and related manufacturing outsourcing agreement (2000);
- Acquisition of manufacturing operations of NEC do Brasil S.A. in Guarulhos, Brazil (US$120 million) and related five-year manufacturing outsourcing agreement worth US$1.2 billion (2000);
- Acquisition from IBM of printed circuit board assembly and test services operations in Rochester, Minnesota and printed circuit board system assembly operations in Santa Palomba and Vimercate, Italy (US$500 million) and related manufacturing outsourcing agreements with annual revenues of approximately US$1.5 billion (2000).
And it is an "art." With perhaps some smugness, Alan Gahtan at top-ranked Toronto technology boutique Mann & Gahtan LLP notes that "I love it when there is a lawyer on the other side who's an M&A lawyer or a securities lawyer or someone else trying to run these [outsourcing] deals, because they're not as experienced on how to do them. It does create an interesting situation."
As Gabor (Gabe) Takach at Torys LLP in Toronto more diplomatically puts it, "The art here is having done it before, having gone through the process a number of times, knowing how to think through how the issues will break and when they will break, and then trying to influence the flow of that so that it won't lead to an advantage on the other side."
What is Outsourcing?
So what is outsourcing? The business logic is pretty straightforward. By spinning off assets or functions, companies can concentrate on what they do best; where they add the greatest value. This enhanced focus, arguably, leads to a greater return on invested capital. Moreover, specialized external suppliers should have greater productive capacity, cheaper labor sources, and higher levels of expertise that will again contribute to a greater return on capital when the outsourced services or products are purchased from the external supplier.
Of course, matters are not quite so simple. Rarely is outsourcing an either/or decision. An insightful analysis of the practice is presented by Stephen J. Doig, Ronald C. Ritter, Kurt Speckhals and Daniel Woolson in "Has Outsourcing Gone Too Far?" (2001) The McKinsey Quarterly, No. 4.
Nevertheless, over the past several years, more and more companies have turned over their non-core, non-revenue-producing activities to an outside contractor, helping them cut expenses and keep on top of technological developments. Once seen largely as a cost-cutting measure, outsourcing is now recognized as a powerful tool for business growth.
Companies spend massive amounts of money each year to outsource their business functions to firms such as EDS Canada Inc., IBM Canada, CGI Group Inc. and Celestica Inc. The origins of outsourcing can be traced as far back as the 1960s, when Ross Perot established Electronic Data Systems (EDS) and began processing clients' data by tapping into idle time on other companies' mainframes. The phenomenon gained momentum over the years, and by the early 1990s many companies were handing over important areas of their businesses-including employees and assets-to experienced service providers to focus instead on their core, value-added areas. "When you're talking about a Fortune 500 company, the cost of running a data center...can be anywhere from a $50 million a year proposition all the way up to $100 million, and even more in some cases," notes George Atis, who leads the outsourcing group at McMillan Binch in Toronto.
Outsourcing has evolved to cover just about every business function imaginable. And the early, huge success of information technology (IT) outsourcing has led to business process outsourcing (BPO) generally, in which entire areas of a business are outsourced.
"What companies found after the big IT wave was that there were other functions within a corporation that were not core to what it did and hence executives thought, well, why not outsource that function?" says Atis. Former in-house areas that are now being outsourced effectively include finance, sales and marketing, customer service, payroll, auditing, human resources, manufacturing and distribution. Firms that provide specialty outsourcing services include Ceridian, which offers payroll and HR solutions, and IKON Office Solutions, which provides firms with such diverse services as on-site facilities management, mailroom operations and litigation support.
"Outsourcing tends to be a feasible alternative for two reasons: there's a shortage of skilled workers in Canada and cost-cutting is a high-ranking corporate priority," says Richard Austin, chief legal counsel at EDS Canada.
"It's an exploding area that's had a lot of growth in the last five or six years," confirms Mario LaVoie, general counsel for IBM Canada. At first, many companies questioned whether the specialists they hired could do the job and worried about what they'd do if the performance was not up to snuff. "Going back to the early 1990s, lots of customers were concerned about outsourcing because it's like giving away your first-born child," says LaVoie, although he insists that's less of a concern now. Companies "realized there is a risk with these things, but it becomes a calculated and educated risk."
Several mega-deals were inked last year by large corporations and service providers. Air Canada and IBM entered into a seven-year, $1.4 billion strategic partnership in July to pursue "new business opportunities in the areas of customer service and leading-edge travel industry solutions." IBM also signed a 10-year, $1.1 billion deal with National Bank of Canada in December to manage a broad range of the bank's computer systems and functions. In November, Nortel Networks took on the transformation of the entire telephone network of Sprint Local Telecommunications Division in a deal worth a whopping US$1.1 billion over four years. IBM is managing several key information technology functions for Scotiabank in a seven-year, $900 million deal. Also last year, CIBC became the first major financial institution in Canada to outsource its human resources operations and technology services to an external supplier, in a $227 million deal with EDS.
The Outsourcing Agreement
An outsourcing contract is one of the most important yet complicated agreements a company can get involved in. For several years, a key part of its business is in someone else's hands-a scary proposition for many. "You're basically taking a business and you have to think about protecting the company, which has now lost control of that business, and protecting it for a 10-year period," says Stikeman Elliott partner Alison Youngman. "It's a critically important process."
Lawyers working on outsourcing agreements prefer to be involved in the entire process, from the early planning stages, through the Request For Proposals (RFP), to finalizing the deal. These are extremely intricate transactions that can routinely take three to six months and sometimes a year or more. Even after the deal is signed, a lawyer can be involved during the transition and compliance stages until the contract ends. "You provide your client with a performance matrix," says George Atis, which calls for various functions to be performed at certain times. "There are a whole series of things in the contract that call for specific procedures or notices. These contracts are typically over 100 pages easily, with the schedules they're probably over 500 pages."
"It's tricky," notes Richard Raysman, a partner at New York City-based Brown Raysman Millstein Felder & Steiner LLP, a leading U.S. outsourcing firm. "Vendors have to be extraordinarily careful in how they respond to the RFPs because they want to get the deal, so they have to be very accommodating to get the deal. On the other hand, they want to come in with something they can live with after the deal. It's a fine line."
Raysman goes on to point out that, "for the customer, once they outsource, it's like letting the horse out of the barn: they can't get it back in again. Once they've transferred 100 employees, they can't bring those people back in again, so to that extent they've lost a lot of leverage. At that point, the only protection they have is what's in the agreement. So the agreement is extraordinarily important in an outsourcing deal. People always joke that they're going to put it in a drawer afterwards. This is an agreement that doesn't go in the drawer because the customer signs an agreement and the people who negotiated on the other side are not necessarily the same people who are going to be operating it."
Many major corporations have a pretty good idea about how much work is involved in a deal, but "less sophisticated clients will approach you thinking you can put the deal together in a week," says Alan Gahtan. "Three months later it's 'I told you.'"
The deals can get so complicated and be so time-consuming that some lawyers have had to decline other major transactions. A typical deal can involve many facets of a company's functions, including labor issues, pensions, tax and human resources. For this reason, a law firm's bench strength, if it is to be retained, requires thorough consideration.
Big IT outsourcing vendors like IBM and EDS have their own in-house legal counsel working on transactions on a regular basis, but a company buying services in a one-off deal must choose its counsel carefully. Canadian companies considering a BPO or IT outsourcing transaction should "retain an experienced, Canadian, client-side outsourcing lawyer early in the process of a deal to help plan legal strategy, shape the deal and streamline negotiations," says Atis. "Commencing an outsourcing deal with a strategy that allows the vendor to lead is like coughing up the puck to Gretzky in front of your own net a few times: it's not too long before it's game over."
Outsourcing Pitfalls
There is no question that badly negotiated outsourcing transactions will come back to haunt the parties, and their lawyers. "They are business-critical," as Duncan Card of Davies Ward Phillips & Vineberg LLP in Toronto puts it. "You can't risk getting them screwed up."
One of the important threshold decisions in an outsourcing deal is deciding how many years it will run. In order to make the deal attractive to both sides, it has to be long-term. The outsourcer buys the hardware and takes over employees-a hefty up-front expense that's recovered by having a contract that runs for several years. The longer the term, the less the annual fee. "The customer doesn't want to get stuck with a seven- or eight-year term if it turns out that the outsourcer can't perform," explains Adam Vereshack, "so the customer is always looking for as short a term as possible." In order to do that, instead of paying a million dollars a month in a long-term contract, the customer could end up paying one and a half million for a shorter term. As Vereshack puts it, "he's caught between a rock and a hard place."
A common mistake is failing to think of the deal in the long term. Gabe Takach characterizes these contracts as long-term relationships "where you really need to think about the what-ifs, not between now and a 90-day closing period, but between now and a 10-year period. You have a completely different mindset in addressing issues in a contract of that sort. The closest you can come to in a comparison is a lease, which usually is long-term."
One complaint frequently voiced by outsourcing practitioners is that they are left out of many deals in the early planning stages. The optimum place in the process for lawyers is right at the beginning, before an RFP goes out and documents are written up. "Those planning sessions have huge implications for the back end, for time and risk and resolution of the issues. That's where we like to be," says Takach. "We probably earn more of our keep in that role rather than the back end. At the back end, anybody can write a force majeure clause, that's not the art."
"The average deal is one where the businessmen think that they know what they're doing and they cook it to a point where they say 'okay, it's now time to write it,'" says Takach. "Then they call us in and they say 'now you deal with this and this point.' So you end up with a catch-up." Unfortunately that's how many people think of their lawyers' usefulness. "For clients that know us better, and for in-house counsel that are a little bit more enlightened about just how they can benefit from people who've done it before, where we get called in earlier on, those we find much more beneficial. Of course, we can't control it. By and large, in the average case we're brought in too late in our view. It's not too late in the sense that you can't do anything about it, but it is not the optimum place to come in. Optimum would be right from the beginning, from the planning stage."
A favorite negotiating ploy is to hold meetings without calling in lawyers. "Sure neither party has lawyers, but there's really an imbalance of skill in negotiating these things between the vendors who've done a few of these and a customer where that may be the first time they're doing it," says Gahtan. "The smart ones call us in before they do the RFP...the RFP and the proposal set the tone for the whole negotiation."
A good relationship between the vendor and the buyer is vital. "The difference between a good deal and a bad deal depends on the relationship management between the two entities that are outsourcing," says Youngman. "I spend a lot of time with the clients working on putting in place a relationship management structure, and telling them that the key is going to be to get the right people at the right levels and unless that happens, you're going to have a disaster."
George Atis recommends a dual-track negotiation to his clients, since it's much less risky. "Proceed simultaneously with two vendors down the road so that if something goes wrong with one vendor, you're basically at a parallel point with your other vendor...it's more expensive, but at the end of the day those costs pay for themselves by making the right choice."
Outsourcing Specialization
A very senior technology lawyer once told Atis that outsourcing is "just a corporate divestiture transaction with some bells and whistles." Atis begs to differ. "Anyone who does this on an ad hoc basis, who says to a lawyer 'here's the deal, just paper it up,' I think it's a formula for disaster."
Takach agrees that it's a highly specialized area. "It can't be someone who's doing M&A transactions all day and then you just pop him into one of these situations on a one-off basis, because he won't be any better off than the people who are doing it on a single-instance basis."
"It's a unique skill set," says Card, whose work over the past 20 years has involved commercial transactions, private M&A, international trade and intellectual property. "It's very difficult for counsel who may have a general corporate/commercial practice who haven't done this before to credibly say to a client they're the right guy to do a billion-dollar outsourcing deal." Card goes on to add that "Like an M&A deal, there's a lot of quarterbacking of issues, there's a lot of due diligence stuff that has to be coordinated, there are HR considerations. There's the corporate deal, because a lot of these are third-party companies that the two parties create that give services back...it's hard to imagine commercial deals that get bigger than this." These deals "give you that range of really macro to really micro where you get into the nitty-gritty of words. The significance attached to the placing of a comma can be huge."
Along with this legal expertise, an outsourcing lawyer should also be able to act as strategic advisor, project manager and negotiator on a deal. There have been many instances of lawyers from other practice areas who have jumped into the outsourcing pool only to find themselves in over their heads.
Inexperienced lawyers create problems during the negotiation process. "The attorney representing the customer won't necessarily grasp the reasons why we may be asking for a particular set of terms and conditions and the reason behind that," says LaVoie at IBM. "It takes a lot more time to do it when we have an inexperienced attorney across the table. The customer in those instances is a little confused, because they don't know if we are posturing or asking for things that are outrageous, or are we asking for things that are fairly common in the industry? If I deal with people who have a deep knowledge of this, they know how to cut to the chase, they know what the issues are, they know how to address the risk and they know what they want for their customers, then we can negotiate the hard issues."
Richard Austin likens outsourcing to a marriage: there's a courtship, the signing of a contract, a period of bliss and harmony and possibly at the end there's a divorce. "So you've got to think about what provisions do you put into the contract that deal with the ceremony and the marriage, what you think about the deal going forward, who's going to look after the kids, who works what hours, then you have to figure out how you divide things up at the end."
While a large number of outsourcing deals work out in everyone's best interests, as in any marriage things can turn sour. If it's done properly, a deal has a good chance of working out, but "where the deal has been rushed through and rammed down one party's throat, those have been formulas for disaster," says Atis.
Canadian Lawyers Lagging?
Some would argue that Canadian law firms haven't taken full advantage of the potential afforded by outsourcing deals. George Atis believes the U.S. currently leads the way. "A lot of the mega-deals have been done by U.S. counsel coming up to Canada and being retained by the big banks, for example. Canadian lawyers have played their part, because there are local employment issues, labor issues...but they're not leading the big deals." Atis believes that Canadian lawyers have not acquired as deep a skill set as their U.S. counterparts. "I can't say we've dropped the ball, we've sort of ignored the ball...if we had set up and aligned our practices in the early 1990s...we would be at the same level as U.S. firms. I don't think people in Canada realized the size of the market."
Atis has worked extensively on both sides of the outsourcing fence since 1996, starting at SHL Systemhouse, then working at Shaw Pittman before heading back to Toronto last year to head up McMillan Binch's outsourcing team. Atis sees himself as a trendsetter who brings a "scientific approach" to doing these deals. "Essentially this is a new area and there are fine lawyers in the city who do this. I don't think they do it as the U.S. people do it and that's the approach that I'm bringing to Canada."
In the U.S. the business case for hiring an outsourcing lawyer is clear, Atis says, since there's knowledge of the industry, vendors, terms and specific issues related to the type of deal. "Outsourcing is a specialized legal practice area, although it has been largely ignored as such in Canada," Atis argues. "In Canada there is a feeling that outsourcing deals can be done by corporate lawyers and M&A lawyers or solid transactional lawyers. There's some truth to that, because an outsourcing transaction is a complicated deal and transactional lawyers have the experience. But when you're dealing with the specific issues of outsourcing, whether it's service levels or knowledge of data centers and the issues to be looking for, that is where the outsourcing lawyer comes in. When you've done enough deals, you start recognizing triggers, issues and you start planning for them from day one. When you go into a negotiation, you have usually prepared immensely with your client to say these are the specific risk areas for your business."
There have been cases of American lawyers coming into Canada to act as lead counsel on deals. Atis notes, "It is no secret that U.S. lawyers obtain TN-1 visas...and enter Canada as 'consultants' to represent Canadian companies and negotiate local outsourcing deals." A couple of major deals done in Canada over the last year or so by non-Canadian law firms put some noses out of joint among the Toronto outsourcing bar. Air Canada restructured its outsourcing agreement and Bank of Nova Scotia underwent a major IT deal. Both chose American law firms.
"I am generally upset when this happens," says Takach. He believes that Canadian law firms need to do more to sell themselves, although "the fact is that we have as much work as we can handle now, so I'm not sure what we would do with the additional marketing."
"A lot of corporates are ignoring the home-grown expertise and not seeking it out," confirms Alison Youngman. "I'm not sure that we have done the greatest job touting our capabilities...I think it's very typical of Canadians to believe that somebody else can do it better than Canadians. It's part of our psyche.
"I really believe that if people start thinking of their lawyers as a part of their business team when they're thinking of outsourcing, they'll find that they'll develop a better relationship," continues Youngman. "I really do think that we can assist them in ways that they probably don't think we can assist them. And they don't have to go to the States to get the expertise."
Canadian lawyers have been passed over to some extent, agrees Vereshack, but he attributes it partly to the fact that the U.S. market is so large that some U.S. consultants who specialize in outsourcing work with lawyers right from the beginning of the process. They have entered strategic alliances with major American law firms and package price a deal. Canadian lawyers are thus precluded from the transaction because the U.S. outsourcing consultants have their own law firm. "They'll hire a local firm, but it's a very small piece of the transaction and it's not where the money is. The money's in negotiating the outsourcing agreement itself." Vereshack says, "The smart U.S. outsourcers and the consultants package price the deal, they do it as a percentage of the outsourcing. They say it's 1 per cent for example and it includes consulting and legal.... It could be done here. But, to my knowledge, so far none of the law firms here have taken the initiative of hooking up with a consulting firm."
Washington, D.C.-based Shaw Pittman is widely recognized as perhaps the preeminent outsourcing law firm in North America and maybe the world, with at least 70 of its 440 lawyers devoting their practice to outsourcing. The firm started working on major deals as far back as 1991, and now has annual revenues of about $40 million in outsourcing alone. "We were fortunate to handle some of the earliest transactions," says Paul Mickey, Jr., the firm's managing partner. "By word of mouth, our ability to handle outsourcing on the customer side spread and we got asked to do as many as we could handle." Part of the firm's successful strategy was to move many of its stronger partners and associates into its outsourcing practice. At the same time, it made some very successful lateral hires. The firm has branded itself over the past few years as a technology transactions practice, and boasts of having done in excess of 400 outsourcing transactions.
Three years ago, Shaw Pittman opened in London, England. "Our existing outsourcing relationships were increasingly taking us to Europe," says Mickey. "We've been able to build a 25-lawyer, very successful practice, a key element of which is outsourcing."
Despite the fact that his firm has acted for several major Canadian clients, including Air Canada, CIBC and Seagram, Mickey doesn't believe that American lawyers are taking business away from Canadians. "It's a substantial and growing market and there's plenty of opportunity for us to be involved and for Canadian firms to have very active practices as well."
Not everybody agrees that Canadian lawyers have missed the boat. "I probably have been more involved in Canada-U.S. outsourcing deals than I have seen lead American attorneys involved in U.S.-Canada outsourcing deals," says Duncan Card. "We have a very sophisticated bar in Canada. It's not large, but it's very specialized and sophisticated." Having done international deals, and seeing the quality of work done in other jurisdictions, Card is convinced that "we are absolutely among the best in the world."
Alan Gahtan believes that most Canadian outsourcing transactions are done by Canadian lawyers. Although there have been some deals done by Americans, "the problem is the customers and the vendors are very large entities and no one wants to talk about them and get locked out of work."
"We have a smaller market, a smaller number of players, and it hasn't been perceived as a sexy area. That's going to change," insists Adam Vereshack. "The lawyers in the States are charging in U.S. dollars, and their hourly rates are higher and experience here is just as good. We're a lot cheaper."
The Future of Outsourcing
Many predict that the outsourcing market will continue to expand dramatically over the next few years, giving rise to a legal cornucopia. The dollar amounts are huge. According to a 2000 Dun & Bradstreet study, the forecast for Canadian outsourcing deals (specifically defined in this study as "the use of outside partners to perform tasks that traditionally would have been performed inside the company") in 2001 was $66 billion, compared to $33.1 billion in 1997. And the forecast for the next few years is excellent. Dataquest Inc., a unit of Gartner, Inc., projected last year that the global outsourcing market for finance and accounting work alone will grow from $12 billion in 1999 to $37.7 billion by 2004.
Alison Youngman looks forward to the potential with relish. "I think it is going to be huge. In recessionary times, I think outsourcing is a tool that executives would be looking to."
Richard Austin at EDS believes that energy and utility deregulation will largely drive future growth in the outsourcing sector. He says the IT services market's economic prognosis is excellent, and forecasts steady growth at 10 per cent compounded over the next five years. "I expect that there's going to be a fair amount of activity in the financial services sector...I think security will become a critical issue for many organizations." In fact, many companies have undergone a seismic shift in thinking about security as a result of the terrorist attacks in the U.S. "Security was important before September 11," says Austin. "After September 11 it is a key driver."
Outsourcing "will be a boom area," says Atis. "In this economy, I can see a lot of BPO activity in the next few years, in all facets...anything that a specialty provider can do better and more efficiently, companies may look to do on the outside." Extrapolating the numbers taken from Dun & Bradstreet's survey, Atis predicts that "the Canadian outsourcing market for the next two to four years should be massive."
It certainly looks like the Canadian outsourcing bar will be very busy in the foreseeable future. There are about 50 major companies in Canada who could outsource their IT services but haven't-yet, according to Vereshack, who says, "If you've got 50 companies in the billion-dollar range, you've got a $50 billion estimate."
But, as Zero Mostel would put it, "If you want to see some action, you got to show a little ankle."
*article courtesy of Ann Macaulay.