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Article

Managing Subcontracting Risk

Date

November 11, 2010

AUTHOR(s)

George S. Takach


When outsourcing to IT service providers, customers should be aware of the risks posed by their suppliers’ use of subcontractors and take steps to manage those risks. In this article, we discuss ways that customers can better protect themselves, including approving upfront the subcontractors to be used and contractually requiring the supplier to obtain the customer’s consent to any subcontracting.

In times gone by, a local television station would regularly run a public service announcement just before the late night news: "It’s 11 o’clock, do you know where your children are?" This was a good question for parents (and still is), and lends itself to a useful paraphrase: "It’s 2010, do you know who your IT service provider’s subcontractors are?" (And of course this is a good question to ask about all of your service providers — keep in mind that BP’s recent oil spill in the Gulf of Mexico was actually caused by a subcontractor.)

This is a particularly timely and compelling question to ask in an age of outsourcing and offshoring, when various chunks of work are sent to the four corners of the world in search of less expensive delivery resources. Consider the following scenario.

A Surprising Subcontractor

You work for a fair-sized financial services company, and you’ve outsourced to a certain supplier various data entry and processing functions. For the past six months (since your relationship with the supplier began), the supplier has been sharing with you tales of economic woe about how expensive labour is becoming in all of their normal operating locations; while their staff’s wages are still well below yours here in North America, they have nonetheless risen in local terms at an about 15 per cent annual rate over the past few years, a rate your supplier simply cannot afford.

The supplier’s complaints notwithstanding, you were not prepared for the headline in your city’s leading commercial newspaper to the effect that your supplier had recently entered into a subcontracting deal with a local prison (that’s right, you read it correctly!) facility whereby inmates were being pressed into service doing data entry and other related duties. In the accompanying article, your supplier is quoted extolling the virtues of using convicts for labour, especially their reasonable daily rates (which are kept very low by the prison authority).

Importantly, this story of an offshore service provider using prison inmates as subcontractors to do data processing for financial services clients is, amazingly, not fiction. Earlier this year, just such a real world situation came to light. And when questioned about the use of such a subcontractor, the IT services company essentially responded that times were tough, and that it had to do whatever it could to keep costs under control. Moreover, it argued, the inmates weren’t being asked to do call centre work that would have them talking to North American clients of its financial institution customers. (The supplier did, however, confirm that the inmates were given access to personal information in the course of performing their business process operations.)

Supplier Flexibility

To conclude the not-so-fictional hypothetical scenario started above: After reading the headline, you run to your agreement with the supplier to see what it says about subcontractors. Your heart sinks — the contract expressly provides that the supplier can subcontract and delegate work as it sees fit, so long as the agreement’s service levels are met at all times (the service levels address performance metrics such as the accuracy of the data entry work, and the efficiency with which it is done).

Your contract is in line with the standard agreements of many IT services providers, though we don’t want to suggest that reputable, first-tier suppliers would want to use prison inmates as subcontractors! But all suppliers do generally want to have a broad, even unfettered discretion, to be able to use subcontractors instead of their own employees to deliver services to their customers.

Subcontracting is attractive to suppliers because often they will not have the necessary skill or capacity in-house, so they will want to "fill out the services team" through subcontractors. Or, the subcontractor is willing to do the work at a lower cost than the supplier could do it using its full-time employee staff.

Approving Subcontractors Upfront

Customers are generally fine with a supplier using a subcontractor that was identified at the very outset as part of the supplier’s proposal (typically in response to the customer’s RFP). In such a scenario, the customer can evaluate the skills and reputation of the subcontractor, just as it is doing for the main supplier.

Moreover, when asked upfront to approve the use of a subcontractor in this fashion, the customer can factor the cost savings represented by the use of the subcontractor (whose staff typically work for lower wages than the supplier’s own employees) into the overall economics of the bid by the supplier. Assuming the bid is a competitive one, the customer can then compare the overall price of this particular service offering (which includes the subcontracting), with bids that do not contemplate subcontracting. The key point is that when a supplier indicates upfront what subcontractors it intends to use, the customer can make an informed decision.

Introducing Subcontractors Later

Many suppliers argue, however, that they should have this same right (to substitute subcontractors for internal employees) even after the contract is signed (and although the work was awarded to the supplier on the basis that no subcontractor was contemplated). This is generally not acceptable to customers, for two good reasons.

First, the customer wants to be comfortable as to the identity and capability of the subcontractor before the customer agrees to them. Second, the customer also wants to ensure that if the supplier is materially reducing its cost structure by subcontracting the relevant work, then some of these savings will end up in the customer’s pocket as well. In short, it makes sense for customers generally not to believe it fair or reasonable that they sign up (in the initial contract) to a particular service-delivery model for a particular price, and then allow the supplier to unilaterally change the service-delivery model, and unilaterally reap the resulting economic benefits, once the work is underway.

Consider the following example. You are looking to outsource a critical, client-facing application (such as your online e-commerce site). Two suppliers respond to your RFP. One is a "Tier 1 supplier," and the other is a "Tier 3 supplier." The Tier 1 supplier bids a price literally twice as expensive as the Tier 3 supplier, but you nevertheless choose the Tier 1 supplier because it has a great (and warranted) reputation for quality and for ensuring 100 per cent uptime (an important consideration with a critical online application).

It would arguably be quite unfair if the Tier 1 supplier, the day it is awarded this contract, turned around and subcontracted the work to the Tier 3 supplier, thereby allowing the Tier 1 supplier to pocket the price differential. If you would have been comfortable enough with the Tier 3 supplier, you would have chosen them and pocketed the cost savings yourself. Therefore, the Tier 1 supplier should not be able to do indirectly (through a subcontracting clause in the agreement) what you were unwilling to do directly.

The Tier 1 supplier responds to you: "But we’re on the hook if our subcontractor (the Tier 3 supplier) defaults, so why are you concerned?" Well, for several reasons. First, the contract never permits complete financial recovery of all losses because it will invariably contain limitations on the supplier’s liability. If you want to test this hypothesis, see if the supplier will agree to indemnify you for all damages resulting from a subcontractor default, including consequential damages and lost profits! Not likely.

Moreover, you will not be able to be fully compensated for loss of reputation, and the loss of goodwill that this represents (if your e-commerce site goes down). Equally, the service-level credit that such an outage will trigger does not even begin to partially compensate you for the real damages you will suffer from such an outage. This is why you selected the Tier 1 supplier rather than the Tier 3 supplier in the first place.

Approving Subcontractors Later

It is for these reasons that a clause ought to be put in the contract requiring the supplier to obtain the customer’s consent to any subcontracting. Now, there may be a limited type of subcontracting for which such approval is not required, or perhaps the standard of consent might be qualified by "not to be unreasonably withheld." But otherwise the consent should be a meaningful one, such that it can be withheld at the customer’s discretion unless the supplier can truly make a compelling case as to why it is in the customer’s interest to permit the subcontracting.

Finally, as part of the approval of the subcontractor, the contract should make it crystal clear that the supplier is fully and unconditionally responsible for the actions (and failures/omissions) of the subcontractor. In other words, in law the customer wants the subcontractor treated as if it were part of the supplier.

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