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Tech & Sourcing @ Morgan Lewis


Outsourcing agreements are typically long-term arrangements and the functions outsourced, whether IT or business processes, often key to the continued operation of the customer’s business. It is therefore important that both the customer and the supplier undertake due diligence prior to entering into such arrangements to ensure that, for example, both parties are clear as to the customer’s service requirements and objectives and how these will be met by the supplier.

In this post, we look at due diligence from the perspective of both the customer and the supplier.

Customer Due Diligence

The customer’s due diligence will focus on:

  1. Its own needs: for example, the services that the customer is looking to outsource and its current, and likely, future service requirements. The customer should also identify any objectives that the business would like to achieve through the outsourcing: for example, is it looking to transform the delivery of the services, such as through automation or other innovative approaches? Other points to consider will include the risk of outsourcing the services (discussed further below) and any regulatory requirements.
  2. The prospective suppliers: for example, do they have the necessary expertise to provide the services in a way that meets the customer’s requirements, and how do they propose to do this? The customer should also consider the geographical reach of the supplier in the context of the services to be provided and the financial standing of the supplier. Also important will be the commercial model proposed by the supplier, including the impact of changes in volume on charges.
  3. Business case protection: for example, will the supplier’s solution and pricing hold for the term of the arrangement? Are there hidden internal costs or supplier costs that have not been identified that will impact the anticipated savings? In connection with this diligence, it is important to closely review the supplier’s assumptions and limitations.

Outsourcing can present risks to the customer’s business, particularly when the services being outsourced are complex and/or business critical. It is therefore important for the customer to identify the risks associated with the outsourcing and develop and implement a strategy to mitigate the risks.

Supplier Due Diligence

Elements of the supplier due diligence mirrors that of the customer: for example, the supplier will be looking to have a clear understanding of the customer’s requirements and objectives, and to ensure that it is able to achieve these.

Where a proposed arrangement is more complex, the supplier will likely undertake more detailed due diligence. Due diligence exercises can require relatively substantial resource investment by the supplier, and therefore in a competitive bid process, suppliers may require that they have been down-selected (or are at least one of a few frontrunners) prior to undertaking such activities, with only preliminary levels of due diligence being undertaken prior to down-select. Similarly, customers may be reluctant to commit the resources necessary for due diligence exercises by multiple suppliers prior to down-select.

The due diligence that the supplier carries out will usually focus on areas such as the services that are currently being performed (whether by the customer itself or a third-party supplier) and the service levels being achieved. Suppliers will also investigate any future customer requirements and any changes anticipated in the future; for example, changes in volumes, and any improvements required to the services and the likely cost of implementing such improvements.

Other items the supplier will wish to consider in respect of the existing services include ownership of intellectual property and the likelihood of being able to obtain licences to use such intellectual property, ownership of relevant assets and the age and condition of such assets, and (if applicable) how its IT will interface with the customer systems.

Employee Transfers

In the United Kingdom and other jurisdictions where the Transferof Undertakings (Protection of Employment) Regulations 2006 (TUPE) apply, due diligence should be undertaken by both parties into the personnel currently providing the services and those that are likely to transfer by operation of law to the supplier. The supplier will need to consider how the transfer of such personnel will affect its cost of providing the services and utilization of such personnel as part of the service delivery. Where the supplier already has a sufficient number of personnel, it may be relevant to consider redundancy and the approach to redundancy costs.

In the United States and other jurisdictions where automatic transfer regulations are not applicable, the parties will need to assess the terms of any anticipated offers, including rationalization of compensation and benefits and the impact on the pricing if any. The applicability of severance at the time of transfer or during some minimum retention period post-hiring should be assessed, including the administrative and financial responsibilities associated with severance.

The Outsourcing

The due diligence undertaken by both the customer and the supplier will ultimately feed into the final outsourcing agreement. For example, the description of the services, any obligations regarding transformation of the services, and the service levels. The approach that the supplier takes to the commercial model may also be influenced by the level of due diligence information that it has undertaken.