Tech & Sourcing @ Morgan Lewis


Welcome to the conclusion of our two-part Spotlight post with Lee Harding in which we discuss key employment/labor and employment law issues in relation to UK and EU outsourcing transactions. In Part 1, we talked about key initial considerations and specific timescales involved.

Lee, welcome back. We understand that the issues you raised last week may affect both the supplier and customer—are there any key differences in what each business should consider?

Every outsourcing transaction is unique, but there are certain themes that will be especially important for each type of business, depending on whether it is the supplier or the contractor.

For the customer, a key consideration will often be ensuring that the outsourcing transaction can be managed smoothly in a way that does not create disruption or inconvenience for its business and does not, for example, affect its ability to provide products and services. There may be industry-specific considerations. For example, if the customer is a regulated financial services business, it might be necessary to make certain notifications to regulators or to ensure that additional planning is in place to protect consumers.

The customer will often want to ensure that the costs associated with the outsourcing transaction are kept to a minimum. There will sometimes be a tension here between the needs of the supplier and customer. For example, deciding that the automatic transfer principle does not apply in a certain country might result in lower costs for the supplier taking on those services. By contrast, such an outcome might result in significant costs for the customer if it needs to go through a large-scale restructuring exercise with any unwanted staff.

Even if cost savings can be found in an outsourcing solution, the customer may want to provide certain protections to its staff in order to satisfy both internal and external stakeholders that the customer is looking after its people. Investors are increasingly focusing on this issue as part of a holistic assessment of environmental, sustainability, and governance targets.

The customer may also want to prescribe the manner in which any staff working on the services are engaged. For example, in the United Kingdom there has been a significant tightening of restrictions placed on suppliers looking to engage atypical workers, such as independent contractors, in light of the off-payroll working rules being introduced to the private sector. Put simply, these rules are designed to place more responsibility on the end user for tax and social security contribution liabilities when engaging such workers through an intermediary. There are some carveouts for these restrictions, but many customers are taking a conservative approach as a matter of market practice and insisting on suppliers using employees.

Another issue that can often arise is ensuring that the supplier carries out any necessary background and vetting checks on staff engaged on the services. For the customer, this may be important if it has promised to meet such obligations to its own customers and needs to flow down those obligations to suppliers.

From a supplier’s perspective, one of the key considerations will be to ensure that it has full visibility of any potential liability, both upon entry into the contract and following any exit from the services. Often, the supplier will want to avoid so-called stranded liabilities at the end of the contract, i.e., being left with all of the staff costs but none of the revenue from its services. The supplier will need to ensure that these costs are properly baked into its business model and that appropriate commercial protection is provided.

How are these potential issues generally dealt with? Are there both contractual and operational considerations?

Where the automatic transfer principle applies, it is common for the customer to be broadly responsible for any employment liabilities that occur under the customer’s stewardship of the services (i.e., prior to the transfer date), and for the supplier to be broadly responsible for any employment liabilities that occur under the supplier’s stewardship of the service (i.e., after the transfer date). If there are any deviations from this principle, there should be a good commercial justification for doing so. To take one example, it is not uncommon for a customer to take responsibility for any unfunded pension liabilities that carry across to the supplier (even where those liabilities have not been triggered prior to the transfer date) on the basis that such costs have not been factored into the supplier’s business model.

To take another example, there might be a situation where so-called out-of-scope employees assert that they have transferred from the customer to the supplier. These individuals are those persons that neither party expected to transfer and who were not considered to be assigned to the transferring services.

In the first instance, the employment considerations are addressed through appropriate warranties and indemnities. Broadly speaking, the customer might indemnify the supplier for any employment liability that arises prior to the transfer whereas the supplier might be responsible for any liability that arises after the transfer.

There will be some exceptions to this principle. If, for example, a supplier fails to comply with its obligations to inform and consult with employee representatives because of the fault of the supplier (perhaps insufficient information was provided by the customer or the previous supplier), the parties might agree that the customer should be responsible for this failure.

There will also be other scenarios to take into account. Sometimes, liability might arise where neither party is at fault, such as if an employee asserts that he or she has transferred under the automatic transfer principle where neither party was expecting that person to transfer. In this situation, it is common to agree on a dispute resolution process that is fair to both parties.

In addition to contractual provisions, there will be important operational considerations. Those responsible for managing the contract will need to be familiar with the various obligations that may apply. There might be regular reporting obligations or the supplier might be prohibited from taking such actions at certain times, such as redeploying staff or changing terms and conditions without the prior written consent of the customer.

Further, in many countries, the supplier will need to manage the project staff in a dedicated and organized way so as to show the supplier that those staff are properly assigned to the services and should therefore automatically transfer with the services at the end of the contract. If the contract is managed more as a shared service for a number of different clients, those individuals may stay with the supplier as a matter of law, which would then equate to stranded employment liabilities. In other words, the supplier may be responsible for any severance costs associated with any unwanted staff.

Are there any other transactions where clients should consider labor and employment issues?

Yes, for most transactions, there will be a need to consider labor and employment law issues to a lesser or greater extent.

For a business rich in intellectual property (IP), there might be a need to ensure that any intellectual property created by staff has been properly assigned to the target company being acquired. Sometimes, IP will be assigned to a different company for tax or other reasons. Similarly, the buyer may want some assurance that any IP or confidential information used by the business has been lawfully developed by staff. There are high-profile examples where this did not happen, and the buyer then had to settle expensive trade secret lawsuits with third parties and effectively shut down the business.

If a target company possesses important relationships with staff or employees, the buyer will want to ensure that the right business protections are in place, such as appropriately drafted notice, garden leave, and restrictive covenant protections. By the same token, key employees will need to be incentivized to stay through appropriate retention arrangements that align the interests of those employees with the future growth and success of the acquired business.

Increasingly, clients are looking at wider cultural issues to ensure the right fit between the buyer and the business being acquired. These workplace culture issues will be essential for any future integration to achieve the synergy it seeks.

We thank Lee for sharing his thoughts and insights on labor and employment issues in technology transactions.