Satyam's sting

The recent turmoil at Satyam Computer Services Ltd. is forcing its customers and other  companies with significant offshore sourcing connections to take a fresh look at these relationships. Previously one of India's largest and most prominent providers of IT and business process outsourcing services, Satyam has been plagued by a series of missteps -- beginning in October with unconfirmed allegations of a World Bank security breach and culminating in the Jan. 7 announcement of massive accounting irregularities by Ramalinga Raju, Satyam's currently imprisoned former chairman. With Satyam's continued viability at risk, its clients must react quickly and strategically to protect themselves.

The company's future is uncertain. The vast majority of previously reported cash assets were nonexistent, creating uncertainty as to whether Satyam can meet payroll and other operating expenses, despite its recent assurances. Key employees may move to other vendors, or Satyam may institute layoffs, resulting in the loss of intellectual capital and possibly causing service disruptions. Customers are threatening terminating relationships; State Farm Insurance Co. has reportedly done so. Other customers are likely contemplating downsizing and other contingency plans, all as Satyam is more dependent than ever on customer-generated revenues.

Continue reading below

Adding to Satyam's woes, the Indian government has rejected rumors of a possible bailout. Satyam's government-appointed board has reported that it is not currently pursuing a merger or sale of the company, though the market is rife with reports of bidder activity. Raising funds from banks, investors and other channels will be challenging, especially in the short term, while Satyam struggles to restate its financial accounts and provide some semblance of normalcy. Worst-case scenario, the company could be liquidated.

If your company has an existing relationship with Satyam, an assessment of the extent of your exposure is the first step in mitigating your ultimate risk. This assessment should take into account the nature, criticality and portability of the services Satyam is providing. Core IT or BPO services involving an integral component of your company's operations will merit more attention than a discreet consulting engagement. We recommend companies review their complete Satyam agreement, including schedules, amendments and subsequent work orders, to get a full understanding of the legal exposure. However, as these contracts are often "put in a drawer" until something goes wrong, don't rely solely on the four corners of the contract. Seek technical and business input for practical insight. Customers often negotiate for contractual rights that are never exercised in practice. For example, while your contract may require Satyam to engage in regular knowledge transfer sessions, these sessions may not have been implemented.

A thorough analysis and understanding of your termination rights and obligations is essential in the contract review. While most agreements allow customers to terminate for convenience, in longer-term outsourcing agreements, provisions typically require customers provide anywhere from 30 to 180 days (or more) advance notice or pay a (sometimes significant) early termination fee. Assuming Satyam is otherwise materially meeting performance obligations, consider whether the current situation triggers other, nonperformance-related termination rights. For instance, many sophisticated customers require the provider meet ongoing financial covenants, the failure of which triggers a termination right, typically without the payment of a termination fee. Failure to meet key personnel continuity or attrition requirements, repeated failures to meet specified service levels or a change of control of Satyam may also trigger termination rights. The analysis shouldn't stop once you've determined your termination rights and corresponding notice and payment obligations. You should also assess the nature and extent of the termination assistance services Satyam must provide (assuming it is in a position to do so), and your rights with respect to critical software, hardware and third-party services contracts. You should also determine whether the contract permits (or prohibits) solicitation of your Satyam account team.

Termination rights are only part of the analysis -- the associated costs and risks are also critical determinants of next steps. The largest likely costs will be in transitioning the outsourced functions. Most companies don't retain sufficient resources to perform outsourced functions in-house and will have to find other providers. Without time to engage in a full request for proposal process, your best option may be to move to another existing service provider, preferably one with whom you have a master agreement and governance regime in place that would facilitate the negotiation and transition process and possibly merit volume-based discounts.

Should you terminate your contract with Satyam, know that switching outsourcing providers can be difficult and expensive and is not without risks. Rushing into a new agreement may only create future problems if not done thoughtfully. Select your new provider and negotiate a contract with as much care and diligence as circumstances permit. Where possible, include protections mitigating your risks in the event Satyam-like troubles taint your new provider. Under time constraints, consider a phased approach, signing a short-term agreement to get transition started, but avoiding a long-term commitment until the details are worked out.

Even if terminating the relationship isn't the best immediate option, the threat of termination may give you leverage to restructure the deal or obtain additional contractual safeguards. Those who elect to remain will at least want to closely monitor Satyam's performance and ongoing viability. Maintain close contact with your Satyam team, including senior-level management. Institute recurring discussions regarding Satyam's performance of the services and the status of its risk management and remediation efforts. Along with regular meetings, you should assess Satyam's existing reporting requirements. Detailed performance reports, encompassing all key operational measures and delivered timely, will be particularly important in identifying potential problems. Regular financial reporting should also be instituted.

Consider whether to exercise existing protective contract amendments or request additional ones. Most agreements include specific service level requirements and associated remedies, often including service level credits and termination rights. If existing service levels and remedies don't adequately cover key areas, you may want to initiate the process for implementing new or increased service levels, which often requires advance notice, or seek enhanced remedies, perhaps including additional termination rights.

Revisit your exit strategy and corresponding termination rights. Put a termination plan in place now and provide for the plan to be updated regularly. Your plan should address steps that will allow for the continuation of the services on short notice in the event Satyam or your account team disappears. For example, consider implementing a mechanism to have your data delivered to you regularly or mirrored on your own servers. If Satyam is performing consulting or application development work, confirm your ownership rights and secure any developed code and works in process. Be sure applicable IP assignments are in place, especially in India, where proper assignments are critical to perfecting ownership. Consider instituting ongoing knowledge transfer sessions.

Most outsourcing agreements include robust audit rights. Time permitting, you may want to conduct an operational audit to confirm Satyam is doing what you have contracted for -- including compliance with obligations regarding data security, record retention, systems updates and refreshes, and maintaining robust procedures manuals. Address any inconsistencies immediately.

You should also prepare to answer questions about the risks of your entire outsourcing strategy from senior management, the board and other stakeholders. To that end, consider reviewing your sourcing portfolio to identify vulnerabilities and departures from best practices. Where you find gaps, the uncertainty generated by Satyam may motivate your organization to demand changes and soften your suppliers' resistance.

While there are lessons here, the impact of these events shouldn't be overstated. There will be demands for increased oversight and regulation of public companies in India, perhaps leading to measures like Sarbanes-Oxley, if Enron is an accurate barometer. However, there are no indications that this is a wider epidemic across Indian service providers generally. Outsourcing, done tactically and with appropriate diligence, can provide significant cost savings and other strategic benefits that are not outweighed by the risks posed by recent events.

Karen M. Sanzaro is a partner in the global technology, outsourcing and privacy group of Hunton & Williams LLP.

Comments

Post a comment

Name:

Email Address:

URL:

Remember personal info?

Comments: (you may use HTML tags for style)

Please only click "Post" once. It may take a few moments to process.