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Companies in all sizes and industries are turning to outside vendors to perform non-core functions. They outsource to achieve cost reductions (which according to Forrester Research can be as much as 25 to 40 percent), and so they can concentrate on their core competencies and let external vendors provide economies of scale and expertise for the other operations.

The range of functions that executives are willing to outsource is expanding as vendors increase their capabilities. Companies are mow contracting out processes that are more integral to their business, including call-center operations, procurement, financial operations (e.g., accounts payable), and HR operations.

International outsourcing, or offshoring, is an important part of this trend. It frequently has advantages over domestic outsourcing, including even greater cost-savings, but it presents some unique problems. This article summarizes the common ones and suggests some effective ways to approach them.

Choice Of Models

International outsourcing arrangements typically follow one of several models:

The Offshore Subsidiary
A business establishes a "captive" foreign subsidiary to which it transfers IT or business-process operations. This model allows the customer to maximize control over the offshored operations. For particularly sensitive functions or information (such as financial information), this can be essential.

The Offshore Joint Venture
Companies form a joint venture with a local company, often obtaining the additional advantage of an entree to the local market. Recently, Microsoft created a joint venture in China with Tata Consultancy Services (TCS) and several Chinese vendors to provide IT outsourcing services not just to Microsoft but also to other customers in China.

The Contract with a Domestic Vendor That Retains Services Offshore
More widespread than either of the first two, this model involves entering into an outsourcing arrangement with a domestic outsourcing vendor (such as IBM or Accenture) that provides some or all of the services through its overseas captives. The domestic vendor is then responsible for managing and delivering the offshore services. One advantage of this model is that the customer avoids the risks of moving operations to jurisdictions where enforcement rights and remedies may be more difficult than it in the United States.

The Contract with an Offshore Vendor
Customers, particularly multinational corporations and financial services businesses, increasingly are contracting directly with overseas vendors. A number of leading offshore outsourcing companies, such as TCS, Infosys and the newly spun-out Genpact, now have offices in the United States to encourage and support such direct contractual arrangements.

Legal Considerations

Any offshoring contract will need to cover the same points as a purely domestic outsourcing arrangement - for example, the scope of services, service levels, payment terms, credits and penalties, indemnities, and regular reporting requirements. In addition, each of the models cited raises its own distinct legal considerations. For example, joint ventures and subsidiaries raise corporate structure and tax issues, and other issues associated with an equity investment.

Here are some of the key issues to consider in an offshoring agreement:

Due Diligence
It's likely to be more expensive and time-consuming than due diligence onshore, but it's likely to be more important, as well. Hiring a local third party with resources on the ground for assistance is advisable. The customer should be satisfied that the provider is in good financial condition, has sufficient resources to handle the work, has the right management, expertise and skill levels to meet service expectations, has implemented processes to monitor performance, and has appropriate back-up facilities. (See discussion below regarding business continuity.)

Governance
After due diligence, the next step is making sure that you have the infrastructure in place to manage the relationship both at the vendor's and your own site. Strong structural controls to manage the relationship are always an issue with outsourcing, but they are especially important with overseas relationships.

Terms will vary with each offshoring contract, but a few are typical. It's important to have a central office for the outsourced project, to serve as a primary point of contact. With offshoring arrangements, particularly where services may be performed in various locations around the world, the geographical distances involved will require additional efforts to coordinate communications across business units within the vendor and/or customer. There needs to be project managers on both sides to handle day-to-day management, decision-making and reporting. Having a primary day-to-day liaison may mitigate problems caused by cultural unfamiliarity.

Also, a joint senior-executive management committee with authority to oversee the project and resolve disputes between the parties can help ensure good collaboration. The informal resolution process is especially important given the uncertainties of formal dispute resolution procedures abroad.

The importance of governance issues is often underestimated. Governance issues should be part of the contract negotiations and should continue to be addressed through the term of the relationship. To make contract terms meaningful, the customer must monitor and enforce compliance, and should adopt its own internal procedures to maximize the benefits and mitigate the risks of the arrangement. The customer also should be actively involved in the transition of services to the offshore vendor, and with the implementation of the operations in all phases.

Business Continuity
Offshore operations may be more vulnerable to political risks or natural disasters, so vendor and customer should develop contingency plans. Disaster recovery sites in geographically disparate locations may reduce the risk from both natural disaster and political instability. Disaster recovery and other business continuity measures may increase costs, but mitigation of risks is important.

Protection of Intellectual Property and Proprietary Data
Intellectual property rights are important in any outsourcing transaction, but they deserve special attention with offshoring. Often a customer will seek intellectual property rights in technologies developed for the customer by the vendor, but local laws in the destination country can complicate this. Even if the offshoring contract itself is governed by U.S. law, local laws may trump the contract provisions. For example, Indian intellectual property law recognizes the concept of a "work made for hire" and the assignment of intellectual property rights, but with subtle and significant differences from U.S. law. Unless the territorial extent of intellectual property rights is explicitly specified as "worldwide," rights are assumed to be limited to rights in India.

In addition, if an assignee of rights does not exercise the rights within one year of assignment, under Indian law the rights will revert to the assignor unless otherwise specified. Careful review, with the help of local counsel, is necessary to avoid these kinds of traps.

Another issue is whether any proprietary technology will need to be moved offshore. Inadequate legal protections may place key customer technology or information at risk. Although China, India and other countries have laws to protect against misappropriation and infringement, as a practical matter they can be difficult to enforce. One way to mitigate this risk is to compartmentalize the sensitive information so that no single vendor is given a complete copy or understanding of the customer's technology.

Privacy and data security issues can prove difficult. Most developing countries in which vendors operate do not have privacy protection laws comparable to those in industrialized countries. (The EU has broad data protection requirements that govern the collection, use and transfer of certain personal data, while the U.S. has adopted a sector-specific regulatory framework protecting data.)

Moreover, most laws provide that the customer remains responsible for compliance with applicable data security requirements. The customer cannot shift responsibility to the vendor. Thus the customer must require compliance by way of contract. In some cases, the regulatory framework will require changes in the deal structure to ensure that the flow of personal data complies with applicable requirements.

Labor and Employment
When deciding to offshore operations, companies may lay off domestic employees whose functions are being outsourced. In the United States, such companies may have obligations under state and federal laws (e.g., the WARN law that requires companies of a certain size to provide advance notice in specified circumstances). Similar and generally more stringent laws exist in the EU.

A customer should make itself aware of the employment laws and rules in the destination country, even when contracting with a vendor.

Taxation
Offshoring can raise significant tax issues. Customers should consult with international tax counsel to minimize tax liability. Whether or not outsourced activities in a foreign jurisdiction would be taxable by that jurisdiction must be determined on a case-by-case basis.

Other Considerations
Finally, customers in certain regulated industries may also be subject to legislation or specific industry standards. In the financial services sector, for example, offshoring arrangements are scrutinized by regulators. In the United States both the Office of the Comptroller of the Currency and the Office of Thrift Supervision have issued specific guidance to their regulated financial institutions regarding the extent of due diligence required before a financial institution can outsource services to an offshore vendor.