Legal Download 2.0 - Understanding offshoring risks

Offshoring carries additional risks to outsourcing, and CIOs need to understand how to protect against these risks, says Hinal Patel

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By  Hinal Patel Published  November 11, 2008

Offshoring, the movement of business operations from one country to other, usually less expensive countries, is a strategy that has been deployed by CIOs and business transformation managers for some time now.

It is this trend that underpins the IT and business process outsourcing success story of countries like India. However, offshoring comes with a number of additional risks in comparison with ‘regular’ outsourcing. In this article, we seek to highlight some of these additional risks which CIOs and business transformation managers should take steps to protect their organisations against, when considering offshoring business functions.

Legal risks

Contractual structure

There are a variety of contractual structures available to regulate the offshoring activity and each has advantages and disadvantages. Options include contracting with a local party that has facilities offshore, contracting with an offshore entity or incorporating or acquiring an entity abroad to provide the services. The structure through which the offshored services are delivered will impact the risk profile for the offshoring and these risks will need to be mitigated through operational and contractual mechanisms.

Governing law and jurisdiction

Each party will want to contract under a governing law with which it is comfortable. What amounts to ‘comfort’ varies from organisation to organisation and will depend in part on knowledge of the governing law, whether the organisation is familiar with the civil or common law legal system and political and geographical reasons. Engaging qualified counsel to advise on the legal risks arising under the relevant governing law is an important part of managing legal risk.

The parties will also need to consider what dispute resolution forum or “jurisdiction” is appropriate. Typically for cross-border contracts, international arbitration is favoured due to the theoretical ease of enforcing foreign arbitral awards in states that have signed up to the New York Convention (Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 1958). However, this is not to say that another dispute resolution forum is not appropriate or even preferable. There are many options to choose from and parties should obtain advice from expert counsel to assist in selecting a preferable forum to enable quick, easy and cost-effective dispute resolution and enforcement.

Practical risks

Confidentiality

With any offshoring activity, the offshorer is likely to be even more concerned about the maintenance of its confidential information given confidential information will be moved offshore. It is in the offshorer’s interest to ensure that all confidential information is clearly designated as such (to the extent reasonable to do so) and that it is comfortable with the service provider's confidentiality systems and processes. The service provider on the other hand needs to ensure it has (and can demonstrate that it has) systems and processes in place that protect the offshorer’s confidential information.

Security of data

The risk to the security of personal or corporate data which exists in any business is exacerbated when business functions are offshored. The service provider has distance on its side and the offshorer cannot always be certain that the security standards operated by the security provider will be satisfactory and sufficient. At the very least, the offshorer will need to obtain robust audit rights in order to verify that the service provider is deploying the systems and processes that it agreed to deploy.

In addition, if data is being constantly transferred electronically from the offshorer to the service provider, there are more opportunities for the information to be lost, damaged or misused. It is therefore important to ensure that the service provider is required to have technical and operational safeguards in place such as resilient and diverse communications links coupled with regular data back-up and storage.

Loss of business knowledge

To many companies, expertise within the business is its primary asset. Opting to move this knowledge to another entity physically based offshore is not a decision that should be taken lightly. In addition to the security risks involved in the transfer of knowledge and expertise, and the potential consequential damage to the company’s prosperity and brand, moving business expertise to the service provider could create additional competition from an unexpected source - the offshore entity itself. These risks can, of course, be reduced by taking proper legal advice on protecting intellectual property rights as well as the other protections available.

Service issues

It is not uncommon for there to be degraded performance for a period of time after the service provider commences providing the services. The offshorer needs to be alive to this and although it may be reasonable for the service provider to be allowed some time in which to ramp-up its performance, due regard will need to be had to the amount being paid for the degraded services and the extent to which the services are permitted to degrade before certain contractual rights are triggered.

Failure to deliver

It will come as no surprise that offshore service providers fail to deliver like any other service provider and such failure may well erode any cost-savings derived from the offshoring. It is therefore important that those looking to offshore consider the impact of failure and put in place, where possible, governance processes and contingency plans from the outset. In addition, early steps such as thorough due diligence are strongly recommended as this may well expose service delivery issues before the parties invest significant sums in the venture.

Turnover of key personnel

As a result of the offshoring ‘boom’, skilled key personnel are in demand in popular offshoring destinations. This has in turn led to high staff attrition rates. Reports suggest that turnover of key personnel in key offshoring destinations such as India may be as high as 15-20%. Apart from the knowledge and confidential information that is lost when skilled personnel leave the service provider, it can disrupt the operations of the service provider, which may well have a negative impact on service delivery. Service providers are well aware of this issue and more often than not have put in place mechanisms to protect their offshorer customers (and themselves) from breaches of confidentiality and knowledge drain, as well as having generous incentives to retain personnel. That said, it is still important to ensure that appropriate provisions are included in the contract.

Geo-political risks

Lastly, geo-political risks are worthy of attention when considering potential offshoring locations. Political and economic stability, the national infrastructure of the offshore jurisdiction and culture clashes, to name a few, are very real concerns and the parties need to build flexibility and contingency into their contractual arrangements to allow for such risks to be managed.

The points outlined above are just a few examples of the potential pitfalls that exist when offshoring business operations. Whilst offshoring is generally considered to be a cost-effective option for many organisations, those cost savings will not be realised if relevant risks are not minimised and properly managed. Customers should therefore obtain appropriate advice prior to, during and, sometimes, after concluding contracts.

The author, Hinal Patel, is a Partner with DLA Piper (Dubai).

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