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Best Practices in Due Diligence on Existing Contracts

28 July 2009
Business & Technology Sourcing Review - Issue 13

Many an outsourcing deal has foundered on third-party contracts. Signings have been put off for weeks. Business cases have dissolved at the eleventh hour.  Surprise costs have shown up during transition or even after the ongoing services have commenced. Even worse, executive management has wondered how facts that have been in written contracts for years could pop up so late.

Fortunately, none of that needs to happen. You can complete due diligence review in an efficient and cost-effective way well in advance. Doing so can tell you what you need to know to assess risk, gauge costs and contract for issues. If you start with a good process, you are well on the way to a good result. This article provides an overview of best practices.

Create a Team

The first step is to assign a team responsible for the due diligence effort. The team at a minimum will include a lawyer with enough experience to make judgment calls on the meaning of the contract language in the third-party contracts. In addition, such a team often includes other contract reviewers, members of the procurement group familiar with the contracts, and members of the deal team familiar with how third-party technology and services will be used. A team leader should be named to manage the review project, because it will generally involve hundreds if not thousands of separate steps.

Getting Started

On the customer side, the team leader’s first goal is to get copies of the contracts that will need to be reviewed. This may be harder than you would expect. The contracts may be spread across business units, filed in a manager’s office, or discarded when the negotiator left the company.  The only clues that a contract should exist might be accounts payable records and lists of software running on systems.

The team leader also should work to understand the customer’s contracting history. Did the customer try to include outsourcing-friendly provisions? If not, they aren’t likely to turn up. Did the customer have form agreements? If so, the review might be simplified by examining the base form to know where the key provisions might be. If the customer’s practice was to try to obtain outsourcing-friendly provisions in separate amendments, reviewers can look first for amendments before reviewing the entire contract.

Record Summary Information Consistently

It is important to ensure that every member of the review team uses the same words, acronyms and phrases to describe the same contractual provisions. This permits multiple reviewers to produce work product with a commonly understood meaning. 

The best practice is for the team leader to prepare review instructions that outline the expectations and guidelines applicable to each team member’s review.   Quality assurance on initial work product early in the review process will identify problems in the instructions, which should then be corrected immediately to avoid re-work at the end of the due diligence review.

Tailor Review to the Deal

The review instructions should be tailored to the peculiarities of the deal. Ideally, the review should produce work product that efficiently answers all of the questions that the negotiation teams will raise. Thus, it is helpful to review the instructions with members of the negotiation team (including technical, business and administrative members) before providing them to the review team.

Use the Right Software

Reviewers should record information in a standard format using the same software package. This will allow them to produce a single computer file containing all of the collected information. In selecting a software package, you should consider the following:

  • Number of contracts
  • Training for reviewer
  • The software’s  current availability on the customer’s and service provider’s desktops
  • The software’s query, reporting, and mail merge capabilities
  • The software’s ease of use as a tracking database

Review Deal Terms with Review Team

At the outset, the team leader should take the time to familiarize the review team with the key terms of the deal, such as the nature of the outsourcing arrangement and who and what will be transferred to the service provider. In addition, the team leader should lay out the key questions to be answered, which may include questions regarding what counterparty consents will be required, what the customer’s outstanding financial obligations are and what fees would be triggered by the deal. Dedicating this time at the start of the project will make it less likely that a reviewer will miss an important item of information due to a lack of familiarity with the deal.

Streamline the Process and Separate the Wheat from the Chaff

A successful due diligence process does not require gathering every minute piece of information from each customer contract. You can streamline the process and cut costs by working with the business and technical teams to focus on the contracts that matter and exclude those that don’t. Here are a few helpful tips to keep in mind:

  • Companies rarely purge old contracts. As a result, their contract file will likely contain a number of terminated contracts that may not need to be reviewed.  A report of payments over the past two years from the customer’s accounts payable system can help determine whether a contract has expired and how important it is. 
  • The technical team may be able to provide a list of software to be accessed by the service provider. If this list is available before due diligence begins, reviewers can use it to avoid wasting effort on reviewing contracts for software that will not be affected by the deal.
  • The service provider may have relationships with vendors that provide broad consents or licenses. Such relationships may cover all the rights needed in order to complete the deal.
  • Consider having a reviewer create a high-level contract inventory by performing a quick “first pass” review. Provide this inventory to financial, technical and administrative experts to identify important contracts and those that do not require review.
  • Cut costs by finding out what databases already exist. For example, the vendor’s address for notices might already be in the customer’s accounts payable system.
  • Only use experienced lawyers to perform a second-level review of key contracts and to perform quality assurance.

Be Wary of Hard-Coded Cost Information

The cost information hard-coded into a contract should be treated with suspicion. A variety of cost adjustments, such as changes in annual maintenance prices, are generally not reflected in a customer’s contract file. Hard-coded cost information should be validated by reviewing the customer’s accounts payable system or contacting the business expert responsible for administering the contract.

Consider Assuming the Worst

You may consider simply sending letters to all contract vendors requesting each vendor’s consent to all of the contemplated outsourcing activities. The review team would then only need to review contracts for vendors that refuse to give consent. This approach may make sense if (i) few contracts are expected to permit the deal; (ii) the cost of obtaining consents would be less than the cost of finding contracts that require consent; (iii) the deal isn’t confidential; and (iv) the review is not intended to gather other valuable information.  In the right circumstances, this approach can dramatically reduce due diligence costs.

Separate Legal Judgment from Fact Gathering

The initial review team should simply gather well-defined facts. The legal analysis of these facts should be conducted as a separate exercise. This will cut costs by allowing the review effort to be conducted by individuals with low hourly rates. Here are a few helpful tips to illustrate this point:

  • You might instruct a reviewer to determine whether a contract is silent with respect to assignment. However, reviewers should not be required to make a legal judgment on whether such silence means that assignment is permitted or prohibited in the context of the contract.
  • A reviewer who is uncomfortable interpreting or understanding certain language in a contract should mark the section for further analysis by a second-level reviewer and move on to another section.

Set Standards to Allow Second-Level Quality Assurance

Reviewers should collect sufficient supporting information to allow for an efficient second-level review if the contracts will not be readily available after the initial review. This can be accomplished by having the key pages of each file scanned electronically or by typing the exact contract language that supports a summary or conclusion into the relevant contract summary.

Increase Value by Collecting Data for Multiple Reasons

It takes time for a reviewer to understand a contract well enough to answer questions about it. Consider leveraging that time to produce a useful database for vendor management, for future contracting or for verifying vendor invoices. For example, the model instructions referenced above require the reviewer to determine the renewal terms for the various contracts.

Brad Peterson focuses on business and technology sourcing and information technology transactions. In the past three years, Brad has represented clients in over $4 billion of outsourcing contracts. He has experience with information technology outsourcing, business process outsourcing, offshore outsourcing, second-stage outsourcing and in-sourcing transactions. He has also assisted clients in renegotiating and terminating major sourcing arrangements.

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