A Step Up on Step-In Rights

by Pillsbury Global Sourcing Practice
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Most outsourcing contracts that I see contain a step-in right for the customer. Generally, a step-in right allows the customer to take over the outsourced operations if the supplier cannot or does not perform, and then "step out" when the supplier demonstrates that it will meet its contractual obligations.

How realistic is it that a customer can ever exercise those rights, and are they worth the additional time and angst to negotiate?

Outsourcing contracts are not the only type of agreements in which you will find step-in rights. They are used in many other commercial agreements, including construction, project finance and development agreements. In those relationships, step-in rights are generally more straightforward and easier to exercise than in an outsourcing relationship, where it may be impossible to "step-in" and perform the supplier's obligations.

Outsourcing arrangements can be a mix of service models. The supplier may provide all services from a multi-client service center or, at the other extreme, may be operating and providing services only from the customer's premises, using the customer's equipment, tools and applications. Often, there is a mix of on-premise and remote services.

The model in which the supplier is on the customer's premises and operating the customer's systems is the one in which step-in rights could be most easily exercised. But even in that model are you, as the customer, equipped to step-in? Do you have the in-house resources who can take over the day to day activities that the supplier performs? Chances are, as a result of outsourcing, you have a much leaner organization, and probably don't have the resources or skill sets to take over the supplier's operations. The alternative is to engage a third party to step-in on your behalf. That will necessitate finding the right third party, negotiating an agreement with them, and (as the arrangement is likely to be for a limited period), paying a much higher price for those services which you may or may not be able to recover from your incumbent supplier. If you are experiencing the type of service failures that are causing you to consider exercising step-in rights, then it is unlikely that you could tolerate continuing failures during the time it would take to put a third party arrangement in place. 

If any or all of the services are provided from the supplier's shared service environment then it is unlikely that you will be able to exercise step-in rights. Other clients will not permit a third party to have access to an environment where their services are being performed, and understandably so. Even if your specific services are provided from a dedicated and isolated environment within the supplier's service center, the problems of having the necessary in-house resources, or finding a third party to take over the operations as discussed above could be prohibitive.

So, if they are difficult or impossible to exercise, is there a benefit to having a step-in right in your outsourcing contract? Absolutely. As the customer, you need to have every avenue available to you if the supplier is failing in its performance of the services. However, there may be similar rights that you could consider that will not only give you leverage in dealing with the supplier when it is in default, but also might provide you with solutions to help the supplier get back on track in service performance. Here are some examples:

  • Third party consultants who will work with the supplier to improve their performance. Consider requiring the supplier to engage a third party (that you approve) to help them turn around service performance. This could involve having the consultant analyze the performance, and the reasons for default, structure a turn-around plan and require the supplier to implement the turn-around plan in accordance with the consultant's recommendations. This may not provide a quick-fix for the problems you are facing, but may have the benefit of improving the services and relationship for the remaining term of the agreement.
  • Have your management team engage with the Supplier. If you have the resources, a right to have members of your management team working side-by-side with the supplier may also help turn around performance. Being under the constant scrutiny of customer management will cause the supplier to be on its best behavior, and that in itself may address the problem. Additionally, your team may be able to provide input on your business needs and environment that is not otherwise visible to the supplier, better aligning the services with your needs. Even if neither of these have an impact, both you and the supplier will have a better understanding of the challenges and frustrations the other is facing.
  • Obtain visibility into the supplier's staffing and HR challenges. Many suppliers will take the position that they supply a service, and don't guarantee the allocation of any specific number or type of resources to the performance of the services. Most customers agree that the supplier should have flexibility to staff the services as it thinks fit, as long as it meets the required service levels.  On the other hand, when faced with chronic problems, understanding the organizational structure of the service team, the number of resources, the time they are allocated to the services, the skill and experience levels of resources, and the turnover rate of staff may provide considerable insight into the reasons for poor performance. Having visibility is not, in itself, sufficient. You will also need the right to require the supplier to make changes to its staffing in order to remedy poor performance.

In many cases, righting the ship and seeing the contract through to the end of its term may be a less painful solution for the customer than terminating for breach. These three options provide a greater chance of success in achieving that goal.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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