Outsourcing Contract Scrutiny Should Grow After Satyam Scandal

The multibillion-dollar fraud by Indian outsourcing company Satyam and the resulting precariousness of Satyam's existence should increase the scrutiny companies place on increasingly large and complicated contracts for outsourced technology services, legal experts and industry observers say.

"People had gotten so comfortable with the provision of services that some may have taken their eye off critical aspects in the arrangement. They shouldn't just say, 'This has always worked and therefore it will work again,' " Jim Harvey, a partner and co-chair of law firm Hunton & Williams' global technology and outsourcing practice, said in an interview. "People need to do serious deals seriously."

That includes not only working over contracts with a fine-tooth comb, but also doing the legwork to make sure everything's up to par with a vendor even before sitting down at the table to negotiate. The CIO of a Fortune 500 company interviewed by InformationWeek agrees. While the CIO, who asked for anonymity, said that while he remains confident in his current IT services provider, Infosys, the Satyam news "gets you thinking about doing more due diligence" with vendors.

Last week, Satyam chairman Ramalinga Raju resigned (and was later arrested along with two other executives) after announcing he'd falsified company revenue and margins. Several board members also resigned, and the rest were removed by the Indian government, which announced it would be constituting a new board. Satyam's market value has plummeted, leaving the company's solvency under question and Satyam customers scrambling to figure out how to react if India's government doesn't step in to provide liquidity in as it has suggested it might do.

One problem: Companies that didn't explicitly make it part of their contracts may find it hard to back out of their relationship with Satyam. "Satyam's problems give you leverage, but without a specific clause, it's not easy to terminate a contract," said Harvey's co-chair, Randall Parks. Companies without termination clauses likely will have to pay penalty fees to Satyam to get out of their contracts, similar to those consumers might have to pay to mobile phone carriers.

According to Harvey, properly negotiated contracts should include sections that trigger the ability to terminate an agreement (or even just meetings between a customer and outsourcing partner to make sure all parties are comfortable with the situation) if a vendor's credit-worthiness slips or there's material adverse change to the its business. Typically, these types of clauses aren't standard, but have to be negotiated.

Jacob Jegher, senior analyst at Celent, a strategic consultancy to the financial industry, said he expects that future deals between financial firms and Indian outsourcers will be subject to much stricter investigation and will be looked over with a fine-tooth comb before signing. "One of the things banks are looking to in the United States is risk aversion," he said in an interview. "And fraud is a showstopper." Fraud is one of the reasons lawyers often insist on "expansive" audit rights from outsourcing vendors, Shaalu Mehra, a partner in law firm Perkins Coie's licensing and technology group, said in an interview. It's been difficult to get vendors to agree to these clauses in the past, Mehra added, noting that no vendor typically wants its customers to be able to see its cost structures.

Even after a company gets out of a contract with Satyam, it isn't necessarily in the clear. Without contingency plans in place, companies will find it difficult to quickly transition work from Satyam to another outsourcing company, especially if Satyam were to go belly-up. In that scenario, there would be little legal recourse for customers other than suing company founders or taking out bankruptcy claims in the case of a bankruptcy, Mehra said.

"This underscores the extracontractual protections companies should have with vendors," Mehra said. "It's often necessary to redirect services to other parties or bring them in-house. My clients have often been well served by maintaining a portion of their operations in-house and not compromising institutional knowledge. I've always been a big proponent of multisourcing." In the last few years, Mehra's seen a marked trend toward shorter-term contracts and spreading work among multiple outsourcing vendors.

Satyam's problems also are provoking non-Satyam customers to seek legal advice, said Parks. "In the short term, customers are looking for additional assurances," he said. Parks said some of his firm's non-Satyam clients are seeking evaluation about adding new clauses to existing contracts, including "protections" related to a vendor's credit situation, financial reporting, and maintaining a minimum net worth.

Pradeep Kar, founder and chairman of Microland, a privately held, India-based IT infrastructure services provider, (and a board member of InformationWeek's parent company, United Business Media), said it's too early to tell whether the Indian IT services industry as a whole needs more governance. However, it's possible customers will have some of their fears assuaged by investigations already under way by organizations like the Institute of Chartered Accountants of India into how such fraud was missed for such a long time. "I think India will look at its system and governance very carefully in the same way we did after Enron," Harvey said.

Please join us for InformationWeek's Editorial Webcast: "Offshore In India: What's Next?" on Thursday, January 22, 2009 at 11 a.m. EST. Editor-In-Chief Rob Preston and a panel of top executives from the Indian IT industry will discuss these and other issues. Register with this link.