Risk Mitigation in SourcingProactively Managing Risk

July 14, 2005

Presented By:John Funk and Shawn Helms

Institute for Supply Management - Dallas

About Jones Day

One of the world's leading law firms with more than 2,200 lawyers in 30 locations around the world

Represents more than half of the Fortune 500 companies

Jones Day was ranked No. 1 for client service in BTI Consulting Group's survey of Fortune 1000 corporate counsel in 2004

United StatesAtlanta Los AngelesChicago Menlo ParkCleveland New YorkColumbus PittsburghDallas San DiegoHouston San FranciscoIrvine Washington

Asia/AustraliaBeijing SingaporeHong Kong SydneyNew Delhi TaipeiShanghai Tokyo

EuropeBrussels MilanFrankfurt MoscowLondon MunichMadrid Paris

Global Reach: 2,200 Lawyers in 30 Offices Worldwide

BTI Consulting Group#1 Client Service Ranking

“BTI would like to congratulate the 2004 Client Service 30 for their superior client service and dedication to client satisfaction. This year’s top winner is:

Jones Day

For three years, Jones Day has held one of the top two positions, securing the top spot in both 2002 and 2004. Jones Day is raising the bar in client service. This year, Jones Day scores 34.7% higher than the number two firm . . . .”

John Funk– Partner at Jones Day

– Over 24 years of experience in licensing matters and complex information technology and business process outsourcing transactions

– Leads Jones Day's global Outsourcing Practice and the technology transactions practice in the Dallas office

Shawn Helms– Associate at Jones Day

– Focuses on complex technology, outsourcing, IP, strategic sourcing and data privacy issues

– Prior to joining Jones Day, was in-house counsel at Sprint Corporation providing legal support to SCM

Presenters

Role of Legal in the Sourcing Process

Manage legal and business risk

Solve problems

Assist in relationship management

The Contract

Purpose of the contract

Necessary evil? or an opportunity?

Most negotiated provisions

The Contract -- Purpose

Reflect the Business “Deal”

– First and foremost, the terms and conditions must accurately reflect the actual business deal between the parties

Allocate Risk

– The contract must anticipate the business and legal risks of the transaction and allocate those risks between the parties

Relationship Management

– A well-constructed contract is an important tool to a successful sourcing relationship

The Contract -- An Opportunity

Necessary Evil or an opportunity?

– The contract should not be seen as a "necessary evil," but rather as an opportunity for each party to set the appropriate expectations regarding the ongoing business arrangement

– Do not negotiate the contract under the assumption that the “relationship” will govern and no one will ever read the specific terms and conditions

The Contract -- Most Negotiated T&Cs

A 2004 study by the International Association of Contract and Commercial Managers (IACCM) identified the 10 most negotiated contract provisions

– Limitation of Liability – Payment Terms

– Warranties and Maintenance – Term and Termination

– Price / Charges – Delivery and Acceptance

– Indemnities – Liquidated Damages / Performance Credits

– Intellectual Property Rights – Confidentiality / Data Protection

What is Operational Risk?

“Operational Risk” is the potential exposure to unexpected financial, reputational or other damage arising from the way in which an organization pursues its business objectives, including its sourcing strategy

While shifting risk to the service provider has always been a goal of sourcing, operational risk always remains with the customer

One important goal of the strategic sourcing process - and of the contract - is to identify and mitigate operational risk

Impacts of Operational Risk

Financial (Direct)

– Revenue Volatility

– Expense Volatility

– Cost of Controls

Non-Financial (Indirect)

– Reputation

– Customer Satisfaction

– Employee Satisfaction

– Adverse Legal Consequences

– Adverse Political Consequences

– Investor Confidence

Major Operational Risks in Sourcing Transactions Defective or Inadequate Product or Service

Reduced Business Flexibility

Loss of Control of Key Business Functions or Technology

High Prices

Intellectual Property Risks

Risks - Defective or Inadequate Product or Service

Pre-Contract Mitigation Strategies

– Appropriate diligence in RFx process (inspection, references, etc.)

Contract Mitigation Strategies

– Clearly specified acceptance process and criteria

– Appropriate warranties and performance metrics

– Visibility (early warning signs)

– Requirement of process or technology improvement

– Robust dispute resolution process

– Accountable Supplier representative

– Ability to terminate

Risks - Reduced Business Flexibility Supplier Lock-In

– Long term contract with no practical ability to terminate

– Exclusive or “requirements” contracts

– Minimum purchase commitments

– High transition costs

Technology and Business Process Lock-In

– Tight integration of related systems

– High costs of replacement system • inability to rip and replace

– High training costs

Risks - Reduced Business Flexibility Mitigation Strategies

– Shorter term with no auto-renewal

– No, or low, minimum commitments

– Ability to use third parties, where practicable

– Ability to terminate early without significant financial penalties

– Require suppliers to provide transition services

– Obtain perpetual licenses on software and data formats

– Avoid right to use (RTU) licenses

– Utilize “off-the-shelf” systems that do not require significant Supplier-specific customization

– Negotiate “pay-by-the-drink” maintenance instead of annual maintenance contracts and pre-payments

– Software escrow (mixed results)

Risks - Loss of Control of Key Business Functions and Technology Where is the “Throat to Choke”

Mitigation Strategies

– Relationship Managers

– Robust Governance Mechanisms

– Robust Escalation Procedures

Risks - High Prices

Mitigation Strategies

– Price Caps

– Indexed Price Adjustments

– Most Favored Customer

– Market Testing Provisions

– Benchmarking

Risks - Intellectual Property Loss of (or failure to capture the value of)

intellectual property

Ownership of developed works

Supplier's access to Customer's confidential and proprietary information and technology

Third party IP claims against Customer

Risks - Intellectual Property Mitigation Strategies

– Obtain appropriate IP indemnity• worldwide, all IP, defense and damages, unlimited

– Obtain appropriate confidentiality restrictions• all confidential information should be marked confidential

– Carefully negotiate IP ownership rights

Risks - Intellectual Property When negotiating IP ownership rights, consider the

following factors:– What is customer's current IP portfolio?

– Is customer relinquishing or disclosing IP as part of the transaction?

– Is customer paying for the development?

– Are customer and the supplier working collaboratively?

– Could the development be used by a competitor to customer's detriment?

– What is the "value" of potential developments?

– What are the potential trade-offs for allowing supplier to own the development?

Strategies for SCM Utilization of Legal

Timing of contract presentation

– During RFx process?

– Requirement and format of Supplier's response

When to bring in lawyers and outside counsel

Separate exhibits for operational and pricing terms

– Specifications, pricing, performance metrics, etc.

Utilize lawyers to help ensure establishment of most advantageous contractual structure

– Don't try to fit a "square supplier" into a standard "round contract" just because it is the "form"

Contract interpretation and relationship management

Relationship Management

Dedicate sufficient resources to enable effective contract management, tracking and reporting

Manage to the contract -- not despite the contract

Promote effective communication between accountable parties

Establish trust by fulfilling your contractual obligations

– e.g. pay on time, communicate appropriately

Establish a relationship that will allow flexibility when business needs change

Negotiate appropriate change management provisions

Trends in Sourcing

More emphasis on services and bundling of commodities with ”value-added" services

Globalization of supply chain

Focus on best supplier vs. lowest price

Automation of commodity purchases

Complex strategic sourcing transactions

– information technology outsourcing

– business process outsourcing

– offshoring

Questions?

John Funk

jafunk@jonesday.com

214-969-2981

Bio at:http://www.jonesday.com/jafunk

Shawn Helms

shelms@jonesday.com

214-969-2943

Bio at:http://www.jonesday.com/shelms