In any sourcing transaction with cross-border elements there will be key legal issues which have to be factored into the deal making process. A good grasp of the dozen or so areas which tend to crop up time and time again is fundamental for professionals working on international projects.

1. 1.Local law
   

While the “compliance with laws” clause in domestic sourcing agreements is usually relatively innocuous, its offshoring equivalent warrants greater consideration. An obligation to comply with the local law of the offshore jurisdiction will apply primarily to the supplier who is based there. But the customer may also be taking on local law obligations by virtue of the offshoring structure. This will certainly be the case in transactions using the captive build and joint venture models.

Local laws can have a significant impact on the drafting of the agreement because some provisions may be unenforceable unless they comply with local mandatory requirements (most commonly relating to termination, limitation of liability, exclusivity and dispute resolution). A statement should be included in all offshoring agreements to the effect that its provisions have been freely negotiated in good faith by the parties who therefore consider them reasonable and fair.  

An area of law which is becoming increasingly prominent in offshoring is compliance with environmental legislation in the local jurisdiction. In Sri Lanka for example a licence is required from the Central Environmental Authority which performs inspections and conducts Environmental Impact Assessments.

Finally, choice of law governing the contract itself is worthy of attention. Without an express provision in the agreement, governing law will be determined by the conflict of laws rules of the jurisdiction in which a claim is brought. In an outsourcing transaction this will likely be the country where the supplier is performing its obligations. Of course in most cases the parties will agree an express governing law provision rather than leave matters open. The important point is that the same governing law should apply to all local service agreements (where using a master services agreement structure), subject to any prevailing mandatory law requirements.

Sometimes the parties will want to exclude elements of the selected governing law by carving out their application to the contract. Commonly excluded statutes include the Vienna Sales Convention 1980 and any conflict of law rules which stipulate an alternative law applying to disputes. In practice there may be some elements of governing law which cannot be excluded and the parties should take care not to try to contract out of these because attempting to do so may have wider implications.

2. 2.Regulatory Considerations
   

Regulatory considerations divide broadly into those which fall directly on the customer in its domestic jurisdiction, and those which will (or should) be imposed on the supplier in the offshore jurisdiction.

In practice of course it’s impossible to delineate customer and supplier responsibilities quite so neatly because the supplier’s actions will affect the customer’s regulatory compliance (and the supplier will in turn look to the customer for experience of operating in the relevant regulated industry). Knowledge transfer is important on both sides.

The customer should be alive to both onshore and offshore regulatory constraints and adapt its requirements accordingly. Failure to do so may lead to financial penalties and significant delays. Onerous regulatory obligations in a particular jurisdiction may even persuade the customer not to offshore to that location and should therefore feature in its initial analysis. Joint venture and captive build offshorings are most likely to attract regulatory constraints which apply to the customer; suppliers tend to assume the burden of regulatory compliance where alternative structures are used.

Regulatory constraints will vary according to the industry in which the customer operates. Customers in some industries are prohibited altogether from offshoring particular functions and others, such as the aviation industry, impose strict guidelines on outsourcing. Customers should engage with regulators as part of the process of considering which functions to outsource and, if offshoring to a number of jurisdictions which are likely to require regulator notification, adopt a co-ordinated approach.

3. 3.Competition law
   

Competition law, which will apply irrespective of any governing law provisions in the agreement, is an important consideration in offshoring. Certain provisions (or in some cases the whole agreement) may be void and unenforceable if the arrangement is found to be anti-competitive, and severe financial penalties may result. European competition law on merger control and the prohibition of anti-competitive behaviour is most relevant to nearshoring when using the ‘Build, Operate, Transfer’, ‘Joint Venture’ or service provision models which involve a transfer of undertakings.

Under the Merger Control Rules (Regulation 139/2004) concentrations of actual or potential competitor companies which meet the high turnover threshold must receive advance approval from competition authorities. The relevant combined turnover for an outsourcing can be difficult to assess because the affected proportion of the customer’s business, including staff and assets, is often unclear. 

Article 101 of the Treaty on the Functioning of the European Union, which prohibits anti-competitive agreements (i.e. those which restrict, prevent or distort competition in the EU), will apply to offshoring contracts which contain anti-competitive provisions. There are exemptions, such as the de minimis principle and the new Vertical Restraints Block Exemption which came into force in June 2010 which applies where the supplier’s relevant market share is less than 30% and there are no unjustified restrictions in the agreement (e.g. price fixing), so the parties should consider the shape of the deal in the light of these.

4. 4.Export control
   

Offshoring arrangements may require an export licence for the provision of certain ‘dual use’ items (i.e. which may have a civil and military use, including computers, telecommunications equipment and software). In Europe the EU Dual-Use Regulation (EC 428/2009) is the main legal instrument for controls on dual-use items. The definition of export under the Regulation is very wide and includes transmission outside the EU of software and technology by electronic means. The exporter is the person who decides to export software and technology, which could apply to the supplier providing dual-use items to a customer outside the EU under an offshoring arrangement, or to the customer providing dual-use items to the supplier for the purpose of the offshoring.

The main UK export legislation is contained in the Export Control Act 2002 and the Export Control Order 2008, which are overridden by the directly applicable EU Dual-Use Regulation. The US equivalent export legislation, the Code of Federal Regulations Title 15 chapter VII, subchapter C (known as the Export Administration Regulations), may apply where a supplier has a US company in its supply chain or to any offshoring to a US entity, since it applies to the export of Dual-Use items which are defined as broadly as under the EU Dual-Use Regulation. 

Offshoring agreements should oblige the supplier to comply with any registration or licensing requirements, such as those in India and China, and to produce evidence of compliance on demand. Customers should further be aware of their obligations in this respect (which the supplier may request to be set out in the agreement).

5. 5.Applicable US Legislation
   

US legislation which may impose obligations and restrictions on offshoring arrangements include the USA PATRIOT Act (or, to give it its full title, Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001), and the Sarbanes Oxley Act 2002. 

The US government can use the PATRIOT Act to obtain any business records (which includes contractual documents or technical information) for purposes relating to the gathering of foreign intelligence. This applies to business records under the control of any US supplier or sub-contractor, and potentially also to any supplier or sub-contractor outside the US which has a US parent company. This means that any customer which offshores functions to a supplier in the US (or a supplier which is part of a corporate group with a US parent), or to any supplier using sub-contractors in the US (or subcontractors which are part of a corporate group with a US parent), must consider the implications of the PATRIOT Act. The inclusion of a statement that customer information is merely processed (rather than controlled) by the supplier, and an obligation on the supplier to resist any application for disclosure under the PATRIOT Act (and to flow this obligation down to any sub-contractor in the offshoring agreement) may mitigate the risk of the customer’s information being disclosed. 

While the Sarbanes Oxley Act sits on the US statute book, it too is of wider application because it applies to foreign entities with Securities Exchange Act or Securities Act registrations and their auditors, imposing reporting obligations, accountability for corporate officers, auditors and legal counsel and requires suitable internal controls. Any applicable obligations should be contractualised to ensure supplier compliance.

6. 6.Data Protection
   

Data protection legislation as it applies to customers based in the EU is covered in my previous blog posts, accessible here, here and here.

7. 7.Insolvency
   

Supplier insolvency is a risk most keenly felt during economic uncertainty. Financial distress may affect service levels or prevent the supplier from providing the services altogether. Insolvency can also affect the transfer of supplier personnel, IPR, assets and equipment and should therefore be considered in the context of these areas of the agreement. The customer should investigate the treatment of insolvency in the offshore jurisdiction under statute, common law and according to custom by obtaining local legal advice. Since it’s uncommon in most jurisdictions for the offshoring agreement to be terminated by statue in the event of insolvency, it’s important for the customer to reserve this right expressly in the contract.

In certain jurisdictions (including the UK) unprofitable contracts entered into by an insolvent party can be disclaimed by a liquidator, which could leave the customer as an unsecured creditor claiming damages from an insolvent supplier.

The agreement should clearly set out the effect of the supplier’s insolvency on any intellectual property licensed to the customer as part of the offshoring agreement. In the US, section 365(n) of the Bankruptcy Code allows licensees either to elect to retain their exclusive rights as they were before the insolvency (subject to limitations set out in statute and the licensee making continued payments to the licensor), or to treat the licence as terminated by the supplier’s rejection of the licence (or the rejection of the trustee in bankruptcy) and seek damages. This is of limited application, however, in that it doesn’t apply to trademarks or tradenames. It should therefore be supplemented by express contractual provisions.

8. 8.Tax
   

The customer should seek local tax advice at the same early stage in the offshoring that it obtains local legal and regulatory advice because this may be decisive in determining the chosen offshore deal shape.

Government-offered incentives to attract offshoring often include tax breaks. The customer may benefit from a reduction in charges to reflect any tax relief for which the supplier is eligible. Where this is the case, suppliers will try to contract at a set price with an option for increasing the price if the tax relief is lost.

The model of asset ownership selected for the offshoring will also be affected by the tax regime of the offshore jurisdiction. In India capital gains tax is payable on any profit made by the supplier where assets are sold as part of the outsourcing arrangement. Services tax applies to the provision of services.

9. 9.Intellectual Property Rights (“IP”) and Confidential Information
   

One of the main concerns for a customer in selecting an offshoring partner will be its ability to safeguard confidential information and trade secrets. The customer should factor into its consideration of which functions to offshore the nature of IP protection in its chosen offshore jurisdictions. Some jurisdictions may not protect trade secrets under national law. The customer should conduct an IP audit, including a gap analysis between the domestic and local IP regime, in order to establish the risk of IP infringement under the offshoring arrangement. This should extend beyond the legal regime alone since the level of theft and IP infringement will also be relevant. Software piracy rates in Venezuela, China and Vietnam exceed 80%, which can dissuade customers from offshoring there, whereas the Czech Republic (which has the lowest rate (39%)) is a much more attractive offshore location to customers who are concerned about IP infringement.

Enforcing the customer’s rights in relation to IP infringement can be very difficult in certain jurisdictions, even where robust regimes appear to exist. This is true of China, whose IP regime is not yet complete and where a high burden of proof is placed on claimants in IP infringement cases. Certain Chinese government agencies can enforce IP at no cost to the rights holder, but these agencies’ limited resources tend to render this a less attractive enforcement option. 

The outsourcing contract should set out the agreed position in relation to IP ownership and ensure that any party assigning IP is legally entitled to do so. The parties should also consider any relevant registration requirements necessary to effect the transfer of the IP in the offshore jurisdiction. This is a prominent feature of Chinese IP law (apart from in respect of copyright and established trade marks).

There is relatively little variance across developed nations in the protection afforded to the main categories of IP – copyright, designs, patents and trade marks. One area which does vary, however, is the ownership of IP created by employees in the course of employment. China, the Russian Federation and Germany do not follow the principle under English law that the employer owns such IP. In all three jurisdictions the employee owns all copyright it creates and employers automatically receive a licence to use it. In the Russian Federation this default position may be overridden by express provisions in the employment contract. In China the term of the employer’s licence will be two years and the employee will be entitled to remuneration unless the employer initially asked the employee to create the copyright, in which case it will be owned by the employer. In Germany the licence must be royalty free. In the Russian Federation inventions made during the course of employment will initially be owned by the employee until ownership automatically passes to the employer four months later, unless the employer waives this right. The employee is entitled to a level of compensation set by statute in exchange for this assignment.

Accordingly, it is vital the customer receives an assignment of copyright, associated moral rights are waived and the supplier is obliged to perfect any assignment through the inclusion of a further assurances clause. The agreement should also set out who will be responsible for paying any necessary fees to employees. 

10. 10.International IP protection
    

The Berne Convention for the Protection of Literary and Artistic Works provides comfort to customers offshoring to one of the 164 (as at May 2010) contracting states by stipulating guidelines for the minimum protection of copyright to be provided under their domestic laws. Customers are afforded the same protection as national copyright holders for a minimum of 50 years, unless that level of protection is higher than the customer would enjoy in its home country.

The Universal Copyright Convention is often referred to as the Berne Convention for developing countries because the signatory countries provide the same level of protection for foreign copyright holders as they do for national copyright holders.

The Berne Convention’s reach is wider than its signatory nations, since all members of the World Trade Organization (“WTO”) are required to accept almost all of its conditions by virtue of the Agreement on Trade-Related Aspects of Intellectual Property Rights (“TRIPS”), which established common international rules for the management of IP. The TRIPS Agreement sets out:

1. •how to apply the fundamental principles of the trading system and other international IP agreements;
   

2. •how to protect IP adequately;
   

3. •how signatory countries should enforce IP at a national level;
   

4. •how IP disputes between WTO members should be settled; and
   

5. •how the new system should be transitioned.
   

The TRIPS Agreement stipulates that signatory nations should not discriminate between national IP and IP from other nations and should treat all WTO members equally. In selecting an offshore location a customer should consider any potential issues which it may encounter when enforcing the TRIPS Agreement since its provisions would have to be enforced locally.

While these international protections should provide some comfort to the customer, they should not be relied upon in isolation. The offshoring agreement should clearly set out the ownership of all IP (both proprietary at the start of the offshoring arrangement and that which is developed during the course of the relationship) and the conditions upon which it is licensed to the other party. In addition to contractual provisions, there are practical steps which can and should be implemented, including mandating password protection, conducting site visits, and escrow arrangements.

11. 11.Labour Law
    

Employment issues may be instrumental in shaping the structure of an outsourcing deal and local legal advice should be sought as early as possible. Customers who select the third party supplier model should consider whether the Transfer of Undertakings (Protection of Employment) Regulations 2006 (“TUPE”) (if the customer receives the services in the UK prior to the offshoring) or equivalent, applies to the transfer of the relevant functions. The obligation to consult employees regarding any transfer of an undertaking may arise early in the process and financial and criminal penalties can apply for breaches. Customers are sometimes keen to avoid early engagement with their employees for fear of demotivating those who consider it unlikely their employment will transfer to the offshore supplier.

In October 2008, the Employment Appeals Tribunal ruled that TUPE can afford protection to employees where an undertaking is transferred outside Europe, if it was situated in the UK immediately before the transfer. While the interpretation of this in relation to offshoring remains unclear, it’s likely that an employee would be deemed to transfer to the supplier on the same terms of employment, which would include the offshore location. The supplier would therefore be forced to employ that employee in the foreign jurisdiction or make the employee redundant (if such a concept exists in the relevant jurisdiction – it does not in Brazil for example).

Employees may be deterred from bringing a claim against an offshore supplier if it’s located in a jurisdiction which does not recognise unfair dismissal or redundancy or where it’s difficult to enforce UK court judgements. Employees may benefit from the additional TUPE obligations imposed on their employer since the customer and the supplier would be jointly and severally liable for any failure to inform and consult employees regarding TUPE. TUPE is therefore effectively confined to determining who will make the redundancy payments because few UK employees would want to transfer abroad. Customers should therefore ensure that they have the benefit of an indemnity in respect of any potential TUPE liability.

Customers should consider the acquired rights equivalent legislation in offshore jurisdictions in order to understand the obligations on the supplier that should be included in the exit plan in terms of access to staff lists and pensions information on expiry or termination of the contract.

If the customer chooses to offshore using the captive or JVC model, it will need to comply with local labour laws in relation to its staff. The customer should therefore investigate local working practices, employment taxes and social security as part of its location due diligence to ascertain the extent of these obligations. In China for example an employment relationship can only be terminated on statutory grounds (e.g. gross negligence, dissolution) after it has been extended twice, which can be onerous. In Brazil an employer’s social security contributions are approximately 27% of the gross payroll. In Germany if a works agreement entered into by a works council governs the employee’s hours of employment, the employer will be fined if it fails to actively enforce those hours, even where the employee voluntarily exceeds them.

The customer may also be responsible for arranging the necessary work permits for any of its staff which will work in the offshore entity. In India, foreign workers require work permits or employment visas if they intend to work in India for longer than six months and this obligation will fall on the customer if offshoring using a captive or JVC. This will involve registering with the Foreign Registration Office or the Foreigners Regional Registration Office within fourteen days of arriving in India.

International termination of employment can be complex and may require consultation with and notification to Works Councils, Employee Representatives, Trade Unions and/or Labour Management Councils.

In certain cases, government approval may also be required. The customer should comply with these obligations or ensure that the supplier does.

12. 12.Jurisdiction and Enforcement
    

The customer and supplier should consider whether the jurisdiction clause in the agreement should be exclusive or non-exclusive. This will often be determined by the availability of interim relief in the offshore courts and whether it’s necessary for disputes to be heard in a particular venue, e.g. because of the complexity of the subject matter. If an exclusive jurisdiction is selected the court specified in the agreement will hear any disputes and the clause will compel any other court (which may by virtue of statute have jurisdiction to hear the dispute) to deny it. The inclusion of a non-exclusive jurisdiction clause will allow the parties to bring any dispute before the court of their choice. The customer may be disadvantaged by its domicile being the exclusive jurisdiction, if judgements from that jurisdiction cannot be enforced against the supplier in its home jurisdiction – in such a case, the supplier will be able to enforce a judgement against the customer but this will not be reciprocal.

The parties to a master service agreement should ensure that the jurisdiction clause clearly sets out whether it also applies to disputes which arise under the local service agreements called off under the master services agreement.

Arbitration is a popular form of dispute resolution in outsourcing agreements due to its speed, confidentiality, flexibility and the experience of the arbitrators which is particularly pertinent in international disputes. Rather than having to plead in the official language of the jurisdiction (as is the case for disputes heard in the courts), the parties will be able to select the language of the arbitration. Enforcement of arbitral awards in foreign jurisdictions under the New York Convention (UN Convention on the Recognition and Enforcement of Foreign Arbitral Awards 1958), which has been signed by over 140 countries, is less complicated than the enforcement of court orders and judgements in jurisdictions other than the one in which they were obtained, although certain jurisdictions have reciprocal enforcement agreements such as Sri Lanka and the UK and Hong Kong and China. The more traditional offshoring destinations do not tend to have reciprocal agreements with the UK or other EU member states.

Many outsourcing agreements include a two-tier dispute resolution process under which disputes will be escalated in accordance with the governance structure.

Enforceability and enforcement will be determining factors in establishing the appropriate jurisdiction for the agreement. Customers should consider the likelihood of the supplier successfully convincing a court in its country of domicile to accept jurisdiction for any dispute notwithstanding any express jurisdiction provisions agreed between the parties and set out in the contract.

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There is no magic formula for successful offshoring but there are a number of building blocks which can combine to form a solid foundation for the relationship.

The customer must find the right offshore location and the right supplier. This is usually best achieved through the early engagement of a local advisory team who can provide a clear and accurate assessment of the regulatory, cultural and legal landscape. The customer must also assess the operations to be offshored and the functions it will retain to manage the relationship. In most cases, domestic regulatory implications are just as important as well.  

Advice and due diligence will shape the commercial and contractual model for the offshoring and are important factors in ensuring the customer realises the benefits underlying its business case. This structure should be developed through the negotiation of the agreement to include bespoke elements such as a strong governance model to provide joint oversight for the customer and supplier