Substantial and frequently changing hurdles stand between food companies and success. A company’s bottom line often is subject to increased costs brought about by economic recession, natural disasters, fluctuating commodity prices, regulatory changes and changing consumer demands, among other obstacles. The Food Safety Modernization Act (FSMA), for example, has imposed a host of food safety-related requirements on food companies that may be costly to fulfill, with more on the way come full implementation.
In an effort to counter the costs of such hurdles and to protect their bottom line, food companies of all sizes are more often outsourcing business functions (human resources, information technology, etc.) and manufacturing operations (research and development, testing, packaging, etc.). When well planned, outsourcing arrangements may prove quite beneficial.
But as with any supply relationship, changing circumstances may make an outsourcing arrangement unrewarding. Moreover, where an entire business function or manufacturing operation is outsourced, the potential risks rise for business disruption and increased costs. A failure in a critical outsourced business process or manufacturing operation may have a substantial, and potentially devastating, effect on the company’s business. (For more about the benefits and risks of outsourcing food safety testing, see sidebar “Lab Outsourcing”)
What can a food company do to adequately protect itself against risks that underlie outsourcing? In short, a food company should properly plan for the life of the outsourcing relationship. Proper planning comprises at least four considerations:
1. Thorough due diligence regarding, and preparation for, the outsourced relationship
2. Thoughtful negotiation of the outsourced relationship
3. Precise drafting of the agreement that governs the outsourced relationship
4. Vigilant management of the outsourced relationship and agreement
Each aspect of planning is complex. Moreover, given the variety and complexity of outsourcing relationships and outsourced processes and operations, unique due diligence and risk management considerations may exist and should be assessed in conjunction with a particular relationship. This article addresses outsourcing relationships generally, highlighting key strategies, issues and considerations that will help food companies plan for such relationships and avoid outsourcing errors.
Preparation for the Outsourced Relationship
Mismatched expectations between a food company and outsourcing partner make it easy for the relationship to fail. Preparation for an outsourcing relationship thus requires two assessments—one internal and the other external.
First, a company must assess how the process or operation to be outsourced fits within its overall business. It is essential to consider any issues unique or critical to that function that may be of particular concern in outsourcing. It also is essential to consider the costs to transition to an outsourced relationship and the subsequent costs to manage it.
If the internal assessment confirms that it is appropriate to outsource, the company should draft a plan that establishes its goals for the relationship. Among other things, an outsourcing plan should:
• Specify the company’s objectives, both operational and financial
• Define the scope of the function or operation to be outsourced
• Set forth any requirements and specifications of the outsourced function or operation
• Explain operational, technical and financial metrics against which to measure potential outsourcing partners
• Describe expected performance outcomes
• Assess how the company intends to manage the outsourced relationship, including consideration of necessary personnel
The plan also should spell out any essential criteria that might affect the success of the outsourcing relationship, such as U.S. Food and Drug Administration regulations, U.S. Department of Agriculture regulations, or industry best practice standards governing the particular operation. It may be more fruitful to select a supplier that understands and has experience in the food industry. In addition, the plan should take into consideration the personnel or consultants needed to assess whether to outsource, to select an outsourcing partner and subsequently to manage the outsourcing relationship. Without knowledgeable personnel or consultants to form the plan, assess partners and manage the relationship, it may be doomed from the start.
Second, a food company should use its outsourcing plan as the foundation for the matters it examines when performing due diligence on prospective outsourcing partners. In addition to assessing a potential supplier against operational, technical and financial metrics, careful due diligence also entails research into the potential supplier, including sharing of information and review of material about the supplier that would impact the efficacy of any relationship. This includes the potential supplier’s procedures, culture, accreditation, certification, food industry experience, equipment, facilities, finances and financial stability. Where feasible, both high-level businesspeople and technical personnel who know the process or operation to be outsourced should interview the potential supplier in person to determine whether the supplier understands the company’s business and industry, and to assess the potential supplier’s compatibility with the company and its culture. If a potential outsourcing partner is located outside the United States, additional consideration should be given to conditions that may be unique to that candidate’s locale, including environmental factors, accessibility, political unrest, labor pool, energy, telecommunications and transportation infrastructure, food, consumer and safety laws and pertinent other laws and regulations.
A natural tension exists between a food company’s desire to cut costs by outsourcing and its obligation to meet food safety and consumer demands. Suppose, for example, that a company’s manufacture of its food product requires microbiological testing subject to regulatory parameters or marketplace demand. Such testing may already be, or may soon become, so specialized that the company believes that purchasing or upgrading the necessary laboratory equipment and retaining trained scientists to perform the tests would be too expensive to do in-house. Nevertheless, the food company retains responsibility for compliance with the testing specifications regardless of cost. Thus, the company must perform sufficient internal and external due diligence to mitigate the risk of the outsourcing partner’s noncompliance to determine whether the company would benefit by outsourcing and whether those benefits outweigh the risks.
Due diligence also plays a critical legal function. Information gathered during due diligence will affect the content of the outsourcing agreement. That is, unless a food company first identifies its critical business needs and then assesses potential supply partners in light of those needs, it may not have enough information to perform an adequate cost-benefit analysis or to negotiate, reflect and protect those needs in an effective outsourcing agreement.
Thoughtful Negotiation and Precise Drafting of the Outsourcing Agreement
A well-negotiated, well-written outsourcing agreement is critical to form a productive outsourcing relationship. Boilerplate is almost unavoidable in formal agreements, but relying on boilerplate increases the chances of a company misunderstanding the impact of contractual terms. Thus, a company should instead carefully consider, negotiate and contract for each aspect of the outsourcing relationship. This is especially true for food companies that are particularly susceptible to the unpredictable nature of consumer perception. Even were a problem caused by its supplier, consumers are unlikely to appreciate a distinction between the food company and its outsourcing partners. A food company may not be able to recover in the eye of the consumer even if the company did not directly cause a problem.
Given the complexities of an outsourcing relationship, food companies must address a number of considerations to make an outsourcing relationship successful. The particular considerations will vary, depending on the circumstances and nature of the relationship. But generally, when effectively drafted, an outsourcing contract should, among other considerations:
• Identify precisely who is the supplier
• Specify the services, and the scope of those services, to be supplied
• Detail the government regulations and industry standards to which the supplier is subject
• Detail the business needs of the food company that the supplier must meet
• Specify the price for the supplier’s services and account for price variances where circumstances change
• State the length of the agreement
• Contain an appropriate warranty of the supplier’s performance
• Define the metrics by which the supplier’s performance will be measured
• Specify the incentives and penalties for the supplier complying with or breaching the performance metrics
• Provide for a clear and understandable method of declaring breach, cure and termination
• Specify the manner and venue in which disputes will be resolved
• Define the laws and regulations that govern the relationship
• Eliminate, mitigate or otherwise anticipate and address potential risks to the company that cannot be avoided altogether by limiting and defining the supplier’s rights
• Provide for the transparent, and if necessary, traceable steps in the company’s supply chain required by FSMA
Further examination of a few of those key considerations follows.
Regulatory Compliance. If an outsourced process or operation is subject to government regulation, the parties must negotiate who is responsible for compliance. Generally, a food company cannot outsource compliance with the law. If a company is obligated to comply with a regulation and fails to do so, outsourcing is no defense against government action. The company must identify the regulations at issue, advise the supplier of the regulations and make compliance one of the performance metrics to which the supplier is subject.
In addition, the parties should address how changes in regulations and laws will affect their relationship. To that end, the outsourcing agreement should specify who will be responsible for determining what precisely those changes require, how those changes apply to the processes or operations outsourced and how the parties will allocate responsibilities for incorporating those changes into the outsourced activity. Further, the outsourcing agreement should specify how the parties will account for and address any increase or decrease in costs attendant to changes in the law.
Quality of Service. To ensure quality of service, an outsourcing agreement should:
• Define rigorous quality assurance (and if applicable, regulatory compliance) standards with enforceable service warranties
• Require regular compliance audits, conducted by both the supplier and the food company
• Provide a mechanism by which the company can participate in addressing and resolving problems identified
• Provide for the right to reduce the scope of the services or operations provided, or for termination, if the supplier does not meet the requirements
Flexibility. Business needs and strategies addressed at the outset of the outsourcing relationship can change. Among other measures designed to ensure flexibility, the term of an outsourcing agreement should:
• Be short in duration but provide the company the right to renew
• Provide the company the right to review the contract in light of changed business needs or extraordinary events
• Address service and quality in the event of a force majeure event, either limiting the supplier’s rights in response to a true disaster or allowing the outsourcing company to terminate if the supplier cannot perform
Further, the terms used should be definite so that the parties know, with precision, what conduct or quality deficiencies of the supplier would run afoul of the parties’ agreement. For example, parties often include terms such as “material breach” and “generally accepted standards.” Absent a more specific definition of those terms in the context of the outsourcing relationship, such terms may foster misunderstanding and prolong resolution of disputes. The parties should be as specific as possible with their description of contractual standards for compliance.
Exit Plan. Broad termination rights also are critical to an effective outsourcing agreement. To that end, an agreement should provide a food company termination rights tied to inadequate services or changed circumstances that materially affect the outsourcing relationship, including quality and economics. In addition, an agreement should include protections for the company designed to facilitate an effective transition of the outsourced services to another supplier or back to the company. For example, certain suppliers may not be able to comply with FSMA requirements without a significant increase in costs. In anticipation of such changes to regulatory circumstances, the company should leave itself an appropriate out so that outsourcing remains cost effective.
At the same time, to reduce the risk that the supplier may prematurely terminate the agreement and leave the company without a critical service or needed supply, the agreement should allow the supplier to terminate only for limited reasons and provide the company with damages in the event of wrongful termination. In the same vein, the outsourcing company should not assume the supplier’s business risks, and thus, the supplier’s right to claim damages for lost profits should be eliminated or capped.
Dispute Resolution. In an effort to mitigate or reduce risk should a dispute arise, the outsourcing agreement should specify a mechanism for dispute resolution. Typically, outsourcers want to avoid litigation. The critical issue is the relationship, and litigation that takes a long time to resolve may cause damage to the relationship separate from the underlying dispute. Consequently, it is critical that the agreement address clearly and in detail the mechanism for resolving disputes, including a clear statement of the parties’ obligations pending resolution to ensure the continuation of services, if appropriate. Equally critical, the agreement should contain a provision for the law and venue of the company’s choice. When the supplier is located abroad, arbitration may be the preferred means to resolve an international dispute. When the parties are from different countries, the food company should be sure to determine what international treaties and conventions may govern the outsourcing relationship.
It is important to consider a situation where a customer sues the food company over operations or processes that are outsourced. Often, companies seek indemnity and duty-to-defend provisions over consumer claims. As part of the external due diligence, the company should assess whether the supplier has the ability to pay judgments and whether it would be prudent to have the supplier defend such an action. Depending on the circumstances, such as where the company’s reputation is at stake, the company may not want the supplier to directly defend. One way to resolve this dilemma is to allow the company to choose whether it wants the supplier to defend, with a right to assess costs of such litigation against the supplier regardless of which option it selects.
Careful Management of the Outsourcing Relationship
Even with an effective agreement, a food company must still closely manage the relationship. To that end, a company should make sure that the outsourcing agreement provides it with an appropriate level of oversight and control over the supplier’s operations and the ability to communicate directly with key supplier personnel. (The company must also ensure that it retains personnel knowledgeable enough to do so.) Rote reliance on a supply partner may undermine protections the company builds into the outsourcing agreement.
Conclusion
Outsourcing business functions and manufacturing operations may increase efficiency and cut costs. With proper planning, careful contracting and ongoing oversight of the outsourcing relationship, any potential monetary loss or damage to the company may be eliminated.
John T. Shapiro is a partner and member of the food industry team (http://foodlaw.freebornpeters.com) at the Chicago law firm Freeborn & Peters LLP. His areas of focus include solving clients’ complex business disputes, counseling clients on litigation, employment and business issues and providing general corporate advice. Reach him at 312-360-6389 or jshapiro@freebornpeters.com.
Lab Outsourcing
Increased consumer and government concern for food safety, plus heightened regulatory oversight, has made food product analysis more important than ever. Consequently, food companies are turning to outside laboratories more often for the technical expertise needed to meet those demands.
Typically, outsourcing testing functions allows companies to more economically keep abreast of and satisfy regulatory requirements, and take advantage of advances in testing technology and techniques. However, absent a proper outsourcing relationship, including an agreement that memorializes the parties’ interactions, such benefits may be fleeting.
For an outsourcing laboratory relationship to be successful, a food company must define standards that are critical to the relationship and set operational metrics by which to measure the relationship, including but not limited to the following criteria and issues:
• Food industry experience
• Relevant accreditation or certification
• Pertinent analytical experience
• Acceptable and consistent testing methodologies
• Up-to-date facilities and equipment
• Appropriate quality assurance policy
• Required outputs
• Adequate logistics for storing, handling and shipping product
• Necessary management and personnel
• Competitive and flexible pricing
In short, a food company must set well-defined objectives for itself and its laboratory partners before it enters into an outsourcing relationship.
