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Much has been written over the past several years about U.S. technology companies outsourcing work to contractors located overseas, a practice known as offshoring. Many software development and programming jobs have been moved to India, Russia and other countries that promise labor and other cost savings. According to Forrester Research of Cambridge, Mass., U.S. employers plan to move about $136 billion in wages offshore this year, up from $4 billion in 2000. Recent news articles have estimated that 400,000 to 500,000 information technology jobs were lost to outsourcing over the last few years. This has created a public image problem for some companies, and a marketing opportunity for others. While most companies don’t seem particularly worried that offshoring hurts their public image, public pressure has led Congress to consider anti-outsourcing legislation. Democratic presidential candidate John Kerry has proposed eliminating what he calls tax subsidies that encourage companies to ship jobs to foreign countries. The conventional cost-benefit analysis is that workers in India and other foreign countries have a much lower cost of living and a lower wage rate while at the same time being well-educated and highly skilled. But the analysis should not end there. Nor should it end in a political knee-jerk reaction to regulate offshoring. For many business managers, the bottom line benefits outweigh all other concerns, especially soft issues, like lost jobs, potential customer concerns about buying American, or cross-cultural friction. But offshoring has begun to reveal some hidden costs that could reduce, if not entirely offset, its benefits. The key to a successful offshoring arrangement is a carefully negotiated contract with appropriate cost-sharing pass-throughs and pricing adjustments allowing the parties to share risks. The hidden risks and costs must be considered to craft a good deal. Consider the challenge of the typical offshoring arrangement. The vendor is expected to coordinate a rollout of global services for its client with very little time to conduct legal and financial due diligence on the client and its business before estimating the price and achievable deadlines for delivering services. The client purchasing the vendor’s services must rapidly assess the vendor’s reputation for service and how the client’s own reputation will be affected by partnering with this overseas vendor. HIDDEN COSTS OVERLOOKED In this fast and complex negotiating environment, hidden structural, cultural, legal and financial risks and costs are often overlooked. The structural issues include “scope creep” — requiring the offshore vendor to do more and more for the same initial fee. For the offshoring client, another, often-overlooked structural cost is whether the vendor will be subcontracting out some of the work. The client may find that it is being outsourced by the outsourcer. Another structural challenge is setting performance standards and penalties that are meaningful for both parties. They must be clearly understood by the parties. The penalties may be limited by the foreign legal system involved, which brings us to the next source of hidden problems — cultural and legal differences. Cultural, however, does not only mean diplomatic behavior, but also differences between national legal systems. For example, the U.S. and Great Britain follow a common law system that relies heavily on judge-made law. In contrast, Japan and many European and Latin American nations follow the Napoleonic code or other statute-based legal systems that allow little place for equitable interpretation. As a result, contracts may be more strictly interpreted and may even be determined invalid. In addition, intellectual property regulations vary dramatically from country to country. The U.S. has copyright standards that provide rights even without registration or attaching symbols for notice that a work is copyrighted. This is in sharp contrast to many countries (and prior U.S. law) that required strict filing and notice requirements or all rights were lost. Many of the protections in the Digital Millennium Copyright Act, or DCMA, also have not been adopted in other countries, leaving digital works more exposed to unscrupulous offshore contractors. Trademark is also an issue in offshoring, because the service provider’s U.S. employees and the client’s employees may both provide services directly to consumers affecting the client company’s goodwill under the same trademark. Consumers of Dallas-based Dell Computer have long associated its mark with high-quality, low-priced computers. Judging by some online rants over the holiday season, however, Dell’s mark may also have recently been associated with offshore sales representatives and customer service people who have a hard time with English, seemingly unable to veer from their script and unable to respond to questions asked in English. When U.S. companies decide to send some of their domestic employees to work for or assist the vendor in the foreign location, labor laws in those countries may cause unforeseen costs. For example, the European Commission’s Acquired Rights Directive may force a U.S. company to give transferred employees comparable employment terms and benefits, including severance packages as employees at the offshore location. Similarly, the European Commission’s Data Privacy Directive may prohibit the transfer of confidential personnel data to non-European Union countries. Technology providers in this country also recognize the risks of “residual information” to trade secrets and confidentiality provisions. Some U.S. contracts allow workers to use this general know-how gained in one confidential project to be used on the next. Some contracts, however, prohibit residual information as allowing too big a confidentiality loophole. A limit on residual information that would be upheld in the U.S. may not be as well understood or interpreted quite differently by judges in Hamburg, Moscow and New Delhi. U.S. companies, particularly in heavily regulated fields such as banking, insurance and medical services, need to be cognizant of foreign regulatory requirements. Offshoring arrangements may need to include cost-sharing or pricing adjustment mechanisms on a per-country basis. Should something go wrong, smaller corporations may find it extremely difficult to litigate in New Delhi, Johannesburg or even Paris. Cross-cultural legal actions that require interpretation by multiple sets of lawyers could erase any labor cost savings. To reduce this risk, many outsourcing agreements provide for arbitration in supposedly neutral locations. It is important, however, for both parties to confirm that arbitration provisions are upheld under each party’s local laws and that an award granted in arbitration is enforceable in each party’s local courts. The offshoring client should also consider financial issues, such as whether employees or subcontractors of a vendor will be paid in their local currency or in U.S. dollars and provide sharing of risks for currency fluctuations. In addition, some countries lack an independent central bank. These countries’ financial systems may be weak at maintaining price stability for its currency. Offshoring also risks multiple taxation. Two countries having jurisdiction over the same entity may apply different concepts of taxation. International taxation is complex, involving a myriad of competing public interests among different governments. Some countries impose value-added taxes on everything from luggage to Internet services to digital products to manufactured inventories. Political risk is another hidden cost to be considered. Ramifications for the business may ensue if the foreign country is engaged in activity that the U.S. government considers hostile or deserving of trade restrictions. For example, the U.S. has had tense relations at times with India when it was engaged in border skirmishes with Pakistan and when it has tested nuclear weapons. Offshoring means a significant part of your business is reliant on workers in a distant country who may be subject to unanticipated economic, cultural or even natural forces. INSOURCE INSTEAD? U.S. companies should consider a recent trend toward insourcing — bringing offshore products back home. There were reports last year that Ford Motor Co. found that much of the reason for its automobile recalls was due to defective parts manufactured offshore. An article in the March 12 edition of USA Today noted that a number of companies capitalizing on a “Buy American” theme have advertised their decision not to hire workers in other countries to replace U.S. employees. For example, at First Health Managed Care Co. of Downers Grove, Ill., clients are assured that the company will not offshore work. E-Loan, a direct lender based in Pleasanton, Calif., discloses to its home equity customers that some application work is handled in India. It even allows clients to choose between having their applications processed abroad or domestically. In conclusion, U.S. companies considering moving white-collar jobs offshore need to look carefully at the hidden costs, both at home and abroad, and make sure offshoring benefits truly outweigh the costs over the long term. Scott Austin practices intellectual property and business law in the Boca Raton, Fla., office of Arnstein & Lehr, which is based in Chicago. He can be reached at [email protected]. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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