Randall Parks, Hunton and Williams: It puts them all at risk. If you are a Satyam customer what you are looking for most in a long-term partner is stability and integrity and this calls both into question. It may be that the new board and the government can restore the necessary level of confidence but that is far from clear right now. We're seeing a significant amount of anxiety from clients about their relationships with Satyam. Many are looking to exit their arrangements with Satyam if they can-and that's not always viable. If you have a good account team in place and you have some confidence they are going to stay in place you may stay with them, but even that is a question. There are market rumors to that-that employees are putting themselves on the market and once an account team disintegrates the anxiety is only increased.
Waters: Why might it not be possible for Satyam customers to exit contracts?
Parks: If you are under contract with Satyam your rights are governed by the contract. If you've managed to negotiate for yourself termination rights that are linked to Satyam's financial condition or are linked to the concept of material adverse change to Satyam's financial condition or prospects, then you might have a termination right. If account teams do unravel and performance begins to suffer then you might have a termination right linked to a performance failure. But if none of that happens it will be far more difficult to terminate and be sure there wouldn't be any negative consequences for you. You can always terminate for convenience or walk away but the risk is that Satyam or whatever remains of it would have a claim against you for breach of contract.
We've been telling our clients to think about this in a risk-adjusted and risk-managed way. If you simply cannot tolerate the risk of continuing with an unstable partner then maybe you move whether or not you have the right to terminate the agreement and you simply suffer the consequences of the cost of the exit. But if you have a low-risk operation-perhaps it's a simple application development project-maybe you put the project on hold and do what you need to do to secure the work that has already been done. For example, require code to be delivered to you as it's developed, so that your payments are linked to actual delivery of value. Then if something happens, you at least have all of your accumulated product available to you and you could transition to the next person. So it really does depend on the level of exposure and the risk you can tolerate, and whether your contract has the right provisions in it.
Waters: If firms didn't have a right to terminate based on the financial condition of the provider, are they going to look to include that in the future?
Parks: I would hope so. Firms will be saying, "We've learned our lesson; what do we do to protect ourselves in the future?" Right after Enron collapsed all of us realized this could happen to any of our vendors. What should we be doing to ensure that our clients are protected in that case? We added to our contracts, to the extent we didn't already have them, protections against exactly this sort of a meltdown by a large service provider. But those are burdensome on the providers and they negotiated them out over the following years.
Waters: Can you add provisions like that to existing contracts or just new ones?
Parks: You can absolutely add them. Satyam will be looking to re-instill confidence and adding contractual protections is a relatively low-cost way for them to deliver some assurances to their customers. If you have to stay in place you should be asking for these additional contractual protections to the extent you don't already have them. Whether you can actually get somebody to respond effectively to you and make those changes in the next little while is a question given the disruptions, but you absolutely can and should be asking for them now and not only from Satyam. You may want to think about asking for them from your other vendors. There is an opportunity now for clients to reopen their transactions with their customers and improve their contractual protections, and the suppliers ought to be responsive to that. They ought to be looking to make their customers feel more comfortable doing business in constructing outsourcing arrangements. Outsourcing requires a substantial degree of trust. And if that trust is compromised, the industry is going to lose ground. It's up to the industry players to make sure that doesn't happen and do what they can within economic reason to rebuild the confidence.
Waters: Will this scandal have a negative impact on the reputation of outsourcing?
Parks: I think it will have a short-term impact. Once the situation is resolved, the economic drivers behind outsourcing haven't changed-in fact, they have only gotten stronger as the economy has deteriorated worldwide. Companies that are looking to improve their financial performance, where they can't increase revenue very easily, are going to be working on the expense side of their income statements, and outsourcing is a proven way to reduce costs.
Waters: Have you noticed an increase in outsourcing due to the current financial crisis?
Parks: The market signals are unclear. The conventional wisdom is that outsourcing is counter cyclical-that it will be up in a down economy. That will probably be true. What's making the picture a little unclear is the sharp economic decline that we experienced in the fourth quarter really paralyzed economic activity of all types. Now we are seeing people refocus on rightsizing their operations and beginning to pick up business transactions that they couldn't begin to think about in the fourth quarter. We're hearing from the marketplace that there are a lot of outsourcing deals being assessed and we expect to see an uptick in deals late in the first quarter or in the second quarter.
Waters: What can firms do to protect themselves if they have a relationship with Satyam?
Parks: Make sure they know what their exposure is. In a lot of cases IT suppliers-in particular Indian suppliers-have been very good at executing a "penetrate-and-radiate" strategy. They start with a very small contract, prove themselves, then collect additional work orders under that original contract and then before you know it, what started out as a very small arrangement is actually very complex and significant. And because no individual work order was very large, all of them may have escaped the scrutiny of the inside legal department, finance, or at least not have received the level of scrutiny the transaction would have received if it had been combined and viewed as a whole.
Then look at the things that are in the hands of Satyam that you may need to get hold of and secure them. If Satyam has your software, and your data, you want to get it back. If they are going to be in place for a certain period of time perhaps you want to set up a strategy for mirroring that data. Maybe your disaster recovery (DR) site can be reconfigured to serve as an emergency backup and begin to take mirror images of your data on a daily basis so you can guard against an overnight evaporation of your support.
Waters: In this environment of cost-cutting, some firms are looking to consolidate their vendor contracts and use fewer outsourcing providers to reduce unnecessary costs. Will this scandal have an impact on that trend-is it better to spread your exposure a little bit?
Parks: We often advise our clients to have multiple providers. If you have a single provider you are obviously more vulnerable to that provider. Anyone who relies solely on Satyam will tell you that today. In the application development world in the last couple of years we have seen our clients move from single-source arrangements to multi-source arrangements so that they can create miniature marketplaces. If they had access to two or more players they could be sure there was a competitive dynamic maintained during the life of the deal. We've had clients adopt the so-called "champion-challenger" model. The champion makes the best offer and gets 70 percent of the work, while the challenger has the second-best offer and gets 30 percent of the work. But that can change over the life of the deal, depending on their relative performance.
Overall, firms are looking to consolidate a bit. But over-consolidation would be a mistake. If you go sole-source with every provider for every service then you're vulnerable to your suppliers. You may not need 10 applications development providers but you probably ought to have two or three.
Waters: What lessons can be learned from this experience?
Parks: Clients will be demanding more transparency from their vendors. There was a period when it was possible for services vendors to simply point at their customer satisfaction, at their stock price, at their lack of debt, and assure their customers that all was well. Satyam had all of those things and everything wasn't well. I think clients of the future will be using that example in their discussions with their partners as they demand more transparency. Maybe that takes the form of a requirement that the financial statements be delivered periodically but that wouldn't have helped in the Satyam case either-the financial statements were false! So some due diligence beyond that may be required. I wouldn't be surprised if large clients with significant risk exposures asked to conduct their own audits. Maybe not at the level that the big four accountants would do but maybe on a tactical level where certain key balances are verified.
We're definitely going to see more financial covenants. Customers right now who don't have a contractual right to terminate their agreement with Satyam are going to be wondering why not. Part of the reason is that while we asked for them, vendors rejected them, because they said, "If we allow you to have this, then in case we have a bump in our financial performance, the financial covenants could result in a death spiral for us. You have a termination right, you terminate, we lose your revenue, that in turn causes us to fail other financial covenants and there is no way out." So they rejected them, they wouldn't let us have them, and I think customers will be less sympathetic to the death spiral argument.
We were always able to get those for small vendors. Small vendors are willing to give them because that was how they signaled to the market, "You should trust me," because I am willing to put these things in risk for you. Large vendors didn't feel they needed to do that, and were effective with the death spiral argument, so contracts with those larger vendors just don't have those quite so often. And Satyam was effective at doing that.
We'll probably see a lot more careful thinking about self-help rights-for example, the right to have your code delivered to you on a daily basis, the right to have your data mirrored to you on a daily basis, the right to step in and fix performance failures. Step-in rights are highly controversial. Vendors don't want you jumping into the middle of their operations taking something over. It is disruptive and costly. They don't want that. But I think we will see a lot more focus on that.
And we may even see more credit support-for example, letters of credit issued in favor of the customer in case of a provider default. That's not something Satyam will be able to put in place now. They can't borrow very effectively now.
Waters: Will outsourcing customers have a bit more leverage when negotiating contracts with all the outsourcing providers as a result of this?
Parks: Yes-and I don't think that increase in leverage stops at the ocean's edge; that will expend elsewhere. I would not be surprised to see customers citing the Satyam example to major US providers if they ask for additional contractual protections. The financial fraud that appears to have occurred at Satyam isn't limited to India, it can happen anywhere. The example of Enron demonstrates that.