OUTSOURCING AGREEMENTS

Monday, October 23, 2006
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OUTSOURCING AGREEMENTSRudolph Labuschagne
In the Competition Commission’s annual report for 2005/2006 it is noted that mergers notified to the Competition Commission ("the Commission") increased by 31% compared to the previous year and that this increase can be attributed mainly to a positive economic environment. As a result of the current positive economic environment and sentiment not only in South Africa, but worldwide, businesses are encouraged to re-engineer their operations to be more efficient and globally competitive. Some firms may, in order to become or remain competitive, consider the outsourcing of various functions as a strategic alternative, enabling these firms to dedicate resources to their core business functions. Outsourcing, when implemented properly, can reduce costs, improve quality of service and add value. Although outsourcing agreements are quite common in the Information Technology ("IT") industry, examples can be found in virtually every industry and may be applicable to a whole range of activities such as fleet management services, security services and building maintenance and cleaning services. South Africa has in recent years made giant strides in establishing itself as a world-class service provider for business process outsourcing, such as outsourced call centres. The recent listing of Dialogue Group Holdings Limited on the JSE Securities Exchange’s AltX board is evidence of this progress. As South African firms strive to become more competitive in an increasingly globalised economy, one may expect more and more firms to consider the option of outsourcing non-core functions to specialised service providers. Usually outsourcing agreements, in terms of which a service provider is appointed by a principal to perform a specified service to the principal in exchange for a consideration (usually the payment of a service fee), do not constitute notifiable mergers, as there is no acquisition of direct or indirect control by the service provider over the principal’s business or part thereof. In addition, outsourcing agreements do not usually include the transfer or acquisition of assets or employees.

In terms of section 12(1)(a) of the Competition Act, Act No. 89 of 1998, as amended ("the Act"), a merger occurs when one or more firms directly or indirectly acquire or establish direct or indirect control over the whole or part of the business of another firm. In terms of section 12(1)(b)(i) and (ii) of the Act, a merger may be achieved in any manner, including through the purchase or lease of the shares, an interest or assets of the target firm or through an amalgamation or other combination with the target firm.

In the matter between Competition Commission and Edgars Consolidated Stores Limited and another ("the Edcon case") the first respondent did not dispute that the first leg of the transaction gave it control over the book debt and that a book debt is an asset. What was in dispute, however, was whether the rights acquired constituted part of a business. The Competition Tribunal ("Tribunal") had to consider whether or not the acquisition of certain (but not all) assets of a firm was sufficient to constitute a merger as defined in section 12(1)(a) of the Act. To be more precise, what the Tribunal had to consider was whether, in terms of the first leg of the transaction, the acquisition of certain rights constituted the sale of part of a business. In paragraph 22 of its reasons for decision the Tribunal noted as follows:

"The mere acquisition of an asset, assuming it otherwise falls within the thresholds of capture in section 11 of the Act, does not constitute a merger. What the Act clearly sets out, as a limiting feature, is that which is taken control of is a "business" or "part of a business."
And in paragraph 24:

"When an asset becomes a business and when it is just to be considered an asset, is a subject for interpretation. Too wide a notion of business would make any number of ordinary transactions notifiable as mergers, too narrow, would risk creating a loophole for regulatory avoidance."

In formulating a general approach to evaluate, based on the facts of each case, whether or not the acquisition of an asset or assets is sufficient to constitute the acquisition of "the whole or part of a business of another firm", the Tribunal quotes the following passage from Herbert Hovenkamp, Federal Antitrust Policy, The Law of Competition and its Practice:

"In general, if the asset acquisition appears on its face not to affect industrial concentration or the market share of its buyer, the acquisition will be treated as outside the scope of section 7. If it does tend to enlarge the market share or productive capacity of the acquiring firm, or if it increases concentration in the industry, then its effects on competition must be assessed."

In the event that the acquisition of an asset or assets enlarge an acquiring firm’s productive capacity, increase its market share in a relevant market and/or increases market concentration, it is probable that the acquisition will be classified as a merger as contemplated in section 12(1)(a) of the Act.

Even though an outsource agreement may increase market concentration in the market for the provision of a specific outsourced service, the service provider usually does not acquire direct or indirect control over any portion of the principal’s business. One of the principal requirements for a notifiable merger, namely the acquisition of control, is therefore not met and these types of transactions are usually not considered to be notifiable mergers as provided for in section 12(1)(a) of the Act.

A more complex type of outsourcing agreement, sometimes referred to as transfer outsourcing agreements, entails the transfer of the principal’s assets to a service provider, which assets are then utilized by the service provider to perform a service to the principal that was previously performed in-house by the principal itself. These types of transactions are usually implemented through the conclusion of a sale of assets agreement along with the simultaneous conclusion of a services agreement. The structure of the transaction may also include the transfer of employees from the principal to the service provider. A furniture retailer may for instance decide to outsource its delivery function to a specialised logistics firm. Along with concluding a services agreement in terms of which the logistics firm will be responsible for the delivery of purchased products, the logistics firm may agree to acquire the vehicles, equipment and personnel previously used by the furniture retailer to deliver the purchased goods. It is these types of transactions that frequently raises the question as to whether the agreement constitutes a notifiable merger or not. In terms of the Tribunal’s decision in the Edcon case, what has to be considered in the above example is whether the specialised logistics firm’s acquisition of the vehicles, equipment and personnel of the furniture retailer is sufficient to constitute the acquisition of "the whole or part of a business" of the furniture retailer. If the parties (the principal and service provider) are able to show that the transferred assets do not constitute the whole or part of the business of the target firm (or principal) the transaction may not constitute a notifiable merger.

The large merger between Siemens Business Services (Pty) Limited and Medscheme Holdings (Pty) Limited ("the Medscheme case") is an example of a transfer outsourcing agreement frequently encountered in the IT industry. In order to focus on its core business operations, Medscheme Holdings (Pty) Limited ("Medscheme") decided to outsource its non-core IT functions to Siemens Business Services ("SBS"). The transaction was embodied in two agreements, namely a sale of business agreement, in terms of which SBS acquired the in-house IT division of Medsheme as a going concern, and a services agreement in terms of which SBS provided certain IT services to Medscheme.

The large merger between Telkom SA Limited and TPI Investments and Praysa Trade 1062 (Pty) Limited ("the Telkom case") is another example of a transfer outsource agreement and was regulated by four separate agreements. In terms of a sale of business agreement Praysa Trade 1062 (Pty) Limited ("TFMC") acquired as a going concern the Facilities Infrastructure Operations and Property Asset Management divisions ("property divisions"), including staff, of Telkom SA Limited ("Telkom"). Telkom and TFMC simultaneously concluded a facilities management agreement in terms of which TFMC provided services to Telkom that were previously undertaken in-house by Telkom’s property divisions.

In the Medscheme case SBS acquired control over Medscheme’s in-house IT division. In the Telkom case TFMC acquired control over Telkom’s property divisions. It appears that in neither of these cases was the notifiability of the transaction or the jurisdiction of the Commission or Tribunal challenged.

The long running dispute between pharmaceutical manufacturers and full-line wholesalers was a more complex matter to consider. In the interim relief application in the matter between Natal Wholesale Chemists (Proprietary) Limited and Astra Pharmaceuticals (Proprietary) Limited and two others ("the NWC matter") the applicant, a full-line wholesaler, alleged that the first and second respondents, both subsidiaries of multinational foreign-based pharmaceutical manufacturers, concluded agreements with the third respondent, a logistics service provider, that violated section 5(1) of the Act. At the time of hearing the NWC matter the pharmaceutical industry was going through a phase in which manufacturers were transforming the traditional method of distribution. The traditional model of distribution of pharmaceutical products entailed wholesalers purchasing pharmaceutical products from manufacturers and then on-selling these products to retailers such as pharmacies. In terms of the revised method of distribution some manufacturers opted to establish their own distribution firms. These newly-formed distribution firms were subsequently appointed as exclusive distributors of the pharmaceutical products manufactured by their own shareholders and controllers. In the NWC matter the first and second respondents did not form their own distributor, but decided to outsource their non-core business activities such as warehousing and distribution to the third respondent. The third respondent did not, in terms of the traditional model of distribution of pharmaceutical products, purchase products to on-sell to retailers, but provided distribution services to the first and second respondent on a fee-for-service basis. Although the applicant attempted to show that the agency arrangement was a mere sham disguising actual control of the third respondent by the first two respondents, the Tribunal was unable to, on the evidence presented to it, find that the arrangement was anything other than that reflected in the formal agreements, namely an arrangement governed by a number of agency agreements.

Merger regulation has as one of its objectives the consideration of the effects of a transaction in terms of which a firm acquires the market share and productive assets of a competitor firm, thereby potentially reducing the sources of supply and possibly enabling the acquiring firm to exploit its increased market power. It may be argued that, although transfer outsourcing agreements include the transfer of assets, the implementation of these agreements should not require a merger notification to the Commission, unless the assets constitute a recognisable, stand-alone entity able to be independently active in a market not only to the seller of the assets but to third parties as well. In the event that the transferred assets will be used exclusively for the execution of a service agreement, the acquisition of the assets are ancillary to the main objective of the transaction which is the provision of a service and not the acquisition of market share or productive assets. In these instances the acquisition of assets would not affect the sources of supply, as the assets were not previously independently active in any market.

An additional issue to consider is the difficulty in accurately calculating a turnover value derived from the transferred assets, especially if one considers that firms usually outsource their non-core functions, which are not usually revenue drivers. In the above example of the furniture retailer outsourcing its delivery function to a specialised logistics firm, it may be difficult if not near impossible to accurately ascribe a turnover value to the delivery function of the furniture retailer if the price of "free" delivery is included in the price for the product itself.

As the South African economy becomes more competitive and more and more firms opt to outsource their non-core functions to specialised service providers, the question of whether or not certain transfer outsource agreements should be notified or not may become a bone of contention between practitioners and the Commission. The South African competition regulators are, however, notoriously strict in their interpretation of firms’ obligation to notify proposed mergers to the Commission. The Competition Appeal Court noted in the matter between Distillers Corporation (South Africa) Limited and Another v Bulmer (SA)(Pty) Ltd and Another that the obligation to notify will be broadly construed. Firms will be well advised to first engage the Commission on the question of whether or not a specific transfer outsourcing agreement is notifiable or not instead of merely accepting that it’s not and thereby running the risk of paying a fine or even divestiture.