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By Gabrielle M. Wirth and David L. Hayes
Brobeck, Phleger & Harrison LLP

In the 1990's, there was explosive growth in the use of contingent workers, often classified as independent contractors. A key goal achieved by these arrangements was lower total labor costs. Contingent workers are generally less costly than regular employees as they usually do not receive fringe benefits and the employer is not required to pay employment taxes or overtime premiums. Additionally, because of the perceived transient nature of contingent workers, an employer's workforce may be more easily reduced or increased according to market needs.

There were numerous disadvantages to using contingent workers including the increased risk that the contingent workers were actually "employees" under applicable legal standards. The danger involved in misclassifying employees as contingent workers was highlighted in 1996 in the Ninth Circuit case Vizcaino v. Microsoft Corporation in 1996. In that case, the IRS had ruled in 1989 that a large number of individuals working for Microsoft had been improperly classified as independent contractors and were in fact employees, notwithstanding the fact that the workers had signed contracts acknowledging their independent contractor status. The workers then sued Microsoft claiming that, as employees, they should have been able to participate in the Company's 401(k) plan and employee stock purchase plan. After the trial court threw out the claim based on the language of the contracts, the Ninth Circuit Court of Appeals reversed, ruling that the workers were entitled to participate in the benefit plans which were, by their own terms, open to all employees "on the U.S. payroll" of Microsoft. Vizcaino v. Microsoft Corp., 97 F.3d 1187 (9th Cir. 1996).

On rehearing, the Ninth Circuit upheld the coverage of the workers under the employee stock purchase plan, since it incorporated the requirement of section 423 of the Internal Revenue Code that the plan cover all employees (who satisfy certain age and service requirements), but remanded the decision on the 401(k) plan to the plan administrator to interpret the term "U.S. payroll." Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997), cert. den. 1998 U.S. LEXIS 799 (January 26, 1998). Contracting with third party agencies for the use of contingent workers was viewed by some as a quick fix for the Microsoft issue, however, later court decisions left open whether workers engaged through a separate employment agency can nonetheless be considered common law employees of the company to which the workers are assigned.

Today, the increasing trend is to outsource entire departments or functions to separate companies with expertise in the outsourced area. Large corporations have had outsourcing arrangements for years, now medium size and start-up companies are exploring this option. Properly structured outsourcing transactions can enable companies to gain access to highly skilled personnel, improve service levels, and increase productivity. Where the vendor of an outsourced service is a separate company with expertise in the area and maintains primary control over the day to day activities of its workforce, the Microsoft issues can be avoided relatively easily. Services which are frequently outsourced include information technology, customer service, manufacturing, warehousing, accounting, human resources and benefits administration. However, this increasing trend towards outsourcing is aimed not just on reducing cost and avoiding legal problems. The primary benefit of outsourcing is to focus a company's internal capabilities on its "core competencies" key to the company's success. "Do only what you do best and outsource to the experts the rest" is the mantra of the year. Functions critical to the company's business model are usually retained in house.

Outsourcing relationships present their own unique legal challenges. Employers considering outsourcing should carefully evaluate how they structure the outsourcing relationship.

1. Consider the employment related legal issues associated with the initial transition.

At the start of an outsourcing contract, often the employees who had performed the function in house are terminated and hired by the outsourcing firm. The employer needs to evaluate whether this transition triggers severance pay or WARN ACT liability. Severance plans which comply with the requirements of the Employee Retirement Income and Security Act of 1976 should be drafted to clearly exclude these employees from severance benefits if that is the company's intent.

2. Review all benefit plans and obtain proof of the outsourced firms insurance.

The Company should review its own plans to determine if amendment is needed to avoid the unintended coverage of reclassified workers, ala Microsoft. Then, review the Benefit Plans and insurance policies of the outsourcing firm, including but not limited to the workers compensation, general liability and employment practices policies. Include in the contract a requirement that, at a minimum, the Company be notified before cancellation of any policy and, preferably, that the Company be named as an additional insured on the outsourcing firms policies.

3. Do reference checks.

Carefully evaluate the track record and resources of the outsourcing firm. Call references to make sure customers were satisfied. Check claims histories and insurance records.

4. Carefully structure the contract.

Many outsourcing contracts do not define precisely the types, quality and quantity of services to be delivered. The contract should provide for a means to measure whether the benefits the Company seeks to obtain are, in fact, achieved. The expected performance of the outsourcing firm should be meticulously outlined. For example, if the goal is to outsource to a customer support group which can respond to each customer call up to a set maximum in a 24-hour period for a set cost, that should be specified in the contract. Similarly, the precise expectations when demands for services increase or decrease should be outlined. Equally important, the precise duties of each party on termination should be set forth to insure a smooth transition.

5. Think through indemnities.

As the outsourcing firm should be a completely independent entity which controls its own workforce, it should retain full responsibility for compliance with all employment laws. Appropriate representation and indemnity agreements must be obtained. Additionally, give thought to whether the outsourcing company's insurance covers your company for claims arising out of the services it provides.

6. Protect proprietary information.

Outsourcing relationship raise unique issues regarding ownership interests in development, technology transfer and the protection of intellectual property portfolios. Additionally, care must be taken to address data privacy during the contract and the ownership and return of all data at the end of the relationship.

7. Tax Issues

Finally, companies should not overlook the tax implications of outsourcing relationships, implications that can range from state taxes being imposed on payments for services to loss of research and development tax credits. Properly constructed outsourcing arrangements can allow companies to focus resources on areas key to their success while improving service levels of non-core functions. Legal counsel should be consulted as to the legal and practical consequences of these arrangements