By Li Jinnan and Jiang Hualiang, King & Wood’s Banking & Finance Practice

With the recent development of the service outsourcing industry, an increasing number of financial institutions (including banks, securities companies, insurance companies and fund management companies) use financial service outsourcing to reduce costs, enhance core competitiveness, and accomplish strategic goals. Financial institutions are able to benefit significantly from IT outsourcing, which is an important part of financial service outsourcing. At the same time, they must also confront the managing risks that are associated with IT outsourcing. Based on our past experience with counseling on IT outsourcing to financial institutions, the followings are the primary legal issues relating to the terms in and execution of  IT outsourcing agreements, using banking institutions ("banks") as examples. The discussion will focus on how banks should manage potential risks from negotiating such an agreement.

 I. Scope of Outsourcing by and Management Responsibilities of a Bank
A. Scope of Outsourcing

The scope of outsourcing is the first decision a bank needs to make before outsourcing its services. Currently, the China Banking Regulatory Commission ("CBRC") has not established general restrictions regarding the scope of IT outsourcing that a bank can engage in. However, a bank should not outsource its IT technology management responsibilities and must report to the CBRC or its branch offices any important outsourcing engagement (see below Section I Subsection C, Report to Supervisory Authority or Notice to Client). Therefore, relevant supervisory authorities may not permit a bank to outsource the management or maintenance of some of its highly confidential or core information systems.

B. Cross-border Outsourcing

In recent years, a number of financial institutions have engaged outsourcing service providers in India, China, and other developing countries because of the lower labor and operational costs in these countries. However, the accumulation of outsourcing service to one or a few countries may amplify the "Country Risk" of the information. Once an offshore outsourcing country faces an incomprehensible problem, the financial institutions outsourcing their business to such a country may suffer irreparable harm. Therefore, the supervisory authorities in many countries tend to take a cautious regulatory approach towards the cross-border outsourcing implemented by banks.

The CBRC’s Guidelines on Risk Management of Outsourcing by Banking Institutions ("Risk Management Guidelines") require that a bank which conducts cross-border outsourcing shall prudently assess the legal and regulatory risks to ensure the security of the clients’ information. The Risk Management Guidelines also establish that such a bank must make sure the regulatory authority at the place where the service provider is located have signed a memorandum of understanding or other agreements with China’s banking regulatory authority. Moreover, the CBRC’s Guidelines on Risk Management of Commercial Banks’ Information Technology ("Technology Management Guidelines") require that the board of directors shall ensure a bank operates the core system containing client information, account information and product information independently and within the territory of China.

C. Report to the Supervisory Authority or Notice to Client

According to the Technology Management Guidelines, the banks shall exercise precautions when implementing important outsourcings (such as data centers and information technology facilities), and shall report these outsourcings to the CBRC or its branches in writing. In addition, the Guidelines require that any outsourcings involving client information be deemed an important outsourcing of the bank. As the existing PRC law is unclear about the definition of "important outsourcing," we suggest that the banks consult with the competent supervisory authority at their domicile if they are uncertain about whether the outsourcing to be performed will be regarded as an important outsourcing subject to reporting duty to CBRC.

The Administrative Rules on Electronic Banking ("E-Banking Rules") provide that banks shall report any outsourcing of electronic banking. According to the E-Banking Rules, a bank shall report to the CBRC before outsourcing the general design and development of electronic banking transaction processing system, authorization management system, data backup system, and other confidential information management and transmission systems.

In addition, the Risk Management Guidelines require the bank to submit an outsourcing appraisal report to the local branch of the CBRC regularly. However, banks will need further clarification or detailed guidance of the relevant authority on compliance.

In addition to the responsibility of reporting to the supervisory authority, in certain circumstances, the banks also need to inform the relevant clients about their outsourcing arrangement. For example, the Technology Management Guidelines require that a bank shall notify clients any outsourcing involving the client information.

D. Internal Approval

According to the relevant regulations, all IT outsourcing contracts of a bank shall be approved by the bank’s department of information technology risk management, legal department, and its information technology management committee. Certain IT outsourcing contracts may require the approval of the board of directors.

E. Compliance of Offshore Regulatory Authority

When implementing outsourcing, the foreign-invested commercial banks in China shall comply with the requirements of the CBRC as well as those of the regulatory authorities in their home country. Therefore, these banks need to manage the risk arising from the regulatory difference between China and their home country.

II. Summary Terms of Outsourcing Contracts

The CBRC requires that banks must enter into IT outsourcing contracts when engaging IT outsourcing services. The contracts shall be in written forms and clearly provide the rights and responsibilities of the parties. An IT outsourcing contract usually consists of the outsourcing agreement and the service level agreement.

A. Outsourcing Agreement

An outsourcing agreement shall at least contain the following terms: (1) the scope and standards of the outsourcing service; (2) the confidentiality and security of the outsourcing service; (3) the continuity of the outsourcing service; (4) the auditing of and inspection on the outsourcing service; (5) the dispute resolution arrangement of the outsourcing service; (6) the transitional arrangement upon revision or termination of the agreement; and (7) the liabilities in case of default.

The outsourcing agreement shall have both effective binding force on the parties and a certain amount of flexibility. An inadequate outsourcing agreement may lead to uncertainties during the service provider’s performance of the IT outsourcing service. In practice, some outsourcing agreements do not include detailed provisions to govern the service provider’s performance, quality of service, and rights and responsibilities of the parties. In this case, disputes may arise and the business that the bank outsources may be at risk if the parties are unable to timely execute supplementary agreements to address new situations, issues, and risks that arise during the performance of the outsourcing agreement. For these reasons, the banks should strive to make the outsourcing agreement as clear, specific, and meticulous as possible when drafting the agreement. However, due to the nature of IT outsourcing, a bank’s need varies in different phases of business development (especially when two parties have established a long-term cooperative relationship). Therefore, the parties may need to amend the agreement as needed to make sure the performance of the agreement will not be affected. If the outsourcing agreement lacks flexibility, the time budget and financial costs that the parties will need to bear for additional negotiations may increase significantly. The continuity of the bank’s business may also be compromised. Therefore, the outsourcing agreement should be flexible enough to be amended to adapt to the new situations appearing during the execution of the agreement.

B. Service Level Agreement

The service level agreement is entered into by the bank that plans to outsource its business and the outsourcing service provider regarding the assessment of business performance and service quality. The purpose of such an agreement is to evaluate, monitor, and control the operational and financial risks in relation to the IT outsourcing service. A reasonable and meticulous service level agreement is an integral part of a sophisticated IT outsourcing agreement. As an internationally accepted standard to evaluate IT outsourcing service, the service level agreement is a legal document executed by the bank and the service provider and is crucial to the bank’s supervision and management of the service provider.

CBRC requires that a bank considers the following factors when drafting a service level agreement: (1) whether the agreement has established qualitative and quantitative performance indicators to evaluate the service provided to the bank and relevant clients is sufficient; (2) whether the agreement appraises the performance of the service provider through the service quality report, periodical self-evaluation, and internal or independent external auditing; and (3) whether the agreement includes any steps to help the service provider to improve the procedures and performance when the service provider is unable to meet the agreed standards or indicators.

In practice, Chinese banks and their outsourcing service providers are inexperienced in formulating service level agreement. Therefore, the established terms might not suffice in protecting the interests of the parties. For example, the agreement may not include a term to protect the bank’s interests where material technical errors arise during the outsourcing service provider’s performance of the agreed service. In essence, both parties should exercise due care when formulating the service level agreement to ensure that the agreement is able to provide good protection to both parties.

As IT outsourcing for financial institutions in China continues to develop, relevant supervisory regulations are being updated and improved to keep up the latest development of the IT outsourcing practice of banks. Similar to the IT outsourcing of banks, the IT outsourcing of securities companies, futures companies, fund management companies, and insurance companies also involve many important legal and regulatory issues. The financial institutions engaging in IT outsourcing services shall effectively manage their outsourcing contracts to control the risks and make sure that the performance of these contracts will not compromise their responsibilities to the clients and the supervisory authority, as well as their compliance with regulatory requirements.