avoiding supplier insolvency in a shifting marketplace · should take steps to mitigate the risks...

Pillsbury Winthrop Shaw Pittman LLP

Avoiding Supplier Insolvency in a Shifting Marketplace

No Better Time for the Right Outsourcing Series

March 31, 2009

1 | No Better Time for the Right Outsourcing

About the Presenters About Pillsbury Global Sourcing

More than US$450 billion in completed transactions

Over 20 years’ experience in structuring and implementing complex delivery arrangements

Over 500 transactions across a premier customer base

The most experienced firm in the business – architecting the largest service delivery projects and strategic alliances

No Better Time

The only sourcing advisory firm offering integrated professional services (legal, sourcing, domain, financial & change management)

Guiding clients through the full sourcing lifecycle

Using straight-through processing for speed-to-value

Deploying a unique visual sourcing technique using ourpatented ValueChain method

Michael MurphyGlobal Sourcingwww.pillsburylaw.com/michael.murphy

Vipul NishawalaGlobal Sourcingwww.pillsburylaw.com/vipul.nishawala

Erica CarrigInsolvency & Restructuringwww.pillsburylaw.com/erica.carrig


No Better Time

The current economic climate may actually be an opportune time to consider further sourcing initiatives

The three main drivers of opportunity are:

Stronger business cases Favorable market dynamics Lowered execution risk

{ }We are believers in, but not boosters of, the outsourcing industry. If our clients’ needscannot be met by the outsourcing model, we will tell them so. However, we are of the opinion

that the current economic environment could represent an unusual opportunityfor buyers and providers of outsourced services.


The New Risks Affecting Technology and Sourcing

Historically, bankruptcy was not a major consideration for technology or outsourcing transactions between “blue chip” suppliers and reputable, credit-worthy institutional clients.

Recent market changes characterized by giant financial institutions and corporations disappearing over a weekend in a cloud of insolvency, combined with a scarcity of access to capital, have changed the rules of the game.

Outsourcing and technology customers must be aware of potential pitfalls when a supplier becomes insolvent or files for bankruptcy.

{ }While there may be no better time for the right outsourcing, customers should take steps to mitigate the risks of supplier insolvency.


Why Would a Supplier File for Bankruptcy?

Bankruptcy can be an attractive option for a financially distressed outsourcing supplier.

The Bankruptcy Code provides powerful tools to a financially distressed company in a Chapter 11 (reorganization) case.

In particular, § 365 of the Bankruptcy Code will allow bankrupt suppliers to reject burdensome “executory” contracts, while assuming (and perhaps assigning) beneficial or valuable contracts.


Bankruptcy Basics: The Automatic Stay

Once the supplier files for bankruptcy, § 362(a) of the Bankruptcy Code imposes the so-called “automatic stay.”The stay enjoins informal collection actions and virtually all civil actions involving the bankrupt supplier, its property or the property of the estate:

LawsuitsRepossessionsForeclosure salesConditioning future performance on supplier paying its pre-petition debt.

Collection activity may be resumed only with the bankruptcy court’s permission, and the court grants this relief only “for cause.”Willful violation of the automatic stay can result in punitive damages.


Bankruptcy Basics: What Is An Executory Contract?

“Executory contract” is not defined in the Bankruptcy Code.

Courts typically use a definition proposed by Professor Vern Countryman: “A contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.”

In English, that means, A contract in which both parties still have ongoing material obligations.

Customer SupplierObligations


Most Outsourcing Agreements Are Executory

A long-term services agreement that involves transfer of a business process to a service provider

Involves transfer of controlCustomer typically exits the area of business outsourced (i.e., does not retain the ability to do it itself)May involve transfer of knowledge/skills, technology, personnel, assetsMay be technology, business process, or knowledge process

Often financially-driven transactions that require long-term investment for parties to obtain full financial benefits and to achieve objectives.

Customer Supplier

Services

$$$


Why This Matters: If a Contract Is Executory . . .

It cannot be terminated if bankruptcy as the sole basis for termination.Bankruptcy Code invalidates ipso facto terminationMost “termination for bankruptcy” clauses are not enforceable

All defaults must be cured before the bankrupt supplier can assume it (i.e., retained in force) or assign it.

Unlike other counterparties in a typical bankruptcy case, customers who have had their executory contracts assumed or assigned will receive:

Full payment of their claim;Assurance of future performance by the supplier.

Counterparties whose executory contracts are rejected will become general unsecured creditors.


Assumption or Rejection Subject Only to Supplier’s Business Judgment

The decision of the debtor (i.e., the bankrupt supplier) to assume or reject an executory contract is subject to the “business judgment rule.”

A bankrupt supplier generally will have until plan confirmation to assume or reject a contract, although counterparties can move tocompel assumption or rejection prior to that time.

Consequences:This allows for rejection on the bankrupt supplier’s timeline with little regard to the effects on the counterparty.Plan confirmation has been known to take as short as a matter of weeks and as long as years.


Rejection of Executory Contracts

Rejection is treated as a breach of the contract on the day immediately prior to the commencement of the bankruptcy.

Rejection claims are treated as unsecured, pre-petition claims.

Rejection is deemed a breach of the contract and not a termination.

Because breach is deemed a pre-petition breach, state law governs the rights stemming from the breach.

Rejection damages equal ordinary contract damages under state law for breach, reduced to bankruptcy dollars. Specific

performance of the contract is not available.


Assumption of Executory Contracts

The bankrupt supplier must satisfy three requirements before it will be allowed to assume a contract:

Cure any default (other than the bankruptcy itself) or provide adequate assurance that such default will be cured;Compensate (or provide adequate assurance that it will promptly compensate the counterparty) for any monetary loss resulting from the default; andProvide adequate assurance of future performance.

Generally, assumption will be a good result for the customer because defaults will be cured and the contract will continue as if there were no bankruptcy.However, the customer remains in contract with a financially unstable party, so there is ongoing risk—especially if a reorganization converts to a liquidation.


Certain Contracts Are Not Assumable

If applicable nonbankruptcy law would prevent a bankrupt supplier from assigning a contract, the debtor may not be able to assume it (if the counterparty objects to the assumption).

Examples include:Personal Services ContractsIntellectual Property Licenses

Some courts have held that a debtor-licensee may not assume an intellectual property license over the licensor’s objection.Some courts consider intellectual property licenses to be personal in nature and, thus, not capable of being assumed or assigned.

The customer can always agree to the assumption.


Assignment of Executory Contracts

§ 365(f) of the Bankruptcy Code grants the debtor (i.e., the bankrupt supplier) the right to assign the contract to a third party after assumption.

Blanket anti-assignment clauses are generally not enforceable against a debtor except where applicable nonbankruptcy law would prevent assignment (such as personal services contracts).

Before a contract can be assigned, the bankrupt supplier must provide adequate assurance of future performance by the assignee.

Adequate assurance of future performance is a fact-based inquiry typically focusing on the assignee’s ability to comply with financial obligations under the agreements.

Could result in assignment to a “knight in shining armor” or an undesirable party from the counterparty’s perspective.


Severability/Integration of Agreements

A debtor (i.e., the bankrupt supplier) must assume or reject a contract in its entirety. A debtor cannot assume only certain provisions of a contract.

If a contract is severable, however, it may not need to be assumed in its entirety.

A debtor may argue that certain obligations are, in fact, separate contracts so that the debtor can cherry pick certain elements.Similarly, separate closely-related agreement documents may be integrated.

Courts will examine contracts for economic interdependence and intent of the parties to create a single agreement.

Cross-default provisions generally are not enforceable as a condition of assumption unless various agreements form one indivisible transaction.


Post-petition Administrative Expenses

Amounts due under contract that arise post-petition are treated as administrative claims and paid at 100%.

Applies even to contracts that are ultimately rejected for the period from petition to rejection.

But, these are allowed only to the extent of the fair market value of the property at the time of its use under § 503(b)(1)(A).


Executory Contracts: Recap on Assumption and Rejection

Debtor Rejects K:

Debtor Assumes K:

PetitionFiled

Assume orReject

Pre-petition Claims

Administrative Claims

Unsecured (reduced) valueFull value NA/Contract Rejected


§ 365(n)—Special Rights for Licensees of IP

§ 365(n) of Bankruptcy Code grants a right to a licensee and onlyapplies where the debtor is a licensor that rejects the license in bankruptcy.

The licensee can either:Treat the license as terminated; or Retain its rights under such license as such rights existed immediately before the case commenced for the remainder of the contract term (plus any extension).

Allows licensee to retain its interest in intellectual property, even if debtor rejects.


§ 365(n)—Special Rights for Licensees of IP, ctd.

If licensee elects to retain its license rights:It must continue paying royalties (license fees);It may enforce any exclusivity provisions; butIt will not be entitled to any post-petition improvements in the intellectual property; andIt will not be entitled to specific performance of any other components of the license agreement (e.g., Maintenance).

If licensee elects to terminate:The terminated contract will no longer be binding on either party. Licensee will lose the right to the licensed intellectual property and will have an ordinary pre-petition breach of contract claim (unsecured damages claim).


§ 365(n)—Where “Intellectual Property” ≠Intellectual Property

§ 101(35A) defines “intellectual property” as:A. Trade secretB. Invention, process, design, or plant protected under title 35 (the domestic patent

statute)C. Patent applicationD. Plant varietyE. Work of authorship protected under title 17 (the copyright act), orF. Mask work protected under chapter 9 of title 17 (statute protecting certain

computer chip products).

The definition of intellectual property does NOT include trademarks, trade names, and service marks.


Prepackaged Bankruptcies

“Prepackaged Bankruptcy” - key elements of the plan have been agreed to by creditors and stockholders in advance of the bankruptcy filing.

Goal: Shorten and simplify the bankruptcy process to minimize cost and disruption to the company’s business.

A prepackaged plan can move on a quick timeline. A supplier could seek to assume or reject executory contracts within days of the filing (or even on the same day).The plan still must be presented to the Bankruptcy Court for approval and must satisfy all of the regular standards for confirmation.

A pre-packaged plan may be good news for an outsourcing customer:Reduces the period of supplier instability

Increases the likelihood that the company’s operations will continue

But the risk of a pre-arranged breakup of operating units remains


So, Again, How Does this Affect Technology and Sourcing Agreements?

Nearly all technology and sourcing agreements will be treated asexecutory contracts for bankruptcy purposes.

In any case, understanding the principles of bankruptcy law can help you plan as you enter agreements to minimize the insolvency risk.


What Happens if Your Sourcing Supplier Files for Bankruptcy?

If the supplier elects to reject the agreement, the customer will find itself without a service provider on very short notice—likely significantly less notice than is required to perform an orderlytransition.Bankruptcy allows for rejection on the debtor’s timeline with little regard to the effects on the counterparty, but it can take 6 months to a year to re-procure a major outsourced function.If supplier elects to assume the agreement, the supplier is obligated to cure defaults and continue to perform under the agreement.The supplier could elect to assign the agreement to a third party. The customer could be forced to deal with a new supplier over its objection (e.g., where there are competitive or reputational concerns).


Contractual Protections

Negotiate aggressive termination for convenience provisions with concessional termination charges in the event of a material adverse change.Negotiate financial and/or performance guarantees from one or more affiliates of the supplier entity.Include source code escrow in software agreements.Take security interests in relevant collateral to the extent available.Insert targeted restrictions on assignment to help protect against undesired assignment.Negotiate provisions to limit debtor cherry-picking (e.g., keeping the remote monitoring, but not the on-site maintenance).

Pre-bankruptcy planning can help to reduce (although not eliminate) loss from rejection or non-consensual assignment:


Operational Preparedness

People: Assess flight risk; consider approaching supplier staff to discuss continuity plans (if contract allows this); assess immigration status for foreign workers.

IP and Data: Be sure you have a current list of supplier-controlled IP, documentation and datasets and know where the materials are stored, who controls their access, and what access rights your company has to them. Get backups or escrow critical items.

Carefully crafted agreements are not enough. If your supplier appears to be in trouble, here are some practical steps to protect your company’s assets and reduce operational risk:


Operational Preparedness, cont.

Computing Infrastructure: Obtain a current list of critical computing infrastructure (hardware, software, services, facilities) and know your rights to access and/or acquire them from the supplier.

Alternate Supplier: Identify fall-back supplier options and assess dependencies, particularly relating to staff transfer.

Management Assurances: Seek assurances from supplier management regarding ongoing investment and support. Ask supplier to facilitate direct discussions with critical personnel.


Upcoming Sessions

April 28 Changing the Paradigm: Accelerated Savings throughInnovative Pricing and Procurement Techniques

May 19 IT Outsourcing: Devising a Fast and Sustainable Diet

June 9 Renegotiations: Positioning for the Fast Path to Savings

June 30 Procurement & Real Estate Outsourcing: Short Term Strategy with Long Term Results

July 14 M&A – Business Continuity and Cost Effective Operations through Outsourcing

April 14 Finance & Accounting and Human Resources Outsourcing: Back Office on the Front Burner

Pillsbury Winthrop Shaw Pittman LLP

Avoiding Supplier Insolvency in a Shifting Marketplace

No Better Time for the Right Outsourcing Series

March 31, 2009

avoiding supplier insolvency in a shifting marketplace · should take steps to mitigate the risks...

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