Outsourcing Contracts, Licenses and Bankruptcy Law

• Publication year: 2003
• Pages: 0001

Georgia Bar Journal Volume 9.

GSB Vol. 9, No. 3, Pg. 1. Outsourcing Contracts, Licenses and Bankruptcy Law

Georgia State Bar Journal
Vol. 9, No. 3, December 2003

"Outsourcing Contracts, Licenses and Bankruptcy Law"

By John C. Weitnauer

Outsourcing contracts - where one party (the "Customer") obtains services from a third party (the "Service Provider") - abound in today's economy. Customers outsource a vast array of services, from the mundane (i.e., cleaning services for an office building) to the "mission critical" (i.e., data processing)

With every outsourcing contract comes the hidden possibility that the Service Provider may seek bankruptcy protection from its creditors, or perhaps worse still, simply go out of business. This article discusses what can happen to outsourcing contracts, and to any license that may be a material part of that outsourcing contract, from the perspective of the Customer when the Service Provider files bankruptcy.1

HOW CAN YOU PROTECT YOURSELF IN ADVANCE AGAINST THE POSSIBILITY THAT YOUR SERVICE PROVIDER MAY GO OUT OF BUSINESS?

While it is impossible to provide an exhaustive list of the protective steps that are appropriate for outsourcing contracts without knowing the specifics of the outsourced services, one of counsel's roles should be to ensure that an appropriate amount of consideration is given to the Customer's likely predicament in the event the Service Provider shuts down

As an initial matter, the impact on the Customer if its Service Provider goes out of business is directly related to how "core" the services at issue are. While Customers typically devote substantial attention to what might happen if the service contract is terminated (i.e., the termination assistance provisions), less time is likely devoted to considering the possibility that the Service Provider may simply close its doors. If the services are critical to the Customer, it is unlikely that the Customer selected a Service Provider with a known financial weakness With any long-term contract, however, at least some attention should be given to the possibility that the financial circumstances of the Service Provider could deteriorate. In some cases, of course, the services are so important to the Customer that they should not be outsourced at all, due to this type of risk.

If the Customer will be using the software of the Service Provider, ownership2 of the software may be safer than a license; but if a license is all that can be negotiated, a license entitling the Customer to the Service Provider's source code (for use during maintenance of and upgrades to the software) is probably essential.

Further, in the event that the Service Provider's software creates or manipulates data important to the Customer, the Customer will want to have full copies of the relevant data communicated to its information systems as transactions occur, or have such data delivered on a periodic basis in a form that is accessible by the Customer's systems or commercially available software if and when needed.

WHAT HAPPENS AFTER YOUR SERVICE PROVIDER FILES BANKRUPTCY? Chapter 7 or Chapter 11?

A company may file for liquidation under Chapter 7 of the Bankruptcy Code, or reorganization under Chapter 11 of the Bankruptcy Code.3 If a Chapter 7 case is filed, a trustee is appointed to reduce the assets of the estate to money and to distribute those assets to the creditors in order of their priority.4 While the trustee has the power to operate a company in Chapter 7 for a brief period of time,5 it is extremely rare for a trustee to do so.

If a Chapter 11 case is filed, the company becomes a "debtor in possession" and attempts to continue its operations and confirms a plan of reorganization.6 The plan of reorganization is, among other things, a complicated and comprehensive new loan agreement with all of its creditors. Under a typical plan, general unsecured creditors are paid only pennies on the dollar, and the pre-bankruptcy shareholders lose most, if not all, of their stock to one or more classes of creditors. In some cases, the debtor has negotiated its plan with key creditors before filing bankruptcy, and files the bankruptcy case to bind all creditors, since, in bankruptcy, the consent of the requisite majority of creditors can bind all of the creditors. This type of plan is sometimes referred to as a "pre-packaged" plan. But while a plan addresses the losses suffered by creditors and shareholders, it may also address the concerns of parties that have contracts with the debtor.

Before Assumption or Rejection

Unless a pre-packaged plan is filed and quickly confirmed-a process that can take as little as a few weeks or months-the larger, typical Chapter 11 case lasts for many months, sometimes years. During that time, what happens to the outsourcing contract? As will be discussed below, the ultimate disposition of an executory contract in bankruptcy is its assumption or rejection. In the meantime, what happens?

Broadly speaking, the Customer is likely to have one of the following perspectives: (i) get me out of this thing; or (ii) if I keep paying, will the debtor keep performing?

Can the Customer Terminate the Contract?

If the Debtor is Not Otherwise in Default of the Contract

If the debtor is not otherwise in default, can the Customer terminate the contract because the Service Provider has filed bankruptcy? After all, the default provisions in almost every outsourcing contract typically clearly define the filing of a bankruptcy as an event of default. The short answer, however, is "No."

Section 365(e)(1) of the Bankruptcy Code protects the debtor's interest in an executory contract by providing that:

Notwithstanding a provision in an executory contract . . . or in applicable law, an executory contract . . . may not be terminated or modified, and any right or obligation under such contract . . . may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract . . . that is conditioned on -

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a [bankruptcy] case . . .; or

(C) the appointment of or taking possession by a trustee in a [bankruptcy] case . . . or a custodian before such commencement.7

Does it help the Customer if the contract contains the right to terminate for convenience? Probably not. Courts have invalidated "termination at will" or "termination for convenience" clauses as unenforceable ipso facto defaults. However, if the Customer can point to a valid, reasonable basis for its decision to terminate the contract (even if the only contractual right would be "for convenience"), the termination might be recognized as valid and permit the Customer to extricate itself from the relationship reasonably quickly.

If the Debtor Is in Default Of the Contract But Notice of Termination Has Not Yet Been Given

If the debtor is in performance default, can the Customer terminate the contract pursuant to express provisions regarding termination for such default (typically after notice and opportunity to cure), even though the Service Provider has filed bankruptcy? Again, the short answer is "No," at least not without court approval.

The Service Provider will have the protection of the automatic stay, which protects the debtor until such time as the court grants relief to the other party.8 While most non-bankruptcy lawyers have at least a passing awareness of the automatic stay, it is usually understood only in its primary application - that, so long as the stay is in place creditors cannot take any steps to collect their pre-petition debts from the debtor without court approval. However, the reach of the automatic stay is much broader; it prevents a non-debtor party from attempting to terminate the debtor's rights in an executory contract. All hope is not lost, however. If the defaults are serious enough (i.e., performance defaults), a court may be persuaded to end the "breathing spell" provided by the bankruptcy filing so that...