Service Provider Bankruptcy | Article

How To Protect Your Company When Your Service Provider Goes Broke

outsourcing deal failsThere it is on the front page of the business section: One of your suppliers just filed for bankruptcy. Your phone rings off the hook. Your CEO asks, “What happens now?”

Do you have all the answers? Are you prepared for this moment? The practical reality is that when faced with your supplier’s bankruptcy, your rights and the obligations of your supplier change in a number of important – and to some, surprising – respects.

Suppliers’ Options

Once in bankruptcy, your supplier will have the right to assume your contract if the supplier finds it to be beneficial, or to reject it if the supplier finds it to be burdensome. Your supplier will have this right because your contract will be executory, meaning there are material ongoing performance obligations under the contract as of the bankruptcy filing.

Customers’ Limited Options

Under the U.S. Bankruptcy Code, if your supplier does not want to make a quick decision on assumption or rejection of the contract, it probably will be allowed to delay the decision until the end of the case, which can take anywhere from a few months to several years. During this time, you will be automatically prohibited from unilaterally terminating your contract or otherwise enforcing remedies under it. You will have to continue obtaining the outsourced services and paying the supplier under the terms of your contract. It will be difficult to persuade the bankruptcy court to require an accelerated decision on your contract. Obtaining court approval allowing you to terminate requires that you convince the court that the supplier is currently not performing and is likely to be unable to do so in the future. Even when your contract gives you the right to terminate at any time and without cause, many courts still require prior court approval before you can exercise that right.

Supplier Must Cure to Assume

A supplier that (eventually) assumes a contract must timely cure all defaults and perform the contract on a going forward basis. If the supplier had been in default prior to bankruptcy, you can insist on receiving “adequate assurance” of the supplier’s ability to perform. If the supplier breaches the contract after it is assumed, your claim against the supplier for your damages will have priority over pre-bankruptcy unsecured claims.

Supplier’s Right to Assume and Assign

Your supplier will also have the right to “assume and assign” your contract to another supplier. This has happened in a number of telecom bankruptcies (e.g., Exodus Communications) where the supplier sells its business as a going concern to an asset purchaser. The customer’s contract can be assigned to this new supplier – even if the contract prohibits assignment – as long as the defaults are cured and the supplier provides adequate assurance of its future performance.

Rejection and its Consequences

Your supplier has the right, with the court’s approval, to reject and terminate your contract if it determines that your contract is burdensome. This is most likely to arise where the supplier is required to make additional investments to provide its services, as compared to using its existing installed capacity representing sunk costs that cannot be avoided. Though rejection is treated as a contract breach, giving you a claim for damages, your claim will be unsecured and without priority, so any recovery you receive could be only a few cents on the dollar.

The rejection can occur with relatively little notice – 20 days or less. You will have no legal certainty that you will have sufficient time to secure a replacement supplier. Also, if the supplier rejects, you will not be entitled to enforce your contractual right to transition services. As a consequence, iIt is not uncommon for debtors to use the threat of rejection as leverage to renegotiate a contract.

Set-Off Rights

There may be self-help available to you if the supplier owes you money. While the automatic stay prohibits you from exercising your right of set-off (at least when the amounts are owed back and forth under separate contracts), you are entitled to put a temporary freeze on what you owe to the supplier to assure that you will receive full payment of amounts owed to you. You should investigate the existence of set-off rights immediately upon your supplier’s bankruptcy, so that your rights of set-off can be preserved.

An Ounce of Prevention

In our current economic environment, there are more financially challenged suppliers than in recent memory, including many of a scale not previously encountered. Understanding the risks you face with a supplier’s bankruptcy and implementing the appropriate protective measures can make the difference between being in control of your sourcing options – and being a victim of them.

While it is impossible to avoid the limitations you will face once your supplier is in bankruptcy, there are some contractual protections you can employ to help limit your exposure to a supplier bankruptcy. They include:

  • Obtain financial covenants and current financial information that will provide an early warning of deteriorating supplier financial health and permit you to act before a bankruptcy filing.
  • Obtain pre-bankruptcy and bankruptcy-proof rights and remedies, so as to limit your risk and exposure in the event of bankruptcy.
  • Limit your exposure to the extent possible in the event the supplier defaults under its arrangements with subcontractors and other third parties.
  • Retain ownership and control of software, equipment, data, deliverables and work in progress, as well as the right to continue using supplier-owned items that are critical to your business.
  • Prohibit the assignment of the contract or delegation of the supplier’s responsibilities without your approval, so that only you can assess the financial strength of prospective assignees.
  • Make sure that your supplier has the corresponding protections with respect to its subcontractors.

Lessons from the Outsourcing Journal:

  • If your supplier declares bankruptcy, you lose the right to terminate the agreement unilaterally, which will interfere with your ability to find another supplier, and your supplier can terminate the agreement on little notice without providing you any termination assistance.
  • Take precautions at the start of the relationship to limit your exposure. Then monitor the supplier’s financial health to take action before the bankruptcy filing.

Based in Chicago, attorney Paul J. N. Roy is a partner in the Information Technology and Outsourcing Practice of Mayer, Brown, Rowe & Maw, an international law firm headquartered in Chicago, Illinois with 13 offices in the United States and Europe. Paul regularly counsels clients on technology and outsourcing transactions. You can reach Paul at [email protected].

David S. Curry is a partner in the Bankruptcy Practice of Mayer, Brown, Rowe & Maw in Chicago and advises clients on bankruptcy, workouts and reorganizations. David can be reached at [email protected].


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