It is difficult, even now, for prospective customers not to be sorely tempted by the revolutionary products, innovative services and attractive pricing of the new economy providers. However, in the wake of the recent economic downturn, many fear the dangers associated with contracting with them. The marketplace is littered with the remains of failed or crippled ventures that once boasted market caps rivaling even the largest brick and mortar companies. Moreover, with new funding increasingly difficult to find, even the surviving entities often face an uncertain future.
During these unsettling times, it is not necessary to shun the product and service offerings of new economy providers. Nor is it advisable to close your eyes and proceed blindly without regard to the inherent risks. Those contracting with the financially challenged survivors of the new economy must proceed carefully with a clear understanding of the attendant risks.
The dangers associated with contracting with financially strapped providers are obvious - unanticipated performance delays and failures; the sudden loss of critical products and services; the inability to meet your own end user commitments; nagging subcontractor liens and disputes; and the nightmare of supplier insolvency or bankruptcy. Indeed, you may wake up one day to learn that a bankruptcy judge or trustee is now acting as your project manager.
However, you don't have to throw up your hands and run screaming from the new economy providers. While you cannot eliminate all risks, you can reduce or manage such risks by:
- Selecting the provider only after conducting detailed due diligence;
- Negotiating a strong, yet flexible, contract, offering necessary rights, remedies and protections; and
- Following contract execution, actively managing supplier compliance and performance.
Rigorous Supplier Selection Criteria and Due Diligence
In selecting a service provider, it is definitely true that an ounce of prevention is better than a pound of cure! To this end, we urge you to:
- Establish rigorous supplier selection criteria.
- Use the Request for Proposal (RFP) process as a tool to weed out unsuitable candidates early in the process to conserve capital and other resources.
- Conduct detailed financial, technical and operational due diligence before final selection.
Before selecting a supplier, you must satisfy yourself that it has, and will continue to have, sufficient financial resources not only to survive, but also to meet its contractual obligations in the desired time frame. To this end, you should demand both the audited and unaudited financial statements of each prospective provider. If the provider is publicly traded, you also should examine the provider's SEC and other public filings. In addition, you should demand detailed financial information regarding each supplier, including its current and projected cash position, credit history, capital structure, anticipated funding requirements and sources of future funding.
Finally, if appropriate, you may want to speak directly with the provider's bankers and principal investors. Remember, much of the requested information can and should be verified through independent sources, including computer searches of credit, news, industry and other Web-based sources.
You also must satisfy yourself that your prospective supplier can deliver the promised products and services. In addition to detailed technical due diligence, you should demand detailed information regarding:
- The provider's existing customers and their relative satisfaction with its performance.
- The supplier's related industry experience.
- The skills and capabilities of the provider's workforce.
- The identity and professional reputation of its subcontractors and business partners.
- The supplier's intellectual property rights in its technology, software, systems and/or networks.
You also should interview at least some of the provider's customers as well as the key employees to be assigned to you.
Negotiating Contractual Protections
In negotiating with the financially challenged survivors of the new economy, the following objectives are particularly important:
- Obtaining current financial information that will provide an early warning of deteriorating supplier financial health and permit you to act before a bankruptcy filing.
- Arming yourself with pre-bankruptcy and bankruptcy-proof rights and remedies, so as to limit your risk and exposure in the event of bankruptcy.
- Limiting your exposure to the extent possible in the event the provider defaults under its arrangements with subcontractors and other third parties.
- Retaining ownership and control of software, equipment, data, deliverables and work in progress, as well as the right to continue using provider-owned items that are critical to your business.
- Prohibiting the assignment of the contract or delegation of the provider's responsibilities without your approval.
Here are a few of the types of protections that the well-negotiated and structured contract should contain:
- Protection against a supplier's financial instability. The key here is to obtain as much advance notice as possible of a provider's deteriorating financial condition. This will permit you to act prior to bankruptcy or supplier collapse, while you still have options. This is achieved by making sure that the contract:
- Requires the provider to provide financial reports on at least a quarterly basis (yes, just as if you were a bank lender).
- Contains various representations and covenants regarding the provider's financial condition.
- Obligates the provider to provide notice of a material change in its financial condition.
- Imposes on the provider the obligation to post a performance bond following signs of deteriorating financial health.
- Milestones for supplier compliance. Define the provider's contractual obligations with as much precision as possible. For example, document the specifications for each contract deliverable, the dates by which each implementation activity and/or deliverable will be completed, and the service levels and other performance metrics to be met by the provider. To the extent possible, tie the supplier's compensation to the achievement of defined milestones and link financial penalties, termination or other consequences to failure to meet defined dates or service levels.
While this is advisable in all contracts, it is particularly important in these circumstances. You should view every performance failure or delay as possible evidence of financial trouble and should respond accordingly.
- Right to terminate. Insist upon generous termination rights, including the right to terminate prior to bankruptcy based on deteriorating financial condition or inability to pay debts when due. Remember that once a provider files a petition for bankruptcy, you cannot take action against the provider and instead must navigate the arcane world of the bankruptcy courts to obtain a divorce from the provider. Also insist upon the right to terminate based upon:
- A degradation or delay in performance.
- The filing of liens by subcontractors or suppliers.
- Excessive turnover, especially among key supplier personnel, and/or
- A cross-default under a related contract.
Remember to provide for termination assistance services to facilitate your migration to another supplier.
- Rights to customer and supplier owned property. Clearly define your ownership and other rights with respect to software, equipment, data, contract deliverables and work in progress and provide for the immediate delivery of such items to you upon bankruptcy, insolvency, or termination. In addition, clearly define your right to continue using provider owned or supplied items that are critical to your business.
- Liens. Avoid the placement of liens on your property by subcontractors or suppliers claiming to be owed money. To the extent permitted under applicable state law, your contract should:
- Require the provider to immediately discharge the lien or post a payment bond in the amount of the lien.
- Require the waiver of lien rights by the provider's subcontractor and suppliers.
- Include the right to seize equipment and/or other provider property in the event of a lien.
- Require the provider to deliver prescribed notices to subcontractors and suppliers.
- Require the provider to execute any other legal documents necessary to protect or enforce your rights (e.g., recording the contract).
- Include any other rights, remedies or protections available under applicable state law.
- Advance planning for bankruptcy/technology licenses. U.S. bankruptcy laws offer special protection for licensed technology. The contract should therefore be structured to qualify for special treatment under the U. S. Bankruptcy Code. To this end, the contract should:
- Grant a perpetual license that will survive termination of the underlying contract for bankruptcy or other reasons.
- Grant immediate license rights (i.e., avoid rights that spring to life after a bankruptcy filing).
- Create an executory contract, with on-going obligations for both parties (i.e., an ongoing obligation to pay periodic license fees, rather than a single, upfront license payment).
- Split payments for license rights, which will survive bankruptcy, and maintenance/support services, which may be terminated by the bankruptcy trustee.
In addition, the contract should require the provider to deposit source code and technical documentation into escrow, provide for the prompt release of such materials in defined circumstances, such as insolvency or bankruptcy, and permit you or your designee to use such source code and documentation as and to the extent necessary.
- Supplier's right to subcontract or assign. Financially troubled providers sometimes enter into desperate and ill-advised business combinations and arrangements, which may include selling your contract or subcontracting their contractual responsibilities. While recognizing that certain combinations and arrangements may be in your interests, it is important to retain control of the selection of your business partners. Accordingly, the contract should prohibit the assignment of the contract or subcontracting of material responsibilities without your approval.
- Insurance. The contract should require the supplier to carry certain types of insurance to cover business related risks, with the minimum amounts of coverage spelled out in the contract. The insurance policies should name you as a loss payee or additional insured and should permit you to collect directly for losses incurred.
Actively Managing the Supplier Relationship
Having carefully selected the provider and negotiated a tough and protective contract, you must be prepared to actively manage an often dynamic contractual relationship. Here are just some of the keys to managing new economy companies:
- Actively monitor contract compliance and supplier performance.
- Strictly enforce specifications, deadlines and performance metrics.
- View every misstep as possible evidence of financial trouble.
- Closely review required financial and other reports.
- Perform periodic independent due diligence regarding the provider's financial health.
- Be a "squeaky wheel" if the provider is not meeting its contractual obligations.
- Be prepared to terminate prior to a bankruptcy filing if appropriate.
- Develop a contingency plan and identify alternative providers.
- Develop a plan to assist disrupted end users and migrate to a new supplier.
- Retain the right to hire critical supplier employees, at least in defined circumstances.
In these uncertain times, it is not possible to eliminate all of the risks of dealing with the financially challenged survivors of the new economy. If you are unable to live with the very real possibility that your provider may experience financial difficulties, you should probably look elsewhere for products and services. However, if you want to avail yourself of the attractive products and services offered by such providers, you can manage and reduce your risks by following the steps described above.
Daniel Masur is a partner in the Information Technology and Outsourcing Practice at Mayer, Brown & Platt in Washington, D. C. Prior to joining the firm, Dan served as Vice President and General Counsel of I-NET, Inc., a provider of information technology and telecommunications services, including outsourcing services. His email address is: [email protected].
Sonia Baldia assisted in the preparation of this article.