Article New York Law Journal

Plans May Go Awry If Providers Enter Bankruptcy

Software and other information technology that was provided by license in the past is frequently provided through service arrangements today. Technology providers are increasingly meeting the needs of their clients through application service provider (ASP), outsourcing and hosting arrangements. However, the consequent dependence these clients develop upon their outside service providers can become problematic if the outside service provider declares bankruptcy.

While intellectual property licensees can take advantage of 365(n) of the Bankruptcy Code, which allows continued use of certain types of in-licensed intellectual property, no such protection exists for clients that are a party to a service agreement. Because of this, careful planning at the outset of a service arrangement is crucial to achieving smooth continuation of services in the event of a service provider bankruptcy. Which specific measures are appropriate will vary from transaction to transaction, depending on the economic value of the transaction and the degree to which the services provided are mission-critical to the client.

Upon declaration of bankruptcy, a debtor is authorized, subject to bankruptcy court approval, to assume or reject most executory contracts and unexpired leases. An executory contract is generally defined as a contract under which material performance is still pending from both parties. Almost all technology service agreements would likely be classified as executory contracts.

In the event that a debtor rejects an executory contract or unexpired lease, the other party's damages from rejection are a pre-petition, unsecured claim (and are likely to be worth, at best, cents on the dollar). Moreover, subject to certain exceptions that are discussed below, the debtor generally has the power to assign executory contracts and unexpired leases despite provisions in such contracts or leases that attempt to restrict assignment.

Access to Services
Steps taken at the outset of a relationship with a technology service provider may have a substantial effect on the client's ability to maintain continued access to the services if the service provider declares bankruptcy. Yet, even after a relationship is well-established, steps can be taken to minimize the disruption caused by rejection of a service contract. The goals of a client obtaining services from an outside service provider are likely to include: (i) obtaining continued services at consistent service levels from the original provider and being able to terminate the agreement if such levels are not met; (ii) preventing assignment of the agreement to a competitor or other party unacceptable to the client; and (iii) transitioning to another service provider (or enabling the services to be provided in-house) if service levels are not maintained. Set out below are a number of strategies designed to help achieve these goals.

Material Breach
The key focus of a client in a service agreement should be the type and quality of services being provided. In this sense, the declaration of bankruptcy by a service provider is immaterial if the provider does not reject the service agreement and continues to meet its obligations thereunder. In addition, there may be a substantial period of time following commencement of a bankruptcy case before the service provider accepts or rejects the agreement. During this period the client may be expected to continue to make payments even if the service provider has been performing inadequately (although the client could seek to have the court compel acceptance or rejection). For these reasons, service agreements should set out very detailed service levels and specify that the failure to meet the relevant service levels constitutes a material breach that allows the client to terminate the agreement.

Frequently an agreement will provide for the accumulation of "failure points" that result in reductions in payments made by the client to the service provider; if enough failure points are accumulated, the client has the option to terminate the agreement. These provisions should reference the liquidated damages and transition assistance provisions (discussed below). In addition, the service provider should be required to provide assistance, if and when necessary, in transferring its service obligations to another service provider. While this provision may be of little value where a service provider rejects the service agreement in bankruptcy, it may have value prior to assumption or rejection of the agreement and where the service provider assumes the agreement but then fails to maintain the requisite service levels. It should be noted that even if the language of the agreement gives the client the right to terminate, it may still be necessary to petition the bankruptcy court to allow such termination.

Liquidated Damages
One method of attempting to prevent rejection of a service agreement is to include in the agreement a liquidated damages clause. Such a clause may serve to discourage a debtor from rejecting the contract by creating a definite claim in the event of rejection. Because the liquidated damages clause will only create a pre-petition claim for damages, it will have substantially more value if coupled with a security interest in a meaningful set of the service provider's assets (such as those directly related to performing the services). It should be noted that a liquidated damages clause needs to be carefully drafted to minimize the likelihood of unenforceability. This clause will also give some measure of damages if the agreement is terminated for material breach.

While the right to terminate for breach of service levels is an important provision in a bankruptcy or other financial distress scenario, it may be difficult and time-consuming to prove a breach. A better alternative for the client may be the right to terminate for convenience, perhaps coupled with a termination payment to the service provider. So long as this provision is not predicated on the bankruptcy, insolvency or financial condition of the service provider, the parties have wide scope to create provisions that maximize the client's flexibility while maintaining business feasibility for the service provider.

As with material breach, a transition assistance provision should be included, and it may be necessary to petition the bankruptcy court to allow the client to exercise such termination right.

Preventing Assignment
Preventing the service agreement from being assigned in bankruptcy to a competitor of the client or other unacceptable party may prove difficult. Because bankruptcy law will trump an anti-assignment provision in the agreement, the client has few options available. The best option usually is to have general termination rights, as discussed above. If these are secured, the client may terminate the service agreement upon any assignment to an unacceptable party. Without this provision, however, the client would have to structure the agreement as a type of agreement that, under the bankruptcy code, cannot be assigned without consent - agreements where applicable non-bankruptcy law prevents assignment of the contract.

The most frequently cited example of a type of agreement that is not assignable under "applicable non-bankruptcy law" is the personal services contract. Because state law determines what qualifies as a personal services contract, there will be variations by jurisdiction, but a frequent definition is a contract predicated on a relationship of personal trust and confidence.

While technology service agreements do not readily fall under this definition, service providers frequently market their services based upon their experience and expertise. As such, a service agreement could reference the special skills and experience of the service provider and expressly state that it is based upon the client's trust and confidence in, and the judgment of, that particular service provider. If particular employees are important to the project, they can be named in the agreement as well. While it has not yet been established whether or not a bankruptcy court would find this type of agreement to be a personal services contract, the addition of this language may serve to bolster the client's arguments in a bankruptcy proceeding.

Bankruptcy courts have also held that nonexclusive licenses of patents and copyrights are not assignable in bankruptcy by licensees, because assignment of these licenses is restricted by federal patent and copyright law. Therefore, if a service provider utilizes any patents or copyrighted material of the client in the course of providing the services (e.g., by hosting copyrighted materials on a client Web server), the client may wish to incorporate an express license to the relevant patents or copyrights in order to strengthen arguments that the agreements cannot be assigned by the service provider if and when it enters bankruptcy. Although the law is still uncertain with respect to whether a trademark license can be assigned by a licensee in bankruptcy, if the service provider uses a client's trademarks, the service agreement should include a trademark license as well.

Second Sourcing
Determining What You Need. In order to determine how best to maintain a consistent level of service, the most important prerequisite is to determine what services, software, data, equipment and personnel the client would need to replicate the services in the absence of the service provider. The main question is: If the service provider stops providing the services, what would the client need to provide the services itself or through a third party? The answer to this question will inform the structuring of the transaction.

Software. With respect to software, two provisions can help to ensure the client continued access. First, all software and other intellectual property of the service provider that is necessary to duplicate the services should be licensed to the client at the time the services agreement is executed, if possible from a business and economic perspective.

The license should be structured as a present grant of license, with an agreement by the client not to exercise its rights under the license until a breach of the service agreement by the service provider. This license should expressly state that it is a license of "intellectual property" pursuant to 365(n) of the U.S. Bankruptcy Code.

The license should be structured as a separate contract from the service agreement to weaken any argument claiming that the service fees under the service agreement are in fact royalty payments. Since a licensee electing to maintain its rights to licensed intellectual property pursuant to 365(n) is required to continue making royalty payments, it is useful to clearly distinguish the royalty payments from the service fees. Second, the source code, documentation, programmer notes and any other materials necessary for the client to use, maintain and support the software should be escrowed at regular intervals. The escrow agreement should state that it is supplemental to the intellectual property license.

Service agreements generally involve the provision of services using hardware owned and maintained by the service provider. If the service provider enters bankruptcy, however, the client may need time to obtain similar hardware on its own. To mitigate problems in obtaining such hardware, the client should determine what hardware is necessary to duplicate the out-sourced services prior to entering into the service relationship. The client should then ensure that, as a practical matter, replacement hardware is either available within its organization (for example, by being able to host the services on servers used for other, non-critical services) or can be quickly secured from an outside source.

If the hardware used is more specialized, the client's practical options may be limited because it may not be cost effective to keep a back-up supply of specialized hardware in-house, and alternative external sources of such hardware may be limited or may involve long implementation periods. In such situations, it may be necessary for the client to bargain for a security interest in the specialized hardware used by the service provider. If this type of security agreement is obtained, it is necessary to expressly state that the client can make use of the secured property prior to its disposition. In any case, the client should have contingency plans in place to minimize the disruption caused by a lack of access to the necessary hardware.

Space. The client should also ensure that it has access to the physical space necessary to maintain the services that it needs. Some types of equipment require specialized space, including heightened standards for security, heating and cooling, and connectivity. Space issues should be considered together with hardware issues with the ultimate goal being the client having the tools and resources necessary to maintain access to the services it needs as well as a place to keep essential hardware. Obviously, the extent these considerations come into play will vary greatly between different types of transactions.

Personnel. Having access to personnel who can support the technology services can be important if the client seeks to reproduce the services. If possible, the client should avoid agreeing to non-solicitation clauses in the service agreement so it can, if necessary, attempt to acquire key personnel of the service provider. If a non-solicitation clause must be included, it should terminate if and when the agreement is terminated prior to the expiration of the full term. In addition, it is advisable for the provision to state that in the event the client does hire an employee in breach of the non-solicitation clause, the service provider's remedies are limited to monetary damages.

A slightly different approach would be to ensure that individuals within the client entity have the necessary training to maintain the services during any transition. In order to achieve this, however, it may be necessary to require the service provider to hold training sessions for a limited number of employees of the client and to escrow or provide copies of the necessary systems documentation to the client. While the service provider may not be able to train employees of the client to the same level of expertise and skill as the employees of the service provider, the training may be sufficient to allow the client to be able to maintain the technology services during a transition period.

Data. Finally, the client must ensure that it does not lose its valuable electronic data if its service provider declares bankruptcy. This is usually accomplished by requiring the service provider to send copies of all important data to the client. Such transfers should occur as frequently as possible in order to minimize the amount of data that is not in the client's direct possession.

Bankruptcy Remote Entity. A final option to consider is the use of a bankruptcy remote holding company to attempt to insulate the service relationship from a service provider bankruptcy. By way of general overview, a new bankruptcy remote entity would be created to provide the technology services and the capital of this entity structured to prevent it from declaring bankruptcy without the consent of the client.

The client would own some portion of the capital of the bankruptcy remote entity, although substantially all the economic value would remain with the service provider. The assets necessary for performing the services would then be transferred to this new entity and the service agreement entered into between the client and new entity. Interposing a bankruptcy remote entity adds a layer of complexity to the transaction and may not be appropriate in many situations. Nonetheless, the economics of the transaction would remain unchanged for both parties and, especially where the services are mission-critical to the client, the bankruptcy remote entity may provide extra security.

Structuring a service agreement to attempt to mitigate the effects of a service provider bankruptcy requires significant planning and forethought. Where loss of the services would seriously affect the client's operations, it can be well worth the effort.

Michael B. Flaschen is an associate and Stephen Johnson a partner at Kirkland & Ellis in New York.

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This article is reprinted with permission from the December 3, 2001 edition of New York Law Journal. c 2001 NLP IP Company