Bankruptcy in Outsourcing

Posted October 9, 2009 by   · Print This Post Print This Post

Overview.

The possibility of a bankruptcy is a legal risk that affects customers, service providers and their respective employees and their respective supply chains including subcontractors and indirect customers. Bankruptcy rules have a special bite in a normal outsourcing, since outsourcing does not necessarily involve a sale of goods by a vendor. Accordingly, special attention is needed for intellectual property and continuity of services. An understanding of the general rules of U.S. bankruptcy can help focus on solutions, both pre-petition and post-petition.

Customers and Suppliers affected by Bankruptcy.

Bankruptcy of your customer, or one of your direct or indirect suppliers, could deprive you not only of cash flow, but also of amounts already collected. It could also impose duties of a “custodian” to protect and preserve the bankrupt’s assets in your custody, assuming the bankrupt has a positive net worth (i.e., is not insolvent).

Key Issues in Bankrutpcy that Affect Outsourcing.

What should parties to an outsourcing know about bankruptcy before they sign a contract? For starters, you should understand not only the core concepts of a new “entity,” assignment and assumption (or rejection) of executory contracts, the automatic stay, the avoidance of preference payments made within the 90-day period (or, for insiders, one year) prior the filing of the bankruptcy petition, the avoidance of fraudulent transfers, priorities among creditors and the legal consequences of the filing of the bankruptcy petition as it relates to an intellectual property, the bankrupt debtor’s assets held by others and the payment streams to providers of goods and services.

Lost Deals.

Beyond the technicalities, bankruptcy may deprive both the customer and the services provider of the benefits of the bargain they crafted so carefully. To some extent, the parties can negotiate measures to limit the damage. But, once a party is in bankruptcy, exit strategies become less predictable.

Timing: The Beginning.

Bankruptcy occurs when a petition for bankruptcy is filed relating to an insolvent “debtor.” Rights and obligations are defined in relation to the date of the petition. Time is measured as “pre-petition” or “post-petition.”

Debtor; Trustee; Debtor-in-Possession.

Chapter 11 of the Bankruptcy Code specifies the processes and rules for reorganization of a bankrupt, which is referred to as the “debtor.” If the federal Bankruptcy Court fails to appoint a trustee to manage the debtor’s estate, then the debtor may do so as “debtor-in-possession.” A trustee is not appointed in the absence of some “good cause” to do so.

Immediate Effects of the Petition.

By filing a petition, a bankrupt debtor can freeze trade credit existing at the petition date. This is potentially advantageous in the short run but potentially ruinous for the long run as suppliers respond by insisting on a “cash-and-carry” payment schedule.

Executory Contracts.

Bankruptcy can result in the undoing of executory contracts for future performance. The right of the debtor-in-possession to reject such contracts is a principal tool for restructuring and reorganizing the capital structure of the debtor. But the debtor cannot prevent the other party from termination of the contract for actual breach. For services providers, therefore, it is essential to manage credit risks.

This chapter refers to some of the normal operations in a bankruptcy. Since each situation is different, we remain available for consultation on planning pre-petition and strategies post-petition.

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