Case Study: Farmland Industries Inc.

October 16, 2009 by

Farmland Industries Inc., a federation of 1,700 rural farm cooperatives that is the largest farm cooperative in the United States, filed for bankruptcy protection on May 31, 2002, after reportedly rejecting an offer by Smithfield Foods Inc. for acquisition of Farmland’s meat business. The meat business is operated as a joint venture with U.S. Premium Beef Ltd., which has the right of first refusal.

In the 1990’s, Farmland Industries re-directed its capital and took on considerable debt to become a larger processor of farm commodities. The subsequent declines in crop prices resulted in a loss of $90 million for the fiscal year reportedly ended August 31, 2001, with additional losses of $46 million for the half year ended February 28, 2002. Investors in Farmland’s subordinated bonds reportedly aggravated the liquidity crisis by redeeming the cooperative’s bonds in droves. This story offers an example to vendors of the impact of massive changes in a customer’s business environment, as well as the inflexibility a customer faces when it has committed to joint ventures.
This bankruptcy could be bad news for Ernst & Young LLP (or its successor Cap Gemini Ernst & Young). In April 1997, E&Y and Farmland formed OneSystem Group LLC (OSG) as an IT joint venture to provide IT outsourcing and business process outsourcing services to Farmland Industries and the Farmland Cooperative System, the largest farmer-owned cooperative in North America. The joint-venture relationship reportedly introduced results-based metrics and gain-sharing through the establishment of unique payment methods for services funded by realized business savings.

In a bankruptcy, executory contracts may be terminated. In a joint venture where one of the parties is bankrupt, the bankrupt joint venturer may terminate future obligations to provide funding and services, but it still owns the joint venture interest.

Reciprocal Outsourcing by EDS and WorldCom, Inc.

October 16, 2009 by

In July 2002, the EDS share price was rocked by the sudden decline and subsequent bankruptcy filing of WorldCom, Inc., a telecom services company. In October 1999, EDS had entered into a reciprocal deal with WorldCom, where EDS was providing IT services and EDS agreed to act as a reseller for WorldCom. The total of both deals was to exceed $12 billion over an 11 year period.

What caused EDS to suffer in 2002? Did the deal terms adequately protect it? Is this a “failed deal”?

The EDS-WorldCom Agreements.

As of July 2002, the entire relationship consisted of essentially three contracts, two of which are essentially reciprocal agreements for different types of services.

1. IT Services Agreements:
EDS provides IT services to WorldCom, the majority of which are provided under an 11-year, $6.4 billion agreement signed in October 1999. Other IT services agreements exist, but the October 1999 agreement covers the majority of IT services.

2. Network Services Agreement:
WorldCom provides telecom network services to EDS under an 11-year, $6.0 billion agreement signed in October 1999. Outsourced functions include network operations, management and engineering.

3. Fiber Optic Equipment Leveraged Lease:
EDS invested an unrecovered $40 million (approximately) in a 1988 fiber optic leveraged lease agreement with a predecessor to WorldCom.

Key Terms of the EDS-WorldCom Agreements.

1. IT Services Agreements:
EDS announced in July 2002 that the 1999 IT services agreements are for 11 years. The ITS services agreements appear to provide customary fee-for-service obligations.

2. Network Services Agreement:
WorldCom provides telecom network services to EDS under an 11-year, $6.0 billion agreement signed in October 1999. Unlike the normal fee-for-service obligations, this agreement contained “take-or-pay” payment obligations requiring EDS to pay for telecom network services even if it did not use the full capacity. According to a press release by EDS on July 1, 2002:

There are two components of EDS’ annual revenue commitment to WorldCom:

a. A cumulative take-or-pay revenue threshold of $400 million per year that increases during the terms.

b. A higher cumulative threshold of $600 million per year, which includes the previously mentioned $400 million threshold.

In the event that EDS fails to meet the higher annual threshold, EDS would be obligated to pay WorldCom 20% of the difference between EDS’s actual spending and the higher threshold. Thus, for variable consumption of network services below the top threshold, EDS would pay 20% of the shortfall.

EDS is also obligated to pay 100% of any shortfall below the $400 million take-or-pay threshold. Thus, for variable consumption of network services below the bottom threshold, EDS would pay 100% of the shortfall.

Under these terms, EDS guarantees payment of at least $400 million annually, whether or not EDS’s actual needs required the services. EDS assumed the risk of its own planning and forecasting for its demand for the outsourced services. If the usage meets the $400 million annual minimum, then EDS’s amount at risk declines from 100% to 20% of the shortfall to the next threshold. In essence, EDS committed to pay at least $400 million plus 20% of ($600 million less $400 million), or $40 million, or a total of $440 million per year.

Common Elements of Each Reciprocal Outsourcing Deal.

1. Duration.
Each reciprocal outsourcing deal was for the same term, consisting of 10 years plus one start-up year.

2. Transfer of Employees.
In 1999, because EDS assumed responsibility for IT system operations at more than a dozen MCI WorldCom processing centers worldwide, EDS agreed to hire approximately 1,300 MCI WorldCom employees. To support WorldCom’s provision of “select functions” of EDS’s global network services to EDS, WorldCom agreed in 1999 to hire approximately 1,000 employees of EDS.

3. Transition Plan.
Each agreement required a one-year transition plan. The transfer of employees, for example, was not to be complete until after the initial year.

4. Limited Scope.
Each company outsourced only a limited number of functions. This was not a total outsourcing creating a massive dependency, but one with substantial scope and limited dependencies.

5. Inflation Adjustment.
The announced terms of the IT services agreement did not discuss inflation. However, the network services agreement expressly included an inflation adjustment.

Critique.

1. Design of a Reciprocal Outsourcing.
The key to successful reciprocal agreements lies in reciprocity and mutuality of obligations, benefits, timing and risk assumption. The deals undoubtedly followed this model, but there is no showing of a right of EDS to terminate one agreement for a default by WorldCom in the other. The wind-down issues and other rush management strategies have not been detailed. Thus, the public disclosures that we have seen do not address concerns of investors and clients about the inability of one party to perform its obligations due to a sudden decline in its financial condition (such as the restatement of earnings by WorldCom of $3.8 billion in July 2002).

2. Outcome of WorldCom’s Financial Difficulties.
WorldCom’s bankruptcy in July 2002 is the biggest bankruptcy in U.S. history. But the total collapse and liquidation of a $107 billion company is not certain in light of its 20 million long-distance (MCI) users. EDS did offer, as part of its business continuity planning, to assist customers in finding other telecom suppliers, but that may be impossible given the size of WorldCom’s market share in certain key markets. Accordingly, the reorganization under bankruptcy could conceivably result in a leaner, more competitive WorldCom, free of certain past debt load, with better pricing for EDS and its customers.

3. Is this a Failed Deal?
This strategic relationship may be a “failed deal” because there is a significant loss. But the benefits may outweigh the loss.

In 1999, there was no way to predict that WorldCom would fall into bankruptcy in 2002. While EDS might suffer a loss of pre-petition receivables from WorldCom (estimated at approximately $150 million as of June 30, 2002) and unbilled revenue of about 40% of that amount (for another $60 million), a $210 million loss might not be a bad price to pay for the substantial benefits of a deal that has generated several hundred million dollars and continues to generate approximately $160-175 million per quarter in 2002.

UPDATE December 2002:

Bankruptcy: EDS pays off its Customer WorldCom.
EDS agreed to pay $187 million to WorldCom in Chapter 11 extended over a year, with the bulk being paid in four months. In return, WorldCom agreed to pay $15 million to EDS for reimbursement of expenses paid to local telephone companies. But is this a bankruptcy law problem? Yes and no. EDS and WorldCom entered into reciprocal outsourcing service contracts, for IT services from EDS and telecom network services from EDS. The two 1999 deals had minimum cross-purchase terms. So ends a chapter in quantifying EDS’s loss on a bankrupt customer.

C&W US Clients Face Uncertain Future

October 9, 2009 by

By Ed Agar, primesourcingadvisors.com

October 27, 2003 – The drama surrounding Cable and Wireless’ US hosting business remains an unresolved story for its approximately 1,500 clients. Since declaring its intention to exit the U.S. market in early summer, C&W has yet to deliver a clear update with regard to its business direction. C&W seems to be avoiding the inevitable.

Fundamentally, C&W was viewed to have two alternatives: sell the assets and existing contracts to an interested suitor, or declare bankruptcy. Andrew Schroepfer, founder and President of IT Infrastructure research firm Tier 1 Research (tier1research.com), says there may be a third hybrid option on the table. “We believe there is a buyer at the table for some of the marginally profitable data centers and the customer base where C&W would pay the costs to close down some of the other sites. Such an option would save C&W from the bankruptcy issues and save it several hundred millions of dollars from the option to pay to merely close the entire business.”

Most customers of the firm appear to have remained loyal thus far, which confuses Danny E. Stroud, former CEO of managed hosting firm AppliedTheory. “I don’t understand why CIOs, COOs and in-house counsel are not heads-down working on alternative service strategies – why executives are subjecting their valuable IT assets to significant risk exposure is irrational,” he says. “Since the financial shakedown of the last couple of years, there are now many quality providers. Further, with the availability of hosting vendor rankings like the PrimeSourcing Index there is a multitude of data to help buyers make informed decisions.”

The ‘wait and see’ attitude of C&W customers may be attributed to two factors: 1) customers have remained loyal due to renegotiated flexible terms and distressed pricing offers, and 2) transition efforts to a new provider are time consuming, costly, and rife with execution risks for resource-strapped IT departments.

Outsourcing lawyer Bill Bierce of Bierce&Kenerson PC and publisher of outsourcing-law.com (outsourcing-law.com), thinks current customer indifference is a highly risky approach. He recommends that CIOs review their agreements for termination and transition rights in case of bankruptcy. Should C&W opt for bankruptcy and the sheriff padlock the front doors, customers may be facing some nasty surprises:

  • Assets could be locked down, forcing customers to petition the court to move their assets out. It would be expected that IT assets would be frozen a period from several days to several weeks, which is longer than the period of the typical disaster recovery service contingency plan.
  • Bankruptcy could deprive C&W of the flexibility to service its customers in compliance with service level agreements. For managed services, the bankruptcy courts have the right to terminate executory contracts and not pay damages for wrongful termination.
  • Customers may need to get a license to continue to use software licensed by C&W. The US Bankruptcy Code allows the bankrupt service provider to terminate a service but does not require it to allow the user to get access to any software that was used in providing the service.
  • Where a bankrupt managed service provider abuses its credit lines with its own suppliers, paying customers have no assurances that funds will flow downstream to subcontracted suppliers or even if subcontractors will be retained by the bankruptcy courts. As the cash cycle stops, the services may stop, too.

How C&W will respond to its obligations will be played out in the coming months. The experience of Exdous, Intel Online Services, WiTel, MFN, PSInet, Genuity, Northpoint, Rhythms, Network Plus, Winstar and others exiting the data center market has been mixed. In some situations, there have been documented examples of looting, destruction of property, stranded customers, and total withdrawal of services accompanying a dark data center. “Some customers were forced to take extraordinary steps under duress to insure service continuity, while other customers sustained revenue loss and productivity hits,” Stroud says. “Further, costs and performance degradation during a hasty transition to a new provider are generally significant.”

Stan Lepeak, VP of Meta Group Inc. (metagroup.com), a research firm, says the best hope for customers “is a prepackaged bankruptcy that allows the customer relationship to be bought by a ‘white knight’ with the court’s blessing. This process allows the shedding of liabilities.” There must be reasons why suitors have not already grabbed C&W’s US assets for pennies on the dollar. In simple terms, this would seem to indicate the business does not appear to be salvageable and that a clean buyout seems unlikely.

Given the above scenarios, it is recommended that prudent executives start to invoke contingency plans. According to Schroepfer, “aside from acknowledging that avoiding a migration is a good thing, we would move our own operations out of C&W if we were there.”

It is recommended that exit strategies be planned with the assistance of independent hosting consultants and specialized attorneys. Such trusted advisors are needed to understand the ramifications of outsourcing contracts. A critical element that hosting advisors are now assessing in selecting new providers is the vendors’ implementation of quality initiatives like ISO 9001, IT Service Management or Carnegie Mellon’s e-Sourcing Capability Model.

As a next step, Global 2000 firms should identify their degree of risk exposure to their internal audit committees in order to determine applicability for disclosure in SEC filing as part of Management’s Discussion and Analysis forms in compliance with the Sarbanes Oxley Act.

C&W is due to report its mid-year financial results in November, and it is also expected that they will communicate their future direction and intentions at that time. One can anticipate that the competition will feature attractive incentives and deeper price discounting in order to woo prospective C&W clients.

As an observer, it will be interesting to see if C&W clients will be enticed by price incentives or if there will be a ‘flight to quality’. Time alone will tell.

About the author

Ed Agar is co-founder and Principal of PrimeSourcing Advisors, an IT advisory firm. For more information, visit primesourcingadvisors.com.

Bankruptcy in Outsourcing

October 9, 2009 by

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.