Planning for the End Game – Disentanglement
Article 3 of a 3 Part Series
By Gordon & Glickson LLC
Article III
Whether information technology outsourcing is done at the vendor's premises, or at the customer's premises, and regardless of whether any facilities or personnel of the customer are transferred to the vendor at the time the outsourcing agreement is entered into, the least familiar, and perhaps the least understood, aspect of outsourcing transactions is that the outsourcing agreement cannot just be allowed to expire in the manner of more conventional service agreements.
When the customer and vendor finally exhaust their ability, or desire, to continue their association, the customer will normally have to recommence an information technology processing operation, or hire a different vendor to provide one. Because most IT outsourcing operations are relatively “custom,” it would be extremely difficult and costly for the customer to replace those operations upon the expiration of the outsourcing agreement.
Accordingly, the customer should require very detailed obligations from the vendor with respect to the re-transition of the outsourced functions, either back to the customer or to a new vendor. Particularly where a data processing facility has been taken over by a vendor, the process of identifying, tracking, and then reconveying the data center facility and operations is likely to become increasingly complex with the passage of time. Also, because improvements are likely to have been made during the term of the outsourcing agreement, the facility and applications may be worth more at the end of the outsourcing agreement than they were at the beginning. The term “Disentanglement” seems an appropriate one to convey the sense that both the vendor and the customer are likely to become very much entangled over the course of the outsourcing agreement, and they both need a mechanism to disassociate and terminate.
PROBLEMS AND RISKS OF DISENTANGLEMENT
Disentanglement exposes some special problems and risks:
• Identifying the Data Center Properties . If data center properties have been transferred in connection with the outsourcing, the identification of these properties will be a moving target because the properties are in a state of continuing change and the precise date for the conveying of them will be unknown. Provision must be made to ensure that all information needed to operate the facility is adequately safeguarded and ultimately made available to the customer.
• Facilitating the Transfer of the Operation . The outsourcing agreement should contain provisions relating to facilitating the transfer of the operation back to the customer, or a new vendor, and establishing a mechanism to determine the price at which the facility would be conveyed to the customer.
• Minimizing the Risks and Adverse Consequences of Business Failure by the Vendor . While there are no fully satisfactory solutions, we discuss below a number of alternatives in dealing with risks of financial failure.
DISENTANGLEMENT PROVISIONS
Because failure to address disentanglement issues would probably favor the vendor rather than the customer, the bias in the following suggestions may be seen as pro-customer, but the intent here is to illuminate the issues.
- Specify the time or events when disentanglement will occur (e.g., a material default by the vendor, change of ownership or control of the vendor, in the event the vendor experiences financial difficulties, or at the end of a trial period).
- Specify the mechanics of how the disentanglement is precipitated, who is permitted to elect to Disentangle, how is notice given, when is the closing, and the like.
- Specify the elements of the transaction. This may include reacquisition of real and personal property as well as the reemployment of employees and the reestablishment of employee benefits.
- Specify the allocation of duties among the vendor, the successor‑vendor, and the customer during the disentanglement period.
- Specify the allocation of disentanglement costs among the parties. Vendors typically prefer to impose a separate charge, on a time-and-materials basis, for the performance of disentanglement duties. In the alternative, they may propose to re-allocate dedicated personnel, and either reduce or abandon service level requirements. Customers may wish to require the vendor to absorb these costs, even though vendors will claim that this forces them to bid-up the prices for their regular services.
- Specify the prices (or at least, the formula for establishing the prices) at which resources can be re‑acquired by the customer. This factor may be extremely difficult to establish if the facility has changed a great deal.
- In all circumstances, provide for the preservation of the integrity of the data center. In this regard, it is extremely helpful to provide for a mechanism for keeping a current record of the data center properties and of all information needed to operate the facilities. The outsourcing agreement should also require that all licenses or leases provide for consent, in advance, to their re-conveyance to the customer upon disentanglement. The customer should always have access to all technical documentation and source code regarding new software, and the customer should seek to have the exclusive ownership of all new developments created by the vendor that involve the data center. In addition, the vendor should be required to properly maintain the physical property and to establish and maintain disaster protection and recovery capabilities.
DEALING WITH RISKS OF FINANCIAL FAILURE
One of the most difficult issues in disentanglement is the risk that the vendor will sustain a bankruptcy and the customer will be unable to reclaim the data center. The risk of financial failure is an unavoidable risk at some levels and must be evaluated as part of the business decision to outsource to a particular vendor. The worst nightmare is that the data center properties will be kept from the customer and liquidated as an asset of the estate of the vendor in connection with a bankruptcy, requiring the customer to await the process of the bankruptcy court and eventually enter a bidding contest in order to reclaim its data center.
We have encountered a number of ways to address this risk:
• One is to obtain a lien on the data center properties and thereby seek to be able to reclaim them through foreclosure in the event of a financial failure by the vendor.
• A second is to isolate the data center operation from the risks of the remainder of vendor's business by requiring the vendor to create a single purpose subsidiary, the sole activity of which will be the acquisition and operation of the data center. If the vendor is willing, there are several reasons why the single‑purpose subsidiary may be a good idea for the customer. The principal purpose of this structure is to isolate the data center in an entity that is likely to survive and be profitable if kept separate from the vendor's other businesses. Such a structure raises complex additional legal and financial issues on which advice would have to be obtained. The additional complexity makes this solution unusual.
• Other solutions involve structuring of the outsourcing agreement so that title to the facilities is not transferred to the vendor.
Keep in mind that once in bankruptcy, the vendor will have the right to assume or reject the outsourcing agreement depending on its assessment of the value of the outsourcing agreement to it. The vendor will also have the right to assume and assign your contract to another supplier, even where the contract prohibits assignment. Moreover, if a vendor does not want to make a quick decision on assumption or rejections, it may well be allowed to delay that decision until the end of the bankruptcy case, which could be a very long time. During this time you may not be able to terminate the outsourcing agreement or otherwise enforce some of its provisions. Bankruptcy court approval would be required in this period to terminate, a potentially difficult and expensive process.
Accordingly, pre‑planning is the key to dealing with the financial risk of the vendor going bankrupt. In this regard, you should obtain financial covenants and current financial information that will give you an early notice of financial trouble so that you can act before the bankruptcy filing. Indeed, crafting an outsourcing agreement where the customer retains ownership and control of all software, data, equipment, deliverables and any work in process, as well as the right to use vendor‑owned items, may prove very important. In addition, notwithstanding bankruptcy law, your outsourcing agreement should prohibit the assignment of the outsourcing agreement or the delegation of the vendor's responsibilities, without your express written approval.
Gordon & Glickson LLC, an internationally recognized law firm based in Chicago , has focused exclusively on providing legal and strategic consulting services to the technology marketplace for over twenty-five years. The firm provides corporate, commercial, litigation and finance counsel for its entrepreneurial technology clients, and serves worldwide as strategic and technology counsel for both private and public sector clients. For more information please contact Philip P. McGuigan at 312.321.7659 or at ppmcguigan@ggtech.com.
