Canada: Dealing With Outsourcing Supplier Instability

While it is not possible for customers to completely insulate themselves from the risks associated with supplier instability, there are a few proactive steps that customers can take to manage and mitigate those risks. These include: carefully conducting due diligence before entering into an outsourcing arrangement and performing periodic reviews during its course, inserting specific clauses in the outsourcing agreement that pre-emptively address potential issues, and having a response plan in place in case the supplier goes bust.

The economic downturn is affecting suppliers both large and small. Whereas customers have historically focused closely on supplier stability and solvency risk when dealing with smaller suppliers, in today's environment, the continued stability of even the most blue-chip suppliers should not be taken for granted. Customers should look at re-evaluating the viability of all of their outsourcing suppliers and re-assessing the risks associated with their supplier relationships (current and prospective), to ensure they are adequately protected in the event of supplier instability.

Due Diligence

Customers often perform some degree of due diligence before entering into an outsourcing agreement. In doing so, they should ensure that the nature and scope of the due diligence is sufficient for their purposes. For example, if a customer is contracting with a subsidiary of a public company, this due diligence should include information about the financial stability of the subsidiary. The customer should not rely solely on publicly available information about the public parent. Where appropriate, customers should consider whether to require a parent guarantee as part of their contractual arrangements.

In addition to initial due diligence, it is extremely important for customers to conduct regular periodic follow-up due diligence to ensure a supplier's continued stability and to identify any potential issues as early as possible. Customers should build into their contract provisions a requirement that suppliers make available the information the customer requires to perform appropriate due diligence on a regular basis.

Contractual Protections

Due diligence

As discussed above, customers should include in their supplier contracts processes to conduct periodic due diligence. In order to make this exercise meaningful, customers should also clearly stipulate their rights and remedies if the due diligence identifies any issues. These rights may include such things as triggers for:

  • governance escalation processes;
  • termination rights;
  • commencement of transition assistance (possibly at no additional charge);
  • access to and training on the supplier's source code;
  • removal of restrictive covenants, such as exclusive supplier commitments or non-solicitation commitments; and
  • removal of minimum-volume commitments.

The types of due diligence results that will be sufficient to trigger the customer's rights and remedies will likely be the subject of significant negotiation: suppliers will generally want to limit trigger events to actual bankruptcy events or similarly catastrophic events, such as injunctive proceedings relating to core intellectual property. From the customer's perspective, however, this would be too little, too late; the purpose of periodic due diligence is to identify risks before they become critical and can still be mitigated.

Termination rights

Under most outsourcing contracts, the customer will have a right to terminate upon the initiation of bankruptcy or similar proceedings. It is important to recognize, however, that once a bankruptcy or restructuring filing is commenced, rights and remedies set out in a contract are often stayed. As a result, a customer's right to terminate its contract with a supplier upon the occurrence of a bankruptcy or restructuring petition or filing may not be meaningful.

If a customer wishes to ensure that it has the ability to exercise a termination right upon a supplier's insolvency, it should broaden the termination right to pre-filing events. These events may include:

  • the supplier ceasing or threatening to cease carrying on business in the ordinary course;
  • the supplier admitting that it is unable to pay its debts generally as they become due, or acknowledging its insolvency;
  • an adverse change in a supplier's credit rating; or
  • the initiation of actions by regulatory authorities that are likely to result in the supplier's inability to provide the services under the agreement.

Suppliers will typically object to such a broad termination trigger, and try to narrow these termination rights as much as possible.

Transition Assistance on Termination

An outsourcing contract should include provisions that address in detail the obligations of the supplier to assist with transition. This assistance should include:

  • a supplier obligation to deliver up information and data;
  • a customer right to acquire hardware, software and personnel from the supplier;
  • a supplier obligation to assist the customer in finding and evaluating an alternative supplier; and
  • performance and personnel commitments by the supplier to ensure a smooth transition.

Post-Termination Intellectual Property Rights

Customers should carefully consider whether, upon termination of a supplier, they will require rights to the supplier's intellectual property in order to continue the service in-house or through another supplier. If continued use of the intellectual property is realistic (as opposed to a complete shift to a new solution from the current supplier's solution), then the customer should negotiate these rights in advance if possible. Careful attention should be paid to the terms relating to the exercise of such rights to ensure they will be enforceable in the event of a bankruptcy or restructuring. The inclusion of terms relating to security interests or partial assignments of critical intellectual property should also be considered where appropriate.

Other Contractual Provisions

To help identify and address supplier instability, customers should consider including a number of other contractual provisions, such as:

  • affirmative covenants requiring the supplier to proactively bring to the customer's attention potentially significant issues, such as significant litigation claims, rather than waiting for the periodic due diligence review;
  • requirements for the immediate delivery of confidential information and data, including any customer personal information to the customer, upon the customer's request;
  • source code escrow, source code licence or source code access and training provisions that will enable the customer to use and support a solution without the supplier;
  • removal of restrictive covenants, such as exclusive supplier commitments, non-solicitation commitments or confidentiality restrictions; and
  • removal of minimum-volume commitments.

Supplier Instability Response Plan

While it is advisable and important to include transition assistance provisions in the agreement, the reality is that customers should not count on receiving proper transition assistance from the supplier when the supplier is suffering from significant instability. Customers should, therefore, have internal governance processes and plans in place to ensure that a bankruptcy mitigation plan is put into action at the earliest appropriate opportunity.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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