Failed Deals: CSC Sues Sears over Termination
October 9, 2009 by Bierce & Kenerson, P.C.
Sears and Computer Sciences Corporation entered into a $1.6 billion IT infrastructure outsourcing in June 2004. By April 2005, Sears had given notice of termination for cause. Claiming the termination was in bad faith as a means of escaping a termination fee, CSC sued Sears alleging irreparable injury to reputation and seeking to enjoin the termination. The dispute took the case out of an arbitration clause and into the courtroom in proceedings seeking an injunction. What happened? What lessons can we learn?
Background.
The following report of the facts is based on allegations in court documents and SEC disclosures. The author has no access to sealed records or the actual agreement or correspondence between the parties.
Sears hired CSC in 2004 for a $1.6 billion outsourcing to manage IT infrastructure for Sears’ operations. The scope of services included managing desktops, servers, systems to support Sears-related websites, voice and data networks and decision support technology, for Sears and its subsidiaries. K-Mart, with a fresh start after completing its reorganization in bankruptcy, then entered into an agreement to acquire or merge with Sears. The merger was to take effect on about March 3, 2005, but occurred on March 24, 2005.
The Termination Fee.
The termination provisions in the Sears-CSC outsourcing contract required Sears to pay a termination fee upon any termination for Sears’ convenience. If Sears were to terminate for cause, Sears would not pay the termination fee.
The amount of the termination fee was not fixed for the entire contract term. Rather, it would increase from the date of contact signature as CSC invested in software, hardware, subcontracts, training, process development and other implementation during transition. After completion of transition, the termination fee would decline over the remaining term of the contract.
The Dispute.
Before March 3, 2004, Sears probably anticipated that its merger with K-Mart might be delayed for legal or regulatory reasons. The Sears-CSC termination fee was increasing over time as CSC continued to invest in the transitional implementation phase of the statement of work. Evidently, the termination fee would be greater after February 28, 2005 than before that date. Thus, Sears was motivated to terminate the agreement early, but would still pay a large termination fee if the termination were determined to have been for Sears’ convenience and not for cause.
Sears apparently approached CSC to negotiate a ceiling on the termination fee. CSC refused to negotiate.
Sears then terminated for cause. Sears alleged that CSC had breached because it had failed timely to meet implementation milestones and had been forced to bring in the Red Team (crisis management) to rectify CSC’s alleged breach.
CSC sued Sears for an injunction to terminate the notice of termination for cause and to enjoin Sears from invoking the post-termination provisions of the outsourcing agreement unless the termination were characterized as done for Sears’ convenience.
Legal Issues.
Confidentiality of Court Records.
At CSC’s request, the lower court sealed the pleadings, affidavits and supporting documents such as the outsourcing contract and correspondence between the parties as to the fulfillment of contract obligations. The appellate court rejected CSC’s request to seal all appellate records and findings, thus opening the record for some public perusal.Disclosure of the Dispute.
Sears filed a disclosure with the Securities and Exchange Commission that identified the termination of a material contract. This disclosure, mandated by the SEC under a rulemaking effective August 23, 2004, simply alluded to a dispute over whether the termination was for cause or for convenience. Sears informed its investors that the difference involved tens of millions of dollars. CSC also filed its own SEC disclosure.Injunctive Relief: Was this Just a Dispute over Money Damages?
Sears claimed that CSC had no right to seek judicial relief because an arbitration clause mandated that all disputes be arbitrated. CSC sought judicial relief because the arbitration clause probably allowed an exceptional right for either party to seek equitable relief from a court.
Equitable relief is a concept developed centuries ago under common law principles, which require that the injured party must prove that it is suffering or will suffer irreparable injury as a consequence of the threatened or ongoing actions of the respondent. Equitable relief is not granted if the dispute is merely an argument over the non-payment of money.
Consequently, Sears responded that the dispute was only a matter of money, not one involving irreparable injury. CSC claimed irreparable injury due to the existence of Sears’ allegedly “pretextual” claim, made in bad faith and concocted to evade a termination fee, for termination for cause.
The lower court and the appellate court both agreed with Sears and rejected CSC’s request for equitable relief, sending the case to arbitration.
Lessons Learned: New Best Practices.
This dispute highlights a number of issues under contractual clauses governing relationship management, dispute resolution and termination. Aside from the contractual provisions, the dispute shows from evolving concerns for the enterprise customer and the service provider under common law principles of equitable relief, the Sarbanes-Oxley Act of 2002 and implementing SEC regulations. The dispute suggests some new clauses and planning tools should be included in the normal outsourcing contract as new “best practices.”.
Impact of Sarbanes-Oxley Upon Outsourcing
October 9, 2009 by Bierce & Kenerson, P.C.
Corporate Governance and Accountability under Sarbanes-Oxley Act of 2002.
On July 30, 2002, President George W. Bush signed the Sarbanes-Oxley Act of 2002. The bill establishes new rules of corporate governance and accountability for accounting for U.S. and foreign publicly owned companies whose shares are registered with the U.S. Securities and Exchange Commission. If you work for such a company, you have some immediate actions for timely compliance, some by August 30, 2002.
This legislation has potential importance to both outsourcers and their customers, as well as their accountants, executives, investment bankers, employees and attorneys.
Scope of the Law.
Enacted in the wake of a series of corporate accounting scandals, this vast and sweeping legislation establishes a public accounting oversight board, adopts certain minimal measures to preserve auditor independence, amends federal security laws to hold insiders and corporate executives and directors to higher standards of care in trading securities (including blackout periods during which such trading is prohibited), increases and extends corporate disclosures of accounting matters, sets standards for “corporate and criminal fraud accountability” and hardens the penalties for “white collar crime.” For particular provisions on corporate responsibility for financial reports and the accuracy of financial reports (including “off balance sheet transactions”), see our copy of the law at Sarbanes-Oxley_Legislative_Text.
Study on Manipulative Accounting.
Investment bankers will now become the subject of a new SEC study. But the study will go further, covering topics that affect virtually every publicly traded outsourcing services provider and its methods of operation. The study will review, among other issues relating to Enron and Global Crossing’s bankruptcies, the role of investment bankers and other advisors:
in creating and marketing transactions which may have been designed solely to enable companies to manipulate revenue streams, obtain loans, or move liabilities off balance sheets without altering the economic and business risks faced by the companies or any other mechanism to obscure a company’s financial picture.
Impact of Sarbanes-Oxley Act of 2002 on Outsourcing Service Providers.
For outsourcing service providers, the new law creates the risk that the SEC might seek to impose penalties for failure to adopt conservative accounting principles. We think that this law could create challenges for outsourcers that adopt the percentage of completion method of accounting, which may be appropriate but nonetheless perhaps not as credible or conservative as the “as collected” basis. Take our Survey on related accounting issues.
Impact of Sarbanes-Oxley Act of 2002 on Employees.
The Sarbanes-Oxley Act of 2002 protects employees from termination or other major adverse effect if they report alleged violations of the accounting rules or corporate governance requirements of that law. For a copy of the act as it applies to employees, please refer to our copy of the law at Sarbanes_Oxley_legislative_text
Please note that this gives new protections to whisteblowers who are employees, but also to non-employees as well. Please refer to our copy of the law at /Sarbanes_Oxley_ACT_2002_legislative_text
Impact of Sarbanes-Oxley Act of 2002 on the Role of Attorneys in Outsourcing.
The Sarbanes-Oxley Act of 2002 on corporate governance and accountability requires attorneys to take their concerns about accounting treatment to in-house lawyers and ultimately to the Board of Directors. Law firms assisting parties to an outsourcing transaction should consult with their clients concerning the accounting treatment implicit in the transactional structures.
Impact of Sarbanes-Oxley Act of 2002 on Venture Capitalists.
The Act will give pause to venture capitalists who fund start-up outsourcing services providers. It raises the legal liability of VC’s who serve on boards of directors, particularly if the portfolio company is targeting an IPO and board membership remains an important component of the VC relationship, compensation, “protection” of VC-organized investor interests and generally investment management.
Impact of Sarbanes-Oxley Act of 2002 on International Outsourcing Services Providers.
Being incorporated outside the United States may have its advantages as well as its disadvantages. Under the Sarbanes-Oxley Act of 2002, foreign companies whose shares are traded on U.S. stock exchanges must comply with new obligations on financial reporting, audit and corporate governance. Foreign services providers such as Accenture Ltd., of Bermuda, that were organized outside the United States prior to relevant “cutoff” dates are likely not to suffer the consequences of U.S. governmental retaliation for foreign “inversion” operations. Unless their securities are listed on a U.S. securities exchange, such foreign services providers may enjoy regulatory freedoms, but such freedoms may elicit suspicion by investors and prospective customers due to the lower level of corporate governance discipline and public disclosure of material information. If you have any question about this process, please contact one of our attorneys.