Transitional Services Agreements: Separation, Extraction and Cross-Licensing Issues

April 20, 2015

Transitional Services Agreements (TSAs) are not new. They have long been a part of M&A transactions but historically they were often left to the last minute of negotiations and viewed as the ‘ugly duckling’ of transaction documents dealing with some IT services. In the modern business world where large multinational organisations rely heavily on complex IT systems, this perception is changing and the TSA ugly duckling is emerging as the beautiful complex swan of M&A with the ability to make or break a deal or, at the very least, heavily influence the deal timetable.

Recent examples of complex transitional arrangements such as those seen in last year’s separation of TSB Bank from Lloyds Banking Group highlight the complexity and fundamental importance of these types of arrangements.

What is a TSA?

In its most basic form, the TSA is an agreement by the seller of a business to supply services to the purchaser of that business for a limited time post-completion. Traditionally, this type of agreement fell within the remit of the IT lawyers’ skill set because the services being provided were often IT-related services. The transitional periods were usually short, and the agreement might have been summarised as simply ‘we’ll continue to do what we did in the 12 months before signing for a short period after completion, and at cost’.

However, both the M&A deals themselves and also the services required have developed since those days. In the past, many divestments involved stand-alone businesses that were fairly self-sufficient. These days, business units carved out for sale are often highly dependent upon other parts of the retained group, and ‘simple’ IT services don’t exist anymore. Businesses as a whole are more dependent upon IT and communications than ever before, and separating these services out is often both extremely complex and time-consuming.

As a result, TSAs have evolved to become lengthy, complex, heavily negotiated agreements setting out the detailed scope of services, service levels and complex charges. The agreement may also include some services being delivered by the divested entity back to the retained group, as well as the more ‘traditional’ services being provided by the retained group to the divested entity. The ‘transitional’ nature of the services is also changing. The length of time it takes to separate IT systems and data from seller group systems and platforms means that short-term TSAs are turning into long-term services arrangements. As a result, the role of the IT lawyer in drafting and negotiating this type of arrangement is crucial and can add real value to the wider corporate transaction.

The Buyer’s and Seller’s Perspective

As with all commercially negotiated agreements, the position that a party will seek to take in a TSA will depend upon the side of the fence it sits on. The challenge for a TSA, amongst other things, is to provide a mechanism which satisfies the buyer’s desire to ensure business continuity with the seller’s desire for a clean break.

From the buyer’s perspective, it will also be keen to integrate the acquired business with the rest of the buyer’s group and therefore achieve the synergies envisaged as part of the M&A transaction.

From the seller’s perspective, it will be keen for a clean break as quickly as possible. The seller will also be keen to remind the buyer that it is not a professional service provider and will therefore wish to provide minimal services for a short period of time with limited liability.

Key Issues

Given the TSA’s emerging role as a mini (or midi) outsourcing arrangement, many of the key issues which arise in the context of negotiations are similar to those which IT lawyers may be familiar with in the context of outsourcing arrangements.

Scope, standard and duration – the scope of the services themselves is absolutely key to success in a TSA arrangement but often difficult for the parties to pin down. In transactions where the divested entity and the retained group are heavily integrated and dependent upon one another, it may be difficult for the parties (particularly the buyer) to identify and adequately describe the services to be provided. As a result, the buyer will often seek to include drafting which deals with ‘missed services’ (ie services which were not determinable at the time of the TSA’s commencement).

Service levels are also often particularly difficult to articulate in TSAs. Where services have been provided internally in the past there may not be any measurable service levels attached to them which the parties are able to use going forward. Often the parties may need to undertake an audit either before or possibly after signing in order to ascertain the service levels which can then be migrated into the TSA arrangement. As an absolute minimum, the buyer will be keen to ensure that the services are provided to the same standard, scope and scale after completion as they were provided in the 6-12 months prior to completion.

If the parties to the TSA are in the financial services sector, they will also need to consider the scope of the TSA and whether or not it constitutes a ‘material outsourcing’ or relates to an ‘important’ or ‘critical’ function for regulatory purposes. If so, the arrangements will need to comply with the rules under SYSC in order to be compliant.

Ease of Separation/Reliance on Third-party Agreements – The ease (or otherwise) with which the divested entity can be separated from the seller is the cornerstone to all TSAs. It impacts on both the services required under the TSA and the duration for which such services are to be provided. One of the issues with separation can be the extent to which third-party licences are used and third-party consents required in order to provide the services. Sellers often have long-term contracts with third parties covering the entire seller group. It is necessary, but time-consuming, to review these contracts carefully to assess how and if the contracts can be split in such a way that the buyer and seller retain the benefits of any agreed terms post-divestment.

Any such renegotiation of third-party contracts will of course require third-party consent. Historically, and particularly in the context of IT providers, this has been viewed as an opportunity by the third parties in question to renegotiate pricing and/or charge for consent. It is therefore important that the TSA deals with the question of third-party consents and allocates responsibility for costs appropriately.

Mechanics, Signing and Completion – In more complex TSAs it is important that the arrangements do not fall away before both parties are ready and able to separate. The TSA should therefore include a mechanism to enable the parties to test separation and closing readiness based on agreed readiness or acceptance criteria. Separation readiness could then be viewed as a condition precedent to completion or there would need to be a mechanism in place allowing the parties to extend the term of the TSA. In such an instance, the parties will need to consider any implications such an extension would have on the charging mechanism.

Liability – As with all commercial agreements, the issue of liability in TSAs is often a thorny one. Historically when parties were contracting for a short transitional period with limited value services being provided, liability was often not heavily negotiated. However, as the services being provided have become more complex and valuable, and the term of the arrangements has extended, there has been an increased focus on liability, with buyers looking to negotiate liability caps similar to those found in their other services agreements.

However, there are a number of issues in relation to liability which are peculiar to the TSA situation. Firstly, the seller is not a professional service provider and is therefore unlikely to be willing to accept a level of liability commensurate to that expected from such professional service providers. Often there may also be a heavy reliance on third-party providers with the seller effectively just ‘passing through’ the services to the divested entity – should the liability therefore also be on a pass-through basis? Thirdly, the services may only be being provided under the TSA at cost, with the seller applying no or little margin of profit to the provision of the services. In such instances, the seller is likely to be unwilling to accept high liability caps.

Project Verde – Case Study

The 2014 separation of TSB Bank from Lloyds Banking Group highlighted the complexities of modern day transitional service arrangements.

Lloyds Banking Group received a government bail-out in 2009. Using its powers under the State Aid rules, the EU then mandated the creation of a competitor bank by the sale of 631 branches and a specified number of current and mortgage accounts. Lloyd’s original plan to sell to the Cooperative Banking Group failed and it was then decided to realise funds for the taxpayer by selling 20-30% at IPO and the remainder by December 2015.

The separation of TSB Bank from Lloyds and subsequent transitional services arrangements was a highly complex operation, and absolutely fundamental to the success of the project as a whole. The transitional arrangements were effectively a first generation outsourcing of the entirety of TSB’s banking operations on a scale unprecedented in the market. The parties also intended to use a platform-as-a-service model in relation to the IT systems being utilised, therefore creating significant tensions with the regulatory requirements found in the FCA Handbook in relation to adequate systems and controls. Lloyds, the service provider, was also TSB’s closest competitor, raising significant competition law issues and concerns as to TSB’s ability to innovate in the market.

The TSA entered into by the parties was for an initial term of 2.5 years, with a long-term service agreement then taking over for a further period of up to 7.5 years. The TSA services covered all IT services and business critical services required to run TSB. The services covered everything from mail and courier services, loans and cards processing, e-payments processing, cheque clearing, and mortgage services, through to ATM operations, travel money, business continuity management and treasury operations. In total, there were 35 service schedules attached to the TSA.

In recognition of the potential conflict of interest that Lloyds may face in its position as both a significant service provider and competitor to TSB, the parties negotiated arm’s length contractual obligations under the TSA, including with respect to service performance, recovery of service, change management, confidentiality/data security and disaster recovery, as well as various requirements to manage potential conflicts and associated competition/regulatory risks, such as information sharing protocols, data access controls and the segregation (where appropriate) and training of staff.

Another key area of negotiation and regulatory scrutiny, was in relation to exit or termination of the arrangements (for whatever reason), given the high dependency by TSB on Lloyds IT systems and services. The TSA provides a mechanism for the parties to define and agree their respective obligations in an exit/termination scenario through detailed technical and commercial plans. Due to the criticality of the IT services, the parties have defined in advance some specific exit options for TSB, namely: (i) the creation of a cloned and carved-out set of IT systems which would be transferred to a third-party provider to operate on TSB’s behalf; (ii) the migration of TSB’s data to the IT systems of a third-party service provider; or (iii) the migration of TSB’s data to the IT systems of another financial institution in the event that TSB enters into a merger or acquisition.

Business Impact

The complexities of modern day transitional services arrangements mean that these types of agreements can no longer be left to the last minute as part of the wider corporate transaction. These agreements are often now on a par with major IT and business process outsourcing agreements and, as such, appropriate time and resources needs to be spent ensuring that the deal is adequately papered.

In regulated sectors such as financial services, transitional arrangements may also be subject to regulatory scrutiny adding an additional layer of complexity to drafting and negotiations.

Lawyers can no longer ignore the transformation of the ugly duckling TSA.

Nick Pantlin is a partner and Miriam Everett is a professional support lawyer in the TMT & Outsourcing practice at Herbert Smith Freehills