Software Licensing In A Tough Economy

Software is tangled into the operation of most businesses that it is impossible to successfully operate without it. At the same time, software companies rely on their contracts to protect their ownership interests.

Economic worries require both parties to place more importance on protecting their rights under software licenses. This memorandum looks at risks and liabilities that may come from the financial instability or bankruptcy of either party to a license. It looks at ways parties can reduce exposure to business risk or financial liability.

The treatment of a software license when the licensor or licensee files for bankruptcy depends on whether the license is considred executory or nonexecutory. If the license is executory, the law generally lets a debtor do one of three things: (1) assume the agreement, (2) assume and assign the agreement to a third party, or (3) reject the agreement. Generally speaking, a debtor may get the full benefit of an executory agreement unless it assumes all the obligations under the agreement, including curing all defaults under the agreement. The same is not true for a nonexecutory agreement.

The Bankruptcy Code does not define executory. Most courts say that a contract under which the obligations of both the parties to the contract are so far unperformed that the failure of either to complete performance would be a material breach excusing the performance of the other is executory. Where performance is substantially completed by one or both parties, the license is nonexecutory.

Whether a software license is executory will depend on an analysis of the license and the remaining obligations of each party under it. Most software licenses with ongoing payment obligations by the licensee will likely qualify as an executory contract, however, courts will look to the substance of the license rather than form. A royaltyfree or fully paidup license of software may not be a license at all, but rather a nonexecutory assignment of a property interest.

Licensor Bankruptcy

Nonexecutory License

When a licensor files for bankruptcy, a licensee can be in a tough spot, especially if the license is nonexecutory. The licensor may seek to breach the license by refusing to provide necessary support or software upgrades, or by relicensing the software to a third party. The Bankruptcy Code has little protection for a party to a nonexecutory contract. The only course may be to file a general unsecured claim against the debtor. A licensee should try to protect itself from a licensor's bankruptcy as far as possible. This might include getting a security interest in the software, getting a technology escrow, drafting the license so it will be treated as an executory contract or drafting the license to include nonmoney remedies that will survive the licensor's bankruptcy.

Executory License

Bankruptcy laws were rewritten in 1987 to protect licensees from a licensor's bankruptcy. If the debtor/licensor rejects the license agreement, the nondebtor/licensee has two options. First, it can bring a claim for damages to the extent the rejection caused the licensor to fail to meet its obligations under the license. Under this option, the licensee gives up any right to use the software in the future. Second, it can retain the rights to use the software for the time provided for under the license and any contract extension periods.

The debtor can reject the license agreement, which means executory provisions are null and void, but the licensee can elect to retain its rights under the license. If the licensee elects to retain its rights, it must continue to pay the license fees and give up some remedies otherwise available under the law. The licensee does not need to affirmatively elect to retain its intellectual property rights to preserve its license.

Most licensees elect to keep using the software. Although the licensee may continue using the software, it cannot force the licensor to meet other contract obligations except any exclusivity provisions. The licensor is relieved of any obligation to provide services such as training, maintenance, support, documentation, or updates. The licensee is able to require the debtor to provide it with any intellectual property in its possession, provided the rights were included in the license. The licensee must continue to pay all royalties due the licensor. This is a good reason to have separate agreements or payment schedules for the license and any other obligations like development and maintenance and support services. Using a single contractual document will make it look executory because of the existence of longterm ongoing obligations. Separate agreements or payment schedules lower the risk of an agreement being rejected because each obligation is associated with a specific payment and a licensor will not be entitled to receive the separate fee unless it performs the separate service.

To make sure the protections of the law are available to it, the licensee should make sure the license specifically provides the software is "intellectual property" under the Code and the license is governed by the Code if the licensor files for bankruptcy protection.

To further ensure the law is available to it, the licensee should be sure to include sufficient continuing obligations in the license by both sides to make it an executory agreement. A licensee also should clearly state the contractual obligations deemed material so that breach by one party of that provision would excuse continued performance by the other.

To limit financial risk, the licensee should define payments made for training and support from general license fees. These collateral obligations should be in a separate agreement or payment schedule. Lumping all fees together means the licensee could be required to pay for services the licensor is no longer providing.

Many licensees seek to limit their risk with a source code escrow. Such an escrow will ensure the licensee will have access to the source code for the software if the licensor rejects the license and refuses to perform its obligations under the license agreement.

Another option is for the licensee to get a security interest in the software. In addition to protecting the licensee's interest in the software, it also will secure any rejection damages claim available to the licensee if the debtor rejects the license agreement. Because the security interest limits the benefits available to a debtor on rejecting the license, it will give the debtor an incentive to assume the license. To perfect a security interest in software, the licensee must comply with both the Uniform Commercial Code and copyright law, which requires a notice be filed with the Copyright Office. The grant of a security interest is considered to be the transfer of copyright ownership.

The licensee should include equitable remedies in the license agreement like the right to enforce any exclusivity provisions in favor of the licensee with an injunction against infringement. These remedies are important where the license is not executory and not entitled to the remedies available under bankruptcy law. Most courts will enforce such a provision where it is not an alternative or substitute for money.

The Licensee's Bankruptcy

Nonexecutory License

A software licensor's primary concern when a licensee files for bankruptcy is payment. If the license is nonexecutory, for example, where the licensor has already substantially performed its obligations, then the licensor's only remedy may be to file a general unsecured claim against the estate. One technique is to get a security interest in the licensed software or other assets, which will incentivize the licensee to honor its commitments under the license agreement. Another technique is to draft the license to ensure it will be treated as an executory contract, which may make it difficult for the licensee to assume or assign the license without the licensor's consent.

Executory License

Many licensors include language in their license agreements automatically terminating the license agreement upon a licensee's bankruptcy. That language is not enforceable. The Code provides that an executory contract of the debtor may not be terminated or modified after a bankruptcy filing because of a provision in the agreement conditioned on the insolvency or financial condition of the debtor or the commencement of a bankruptcy filing. Any attempt by the nonbankrupt party to unilaterally terminate a contract covered by the Code without first seeking relief from the automatic stay may expose it to significant liability.

To provide greater protection, a licensor can include certain performance requirements in the license agreement that would allow it to terminate the agreement if the licensee fails to abide by them. These may include requiring the licensee to continue operating, maintain a minimum amount of sales, etc. These rights are distinct from those provisions placed in a license agreement allowing the licensor to terminate the license for the licensee's bankruptcy.

A licensor may terminate a license before a licensee's bankruptcy filing if the termination is effected before filing. The fact that the effective date of notice of termination does not occur until after the licensee files for bankruptcy should not affect the result as long as the termination is complete and not subject to cure or reversal. Where the termination is subject to cure or reversal at the time of the bankruptcy filing, however, the licensee will have an opportunity to cure the default and prevent the termination from occurring.

Under the Bankruptcy Code, a software licensee who declares bankruptcy and desires to assume an executory agreement must cure all breaches, fully perform its obligations, and provide adequate assurances that it will perform in the future. If the licensee fails to do so, it must reject the agreement and relinquish all rights to the underlying intellectual property.

There is a limit on a debtor licensee's ability to assign a software license to a third party. It appears a debtor licensee cannot assign a nonexclusive software license to another entity without the licensor's consent, even where there is no prohibition to such assignment under the license agreement. The same limitations may not apply to the assignment of an exclusive software license, which may be characterized as an assignment of a property interest rather than the license of limited rights to use the software.

Licensees also need to be concerned about their right to assume a license in the event of their bankruptcy as there is a split among the courts. The Fourth Circuit Court of Appeals has held that the Bankruptcy Code precluded the debtor licensee from assuming the contract without the licensor's consent even though the license agreement permitted the debtor to assign the license. This position has been adopted by the Third, Fourth, Ninth, and Eleventh Circuits.

The First Circuit along with a majority of bankruptcy courts has adopted a test under which a court examines, on a casebycase basis, whether the nondebtor would be required to accept performance from a party other than the party with which it initially contracted. Further, a debtor is not to be prevented from assuming a license unless it actually intends to assign the license to a third party.

A careful licensee should include language that in the event of its bankruptcy and subsequent decision to assume the license, the licensor agrees it will consent to and accept the assumption. A licensor who agrees to such a provision may wish to limit a consent to assumption provision to situations that do not involve a change in control of the licensee.