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Bankruptcy Issues in Software Licensing
This paper looks at the issues that develop when one party involved in a software license
agreement files for bankruptcy. This paper will investigate what aspects of bankruptcy have an
effect on licensees and licensors and how the various obligations which software licenses may
contain affect the license in the event of one partys bankruptcy. This paper will also address
what licensing steps both licensees and licensors may take to protect their rights in the event they
or the other party enters bankruptcy. The focus here will be confined to software license
negotiations between individual companies.
The reason that bankruptcy presents such a threat to companies is that software licenses
represent an important part of a companys intangible assets, whether it is the licensee who
depends on continued use of the software it has licensed for or the licensor who depends on the
continued payments due under the license. Because software licenses are contractual assets, they
are particularly vulnerable to the Bankruptcy Code which views the debtor's assets to be
alienable.1 In particular, the Bankruptcy Code's granting of rejection, assumption, and assignment
rights of the debtor's contracts threatens the intellectual property rights of licensees and licensors.
I. The Conflicting Policies of Bankruptcy and Intellectual Property
The purpose of intellectual property law as stated in the Constitution promotes the
progress of science and useful arts, by securing for limited times to authors and inventors the
1Menell, Peter S.,Bankruptcy Treatment of Intellectual Property Assets; An Economic
Analysis, Berkeley Tech. L. J. 1, 45 (2007).
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exclusive right to their respective writings and discoveries.2
In effect, the goal of intellectual
property law is to encourage innovators to share their developments with society by granting
them special protections.
Bankruptcy law has a different purpose. Broadly speaking, bankrutpcy endeavors to
provide creditors with the maximum recovery possible by either (1) liquidating the debtor's assets
or (2) reorganizing the debtor so that it may become financially stable in the future. The first type
of bankruptcy, liquidation of assets under Chapter 7, is less relevant to our discussion because it
does not present many issues related to software licensing both because Chapter 11 is more
common among companies and because Chapter 7 generally results in the termination of the
license. Because Chapter 11 involves reorganization of the debtor, it presents important questions
regarding how bankruptcy will affect a software license and the parties rights under the license.
The Bankruptcy Code accomplishes its goal of maximizing recovery for creditors by
granting debtors special protections from creditors and by systemizing the recovery of creditors.
In order to accomplish these goals the Bankruptcy Code requires the creation of a bankruptcy
estate that assumes the debtors assets and liabilities so that they are properly managed and
allocated. While the bankruptcy courts oversee this process, the bankruptcy court will appoint a
trustee who will manage the debtors bankruptcy estate. In the case of companies in Chapter 11
bankruptcy, it is more common that the court will allow the debtor-company to manage itself.
This circumstance is referred to as the debtor-in-possession and is common because managing a
reorganized company requires relevant business experience and specific knowledge of the
company in bankruptcy.3
The trustee or debtor-in-possession is granted special powers with
respect to managing the debtor-companys finances and is required to use these powers to
2U.S. CONST., art. I, 8, cl. 8.
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accomplish the bankruptcy goals of maximizing creditor recovery and stabilizing the debtors
finances. The most important power granted under bankruptcy relevant to this discussion is the
trustee/debtor-in-possessions power to reject, assume, or assume and assign certain of the
debtors outstanding contracts in order to maximize the value of the debtors assets.4
This aspect of the Bankruptcy Code allowing the rejection, assumption, and/or
assignment of the debtors executory contracts is at odds with the policy of intellectual property
law and, in particular, with software licensing. Because intellectual property law grants
intellectual property holders the right to restrict others from using their intellectual property and
therefore license its use, bankruptcy can threaten this right by granting debtors special rights
change to reject, assume, and/or assign licenses for intellectual property.
II. Rejection of Contracts in Bankruptcy
Once the bankruptcy estate is formed and the trustee/debtor-in-possession is appointed, it
will evaluate the debtor companys assets and liabilities and determine how best to utilize the
companys assets. This process involves evaluating the companys contracts and licenses
according to whether they represent assets or liabilities. Since contracts represent agreements of
exchanged performance between parties, they could be in any state of completion. The debtor
may have more outstanding obligations remaining than the other party, in which case the contract
may be a liability. Furthermore, the debtor may be owed more than it has left to perform, in
which case the contract is an asset. Because this evaluation requires subjective in-depth
knowledge of the debtor companys business, the Bankruptcy Code gives the
3See 11 U.S.C. 321(a)(2).4 11 U.S.C. 365.
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trustee/debtor-in-possession the benefit of the doubt with respect to the evaluation of these
contracts.5
This deference to the trustee/debtor-in-possessions judgment relies on the same
standard as the business judgment rule in corporate law. 6
A second important evaluation that the trustee/debtor-in-possession must make is whether
contracts are executory. The definition of executory contract can be hard to pin down as it has not
been statutorily defined. The most frequent definition cited by courts and legal articles is the
Countryman definition put forth by bankruptcy scholar professor Vern Countryman.
Countryman defined executory contracts as those in which the obligations of both the bankrupt
and the other party to the contract are so far unperformed that failure of either to complete
performance would constitute a material breach excusing the performance of the other.7
The executory classification has a critical impact on the fate of a software license in
bankruptcy because 365 of the Bankruptcy Code authorizes the trustee/debtor-in-possession to
assume or reject any executory contract or unexpired lease of the debtor.8
If the
trustee/debtor-in-possession decides that a software license is a liability and qualifies as an
executory contract, she will likely reject the license. If the software license is validly rejected,
then the other party to the software license can only bring a claim against the bankruptcy estate
for damages, but will have to get in line with the other creditors. This presents a problem for
companies who engage in software licensing because the damages are hard to recoup from the
5 Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc. (In re Richmond MetalFinishers, Inc.), 756 F.2d 1043, 1047 (4th Cir. 1985).6
Jennifer S. Bisk, Software Licenses Through the Bankruptcy Looking Glass: Drafting
Individually Negotiated Software Licenses that Protect the Clients Interests in
Bankruptcy, Fordham Intellectual Property, Media and Entertainment Law Journal 611,
at (Spring 2007).7Id. at 617 (citingVern Countryman, Executory Contracts in Bankruptcy Law: Part I,
57 MINN. L. REV. 439, 460 (1973).).
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insolvent debtor. Furthermore, even when monetary damages are available they are an inadequate
remedy for the loss of both the companys rights under the license and what it had invested in the
software.
The other two options available under 365 are employed if the executory contract is
deemed an asset. In this circumstance, the trustee/debtor-in-possession may assume the contract
or, if the contract is assignable, assume the contract and then essentially sell the license by
assigning it to a third party. In order for the debtor to assume the contract, it must cure any
outstanding defaults and provide sufficient assurance of future performance of the contract in
default.9 Like rejection, this presents an unfavorable set of circumstances to the other party to the
software license, who is forced to continue its obligations under the license with either the
insolvent debtor or another party of the debtors choosing. Therefore, the executory classification
is the most important issue that determines the susceptibility of a software license to unfavorable
treatment in the event of bankruptcy.
a. Bankruptcy Treatment of Ipso Facto Clauses
365(e) of the Bankruptcy Code makes invalid any provisions of a contract that are
conditioned on the filing of bankruptcy. 365(e) states:
(e)(1) Notwithstanding a provision in an executory contract or unexpired lease, or in
applicable law, an executory contract or unexpired lease of the debtor may not be
terminated or modified, and any right or obligation under such contract or lease may not
be terminated or modified, at any time after the commencement of the case solely because
811 U.S.C. 365 (2000).
911 U.S.C. 365(b).
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of a provision in such contract or lease that is conditioned on(A) the insolvency or
financial condition of the debtor at any time before the closing of the case; (B) the
commencement of a case under this title; or (C) the appointment of or taking possession
by a trustee in a case under this title or a custodian before such commencement.10
Therefore neither a licensor nor a licensee can terminate a license before or after the other
party enters bankruptcy based on provisions in the contract that allow termination upon a partys
insolvency or filing for bankruptcy. 365(e) severely limits the available means for drafting a
software license that avoids bankruptcy of a party altogether. In this respect, bankruptcy is a risk
that is nearly unavoidable by licensing provisions alone.
IV. Software License Agreements as Executory Contracts
Software Licenses are unique in that they reflect the overlapping areas of intellectual
property that software involves. Software is primarily protected by copyright and trade secret
law, but some software may have aspects that are protected by patent law and other areas of
intellectual property. This characteristic is a primary reason why software licenses are the
predominant method for granting software rights, since licensing allows the software vendor to
impose restrictions that grant protections not available by intellectual property law.
Software licenses can be differentiated according to the nature of the parties, for example,
licenses between businesses and licenses granted by a business to a consumer. The present
discussion is limited to software licenses between businesses because only these licenses present
major bankruptcy issues. In general, software licenses between businesses, business-to-business
software agreements, tend to be executory in nature because they typically contain requirements
1011 U.S.C 365(e).
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that qualify as ongoing obligation of performance even if they are passive obligations to refrain
from something. Due to this general characteristic, the courts have been apt to consider all
business-to-business software licenses executory.11 Despite their general executory classification,
however, not all business-to-business software licenses are executory. Some licenses may contain
requirements that do not qualify as significant ongoing obligations.
An exclusive software license is more often non-executory because it involves a more
complete transfer of rights, such as that of a sale. The exclusive license gives the licensee sole
use of the software at the exclusion of others including the licensor. Because the licensee
receives exclusive rights, there are inherently fewer ongoing obligations in an exclusive license.
Therefore, exclusive licenses are usually non-executory.
The more complete the transfer of rights in a license, the more likely a license will be
deemed non-executory in bankruptcy.12 Furthermore, both exclusive and nonexclusive licenses
may expressly state that they are non-executory but still include significant ongoing obligations
that would lead a court to classify it as executory.13
Therefore in negotiating an exclusive
software license, the diligent licensee should draft an exclusive license so that it does not require
significant ongoing obligations. For example, in negotiating payment for an exclusive license, the
licensee should opt for a lump sum payment or short-term installments, rather than long-term
payment arrangements that will be deemed an ongoing obligation.
a. Executory Obligations
11Menell, supra note 1, at 28.
12Bisk, supra note 6, at 623.
13Id.
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As stated above, software licenses that require significant ongoing obligations from one
or both parties will be deemed executory and open to rejection by the trustee/DIP. To determine
the rejectibility of a software license, one must evaluate the license according to the Countryman
definition to determine the nature and significance of the obligations remaining between the
parties. Significant obligations that would qualify a license as executory include: (1)duties to give
notice, (2)requirements to pay royalties, (3)labeling and marketing limitations, (4)duties to
maintain or upgrade software, and (5)restrictions on sub-licensing. The above obligations are
ongoing during the term of the contract and will therefore result in a software license being
deemed executory. Obligations that are less easily classified as executory are those that are less
significant such as those that are passive and do not require a partys performance. Even if
obligations exist that are not ongoing, if they are outstanding and not fully performed such as
installment payments, a court might qualify them as executory. There is little uniformity among
the courts in classifying certain less significant obligations as executory.
One such obligation that has received differing classification as executory is a licensors
implied promise not to sue the licensee for infringement.14 Although the relevant cases involve
patent licenses the holdings are applicable to software licenses because holdings in patent
licensing cases are generally treated as binding on relevant issues involving software licenses.15
In one case, even where there were no outstanding obligations besides the duty implied by all
patent licenses that the licensor not sue the licensee for infringement, courts have judged this
duty a sufficiently significant ongoing obligation to qualify the license as executory.16 The court
inIn re Access qualified the duty sufficiently significant to be executory because it reasoned that
14Bisk, supra note 6, at 624.
15Id.
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the duty is the raison d'etre for a patent license.17
In a software licensing case, a duty not to sue
could render the contract executory because software licenses also grant the licensee the right to
use the software and thus imply an obligation that the licensor not sue the licensee for using the
software.
Other courts have considered an implied duty not to sue insufficiently significant to
render a license executory.18
In re Gencorthe court deemed the implied duty not to sue merely a
condition of payment by the licensee, whose failure would excuse further payment rather than a
material unperformed obligation, of kind sufficient to make patent licensing agreement
executory.19 Given this ruling, a court would likely not find executory a software contract
based merely on an implied duty not to sue which is not expressly stated in the license since this
duty is not as fundamental a purpose of software licenses as is the case in patent licenses.
However this line of cases demonstrates the need to consider passive obligations that may seem
insignificant yet are ongoing and therefore possible to construe as executory.
One passive obligation that nonexclusive software licenses almost universally require is
that of a duty of confidentiality between the software developer and licensee. This duty is a
similarly passive obligation like the duty not to sue. These treatments of passive obligations as
executory demonstrate the necessity for the drafter of a software license to thoroughly evaluate
every obligation created by the license, including passive and implicit obligations, in order to
determine if the license will be deemed executory in a future bankruptcy proceeding. Below we
16In re Access Beyond Techs. Inc., 237 B.R. 32, 43 (Bankr. D. Del. 1999).
17Id. at 42.
18In re Gencor Indus., Inc., 298 B.R. 902, at 902 (Bankr. M.D. Fla. 2003).
19Id.
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will consider the specific risks that executory treatment of software licenses poses to licensors
and licensees in the event of bankruptcy.
V. Risks to Software Licensees Facing a Bankrupt Licensor
Since companies that license for the use of software rely on the license as an assurance of
continued use during the term of the contract, the ability of an insolvent licensor to reject the
license in bankruptcy is a significant threat to licensees. Although this risk has since been
addressed by Congress in enacting the Intellectual Property Bankruptcy Protection Act (IPBPA),
licensees still lose rights when a bankrupt licensor rejects a software license. The landmark case
which demonstrated this issue and encouraged Congress to enact the IPBPA wasLubrizol.20
In
Lubrizol, Richmond Metal Finishers granted Lubrizol a non-exclusive license to use its patented
process for coating metal. The reorganization plan that Richmond, the debtor-in-possession,
presented to the bankruptcy court included the rejection of the license to Lubrizol in order to
allow Richmond to sell the patented process without the burden of the license to Lubrizol. The
court reflected that the bankruptcy code did not permit it to consider the inequity of allowing a
licensor to deny the licensee of all the rights to intellectual property that were granted previously
under the rejected license; therefore, it concluded that only congress could reform the law to
create protection for licensees.21
In 1988 Congress responded to situation illustrated by Lubrizol by enacting the
Intellectual Property Bankruptcy Protection Act (IPBA). The IPBA, which is codified in
365(n), allows licensees whose license has been rejected by a debtor-licensor to choose between
20Lubrizol, 756 F.2d at 1047.
21Id. at 1048.
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two options: (1) to accept the termination of the license and assert a breach of contract claim
against the debtor-licensor or (2) retain its licensed rights in the intellectual property for the
duration of the contract.22 Although 365(n) addresses the great inequity ofLubrizol by granting
licensees an option to keep using the licensed intellectual property this alternative comes with
risks and minimal rights. The downside of 365(n)(1)(B) lies in the fact that it does not give
back the benefits of the other obligations of the licensor, but the licensee is required to continue
payment and performance obligations agreed upon in the license. Furthermore in opting for
365(n)(1)(B) the licensee is opting to continue performing under the license and is effectively
waiving its option to sue the licensor for breach. The licensor is absolved of obligations other
than the passive obligations under the license related to allowing the licensees use.23
The only
actions the licensee can take against the licensor once it opts to retain use under 365(n) is to
enforce the passive obligations. Therefore opting for 365(n)(1)(B) requires the licensee to take
a great risk in waiving its breach claim in exchange for continued use of the software without the
security of being able to sue for damages in the future. The only exception to this waiver is that
the licensee may present a bankruptcy claim for the non-passive performance obligations that the
licensor failed to perform.24
Lastly, the licensee has a limited prospect of recovery of damages for
the licensors performance obligations because these are difficult to calculate and the licensees
2211 U.S.C. 365(n)(1)(A) & (B).23
See In re Szombathy, 1996 Bankr. WL 417121 (Bankr. N.D. Ill. 1996) rev'd in part
on
other grounds, Szombathy v. Controlled Shredders, Inc., 1997 WL 189314 (N.D. Ill.
Apr14, 1997).24
Bisk, supra note 6, at 617; Douglas G. Baird, Elements of Bankruptcy, 92 (3d ed.
2001).
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claim will be among the pool of unsecured claims, which are permitted recovery from assets
remaining after the debtors higher priority claims, e.g., secured claims, are satisfied.25
a. Free and Clear Sale Risks
Another issue facing licensees if a licensor files for bankruptcy is: What happens when
the licensor subsequently sells the underlying intellectual property rights? Might the licensee lose
its right to use the software? This issue is problematic because it has recently developed and
stands wholly unresolved. As was the result in Qualitech, the case that presented this issue, it is
possible that a licensee might lose its license rights altogether upon a free and clear sale.26
Although the case at issue involved real property rights, the issue applies to software licenses
because the relevant bankruptcy mechanisms at issue are the same for real property and
intellectual property licenses.27 The issue in Qualitech was how to resolve the conflict between
365(f), which allows sale of the debtors property free and clear of a lessees possessory interest,
and 365(h), which protects a leaseholder right in the debtors property.28
The problem is that
365(h) does not contain language suggesting that it supersedes 365(f). The Seventh Circuit
ruled that 365(h) does not supercede 365(f); therefore, the property should be sold free and
clear of the encumbrance. The court also concluded that the leaseholder was not unjustly harmed
because it could receive equitable monetary compensation. For a software licensee, the Qualitech
ruling suggests it might lose its right granted by 365(n) to continued use of the software in the
2511 U.S.C. 1122(B).
26Precision Indus., Inc. v. Qualitech Steel (In re Qualitech Steel Corp.), 327 F.3d 537,
540 (7th Cir. 2003).27
11 U.S.C. 365(h), (n).28
11 U.S.C. 365(f).
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event that the trustee/debtor-in-possession wishes to sell (assign) its ownership rights to the
software free and clear of the license to the licensee.29
VI. Risks to Software Licensees if they Face Bankruptcy
Unlike the software licensee faced with an insolvent licensor, a licensee who enters
bankruptcy faces risks that are not addressed by the IPBPA and 365(n). In the worst case
scenario, the licensee could lose all its rights to the software when it reorganizes but is barred
from assuming its own software license. This problem has arisen in the context of 365(c),
which presents an exception to the trustee/debtor-in-possessions right to assume or assume and
assign a contract where applicable law excuses a party, other than the debtor, to such contract or
lease from accepting performance from or rendering performance to an entity other than the
debtor.30
To further complicate matters, the language of 365(f) is directly at odds with
365(c)(1) in that it grants the trustee/debtor-in-possession the power to reject, assume, or assume
and assign an executory contract notwithstanding applicable law. As a result of this conflict,
the courts differ in their interpretation of 365(c)(1) and 365(f).31
Most courts give deference
to 365(c)(1) when the executory contract is for personal services.32
Unfortunately for the
software licensee, the courts view nonexclusive licenses as personal service contracts because the
licensor has evaluated and relied on the promised performance of the named licensee when
29Jon Minear,Your Licensor Has a License to Kill, and it May be Yours: Why the Ninth
Circuit Should Resist Bankruptcy Law that Threatens Intellectual Property Rights, 31
Seattle U. L. Rev. 107 (Fall 2007); Bisk, supra note 2, at 633.30
11 U.S.C. 365(c)(1)(A).31
Bisk,supra note 6, at 635.32
Id. at 635.
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negotiating the terms of the license, and any substitution of licensee means a change in the
substance of the terms of the agreement.33
Nonexclusive patent and copyright licenses are
non-assignable for this reason.34
Nonexclusive software licenses between companies are generally treated as personal
service contracts because they typically involve obligations which are similarly specific to the
parties such as a software upgrade requirement. For the software licensee, this means that they
may be barred from assigning the software license. The software license is often a significant
asset and the inability to sell this license to a third party means the loss of an important asset and
may hinder the licensees ability to continue functioning.
An even more dangerous prospect stemming from the language opposing implications of
365(c)(1) and 365(f) is that the reorganized licensee will be barred from assuming its own
license. This prospect has harsh implications to the reorganized licensee since continued
operation depends on the licensed software. In this circumstance, a licensee will be in a weak
bargaining position for a new license from the licensor.35
This question is the source of a divisive split among the courts between two tests for
determining whether a bankrupt licensee may assume a license. The first test, the hypothetical
test, prevents the debtor from assuming the executory contract over the non-debtors objection
if applicable law would bar assignment to a hypothetical third party, even where the debtor in
possession has no intention of assigning the contract in question to any such third party.36 The
other test, the actual test, allows assumption as long as the debtor does not seek to assign the
33Id. at 619.
34In re Golden Books Family Entmt, 269 B.R. 300, 309 (Bankr. Del. 2001).
35Bisk,supra note 2, at 635.
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contract.37
Essentially the hypothetical test bars assumption whereas the actual test allows
assumption.
While this issue has not reached the Supreme Court, the Ninth Circuit and Fourth Circuit
have ruled in favor of the hypothetical test.38 Of particular relevance is the Fourth Circuit ruling
in Sunterra because it involved assumption of a nonexclusive software license in bankruptcy.
Sunterra involved a resort paid $3.5 million for a nonexclusive license to use software for
making reservations. The resort, Sunterra, invested $38 million in developing the software for its
business and subsequently filed for bankruptcy. Before reaching the Fourth Circuit, both the
bankruptcy court and district court had relied on the actual test in allowing Sunterras assumption
of the license. Both lower courts reasoned that the actual test was more equitable because RCI
would not be harmed if Sunterra were permitted to continue using the software for the term of the
license. The Fourth Circuit reversed the earlier rulings on the grounds that it deemed the
hypothetical test the proper test regardless of policy implications.
The second case, Catapult, involved assumption of a patent license. In that case the Ninth
Circuit reversed a ruling by the bankruptcy court and affirmed by the district court allowing
assumption based upon actual test. While Catapultinvolved a patent license, the court
considered the issue of assumption generally for all executory contracts; therefore the
36Id. at 636 (citingPerlman v. Catapult Entmt, Inc. (In re Catapult Entmt, Inc.), 165F.3d 747, 750 (9
thCir. 1999)).
37Michelle Morgan Harner et al., Debtors Beware: The Expanding Universe of
Non-Assumable/Non-Assignable Contracts in Bankruptcy, 13 AM.BANKR.INST.L.REV. 187, 187 (2005).38
See RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.) , 361 F.3d 257 (4th Cir.
2004);Perlman v. Catapult Entmt, Inc. (In re Catapult Entmt, Inc.), 165 F.3d 747 (9th
Cir. 1999).
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hypothetical test would apply to an issue of assumption of an executory software license in the
Seventh Circuit.
The Catapultand Sunterra rulings present software licensees with a dangerous situation
that should be considered in preparing their software licenses. While the rulings are not binding
on courts in other circuits, they are likely to influence the opinions of other courts and may mark
a transition among the courts to the hypothetical test. Unless Congress steps in as it did after
Lubrizol and enacts protection for the licensee in bankruptcy, software licensees are threatened
with losing their software licenses altogether in the event that they file for bankruptcy.
VII. Licensee Measures of Protection
A software licensees surest means of protection from being blocked from assumption in
bankruptcy is to license for software through non-executory means such as an exclusive contract
or non-exclusive contract that imposes no significant ongoing obligations. The licensee should
carefully draft the license so that it cannot be construed as a personal services contract requiring
obligations that are specific to the parties. Drafting a non-executory license is also difficult
because obligations are inherent to any license, and the courts have often found passive
obligations such as duties of confidentiality to be executory. Also problematic is the fact that the
courts disagree over what obligations are executory and have even found exclusive licenses to be
executory based on less significant passive obligations such as the duty of confidentiality. This
circumstance creates an uncertain predicament for the licensee negotiating a license since the
licensee must walk a tightrope between including provisions that protect the licensees rights but
increase its executoriness and excluding such provisions but losing license rights.
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a. Escrow Agreements
One mechanism that licensees can use to protect their software license rights is the source
code escrow agreement. Source code is, in essence, the set of architectural plans for the software
and is necessary for making improvements or repairs to software. Source code escrow involves
depositing the source code with a third party, generally a business that is independent and
serves just this purpose.39
The escrow process will involve inclusion of escrow provisions within
the software license that make reference to an escrow agreement which will be signed by the
licensor, licensee, and escrow agent.40 The escrow contract grants the escrow agent the power to
release the software source code to the beneficiary (the licensee) when certain conditions are met.
These conditions will be stipulated in both the license and escrow agreement. While escrow
offers strong protection for the licensee, the benefit still depends on license provisions that
trigger release of the software. Therefore, since the goal of this protection is to release the code in
the event of the licensors insolvency, escrow agreements are susceptible to the Bankruptcy
Codes invalidation of ipso facto provisions. Because 365(e) prohibits conditions based on
insolvency as well as bankruptcy, a licensee cannot depend on provisions that release the escrow
on the licensors insolvency even before bankruptcy.41
The only solution is to draft escrow
provisions that release the software code to the licensee before bankruptcy and conditioned on
circumstances unrelated to insolvency.
b. The Ride-Through Option
39James E. Raymond, Software Licenses, Source Code Escrows, and Trustee Power
Under11 U.S.C. 365, 1 J. BUS. ENTREPRENEURSHIP & L. 43, at 49 (2007).40
Id.41
Menell, supra note 1,at 32.
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The Fourth Circuit and Ninth Circuit Courts rulings ascribing to the hypothetical test
means that a licensee is essentially short on options in the event of bankruptcy. One hypothetical
way a licensee may avoid losing its in this manner is by neither rejecting or assuming the
software license in order to avoid giving the licensor an opportunity to object to the license. This
method of letting an executory contract pass through bankruptcy is referred to as the
ride-through doctrine.42
The scenario has only been tested in one case,In re Hernandez, 287
B.R. 795, 803 (Bankr. D. Ariz. 2002). InHernandezthe court allowed the licensee to continue
using the license without assuming or rejecting the license. However, one caveat to this option is
that ride-through eliminates protections offered by bankruptcy. First, it is not clear whether a
licensee can even ride-through if the licensor objects.43
Even if the licensee has not breached
any obligations under license a court might allow the licensor to terminate the contract if it
considers bankruptcy a breach by the licensee. The licensee also loses the protection of 365(e)
which invalidates ipso facto clauses conditioning termination on bankruptcy. Therefore, a
licensee should negotiate against ipso facto clauses and should not attempt a ride-through on a
license containing such clauses. The availability of a ride-through when a licensor objects is
uncertain, but because the licensee has not affirmatively assumed the license, it is possible the
courts would not block the licensee from the ride-through. This option is the only currently
available prospect for a bankrupt licensee to continue using the license in a jurisdiction that
adheres to the hypothetical test.
VIII. Risks to Licensors if its Licensee Faces Bankruptcy
42Menell,supra note 1, at 43.
43Id.
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In light of the generous protections granted the debtor under the Bankruptcy Code,
software licensors threatened with an insolvent licensee stand to lose significant rights. The first
issue for licensors is whether they can terminate the software license when it appears that the
licensee is nearing insolvency. The licensor may wish to terminate the license when the licensee
becomes insolvent or enters bankruptcy rather than continue its obligations when facing a
licensee that may not be able to continue its payment obligations. As is common practice, the
licensor may have negotiated for provisions in the license which terminate the license upon the
insolvency or bankruptcy of the licensee. As described above, these provisions, known as ipso
facto clauses, are barred under 365(e) for executory contracts. Therefore, the only way to
terminate the contract before the licensee enters bankruptcy is if the license includes conditions
for termination that do not directly relate to insolvency or bankruptcy. This is a complicated
undertaking since the licensors goal is to draft conditions allowing it to terminate upon the
licensees insolvency, but any condition related to this situation will be construed as an ipso facto
clause. If the licensor cannot terminate the license because termination is barred by 365(e), the
licensor should continue to perform its obligations because failure to perform the obligations
could put the licensor in breach of the contract and allow the licensee to sue for breach.
The next issue for licensors is what options are available once the licensee enters
bankruptcy and attempts to reject, assume, or assign the license. As explained above, the
Bankruptcy Code gives the debtor-in-possession great latitude in allocating the debtors assets
and liabilities and gives the trustee/debtor the right to reject, assume, or assume/assign executory
contracts. Also as discussed above, rejection is readily granted by the courts, but assumption and
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assignment are allowed where applicable law permits.44
The courts disagree on when 365(c)
trumps 365(f) and applicable law bars assumption. This issue presents a licensor with the
problematic issue of whether the relevant courts will allow their licensees assumption or
assignment of the license. As discussed previously, the courts bar assignment for personal
services contracts and apply either the hypothetical or actual test in determining the assumability
of the license. While the Ninth Circuit and Fourth Circuit have adopted the hypothetical test, the
others have not established a preferred test. Since a licensee whose business is located in the
Ninth and Fourth Circuits would be required to file bankruptcy in those jurisdictions, a licensor
of such a licensee could predict that the licensee would be barred from assumption in the event of
bankruptcy. However, licensors of licensees in other jurisdictions face uncertainty with respect to
whether the assumption would be allowed by the relevant courts.
Although assignment is permitted less frequently than assumption because executory
contracts are often considered personal contracts and most courts give deference to 365(c) for
personal service contracts, this issue is not completely uniform, and therefore presents some
uncertainty for licensors. This presents the risk that a court may not consider the software license
to be a personal services contract if the court views that the executory obligations in the license is
not specific to the parties.
To protect itself from assumption or assignment risks, the prudent licensor should
negotiate for provisions barring assumption or assignment. Second, a licensor should draft
obligations so that they are specific to the parties. Third, the licensor should include obligations
that are ongoing and require non-passive performance by the licensee so that the obligations will
4411 U.S.C. 365(c), (f).
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be judged significantly ongoing to be executory and specific to the parties so that they will be
deemed personal services.
Conclusion
Bankruptcy poses severe consequences to licensees and licensors. Since all companies
now depend on software that is integral to their particular businesses software, licenses are
extremely crucial to a companys continued viability. A companys dependence on software is
even greater when software is developed specifically for the companys needs. This dependence
on software makes vulnerability of software licenses to bankruptcy mechanisms a serious threat
to companies. As illustrated above, both licensees and licensors face this risk. Licensors are
vulnerable to the powerful protections offered to debtors. A licensor could face having to
continue to expend resources to perform its obligations under the license while the insolvent
licensee may not be able to continue its obligations of payment. Licensor obligations related to
improving and maintaining software can require substantial resources that the licensor may be
unable to recoup from an insolvent licensee.
A licensee faces risks both if it or its licensor enters bankruptcy. Licensees depend on the
continued use of software to maintain their businesses. The licensees rights to use the software
lie in the protections granted by the license. An insolvent licensee is financially vulnerable and
may be unable to re-establish its viability if it is barred from assuming the license and thus
unable to use the software. Similarly, a bankrupt licensees reorganization may depend on its
ability to sell its rights to a license to another party through assignment. The non-bankrupt
licensee is equally at risk if its licensor becomes insolvent and rejects its license because it faces
two equally unsatisfactory options: accept the rejection and try to recoup its losses from the
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bankruptcy estate or waive its breach claim and continue to use the software under 365(n)
without benefits available under the license. In either case, the licensee is likely to suffer
financial losses that it is unlikely to recoup from the bankrupt licensor. The option to continue
using the software is the only statutory protection within the bankruptcy which is specifically
intended to protect rights under an intellectual property license, but it is an inadequate protection
because it only prevents the most serious harm to a licensee.
The prudent licensor and licensee should consider these risks in licensing for software by
considering these risks and the available options during the licensing process. While some of the
risks are not completely preventable, considering the relevant risk early on affords the most
protection. One important step is to evaluate the financial viability of the other party thoroughly
before entering into a software license. Another step is to consider the greater risk of entering
into an executory contract. If the party can satisfy its purposes through a non-executory contract,
such a contract would not be as vulnerable to bankruptcy. Since executory licenses are often
necessary, a party should draft the executory obligations carefully and consider the risks in
drafting obligations that offer the most protection. One precaution favoring the licensor is to
require performance by the specified party so that the software license will qualify as a personal
services contract and will be less vulnerable to assumption or assignment in bankruptcy.
A significant implication of the vulnerability to bankruptcy of software licenses and other
technology licenses is the need for statutory protections that remedy this vulnerability. The
Bankruptcy Code is not as old as the laws granting intellectual property protection and yet it was
created without adequate consideration of the implications of its powerful mechanisms. The
enactment of 365(n) is a limited protection and does not protect most of the risks to licenses.
As technology develops, it becomes more and more integral to business and leads businesses to
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become dependent on very specific technologies. Statutory amendment to the Bankruptcy Code
would be the most adequate remedy to the uncertain and often inequitable implications resulting
from the Bankruptcy Codes broad reach. Bankruptcy law conflicts with intellectual property law
because it grants overly broad protections without adequate limitations. This problem presents
disproportionate risks to technology licensing because traditional forms of protection such as
security interests and monetary damages are not suited to the novel rights and interests involved
in technology licensing.