Computer Software: How To Protect The Rights Of A Licensee When The Licensor Files For Bankruptcy Relief

By Shelly Rothschild, Esq.

 

There are three basic ways to try to protect the rights of a licensee of computer software from disruption in a bankruptcy case filed by the licensor: 1) obtain an outright transfer by the licensor to the licensee of all intellectual property rights relating to the computer software, rather than just a limited license; 2) obtain a security interest in all assets of the licensor, including all intellectual property rights; 3) obtain the source code for the computer software or have the source code placed in an escrow, obtain a license to use the source code, and provide for release of the source code upon a default or bankruptcy.

 

A. OWNERSHIP

First and best is to obtain a present transfer to the licensee of the licensor's rights to the software. This is because any property or rights that continue to be owned by the licensor and are only licensed to the licensee will be subject to special protections and powers that debtors in bankruptcy cases have, including the "automatic stay" and the right to "reject" licensing agreements. The automatic stay generally will prevent a licensee from taking action to enforce its rights against the licensor or its property after a bankruptcy case is filed.

"Rejection" of a contract permits the debtor to terminate the license to use the rights, unless the licensee falls within an exception contained in Bankruptcy Code Section 365 (n). To prevent the exercise of these special bankruptcy powers by the licensor, the rights would have to no longer be property of the licensor. Thus, if the licensor transferred the copyright and trademark for the software to the licensee, the risk of entanglement in the licensor's bankruptcy case would be reduced.

 

However, there are some problems with this approach. First, the licensor may be unwilling to give up ownership of these rights. Second, it probably would be cheaper for the licensee to license the rights, rather than to purchase them. Third, if the transfer documents are not well-drafted, the transfer may be re-characterized by a court as a license, rather than a real transfer of ownership, and therefore, the licensee's rights still may be subject to rejection. Fourth, the rights may not be in existence and capable of being fixed and registered because the software may not yet have been completed. Fifth, certain transfers may be "avoided" or undone by the licensor in a bankruptcy case as "fraudulent conveyances" or "preferences." A "preference" generally is a transfer that takes place within 90 days before the bankruptcy case is filed while the debtor is having financial difficulties. A "fraudulent conveyance" is generally a transfer for inadequate consideration that takes place within one year or more prior to bankruptcy while the debtor is having financial problems. As such, if the licensor is in financial trouble, it could agree to a transfer of rights to the licensee and then could seek to overturn the transfer after bankruptcy.

Nevertheless, a licensee should at least try to obtain ownership of the trademark for the software for the following reason: The special exception for intellectual property licenses under Bankruptcy Code Section 365(n), which protects the rights of a licensee, does not apply to trademarks or service marks. Therefore, the licensor could "reject" the licensee's right to use these marks, even though licensee might be able to retain its right to U.S. copyrights and patents. If the use of these trademarks is essential to the licensee's marketing and distribution of the software, then the licensee has the substantial risk of losing any benefit from the licensing agreement in a bankruptcy case. The best way to protect the right to use the trademark if the licensor goes into bankruptcy is for the licensee to obtain a present assignment of the trademark preferably by means of a document that is separate from the licensing agreement.

 

B. SECURITY INTEREST

Another method for a licensee to protect itself in bankruptcy is to obtain a security interest in all assets of the licensor to secure payment to the licensee of the licensor's obligations under the software license agreement. The assets taken as collateral should include all intellectual property rights, trademarks, trade secrets, patents, copyrights, general intangibles, accounts receivable, bank accounts, and the proceeds and products of each. For copyrights, the licensee will need a copyright mortgage, as well as a security agreement and UCC financing statements, and the interests must be perfected by filing with the United States Copyright Office in Washington, as well as on the state level. If the licensor has not registered the copyrights, the licensee may have to do so first in order to record its copyright mortgage. California also has special procedures for perfecting security interests in bank accounts.

 

The benefits of a security interest are many: Secured creditors get special treatment in bankruptcy cases. They are given priority over general unsecured creditors and get to be paid first out of the assets that are their collateral. A security interest is the best way to ensure that a licensee will get paid if the license agreement is breached or terminated. Upon rejection of a license agreement in a bankruptcy case, the licensee will only retain certain limited rights under the license and will lose its right to force the licensor to provide it with technical assistance to debug, maintain, market, and update the software. As a result, the licensee may get sued by sub-licensees and customers. Without security, the licensee will only have an unsecured claim for these losses. In most bankruptcy cases, creditors that hold only unsecured claims get paid only pennies on the dollar of what they are owed, or nothing at all. A secure source of payment thus will be of great value.

 

In addition, under certain circumstances, the secured creditor may be able to foreclose upon and become the owner of the collateral. If this includes the licensed rights, then the licensee would be able to obtain the rights even if the license had been rejected. A secured creditor has great leverage in a bankruptcy case. The debtor cannot sell or use its collateral without the creditor's consent or litigation. The creditor also gets the right to post-bankruptcy interest and attorneys fees, if its collateral is valued at more than the amount owed. However, the downside of a security interest is that a court may not permit foreclosure on the licensed rights, or it may take so long to get court approval that the rights may have lost their value. On the other hand, a security interest may be the only way for a licensee to get the trademark for the software, if the licensor will not agree to an outright assignment.

 

C. ESCROW SOURCE CODE

The third method is to structure and draft the license arrangement so as to take greatest advantage of the special protections granted to licensees of certain intellectual property under Section 365(n) of the Bankruptcy Code. First and foremost of these protections is enforcement of a licensee's right to demand the turnover of intellectual property from the licensor or a third party, such as an escrow agent, if this right is expressly divided for in the licensing agreement or a supplementary agreement. The second special right accorded to licensees protected by Section 365(n) is the continued right to exclusivity, again if this right is expressly provided for in the license agreement or a supplementary agreement. Only licensees who have gotten these rights in writing can exercise them after bankruptcy if the debtor chooses to "reject" the licensing agreement. Upon a rejection, which generally is easy for the debtor to obtain, all other rights under the license agreement will become unenforceable, leaving the licensee with only a general unsecured claim (unless it has obtained collateral). In addition, these special rights must be obtained before bankruptcy because the protections provided by Section 365(n) only apply to intellectual property rights that were in existence on the date of bankruptcy.

 

The importance of the right to require a turnover of intellectual property from the debtor or an escrow is the following: After the debtor rejects a software licensing agreement, the licensee can either choose to treat the contract as terminated, or retain its rights to the license, but with certain modifications. The licensee gets to keep exclusivity, and the right to a turnover of the intellectual property as it existed on the date of bankruptcy, but all other rights that require action by the licensor are no longer enforceable. Therefore, any obligations that the licensor has to give updates to the licensee will no longer be valid, and the licensor may be able to license any new or revised technology to someone else. In addition, any affirmative obligations that the licensor had to maintain, repair, or debug the software, to render technical assistance, or to train licensee employees no longer is enforceable. Accordingly, upon rejection, the licensee will be unable to rely on the licensor for any assistance in debugging, modifying, repairing, marketing, or updating the software.

 

Since the licensor will no longer be required to assist the licensee after rejection of the license agreement, the only way that the licensee will be able to maintain the computer software is if it has access to the source code. The best access is for the source code to be turned over to the licensee upon execution of the software licensing agreement, which, unfortunately, is rarely granted. Alternatively, the license agreement should provide that the source code will be placed in escrow, immediately upon execution of the license agreement. The escrow should be covered by a separate escrow agreement that provides for the automatic turnover of the source code to the licensee upon the occurrence of certain specified events, such as rejection of the license agreement, filing of a bankruptcy case by or against licensor, or breach of the licensor's obligations under the license agreement. The escrow should be updated as the source code is; it should contain all the documents that a programmer would need to debug, maintain and upgrade the software. The escrow also should contain the names of the key employees who worked on the source code, in the event that further development is needed. The escrow agent should be a professional technology escrow company. They will know how to properly store the source code, and they also can do technical verification. Verification is important because the licensee will want to be sure that the source code placed in the escrow conforms to specifications and will operate correctly. In this regard, it is crucial that the license agreement also contain warranties that the software will conform to specifications and operate correctly, with a corresponding duty on the part of the licensor to fix the software at its own cost if these warranties are breached. This will ensure that the escrowed source code is for software that will work properly. The licensor also should indemnify the licensee for any problems with the source code and any claims made by sub-licensees and customers.

Further, the licensee should be given a present license to use the source code to make repairs and derivative works, not just at the time that the source code is released. The licensee only will retain the rights that existed prior to the bankruptcy. If the source code license does not come into effect until the escrow is released, and that occurs after bankruptcy, then the license to use the source code will not be enforceable. The licensor will be protected because the licensee will be unable to use the source code until it is released. Accordingly, in order to maintain the software, the licensee must provide in the license agreement for 1) a source code escrow and 2) a license to use the source code at present.

 

There are a number of other drafting suggestions to take maximum advantage of Section 365 (n). This section cuts off the licensee's rights to future updates or versions of the software. However, it preserves the right to exclusivity. As such, exclusive rights should be obtained wherever possible. Future derivative works may run afoul of a licensee's exclusive rights to an earlier version, giving the licensee some bargaining leverage. Section 365 also cuts off the licensee's rights to set off its claims against royalties paid to the licensor to retain its license. It may not, however, cut off a right to "recoupment," i.e., the right to deduct the cost of affirmative obligations that licensor has failed to provide, such as technical assistance. Therefore, the license agreement should expressly provide for the right to recoup.

 

In addition, a recent court case found that mI license fees paid by a licensee were "royalties" that the licensee had to keep on paying to retain the license after rejection. Accordingly, if part of what the licensee is paying the licensor is for maintenance, repair, updates and technical assistance, these should be separately stated and broken out, or put in a separate agreement and deducted from the total amount being paid for use of the license. If the licensor rejects the license and refuses to fulfill these affirmative obligations, the licensee will not have to pay the full license fee for services that it is not receiving. Lastly, Section 365(n) preserves a licensee's rights not only during the contract term, but also during extensions thereof, if such extensions are provided in the contract. Accordingly, a licensee should not provide for automatic termination of a software license upon a bankruptcy filing by the licensor and should include provisions for automatic extensions of the license term.

 

This Article also will be published in the 1999/2000 edition of The Entertainment, Publishing and the Arts Handbook.

Shelly Rothschild is a partner in the Bankruptcy Department of the Los Angeles office of Holland & Knight. Ms. Rothschild has experience in business law and litigation, including workouts, reorganizations, bankruptcies, creditors' rights, and entertainment and technology transactions. Ms. Rothschild represents creditors committees, motion picture studios, production companies, television networks, publishers, film distributors, record companies, licensors, landlords and licensees.

Ms. Rothschild is a member of the Board of Directors of the Bankruptcy Strategist newsletter. She also is a member of the Bankruptcy Committee of the Los Angeles County Bar Association, and the Los Angeles Copyright Society. She formerly was Chair of the Task Force on Revisions to Uniform Commercial Code Article 9 formed by the Business Bankruptcy Committee of the American Bar Association's Business Law Section, a member of the Board of Governors and Executive Committee of the Financial Lawyers Conference, and a member of the Debtor/Creditor Relations and Bankruptcy.

Ms. Rothschild received a BA from Smith College in 1970 and a JD degree from Boston University in 1976 where she was the winner of the Homer Albers Moot Court Competition.