Bankruptcy Issues in Software Licensing

8/6/2019 Bankruptcy Issues in Software Licensing

1/23

1

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).


2/23

2

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.


3/23

3

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.


4/23

4

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).).


5/23

5

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).


6/23

6

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).


7/23

7

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.


8/23

8

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.


9/23

9

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.


10/23

10

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.


11/23

11

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).


12/23

12

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).


13/23

13

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.


14/23

14

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.


15/23

15

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).


16/23

16

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.


17/23

17

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.


18/23

18

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.


19/23

19

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


20/23

20

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).


21/23

21

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


22/23

22

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


23/23

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.

Bankruptcy Issues in Software Licensing

Documents

Transcript of Bankruptcy Issues in Software Licensing