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

Menell, Peter S., Bankruptcy Treatment of Intellectual Property Assets; An Economic Analysis, Berkeley Tech. L. J. 1, 45 (2007). 1

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
2

U.S. CONST., art. I, 8, cl. 8.

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

3 4

See 11 U.S.C. 321(a)(2). 11 U.S.C. 365.

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

Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers, 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). 7 Id. at 617 (citing Vern Countryman, Executory Contracts in Bankruptcy Law: Part I, 57 MINN. L. REV. 439, 460 (1973).). 4

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

8 9

11 U.S.C. 365 (2000). 11 U.S.C. 365(b).

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
10

11 U.S.C 365(e).

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

11 12

Menell, supra note 1, at 28. Bisk, supra note 6, at 623. 13 Id. 7

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 in In re Access qualified the duty sufficiently significant to be executory because it reasoned that

14 15

Bisk, supra note 6, at 624. Id.

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 Gencor the 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

16 17

In re Access Beyond Techs. Inc., 237 B.R. 32, 43 (Bankr. D. Del. 1999). Id. at 42. 18 In re Gencor Indus., Inc., 298 B.R. 902, at 902 (Bankr. M.D. Fla. 2003). 19 Id. 9

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 was Lubrizol.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

20 21

Lubrizol, 756 F.2d at 1047. Id. at 1048.

10

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 of Lubrizol 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

22 23

11 U.S.C. 365(n)(1)(A) & (B). 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. Apr 14, 1997). 24 Bisk, supra note 6, at 617; Douglas G. Baird, Elements of Bankruptcy, 92 (3d ed. 2001). 11

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

25 26

11 U.S.C. 1122(B). Precision 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). 12

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

29

Jon 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. 13

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

33 34

Id. at 619. In re Golden Books Family Entmt, 269 B.R. 300, 309 (Bankr. Del. 2001). 35 Bisk, supra note 2, at 635. 14

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 Catapult involved a patent license, the court considered the issue of assumption generally for all executory contracts; therefore the

36

Id. at 636 (citing Perlman v. Catapult Entmt, Inc. (In re Catapult Entmt, Inc.), 165 F.3d 747, 750 (9th Cir. 1999)). 37 Michelle 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). 15

hypothetical test would apply to an issue of assumption of an executory software license in the Seventh Circuit. The Catapult and 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.

16

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

39

James E. Raymond, Software Licenses, Source Code Escrows, and Trustee Power Under 11 U.S.C. 365, 1 J. BUS. ENTREPRENEURSHIP & L. 43, at 49 (2007). 40 Id. 41 Menell, supra note 1, at 32. 17

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). In Hernandez the 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

42 43

Menell, supra note 1, at 43. Id.

18

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

19

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

44

11 U.S.C. 365(c), (f).

20

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.

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