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When software vendors seek protection under bankruptcy law, the interests of licensees are placed at risk.

Consider the following hypothetical scenario: Last year, Acme Corporation licensed computer software known as “MarketPro” from Buller Software Inc. The license agreement provided Acme, as licensee, with the exclusive right to use the software in Acme’s industry. Acme uses the software on a daily basis and the software forms the backbone of Acme’s sales and marketing support.

Over the last few months, newspapers have reported Buller’s financial problems and there have been rumors of a potential bankruptcy filing. Acme received notice last month that Buller filed a Chapter 11 petition and just received notice this week that Buller is asking the bankruptcy court for permission to reject its license agreement with Acme.

Is there anything licensee Acme can do now to protect its interests and make sure that its rights under the license agreement are preserved? Was there anything Acme could have done last year to better protect itself?

Under Bankruptcy Code §365(n), Acme has two options upon Buller’s rejection of the license agreement: It may treat the agreement as terminated or it may retain its rights under the agreement to use the licensed intellectual property for the duration of the contract period.

If Acme chooses to treat the contract as terminated, the rejection would constitute a breach of the license agreement and Acme could then assert a claim for damages as a prepetition general unsecured creditor. Such a claim may be of little value, however, because creditors that hold unsecured claims often get paid just a small fraction of their total claim or nothing at all.

A brighter picture emerges under the second alternative. If Acme elects to retain its rights under the license agreement, then Acme’s right to use the intellectual property is preserved for the term of the contract notwithstanding the licensor’s rejection. See In re Cellnet Data Systems, Inc., 327 F.3d 242 (3rd Cir. 2003).

More specifically, §365(n)(1)(B) allows a licensee to retain its rights to intellectual property under the contract and under any agreement supplementary to the license.

Plusses and Minuses

What are the downsides to a §365(n) election? Well, there are limits to what the licensee can retain under §365(n)(1)(B). The right to retain does not include a right to compel specific performance by the licensor under the contract. This means that after rejection the licensor has no obligation to perform affirmative acts under the license such as providing training, debugging, maintenance, or indemnification. (Under this scenario, however, the licensee will still retain an unsecured claim for a more limited set of damages from rejection because the licensee loses some of the rights it had under the license agreement.)

And if the licensee makes the election to retain the license agreement, the licensee must continue to pay any license fees due for the remaining term, waive any right to a set-off, and waive claims for administration expenses against the bankruptcy estate. Id. §365(n)(2)(C).

The upside is that if the licensee elects to continue to use the licensed property pursuant to §365(n)(1)(B), the licensor is required to allow the licensee access to the intellectual property if the original license agreement and any supplementary agreement so provides, and may not interfere in any way with the licensee’s rights pursuant to the license agreement and any supplementary agreement. Id. §365(n)(3). The licensee can enforce negative covenants as well as enforce exclusivity provisions such as in Acme’s license agreement. Id. §365(n)(1)(B).

Turning back to our hypothetical, if Acme determines that it wants to continue using the software, it has that right under §365(n). Its bankruptcy counsel must submit a written “notice of election” after the licensor rejects the license agreement in order to preserve Acme’s rights.

It is important to file the written notice soon after the rejection in order to block any attempts by the trustee to sell the underlying intellectual property asset (the software code) to a third party, which potentially threatens the licensee’s exclusive right to use.

Although it may still be necessary to resort to litigation in the bankruptcy court, the licensee that fails to make the election will have no legal leg on which to stand.

An Ounce of Prevention

Although §365(n) provides enhanced rights for the licensee in the event that the licensor files a bankruptcy petition, the licensee’s rights may still be impaired in many instances. This brings us to the old saying, “an ounce of prevention is worth a pound of cure,” or perhaps in our case, a pound of source code.

Since §365(n) does not create rights not included in the underlying license agreement or supplementary agreements, it is important to consider the possibility of the licensor’s bankruptcy whenever negotiating or drafting such an agreement.

• First, the licensee should insist that a clause be placed in the license agreement stating in sum and substance that the licenses granted therein are directly addressed by §365(n). This way, there will be increased certainty that the licensee can avail itself of the statute’s benefits.

Second, the licensee may consider entering into a software escrow agreement supplementary to the license agreement.

One of the big problems faced by a licensee when the licensor files in bankruptcy is that the licensee can, for all practical purposes, lose access to the source code. In our hypothetical, this code is particularly important to enable Acme’s programmers to correct any bugs or defects that the software may contain. Because §365(n) does not impose affirmative obligations on the licensor, Acme is placed in a problematic position should Buller fail to turn over the code.

As noted above, upon rejection, the licensor no longer has any affirmative obligation to, for example, debug the software, and even if the licensor still has the source code it may be time-consuming to compel the licensor to turn over the code post-bankruptcy. As a result, a licensee should attempt to include in the license agreement a provision providing the licensee with access to the underlying source code held by the licensor so long as the royalty or license fees are paid.

Alternatively, the licensee can seek to include a provision that permits direct access to the source code by the licensor in the event that the licensor fails to or is unable to fulfill its affirmative obligations to debug, maintain, train, and so on.

Next, license agreements often contain restrictive covenants that, for example, preclude a licensee’s access to the licensor’s employees or ex-employees. However, the licensee should attempt to include a provision that extinguishes some or all of these restrictive covenants in the event that the licensor fails to fulfill its obligations under the license agreement. This way, the licensee would be able to directly hire the licensor’s top programmer to provide debugging, maintenance, or training services without running afoul of any restrictive covenants should the licensor fail to provide the aforementioned services pursuant to the license agreement.

At the same time, the licensee should insist that the source code be placed with a professional escrow agent that will release the source code to the licensee upon the occurrence of one or more specifically delineated events, such as the failure of the licensor to turn over the source code or upon rejection of the license agreement.

Indeed, §365(n)(3)(B) specifically provides that the trustee cannot interfere with the licensee’s right to the intellectual property provided in the license agreement, including any right to obtain such intellectual property from another entity such as a third party escrow agent.

It is also important to ensure that any updates to the source code are reflected in the source code copy held by the escrow agent. One should also include a provision in the escrow agreement that the escrow agreement is supplementary to the license agreement and is also covered by §365(n). The escrow agreement should also state that the source code is not the property of the bankruptcy estate under §541.

• Third, the licensee may also attempt to negotiate 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. This way, the licensee will receive special treatment under the Bankruptcy Code as a secured creditor. The licensee will then receive priority payment over general unsecured creditors. As a practical matter, the licensor may be extremely reluctant to grant such a security interest.

• Fourth, the licensee should attempt to itemize the royalty or license fees set forth in the license agreement. Even if the licensee elects to retain the license agreement, the licensor after rejection will not be required to perform certain obligations under the agreement, such as debugging, maintenance and training.

If the royalty or license fees are a lump sum, the licensee may be required to continue making full payments for the use of the software even though the licensee is not receiving all of the services for which it bargained. If the fees were itemized, however, the amount it would be required to pay under §365(n) may be reduced, since fewer services are being provided.

• Fifth, the licensee should consider including a provision requiring arbitration of disputes under the license agreement as well as a recoupment provision. This way, the arbitrator can fix the amount of damages resulting from the licensor’s default in failing, for example, to provide certain promised services.

One benefit here is that if the royalty or licensee fee is not properly itemized, the licensee may then use this amount fixed by the arbitrator to adjust the amount of fees due by the licensee to the licensor. While the licensee waives its right to set-off under §365(n)(2)(C), it does not waive its right to recoupment, i.e., deduction from amounts due the other party the cost or damages resulting from that party’s failure to comply with its cross obligations arising under the same agreement.) Thus, if Acme has to pay an outside expert $10,000 to debug the software because the licensor fails to do so, Acme would be able to recoup that amount.

Disputes over the amount of recoupment would be resolved by an arbitrator under the arbitration clause. This forum can often provide a swifter resolution of the issue. In addition, arbitration may provide a better chance at a favorable outcome for the licensee.

Bankruptcy courts are often reluctant to enter a decision diminishing the value of the bankruptcy estate because the court will take into account the interests of other creditors as well. By contrast, the arbitrator will be more likely to focus only on the license dispute and not on the interests of any other parties, thereby leveling the playing field.

Kronfeld is an associate at Gibbons, Del Deo, Dolan, Griffinger & Vecchione of Newark, where he is a member of the insolvency department and the financial services practice group.

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