27.5 Contractual provisions for software license agreements

27.5.6 Bankruptcy of supplier

All licensing agreements should be drafted in anticipation of the risk of the supplier/licensor's insolvency or bankruptcy, particularly for mission-critical software. Specific provisions of the United States Bankruptcy Code are designed to protect the rights of intellectual property licensees in the event of a licensor's bankruptcy.

Section 365(n) of the Bankruptcy Code gives a debtor (here, the licensor) the right to exercise its business judgment to determine which of its contracts it will "assume" (or continue to perform), and which it will "reject" (or breach with the bankruptcy rules), provided that the contracts are deemed "executory." A contract is commonly considered "executory" if the obligations of both the debtor and the non-debtor party to the contract "are so far unperformed that the failure of either to complete the performance would constitute a material breach excusing the performance of the other." A nonexclusive license typically imposes sufficient out-going obligations on each party to be deemed to fit within this definition of "executoriness." Section 365(n) allows the licensee to retain most of its contract rights before and even after the debtor has rejected the license. Section 365(n) allows the licensee to elect, by notice to the debtor, whether it wishes to have the debtor continue to perform its obligations orto deliver possession of the intellectual property to the licensee. In addition, Section 365(n) prohibits the debtor from interfering with the licensee's rights as provided in the contract. Upon rejection of the license by the debtor, the licensee may elect either to (i) treat the license as terminated and file a claim for rejection damages against the debtor's estate or (ii) retain its right to use the intellectual property in exchange for payment of all royalties due over the duration of the license and a waiver of all rights of setoff it may have against the debtor. Section 365(n) also protects the licensee's rights under an "agreement supplementary to" the license, such as a third-party technology escrow agreement.

To protect the Commonwealth under Section 365(n) of the Bankruptcy Code, the contract should provide the following:

Licenses granted under the supplier's license are deemed to be "intellectual property" as defined under Section 101(35A) of the Bankruptcy Code, and that the licensee shall retain and may fully exercise its rights under Section 365(n) in the event of the bankruptcy of licensor.

The Commonwealth (licensee) should have a present right to use and repair the intellectual property and to make derivative works as of the effective date of the license, even if the Commonwealth is not presently in possession of the source code.

The agreement should include sufficient ongoing duties on the part of licensor and licensee that the license will be deemed "executory" in the event of a bankruptcy filing. Examples of obligations which are executory include a duty for the licensor to notify the licensee of patent infringement suits and to defend the licensee against infringement claims; as well as indemnities and warranties.

If feasible, create separate agreements for: (i) trademarks and trade names, which do not fall within the Bankruptcy code definition of "intellectual property"; and (ii) affirmative obligations imposed upon the licensor, such as maintenance and support services, to which Section 365(n) does not authorize the licensee to retain rights. If maintenance and support services are included in the agreement, separately itemize that portion of the fees payable by the licensee that correspond to these obligations and stipulate that such fees will be reduced or eliminated if the licensor ceases to perform the services.

Include a statement that failure by the licensee to assert its rights to benefits provided by Section 365(n) will not be deemed a termination of the agreement in the event that it is rejected by the licensor.

Create a separate technology escrow agreement (cross-referenced to the license agreement) by which the licensor must provide source code for all intellectual property, including upgrades and modifications, to a third-party escrow agent. In addition to audit provisions and requirements concerning storage and maintenance of the software, the escrow agreement should recite that it is an "agreement supplementary to" the license as provided in Section 365(n) of the Bankruptcy Code, and specify trigger conditions for automatic release of the source code to the licensee, such as the cessation of business operations or failure of supplier to support the licensed property.