Software Licensing & Bankruptcy

Given the state of the economy, companies are more and more focused on bankruptcy issues. In software licensing transactions where the software is a mission critical application for the licensee, it is not uncommon for the licensee to require that the source code be placed in escrow. Typically, the purpose of the escrow is to provide the licensee with a comfort level that the source code will be available for the licensee’s use if certain events occur. These events are typically referred to as “release events.” One release event that is commonly negotiated in technology escrow agreements is the bankruptcy of the licensor. For more on this issue you can listen to my podcast on this topic.

The licensee’s fear arises (at least in part), from the generally accepted perception that bankruptcy is a bad thing. And, as a licensee, if a bad thing happens to my mission critical application licensor, I want a back up plan. On the other hand, licensor’s carefully guard the confidentiality of their source code. Accordingly, they generally resist release events which would allow the source code to be released while the licensor is still in business. In the abstract, however, the bankruptcy of the licensor does not always spell disaster for the licensee.

In an involuntary bankruptcy of a licensor, the licensor can always get out of bankruptcy by paying off or settling with the creditors that put the licensor into the bankruptcy. Of course if the licensor does not or cannot do so, then the bankruptcy will continue. If the bankruptcy continues as a chapter 7 liquidation, then there is an expectation that the licensor will eventually go out of business. In this case, the licensee would be rightfully concerned about the ability of the licensor to continue to support the software. However, if the involuntary bankruptcy is either filed as a chapter 11 reorganization or the licensor converts it to a chapter 11 reorganization, then the expectation is that the licensor will reorganize its financial position and will not go out of business.

In a voluntary bankruptcy, the key risk for the licensee turns on whether the case will proceed as a chapter 7 liquidation or a chapter 11 reorganization. If the licensor voluntarily files for a chapter 7 liquidation, then, as mentioned above, the licensee has good reason to be concerned. If, however, the licensor files for a chapter 11 reorganization, then, as long as the licensor does not otherwise breach it support and maintenance obligations, there is no need for the licensee to have access to the source code (other than the licensee’s general insecurity). Filing for bankruptcy under chapter 11 does not mean that the licensor will go out of business. It is quite possible that the licensor could file for bankruptcy under chapter 11 and “come out of bankruptcy” with a reorganized and stronger financial position, and, without a "hic up" in the performance of its support and maintenance obligations during the bankruptcy.

From the licensor’s perspective, the risk of compromising the confidentiality of its source code (the company’s key asset) can be terribly problematic. This is especially important where the software and source code will perform a pivotal role in the ability of the licensor to reorganize itself in the context of the bankruptcy. When considering bankruptcy as a release event under a source code escrow, analyzing the pros and cons of the possible scenarios may not be as straight forward as it otherwise seems.