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"The Ts and Cs of Technology Escrow".

In response to Contract Management's July 2005 article on the "Ts and Cs of Technology Escrow," a reader wrote in to thank us for providing an article that was far more comprehensive than prior articles on the same topic. However, some questions on this topic remain, and these questions will be addressed in this follow-up piece.

Technology Escrow and Bankruptcy Law

Question: If a software vendor files for protection, or dissolution, under the bankruptcy law, the judge has total control of all business matters. Clauses in any contract that deal with the buyer's rights following a bankruptcy filing are no longer fully applicable. The judge has a primary duty to protect and preserve the bankrupt's assets for the benefit of the creditors. Doesn't this negate the need for technology escrow?

Answer: These statements are true and legally correct, but this does not negate the need for technology escrow. Since the Intellectual Property Bankruptcy Protection Act of 1988 was passed to law, licensees (buyers) that are party to a license that explicitly have an escrow agreement that is supplementary to the license will have the protection of the court to access the code in escrow in the event that the debtor (software vendor) rejects the obligations in the license agreement. To date, the courts have not stopped an escrow agent from releasing code to the detriment of the buyer.

Usually, a beneficiary to an escrow deposit account containing source code doesn't really want to own or take over the asset. Maintaining or developing code is not their core competency, and ultimately, they would rather that the debtor re-emerge and maintain the code--or that the court would sell the assets to another vendor who will take on the obligations. In the experience of this escrow agent, this is the reason that many agreements are structured to include the provisions of support failure that are likely to occur in advance of the formal bankruptcy filing. Practically speaking, most of the releases of source code occur under the following circumstances and in this order:

(1) Maintenance failure;

(2) Ceasing to do business in an ordinary course (not formal bankruptcy filing); and

(3) Chapter 11 or 7 bankruptcy filings.

Question: Why is technology escrow such a good solution, if bankruptcy proceedings may suspend access to the software source code?

Answer: Industry best practices are to structure release conditions around support and maintenance breaches and not bankruptcy alone so as to avoid the potential problem entirely. One could argue that with 365(e), the ipso facto clause, that anything solely structured around bankruptcy can be held null and void. Unfortunately, beneficiaries relying solely on bankruptcy as the only release condition are not gaining the full benefit of the escrow agreement. Clearly, under these circumstances, perhaps they simply let the other party drive the escrow arrangement and failed to use a best practice strategy associated with "thinking beyond bankruptcy" as a release condition. More and more beneficiaries are writing in other more subjective release conditions that allow them to get access to the code without involving a bankruptcy judge.

Considering the question, Section 365(n) of the Bankruptcy Code allows the beneficiary to retain its rights under such "executory" agreements, including licensing agreements devoid of any bankruptcy court proceedings.

Question: In bankruptcy, the creditors are first in line for relief and remedy. Potential damage to the buyer is not a major consideration to the court. So, if a software license provides for transfer of source to the buyer without equitable consideration, the court has the power--and might use it--to invalidate those terms. Isn't that correct?

Answer: Practically speaking, to put a dollar value on the source code license to encourage the bankruptcy trustee to release (or sell) the code is a great idea but a difficult number to come up with between the parties during the already lengthy negotiations. The question I would pose to the bankruptcy trustee is that there may be more revenue in selling the asset to another developer willing to take on the obligations to support the product in exchange for the stream of ongoing maintenance fees. This may net the debtor more money in commanding a higher price for the IP asset. Although we have seen parties establish escrow agreements, where the payment of monies is part of the release of the code to the client, these instances are rare because many buyers don't feel right "paying more" after a developer they have already paid has failed to perform.

Final Comments: Thanks for clarifying. I have a few other suggestions from a legal standpoint. If a buyer plans to use software from a vendor where business failure is even remotely possible, at a minimum, the license should include a cost line for a source license and another line should place a value on that source code. In that way, the court might be persuaded that this asset has been properly evaluated and might also be persuaded to allow release from escrow. The buyer needs to budget for some funds to cover this real cost. And, a prudent buyer will have some fallback strategy in the event that the software source is not released by the court.

As a further comment, it would be useful if the parties could identify the persons, within the vendor staff, who are key to understanding and using the software and the source code. There should be language that would permit the buyer to make an offer of employment to those persons, in the event of business discontinuance or a decision on the part of the vendor to cease supporting the software. This might not be acceptable to the court, but it is worth an attempt.

Response: You raise an excellent point, and we fully agree that there should be language to this effect written into both the licensing agreement and the escrow agreement. We encourage beneficiaries to specify that the deposit materials include contact information for key programmers, who can maintain the code for their clients should their previous employer (the software vendor) go out of business. To the best of our knowledge, no court has ever denied this provision.

In summary, we strongly recommend that you don't set up your escrow agreement with bankruptcy as the sole release condition. The goal of an escrow is to maximize your protection across a range of scenarios. To date, we are not aware of a case where an escrow has been stopped; however, in the textbooks, it can occur.

About the Author

FRANK BRUNO is a senior business strategist for Iron Mountain's Intellectual Property Management business unit and consults with developers, corporations, and intellectual property law professionals throughout the United States on IP management best practices. He has spoken at many professional and industry events, including the NCMA World Congress and NCMA Commercial Contract Management Conference 2004. Send comments on this article to
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Author:Bruno, Frank
Publication:Contract Management
Date:Nov 1, 2005
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