Bar News - July 19, 2017
Federal Practice, Bankruptcy & International Law: Protecting the Rights of Software Licensors in Bankruptcy
By: Steven Grill
The US Bankruptcy Code, drafted about 40 years ago, pays scant attention to many of the unique issues that arise with respect to debts owed on account of software sales. This article scratches the surface of some of the issues that arise in this statutory void.
Is Software a “Good”?
Because some provisions of the Code favor sellers of “goods,” it matters whether or not software is a “good.” Section 503(b)(9), for example, allows a seller of “goods” delivered to the debtor during the 20 days before the petition date to assert a priority claim for an administrative expense. In addition, Section 546(c) allows vendors to reclaim “goods” delivered to the debtor in the ordinary course of business during the 45 days before the petition date.
Courts have often held that software is a “good,” largely because the software had been delivered to the customer in a tangible, moveable object such as a CD-ROM. See, e.g., Micro Data Base Sys. v. Dharma Sys. (7th Cir. 1998) (applying New Hampshire law). Cf. In re Escalera Res. Co (Bankr. D. Colo., 2017) (electricity is a “good,” and if supplied to the debtor during the 20-day period preceding bankruptcy, seller has a priority claim under Section 503(b)(9).)
Today, however, it is far more common for software to be “delivered” by transmitting packets of digital code directly to the customer via the Internet. Moreover, many modern software transactions are subscriptions, in which a license is granted to use the software only for a specified period, after which the subscription must be renewed. In some cases, the software does not reside on the customer’s hardware at all, but instead is hosted by the vendor in the cloud. In addition, software is often a dynamic product that is actively managed, maintained, and upgraded throughout the life of the subscription. For these reasons (and others), software licenses should not be considered sales of “goods.” See Digital Ally, Inc. v. Z3 Technology LLC (D. Kan., 2010) (software license agreement not a sale of “goods”). As more courts recognize that software licenses are not sales of “goods,” sellers of software will no longer be able to take advantage of provisions in the Code that give favorable treatment in bankruptcy to sellers of “goods.”
Software Licenses as “Executory Contracts”
Although a software license is not a “good,” there are other potential avenues for favorable treatment under the Bankruptcy Code. Most important, software licenses can be deemed “executory contracts” subject to the potentially favorable provisions of Section 365 (see, e.g., In re BuildNet, Inc. (Bankr. MDNC, 2002)). The Code does not define “executory contracts,” but the term is generally taken to mean contracts having unfulfilled material obligations.
As a party to an “executory contract,” a software licensor may be in a better position to maximize recovery of the purchase price than a seller of goods. Many reorganization cases result in sales of substantial portions of the debtor’s businesses, and in such cases debtors may want to assign their software licenses to purchasers. Pursuant to Section 365(b), these executory contracts cannot be assigned unless they are first assumed by the debtor, which in turn requires that the debtor first cures any defaults – including payment defaults – and provides adequate assurance that future payments will also be made. See Tech Pharm. Servs. v. RPD Holdings, LLC (In re Provider Meds LLC) (Bankr. N.D. Tex. Jan. 18, 2017) (software license was an executory contract that could not be sold in accordance with Section 363(b), but rather had to be assumed in accordance with Section 365(a) and then assigned in accordance with Section 365(f).)
Strategies for Licensors of Software to Maximize Recovery in Bankruptcy
Proper drafting of license agreements can help improve the odds of a favorable outcome in bankruptcy. Agreements that define software as a service and clearly describe the licensor’s ongoing obligations stand a better chance of being deemed “executory.” Additionally, clauses that prohibit assignment unless the licensor consents may give licensors leverage during the reorganization process, particularly if there is a dispute regarding what constitutes a valid cure. These clauses are enforceable under Section 365(c), but beware of Section 365(e)(1), which invalidates clauses that provide for termination of a license merely because a party has filed for bankruptcy.
It is critical for a licensor to monitor customer bankruptcy cases diligently. If there is a potential purchaser when the case is filed, the case may move very quickly to an asset sale. If the licensor has not made it known that it intends to claim its agreements are executory contracts, it may not receive notice of specific procedures dealing with rejection and assumption of those agreements, and may miss the chance to argue that its license must be “cured,” assumed, and assigned. What is more, in all bankruptcy cases, there will be a deadline for filing administrative expense claims, and a licensor who misses this deadline may be unable to assert a priority claim for the debtor’s use of software during the pendency of the bankruptcy case.
Note that even if the license is rejected (in which case most of the amount due may be a general unsecured claim for rejection damages), the debtor’s use of the software prior to rejection may still give rise to an administrative claim for the value of the use prior to rejection.
If a licensor misses applicable deadlines, but then learns that the asset purchaser has assumed its license without proper consent, it may be able to assert non-bankruptcy claims against the purchaser, including unjust enrichment claims under state law and federal copyright infringement claims.
Navigating a customer’s bankruptcy is always difficult. Software licenses, in particular, raise complex legal issues. Careful attention should be paid to these issues in order to maximize potential recoveries for licensors while avoiding potential pitfalls.
Steve Grill is a shareholder in Devine Millimet’s Manchester office. He helps clients resolve difficult business and financial disputes and focuses his practice on telecommunications, technology and intellectual property issues.