A Practical Guide to Software Leasing

Software Loan (Secured or Unsecured). Where the lessor chooses a debt instrument such as a lease that creates a security interest, the lessor is not the owner or licensor of the software, but is simply financing the price of the software on either an unsecured or a secured basis. In the case of an unsecured financing, there is no grant of a security interest by the lessee, although the lessee does agree that upon default the lessor may terminate the financed license and any related services. The remedy of termination of the license and related services may, however, be difficult to enforce in the event of a lessee bankruptcy. A more common scenario is where the lessor includes in the lease an express grant by the lessee to the lessor of a security interest in the financed software. In fact, it is preferable to include an express granting clause, rather than rely on a precautionary grant of a security interest in the lease. It is also prudent to include express authorization from the lessee to the lessor allowing the lessor to file a UCC-1 financing statement.

If the lease includes an express grant of a security interest in the software license, then the transaction will be subject to UCC Article 9. Note, however, that under UCC '9-408 and federal intellectual property law, the lessor will not have any right to remarket the software license unless either (a) the license is expressly transferable by its terms; or (b) the lessor obtains consent from the licensor. Given this restriction on remarketing, does a security interest in a software license have any value? The answer is “yes,” in that (i) there may be cash flows under the license such as refunds or rights of reimbursement in the event of a licensor breach of warranty; and (ii) in a bankruptcy of the lessee, it may be advantageous to the lessor to have the status of a secured party.

Although it is acceptable to use a “lease” to document a Software Loan, it is very common to use an unsecured or secured installment payment agreement (IPA) or promissory note instead of a lease. The lessor may wish to balance the benefits of a negotiable instrument (with no mention of the underlying software license transaction) against a nonnegotiable IPA (that contains recitals describing the underlying software license transaction) with a clear “hell or high water” clause and waiver of defenses against assignees. If the lessor is working closely with the software vendor, then it is often preferable to include the “hell or high water” language. In any event, it is prudent to ask the licensor and lessee to execute an amendment to the license, creating a cross-default between the Software Loan and the license.

True Lease or License-Sublicense Structure. Where the parties desire a true lease structure, the better view is that the lessor must become a licensee of the software from the licensor, and a sublicensor to the lessee. (Some would argue that a mere right of the lessor to terminate the license upon a lease default is sufficient to create a true lease. However, without judicial precedent to support this view, there would appear to be considerable risk in taking this position.) There are two ways for a lessor to become a licensee-sublicensor: (a) a Transfer and Licenseback or (b) a Pass-Through License. The Transfer and Licenseback is similar to a sale and leaseback of equipment. The lessee enters into a license with the licensor and then sells the license to, and leases/licenses it back from, the lessor. Given the nature of nonexclusive licenses of intellectual property, a Transfer and Licenseback can be accomplished only with the consent of the licensor. In the Pass-Through License structure, the lessor purchases the license from the licensor and sublicenses/leases it to the lessee. As with the Transfer and Licenseback, the Pass-Through License requires licensor consent.

The True Lease or License-Sublicense Structures are not governed by UCC Article 9. In fact, they are not governed by UCC Article 2 (sale of goods) or 2A (lease of goods) either. The true lease financing of software falls outside of the statutory framework, except in the states of Maryland and Virginia, which have adopted the Uniform Computer Information Transactions Act (UCITA). UCITA, among other things, specifically provides for the financing of software in a license-sublicense structure that is analogous to a finance lease under UCC Article 2A.

Note that a “true lease” of software for commercial law purposes may or may not qualify for true lease, off-balance sheet accounting treatment. For example, if a lessor cannot obtain any remarketing rights or remarketing assistance from the licensor, then it would be highly unusual for the lessor to take any residual risk in a software license. Therefore, typically a lease of software will have a fixed term with no end-of-lease purchase option. It would be difficult for the licensor to book revenue if the licensor supported the residuals, because the software revenue recognition rules do not allow the licensor to have any continuing involvement with the lessor. The key here is to consult early on with the accountants before settling on a particular lease structure.

Documentation Issues

In addition to the issues that arise in all leases, there are a number of issues that are somewhat unique to software.

UCC definition of goods. Note that the UCC Article 9 definition of “goods” includes a computer program embedded in goods, but does not include most application software licenses. Also, the UCC Article 2A definition of “goods” does not include intangible property. Therefore, it is important to define the software license carefully in the lease, and not rely upon the term “goods” or “equipment.”

“Hell or high water” clause and waiver of defenses against assignees. Perhaps the most important provisions to add to the lease are the “hell or high water” clause and the waiver of defenses against assignees. Also, the lessor should check the license to make sure that it does not provide for cancelable installment payments. It is much easier to justify a “hell or high water” clause if the only alternative the lessee had to lease financing was to pay cash upfront.

Special license-sublicense terms. In the True Lease structures, there should be a pass-through of warranties from the licensor to the lessee. In addition, the licensor should provide express authorization to the lessor to sublicense and lease the software license to lessee. There should be a conspicuous waiver by the lessor of all express and implied warranties. In fact, it would be prudent for the lessor to comply with requirements of UCC Articles 2 and 2A, as well as UCITA, regarding disclaimers of warranties. The lessee should covenant to comply with the terms and conditions of the head-license. If the lessor is licensing from a reseller, then the lessor should either read the licensor-reseller agreement or have the reseller represent and warrant that it has the power and authority (i) to license the software to lessor; and (ii) to grant the lessor the right to sublicense/lease the software to the lessee.

Covenants of the lessee. The lessee should covenant to keep the software license free of liens and encumbrances. Note that the licensee may have the status of a licensee in the ordinary course under UCC '9-321, although only with respect to liens created by the lessee's immediate licensor. It may also be prudent to require the lessee to agree to exercise any rights that it may have under Section 365(n) of the Bankruptcy Code, to continue using the software in the event of a licensor bankruptcy.

Defaults. As mentioned earlier, if at all possible, it is prudent to have the licensor and lessee amend the license to create a cross default to the lease. Otherwise, the lessor may not technically have any right to cause the license to be terminated upon a lease default. The lessor is typically made an express third-party beneficiary to the amendment of the license and the cross-default provision provided therein.

Remedies. In addition to the standard lease remedies, the lessor should have a right to cause the lessee to stop using the software license upon a lease default. The lessor should also have a right to terminate any related services.

UCC Issues

Perfection. A UCC-1 financing statement is required in the Software Loan structure to perfect the security interest in the software license. (A filing with the U.S. Copyright Office is required to perfect a security interest in a registered copyright, but the prevailing view is that a UCC-1 financing statement is sufficient to perfect a security interest in a nonexclusive license of a copyright.)

Priority. Note that it is not possible to have a purchase money priority security interest in 100% software, so it is necessary to order a UCC search against the lessee and to obtain lien waivers from any prior lienholders.

Restrictions on assignment. Under UCC 9-408, restrictions on assignment in a license are ineffective to impair the creation, attachment, or perfection of a security interest. However, the security interest may not be enforceable under UCC '9-408 or under federal intellectual property law. Therefore, if the lessor is seeking an enforceable assignment of rights under the license, then the lessor must obtain the licensor's consent. It is always prudent to read the license and/or reseller agreement to see what restrictions there may be.

A 100% software lease is not chattel paper. A 100% software lease is not “chattel paper” under the UCC Article 9 definition. Therefore, any party financing the lessor's lease portfolio will not be able to rely on the familiar chattel paper superpriority.

Software licenses are not inventory. Stand-alone software licenses are not goods and therefore are not inventory either. As a result, if a lessor is providing lease financing to customers of a licensor or reseller, then, in a priority dispute, lenders to the licensor or reseller will not have the benefit of a UCC '9-324(b) purchase money priority security interest in inventory.

Support from the Licensor

Although it is beyond the scope of this article to discuss vendor finance arrangements in any detail, it is worth mentioning a few of the key rights and remedies that the lessor may want to obtain from the licensor, including the following:

• an agreement not to consent to a transfer of the license from the lessee to the debtor-in-possession in the event of a lessee bankruptcy (see the In Re Catapult case);
• an agreement to cooperate with the lessor in the termination of the software license and related support services (assuming there is an appropriate cross-default provision in an amendment to the license);
• an acknowledgement of, and consent to, the security interest in the license, including an agreement to pay the proceeds of any warranty claims directly to lessor;
• an agreement not to provide the lessee with a new license until the lessor is paid in full under the lease; and
• consent to the transfer of the license to a buyer of the lessee's business.

Credit Policy Issues

In addition to the careful documentation of a software lease, there are a number of other ways in which a lessor can reduce risk inherent in a software lease transaction, including the following:

• finance only investment grade customers (although this will not be a satisfactory solution for licensors or lessees who do not qualify for financing);
• finance only mission-critical software, so that the risk of default is minimized;
• negotiate blind discounts from the licensor so as to enhance the yield;
• limit the financing of maintenance to 1 year of maintenance at a time; and
• avoid other forms of inherent performance risk, such as the financing of future deliverables.

Conclusion

Even though UCITA has not been widely adopted and Revised UCC Article 9 does not cover true leases of software, it is fair to say that much progress has been made in the last few years in terms of articulating the standards for financing software. Much work remains to be done, but software financing and leasing remains an area of opportunity for lessors who are willing to take a calculated risk.

Although the demand for software financing and leasing continues to grow at a tremendous rate, software financing and leasing remains one of the most challenging and least understood areas of leasing. The focus of this article is on the financing and leasing of 100% software, although there is some discussion of mixed leases of equipment and software. The goal is to provide lessors with a practical guide to the issues arising in a typical software financing or leasing transaction. The emphasis is on direct leases between a lessor and a lessee, as opposed to a vendor finance arrangement where the software licensor is also a party.

Structure Loan v. True Lease

One of the threshold issues that a lessor must decide is whether (a) to finance the software with a debt instrument, which could be a lease that creates a security interest, a promissory note, or an installment payment agreement, or (b) to attempt to finance the software with a true lease. By far the most common choice is to use a debt instrument, although true leases are common in certain markets.

Software Loan (Secured or Unsecured). Where the lessor chooses a debt instrument such as a lease that creates a security interest, the lessor is not the owner or licensor of the software, but is simply financing the price of the software on either an unsecured or a secured basis. In the case of an unsecured financing, there is no grant of a security interest by the lessee, although the lessee does agree that upon default the lessor may terminate the financed license and any related services. The remedy of termination of the license and related services may, however, be difficult to enforce in the event of a lessee bankruptcy. A more common scenario is where the lessor includes in the lease an express grant by the lessee to the lessor of a security interest in the financed software. In fact, it is preferable to include an express granting clause, rather than rely on a precautionary grant of a security interest in the lease. It is also prudent to include express authorization from the lessee to the lessor allowing the lessor to file a UCC-1 financing statement.

If the lease includes an express grant of a security interest in the software license, then the transaction will be subject to UCC Article 9. Note, however, that under UCC '9-408 and federal intellectual property law, the lessor will not have any right to remarket the software license unless either (a) the license is expressly transferable by its terms; or (b) the lessor obtains consent from the licensor. Given this restriction on remarketing, does a security interest in a software license have any value? The answer is “yes,” in that (i) there may be cash flows under the license such as refunds or rights of reimbursement in the event of a licensor breach of warranty; and (ii) in a bankruptcy of the lessee, it may be advantageous to the lessor to have the status of a secured party.

Although it is acceptable to use a “lease” to document a Software Loan, it is very common to use an unsecured or secured installment payment agreement (IPA) or promissory note instead of a lease. The lessor may wish to balance the benefits of a negotiable instrument (with no mention of the underlying software license transaction) against a nonnegotiable IPA (that contains recitals describing the underlying software license transaction) with a clear “hell or high water” clause and waiver of defenses against assignees. If the lessor is working closely with the software vendor, then it is often preferable to include the “hell or high water” language. In any event, it is prudent to ask the licensor and lessee to execute an amendment to the license, creating a cross-default between the Software Loan and the license.

True Lease or License-Sublicense Structure. Where the parties desire a true lease structure, the better view is that the lessor must become a licensee of the software from the licensor, and a sublicensor to the lessee. (Some would argue that a mere right of the lessor to terminate the license upon a lease default is sufficient to create a true lease. However, without judicial precedent to support this view, there would appear to be considerable risk in taking this position.) There are two ways for a lessor to become a licensee-sublicensor: (a) a Transfer and Licenseback or (b) a Pass-Through License. The Transfer and Licenseback is similar to a sale and leaseback of equipment. The lessee enters into a license with the licensor and then sells the license to, and leases/licenses it back from, the lessor. Given the nature of nonexclusive licenses of intellectual property, a Transfer and Licenseback can be accomplished only with the consent of the licensor. In the Pass-Through License structure, the lessor purchases the license from the licensor and sublicenses/leases it to the lessee. As with the Transfer and Licenseback, the Pass-Through License requires licensor consent.

The True Lease or License-Sublicense Structures are not governed by UCC Article 9. In fact, they are not governed by UCC Article 2 (sale of goods) or 2A (lease of goods) either. The true lease financing of software falls outside of the statutory framework, except in the states of Maryland and Virginia, which have adopted the Uniform Computer Information Transactions Act (UCITA). UCITA, among other things, specifically provides for the financing of software in a license-sublicense structure that is analogous to a finance lease under UCC Article 2A.

Note that a “true lease” of software for commercial law purposes may or may not qualify for true lease, off-balance sheet accounting treatment. For example, if a lessor cannot obtain any remarketing rights or remarketing assistance from the licensor, then it would be highly unusual for the lessor to take any residual risk in a software license. Therefore, typically a lease of software will have a fixed term with no end-of-lease purchase option. It would be difficult for the licensor to book revenue if the licensor supported the residuals, because the software revenue recognition rules do not allow the licensor to have any continuing involvement with the lessor. The key here is to consult early on with the accountants before settling on a particular lease structure.

Documentation Issues

In addition to the issues that arise in all leases, there are a number of issues that are somewhat unique to software.

UCC definition of goods. Note that the UCC Article 9 definition of “goods” includes a computer program embedded in goods, but does not include most application software licenses. Also, the UCC Article 2A definition of “goods” does not include intangible property. Therefore, it is important to define the software license carefully in the lease, and not rely upon the term “goods” or “equipment.”

“Hell or high water” clause and waiver of defenses against assignees. Perhaps the most important provisions to add to the lease are the “hell or high water” clause and the waiver of defenses against assignees. Also, the lessor should check the license to make sure that it does not provide for cancelable installment payments. It is much easier to justify a “hell or high water” clause if the only alternative the lessee had to lease financing was to pay cash upfront.

Special license-sublicense terms. In the True Lease structures, there should be a pass-through of warranties from the licensor to the lessee. In addition, the licensor should provide express authorization to the lessor to sublicense and lease the software license to lessee. There should be a conspicuous waiver by the lessor of all express and implied warranties. In fact, it would be prudent for the lessor to comply with requirements of UCC Articles 2 and 2A, as well as UCITA, regarding disclaimers of warranties. The lessee should covenant to comply with the terms and conditions of the head-license. If the lessor is licensing from a reseller, then the lessor should either read the licensor-reseller agreement or have the reseller represent and warrant that it has the power and authority (i) to license the software to lessor; and (ii) to grant the lessor the right to sublicense/lease the software to the lessee.

Covenants of the lessee. The lessee should covenant to keep the software license free of liens and encumbrances. Note that the licensee may have the status of a licensee in the ordinary course under UCC '9-321, although only with respect to liens created by the lessee's immediate licensor. It may also be prudent to require the lessee to agree to exercise any rights that it may have under Section 365(n) of the Bankruptcy Code, to continue using the software in the event of a licensor bankruptcy.

Defaults. As mentioned earlier, if at all possible, it is prudent to have the licensor and lessee amend the license to create a cross default to the lease. Otherwise, the lessor may not technically have any right to cause the license to be terminated upon a lease default. The lessor is typically made an express third-party beneficiary to the amendment of the license and the cross-default provision provided therein.

Remedies. In addition to the standard lease remedies, the lessor should have a right to cause the lessee to stop using the software license upon a lease default. The lessor should also have a right to terminate any related services.

UCC Issues

Perfection. A UCC-1 financing statement is required in the Software Loan structure to perfect the security interest in the software license. (A filing with the U.S. Copyright Office is required to perfect a security interest in a registered copyright, but the prevailing view is that a UCC-1 financing statement is sufficient to perfect a security interest in a nonexclusive license of a copyright.)

Priority. Note that it is not possible to have a purchase money priority security interest in 100% software, so it is necessary to order a UCC search against the lessee and to obtain lien waivers from any prior lienholders.

Restrictions on assignment. Under UCC 9-408, restrictions on assignment in a license are ineffective to impair the creation, attachment, or perfection of a security interest. However, the security interest may not be enforceable under UCC '9-408 or under federal intellectual property law. Therefore, if the lessor is seeking an enforceable assignment of rights under the license, then the lessor must obtain the licensor's consent. It is always prudent to read the license and/or reseller agreement to see what restrictions there may be.

A 100% software lease is not chattel paper. A 100% software lease is not “chattel paper” under the UCC Article 9 definition. Therefore, any party financing the lessor's lease portfolio will not be able to rely on the familiar chattel paper superpriority.

Software licenses are not inventory. Stand-alone software licenses are not goods and therefore are not inventory either. As a result, if a lessor is providing lease financing to customers of a licensor or reseller, then, in a priority dispute, lenders to the licensor or reseller will not have the benefit of a UCC '9-324(b) purchase money priority security interest in inventory.

Support from the Licensor

Although it is beyond the scope of this article to discuss vendor finance arrangements in any detail, it is worth mentioning a few of the key rights and remedies that the lessor may want to obtain from the licensor, including the following:

• an agreement not to consent to a transfer of the license from the lessee to the debtor-in-possession in the event of a lessee bankruptcy (see the In Re Catapult case);
• an agreement to cooperate with the lessor in the termination of the software license and related support services (assuming there is an appropriate cross-default provision in an amendment to the license);
• an acknowledgement of, and consent to, the security interest in the license, including an agreement to pay the proceeds of any warranty claims directly to lessor;
• an agreement not to provide the lessee with a new license until the lessor is paid in full under the lease; and
• consent to the transfer of the license to a buyer of the lessee's business.

Credit Policy Issues

In addition to the careful documentation of a software lease, there are a number of other ways in which a lessor can reduce risk inherent in a software lease transaction, including the following:

• finance only investment grade customers (although this will not be a satisfactory solution for licensors or lessees who do not qualify for financing);
• finance only mission-critical software, so that the risk of default is minimized;
• negotiate blind discounts from the licensor so as to enhance the yield;
• limit the financing of maintenance to 1 year of maintenance at a time; and
• avoid other forms of inherent performance risk, such as the financing of future deliverables.

Conclusion

Even though UCITA has not been widely adopted and Revised UCC Article 9 does not cover true leases of software, it is fair to say that much progress has been made in the last few years in terms of articulating the standards for financing software. Much work remains to be done, but software financing and leasing remains an area of opportunity for lessors who are willing to take a calculated risk.