Assumption Of Software Licenses In Bankruptcy

Is a software license assumable by a licensee in the event the licensee seeks bankruptcy protection?

A recent Fourth Circuit Court of Appeals ruling has demonstrated the critical importance of this question to software licensees. The risk of nonassumption may prove quite significant. This article discusses this risk and suggests a potential license provision addressing the risk.

In Re Sunterra Corp.

The importance of the assumption question concerning software licenses to debtor licensees was emphasized by In re Sunterra Corporation (RCI Technology Corp. v. Sunterra Corp.), 361 F. 3d 257 (4th Cir. 2004). In that case, the Fourth Circuit reversed the district court by holding that the debtor-in-bankruptcy did not have the right to assume the RCI software license in question without the software licensor's consent. I have never seen this risk addressed in any software license. As such, this ruling may prove very significant because it raises the need for new contract protection to address this “assumption” risk.

In Sunterra, the Fourth Circuit found that '365(c) of the U.S. Bankruptcy Code does not permit Sunterra, the debtor licensee, to assume its nonexclusive software license with RCI without RCI's consent to the assumption. Sunterra was precluded from assuming its RCI software license to use and modify RCI's Premier Software. Under the RCI software license agreement, Sunterra owned any “enhancements” and granted RCI a license to use the Sunterra Enhancements. Sunterra had invested millions of dollars in the Premier Software. Under the circumstances, the RCI software license had become critical to Sunterra's operations, but its ability to assume the license as part of its plan to exit its bankruptcy was dependent on the licensor's consent.

In the Sunterra bankruptcy proceeding, RCI filed a motion with the bankruptcy court to deem its license with Sunterra rejected, and RCI asserted further that because it had refused to consent to the assumption of the license agreement, the court was required by law to deem the license rejected.

In ruling against Sunterra and its intent to assume the RCI license, the Fourth Circuit followed the “literal test” applicable to the interpretation and application of '365(c) of the Bankruptcy Code. The literal test provides that a debtor in possession may not assume an executory contract over a nondebtor's objection if applicable law (eg, the copyright laws) would bar assignment to a hypothetical third party. This prohibition applies even where the debtor in possession has no intention of assigning the contract in question to any third party. Software licenses are copyright licenses. Copyright law prohibits the assignment of a copyright license without the consent of the copyright-holder licensor. As such, '365(c) places the licensee at risk if the licensee ever seeks to assume a particular software license in a bankruptcy proceeding. The gist: The assumption option might not be available to the licensee.

License is an Executory Agreement

The Fourth Circuit determined that the RCI software license was an executory agreement. In so ruling, the Fourth Circuit applied the “Countryman Test” and found that the RCI software license was executory at the time Sunterra applied for bankruptcy protection because each party owed at least one continuing material duty to the other under the agreement. In particular, the parties each possessed an ongoing obligation to maintain the confidentiality of the source code of the software developed by the other. That being the case, the Fourth Circuit found that '365(c), under the literal test, prohibits Sunterra from assuming the RCI license agreement without RCI's consent.

Under '365(c), the Fourth Circuit considers “assumption” and “assignment” in connection with an executory software license to be independent acts both of which require the licensor's consent.

Managing the Nonassumption Risk

Nonassumption of a software license in a bankruptcy is likely to be a rare event. However, in view of the catastrophic consequences in the event of such a nonassumption, consideration must be given to managing the assumption risk. The nonassumption risk should be manageable by a contract provision. Below is a simple provision dealing with the nonassumption risk.

Assumption. Notwithstanding any provision to the contrary, in the event Licensee declares bankruptcy and elects to assume this License Agreement in the bankruptcy proceeding, Licensor hereby consents to such assumption by Licensee provided Licensee agrees to comply with all of the terms and conditions of the License Agreement.

This provision starts with the proverbial “notwithstanding any provision to the contrary” because most license agreements provide for termination in the event of bankruptcy, even though such provisions are ipso facto invalid and unenforceable pursuant to '365(e) of the Bankruptcy Code. The licensor's consent to an assumption occurs only if the licensee makes the decision to assume the license, but the provision doesn't obligate the licensee to assume the license. In the majority of bankruptcy situations, it is likely that the licensee will reject most software licenses; however, there is a contingent risk respecting assumption for which the licensee should seek protection.

Conclusion

The Sunterra ruling underscores the potential importance of the assumption decision to software licensees in bankruptcy proceedings. Software licensees must contemplate the risk of nonassumption and, in some situations, should seek to manage the risk by including a contract provision that obtains the licensor's advance consent to a licensee's assumption of the license agreement in the event the licensee makes the decision to assume the license during a bankruptcy proceeding.

Is a software license assumable by a licensee in the event the licensee seeks bankruptcy protection?

A recent Fourth Circuit Court of Appeals ruling has demonstrated the critical importance of this question to software licensees. The risk of nonassumption may prove quite significant. This article discusses this risk and suggests a potential license provision addressing the risk.

In Re Sunterra Corp.

The importance of the assumption question concerning software licenses to debtor licensees was emphasized by In re Sunterra Corporation (RCI Technology Corp. v. Sunterra Corp.), 361 F. 3d 257 (4th Cir. 2004). In that case, the Fourth Circuit reversed the district court by holding that the debtor-in-bankruptcy did not have the right to assume the RCI software license in question without the software licensor's consent. I have never seen this risk addressed in any software license. As such, this ruling may prove very significant because it raises the need for new contract protection to address this “assumption” risk.

In Sunterra, the Fourth Circuit found that '365(c) of the U.S. Bankruptcy Code does not permit Sunterra, the debtor licensee, to assume its nonexclusive software license with RCI without RCI's consent to the assumption. Sunterra was precluded from assuming its RCI software license to use and modify RCI's Premier Software. Under the RCI software license agreement, Sunterra owned any “enhancements” and granted RCI a license to use the Sunterra Enhancements. Sunterra had invested millions of dollars in the Premier Software. Under the circumstances, the RCI software license had become critical to Sunterra's operations, but its ability to assume the license as part of its plan to exit its bankruptcy was dependent on the licensor's consent.

In the Sunterra bankruptcy proceeding, RCI filed a motion with the bankruptcy court to deem its license with Sunterra rejected, and RCI asserted further that because it had refused to consent to the assumption of the license agreement, the court was required by law to deem the license rejected.

In ruling against Sunterra and its intent to assume the RCI license, the Fourth Circuit followed the “literal test” applicable to the interpretation and application of '365(c) of the Bankruptcy Code. The literal test provides that a debtor in possession may not assume an executory contract over a nondebtor's objection if applicable law (eg, the copyright laws) would bar assignment to a hypothetical third party. This prohibition applies even where the debtor in possession has no intention of assigning the contract in question to any third party. Software licenses are copyright licenses. Copyright law prohibits the assignment of a copyright license without the consent of the copyright-holder licensor. As such, '365(c) places the licensee at risk if the licensee ever seeks to assume a particular software license in a bankruptcy proceeding. The gist: The assumption option might not be available to the licensee.

License is an Executory Agreement

The Fourth Circuit determined that the RCI software license was an executory agreement. In so ruling, the Fourth Circuit applied the “Countryman Test” and found that the RCI software license was executory at the time Sunterra applied for bankruptcy protection because each party owed at least one continuing material duty to the other under the agreement. In particular, the parties each possessed an ongoing obligation to maintain the confidentiality of the source code of the software developed by the other. That being the case, the Fourth Circuit found that '365(c), under the literal test, prohibits Sunterra from assuming the RCI license agreement without RCI's consent.

Under '365(c), the Fourth Circuit considers “assumption” and “assignment” in connection with an executory software license to be independent acts both of which require the licensor's consent.

Managing the Nonassumption Risk

Nonassumption of a software license in a bankruptcy is likely to be a rare event. However, in view of the catastrophic consequences in the event of such a nonassumption, consideration must be given to managing the assumption risk. The nonassumption risk should be manageable by a contract provision. Below is a simple provision dealing with the nonassumption risk.

Assumption. Notwithstanding any provision to the contrary, in the event Licensee declares bankruptcy and elects to assume this License Agreement in the bankruptcy proceeding, Licensor hereby consents to such assumption by Licensee provided Licensee agrees to comply with all of the terms and conditions of the License Agreement.

This provision starts with the proverbial “notwithstanding any provision to the contrary” because most license agreements provide for termination in the event of bankruptcy, even though such provisions are ipso facto invalid and unenforceable pursuant to '365(e) of the Bankruptcy Code. The licensor's consent to an assumption occurs only if the licensee makes the decision to assume the license, but the provision doesn't obligate the licensee to assume the license. In the majority of bankruptcy situations, it is likely that the licensee will reject most software licenses; however, there is a contingent risk respecting assumption for which the licensee should seek protection.

Conclusion

The Sunterra ruling underscores the potential importance of the assumption decision to software licensees in bankruptcy proceedings. Software licensees must contemplate the risk of nonassumption and, in some situations, should seek to manage the risk by including a contract provision that obtains the licensor's advance consent to a licensee's assumption of the license agreement in the event the licensee makes the decision to assume the license during a bankruptcy proceeding.