+27 (0)21 880-5160 | service@swart.law

Source code escrow agreements and developer insolvency

by Jeremy Speres on 22 May 2012

The outsourcing of software development is common place, with many businesses outsourcing all of their development needs or certain mission critical components thereof. This very often leaves such businesses in a precarious position. The software developer is not prepared to assign its copyright in the software to the business nor is it prepared to reveal the software’s source code, or is only prepared to do so for a sum the business is not prepared to pay. The business (‘the licensee’) is therefore forced to merely license the software from the developer.

Source code is the human readable textual description of a software application compiled by a programmer in a specific programming language.   Developers are usually loathe to reveal their source code in the interests of preventing copying, competition as well as fostering dependence on the developer for support, upgrades etc (B Prozesky-Kuschke ‘Depositum and escrow: Their current application in computer source code in South African law’ (2003) 2 De Jure 278 at 279-80).   Should a developer become insolvent or lose interest in servicing updates or fixes or refuse to assist other programmers in the integration of its software with other software, the licensee will be faced with a problem – it will not have access to the source code which will inevitably be required by subsequent developers to effect these tasks. 

In this situation the licensee has few options, none of which seem very attractive.  The licensee could attempt to have the software reverse engineered , which is tricky if not impossible in most cases, and which could well be illegal.  Many end user licence agreements (‘EULAs’) proscribe reverse engineering.  Reverse engineering could also amount to copyright infringement in certain circumstances, or could even constitute a criminal offence in terms of section 86(3) and (4) of the Electronic Communications and Transactions Act 25 of 2002 if software is used to overcome security measures.  In addition to reverse engineering, the licensee could have similar software redeveloped, wasting costs and time.  

Enter source code escrow  agreements.  In terms of these agreements, the developer and the licensee agree that the source code is placed in safekeeping with a third party escrow agent (‘agent’).  The source code can then be accessed by the licensee in the trigger circumstances listed in the escrow agreement, such as the liquidation of the developer or where the developer refuses to service updates or fixes.  These agreements are usually concluded as tripartite agreements between the agent, developer and the licensee, so that the licensee is able to enforce contractual rights against both the developer and the agent.  Interestingly, source code releases under escrow agreements in the UK increased 150% between 2008 and 2009 as a result of the recession (Out-law.com ‘Recession forces software escrow releases to jump by 150%’, available at http://www.out-law.com/page-10641 (accessed 27 October 2010)).

What becomes of an escrow agreement upon the liquidation (read to include sequestration) of the developer?  As a general rule, the effect of liquidation on executory or partly performed contracts is that liquidation does not automatically terminate the contract and the liquidator (read to include trustee) can elect whether to abide by the contract or terminate it.  If the liquidator decides to terminate the contract, the other party to the contract is merely left with a concurrent claim for damages.   This election operates only in relation to contracts which, at the date of the commencement of the concursus creditorum (ie the date a provisional sequestration order is granted or the date an application for winding-up is made, provided a winding-up order is granted), are executory, ie ‘those in which one or the other, or all the obligations undertaken remain unfulfilled.’ 

In the US, where executory contracts also feature in bankrupcy law, most courts apply the so called ‘Countryman test’ which provides that ‘[An executory contract is a] contract under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.’ (Vern Countryman quoted in Warrin Agin 'Drafting the Intellectual Property License: Bankruptcy Considerations' (2000) Journal of Bankruptcy Law and Practice Vol. 9, No. 6, 591 at 591.  Available at http://www.swiggartagin.com/articles/drafting.pdf (accessed 26 September 2010)).

So the question is, are escrow agreements executory contracts in the sense that obligations remain unfulfilled at concursus creditorum and their non-performance would amount to a material breach?  Such agreements do involve continuous material obligations for developers, eg the obligation to lodge upgrades and new versions of the source code with the agent, therefore escrow agreements are liable to be terminated as executory contracts in terms of South African and US law.

If an escrow agreement is terminated by a liquidator as an executory contract then what rights does the licensee have to use the source code post termination?  If the escrow agreement was a tripartite agreement between the agent, developer and licensee then this could be problematic for the licensee as its contractual rights would be terminated along with the entire tripartite agreement.   However, if the escrow arrangement was structured as two separate agreements - one between the developer and agent and one between the licensee and agent - then the latter agreement could not be rejected by the developer’s liquidator due to lack of privity (See Richard Cieri and Michelle Morgan 'Licensing Intellectual Property and Technology from the Financially-Troubled or Startup Company' The Business Lawyer (August 2000) 1649 at 1680).   However, regardless of the structure of the escrow arrangement or whether the escrow agreement can be drafted as a non-executory contract, what of the copyright licence permitting the agent and the licensee to use/reproduce the source code once the trigger conditions are met?

One would need to consider whether the agent's and the licensee’s copyright licence terminates along with the liquidator's rejection of the escrow agreement.  US authors, applying the Countryman test, hold that almost all intellectual property license agreements will constitute executory contracts for bankruptcy purposes (See Agin (supra) at 591).   This is because licences involve obligations for the licensee and the licensor that continue until termination of the licence, eg the licensor's obligation not to sue the licensee for infringement.  In the South African case of Video Parktown North (Pty) Ltd v Paramount Pictures Corporation; Shelbourne Associates & Others; Century Associates & Others,  the court classified a licence agreement as a pactum de non petendo, an agreement not to sue.  Therefore, it is likely that a licence agreement will be considered executory and liable to rejection by the liquidator, leaving the licensee with an unsecured claim for damages against the developer’s insolvent estate and without any right to use the source code, despite the fact that the development arrangement was subject to an escrow agreement.  

This danger has been recognised in the US where section 365(n) of the Bankruptcy Code  protects a licensee’s rights to certain intellectual property, including copyright, in terms of a licence agreement and any supplementary agreement (eg an escrow agreement) post termination of the licence by a trustee.  Given that our courts have not yet had the opportunity to consider the effect of a developer’s insolvency upon escrow arrangements, parliament should consider addressing this uncertainty in a similar fashion.  

The shift towards open source software as a result of its recognised benefits,  where source code is by definition open, should temper the need for escrow arrangements.  However, how can a licensee manage its risk where the relevant software is not subject to an open source licence?  Ideally a licensee should conduct a due diligence of any potential developer, especially where the developer is to develop mission critical software.  The licensee could take assignment of the copyright up front coupled with a licence back to the developer, however developers may not be comfortable with such an arrangement.  Another option could be to provide for a suspended assignment to the licensee that is triggered upon an act of insolvency.  Care must however be taken to avoid such arrangements being set aside as voidable dispositions in terms of the Insolvency Act 24 of 1936.  It is to be noted that courts in the UK have found so called copyright reversion clauses, whereby the copyright is automatically assigned to the licensee on the day immediately preceding the day of the insolvency event, to be enforceable (see here: http://jiplp.blogspot.com/2011/03/automatic-reversion-clauses-in.html).

Finally, as is often the case with trade mark licensing arrangements, the developer could assign the copyright licence to a trust or another entity that stands separately to its operating (risk exposed) activities, however the commercial realities of such an arrangement may be discouraging.

An edited version of this article appeared in the December 2010 edition of Without Prejudice magazine.  The original footnotes containing various authorities have been removed for ease of reading.  The original article with footnotes is available on request

© Swart Attorneys | Swart Attorneys is the trading name of D Swart & Associates Incorporated, a company registered in South Africa with registration number 2003/021176/21.