Insolvency Issues for IT Contracts

Toronto, Canada

Richard F.D. CorleyPartner

Canadian IT Law Association ConferenceOctober 27, 2015

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• Introduction

• Protection of IP license rights under insolvency

• Insolvency issues in cloud computing arrangements

• IP rights, insolvency and software escrow

• Questions ?

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Protection of IP License Rights Under Insolvency• Issues in the U.S.

Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. (1986) Lubrizol entered into a non-exclusive license agreement for the use of a metal

coating process technology owned by Richmond Metal Finishers (RMF). RMF filed for bankruptcy, rejecting the license and its contractual obligations to

Lubrizol, it resolved to sell the licensed technology to a third party,. The U.S. Fourth Circuit Court of Appeal permitted the trustee to reject the license. This decision was immediately criticized for the commercial uncertainty it created

in IP licenses.

• Similar Issues in Canada

Re T. Eaton Co. (1999), Royal Bank of Canada v. Body Blue Inc. (2008). These subsequent Canadian cases followed a similar line of reasoning as in

Lubrizol, and in each case found that the acquirer of the assets of the insolvent entity was no longer bound by grants of licenses made prior to the insolvency.

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Protection of IP License Rights Under Insolvency• U.S. Solution

In 1988 the U.S. Bankruptcy Code was amended to add § 365(n) Which provides that upon a stated rejection of an IP license, the licensee may

either: (1) pursue its claim for damages as an unsecured creditor under the Bankruptcy Code or (2) retain its rights and obligations under the license, including payment of any royalties or license payments due thereunder, but without the benefit of the right of setoff, if applicable.

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Protection of IP License Rights Under Insolvency• Canadian Solution

In 2009, the Bankruptcy and Insolvency Act (“BIA”) and the Companies’ Creditors Arrangement Act (“CCAA”) were amended to address the disclaimer of IP licenses.

s.65.11(7) of the BIA and s.32(6) of the CCAA were amended to include the following provision:

If the company has granted a right to use intellectual property to a party to an agreement, the disclaimer or resiliation does not affect the party’s right to use the intellectual property — including the party’s right to enforce an exclusive use — during the term of the agreement, including any period for which the party extends the agreement as of right, as long as the party continues to

perform its obligations under the agreement in relation to the use of the intellectual property.

Open IssuesDoes “intellectual property” include trademarks or trade secrets?What does the right to “use” the IP include?Must the debtor-licensor continue to perform its obligations under the agreement?

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Cloud Computing Trends for 2015

• The cloud will continue to grow, and businesses will adopt it more rapidly

The cloud is becoming more widely and economically available across a wider domain of applications

As understanding of the cloud has increased, security concerns have decreased, prompting even large businesses with significant security concerns to switch to the cloud

• Hybrid is the cloud of choice More organizations are working towards the adoption of the hybrid model The hybrid permits companies to use the cloud as necessary without eliminating

their current data storage systems

• Use of the cloud will become more central to business As the cloud becomes more economically available, IT departments will be able

to innovate and experiment more freely

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Insolvency Implications

• Potential for Loss of Control / Access to:

Customer Data Software Hardware Operational Services

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Insolvency Implications

• Customer Data Backup Options

Backup to Customer-Owned Equipment Backup to Third Party Data Store Backup to Third Party Service Provider

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Insolvency Implications

• Software Options

Customer copy of object code and access to source code Escrow Agent copy of object code and source code Third Party Service Provider has working copy of object code and access

to source code

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Insolvency Implications

• Hardware Options

Customer-owned hardware Customer security interest in hardware Access to duplicate / replacement hardware and/or service through Third

Party Service Provider

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Insolvency Implications• Ongoing Services

Customer or Third Party Hosted: DR Plan Business Continuity Plan

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Key Business Issues

• Do your business requirements fit comfortably in a CC model?

Unlike outsourcing agreements, which are highly negotiated and customized, the terms and conditions applicable to “off the shelf” cloud services tend to be more standardized

The customer must verify whether the terms and conditions are appropriate and acceptable and whether changes must be and can be made to meet the customer’s requirements

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Key Business Issues

• Do your business requirements fit comfortably in a CC model? (continued)

Requirements for flexibility and change, or unusually high performance standards, may preclude use of a CC model

Spectrum between a super commodity whose needs can be met by a “one size fits all”-type solution and a proprietary system that requires high levels of customization− E.g. unenhanced email service vs. proprietary trading/hedging system

The extent of flexibility in the terms and conditions will depend on the CC model, the size of the deal, and other factors affecting the relative bargaining power of the parties

The customer has more negotiating power before signing on to a CC solution and should use that bargaining power to get what it needs

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Key Business Issues

• Does the CC solution line up with the requirements of the business?

Differences in capabilities of a “one size fits all” service provider vs. a service provider who can provide customized solutions

Due diligence is required to assess and compare requirements to capabilities

Perform a careful gap analysis

• Does the service provider meet the standards required for a trusted counterparty?

Due diligence with existing customers, in addition to other due diligence, is recommended

Risk of insolvency is one element of the analysis

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Key Legal Issues

• Jurisdiction

Location of data can be important in many contexts, including when dealing with record retention requirements, personal information and other sensitive business information

Jurisdictional issues can be particularly important in regulated industries such as financial services and can further complicate matters in the event of an insolvency

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Key Legal Issues

• Jurisdiction (continued)

Businesses must consider:

Are there requirements that data be kept within a given jurisdiction?− Consider contractual, regulatory and legislative requirements

Is the provider sufficiently flexible to allow compliance with new requirements?− Consider ability to adjust service to meet new regulations or other requirements

Will the provider guarantee that it will not expand or move data into a risky or unfavorable jurisdiction?− Consider future expansion of the provider into other jurisdictions

Could the use of CC subject clients, subsidiaries, business partners or others to foreign laws with different requirements than those in effect in Canada?− Consider mandatory data disclosure, data seizure, etc.

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Main Terms and Conditions

• Termination (Grounds and Consequences)

Ensure that agreement enumerates the circumstances and terms under which a party may terminate the contract before the expiry date (material breach, force majeure, insolvency, convenience, change of control, etc.)

Agreement must set out the rights and liabilities of the parties in each such eventuality

Ensure that the provider will not be able to hold the customer’s data hostage if there is a dispute

Provide for transition assistance upon termination

Termination by the customer for convenience at modest cost is a key safeguard and should be available

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Main Terms and Conditions

• Transition

Ensure that agreement provides for the orderly transition of the services to another supplier or back to the customer

Consider:

Privacy and confidentiality

Service continuity and data integrity

Ensuring a smooth transition via cooperation, data conversion, assistance

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Source Code Escrow Agreements• Typical Terms and Conditions

Release Triggers− The most common release trigger is the bankruptcy of the licensor− Other frequent triggers include the failure to provide the agreed upon levels of service and

maintenance

Rights on Release− Does the licensee have the right to:

● maintain and support the source code?● modify or adapt the licensed software?● add new sites or install the source code onto new computers?● resell or relicense the software?

Dispute settlement provisions− What if the trigger event is disputed?

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Escrow Agreements• Typical Terms and Conditions (Continued)

Verification− What verification procedures can be made in respect of the source code and the related

documentation?− Are the necessary computer system components in place to ensure functionality and

execution of the source code (i.e. operating systems, databases, third party software, systems defaults, batch or executable files and software drivers)?

Frequency of Updates− How often will the escrowed materials be updated?

Protections in Bankruptcy or Insolvency?− Can the escrow arrangement be attacked by a trustee in bankruptcy?

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Escrow Agreements• Insolvency Issues and Considerations

The amendments to the CCAA and the BIA provide protection to licensees to the extent that the licenses confer rights of use over software or other IP

Subsequent to the amendments of the CCAA and the BIA, there has been limited Canadian case law in which a software escrow agreement has been attacked by a trustee in bankruptcy or a subsequent assignee. However, there are a variety of approaches that can be used to protect the escrow: Stating that the escrowed materials are held in trust for the benefit of the licensee Granting a security interest to the licensee in the escrowed materials Granting some form of partial assignment of the escrowed materials to the

licensee

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Questions?

Richard Corley is a Partner and Chair of the Outsourcing Group at Goodmans. He has more than 25 years of experience working closely with technology companies in Canada. He has acted as lead counsel to major corporations in complex outsourcing transactions, joint ventures, technology acquisitions and licensing, cleantech transactions, and in a variety of other technology-related commercial and corporate law matters.

Richard is recognized as a leading lawyer in numerous publications including: The Legal 500 Canada - Leading Individual, Technology, Media and Telecoms, Chambers Global Guide to the World’s Leading Lawyers for Business (IT: Band 1 ranking), Law Business Research's The International Who's Who of Business Lawyers and Legal Media Group's The Best of the Best (IT), The Lexpert /American Lawyer Guide to the Leading 500 Lawyers in Canada (Computer & IT Law), The Canadian Legal Lexpert Directory (Technology Transactions and Computer & IT Law), The Lexpert Guide to the Leading US/Canada Cross-border Corporate Lawyers in Canada and The Best Lawyers in Canada (IT, and Technology Law).

For more information, see www.goodmans.ca

Richard F.D. CorleyPartner

Goodmans LLPDirect: 416-597-4197Facsimile: 416-979-1234 rcorley@goodmans.ca

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