This article has been written by Sayantani Chakraborty, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho. The article has been edited by Ruchika Mohapatra (Associate, LawSikho) and Dipshi Swara (Senior Associate, LawSikho).
The sign of maturity is often synonymized with questioning others’ beliefs or practices and the same stands true for the business culture today. If we consider the source code escrow, many companies have a standard policy to escrow the source code of the software product to which they would be the licensee. The source code escrow agreement is entered as an investment to run their business. Before we delve into the agreement aspect of it, let’s understand the meaning of source code escrow and why it is important.
Meaning of “source-code”
Companies around the globe run on several custom software applications and this software is developed by the software developers. Implementation of this software is crucial to the running of the business thus, the developers enter into license agreements with the companies. The developers store the “source code” critical for business in the escrow account. The source code is defined as a “logical statement in sequential format written in a computer programming language”.
It directs the software and controls the data. The source code is written and designed by software developers and they use programming languages such as C++ or Java to develop a source code. After the formulation of the source code they are made into “executable codes”. The executable code is used to download, install, and can run on a computer system of the organization. But the executable mode prevents the customer from seeing the actual function of the software or modifying the operation of the software.
Repairing the software or making any operational changes is only possible with the help of the source code, and this source code and documentation related to it remain with the escrow agent. The source code or the documentation is released only when the developer or the licensor files bankruptcy and fails to carry the obligations under the license agreement. The arrangement between the licensor and the licensee is an arrangement and can also be termed as a “software escrow agreement”. It is the same as that of the “source-code escrow agreement and is explained in detail further in this article.
Software Escrow Agreement
A software escrow agreement is an agreement consisting of three parties namely, the software developer, the buyer, and the end-user who is also known as the beneficiary and the escrow agent. The escrow agent is the neutral party in this agreement. For a comprehensive intellectual property strategy, many companies adopt certain mechanisms to protect their investment in the software they purchase from software developers to run their businesses. Software escrow agreement is one such mechanism to protect such investment.
A software escrow is the deposition of the source code by the software developer to a neutral software escrow agent (third-party). A software escrow agreement comes into the picture when the buyer (licensee) enters into a software licensing agreement with a software developer (licensor) to ensure that the developer carries out the maintenance and development obligations under the license agreement.
Need for Source-Code Escrow Agreements
The software developers often enter into licensing agreements with companies but the major share of their profits comes from maintenance agreements. The maintenance contracts fetch more profits than the licensing fees and the developers can hold the companies to stay in the contract for a longer period. This kind of contract entails services in addition to the maintenance of the code. It is pertinent to mention that although most developers offer software licenses to the clients the license is only for the object code which can be read by a machine, unlike the source code which can be deciphered by a person.
Apart from leveraging the maintenance contract by establishing a long-term association with the clients, the developers fear the risk of the source code being copied, modified which would affect the other parts of the code. On the other hand, the licensee or the client always wants to protect their investment in the software and ensure that it is not lost in case the developer fails to maintain the same as per the license agreement and stops providing the object code. Therefore, the licensee requires access to the source code as the developer no longer shares the object code as per the agreement.
Source-Code Escrow Agreement as a risk minimization strategy
While negotiating a software license agreement, any prudent licensee would weigh the contingencies in the event the developer or the licensor goes out of business or become insolvent. In such a situation what follows the licensee’s request for the source code and other critical data to be able to run their business.
The perspective of the Licensor
From the software developer’s perspective, giving away the source code to the licensee might prove to be risky. The licensor fears that the licensee would not keep the source code safe and secure and if all the licensees demand the source code then there would be a huge loss to the business of the developer.
The second risk is to minimize the chance of releasing the source code to the licensee. The developers tend to maintain a circumstance wherein the escrow agent would not release the source code due to incumbent business decisions. If the product reaches its end then it would not trigger a release event and the licensor would invoke the migration clause of the agreement.
The perspective of the licensee
The licensee’s concern is that if it does not get access to the source code and other materials to maintain and update the software they are heavily dependent on, their business would suffer immensely.
Further, if the developer does not file bankruptcy it would continue to exist as a business and fails to abide by the terms of the escrow agreement. Another perspective of the licensee is that the developer can be acquired by a competitor of the licensor which would be harmful to the licensor. The risk factor lies in the changing dynamics between the developer and the acquirer, wherein the latter refuses to provide the support it had agreed to before the acquisition.
Why Escrow Agreements are ineffective
The reasons mentioned above make a source-code escrow agreement an excellent business and investment decision by the customers. However, certain concerns weigh more than the prospects of such an arrangement. They are as follows:
1. Escrows are hardly released
A small number of escrows are released by the escrow agents, even the dominant agents do not release the source codes as per the agreement. It is fathomed that either the events that trigger the release do not occur or the customers find it easy to go for other developers.
2. Outdated or defective Escrow Source-code
Many customers consider the escrow agreement as their “insurance policy” but often they are devastated when the release event takes place. Either the source code is found to be defective or they become outdated due to lack of maintenance by the developer.
3. Licensee unable to use the source-code
The purpose of escrowing the source code is mainly due to the vendor which provides technical know-how, skill, and expertise to the customer as the customer does not possess the capability or the required expertise. So, even if the customer can release the source code, it cannot implement the same internally.
4. Delays and lawsuits
Often it is seen that the vendor causes a delay in releasing the source code and the customers have no recourse to prevent such actions on the part of vendors. The clause of the agreement states that the vendor’s permission or approval is a prerequisite for the release of the source code. This situation results in mediation or arbitration between the parties and sometimes lawsuits are filed as well adding to the delay.
5. Expense is borne by the licensee
While escrow agreements are entered into keeping in mind, the investment risks of the customers, the drafting, negotiation and the fees of the lawyers is borne by the licensor in most cases. No matter how intensely these agreements are negotiated, the customers are an at all-time risk that the vendor/licensor disputes their claim to the source code. Despite spending thousands of dollars on the escrow arrangements, the customers are still unsure about the proper release of the code and the related documents.
Negotiating the Source-code Escrow Agreement
Once a developer develops a software application, it becomes his intellectual property. The owner of intellectual property would never want anyone to copy the source code of the software he developed. At the same time, some businesses require software applications to run their businesses and that software becomes critical to their businesses. Therefore, the source-code escrow agreement comes into the picture. However, it is difficult to negotiate this kind of agreement wherein three parties are involved, nonetheless, it can be beneficial for the licensor. On the contrary, the licensee is at a loss if the arrangement is not negotiated sternly concerning the “release” clause.
Let’s see some of the important clauses of the Source-Code Escrow Agreement which is attached and is supplementary to the main Licensing Agreement between the Developer and Licensee:
1. Definition Clause– the main terms used in the agreement must be precisely defined under the definition clause. Those terms include but are not limited to: “User”, “Developer”, “Escrow Agent”, “License Agreement”, “and Bankruptcy Code”.
2. Purpose of the Agreement – Shall define the purpose of the parties behind the entering of the agreement/arrangement. That the developer will store with escrow agent certain source-code. The vendor would have access to the code as per the terms of the agreement.
3. Materials – The materials pertain to the documents, code, trade secrets or any other intellectual property deposited with the escrow agent by the vendor. These are licensed to the users and users can claim them in any event of default as per the terms of the agreement.
4. Treatment of Material– It is agreed that the materials shall not be disclosed or shared except to the developer and the user who is entitled to them as per the terms of the agreement.
5. Release Conditions – this clause is the most important wherein the licensee shall negotiate intensely as the vendor refuses to release the source code easily fearing intellectual property theft:
a. Bankruptcy of the licensor
b. Event of default
c. Contrary Instructions from Licensor
6. Representations and Warranties by Escrow Agent
7. Representations and Warranties by Developer
8. Fees – The escrow agent shall be paid by the developer or the user or by both as agreed by the parties. Mostly it is paid by the user/licensee.
9. Discharge of Escrow agent– The agent is discharged if the developer takes away all the materials, documents from the agent.
10. Indemnity and liability of the escrow agent– The developer is liable to indemnify the escrow agent and shall hold it not liable for any loss except any loss that is incurred due to negligence of the agent itself.
11. Termination Clause – The parties must mention the events under which the agreement shall be terminated by either of them.
12. Applicable law – The law of the country or any state law or federal shall apply to the agreement.
13. Dispute Resolution/Arbitration Clause– The parties often choose arbitration as a method of dispute resolution between them. Mediation is also considered but in few cases only.
14. Notices – The notice period for any termination shall be mentioned and the mode of communication such notices shall be mentioned clearly by the parties.
The above terms of the agreement are not exclusive and can be tailored as per the requirement of the parties to the agreement. The general clauses have been covered in this article which is nevertheless less important.
Software escrows are vital for the software licensors as their strategy is to protect the intellectual property attached to them. The licensees on the other side face difficulty in accessing the source code vital to running their businesses. Thus, it is essential to negotiate the terms of the source-code escrow agreement diligently, keeping in mind the issues that might arise in the event of bankruptcy, non-maintenance, or other legal battles. It is suggested that the licensee must incorporate a clause where the developer shall provide technical personnel in the event of a release of the code when the licensee is unable to make it work. This kind of agreement does not work in a vacuum unless the licensee includes such clauses that provide for hiring personnel from outside who are familiar with the software application when an unwantedsituation arises.
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