How to Deal With an Insolvent IT Supplier

As the slump in the technology market continues and the recession begins to affect some of the major players within the software market, companies need to start asking what will be the impact on their business if their software supplier goes bust and how best can they protect themselves?

The main problem facing a purchaser if its software supplier is made insolvent/bankrupt is that they may no longer be able to have support, error corrections or modifications carried out on the software. Generally a software licence will only grant use of the object code (i.e. that part of the software which is translated into a computer readable form) and without the source code (i.e. that part which of the computer program written in a form comprehensible to a human being) a user will be unable to correct errors or modify the software. Although an EC Directive as implemented by the Copyright (Computer Programs) Regulations 1992 allows a user of software to copy or adapt software for the purpose of correcting errors in it, this right is limited and can be excluded under the terms of the software licence granted to the user.

When purchasers procure a new software system they often conduct a fairly exhaustive investigation into the software supplier's financial strength and the suitability of the product for their purposes. As part of this they often ask to talk with existing customers before concluding an agreement. However, in the current climate a prudent purchaser should also consider other ways to reduce the risks.

There are three main questions a company should be asking a software supplier in order to safe guard against the supplier becoming insolvent, these are:

• Have you placed a copy of your software (source code) with a third party escrow agent?
• Have you licensed any third parties to provide support and maintenance for your software?
• What is the likely impact upon the smooth running of your business if you replace the software with a competitor's software at short notice? (and an internal question - is there another software product which is available?)

An escrow contract is a tripartite agreement entered into between the purchaser, the software supplier and the escrow agent. The supplier deposits the software source code and supporting technical information with an escrow agent. The agent agrees to make the source code available to the customer if the supplier breaches its contractual support and maintenance obligations or becomes insolvent.

The benefits of such an arrangement are mutual. The purchaser is happy because the confidentiality in a major asset of the company is protected. The customer has the comfort of knowing that he will have access to the source code rather than a worthless claim against an insolvent company. The escrow agent will be happy provided his fees are paid for storing and releasing the software and his instructions are unambiguous. One group of people, who will not be so happy, will be the creditors of the software supplier, since the escrow arrangement involves the release of major asset of the supplier.

Check not only that the contract has been properly drafted and signed, but also that the supplier has really carried out all its obligations.

Has the supplier deposited everything that it is required to with the escrow agent? As few software products remain static, it is important to ask whether the contract requires the supplier to deposit all updates and enhancements with the agent. Do you have the systems in place to check that this has? Most contracts require that the agent to notify the customer when material is deposited.

Is the material sufficient to enable you to understand and use the computer program, fix bugs and make enhancements? It will be near impossible to do this with only the source code, so what other technical documentation will you need to understand and make use of it? The names and contact details of the original authors and support technicians can be valuable.

When you have checked that the suppliers have signed the escrow contract and chased them up to deposit all the right material with the escrow agent, you need to know whether that material will work. Some professional escrow agents offer verification services. These range from simple integrity testing to check that the media deposited is readable and contains accessible, virus-free source code, to a full verification to test that the source code deposited can be used to create the working application of the software as licensed to the customer.

In an ideal world you would require re-verification with every modification to the software to make sure that the amended version of the source code has been deposited. However, verification is not cheap so inevitably some risk/cost compromises have to be made. Nonetheless, how comfortable do you feel unless at least one version of the software has undergone full verification?

There are a number of areas of doubt about the effectiveness of escrow agreements upon insolvency. One problem is that a release of the escrowed material by the agent may amount to a breach of section 127 Insolvency Act 1986 and a claim would lie against the business for recovery of the escrowed materials. Section 127 provides that, in a winding up by the court, any disposition of the company's property made after the commencement of a winding up is, unless the court orders otherwise, void. The release of deposited escrow material may amount to a disposition of the company's property and therefore a court order may be required before the agent can release the escrowed material. In principle, the court would allow such a disposition because it is unlikely to result in a reduction of assets available for distribution to the unsecured creditors.

If the supplier goes into liquidation, the liquidator may disclaim onerous property which includes unprofitable contracts. Escrow agreements may amount to unprofitable contracts because they result in the disposition of potentially valuable intellectual property rights. A similar point arises if a receiver is appointed. When a company goes into administration there is a statutory moratorium which prevents steps being taken against property of that company. This would includes steps to enforce any security over the company's property. If it is accepted that the exercise of your right against a source code escrow agent is, in effect, the enforcement of a claim against the property of the supplier company, then the release of the source code may be frozen for the duration of the administration.

The above problems will only arise if the supplier is bankrupt, or enters into liquidation, receivership or the like. Escrow agreements are still useful in the event of the supplier being in breach of his contractual obligations and therefore it is still worthwhile entering into an escrow agreement.