Application of Technology Custody in Dealing with Bankruptcy Risks in Practice

LABEL： Telecommunications, media, entertainmentand high technology , Debt restructuring , Intellectual property ,

Previously, in "Transitioning from License in to License out - What is the quality of your 'independent intellectual property'?", we sorted out the intellectual property infringement issues involved in the process of license out for enterprises and provided practical suggestions for their reference. In addition, there is another issue in technology licensing transactions that has often been overlooked by Chinese companies, namely the impact of the bankruptcy of the technology licensor on technology licensing. As Chinese technology companies gradually shift from technology import ("license in") to technology export ("license out"), they often encounter "bankruptcy protection" demands from overseas licensees. We will explore this issue in this article and provide a detailed introduction to the common response plan "technology hosting" abroad.
1、 The impact of licensor bankruptcy on technology licensing contracts

The technology license contract usually includes a "bankruptcy termination clause" - if the licensee goes bankrupt, the licensor will have the right to unilaterally terminate the license contract. Once the licensee encounters bankruptcy, it is usually unable to continue to perform the license contract normally (such as paying license fees on time, implementing licensed technology for production and sales, etc.). Therefore, the licensor usually requests a "bankruptcy termination right" to take the initiative to terminate the contract in its own hands to fully protect its own interests.

However, when there is a risk of bankruptcy in terms of licensing, the licensee is usually unwilling to terminate the technology license they have obtained. This is because the licensee often invests heavily in implementing the licensed technology, and terminating the license will have a serious impact on the licensee's business operations, and bankruptcy distribution is often far from compensating for its losses; In addition, licensed technology is often an essential foundation for the licensee's business, and once lost, it is often difficult to obtain alternative solutions in a short period of time. A stable technology license is crucial for the licensee to maintain business operations, especially for long-term and significant technology license transactions.

Although the licensee usually does not require a "bankruptcy termination right" in the contract regarding the licensor's bankruptcy risk, once the licensor goes bankrupt, the licensor or its bankruptcy administrator may still choose to terminate the license contract in accordance with bankruptcy related laws and regulations (specifically subject to the applicable laws and regulations of the bankrupt entity). According to the provisions of China's Enterprise Bankruptcy Law, the administrator shall formulate a proposal on the management and disposal of the debtor's property and submit it to the creditors' meeting for voting; The bankruptcy administrator has the right to choose to terminate or continue to perform contracts that were established before the acceptance of the bankruptcy application but have not been fully performed by both the debtor and the other party. In practice, the principle of the administrator disposing of assets and choosing whether to continue to perform the contract is to maximize the value of the debtor's property and protect the interests of all creditors. In the restructuring process, there is a higher possibility that the company's core assets (such as core patented technology) will continue to be retained by the company, and the possibility of continuing to perform technology licensing contracts will also increase accordingly; In bankruptcy liquidation procedures, the possibility of contract termination and asset disposal and price change is higher. This means that under Chinese law, regardless of whether there is a clear agreement in the technology license contract, once the licensor goes bankrupt and both parties have not fulfilled the technology license contract, the licensee may still face the risk of the license contract being terminated.

In order to maintain the stability of technology licensing contracts, especially to ensure that the parties to the contract can exercise their agreed rights within the time limit specified in the contract, some countries restrict the right of the bankruptcy administrator to terminate the contract in the event of the licensor's bankruptcy. For example, Section 365 (n) of the United States Bankruptcy Code provides that in the event of the bankruptcy of an intellectual property owner, if the bankruptcy administrator decides to refuse to perform the intellectual property license contract, the licensee will have the option to accept the bankruptcy administrator's decision and claim damages; You can also choose to continue using the licensed intellectual property in accordance with the contract and pay the licensing fee. That is to say, under US law, even if the licensor goes bankrupt, the licensee can still choose to continue using the licensed intellectual property without worrying about the license being terminated. However, currently there is no similar provision in China's Enterprise Bankruptcy Law. Chinese bankruptcy administrators must have reasonable grounds to prove that continuing to perform the license contract is beneficial to all creditors.

Because the bankruptcy of the licensor may directly affect the survival of the license, some licensees may consider explicitly stipulating in the contract that when the licensor goes bankrupt, if the bankruptcy administrator disposes of the licensed technology, the bankruptcy administrator should ensure that the transferee continues to perform the technology license contract; If the bankruptcy administrator terminates the license contract, the licensee can still continue to implement the licensed technology (but still needs to pay the license fee according to the agreement). However, the aforementioned agreement ultimately remains a contractual agreement between the two parties. In the event of the licensor's actual bankruptcy, the bankruptcy administrator may still directly terminate the contract between the two parties for the purpose of maximizing asset value and protecting the interests of creditors. In this case, the aforementioned contractual guarantees will be difficult to play a role in practice.

Another common bankruptcy protection method abroad is "technology custody", which requires the licensor to entrust the licensed technology materials to a third-party escrow agent for custody, and in the event of the licensor's bankruptcy, the third-party escrow agent will deliver the licensed technology materials to the licensee. In practice, this scheme is mainly applicable in software licenses granted in the form of object code. Once the licensor goes bankrupt, it will be difficult for them to continue to fulfill their obligations to update, maintain, and continue development under the license contract. The licensee needs to obtain the source code of the licensed software to update and maintain it themselves. It should be noted that technology hosting is more common in other countries such as the United States, because under the bankruptcy laws of these countries, the licensee can still retain the license even in the event of the licensor's bankruptcy, and the main loss is the licensor's update and maintenance services. Given that under Chinese law, bankruptcy administrators usually directly terminate license contracts and technology licenses, in this case, even if the licensee obtains the source code, they may not have the right to continue using the licensed technology. Therefore, the applicability of technology custody schemes in China has become extremely limited.

However, technology custody is a common bankruptcy protection method abroad, and Chinese companies often encounter technology custody demands from overseas licensees when exporting their technology. Helping Chinese companies understand the specific arrangements for technology custody still has certain practical significance. We have introduced the technology hosting arrangement in the following text.
2、 What is technology hosting?

In trading projects, "custody" generally refers to asset custody, which means that both parties agree to deposit a portion of the transaction consideration into a third-party custody account. Only when the agreed conditions are met, the third-party custody agent will pay the funds to one party. Similar to asset custody, technology custody refers to entrusting licensed technology related materials (such as the source code of licensed software) to a third-party custody agent for custody in technology licensing transactions, and the custody agent can only release the technology materials to one party when the conditions explicitly agreed upon by both parties are met.

In software licensing projects, the licensor typically chooses to deliver the licensed software in the form of object code rather than providing the software source code. This is because the software source code is the technical core of the licensor, and once obtained by others, the licensing convenience may lose its technical advantage. If the licensee obtains the software source code, they can easily learn about the development ideas of the licensed software and carry out secondary development of the licensed software, creating new technologies belonging to the licensee. Therefore, in order to enhance control over the software and maintain technological advantages, the licensor is generally unwilling to deliver the software source code to the licensee. When it does not involve granting secondary development rights to the licensee, this object code licensing method can basically meet the commercial needs of the licensee. However, in some software license contracts, the licensor (i.e. software rights holder) also has the obligation to modify the software, improve software functionality, and maintain the normal operation of the software. Once the licensor fails to fulfill the aforementioned update and maintenance obligations in the event of bankruptcy, breach of contract, or unreasonable price requirements, and the licensee is unable to access the software source code for self updating and maintenance, the licensee's use of the licensed software will be directly affected. For critical systems that the licensee's business heavily relies on, once updates and maintenance are stopped, the licensee will suffer irreparable losses.

In this case, technology hosting will be a turning point between the licensor's willingness to protect the source code and the licensee's reasonable demands - the licensor will store the source code in a third-party hosting agent recognized by both parties (usually a professional technology hosting service agency), and the hosting agent will only release the source code to the licensee in specific circumstances agreed upon by both parties in advance (such as the licensor's bankruptcy), and both parties explicitly agree on the licensee's usage rights after the technology release in the license agreement or hosting agreement. Through technical hosting, the licensor can protect its source code from unauthorized disclosure, while the licensee also receives guarantees to maintain business stability and continuity in the event that the licensor is unable to fulfill contractual obligations.

In addition to the aforementioned software license projects, with the complexity and diversification of technology cooperation transactions, the technology hosting method is also worth learning from in some license transaction projects that provide technology output in the form of technical services or provide technical support through semi-finished products in the form of "black boxes".
3、 How to determine whether technical hosting is necessary?

Although technology hosting can resolve conflicts between licensing parties in protecting technology and maintaining business stability and continuity, not every technology licensing contract needs to consider technology hosting arrangements. Both parties need to determine whether a custody arrangement is necessary based on the actual situation of the technology license. Below, we will take software license transactions as an example to briefly introduce a series of considerations related to software source code hosting from the perspectives of both the licensee and the licensor.
1. Considerations of the licensor

For the licensor, whether to agree to the licensee's technology hosting requirements should consider not only the security of its hosting technology, but also the reasonableness of the licensee's commercial needs, the licensor's own business situation, and the cost of technology hosting:

The security of hosting technology: Technology hosting means that the licensor needs to hand over the source code and other technical information to a third-party hosting agent. Whether the hosted technical information is securely stored and whether it will be used or disclosed without authorization during the hosting process should be the licensor's main concern. The licensor needs to make a comprehensive judgment based on the professional competence and commercial reputation of the third-party escrow agent.

The reasonableness of the licensee's commercial needs: Not all software license projects have a reasonable demand for the licensee to access the source code, such as: (i) in some mature, standard software license projects, the licensee only has the right to use the licensed software in accordance with the agreement and does not involve software patches, updates, or maintenance; (ii) The licensed software is not the core software on which the licensee's business operations rely. In this case, even if the licensed software cannot be updated or maintained, the losses suffered by the licensee are controllable. Based on our experience, typically only software that is crucial to the licensee's business operations will be considered for technology hosting by the licensor to alleviate the licensee's concerns.

The licensor's own business situation: If the licensor objectively faces financial difficulties, there may be a risk of bankruptcy or inability to continue providing services, and the licensee's proposal of technology custody to protect its own interests is also reasonable. The licensor can provide technology hosting as a safeguard measure to eliminate the concerns of the licensee.

The cost of technology hosting: Technology hosting usually requires a professional hosting agent to provide it. The hosting agent needs to charge service fees based on the hosting object, the required services (such as whether the hosting agent needs to provide inspection services), the deadline, and delivery arrangements. The licensor shall take into account the amount of hosting service fees together. If the hosting service fee that the licensor should bear is not commensurate with the amount of the technology license itself (such as the hosting service fee exceeding the software license fee or occupying a higher proportion), the licensor usually refuses to agree to the technology hosting arrangement for commercial benefits.

Although the source code is the technical core of the licensor, responding to the licensee's reasonable demands through necessary hosting arrangements in specific circumstances may be a wise move to maintain a cooperative relationship and market position. If the licensor decides to adopt technology custody based on the aforementioned evaluation, it may consider the following measures to safeguard its own interests: (i) selecting a professional and reliable third-party custody agent (which may be required to provide relevant case introductions, specific technical and management measures to prove its professionalism and reliability); (ii) Only provide the necessary source code to the hosting agent to meet the commercial demands of the licensee; (iii) Strictly limit the release conditions of the source code in the custody contract (such as limited to entering bankruptcy proceedings only), and also strictly restrict the licensee's use of the source code after release; (iv) Consider requiring the licensee to fully bear or reasonably share the hosting service fees.
2. Considerations of the licensee

Correspondingly, when determining whether to request technology hosting, the licensee should consider the following factors: (i) whether the licensor's financial and operational conditions are good, and whether there is a possibility of difficulty in providing software updates or maintenance services (such as bankruptcy); (ii) The importance of licensed software to the licensee's business; (iii) In the event that the licensor is unable to provide update or maintenance services and the licensee is unable to access the source code, whether the licensee can obtain alternative services on its own or from third parties, as well as potential costs (such as new software procurement costs, data migration costs, new software training costs, hardware investment based on the software, business interruption losses, etc.), and other negative impacts that business operations may suffer; (iv) Whether the cost of hosting service fees borne by the licensee is commensurate with the potential risks.

If the licensee deems it necessary to request the licensor to conduct technology hosting after evaluation, the following points should be noted: (i) choose a professional and reliable third-party hosting agent; (ii) The source code and related technical materials delivered by the licensor to the hosting agent shall be complete, accurate (for example, if specific tools are required for software updates and maintenance, the licensor shall host such tools together with the source code), and able to meet the commercial demands of the licensee; (iii) In necessary circumstances, it may be considered to require oneself or entrust a hosting agent to inspect the technical content of the delivered hosting, and to require the licensor to update the source code of the delivered hosting in a timely manner; (iv) Clarify the release conditions of the source code, such as the licensor's bankruptcy, major breach, inability to provide software updates or maintenance, etc; (v) Consider requiring the licensor to fully bear (especially in cases where there is an objective risk of bankruptcy) or reasonably share the cost of custody services.
4、 What are the key terms of a technology hosting agreement?

After considering the aforementioned factors, both parties in the transaction generally agree in the license agreement that the licensor should host the source code and briefly specify the conditions for releasing the source code. Afterwards, both parties will screen third-party custody agents and ultimately sign custody agreements with them; After the hosting agreement takes effect, the licensor will submit the source code and other hosting objects to the hosting agent for safekeeping in accordance with the hosting agreement; The escrow agent shall properly safeguard the escrow object and provide the source code to the licensee in accordance with the release procedure stipulated in the agreement.

The hosting agreement signed between the two parties of the license transaction and the third-party hosting agent will provide detailed provisions for the entire hosting arrangement (such as the arrangement for delivering the source code to the hosting agent, the triggering conditions for the hosting agent to release the source code, etc.). Usually, the hosting agent will provide a hosting agreement template for both parties to review and modify. However, considering that technology hosting is essentially closely related to the commercial arrangements of both parties, the hosting agreement template may not fully reflect the commercial considerations of both parties. The licensor and licensee still need to improve the hosting agreement based on the characteristics of the licensing transaction.

In view of this, we have summarized the key terms of the hosting agreement in the software license scenario below for reference by enterprises when drafting and negotiating hosting agreements:

Scope of hosting objects: Both parties need to accurately define the content scope of the delivered hosting objects to ensure that the source code and related materials delivered for hosting are necessary, complete, accurate, and usable. When defining the hosting object, both parties should also consider whether to require the licensor to regularly update the hosting object, whether to include software updates or maintain necessary third-party materials or tools. Accurately defining the custodial object is not only to ensure the technical security of the licensor, avoid unnecessary disclosure risks, but also to ensure the realization of the licensee's reasonable business objectives.

Inspection arrangement for hosted objects: To ensure that the hosted objects are complete, accurate, and usable, cautious licensees may require themselves or entrust hosting agents to inspect the hosted objects, such as checking the integrity, readability, virus-free and malicious code, unencrypted, and meeting specific requirements of the licensee. In addition, both parties should also agree on the allocation of inspection fees and remedial measures for defects discovered during inspection in the custody agreement.

Source code release trigger event: The trigger event is a core clause of the hosting agreement, directly related to the technical confidentiality of the licensor and whether the commercial demands of the licensee can be realized. Generally speaking, triggering events can include the licensor's bankruptcy, cessation of business, failure to fulfill software update or maintenance obligations, depending on the characteristics of the licensing project. In addition, both parties need to consider a series of procedural arrangements related to the triggering event in the agreement, such as how to inform the escrow agent after the triggering event occurs, whether the escrow agent can release the escrow object on its own or with the consent of one or both parties, how to handle disputes over whether the triggering event occurs, and the notification obligations of the escrow agent before and after releasing the escrow object.

Custody fees and payments: Custody agents generally charge account establishment fees, annual custody fees, release fees, and other service fees (such as auditing, verification, etc.). Specifically, the custodian institution will adopt different charging models based on the scope and complexity of the services provided, such as charging a fixed fee based on the duration of custody, paying separately for additional services according to customer needs, and customizing quotes based on specific project requirements. The custody agreement needs to clearly stipulate the composition and amount of custody fees, as well as the plan and payment arrangement for both parties to share the costs.

Usage restrictions after source code release: The purpose of technical hosting is for the licensee to obtain the source code in the event of a specific triggering event to ensure the normal operation of the licensed software. Therefore, the licensor usually explicitly restricts the licensee from using the hosting object for specific purposes such as updates and maintenance, and not for changing the basic functions of the software or conducting derivative development after obtaining it in the hosting agreement; (ii) Strictly abide by confidentiality obligations and shall not transfer or provide the entrusted objects obtained to the outside world. In addition, in order to supervise the use of custodial objects by the licensee, the licensor may also request an audit of the licensee's usage behavior.

Arrangements after the termination of the hosting agreement: As a service provider, the hosting agent usually requires the right to unilaterally terminate the hosting agreement with reasonable advance notice, as well as the right to unilaterally terminate the hosting agreement in the event of substantial breach of the hosting agreement by both technology licensing parties (such as failure to pay hosting service fees on time). Once the custody agreement is terminated, the custody institution usually requires the transfer of the custody object to other custody agents or a designated party as agreed, or the destruction of the custody object after a certain period of time. From the perspective of the licensor, the licensor does not want the escrow agent to arbitrarily deliver the escrow object to the licensee or other third parties; From the perspective of the licensee, the licensee does not wish for the escrow agent to destroy the escrow object or return it to the licensor or a third party beyond the control of the licensee. Therefore, both the licensor and the licensee should carefully consider the disposal arrangements for the custodial objects after the termination of the custodial agreement. The common arrangements after the termination of the custody agreement are: (i) if the licensee confirms that the custody object is no longer needed at this time, the custody agent may return the custody object to the licensor or destroy it; (ii) The licensor and licensee shall jointly designate a new escrow agent within the period of prior notice of termination by the escrow agent, and the old escrow agent shall transfer the escrow object to the new escrow agent after the termination of the agreement; (ii) If both parties are unable to jointly designate a new custodial agent within the period of termination notified by the custodial agent in advance, the custodial agent may search for a new custodial agent and deliver the custodial object on its own, and the costs incurred shall be borne by the licensing parties.

Summary

Technology hosting provides a secure and flexible means of protection for both licensing parties. By introducing a neutral and professional third-party escrow agent, the licensee is able to ensure long-term stable support and maintenance of the purchased technology, reducing the risk of operational interruptions caused by technology supplier bankruptcy or other reasons; For the licensor, it is possible to achieve licensing transactions and establish long-term stable cooperative relationships with customers under the premise of limited disclosure of technology. Currently, in the process of promoting the license out business model and stepping onto the international stage, many enterprises will encounter technology custody demands from overseas licensees seeking protection in extreme scenarios such as bankruptcy. This requires Chinese enterprises to have a deep understanding of the various considerations and potential advantages and disadvantages of technology custody arrangements. It should be noted that there is no fixed formula for the specific arrangement of technology hosting, which is closely related to the objective situation, negotiation status, and business needs of both parties. Both parties should choose the optimal solution that is beneficial to themselves and can facilitate the transaction in the transaction negotiation based on the actual situation.

Finally, as mentioned earlier, technology hosting is currently only relatively common abroad and has not been widely applied in China. This is mainly because under Chinese law, the bankruptcy administrator is likely to directly terminate the license contract and technology license. In this case, even if the licensee obtains the source code, they have no right to continue using the licensed technology, and technology hosting cannot meet the licensee's concerns about seeking bankruptcy protection. We have also noticed that there are calls in academia and practice for China's Enterprise Bankruptcy Law to emulate foreign laws in protecting licensees, and to set special provisions for the situation of licensor bankruptcy to better balance technology licensing protection and creditor rights protection. If this proposal is adopted in the future revision of China's Enterprise Bankruptcy Law, we believe that technology custody will have a wider application in our country.