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What is a "Source-Code Escrow Agreement"?

By Jay Hollander

Jay Hollander, Esq. is the principal of Hollander and Company LLC, www.hollanderco.com, a New York City law firm concentrating its efforts in the protection and development of property interests relating to real property, intellectual property and commercial interests, as well as related litigation.

The content of this article is intended to provide general information relating to its subject matter. Providing it does not establish any attorney-client relationship and does not constitute legal advice. Personal advice in the context of a mutually agreed attorney-client relationship should be sought about your specific circumstances.

Summary: A source-code escrow agreement is an important part of any custom software licensing deal. The agreement allows the licensee to obtain access to the software's all-important source code under certain circumstances, such as if the licensor goes out of business or fails to make required modifications to the software. This article explains how a source-code escrow agreement works.


Introduction

For generations, whenever people have had problems with complicated matters, a reliable adage advised them to go back to the source, that is, to the beginning. In the custom software field, when there are problems, licensees are also advised to go to the source, but the advice here has a slightly different meaning.

Computer software is a generic name for a long string of code containing instructions for everything from how to start a program, to how to run it, to how to interface with data and other programs.Code for different software programs is not only written in different computer programming languages, such as C++ or Visual Basic or others, but is often written in a style reflecting the programming preferences of the programmer(s) who designed and wrote it.The use of the word "code" to describe these computer instructions is an apt one since, in at least one form, the instructions are unintelligible to people, understandable only by computers. This form of computer code is commonly known as the "object code" or "executable code," so named because the computer understands and executes the coded instructions that have been "compiled" or made ready for computer operation.Now, imagine making a huge investment in such software, which may have even been created or substantially customized especially for your business. Imagine further that your entire business depends upon this software and that any sustained failure in the software could be critically damaging to your business.Finally, imagine that the software fails -- after the programmer goes out of business or refuses to service your account.Now what?As the adage says, you try to go to the source to fix the problem. In this case, the source we're referring to is the "source code," the other version of computer code that's important to any licensee. Source code refers to the version of computer code that is in readable text form, understandable by properly trained people, rather than computers.It is this form of code that is essential for licensees to have access to in order to have any chance of assuring themselves that they will be able to remedy software problems that may come up when their original programmers are no longer able or willing to do so. The only problem is that the source code is jealously guarded by licensors, since it is essentially a step-by-step roadmap to their trade-secret intellectual property

.The Need for a Source-Code Escrow Agreement

Enter the source-code escrow agreement, a vital component of any software licensing deal. Unlike the main software license agreement, the escrow nature of the source code escrow agreement requires there to be a third party, an escrow agent, who will hold the source code in trust for the parties, to be released in accordance with the terms of the agreement.Once the province of banks, there are now several commercial source-code escrow companies out there, each of which has sample escrow agreements that can be used "as is" or tweaked or junked completely in favor of more deal-specific agreements drafted between the licensor and licensee. Examples of such companies and their posted sample agreements are: Sourcefile Escrow Services, Lincoln-Parry, and Fort Knox Escrow Services. There are, however, many others to pick from.Once this third party enters the picture, the nomenclature changes a little and the parties are often referred to by different names, in recognition of the role they play in the escrow arrangement.Since the escrow agreement is essentially a trust agreement, where the source code is placed in trust with the third party, the licensor in these agreements is the party who settles or deposits the source code in trust and is often called the "Settlor."The escrow agent is variously called the "Escrowee," "Escrow Agent," "Trust Agent" or some variation of these, to reinforce the notion that it is acting as a neutral in the transaction, holding the source code and supporting materials, which, themselves, are often referred to as the "Deposit."Lastly, the licensee is often called the "beneficiary" of the agreement, since it is the party that will be given the access to the source code under certain defined conditions.While the exact terms of source-code escrow agreements vary, there are certain aspects of these agreements that both licensors and licensees will need to consider carefully before entering into a source-code escrow agreement. Conceptually, the main issues concern: the extent and frequency of the deposit put in escrow, together with degree of validation applied to it; who bears the cost of the escrow agent's services and of any administrative or litigation costs; the conditions under which the deposit may be released; and, finally, title, confidentiality and warranty considerations.

The Elements of a Source-Code Escrow Agreement

Simply, the "deposit" clauses of the agreement detail exactly what will be given to the escrow agent, how it will be validated, and how often it will be updated.One of the important things to take note of in this context is that the likely scenario in which escrowed materials will be released will be when the original programmer is no longer around to help. That means bringing in new programmers, often unfamiliar with the program or its history, who will need to ramp up to speed as quickly as possible.For this reason, it is common for the licensor or "Settlor" to be required to deposit not only the source code, but also all materials sufficient for a trained computer programmer of general proficiency to maintain and support the software without further assistance from the settlor. This would include things such as design notes, documentation, written flow charts and instructions, etc.Apart from this, it is good practice to require that the source code component of the deposit be accompanied by a running object code version submitted on virus-free magnetic media, compiled and ready to be read by a computer, so that the escrow agent can verify the contents of the deposit in good working order and certify good condition to the beneficiary.Moreover, such agreements usually call for the settlor to deposit any maintenance modifications, updates, new releases or documentation related to the deposit materials that the licensee/beneficiary is entitled to receive under the license agreement within a reasonable time of its delivery to the licensee.Of course, since the verification process requires the escrow agent to make copies of the software, the settlor will have to give the escrow agent a limited license to make such copies for the purposes set forth in the agreement, although the agreement always states that title to the deposit and all associated intellectual property rights remains with the settlor.A related deposit clause requirement concerns the level of verification the Escrow Agent will be called upon to apply to the deposit to certify it. The range here is significant, going all the way from no obligation to verify (not recommended) to stringent procedures allowing validation of the integrity and completeness of the deposit, compared to the version of the software and documentation given to the licensee.From a licensee's viewpoint, the more stringent the procedures used, the safer it will feel, but this is usually balanced with the cost of performing such tests, since the cost is most often borne by the licensee.In fact, since the licensee is rightly considered the beneficiary of the trust, being the party for whose benefit the deposit is made in the first place, the overwhelming majority of source-code escrow agreements impose the overall cost of the storage and maintenance of the deposit, as reflected in the escrow agent's fees, on the licensee/beneficiary.Assuming the deposit is made, verified and updated in good order, the sixty-four-thousand dollar question relates to the conditions under which the escrow agent is required to release it to the licensee/beneficiary or return it to the settlor.While "canned" sample escrow agreements contain certain boilerplate conditions for release, such as bankruptcy or insolvency of the programmer, most often the conditions for release key off certain major default provisions in the underlying software license agreement, which place the licensee at risk of irreparable injury.The most common examples, other than the programmer's going out of business or other unjustified disappearance, are failures to repair or make required modifications to the software within a certain period of time after notice; the programmer's ceasing to further develop or support the software in general; failing to enter into a maintenance agreement concerning the software, and similar contingencies.Even here, licensors insist on certain protections -- and rightly so.First and foremost, licensors typically require the licensee to make written demand to the escrow agent for release of the deposit, citing the "release event" contained in the escrow agreement. In turn, the escrow agent is required to give notice of the demand to the licensor, who will typically have a certain amount of time in which to either agree to the release or dispute it, it being agreed that failure to respond at all within a fixed period of time will be tantamount to agreement.But what if the demand is disputed by the licensor? How does it get resolved? This is a major area of contention since the circumstances under which the demand is made are often time-sensitive. If mission-critical software is failing, most licensees don't want to get into lengthy and expensive litigation over whether they had a right to get the code released.For this reason, source-code escrow agreements frequently contain a provision for expedited arbitration and, sometimes, injunctive relief. In these instances, a related provision must cover whether the licensor or licensee will cover the litigation or arbitration costs and expenses of the escrow agent, with the common compromise being either a 50-50 split between the licensor and licensee, or a scenario where the costs are completely reimbursed by the losing party.Then, there is the issue of title and confidentiality. As noted above, even though the settlor gives a limited license to the escrow agent, title remains in the settlor. In fact, unless specifically negotiated, even if the beneficiary is given access to the code and materials, title will still remain in the settlor, with only a right of use given to the beneficiary, subject to strict limitations.One of the most commonly negotiated limitations concerns which independent contractors the beneficiary may use in the event it gains access to the source code. Since customized software is a competitive field, and since the particular software involved is likely the settlor's trade secret material, software vendors will be wise to include a list of competitors whom the beneficiary is precluded from using as a replacement for the programming vendor.More generally, a careful software vendor will likely require the beneficiary to acknowledge the continuing trade-secret nature of the software, obtain confidentiality agreements from all those who handle the code, and to assign back to the settlor all intellectual property rights to any derivative works that may be created in the process of repairs or modifications.In the ultimate indignity, many source-code escrow agreements provide that, upon release of the source code, any warranties that originally applied to the software were void, on the theory that the settlor should not be responsible for software once it's been tampered with by the beneficiary or its agents. While this actually does make logical sense, it is a bitter pill to swallow for a licensee who is forced to obtain the source code due to inaction by the original vendor.

Conclusion

As you can see from the issues that arise in source code escrow agreements, their negotiation can -- and often is -- as issue-filled as the underlying license agreement. As with the license, the exact give-and-take in the source code escrow agreement is a function of negotiating leverage and the amount of time the software vendor could otherwise resell the core software.The more that the software is one which, in whole or in part, is of a type that the vendor could modify and resell to another customer with different customizations, the more likely it is that the vendor will insist on strong confidentiality protections.Conversely, the bigger the customer, the bigger the software system, and the more at stake in the event of a system crash or malfunction, the more the licensee will resist the settlor-oriented provisions.

Like with all other contract negotiation issues, bargaining power is key component determining how quickly and how extensively licensees will be able to unlock the code at the source of their software problems.

Copyright © Jay Hollander, 2007. All Rights Reserved.

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