Welcome to the first e-bulletin in this new three-part series.
In these series, we aim to highlight IT issues often encountered in corporate transactions involving the technology sector. In each e-bulletin, we will describe a "real-life" scenario, highlighting potential show stopping IT legal issues and suggesting actions that would address and minimise the legal risks involved.*
Part I - Selling what it does not have …
Company A is a software house which has developed a very successful software application (the "package" or "base" software).
Company A also frequently customises its package software application based on specific requirements from its customers ("bespoke" software) and for which, it charges a substantial customisation fee. Many customers prefer to purchase the entire software solution outright, often on account of commercial reasons: the fee paid or the desire to prevent Company A from profiting from the bespoke software it designs.
A review of Company A's customer contracts entered into in the past three years confirms that the terms are consistent with the above description: there are express provisions in the contract stating that customers will "own" the software application.
Company A has attracted a lot of attention from potential buyers and investors because of its software applications and the steady stream of revenue generated by the selling of its customised solutions.
What are the key legal issues then?
Generally speaking, an entity can customise its software applications for other customers because it has the "legal right" to do so. Such legal right can come from Company A being the owner of the copyright in the software application or if it is not the owner, it has obtained rights (eg, by way of a licence) granted by the software application owner. Does Company A have any such legal right?
- In agreeing to "sell the entire software solution" to its first customer, Company A may have inadvertently transferred its ownership rights in the software application, including both the package software and the bespoke part, to that first customer.
- Unless the first customer has given appropriate legal rights back to Company A (eg by way of a "licensing back arrangement") authorising Company A to continue to use or develop the software application, prima facie, Company A no longer has any ownership rights in the software application (the package software and the bespoke part)! Any use, including any further development or customization, of the software application after the first sale is potentially an infringement of the intellectual property rights of the first customer.
Much will depend on the exact wording used in the customers contracts. However, there is now a risk that Company A may have been customising and selling software applications to customers for years which it no longer has the legal right/ownership right to do so. The potential legal risks of this will include:
- Except for Company A's very first customer, representations or warranties given by Company A to its customers stating that it has the legal right to sell, or customise, are not accurate!
- Company A is potentially infringing the copyright of the first customer if it can be established that the first customer indeed has now become the owner of the software application. The first customer may have a potential infringement claim against Company A.
- Other customers to which Company A has "sold" its software applications may also be infringing the rights of the first customer. They may require Company A to compensate their loss if they are prevented by the first customer to continue to use the software application or if they simply do not wish to use a potentially infringing software application, in compliance with their own internal corporate policies on the use of software applications.
What can be done?
All these potential claims and uncertainty over the ownership of the software application are likely to have an impact on Company A, including its valuation and its prospect for sale or attracting additional investment.
To minimise or reduce the legal risks:
- Potential investors and purchaser should require Company A to seek written acknowledgements from customers that (i) it only has ownership rights to the bespoke part of the software application but not the package or base part; and (ii) Company A remains entitled to use the package or base part of the software application, including to develop further customisation.
Word of caution: This quick fix may not be sufficient if part of the "bespoke" software application is used by more than one customers.
- If the package / base part of the software application is critical to the business of Company A, the customer contracts should be carefully reviewed. Unequivocal statements should be included clearly stating that customers are only granted a limited licence to use it in conjunction with the bespoke part of the software application and that ownership of the package / base part remains the property of Company A.
- A proper licensing arrangement must be introduced if any of the bespoke part of the software application is used by more than one customers.
- Any potential investor or purchaser should seek an indemnity from the existing shareholders or the seller of Company A in respect of any of the potential claims described above in the relevant sale or investment agreement.
*Please note that this e-bulletin has been prepared from an English law perspective.