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Software Legal Structures Evolve

Because software consists of computer code which is subject to copyright, the phrase “Software Leasing” is a misnomer, since what is involved is the licensing of the right to use software with the permission of the copyright owner. In practice there may be a chain of assignments and sub-licences resulting in a non-exclusive licence being granted to the User.

Many leasing companies were slow to understand the legal difference between software and goods or equipment, but as the market has matured and Lessors have now become increasingly involved in the provision of software only packages more attention is being paid to the need to ensure that correct legal structures are used in the provision of software finance.

Performance Issues

Case law has established that the supply of software is normally subject to an implied term that it is reasonably fit for its intended purpose 1 St Albans City & DC v International Computers Ltd [1996] 4 All ER 481. Lessors’ exclusion clauses will seek to negate any liability for the performance of the software, but these are subject to statutory control under the Unfair Contract Terms Act 1977 which imposes a “requirement of reasonableness”. Thus performance issues remain an essential issue for Lessors when financing software, so it will normally be necessary to take a view both on the track record of the type of software involved and on the credit-worthiness of the Supplier in the event of a claim for recourse.

Legal Structures

There are essentially four legal structures which have emerged in the provision of software only finance. All but the first involve some complex taxation and accounting issues which are outside the scope of this article save to note the obvious fact that capital allowances are not available in the loan structure.

Loan Agreement

From a legal perspective the simplest and most straightforward mechanism for the provision of software finance is for the Lessor to enter into a Loan Agreement with the User which is entirely separate from the provision of software by the Supplier. The Loan Agreement would normally contain a clause assigning the right to use the software from the User to the Lessor by way of security, which will provide some incentive for the User to maintain instalment payments.

The loan structure has two main advantages. Firstly, the Lessor does not have to concern itself in ensuring that the Supplier has the ability to licence the software.

Secondly, the Lessor has no responsibility for the provision of the software or its performance, so even if the Supplier fails to deliver the software or it proves to be wholly defective, the User remains liable to make payments in full under the Loan Agreement.

However, in practice industry experience suggests that Loan Agreements are somewhat unattractive in the market place, particular where software is part of a package involving hardware or other equipment which is being financed on a Lease Agreement.

Master Licensing Agreement

Under a Master Licence with the Supplier the Lessor enters into the licence chain and obtains permission to sub-licence the software to the User. There is a separate Lease Agreement and normally also a separate Supply Agreement between the Supplier and the User both in relation to the provision of the software and also training and support.

This structure is most commonly used where the Lessor intends to deal regularly with a number of Suppliers. The Master Licence includes suitable indemnities from the Supplier in respect of both intellectual property claims arising from the use of the software and claims arising from its defective performance.

There should also be a term that in the event of termination of the Lease Agreement the Supplier would assist the Lessor by ceasing to provide any further releases or upgrades of the software or any ancillary services to the User, with the aim of ensuring as far as is possible that it would no longer be able to use the software.

This structure has three main disadvantages. Firstly, there may be a risk as to whether the Supplier has proper legal authority to licence the software to the Lessor for sub-licence on to the User. The Lessor will need to be satisfied of the Supplier’s ownership of the relevant copyright or of its rights as assignee.

Secondly, the Lessor’s exclusion clause seeking to negate any liability for the defective performance of the software will be subject to the statutory test of reasonableness; each case turns up on its own facts but the risk will be broadly similar to that in traditional leasing arrangements.

Thirdly, the Lessor faces the potential risk of product liability in the event of the software causing loss or damage to some third party. The Lessor will have an indemnity from the Supplier, but takes the risk of the Supplier’s inability to satisfy that indemnity.

Novation Agreement

A less common legal structure is the use of a Novation Agreement, which is signed by the Supplier, the Lessor and the User in conjunction with a Lease Agreement between the Lessor and the User. This is more commonly used where the Lessor does not have an on-going relationship with the Supplier, or were the software has already been provided by the Supplier to the User subject to the payment of the price.

The effect of a Novation Agreement is the varying of an existing contract of supply between the Supplier and the User so that the User is released from the obligation to pay the price to the Supplier; instead the Lessor pays the Supplier and the User pays the Lessor by instalments.

This structure is likely to improve the Lessor’s prospects of successfully excluding liability for the performance of the software, for the simple reason that both Supplier and User are parties to the Agreement as well as the Lessor, so there is a powerful argument that the User should be left to its contractual remedies against the Supplier under the original Supply Agreement.

Apart from this consideration, the Lessor’s risk is similar to that under a Master Licensing Agreement.

Receivables Financing

A Receivables Financier may also choose to fund a stream of receivables arising from the provision of software, normally involving a Lessor. There are several variants of this structure but it is important to note that the Receivables Financier can normally be in no better position than the Lessor in a claim against the User. But there are some very effective operators with carefully drafted documentation seeking to limit the User’s redress to the Supplier and to exclude the Lessor’s liability for performance issues which has good prospects of satisfying the statutory test of reasonableness, and there is no risk of product liability upon the Receivables Financier.

Further Developments

Recent industry trends towards financing “soft” services such as installation, training, support and maintenance in conjuction with software licensing and the financing of “packaged solutions” of services such as IT support generate fresh challenges for lawyers. Is it safe for a Lessor to pay the Supplier up front were the User is entitled to expect the continued provision of a high quality service (which may be defined in some detail in the contractual documentation proffered by the Supplier)? What view will the Courts take of the Lessor’s exclusion clauses were the Supplier is unable to provide the services to the requisite quality or at all? We will probably have to wait for some time before these and other issues receive authoritative answers from the Courts.

Reproduced with the kind permission of Leasing World.

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1. St Albans City & DC v International Computers Ltd [1996] 4 All ER 481