Secured Credit and Software Financing

Abstract:     
Although software is one of the most important assets many businesses hold, almost nothing has been written about the dynamics of software financing. Under a conventional view of secured financing, the difficulties of liquidating software would limit its value as collateral for secured loans. But the actual transactions belie that view, because lenders advance billions of dollars in asset-based software loans each year.

Part I of the article describes the legal and practical difficulties that make it so impractical for a lender to liquidate software-related collateral: the uncertainty about where to file; the requirement that the borrower deposit the source code with the Copyright Office; the impossibility of perfecting an interest in software-to-be-developed; and the need to obtain the licensor's consent to the liquidation.

The factors described in Part I of the article suggest that software-based lending should be at best risky and unusual. Parts II and III show, however, that businesses have developed transactional structures that overcome those difficulties. First, Part II describes the use of debt to facilitate the development of new software products. The lenders in those transactions ordinarily overcome the difficulties of obtaining value from the underlying assets of their borrowers by developing a highly symbiotic relation with a venture capitalist.

Part III then describes the use of debt to facilitate the acquisition of large-dollar commercial software products. In that context, parties overcome the lack of liquidation value by use of the leverage that comes from a right to terminate the purchaser's use of the software. Because that remedy is independent of the classic secured creditor's remedies of repossession and foreclosure, it poses significant difficulties for the legal system. In one context, proposed revisions to the Uniform Commercial Code purporting to aid software financiers actually have harmed those lenders by calling into question the permissibility of that remedy. More generally, the treatment of the software lender in bankruptcy is complicated by the traditional division of creditors' claims into "secured" and "unsecured" categories, that is used to bestow favorable treatment on the claims classified as "secured." Because the right to terminate use falls outside traditional notions of secured lending, the Bankruptcy Code provides little protection for the lender that relies on that remedy. But that treatment is perverse because the unsecured lender has put itself in a position to be well protected under the state-law system, better protected than it would have been if it had relied on a conventional secured claim.

The end result is a system in which the law encourages software financiers to engage in "sham" secured transactions -- those that purport to take a security interest, but include no right of liquidation. The article recommends resolution of that situation by affording recognition in bankruptcy to the termination right of the software-acquisition lender.

Accepted Paper Series