Information and Communications Technology: Source Code Escrow and the Contracts (Rights of Third Parties) Act 1999

Jane Lambert

3 May 2000
This case note first appeared on the Old Colony House website

Ever since Tweddle v Atkinson (1861) 1 B & S 393 it has been settled in England and Wales that a stranger to a contract cannot enforce a provision of the contract even if the contract was made for his benefit. The rule is subject to numerous statutory and common law exceptions and has been much criticized by judges and academics in this and other common law countries. It has never been the law of Scotland. Nor has it been that of the United States since Lawrence v Fox 20 NY 268 (1859). New Zealand and several Australian states have modified the rule by statute. In its report "Privity of Contract: Contracts for the Benefit of Third Parties" (Law Com No. 242), the Law Commission found that the rule often thwarted the intentions of the contracting parties, caused injustice to third party beneficiaries, caused numerous anomalies and practical difficulties in commercial life.

Source Code Escrow
The practical difficulties that the Law Commissioners identified were in construction and insurance contracts, but they could easily have added source code escrow to their list. The purpose of escrow is to assure a licensed user of a computer program continued maintenance and support whatever happens to the supplier of the software. Escrow benefits the supplier in that he can persuade a customer who may be concerned about his financial viability to take his product. The arrangement operates by the supplier's depositing the source code (that is to say, the computer program written in Latin characters and Arabic numerals with programmers notes and other guidance necessary to understand the way the program works) to the latest version of his software with a trusted third party known as an "escrow agent". Should the supplier become insolvent or otherwise fail to maintain his product in accordance with any agreement that he may have made with his licensees, the escrow agent releases the source code to a maintenance programmer appointed by the licensee who maintains and upgrades the program.
Balancing Rights of Suppliers and users
Access to the source code of a program is essential to detect and correct defects, errors and faults in a program and it is also useful for support and updating. However, the document is commercially sensitive because it discloses the structure of the program. Publishing the source code would enable other programmers to develop similar or superior products. Because of its commercial sensitivity, the document is kept secret and access is allowed only upon an undertaking neither to use nor disclose the materials for any purpose other than as authorized. The escrow agent receives the source code in confidence and keeps it in a secure place for the duration of the agreement. Even if it releases the source code, the escrow agent requires the maintenance programmer to undertake to use the document only for the purpose of support and maintenance. Escrow therefore balances the supplier's need for confidentiality and the customers' need for long-term maintenance.
Escrow Agents
At one time all sorts of institutions, including clearing banks and solicitors, offered escrow services but concerns over security have cut down the field to a small number of specialist companies. The market leader in the United Kingdom is NCC Escrow International Limited of Oxford House, Oxford Road, Manchester, M1 7ED. Major escrow agents in the United States include SourceFile LLC of Oakland California, which is in marketing alliance with the NCC, and Fort Knox Escrow Services of Norcross, Georgia. Local escrow services are available in several other countries including Canada, Australia, Ireland, Netherlands and Germany. In February 1999 representatives of many of those escrow agents met in Manchester to agree CEN/ISS standards for escrow services.
Typical Escrow Agreement
The concept of source code escrow developed in the United States. Like a lot of computer contracts, escrow agreements on the American model were imported uncritically into England and Wales in the early days. These provided for the supplier to deposit the source code with the escrow agent who agreed to hold it in a secure place for so long as the supplier maintained the software and thereafter to release it to the supplier's licensees upon certain "triggering events" which included the supplier's insolvency. An agreement to which the licensees were party from the start would have worked as well in England and Wales as anywhere else, but not every licensee saw the need to incur the cost and trouble of acceding to such a contract unless the supplier was in trouble when it was usually too late. One way round that difficulty might have been a trust. Another way was to invite licensees to enter a confirmatory agreement supplemental to the main escrow agreement. The effectiveness of those agreements against a determined liquidator was never tested in litigation which is probably just as well.
The New Act
Parliament has accepted the Law Commission's call to modify the rule in Tweddle v Atkinson and passed the Contracts (Rights of Third Parties) Act 1999 on the 11 November 1999. The new Act, which applies to England and Wales and Northern Ireland, came into force on that day but did not apply to contracts entered between the 11 November 1999 and the 10 May 2000 unless the parties expressly agreed that it should. The key provision is s. 1 (1):

"Subject to the provisions of this Act, a person who is not a party to a contract ("a third party") may in his own right enforce a term of the contract if:
(a) the contract expressly provides that he may, or
(b) subject to subsection (2), the term purports to confer a benefit on him."

The third party must be expressly identified in the contract by name, as a member of a class or as answering a particular description but need not be in existence when the contract is entered into. Subsection (2) provides that s. 1 (1) (b) does not apply if on a proper construction of the contract it appears that the parties did not intend the term to be enforceable by the third party.

The right of a third party to enforce a contract term may be subject to other relevant terms. The third party has available any remedy that would have been available to him had he been a contracting party including damages, injunction and specific performance. Where a term excludes or includes liability in relation to any matter, references to the third party enforcing the term shall be construed as references to his availing himself of the exclusion or limitation. S. 2 (1) of the Act restricts the right of the contracting parties to rescind or vary the contract in such a way as to extinguish or alter the third party's entitlement without the third party's consent if:

(a) the third party has communicated his assent to the term to the promisor;
(b) the promisor is aware that the third party has relied on the term, or
(c) the promisor can reasonably be expected to have foreseen that the third party would rely on the term and the third party has in fact relied upon it.

However, the contracting parties may expressly agree a term that enables them to rescind or vary the contract term without the third party's consent. The court or an arbitrator can dispense with the third party's consent if, in certain specified circumstances, it cannot be obtained.
Effect on Escrow
Licensees will immediately benefit under the Act, whether they accede to the agreement or not, in any escrow agreement that their suppliers enter after the 11 May 2000, or in any agreement before that date that provides expressly for the new Act to apply. On the other hand, they must still notify their supplier and escrow agent that they consent to the terms that enable them to enforce the agreement if they wish to prevent the parties from rescinding the agreement or varying it in such a way as to affect their rights. Moreover, the parties can impose conditions on the exercise of those rights which may include requiring claims to be settled by arbitration rather than litigation (see the accompanying Explanatory Notes). Escrow agents as well as suppliers have to bear the limitations on the right of contracting parties to rescind or vary an escrow agreement if they wish to terminate it on the ground that the supplier has failed to pay their fees. Probably the best way to protect their revenue is to require payment of all arrears of renewal fees as a condition for the exercise of the right to enforce the agreement. Another difficulty that will have to be addressed is that some licensees may cease to be entitled to access the source code if, for example, they sell or otherwise dispose of the software to someone else or they fail to pay a maintenance fee. Care must be taken to define the third parties as those who have a valid licence and who have entered and performed a software maintenance agreement.
 

 

 

 

 

 

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