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Emerging Cybersecurity Company’s Distress Offers Important Lessons for Licensees and Lenders

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Last week, the United States Court of Appeals for the Sixth Circuit issued a decision in the case of Cyber Solutions International LLC v. Pro Marketing Sales, Inc. Although the decision blazes no new legal territory, the facts of the case and rulings offer important lessons for both lenders and licensees.

The decision recounts the start up efforts of an emerging company focused on cybersecurity technology. As the company grew, it obtained a secured loan from a lender. In return for the loan, the company granted the lender a first position lien on all company assets including intellectual property. As is typical in any secured financing, the lien extended not just to property then owned by the company but also to property subsequently acquired by the company. Pursuant to the loan arrangement, the company agreed to standard provisions such as a restriction on its ability to sell its assets outside of the ordinary course of business without the permission of the lender.

Two years after obtaining the loan, business challenges forced the company to seek the protection of chapter 11 in an effort to restructure its operations and obtain a breathing spell from creditors. During the course of that effort, the company entered into a license agreement with a licensee. Pursuant to that license agreement, the licensee advanced two $200,000 payments to the company. In return, the licensee obtained an exclusive license to company technology then existing as well as certain rights to future technology to be developed.

The license agreement stated that any updates, modifications and improvements paid for by the licensee “shall be the property” of the licensee. In a nod to the existing lien held by the lender, the license agreement also stated that such “liens and security interests” would continue notwithstanding the license agreement.

Although the company emerged from chapter 11, it continued to encounter difficulties and ultimately ended up ceasing operations. As the wind-down commenced, the licensee asserted that it was entitled to ownership of second generation technology developed by the company but financed by the licensee’s payments. The lender of course took the position that its lien covered the technology. After litigation ensued, the lender prevailed in a decision by a federal district court judge. The licensee appealed the district court’s order to the Sixth Circuit. On appeal, the licensee argued that (1) its rights to the technology it financed were superior to those of the lender, and (2) that the district court improperly refused to apply the doctrine of “unclean hands” to the lender’s position.

The Sixth Circuit considered the arguments of the licensee and affirmed the lower court decision. In so ruling the court found that:

  • The plain meaning of the security agreement and the license agreement supported the district court’s conclusion that the technology was part of the lender’s  security interest
  • The company lacked the authority to grant the licensee  superior rights in the technology
  • The district court did not abuse its discretion or commit an error of law by refusing to consider evidence of the lender’s  allegedly unclean hands

In sum, the opinion is interesting as it underscores the important rights granted to properly perfected secured creditors. The position of the licensee, of course, is understandable – it advanced the very funds that appeared to make the second generation technology available. Unfortunately, it did so without any subordination agreement or other documentation making clear that the first lien holder’s rights did not extend to such technology. As the Sixth Circuit noted, the licensee knew it was assuming a risk when it proceeded to advance funds under the license and it apparently determined that the risk was worth taking. The court noted that the licensee “cannot escape the consequences of its decision to enter the License Agreement simply because it is now unhappy with the outcome.” This statement is worth remembering. Risk taking, essential to entrepreneurial efforts, should be done with eyes wide open. The ultimate decision of the court, enforcing the collateral rights of a secured creditor over a competing ownership claim of a licensee, reflects the bargain of the parties as set forth in their respective agreements with the company.

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