Considering intellectual property securitisation
Keith W Medansky and Alan S Dalinka
Piper Rudnick LLP, Chicago, IL
The World Intellectual Property Organisation (WIPO), among others, describes the securitisation of intellectual property (IP) assets as “a new trend”. It has now been more than seven years since the introduction of the so-called Bowie bonds – regarded as the first-ever music royalties future receivable securitisation – which gave rise to IP securitisation as a financing vehicle. In the years since the introduction of the Bowie bonds, a great deal has been written in the business and legal press and in academic journals about securitising various IP portfolios from copyrights (particularly those associated with music and film) and patents (particularly those associated with pharmaceuticals and high technology) to trademarks and even trade secrets and domain names.
But publications on this subject seemed to have peaked between 1999 and 2002. Since then, fewer new significant articles have been published, and there has not been any significant increase in the number or scope of deals reported. The natural question then is: what happened to all of the excitement? Perhaps securitisation was caught in the wake of the financial correction following the dot.com market crash. Or perhaps risk assessment in intellectual property securitisation just has not reached sufficient maturity yet to lead to the predicted boom.
Securitisation transactions involving traditional financial assets have been around since at least the 1980s. In the days before the Bowie bonds, typically the assets being securitised related to tangible receivables such as real estate leases, supply contracts and the like. Such tangible receivables have predictable revenue streams and credit rating agencies are well familiar with the associated risks. In the case of intellectual property rights, the receivables may be licence royalties or other predictable cash flows from the intellectual property.
The owner of the receivables, who is called the originator, groups receivables together and transfers them to a special-purpose vehicle (SPV) that is formed for the sole purpose of acting as an issuer of the securities based on the receivables. The SPV issues debt or equity to investors and uses the proceeds to pay the originator. Debt issued by the SPV (bonds or the like) is serviced by the receivables; equity interests issued by the SPV results in the SPV passing through the revenues produced by the receivables. Recording the security interests in the property secures the commitment to pay the receivables with recourse to seize the property in the event of a default.
No matter what form of security is issued by the SPV, the SPV is created in an effort to make the securitised asset remote from the assets of the originator so that in the event of the originator’s bankruptcy, the court will not include the asset as part of the originator’s estate. The bankruptcy court will look at the originator’s transaction with the SPV to determine whether it is, in fact, a true sale and not just a mere loan. The real transfer of the assets to the independent SPV thus also separates the originator’s finances in such a way that the originator’s creditworthiness ought not to be considered a risk factor that should weigh on the creditworthiness of the securities issued by the SPV.
Securitisation of tangible assets
In the realm of tangible assets, the risks are largely visible in a securitisation transaction. Take for example the securitisation of a portfolio of real estate leases. In this example, a landlord (the originator) transfers to a trust (the SPV) its lessees’ rent obligations over a period of 10 years in exchange for a lump- sum payment. The trust sells bonds backed by the leases with a 10-year maturity, and takes and records a security interest in the leases. The two biggest risks in this sort of hypothetical scenario are fairly plain to see, and are capable, to at least some degree, of being accounted for or mitigated:
• tenants may fail to pay rent – that may be accounted for in due diligence investigation by reviewing the lessees’ creditworthiness; the tenants contracting to mitigate the damage to the lessor (or, more likely, its assign, the SPV); obtaining the lessor’s right to sub-let to mitigate, etc.
• the real estate could be damaged in such a way that the tenants are not required to pay rent (eg, they are not able to inhabit the building) – that may be mitigated by insurance or at least accounted for in the predictable ways in which the damage could occur such as by fire, flood, acts of terrorism, etc.
While, like the real world, this tangible example does not provide a perfect revenue stream, it is a highly predictable revenue stream that can be assigned a reasonably accurate credit rating based upon experience with similar leases or an established history for the property at issue.
David Pullman was responsible for arranging the first securitisation of intellectual property. Musician David Bowie was looking for financing opportunities for, among other things, buying out his manager’s minority share interest in his music catalogue. Bowie’s objectives meant he was looking for a way to raise a lump-sum cash amount rather than to rely upon an income stream – indeed, Bowie reportedly had a regular cash flow of more than US$1 million per year from ownership rights in the copyrights in much of his music catalogue dating back to the 1960s and to the recording masters. So rather than entering into a new traditional distribution agreement at the expiration of his existing recording and distribution agreement, Pullman devised the Bowie bonds to meet Bowie’s need for upfront cash.
Only limited information about the structure of the transaction is publicly available. Certainly, an SPV was formed. The assets Bowie sold to the SPV included the right to certain future royalty payments from 25 pre-1990 albums he recorded (more than 300 copyrights). The SPV issued bonds and Bowie’s record distributor, EMI, provided certain credit enhancements. The bonds received a triple A investment grade rating by Moody’s Investors Services. The bonds had a 10-year average life and had a maturity of 15 years. Prudential Insurance Company purchased the bonds, netting US$55 million for Bowie.
In a debt offering of this kind, the underlying copyrights would be used to secure the bonds. If the SPV defaults on its payment obligations to bondholders, the copyrights are permanently transferred to the bondholders. Until the event of default, of course, the copyright owner would retain the copyrights subject to a security interest held by the bondholders. After the bond obligations are met, the copyright owner holds the copyrights free of the security interest (just as a homeowner that has paid mortgage debt in full owns a home free of the mortgage).
The security interest in the copyrights would be perfected to allow the bondholders’ claims to take precedence over most unsecured claims. The procedure used to perfect security interests in copyrights in the United States is the subject of some debate. Article 9 of the Uniform Commercial Code (UCC) does not mention copyrights and there is some question as to whether collateral interests in copyrights should be perfected by filing a UCC-1 financing statement in the appropriate states as general intangibles under the UCC or by recording a collateral assignment in the Copyright Office. Although recent case law suggests that security interests in copyrights can only be perfected in the Copyright Office, out of an abundance of caution, most careful lenders perfect security interests in all IP rights (patents, copyrights and trademarks) at the state and federal level (Patent Office, Copyright Office and Trademark Office, as the case may be). It should be noted that perfecting security interests in property in the United States varies with the type of property and is largely a function of state law rather than, as is the case with intellectual property law, with reference to a combination of state and federal law.
Other intellectual property securitisations and the risks
The Bowie bonds are not the only example of IP securitisation. Other musicians have done similar securitisations involving their music catalogues. There also have been securitisations involving film catalogues as well. At least one securitisation involving patents for drugs has been done and publicised. Indeed, quite a few published articles have theorised that the possibilities for securitisations include portfolios of trade secrets, trademarks and domain names as well. However, if there have been such transactions, they have been kept fairly confidential and private.
When considering the intangible nature of intellectual property, perhaps it is not surprising that securitisations in this field have not become everyday, well-publicised transactions. Each type of intellectual property comes with its own peculiar set of complexities and unknown risks that are not common to commercial ventures involving tangible property.
In dealing with copyrights, there are several risk factors that need to be analysed. Even in the Bowie bond transaction, it has been reported that the examination and definition of all of the applicable revenue streams associated with the securitised music catalogue required more than a thousand pages of documentation.
Ownership of the copyright is one of the first issues to consider. The United States no longer requires registration of a post-1989 work for copyright to vest in its author(s). Determining who the author is or who the joint authors are may not always be a straightforward investigation. Certainly assignments and other encumbrances must be considered. Depending on the work, heirs may have rights in the work upon the originator’s death and the creator of the work may have the right to terminate any transfer of the copyright under 17 USC §203. The Section 203 right to terminate transfers is particularly problematic because under 17 USC §203(a)(5), the termination may be effected notwithstanding any agreement to the contrary. Thus, the risk of a reversion of rights must be considered when valuing the property.
Likewise, if a work is of joint authorship, each joint author has a right to royalties derived from the work, and if less than all of the joint authors are participating in the securitisation, valuation will be effected and careful consideration will need to be paid to the joint author’s or authors’ rights. Of course, whether the work was a work for hire also needs to be considered, and if a work is a work for hire, where the work was created by an independent contractor rather than an employee of the purported copyright owner, the documentation of the work-for-hire agreement must be carefully considered as well.
Ownership issues can likely be resolved to at least a reasonable degree of certainty. One needs to be aware, though, that perfect certainty probably can never be achieved. Since the copyright registration process does not involve a scouring of all works to determine whether a registered work infringes another pre-existing work, there will always be at least a modicum of risk that another author will initiate a successful infringement action that not only undermines the validity of the copyright and decimates the royalty streams, but places the originator at further risk of a fraud claim by the SPV (and, perhaps the bondholders) for representations made in the initial transfer. Certainly an honest originator would be able to defend the fraud claim on the basis of lack of knowledge of the infringement, but no originator’s copyright could completely escape the consequences of a successful copyright infringement action.
Assuming that ownership issues can be resolved to a reasonable degree of certainty – and with research and diligence one would normally expect them to be and to accept the risk of the unknown – the sources and magnitude of possible royalty streams need to be analysed and valued. Indeed, valuing the royalty stream and its reliability is of critical importance to the investors who purchase royalty-based intellectual property securities. For the originator and underwriters, these valuation issues underlie the legal disclosures required in their offerings under the securities laws and the assumptions driving the transaction. For example, in the case of Bowie’s catalogue, the revenue streams were originally expected to be from traditional performance and distribution rights – such as radio play, records/tapes/discs sales, motion picture use, etc throughout different countries in the world. Today, revenue also comes from new streams such as digital distributions (eg, iTunes®).
The changes in the marketplace that brought new sources of revenue based on digital distribution, also brought unforeseen competition that has impaired the value of the original Bowie bonds. No-one expected at the time the Bowie bonds were first offered that the demand for paid recordings of Bowie music would be threatened by illegal free peer-to-peer file sharing. The recording industry has aggressively and publicly begun to fight widespread digital piracy on the internet in peer-to-peer sharing networks. The estimates of lost revenue in this area are huge.
In any securitisation transaction, the threat of infringement needs to be considered. In some cases, it may be appropriate for the originator to take legal action to terminate infringement of the underlying copyrights and protect the demand for the subject works from unfair competition by infringers. The transactional documents need to explain how the infringement cases will be handled, who will control and pay for the litigation, and who will receive the benefits of settlement payments or a judgment from a successful trial.
Just as the threat of infringement can impact value, historic revenues may prove non-predictive for copyright securitisations due to other intangibles. Music and movies are part of pop culture, which has a way of changing rather rapidly. The popular music of the 1980s or even the popular films of the 1980s are not, as a whole, as popular today and how popular they may be a decade from now is really but conjecture. Tastes change. Whether any particular music or film catalogue has any real staying power in the marketplace is probably not predictable with a large degree of certainty. Similarly, revenues relating to copyrights in expressive works also can be subject to the personality of the artists that create them. An artist that no longer has an incentive to promote a past work – let alone produce new works that keep the artist in the public’s eye – may become forgotten. Or worse, an artist that is accused of some crime of moral turpitude may see his or her works publicly shunned or treated worse.
The more predictable the revenue generated by an IP royalty portfolio, the greater the opportunities from securitisation. But no-one can really successfully predict what other forms of distributions are yet to come and how they may effect future revenues (whether positively or negatively). Thus, valuation remains a main, if not the main, legal and business challenge in structuring IP securitisation transactions.
Other intellectual property
Patents, trade secrets and trademarks have also been the subject of interest for securitisation. In principle, each can generate a stream of royalty income that can be securitised in much the same way described above with respect to copyrights.
Valuation of royalty income in patents and technology can present many unique challenges. Indeed, when dealing with technology, the question of obsolescence also comes into play. The promoters of eight-track players and Betamax® recorders all had some success for a number of years and there may still be valid IP rights owned relating to these technologies. Though there was probably a point in time where each technology looked like the technology would produce a revenue stream for a significant amount of time into the future, one can see from today’s vantage point that none of those technologies could possibly produce the revenue streams of days past.
Trade secrets are, themselves, only really recognised as a product of local state laws in the United States. (There is a Criminal Theft of Trade Secrets Act on the federal level, but for the definition of what is a trade secret, one must look to state law.) On one hand, trade secrets are very intangible property: a trade secret may be reverse engineered legally; may be purposely disclosed to the public for a business reason; and/or may be inadvertently disclosed to the public. Thus, most trade secrets probably do not lend themselves to securitisation.
On the other hand, so long as a trade secret remains confidential and not reverse engineered, it continues to exist in perpetuity. There are certainly some trade secrets that have long-established royalty streams – the secret formula to a certain popular soft drink and the secret herbs and spices for cooking fried chicken are two famous examples. There is no obvious legal reason why royalty streams from these assets could not be securitised. However, as a practical matter, the proprietors of these trade secrets may not want to part with the full control of their valuable assets or put them at risk in the event of default.
Finally, securitisation of trademarks presents many unique concerns. In the United States, a trademark cannot be assigned without its goodwill. Franchise and distribution systems are often built around trademarks (and, more recently, domain names) and the goodwill associated with them, typically in conjunction with some trade secrets. Securitising a portfolio of trademarks (or domain names) requires extreme care to avoid severing the goodwill from the trademarks and still to maintain quality control over the use of the marks in commerce. Upon default, the goodwill must pass with the marks to the secured bondholders or the value of the marks may be jeopardised.
ConclusionIP securitisation remains a valid financing technique which allows rights holders to obtain the financial benefits of a present lump sum in exchange for the right to receive royalties from their works over the long term. For a securitisation to be successful, the value of the royalty stream in question must be predictable and the risks that may undermine the demand for the goods protected by the IP must be understood. As technology evolves it may be difficult to predict how market forces (eg, peer-to-peer file sharing) may impact intellectual property valuation and such uncertainty may temper enthusiasm for this financing technique. However, with appropriate due diligence precautions, cautious asset identifications and careful valuations, securitisation is viable and should be considered as a way to monetise intellectual property.