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Research Paper

Leveraging Knowledge Assets

1.1              Purpose of this Report

Secured credit is a well known and deep-rooted phenomenon. The idea is an intuitively simple one. A debtor grants to its creditor the right, should the debtor default on its loan or credit obligation, to repay itself by appropriating the value of the property that the debtor has charged to secure that obligation. A secured creditor has a priority and enforcement advantage over ordinary creditors who are dependent solely on the debtor’s personal promise to pay. The priority advantage arises because the secured creditor’s right to extract value from the charged property enables it to escape the principle that creditors of an insolvent debtor must share ratably in the balance of whatever assets the debtor may have, a principle that in Canada applies both in and outside of bankruptcy. The enforcement advantage consists in the secured creditor’s recourse to specialized and expeditious remedies to support summary liquidation of the charged assets without the time and expense of having to obtain a formal judgment against the debtor.

Although the institution of secured credit has existed as long as notions of private property and freedom of contract, its legal and practical incidents have undergone periodic change in response to the emergence of new forms of property. Historically, land and luxury tangible things were the principal objects of security. With the transformation of western society from an agrarian to an industrial economy, the focus of property turned to from immovable to movable assets – equipment, raw materials and inventory – and from tangible to intangible assets – the account receivables owing to a business and its reified intangibles such as negotiable instruments, securities and documents of title. That change forced fundamental reform of the legal and institutional framework for secured credit in movables, beginning with federal Bank Act in the late part of the nineteenth century, and culminating in the comprehensive reforms to the movables secured transactions law of all Canadian province in the last quarter of the twentieth century.

With the modern shift to an information, technological and service based economy, intellectual property rights (IPRs) have begun to capture an increasing share of the value of the asset base of firms. With that shift has inevitably come the desire to maximize the collateral value of IPRs for secured lending purposes. This Report focuses on the practical and legal obstacles that may need to be addressed to facilitate access to secured credit based on IPRs. It was commissioned by the Law Commission of Canada in connection with its partnership in the Commercial Law Strategy of the Uniform Law Conference of Canada.

Increasing access to credit for enterprises with significant intellectual property assets can be seen as one element of a more comprehensive strategy for enhancing the competitiveness of Canada’s information based enterprises.³ The costs to the economy of impediments to the use of IPRs as collateral were succinctly described by one economist as follows:

First, loans secured with intellectual property are more costly to negotiate and administer if they can be arranged at all. Second, alternative but less suitable and less efficient financial arrangements may be used in place of loan contracts. That is, proposed projects will still proceed but alternative and less appropriate financial arrangements may be used. For example, there may be more reliance on self-financing or love money than would otherwise be the case. Third, either because alternate financing is too costly or because alternate forms of financing cannot be obtained, some otherwise viable projects simply will not be undertaken.

The resulting losses to the economy are of two kinds. On the projects which proceed using alternate forms of finance, the cost to the economy is the excess cost of the alternative contract. On the projects which do not proceed, the economy loses any excess of the return on the projects not undertaken over the returns on the projects undertaken instead.⁴

Although information-centered enterprises would benefit particularly from improved access to IPR-based lending, the advantages would be felt by all sectors of the economy. This is because there are very few firms today whose overall asset base does not depend on some form of intellectual property. For instance, even if firms do not rely on intellectual property directly to produce revenue, they are likely to be dependent on computer software programs to enhance the efficiency with which they deliver their tangible goods or traditional services to the market place. The aggregate collateral value to a bank or other secured lender that holds security in all the assets of a business except its licensed software is substantially less than it would be with the software.

In its search for possible reform strategies, this Report builds directly on a series of research papers solicited by the Law Commission and presented at a Conference/Roundtable on Leveraging Knowledge Assets in November 2001.⁵ Those papers highlighted two principal perceived impediments to the ability of a debtor to use its IPRs as security to obtain access to credit at lower cost. The first is “the culture of traditional lenders and valuation problems.” The second is uncertainties and gaps in the federal and provincial laws governing intellectual property and secured transactions, along with the need for those laws to respond to the unique characteristics and demands posed by IPRs relative to other forms of property.

Part 2 of this Report looks at the extent to which the first of these perceived impediments – traditional lending culture and valuation difficulties – impedes the optimal utilization of intellectual property collateral. We conclude that there is no evidence to support the perception that financiers are particularly hostile to intellectual property collateral independently of the valuation challenge. As to the valuation issue, there is no question that intellectual property carries inherent difficulties. However, these difficulties vary greatly according to context. Intellectual property rights that have proved their economic value by the reputation of the developer or a sufficient track record can be as “sound as houses” in terms of their reliability as collateral for the duration of their statutory life span. On the other hand, for start up companies for whom access to competitive is most important, valuation can be a real obstacle particularly at the crucial development stage. To a large extent these difficulties cannot be resolved by formal governmental or legal intervention. The reasons lie in the inherent nature of IPRs to which improvements in the expertise and experience of valuation specialists is the most effective practical response. This is not to say that there are not certain features of intellectual property law that do not bear re-thinking in terms of whether their perceived benefit is worth the uncertainties created at the valuation level, and we give several examples of possible reforms of this kind.

In any event, the valuation challenge is not a reason to do nothing about the second perceived obstacle to optimizing the value of intellectual property collateral. The legal risk inherent in the current legal framework governing IPR-based secured lending is a problem about which this Report concludes something can and should be done. Indirectly it will serve to accelerate enhanced valuation practices.

The next Part of this report discusses the valuation challenges in more detail. Part 3 describes the deficiencies in the current framework of law and practice. Part 4 provides a broad overview of the alternative reform strategies and Parts 5 and 6 go on to discuss in detail the implementation, advantages and disadvantages of the two main alternatives. Part 7 discusses a number of issues related to licences of IPRs which are relevant to any reform strategy. Part 8 briefly touches on some enforcement concerns and Part 9 concludes.

1.2              Federal versus Provincial Intellectual Property Rights

Before examining the practical and legal difficulties associated with intellectual property as collateral, we need to be clear about what we mean by the term. For the purposes of this Report, the principal relevant classification is between intellectual property rights that fall within federal legislative jurisdiction (“federal IPRs”) and those that fall within provincial authority (“provincial IPRs”).

Federal IPRs consist of patents,² copyrights,³ trade-marks,⁴ industrial designs,⁵ integrated circuit topographies, ⁶ and plant breeders’ rights,⁷ each governed by its own separate federal Act. It is important to note that all of the federal IP Acts establish ownership registries. In the case of patents, industrial designs, plant breeders’ rights and integrated circuit topographies and registered trade-marks, registration is a prerequisite to protection.⁸ Unregistered copyright is accorded the same protection as registered copyrights – registration is relevant to proof of ownership and to assignments – and unregistered copyrights are pervasive and important.⁹ As will become apparent, in so far as the issue of the approach to the law governing security interests is concerned, the key functional difference between various types of IPRs is the existence or absence of a federal ownership registry.

Provincial IPRs cannot be so easily defined. They are generally not created or regulated by any specific provincial Act or code, but arise instead under provincial law of general application. Examples include trade secrets and confidential information, personality rights, domain name rights, and unregistered trade-marks used within a province.¹⁰ Defining the exact boundaries of provincial IPRs is to some extent subjective. Fortunately, it is not necessary to come up with a precise inventory for the purposes of this Report. For reasons that will emerge, the principal valuation and legal challenges posed by IPR collateral arise in relation to federal IPRs.

Of the six categories of federal IPRs, this Report focuses primarily on patents, copyrights and trade-marks, as the most practically significant (although the principles discussed are readily translatable to industrial designs, integrated circuit topographies and plant breeders’ rights):

Patents: All patents are creatures of the federal Patent Act in the sense that, regardless of the merits of any particular invention, no patent protection exists until the patent has been issued. For this to occur, the patent application must first be scrutinized by the Patent Office. Only if it is found to be novel, useful and not obvious will a patent be issued.¹¹

Copyrights: Unlike patents, no formal application process is required to bring a copyright into existence. Copyright subsists in “every original literary, dramatic, musical and artistic work”¹² (with “literary work” including computer programs)¹³ as soon as it is expressed in material form. Unregistered copyrights are pervasive and important.

Trade-marks: Patents and copyright both give rights in information goods. In contrast, trade-marks protect an association between the particular goods or services and the provider of those wares by allowing the provider to exclusively identify their wares with a distinctive mark

1.3              IPR-Related Intangible Assets

The economic value to an owner of patents, copyrights and trademarks consists in the right to limit and control the use by others of the IPR without compensation. Control is typically exercised through the contractual licensing arrangements, under which the owner/licensor authorizes a licensee to use the IPR in exchange for either an up-front payment or payments over time. The licensor/licensee element produces its own set of potential assets that can potentially be used as collateral by the licensor or the licensee as debtor. Although this Report focuses on federal IPRs, it also covers the use as collateral of these associated rights.

For the licensor, there are the contractual benefits it derives from its licencing arrangements, most notably the stream of royalty payments owed by licensees, which may be assigned as collateral separately or in combination with the licensor’s aggregate of rights against the licensee or both in combination with the IPR right itself. For the licensee, the relevant collateral consists in the value derived from its right to use the intellectual property in accordance with the terms of the licensing contract.

It is possible to structure licensing arrangements in a more complex fashion. The owner/licensor might grant a first-level licensee the right not simply to use the IPR but to sub-licence it to end-users. In such an arrangement, the first-level licensee’s potential collateral would include not just the value of its rights under the licence, but also the potential to separately collateralize the stream of revenues derived from its sub-licensing arrangements with end-users. For the sake of simplicity of discussion, we will assume a simple licensor/owner and licensee/end-user structure since the basic issues remain the same even in the context of a series of licences.

The debtor/owner’s right of suit for damages for IP infringement constitutes a potentially important source of collateral in itself. As an associated intangible, in our view it is best regulated like royalty payments and licences under general secured transactions law. However, the PPSAs at present exclude collateral in the form of a right to sue in tort from their scope (though arguably not the fruits of such a suit) and this may exclude at least partially IP infringement causes of action. We endorse prior recommendations (see Cuming & Walsh) to eliminate this exclusion, a reform that would permit creditors who take security in this form of collateral as part of a general collateral package of intangibles to rely on the general PPSA legal framework.