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Research Paper

Leveraging Knowledge Assets

2.1              Introduction

Cultural inertia is sometimes suggested as a reason for the reluctance of traditional financial institutions to engage in IPR-based financing. However, the research previously solicited by the Commission provides no reason to believe that access to IPR-based collateral is negatively influenced by an irrational lack of appreciation of the value of IPRs on the part of financial institutions. Indeed, the contrary is suggested by the emergence, despite legal hurdles, of specialized IPR-based lending techniques by lenders in some industries, film financing in particular.¹⁴ It follows that efforts to improve access to credit by sensitization of lenders to the opportunities available are not likely to bear fruit.

But while financial institutions may be generally sensitive to the collateral opportunities presented by IPRs, the Commission’s previously commissioned research identifies a number of inherent valuation challenges that may explain why lenders are often perceived to be more cautious when it comes to IPR-based financing relative to secured financing against the value of more traditional categories of property. This chapter lists and explains these inherent valuation challenges. We describe them as “inherent” because they arise from substantive and procedural principles of intellectual property law, which, with a few minor exceptions, we conclude cannot be changed without compromising the public policies and goals of intellectual property law to any unacceptable degree.

2.2              Limited legal life

The legal protection afforded intellectual property rights is based on the theory that economic reward provides an incentive to would-be inventors and artists. But this must be balanced against the public interest in free access to the accumulated intellectual capital of human knowledge so as to promote further cycles of innovation. The balance between these two policies is achieved by limiting the duration of the legal existence of patents and copyrights, at the conclusion of which the knowledge falls into the public domain and can be exploited by anybody without legal interference.

In the case of patents, once the patent is issued, the patentee’s monopoly over the subject matter of the patent¹⁵ is limited to a term of twenty years from the date on which the application was filed,¹⁶ subject to the payment of maintenance fees.¹⁷ For copyrights, the term of protection is longer: the life of the author plus fifty years.¹⁸ However, where the first owner of the copyright is the author, ownership reverts to the heirs of the author 25 years after the death of the author notwithstanding a previous assignment to a second owner.¹⁹

Trade-marks are not subject to any a priori legal life span. Registration under the federal Trade-marks Act protects the mark for an initial period of 15 years and may be renewed indefinitely. However, the trade-mark is lost if abandoned by the owner or, as explained later, if it loses its distinctiveness. Because the legal life of trade-marks thus depends on vigilant and continuous monitoring by the owner, it too has a potentially limited legal life that must be accommodated by lenders at the initial valuation stage.

2.3              Limited economic life

IPRs have a limited economic life that can be much shorter than their legal life: “IP by its very nature is concerned with innovation, and because it is a monopoly granted to encourage further innovation, there is a fundamental problem in the valuation of IP: that IP can be made worthless through becoming obsolete in the market place.”²⁰ The tendency to obsolescence is particularly accelerated for some forms of IPRs. For instance, computer software that “implements cutting edge technology can become fatally inferior to newly developed products in just a short time.”²¹

Because the realizable value of the IPR may have become negligible by the time the debtor defaults and the creditor seeks to enforce its security, lenders must have the expertise to anticipate the extent to which this risk afflicts the particular borrower’s IPRs and discount the value of the collateral accordingly. Even when existing circumstances suggest every reason for confidence in a lucrative return, the duration of the practical life of an IPR is still unpredictable to some degree since it is dependent in part on future factors beyond the control of the debtor (e.g. superior research efforts by competitors or unanticipated product deficiencies). This is also true of trade-marks, which may depend on future fashion trends and marketing for their value.

2.4              Idiosyncratic value

Some IPRs, such as many of the patents in the portfolio of a R&D; intensive company, have no ready market. This is not to say that there is no market at all (although there may not be), but each IPR is to some extent unique and so valuing the asset is more difficult than in the case of more fungible goods, such as wheat or televisions, which are routinely traded on an established market. This increases the cost of valuing the collateral and so increases the cost of using it as security, particularly if the IPR is to be the primary security.²²

The idiosyncratic value problem particularly acute if the enterprise is a new one without a proven track record that is in need of financing to fund it through the early development stage. For these would-be borrowers, access to financing is essentially limited to those financial institutions with sufficient accumulated experience to assess the credibility of the enterprise’s business plan for the particular category of IP under development.²³

2.5              High Use Value Versus Low Liquidated Value

The value of IPRs is often much higher in the hands of the debtor compared to its value in the hands of a new user. For instance, patents and copyrights may be only aspects of an overall product that relies for part of its value on the know-how embodied in the debtor/owner or in a “hybrid, patent-trade secret combination”²⁴ Because the value of the IPR is thus dependent on unique characteristics of the particular debtor/owner, it may have little market value in the traditional secured lending sense under which a lender depends on the liquidated value of the collateral as protection against the risk of non payment by the debtor.²⁵ Should the debtor default, the only potential interested purchasers on a liquidation sale may be the debtors’ competitors, who will likely already have their own IP in place, and will be willing to purchase the IPR only for the value comprised in keeping it out of the hands of a reborn competitor as opposed to its value in the hands of the debtor.²⁶

A similar difficulty limits the collateral value of an item of intellectual property purchased by a debtor from the owner. In many cases, the use value of the IP in the debtor’s business depends on the ongoing technical advice and maintenance support of the owner/developer, an obvious example being the continuing support including the provision of upgrades needed to maintain the value of software. Unless the secured creditor can force the owner/developer to provide those ancillary services to a new user, the liquidated value of the IP is substantially diminished.

To the extent the value of IPRs thus depends on the ongoing expert service of the owner, the collateral value to the owner/debtor of the income stream owed to it by end-users is also diminished. Once the defaulting debtor is no longer in business so that ongoing maintenance is no longer assured, end-users may claim that breach of the maintenance obligation relieves them of their obligation to make continuing payments.²⁷

2.6              Uncertain Validity or Enforceability

The owner’s ability to exploit the economic value of its IPRs depends on its ability to control the use and sale of the right by others. Yet the legal validity and enforceability of IPRs.is not always predictable for reasons that vary as between patent, copyright, and trade-marks.

Patents

Even after a patent has been issued, its validity may be challenged in court at any time during its life for any of the substantive reasons that would have justified the Patent Office in refusing to issue a patent in the first instance: i.e., lack of novelty or utility or obviousness. Because invalidity is a not uncommonly successful defence to a claim for patent infringement, the collateral value of a debtor’s patents, particularly at the early stages, must be discounted to account for this risk.²⁸

Trade-marks

Invalidity may also be raised as a defence to a trade-mark infringement action. Because the function of a trade-mark is to provide the consumer with information about the origin of the wares associated with that trade-mark, the mark must be “distinctive” of the source of the wares: that is, there must be a unique association between the wares and a single source. If the wares lose distinctiveness – for example if a competing source provides the same wares under the same mark without interference from the holder of the mark²⁹ – the mark will become invalid.³⁰ Thus even if initially valid, trade-marks may become invalid if not properly maintained and policed by the owner. The secured lender must take this risk into account at the valuation stage.

The requirement for distinctiveness also means that secured lenders cannot rely on trademarks as independent collateral. At one time, trade-marks could not be assigned “in gross” which is to say they could not be assigned independently of the business as a whole. This was thought to be unduly restrictive of commercial practice and the Act now provides that a trade-mark “is transferable . . .either in connection with or separately from the goodwill of the business. . .”³¹ However, the courts, still concerned with the ultimate goal of protecting the consumer, have held that though the Act provides that the mark may be assigned in gross, it does not ensure that the mark will remain valid after such an assignment. Thus if the mark is associated with one source, and the bare mark is assigned to another company which begins to use it on the same wares, the mark is now associated with two sources – the old and the new – and may therefore lose its distinctiveness and become invalid.³² For this reason, it is risky to take a security interest in a bare trade-mark, since realization by selling the mark to a third party, unaccompanied by the goodwill in the business as a whole, may well lead to invalidity of the mark. This does not occur if the mark is transferred as part of the assignment of the assets generally, so a security interest in important trade-marks may still be a valuable adjunct to a general security interest in the aggregate assets of the debtor enterprise.

Copyrights

Registration of copyrights is not a pre-condition to their validity. The copyright comes into existence as soon as it is expressed in material form. Invalidity per se is not that common a defence in a copyright infringement action.³³ The issue is more one of uncertain enforceablity. Either it is claimed that the defendant did not copy the plaintiff’s work (copying may be more difficult to establish than one might imagine, given that copyright protection may subsist in somewhat abstract aspects of a work, such as a plot line); or that what was copied or allegedly copied was unprotectable, as copyright protects only the expression of the work, as opposed to the idea behind it.³⁴ The protected “expression” extends beyond the literal text of a work; for example fictional characters, if sufficiently well delineated, and detailed plot lines may be protected. But at a the higher levels of abstraction the idea or theme of a work is not protected. The valuation difficulty arises because it is not always possible to predict in advance of a court ruling the precise dividing line between protected expression and the unprotected underlying idea or theme

Moral rights present a potential additional complication to the valuation of copyrights. The Copyright Act separately protects an author’s “moral rights,” including the right to the integrity of the work and the right to be associated with the work.³⁵ Although moral rights may be waived, they cannot be assigned. It follows that without proof of a comprehensive waiver, the value of the copyright in the hands of a non-author owner/debtor is reduced by the potential for continued authorial interference and control.

2.7              Impact on Valuation of IPR-Associated Collateral

It may be thought that valuation is not as serious a problem where the lender is primarily relying on the royalty payments derived from IPRs. After all, here the collateral is a monetary receivable. However, the valuation uncertainties surrounding IPR rights have an impact on a secured creditor’s determination of whether the likely future royalties derived from the IPRs will be sufficient to fully amortize the secured obligation (or the value of the securities to be issued where an assignment of royalties is made in the context of a securitization of royalty payments collateralized by IPRs). Unlike loans collateralized by real or personal property where the obligor normally pays a pre-determined monthly sum, intellectual property royalties are frequently paid based upon sales, and sales can vary widely and unexpectedly, especially if a band becomes unpopular or a patent is declared invalid or is superceded by a better product. In the case of patents, the obligation to make royalty payments may end if the patent is later found to be invalid.

2.8              Possible Responses

2.8.1        Introduction

The extent to which the inherent valuation challenges identified above diminish the attractiveness of IP collateral for secured lenders can vary considerably from one transaction to the next. Some IPRs, for example, a patent on a ‘blockbuster’ pharmaceutical, or the copyright on a popular film, pose little in the way of valuation difficulties by reason of their proven track record. The example of David Bowie’s aggregate copyrights in his music mentioned by Knopf ³⁶ shows that financiers may also be willing to rely on the value of a debtor’s portfolio of patent or copyright rights aggregated as a whole provided that the economic value of at least some of the items within the portfolio have a sufficient historical track record even if the valuation of other items is unpredictable. In still other cases, lenders may be willing to rely on IP collateral by reason simply of the creator’s established reputation in relation to past IP products of the same genre.

These examples aside, it is clear that in many instances, the unique characteristics of IPRs impose inherent valuation constraints on IPR-based secured lending relative to more traditional types of collateral. What, if anything, can be done to reduce the impediments to the reliability of IP collateral that these valuation challenge inevitably pose for secured lenders?

The prior research solicited by the Law Commission indicates that the valuation challenge presented by what was identified above as the “idiosyncratic” nature of intellectual property will be lessened as lenders acquire greater familiarity with the IP world and specialized expertise This is a process which will unfold naturally, without the need in our view for formal governmental intervention as IPRs acquire a more pervasive share of business debtor assets.³⁷ And empirical research indicates that general institutional lenders are increasingly prepared to extend IPR-based secured financing even at the product development stage if venture capital financing is also in place so as to enable the bank to informally rely on the latter’s expert and specialized judgment.³⁸ As IPRs become more commonly used as collateral, valuation techniques will improve thus allowing more widespread use of IPRs as security. In other words, a ‘virtuous circle’ may be created.

2.8.2        Substantive IP Law Reform

However, a number of the inherent valuation challenges identified above are not attributable to a lack of valuation expertise as regards IPRs. Rather they stem from substantive or procedural features of the current Canadian legal framework governing IPRs and related rights. While amendment of these features could reduce uncertainties at the collateral valuation level, this must be balanced against the possibility of undermining important principles of intellectual property law.

For instance, making registration of copyrights a pre-condition to their validity would enable secured creditors to more easily determine the existence and extent of a debtor’s prima facie copyrights. However, such a requirement would run afoul of Canada’s international obligations under the Berne Convention which prohibits the imposition of formalities as a pre-requisite to the right to copyright protection. As another example, we noted earlier that lobbying by businesses to facilitate commercial transactions involving trademarks eventually led to legislative amendments to permit assignments “in gross”. However, the practical impact of this reform has been largely negated by judicial decisions holding that a trade-mark assigned independently of the business with whose it is associated is likely to be found invalid. This effect of this jurisprudence undoubtedly reduces the commercial and collateral value of trade-marks. However, it is fully compatible with the fundamental policy of trade-marks, which is to provide reliable information to consumers as to the source of the wares associated with the trademark.

It has been suggested that valuation risk posed by potential invalidity could be reduced for patents and similar IPRs by limiting the time within which challenges can be made to validity. For instance, Townend suggests that a “successful security market for IP requires detailed scrutiny prior to registration or creation of the right and, leading from this, a limited time within which challenges can be made to the validity of IP, for example within the first year after the product is made available to the public.”³⁹ But this scheme would almost certainly immunize many invalid patents from challenge. It is extremely unlikely that the negative economic effects of thus protecting unjustified monopolies will be offset by the benefits obtained at the level of enhancing overall access to IPR-based secured credit. A less radical way of addressing the invalidity problem would be to devote more resources to initial examination of a patent application by the Patent Office in order to improve the quality of issued patents. However, it is by no means clear that such a step would be cost-effective, since the more stringent examination process would apply even to those patents which are never used as collateral or never challenged.

This is not to say that there are no changes to IP law and institutions that might help to reduce valuation uncertainty without adverse substantive effects on the integrity of intellectual property legal policy. For instance, it was earlier noted earlier that where the first owner of the copyright is the author, ownership reverts to the heirs of the author 25 years after the death of the author notwithstanding any previous assignment.⁴⁰ The policy rationale for this rule is not clear even though the risks it poses to the predictability of duration of the legal life of an assignee/debtor’s copyright protection has some negative impact on the value of the copyright as collateral.

Moral rights are another instance where legal reform might reduce valuation risk without damage to fundamental intellectual property policy. The non-assignability of moral rights may adversely affect the collateral value of the IP in the hands of an assignee/debtor because the author’s retention of control reduces the liquidated value of the IPR should the debtor default. The valuation risk this poses is unpredictable since the circumstances in which the rights can be exercised are difficult to determine in advance. These difficulties can be alleviated by securing a waiver of moral rights from the author and it is common practice to require a waiver on taking an original assignment from the author.⁴¹ In this respect, the Copyright Act provides that where “a waiver of any moral right is made in favour of an owner or a licensee of copyright, it may be invoked by any person authorized by the owner or licensee to use the work, unless there is an indication to the contrary in the waiver.”⁴² It is unclear from this wording whether a subsequent assignee or a secured party, or a purchaser of the copyright from a secured party on default, would be considered a person “authorized by the owner” to use the work so as to be entitled to invoke the benefit of such a waiver. The Act might usefully be amended to provide that in the absence of a contrary indication, the benefits of an authorial waiver extend to subsequent assignees and to the secured creditors of the original assignee and any subsequent assignee. In addition, in the case of registered copyrights, the author should be required to indicate on the record an intention to retain moral rights as a condition of their exercise against subsequent assignees and secured creditors.

2.8.3        Reform of Framework for IP-Based Secured Transactions

We have noted that valuation of IPRs is likely to improve as use of IPRs as collateral becomes more common and conversely it will become more common as valuation improves. Thus it has been suggested that reform of the law governing IP secured financing will encourage further investment by lenders in the acquisition of valuation practice. Or, to put the point in the opposite fashion, the extent to which legal risk raises the cost of lending based on IPRs indirectly impede the development of valuation techniques. As Townend remarks:

. . .if the law was amended . . .to reduce the complexities for creating security, then the market could allow for more widespread securitisation. Conversely, as the opportunities to use IP as security became more widely accepted by a broader group of lenders over a broader spread of IP, then there would be a further need for a reduction in complexity in the law and greater transparency in the rules. This would allow strangers to trust not in each other as the primary source of risk management, but in the vehicles of security and the reliability of the law. This must be the central aim in the reform of security legislation, to develop a legal environment that makes the taking of security over IP as common place as the taking of security over houses in the residential property market.⁴³

With this said, it should be recognized that legal system reform is unlikely to open the floodgates to widespread lending on the basis of IPRs because of valuation problems which are to some extent are inherent in the nature of IPRs. But as IPRs become a more significant proportion of debtor assets valuation will improve and IPRs will become increasingly important as collateral. It also appears that reform of the legal system may be an indirect step towards improved valuation as well as being directly beneficial in reducing legal costs.