Practical Pieces & Perspectives
The 2008 financial crisis spurred Congress into action and led them to enact regulation to protect consumers from financial institutions.[1] The regulation became known as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (hereinafter “Dodd-Frank Act”).[2] Broadly, the goal of the act was to regulate both bank-based financial companies and non-bank financial companies, such as hedge funds, from risky lending, and to protect consumers from these type of actions.[3] More specifically, Congress enacted sets of rules that regulated securitizations of asset backed securities which used different forms of loans as collateral.[4] However, one aspect that has been overlooked is whether these provisions also govern intellectual property assets such as patents and copyrights.
When it comes to securitizing intellectual property assets, the process is similar as to securitizing any other asset backed security.[5] First, there is an originator who is willing to invest in companies for the purpose of obtaining rights to future sources of income based on the company’s intellectual property asset.[6] The future sources of income could be either from sales of the products that are protected under one of the categories of intellectual property law or through royalties that are received from licensing the rights in the intellectual property.[7] More specifically, in the case of patents and copyrights, the revenue source could either be from licensing either type of protection or it can be from selling the underlying products that the intellectual property is protecting. Similar to any other type of asset backed security, the originator will create and subsequently assign the rights to future cash flows from the underlying assets to a special purpose vehicle.[8] The special purpose vehicle will then issue securities which are backed by the future revenue streams.[9] The securities created will be invested in by common individuals thus allowing the special purpose vehicle and the originator to recoup their investment and make a profit.[10] The individuals that invested in the bonds will then be paid by the revenue streams that are obtained by the underlying security.[11]
In this complex structure, the special purpose vehicle needs a servicer that is able to collect the income from the revenue stream and transfer it into the special purpose vehicle.[12] Further, the servicer is in charge of paying the upfront cost that is necessary to operate the special purpose vehicle and the securities that are issued.[13] The servicer will typically deduct these costs from the revenue stream that is being collected from the underlying assets.[14]
One of the costs that the servicer must deduct is the cost for getting the securities rated by a rating agency.[15] Intellectual property backed securities also need to be given a credit rating so that common individuals without specialized knowledge are able to understand the risk levels associated with the security when they are deciding to invest.[16] However, the main difference is that the credit rating agency cannot evaluate intellectual property backed assets in the same manner and must come up with a specialized method as to how to give them an accurate rating.[17] For example, when giving a rating on intellectual property backed securities, Moody’s Investor Service will consider how the technological market is changing with respect to the assets in the pool, how quickly the technology will become obsolete, what brands are present within the portfolio, etc.[18] This shows that credit rating agencies need to consider not only the pool of assets, but also how the world around them is changing.[19]
The main difference between securitizing traditional assets, such as loans, and securitizing intellectual property assets, is that intellectual property assets are intangible, so the risks associated with obtaining intellectual property assets is not as readily discernible.[20]
Risks to consider with securitizing patents or patent applications are whether the patent has been granted, whether an entity is able to freely practice the patent in the market (considering whether there are any potential freedom to operate issues), and the potential for other individuals to infringe the patent rights.[21] These types of risks cannot easily be evaluated and categorized with a monetary value.[22] It is possible for a patent that has been securitized to lose the exclusive right, either through invalidation or abandonment which would then drive the value to zero due to its protections being revoked. Thus, that patent would not bring in a revenue stream which would substantially hurt royalties needed to pay back investors.
Additionally, risk that needs to be considered by the original investors and the credit rating agencies are what the future market for the copyrighted material will be. The reason this is a big concern is because there is a large number of copyrights being produced every day and certain works tend to be less in demand as time goes on.[23] This means that the revenue streams for the works may be less than expected due to a change in demand for content. For example, in 2011, Miramax securitized a catalog of films where the cashflow distribution would come from the DVD sales, T.V. syndications, and digital download sales.[24] The catalog of films that are used as the underlying assets are movies such as Pulp Fiction and Good Will Hunting, movies that already have acclaimed success, however, a risk with acclaimed and established movies that needs to be considered is that there will be a shift in cinematic interests where a new generation of consumers may no longer be interested in those movies and the revenue generated from selling those movies would be drastically reduced.
Currently, part of the regulation for intellectual property securities are recording change in ownership for the underlying assets changes, with an appropriate party.[25] The recordations are governed by the very laws that establish the property right in each of the underlying assets. For copyrights, 17 U.S.C. § 205 requires any transfer of copyright ownership to be recorded in the United States Copyright Office.[26] Subsequently, the Patent Act under 35 U.S.C § 261, requires that a grant or conveyance to a mortgagor for valuable consideration to be recorded with the United States Patent and Trademark Office within three months of the date of the purchase or the mortgage.[27]
In addition to the recordation requirement, the Uniform Commercial Code (U.C.C.) Article 9 also regulates intellectual property backed securities.[28] Under U.C.C. Article 9, when an intellectual property asset is securitized there are two steps that the mortgagor must follow: 1) creation of the security, and 2) perfection of the security, for the security to be considered enforceable.[29] The security is created when a security interest is attached to the collateral and it becomes enforceable against a debtor.[30] Next, a security needs to be perfected.[31] The reason a security needs to be perfected is to put other potential investors on notice that an asset has already been collatarized.[32] To satisfy this requirement, a UCC-1 financial statement needs to be filed with the secretary of state for the particular state that the debtor or borrower is located in.[33] The financial statement will include the name of the debtor, the name of the secured party, and a description of the collateral assets that are covered by the financing statement.[34]
Other than preventing the same collateral assets from being re-collatarized, there are no other methods of regulating intellectual property backed securities. This means that the risks involved with securitizing intellectual property assets are not alleviated for lenders, borrowers, and investors. For example, a lender and the securitizer may shift risk associated with the securities to an investor due to the lack of regulation because they are not required to retain any of the risks from the security.
Further, without proper regulations, a lender also has the ability to take advantage of a borrower. In most cases, the companies who are willing to put up their intellectual property assets as collateral for funding are start-ups or small businesses.[35] These entities need the upfront capital to be able to expand and further research and development.[36] Because of the need for immediate capital, lenders are able to take advantage of these types of businesses and get favorable terms when loaning money as the business is seen as a risk. Some of the favorable terms that lenders could obtain are higher royalty rates for products sold, and royalty payments that continue even after the initial amount loaned and the interest on the loan has been repaid by the borrowers.
Considering the current regulations for intellectual property security are no more than notice requirements, I propose that intellectual property backed securities should fall within the definition of an asset backed security and be regulated under the Dodd-Frank Act.
The reason the Dodd-Frank Act should govern the issuance of intellectual property backed securities is because the requirements for securitizers and the originators creating these securities became more stringent.[37] Under the new requirements, securitizers and originator must retain at least a total 5% of the credit risk.[38] Further, the Dodd-Frank Act created more disclosure requirements that the securitizer would need to fulfill.[39] The main disclosure requirement is that securitizers will need to create a due diligence analysis and provide that analysis to investors.[40]
Originally when Congress enacted the Dodd-Frank Act, the purpose was to regulate asset backed securities where the assets were various types of loans such as student loans or car loans.[41] In fact, the SEC commissioners did not even bother mentioning if intellectual property backed assets should be included in the list.[42] However, the provisions enacted are readily applicable intellectual property securities.
The risk retention provision can be implemented when selling intellectual property backed securities to investors in the same manner it is implemented when selling traditional asset backed securities. Securitizers would have to retain at least 5% of the risk for themselves.[43] This would force securitizers to be more involved with maintaining the underlying assets by paying any maintenance fees required to maintain the intellectual property right and enforcing the rights granted by the assets against would be infringers so that royalty streams do not decrease. By requiring securitizers to have a stake in the risk, it would reduce the complacency that they might assume once they recoup their initial investment and make some profit on the securities.
Additionally, the Dodd-Frank Act’s disclosure requirements[44] would also be a big benefit if applied to intellectual property backed securities. Under the Dodd-Frank Act requirement, securitizers would be required to create a due diligence analysis for the underlying intellectual property assets and provide the analysis to investors.[45] Particularly, the due diligence analysis would have to include the identities of the parties involved, including the underwriters, the third party due diligence service provider, and the issuer of the securities.[46] The securitizer would also have to disclose the:
scope and manner of the due diligence performed, including but not limited to the type of assets that were reviewed, the same size of the assets reviewed, how the sample size was determined and any other type of review conducted with respect to the assets; and findings and conclusions resulting from the review.[47]
This is an important disclosure because it allows investors to get a better understanding of what the underlying assets are (for example, does the security only contain underlying assets that are patents or is it a mix of different types of intellectual property assets), and it gives investors a better understanding of if the security is backed with valuable intellectual property assets or ones that may not produce a steady revenue stream. Further, requiring this level of disclosure would make investing in intellectual property less risky than it currently is under the U.C.C.
With regard to the due diligence requirement[48], the only change that should be implemented is that it should require securitizers to issue a new report on the underlying assets after a 5 to 7-year period. The reason I propose issuing a new report is because of the volatility with intellectual property assets. In this short period of time, it is possible that status of certain assets has changed within this period of time. For example, in the 5 to 7-year span, a patent application that was originally included as an asset in the pool may have been rejected by the patent office and may no longer be of value. This in turn would affect the royalty stream and thus the investors have a right to know about the effects.
As intellectual property backed securities become more prevalent and the number of investors begins to grow, there will be a need to properly regulate the securities. The current regulation under the Uniform Commercial Code does not provide enough protection for the securitizers, borrowers, or the investors; namely, because it only requires filing a notice that doesn’t require much detail. The Dodd-Frank Act, on the other hand, requires securitizers to be more forth coming to the public and retain risks when securitizing risky assets.