SpicyIP brings you a 2 part guest post series on a topic we have spoken very little about on the blog - Securitization of Intellectual Property. Nehaa Chaudhari, a 5th year student at Nalsar University of Law, picks up this oft overlooked area and starts an interesting discussion on widening the market for security instruments tied to intellectual property.
THE SECURITIZATION OF INTELLECTUAL PROPERTY
(This has been split into two posts, PART A and PART B. PART A introduces the concept of securitization and how it plays out in the field of the securitization of intellectual property rights and the generic concerns associated with it. PART B picks up from where PART A left off and analyses specific areas of concern, the rating of intellectual property assets and the issued securities, moving on to concluding observations)
A couple of years ago, the WIPO, among others, heralded the securitization of IP to be a new trend, one that was expected to gather momentum in the early 2000s. The palatable excitement of IP based financing was also evidenced by a significant peak in literature around the same time period, which has since then dried up to almost naught. Instances of IP based financing being reported have also become few and far between. With this as the context, in this post, the author perceives to highlight possible areas of concern in the Indian context that might need to be overcome to facilitate a greater development in the field of the securitization of intellectual property.
Securitization: how it’s done and what it means
A simple securitization transaction begins with recognizing that future receivables are financial assets. These could range from credit card receivables to home loan repayments, or, generically, any future cash flow. These different financial assets are then pooled together and transferred by the company owning these assets (originator) to a special purpose vehicle (SPV). In return, the SPV makes a lump sum payment to the originator. On the basis of the estimated cash flow, i.e., the returns from the assets, security receipts are issued to various investors by the SPV. Therefore, the return that the investor gets, at a future date, is the cash that is realized from these assets.
In financial markets, the collateralization of commercial loans is done by creating a security interest in an asset in favour of the lender. The security interest in question, when created on a financial asset in the nature of future receivables, is another aspect of the process of securitization.
Understanding this concept within the framework of intellectual property, would, therefore mean two things as under:-
Firstly, that future receivables generated from holding intellectual property rights are financial assets, and therefore have the potential to be a part of the securitization process. A simple transaction involving the securitization of IP would follow a procedure similar to any other securitization transaction. The intellectual property rights would be transferred to a special purpose vehicle for a lump sum amount. This special purpose vehicle would then go on to issue security receipts backed by the intellectual property rights to investors, who would then get returns on investment. The returns in question would be when the future receivables are realized. An example of such a transaction could be the Bowie Bonds issued in 1997 by musician David Bowie, in the United States. His bonds were backed by future royalties on publishing rights and on master recordings from earlier albums. The investor was entitled to an annual rate of interest for the duration of the bond, and if this was not paid, the investor would have the right to receive royalties of the asset in question.
Secondly, that commercial loans can be secured by creating a security interest in favour of the lender in receivables from intellectual property rights. The receivables in question could include, for instance, future royalty payments that are likely to be received through the licensing of a patent or a trademark, various rights in the music industry, such as recording rights, the future income from copyrights, distribution rights, etc. In such a scenario, the lenders become the owners of the intellectual property right in question. Subsequently, the lender grants the borrower(s) licenses to use the intellectual property now given to the lender as collateral. An obvious drawback with this model is the fact that the borrower now loses control and all rights over the intellectual property. As a result, he would be unable to generate income from those rights, either through licensing or in the form of royalties etc.
Therefore, a key difference emerges between traditional securitization transaction (for instance, securitization based on the future returns on mortgages) and transactions built on intellectual property. While in the case of the former, there is no concept of making the asset work in order to extract returns from it, the latter are the contrary and are classified as operating asset securitizations. For instance, in the case of the brand ‘Kingfisher Airlines’, placed as collateral with the State Bank of India, today, when the brand image has taken a huge hit, the bank would stand to lose out on money (assuming a substantial portion of the lending is backed by the brand alone) to the extent that the value of the brand, being an operating asset, has declined in the market.
The securitization of intellectual property: areas of concern
For the benefits (see here) purported to be offered by the securitization of intellectual property rights, (either by assigning them as collateral to lenders, or by transferring them to SPVs for issuing to investors in the capital markets, ) in terms of retention of control over assets and providing, by and large a longer term for repayment than a conventional loan, a decade and a half after its conception, this tool of financing is yet to take off in a noticeably big way in many jurisdictions across the world, with some reports, as of 2005, pegging the valuation of IP backed securities at about a billion dollars, whereas other tangible asset backed securities had figures running into trillions of dollars. On the other hand, some also lean towards suggesting that there is indeed a market for the securitization of intellectual property, but it is a discreet one, in order to avoid perceptions of being too needy as borrowers, and too aggressive as lenders
The concerns plaguing the securitization of intellectual property may be categorized into generic ones, largely common across classes, and specific ones which would vary depending on the nature of the right that lay at the base of the security instrument.
[Only generic concerns have been dealt with in this part. The specific concerns have been addressed in Part B.]
A key problem that could be classified as generic, is that of the difficulty in the valuation of intellectual property, and whether or not it will yield the guaranteed returns. This is especially important in the light of continuing technological advancements that might render certain patents and the licenses that flow from them redundant, and the transient shelf life of books, movies, fashion, etc, that employ other means of intellectual property protection, such as copyright, trade dress etc. Another aspect of effective valuation is also to take into account the fact of expanding sources of revenue and rights from the underlying intangible asset, as witnessed by the entertainment industry and the advent of digital distribution, which has now begun to replace distribution of works using conventional means. The emergence of such alternative channels not only requires parties to the transaction to plan for other channels of revenue for the underlying instrument, but also means that parties have to insulate themselves against the risks associated with such channels. In the case of digital distribution, specifically, it would be insulating themselves against risks such as piracy and a related loss of revenue.
Also emerging on the generic side, are the issues surrounding differing laws and practices across jurisdictions that pose difficulties in structuring and executing cross border transactions involving the securitization of intellectual property. While creating a security interest may be permitted for X category of intellectual property in a given country, the same may not be permitted in another country. Further, the nature of the scheme proposed and the nature of the security itself and how the two would play out against one another would also have to be accounted for.
(End of PART A)