«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
There is also an interesting new UK development from the creative organisation for Anti-Copying In Design (‘ACID’), which is in the process of launching an on-line market place108 for creators of design works protected by design rights and copyright.
The site will offer a market place through a safe on-line trading platform. Participants will agree to a corporate charter and IP tracker software will provide a secure viewing and trading environment. Underpinning the site will be legal affiliates who will provide an arbitration service in the event of disputes between parties. There are also plans to link the site to IP finance organisations for funding for creative businesses.
Discussions indicate that MCAM sometimes ends up holding the surplus IP for a period of time, and it does have an income stream arising from pursuit of infringers, but it does not set out to be a patent assertion entity, and the majority of its income is derived from insurance premia.
MCAM does not use brokers and does all its business direct. It bases its valuation methodology on three aspects: its own proprietary search systems for patent information in the surrounding landscape, its assessment of whether patents are in danger (from other innovators, or from infringers) and its own track record of earlier searches and transactions.
MCAM uses state level data on firm defaults or insolvencies to help it understand a firm’s risk of insolvency. The majority of the companies that are the subject of their services are mediumsized unquoted firms, likely to be in a growth phase.
The current UK status of IP insurance products The UK IP insurance market as a whole is currently immature, with a comparatively small number of specialist underwriters and brokers providing services at what businesses have historically regarded as a relatively high cost. Firms currently underwriting IP-related products include Aon, JLT, Samian, and Munich Re.
There has traditionally been something of a ‘Catch 22’ at work: insurers need a spread of risk across a large number of customers in order to offer affordable services, but to do that, they need to understand the risk, which requires a degree of due diligence that tends to push costs up, rather than down, thus reducing the size of the market. This, in turn, means that the insurance tends to be purchased primarily by those most at risk. As the submission from Aon
for this study puts it:
‘Selection’ is where there is a greater likelihood of the insurance being bought by those who anticipate a claim. Often, these fears are realised, resulting in increased costs to the insurer and the need to increase premiums. With premium costs being higher still, cover is only bought by those who are confident of a claim and the cycle continues until costs are so high no one can afford the cover and the policy ceases to be sold.
Conversations with brokers also suggest that the opportunities for policy renewals, common in other areas of insurance activity, are reduced because the threat has either passed by the renewal point, or it has materialised, in which case a claim has already been triggered. This makes it harder to recoup up-front costs over an agreement term.
However, there are some signs that the picture is changing due to market pressure. In Aon’s
It is becoming increasingly common for some businesses to have little or no tangible asset base, but generate income revenue solely from the exploitation of intellectual property. This represents a problem for insurers, whose traditional asset protection solutions focus almost exclusively on tangible assets that can be burnt down, blown up, crashed, lost or stolen. How relevant is asset insurance to the modern business?
Well, significantly less than it was in 1975 and getting less all the time.
162 The role of intellectual property and intangible assets in facilitating business finance
Nigel Swycher is an IP and technology specialist with 20 years’ experience in large law firms (Slaughter and May and Olswang). At Tangential Solutions, he is seeking to create new risk
management solutions for SMEs. His analysis of the current position is as follows:
Insurance to support bank lending Suitable insurance is one way in which bank uncertainties associated with the ultimate realisable value of IP and intangibles could be mitigated. Aon envisages that an insurance product to go
alongside debt could be structured as follows:
In a traditional lending model, the role of the insurer is to guarantee the value of the property against which the debt is secured. If it is damaged or lost, the insurer meets the cost of reinstatement or replacement. In the event of default, the bank takes ownership of the asset and realises this value on the open market to mitigate its loss.
Where IP is used as collateral, the role of the insurer is slightly different. Rather than insure the value of the IP, the insurer would offer a guarantee to the bank to secure a proportion of their debt in the event of default, say 80%. The insurer would then take ownership of the IP in question and sell it to mitigate loss. This means the risk of the IP not fulfilling its value on the open market is transferred to the insurer.
In terms of generating demand for IP insurance, Swycher suggests the following:
One way in which this could happen would be to make it a requirement of an enhanced lending scheme. This would create a ‘virtuous circle’, because due diligence (which is otherwise one of the barriers to entry for insurers, and a reason why costs are high at present) would be covered elsewhere.
The need is for a process which can turn something that looks very company-specific into a generic offering, by applying a set of criteria that can be met by many companies without specific study of their particular market sector.
Insurance to address pension deficits When IP assets are transferred to a pension fund in order to address deficits, as described in Chapter 9, trustees (given their fiduciary duties) closely question the valuation in a downside scenario such as the Perrier example above. One potential role for insurance is to put a guarantee in place to enable the distress value that is being placed in the IP to be maintained in the case
of an unexpected event. Aon notes:
It is inevitable that in such circumstances the market value of the trademark will decrease, which would theoretically trigger a loss under a policy. However, unlike a material loss to a tangible asset, the means by which the loss (for example of reputation damage and the valuation consequences) is reinstated through careful management of the situation and the passage of time needs to be considered. Costs incurred in additional communication to customers, product recall, legal defence and public relations consultancy would be covered by the policy, and any shortfall in the value of the IP would be covered by the insurer issuing a letter of credit (or similar financial guarantee) to make up the shortfall on the books of the pension scheme.
164 The role of intellectual property and intangible assets in facilitating business finance
Aon identifies two further areas where insurance-backed interventions could be beneficial to the
management of IP risks by mitigating losses or addressing unexpected costs:
Chapter 8 Gaining effective controls over IP & intangibles Key points Proper identification of IP and intangibles is essential for appropriate protection when lending There is strong evidence that banks are not currently protecting themselves adequately against the risk of valuable registrable assets going outside their control There is at present no effective notice mechanism for unregistered IP and intangibles SMEs could benefit from there being more visibility and transparency regarding charges over IP assets Introduction Better use of IP As this report demonstrates, there are a number of areas in which greater awareness, understanding and use of IP assets offers potential benefits to lenders. Broadly speaking,
interviews indicate that there are three levels at which these benefits can be realised:
i) Addressing the widely acknowledged ‘information asymmetries’ that exist between borrowers and lenders, as a means of informing credit appetite (applicable to all forms of lending) ii) Providing lenders with better controls than generally exist at present over important value-producing assets (i.e. taking more effective security over the assets, but still regarding the facility itself as unsecured) iii) Harnessing the business value of the assets themselves as collateral (i.e. lending directly against them) There is increasing acknowledgement of the advantages of i) for both borrowers and lenders.
Corporate financier Thomas Gardiner of TFF Group has recently started creating structured deals that are explicitly IP-backed (including a canine obesity treatment and a new haptic
technology). He comments:
The difference between debt and equity relates to risk and return, or rather, the level of return people think should be provided. Banks do not think they can charge enough 166 The role of intellectual property and intangible assets in facilitating business finance
Being better informed is one thing: but to understand the feasibility of harnessing IP assets as security in either context ii) or iii) above, it is necessary to study the ‘fit’ of IP and intangibles in the legal and regulatory environment governing lending, and how compatible this asset class is with long established principles and practices.
In the business-to-business context, both company and personal assets can be harnessed as security. As Chapter 3 illustrated, notwithstanding turbulence in recent times, domestic and commercial property (i.e. real estate) still emerges as the asset of choice in lending decisions because it represents a substantial amount of value, in one place, in an asset class which is well understood, and which is of real value to the owner (and therefore motivates them to maintain their repayments). It is also common for lenders to take ownership of book debts, plant and machinery and other assets which are deemed to have a readily realisable value which will substantially persist even if the business does not continue to trade.
traditionally adopted. There are also regulatory considerations governing the use of different asset classes as security, addressed later in this chapter.
The concept of priority In the absence of agreements to the contrary, debt has priority over equity when determining distributions of value from businesses which go into administration or liquidation – the crucial point at which a lender would need to ‘call in’ the value of their loan109. This means that equity investors stand behind creditors (particularly secured creditors) in the queue; it is one reason why, when using instruments such as venture debt, lenders take considerable comfort from the presence of established venture capital investors with an equity stake – the latter are well motivated to ensure that the business is successful, as they stand to lose all their money if it is not.
Graeme Sands of Clydesdale Bank explains how it gains additional protection from the existence
of equity investment:
The equity stakeholders are primarily interested in growth. If things don’t work out, the secondary exit route is that the investors put in more money; some sort of sale would be a third exit, and not one we would contemplate lightly.
However, this is not the only priority issue that arises. Whenever an asset is used as collateral for a debt, regardless of the type of financial instrument to be used, there will be a question of whether the lender will in fact be ‘first in line’ to realise the value of a particular asset (or set of assets) at the point this may be needed.
The risk can be characterised as having three main dimensions to it:
• Is the borrower the legal owner of the assets which are to be used as security (in other words, is it possible for them to pass good title to the lender)?
• Could anything happen after the facility is put in place that would undermine the legal rights which the lender would otherwise have?
• At the point of determining the loan agreement, does anyone else have a prior existing interest in the assets which could prejudice a lender’s rights?
For IP and intangibles to be suitable for use as security, a lender will have to be confident that appropriate mechanisms exist (at an affordable cost) to satisfy the ownership point, check for existing interests and be in a position to assert their own claims.
References To investigate these issues, the authors have studied the underlying principles and their application in practice through primary and secondary research, discussions with the Prudential Regulation Authority, IP and finance legal experts, insolvency practitioners and through informal 109 Not all debt has equal priority; the pricing of so-called mezzanine finance reflects the fact that it does not generally have the same priority as secured senior debt, and it is priced accordingly.
168 The role of intellectual property and intangible assets in facilitating business finance discussions with lender credit teams. They would like to acknowledge the work done by Professor Iwan Davies, Hodge Chair in Law at Swansea University, and Charles Kerrigan, Partner at Olswang, who have examined and documented the theoretical and practical issues, and whose observations are reproduced with permission throughout this chapter.
Professor Davies is the author of a frequently cited paper in the Oxford Journal of Legal Studies
which examined the issues around intellectual property and security in detail. In it, he states110: