«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
Types of security interest Options available to lenders When considering ways in which to obtain security or control over an asset, assuming ownership by taking a straightforward assignment of the IP is not normally the preferred route. Whilst there is no legal impediment to doing this (because IP can be bought and sold just like any other type
of property), practical considerations mitigate against such an approach. As Davies explains:
This is often a blunt instrument as it will involve the financier in the management and future commercial exploitation of the asset which few lenders could exploit themselves so, in practice, they would need to licence back the right to the debtor111.
In a practical guide recently produced for Lexis Nexis, Kerrigan comments on practice as
Different finance techniques may be used in this area. On one hand a lender may make a secured loan to an operating business which owns and uses valuable IP as part of its day to day operations. On the other hand, it is possible for IP to be the subject of a securitisation transaction in the capital markets if the IP rights have a very predictable revenue stream. A lender will need to be satisfied that it has sufficient control as well as security over the IP assets it has identified. 112 In the SME context, the first of these options would normally be the primary route under consideration and is the main focus for this chapter, though as explained in Chapter 7, there have been a number of successful instances of securitisation transactions around intellectual assets. This area would start to become very important if appetite to invest in IP could be stimulated in, for example, offshore funds.
Swycher comments on his own experiences of advising on security requirements relating to IP:
There are no legal difficulties with granting security over IP - just a perception gap.
Security gives you the ‘long stop’: charges can easily be applied to registered rights, but drafting warranties and covenants that balance the needs of the parties requires care and attention.
Copyright can be harder to identify, but is relatively easy in some areas, such as software (which can then be put into escrow for example). Other unregistered rights are more complicated, but the challenge can be met.
Depending on circumstances, the international dimension will be important because IP is global. The sort of things that need to be confirmed are local bankruptcy laws, which can impede the administrator’s ability to enforce.
111 Ibid 112 Taking security over intellectual property – practical points, a Lexis PSL document produced in partnership with Olswang, 2012 170 The role of intellectual property and intangible assets in facilitating business finance
The chief problem raised by any possessory right is that if the collateral is in the hands of the lender, the borrower cannot use it to repay the debt. Accordingly, whilst these instruments can be relevant for certain types of IP rights which are linked to physical property (such as master recordings of film or music) they are not generally used otherwise. The charge and the mortgage, being non-possessory, form the backbone of business financing in respect of both tangible and intangible assets, because the enterprise does not lose the use of the assets in question.
Technically, whilst the borrower retains possession of the asset under a mortgage, it involves an assignment of personal property which transfers the title to the lender until such time as the
borrower has discharged all their obligations. Davies explains:
Fixed charges Davies sets out the advantages and implications of a charge as opposed to a mortgage when
obtaining security over IP assets as follows:
A charge does not remove the chargor’s title but places an encumbrance on it to the value of the outstanding debt. A charge is a more appropriate security mechanism because all that is needed is a declaration of charge but since this arises in equity and not law, notice must be given to third parties if priority is to be preserved. In this context, the requirement of registration is crucial to establishing and fixing priority for secured creditors and, as such, a distinction can be drawn between registrable and non-registrable IP rights115.
Charges are either ‘fixed’ or ‘floating’, and the difference between the two can prove to be quite important when such charges are applied to IP and intangibles.
Where a lender has provided money to purchase assets such as premises or vehicles, it is clearly important that the company does not dispose of this asset without permission, and so it is normal for these to be covered by a fixed charge116. Fixed charges are also commonly used in invoice discounting and factoring, because the bank needs to ‘own’ these debts in order to be able to collect them if needed. Whilst the actual invoices which are valid naturally change over time, it is possible for the debtor book as a whole to be defined with sufficient precision that a fixed charge can be applied to it. This is necessary to prevent the business from trading its debts (for example by setting up a secondary agreement to borrow against their value).
Fixed charges are also attractive to lenders because they establish priority over other types of creditor; if there is distress, floating charges and assets subject to it may suffer deductions and dilution (see below). However, it is important for banks to be clear that the definitions they apply to different types of charge reflect the nature of the agreements into which they enter. In discussing the subject matter, Stephen Pegge of Lloyds Bank, Jason Oakley of Metro Bank and David Gill, formerly of HSBC, all referenced the Brumark case117, where the UK Privy Council was asked to rule over a New Zealand case where Brumark Investments Ltd had given security over its debts to Westpac.
The effective nature of the charges became critical because when Brumark became insolvent, a dispute arose over the rights of preferential creditors in relation to the collected debts. The Privy Council determined that the charge was in fact floating, despite references within the agreed documentation to a fixed charge, because of the rights conferred on Brumark to use the proceeds from collecting its own debts. It concluded that the book debt and the proceeds were both assets, but different ones. The subsequent Spectrum case118 confirmed the position in UK case law in 2005.
115 See Davies, 2006 116 Interviews for the study have shown that the nature of the charge can still vary according to the business type, however. For example, where funds are used to acquire plant and machinery assets to hire companies, the charge over them will be floating because of the need to use, and even dispose of, the assets in the ordinary course of business – effectively they are ‘stock’. The risk this poses to the financier is generally managed using regular audits and/or returns by the borrower.
117 Agnew vs Commissioners of Inland Revenue Re: Brumark Investments Limited , UKPC 28 118 National Westminster Bank vs. Spectrum Plus Ltd  172 The role of intellectual property and intangible assets in facilitating business finance As a result, where a bank now enters into an invoice discounting arrangement with its customer and the customer continues to collect the debts, it is clearly doing so as the bank’s agent, and the Brumark case is borne in mind when formulating debenture wording in relation to overdrafts which involve book debts (which historically only required the borrower to maintain a minimum overall value of such debts in relation to their facility).
This mechanism acknowledges that there are particular assets within a business that are used to generate business which change regularly, and that it would be impractical to itemise them separately. It may also be inappropriate to do so, because a fixed charge places legal limits on the company’s ability to use these assets to run its business (and thereby repay the debt).
Assets under a floating charge can be dealt with and disposed of as the borrower sees fit.
In the absence of being itemised on a fixed charge, IP may be covered by a floating charge, particularly if it is unregistered and only identifiable as a group (though it is not uncommon for ‘goodwill’ to be associated with a fixed charge). The significance of this is that provided it pays
the loan in accordance with the terms of the debenture (see below), the chargee can sell, replace or otherwise dispose of assets under the floating charge in the normal course of business. This means that a business will be within its rights to dispose of IP (which if it starts to become distressed, but has not yet gone into default, it may well be tempted to do).
At present, the information asymmetries which exist around IP make it unlikely that valueproducing assets will be clearly identified as part of the lending process. The wording of floating charges is often not very specific. Accordingly, when these charges crystallise (see below) they may attach to IP assets generally rather than specifically, and for the reasons stated above, they may not provide the lender with the priority they are seeking.
One particular area of concern for a lender is the ability to grant licences over IP assets. While this may be crucial to a business’s success, inadvisably granting exclusive licences could effectively place control of IP assets outside a lender’s reach.
As referenced in the discussion over Brumark above, in the event of a liquidation, floating charge claims will rank behind mortgages and fixed charges and generally also behind preferential creditors such as employees and HMRC.
Debentures The type of charges which apply in each particular case are generally set out in a debenture document, alongside other terms and conditions which apply to the loan.
Importantly, it has become an implied term in these documents that in the event of a default or other identified event, any floating charge will ‘crystallise’ and convert to a fixed charge, meaning that the company’s right to deal with the assets in the ordinary course of business will cease.
Other events apart from non-payment would include invalidity of any of the lending or security documents, insolvency or liquidation.
Prior to drawing up the debenture it will be necessary to conduct due diligence associated with the Law of Property (Miscellaneous Provisions) Act 1984. This deals with borrower guarantees, the right to grant a charge in the first place and that there are no other encumbrances (and similar).
Lenders also need to be mindful of the fact that notwithstanding this due diligence and the need to observe the registration requirements set out below, IP can be challenged. If significant value is being attributed to IP in the context of a transaction, it will be important to assess the likelihood of registered intellectual property being vulnerable to potential challenge and how likely it is to be successfully defended should this occur.
174 The role of intellectual property and intangible assets in facilitating business finance
The issue relates to establishing priority, which is a matter of making sure that actual notice of
the existence of the interest has been given. This is not a clear-cut matter, as Davies explains:
For this reason, as Kerrigan identifies:
It has not been conclusively determined whether registration at Companies House amounts to notice for priority purposes in relation to IP. The safer view is that both the Patents Act 1977 and the Trade Marks Act 1994 require actual notice of security interests to be given and therefore registration at Companies House alone is not sufficient122.
In a similar (but not identical) way to the rules governing registration of property interests at the Land Registry, it is therefore important for registered IP rights to be appropriately recorded123, in order to provide a notice mechanism to prevent unauthorised transfers from taking priority over the lender’s interests. This has to be done within six months in order to provide the lender with the ability to claim costs in proceedings for infringement of the patent prior to registration.
There are three official registries in the UK:
• Charges and mortgages against patents need to be recorded at the Patents Registry
• In the case of registered trade marks, this will be either the UK Trade Mark Registry and/ or OHIM (in the case of a Community Trade Mark)
• If the design is registered, the charge has to be registered in writing at the Designs Registry (if UK) and at OHIM (if EU). At the latter, there are additional fees to be paid and formalities to be observed both at creation of the charge and any subsequent transfer Designs can prove to be more complicated because there may be up to four different types of rights at work – both registered designs and unregistered design right, for both the UK and the EU. These provide different levels of protection, for different aspects, and last for varying periods of time. However, for transfer purposes, the registered right normally subsumes the unregistered portion provided the Registrar is satisfied that the applicant is entitled to transfer both.
Interests in unregistered rights If the application comprises multiple IP rights, then these may be subject to security interests
either en bloc or individually. As Kerrigan points out:
IP rights do not necessarily align themselves with single assets in the business world.
A single asset in legal terms may be made up of a number of IP rights. A website, for example, will include a trade mark in the domain name, copyright in the layout and design of the website, as well as the content posted on the site and copyright in the computer code, among other things124.
122 See Lexis/Olswang, 2012 123 See Patents Act 1977, s30; Trade Marks Act 1994, s24; Registered Designs Act 1949, s19.