Intellectual property as security in corporate transactions
By Christoph J. Crützen
The fact that intellectual property qualifies as an object to secure a loan or to form part of a complex financial security transaction has become common knowledge. Nevertheless, recent practice has shown an increasing interest in custom made legal solutions and tools to make use of intellectual property as collateral. The reason for this is that intellectual property and particularly patents, trademarks and copyrights can have substantial value. The demand for tailored security solutions does not only derive from the monetary value of the intellectual property, but is also driven by the essential character intellectual property has for many businesses.
Various interests in legal options
Lending parties in a finance project often consider intellectual property to be much the same as any other collateral. This applies to most corporate transactions wherein intellectual property is of a minor importance. Unless intellectual property is of an outstanding importance for the business or the only valuable asset(s), the approach to include intellectual property as an object of security follows standardized textbook procedures. In the event intellectual property plays a more prominent role in the transaction, the method of granting security is chosen more carefully. And indeed, the legal system provides for a basket of options ranging from the predominant security mechanisms of the transfer of security to pledges, the granting of rights to use the intellectual property and the granting of a usufruct. Just to what extent or what combination of measures is to be selected depends on the interest of the parties involved in the transaction. While the interest of a loan provider to obtain valuable, easy to realize and secure security is relatively easy to determine, the security grantor’s interests are as diverse as life can be. Consequently, not only the method of granting security is the result of a carefully chosen solution but also the contractual rights and obligations under the security agreement vary from a simple back-license to use the intellectual property to a complex regime of rights and obligations.
Security transfer of intellectual property
The transfer of title by way of a security transfer accompanied by the granting of a back license to the transferring party is still a popular practice. The reason for the popularity is the strong position of the secured party. The secured party becomes legal owner and obtains direct control to realize the security. Legal ownership ensures that the secured party has legal control on the asset and can sell the asset without greater obstacles. In particular, in relation to a third party the secured party is fully entitled to dispose of the IP rights and therefore can directly realize the security. The secured party’s benefit comes at the expense of the grantor’s flexibility to use and dispose of the intellectual property. By transferring the right, the collateral provider gives up its ownership and its rights to use the intellectual property. To compensate this loss, the transferring party is granted a back license to use its former intellectual property in the ordinary course of business. In particular, the latter can become the stumbling block. The back license requires a careful balance between the security grantor’s interest to use and exploit the intellectual property and the secured party’s security interest in receiving ownership and maintaining the value of the intellectual property. The security transfer has two elements: the security agreement and the transfer of rights. Whereas the transfer of rights, in principle, requires a degree of certainty with regard to the intellectual property to be transferred, the security agreement requires more attention. The security agreement stipulates the utilization of the collateral, the realization of the collateral and the re-transfer of the intellectual property in case of the fulfillment of all contractual obligations. It has become the balancing element between the security interest of the secured party and the collateral provider. Such balancing of the security transfer on the basis of a back license works for many businesses. In particular, if a company’s intellectual property is of a rather passive nature—for example as measure of protection for a successful brand, the company name or specific products—the security transfer will not affect the conduct of business and the business operations in a way that requires specific attention. Other business models, however, are more focused on the use, disposal and development of intellectual property. While a company developing a specific product is likely to agree to a security transfer, a high-tech company or development service provider will have more issues in transferring its intellectual property. The task becomes even more complicated, if the intellectual property portfolio is particularly complex and the intellectual property is used for various purposes and is actively pursued, such as in litigation, licensing and/or cooperative ventures. In such situations a security transfer of intellectual property can have an impact on relationships and obligations with third parties because it can trigger termination rights as a result of a change in ownership or may entitle a third party to exercise a first right of refusal. The security transfer, however, seems not to be applicable to copyrights and in particular to software. A software development company being predominantly engaged in the development and enhancement of its software relies heavily on its intellectual property and on its exploitation rights. The right to use its intellectual property is fundamental to the business concept and the unlimited right to use and exploit such rights is not only required by the security granting company but also by its customers. As a consequence, the strong security position of a security transfer is often softened to the benefit and flexibility of the security provider.
Pledging intellectual property
The complexity and interests of the parties involved in security transactions results in an increase of security pledges. As opposed to and distinct from a security transfer, the pledge of intellectual property has no effect on the ownership of the rights. The creation of a pledge does not result in a transfer of ownership. The secured party only obtains the right to receive satisfaction arising from the proceeds of the realization of the security. The pledger retains the intellectual property and in particular the right to use its intellectual property. If the intellectual property has been pledged, it is not necessary to agree on a back-license. This is an important difference to the security transfer for the security provider. The interests of the collateral provider and of the secured party can be summed up as follows: On the one hand, the collateral provider does not wish to transfer the ownership of the intellectual property right but to retain the full control and authorization to enforce and apply the intellectual property. On the other hand, the secured party is interested in maintaining the pledged rights and the value of the collateral. Such issues can be addressed as obligations in the security agreement itself. An obstacle for the secured party is the realization of the security pledge. The parties are not entirely free to stipulate how to realize a pledged right. According to Sec. 1277 para. 1 of the German Civil Code (Bürgerliches Gesetzbuch, or BGB), “the pledgee may seek his satisfaction from the right only on the basis of an enforceable judgment in accordance with the provisions governing execution, unless otherwise provided.” The parties may, however, agree to another type of realization, but they are always bound by mandatory statutory law. Therefore, a direct sale would not be possible until the maturity of the pledge arises. The weakness in realization of the security pledge is the main threat to the secured party. Therefore, the pledge is usually applied to situations wherein a security transfer would either be too restrictive or unsuitable. However, the flexibility in the utilization of rights is the reason that a party having to provide collateral is eager to pledge the intellectual property rather than transferring the rights.
Grant a right of usufruct
The granting of a right of usufruct is another option of security. The creation of a usufruct is applicable if the usufruct is granted to a right that is transferable. By way of creation of the usufruct, the collateral taker is entitled to the emoluments of the right. If a right of usufruct is granted for an intellectual property right, the usufructuary would be obliged to maintain the right. This means that the secured party would be responsible to pursue legal actions against infringements of the intellectual property, to defend it against actions and to pay charges and fees. Such obligations for maintaining secured rights or defend them against third party attacks are beyond the expectations of a party requesting security. Therefore, the parties can and will agree to alter these obligations in favor of the secured party. The benefit of the usufruct is that the secured party is entitled to directly take the emoluments of the right. Therefore, in particular in a situation wherein the security grantor is engaged in generating royalties from licenses, the usufruct might be a good option for the secured party. It obtains the right to collect the license fees for licenses already granted and allows the secured party the right to grant new ones as well. However, the party granting the right of usufruct retains—at least on the basis of the security agreement—the flexibility and ownership in the intellectual property.
Granting of rights to use intellectual property
In some constellations, the parties could also consider the granting of a license to the secured party. The secured party receives a right to use the intellectual property that is usually accompanied with the right to transfer the license and to grant sublicenses. The secured party can participate in the economic benefits of the intellectual property on the basis of such a license. If the exclusivity of the license excludes the right of use by the security grantor—at least conditionally in the event that the security provider is in default of its payment obligations—the exclusive license can provide a security position that prove as commercially strong as a security transfer. Obviously, granting a license for security purposes will only be useful if it is granted as an exclusive license. The exclusivity of the license, at least to a certain extent, provides the secured party the freedom to realize the intellectual property.
Combining different options to achieve balanced security mechanisms
Currently, most security transactions involving intellectual property apply, to a greater extent, one of the aforementioned tools to supply collateral in intellectual property. The increase of complexity in the application, use and adaption of intellectual property, however, requires a more comprehensive and flexible approach. To reflect and balance the parties’ interests, the structure of the transaction to supply collateral requires a combination of different tools. A schematic textbook approach no longer lives up to the expectations and demands of complex business models. The combination of security tools provides for a greater extent of flexibility and satisfies the parties’ security interests. If carefully chosen, the combination of different security tools provides a strong position for the secured party as well as a fair and suitable position of the party providing such security.