Just as land was historically the principal measure of a business's value, the industrial revolution made capital goods the principal measure of value. Now, as steel mills and factories decrease in value due to foreign competition, the centerpiece of the American economy has gradually become patents, copyrights, trade secrets and trademarks—the intellectual property revolution. Indeed, intellectual property often comprises a modern business' most valuable asset, even though it is frequently overlooked in financing.

Unfortunately, the value of intellectual property is often hard to determine since, like other assets, it has differing value to an ongoing business vs. a liquidating business. Financiers, however, commonly take security interests in intellectual property without addressing the various issues applicable to such property, such as valuation, perfection and Bankruptcy Code treatment. Thus, it is important for creditors to know that these issues exist, as well as how to address them.

Intellectual Property Valuation

Understanding the valuation of intellectual property is critical because its real value is often underestimated. Such underestimation partially stems from the accounting belief that value is incorporated only in the money and time spent in development. This so-called "cost" or "replacement" approach is flawed because it fails to value true market potential of intellectual property requests.

In fact, to determine true market potential, more than the usual valuation issues, i.e., third-party interests, standard of value, purpose of valuation, etc., apply. Specifically, one must determine the highest and best usage in light of the most reasonable and legal use of the intellectual property, that is physically possible, appropriately supported, and financially feasible, that results in the highest value. Thus, intellectual property lenders must specifically determine the appropriate valuation approach, including (a) the cost approach, (b) the market approach, and (c) the income approach.

While the cost approach uses the economic principle of substitution, the market approach uses the economic premise that in a free and open market, similar property transactions serve as indications of value. However, both the cost approach and the market approach are in contrast to the income approach, which uses the premise of economic income relevant to a particular asset.

Though the application of these various approaches results in differing values, these differing results theoretically stem from the appropriate application. It becomes very important, therefore, to apply the appropriate method to calculate the appropriate value under the appropriate circumstances. Once value is determined, however, care must be taken to properly perfect the full value of the security interest given.

Perfecting Intellectual Property Security Interests

To ensure a lender has secured rights in intellectual property, it is important to properly perfect those rights. Perfecting a security interest in intellectual property consists primarily of transferring an interest in the intellectual property by assignment or lien. The method of assignment or lien is usually set forth by statute, whether federal, i.e., copyright, trademark and patent statutes, or state, i.e., the Uniform Commercial Code (UCC). Before reviewing the relevant statutes, however, consider certain factors in obtaining a security interest.

In particular, prior to any arrangement, whether by assignment or lien, ensure the intellectual property exists as represented, i.e., the intellectual property is valuable and the borrower has the legal right to the represented interest. To verify, a lender should require the borrower to demonstrate that the patents involved are valid, any trademarks or copyrights are properly registered, the title for unpatented know-how is clear and remains largely a secret, and any confidentiality agreements for trade secrets are in place.

Next, all relevant statutes should be reviewed to determine proper perfection. For example, to perfect a patent assignment, 35 U.S.C. §261 requires a written assignment, which must be recorded in the U.S. Patent and Trademark Office (PTO) either prior to the date of such subsequent purchase or mortgage or within three months from the date of the assignment.

In perfecting a trademark assignment, 15 U.S.C. §1060 requires that the assignment include an assignment of the good will of the business in which the trademark is used. Further, to be valid against any subsequent purchaser or mortgagee for valuable consideration without notice, it must be recorded in the PTO either prior to the date of such subsequent purchase or mortgage or within three months from the date of the assignment.

Finally, to perfect a copyright assignment, 17 U.S.C. §101 provides that the executed transfer has priority if (1) it is recorded within one month of its execution in the United States, or two months if executed outside the country, or (2) it is recorded prior to the recordation of the later transfer or the later transfer, even if recorded first, is not made for valuable consideration or on the basis of an agreement to pay royalties, or the later transferee had actual notice of the prior transfer.

Under the UCC, on the other hand, a lien can secure intangibles by describing them in a UCC financing statement filed in the appropriate government recording agency in the jurisdiction where the intangible is located. While federal law pre-empts the UCC, and one might conclude that filing UCC financing statements is ineffective, a federal court in Kansas found that, in bankruptcy, a UCC financing statement alone took precedence over a subsequently executed and recorded patent assignment. As such, to truly perfect a patent interest, the creditor should avail itself of both the UCC and the relevant patent statute.

Moreover, unlike patents, a lien on a trademark can be perfected merely by filing a UCC financing statement describing the intangible and recording it in the jurisdiction where the intangible resides. Recording in the PTO is simply not necessary to perfect. To truly perfect a trademark security interest, however, an assignment should be (1) filed in the PTO reciting the goodwill language described above, (2) filed as a UCC financing statement in the appropriate jurisdiction reciting the elements of the business associated with the trademark, and (3) if they exist, filed in compliance with any state trademark requirements.

Finally, unlike both patents and trademarks, copyright statutes provide for the registration of "alienation or hypothecation" of a copyright, which includes security interests. Thus, to perfect a copyright security interest, one must file in the U.S. Copyright Office. It is, however, not generally recommended that copyrights be the subject matter for a secured interest because extra care must be taken in the due diligence process and it would be a mistake for a lender to strictly rely on a copyright as collateral unless ownership is well known. If a copyright is the subject of a security interest, however, one should also file a UCC financing statement in the appropriate jurisdiction.

Due to the various nuances in perfecting security interests in intellectual property, it is pertinent to consider every potential perfection issue. The failure to do so may result in less collateral than anticipated or no collateral at all, which proves particularly devastating in bankruptcy.

Bankruptcy Code Treatment of Intellectual Property

In light of the role intellectual property plays in today's economy, it is not only important that creditors understand the value of intellectual property, but also the licensee's rights in the event of a licensor's bankruptcy. Intellectual property treatment is set forth in 11 U.S.C. §365(n). Generally, §365 allows a debtor-in-possession to assume or reject executory contracts and unexpired leases. Where the executory contract is a patent license, however, subsection (n) sets forth differing rights that allow the licensee to determine whether to terminate the licensing agreement.

11 U.S.C. §101(35A) defines intellectual property as trade secrets, inventions, processes, designs or plants protected under Title 35 (patent statute), patent applications, works of authorship protected under Title 17 (copyrights), and mask works protected under chapter 9 of Title 17, to the extent protected by applicable non-bankruptcy law. Interestingly enough, §101(35A) does not include trademarks in its definition of intellectual property.

Regardless, under §365(n), if a debtor-in-possession or trustee rejects an executory contract under which the debtor is a licensor of a right to intellectual property, the licensee may treat the contract as terminated or retain its rights under the contract. If the licensee elects to retain the license agreement, then royalty payments and all fees due under the contract must be paid.

Congress, therefore, specifically sought to protect intellectual property licensees. Congress did not, however, provide protection for intellectual property licensors when a licensee files bankruptcy. Thus, the licensor's rights appear limited to that of applicable non-bankruptcy law and/or the operative legal documents whose provisions may or may not be enforceable in the bankruptcy context. Consequently, it is preferable to protect against the bankruptcy potential prior to the petition date, rather than rely on the Bankruptcy Code afterward.

Conclusion

As world economies move further along the information superhighway, and farther away from the manufacturing line, intellectual property will play a greater role in determining the value of a business, not only for mergers, acquisitions and reorganization, but also for financing the ongoing business. As such, it is critical for both creditors and business owners to understand the valuation of intellectual property and the rights therein to realize the true value of these assets.

Note about November 1999 Article: John C. Murray of First American Title Insurance Co. authored the November 1999 "Practice & Procedure" article, "Recharacterization of Synthetic Leases: How a Secured Lease Becomes a Secured Claim."