IP securitization

Author: | Published: 5 Jan 2004
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The Japanese government is keen to improve the regulatory environment for intellectual property (IP), including securitization of these assets. Many Japanese companies are now seeking to obtain financing backed by their IP.

Several IP-backed financing transactions have recently been reported. A non-recourse loan transaction backed by the television broadcasting rights of a series of popular movies was announced in February 2002. The first patent securitization transaction using Tokutei Mokuteki Kaisha (TMK; a special purpose company under the Asset Securitization Law (ASL) - Shisan no Ryudouka ni Kansuru Houritsu) was announced in March 2003. In October a non-recourse loan transaction backed by videodisc and videocassette rights was reported.

Yet Japan's IP securitization market is still developing and many legal, regulatory, and other issues need to be resolved.

 Chart 1 Television broadcasting rights
 

Unique attributes of IP

Compared with other typical asset classes, for instance financial receivables and real estate, IP has some unique attributes.

Rights and assets to be transferred to an SPV
In IP securitizations, the underlying assets will not be limited to the IP rights (see table). To exploit a particular piece of IP, some assets that are tangible - for example, production line and other equipment - and intangible - for example, know-how and skills not protected by the IP laws - may be indispensable. It is thus necessary to understand what IP rights and other tangible and intangible assets might be needed, how they are protected and what procedures (for instance perfection and consent of third party licensors) are required to transfer the IP assets to an SPV.

Interrelation with IP of third parties
The IP assets to be transferred to the SPV may include licences granted to the original holder of the IP assets (the originator) from other parties. Patent revenues are usually generated from many related patents, some of which are not held by the originator. Movie films almost always use copyrights (for example, to an original novel, screenplay, and theme music) of third parties. In these cases, all necessary consents, licences and/or approvals from such other holders of IP assets should be obtained. It should further be noted that if any of the third party licensors goes bankrupt, its trustee might reject such licences in certain situations.

International exploitation
IP is international. Because transaction costs for securitizations are higher than other traditional financing methods, the amount of the underlying assets should be large enough to cover these costs. But there are often not enough IP assets to satisfy such requirements in a single jurisdiction. Valuable patents are usually used all around the world and successful movies are distributed in many countries. If the SPV and its investors want to grasp all relevant cash flows generated in many jurisdictions, it is necessary to understand all relevant legal and other issues in all relevant jurisdictions.

Instability
Even if a patented technology has generated cash flows previously, it risks becoming obsolete once a superior technology is developed during the securitization period. If a brand name (and its royalty stream) is securitized, there is a risk of change in consumers' tastes.

Litigation risks are also much higher in IP securitizations than other traditional asset-backed financings. Litigation could include challenges to the validity of patents, infringement claims against the SPV, infringement claims by the SPV against non-licensed entities attempting to use the IP assets without paying royalties, and product liability claims where the SPV could be a defendant.

Any of these risks can threaten the expected cash flow stream and some structural devices should be installed to mitigate the impact. The patent securitization shown in Chart 2 where the licensee bears these risks cannot be generalized. In practice, such risks should be carefully assessed in advance and adequately disclosed to the investors. It is also difficult to determine who will handle the litigation because the SPV usually does not have any human resources. The conflict of interests issues between the SPV and the licensees or within the SPV, the limitations as to which entity that has standing, and the issue of section 72 of the Practicing Attorneys Law (Bengoshi Hou) should be noted.

 Chart 2 Patents

 

The ASL created a specified share trust (Japanese charitable trust; tokutei mochibun shintaku) in 2000. After the deregulation of the Fair Trade Committee's ordinance promulgated under section 10(2) and section 11 of the Antitrust Law in November 2002, allowing trust banks to hold 100% of a TMK's specified shares, rating agency Standard & Poor's concluded that "transactions with specified share trusts and a single beneficiary can be assigned AAA ratings, subject to the conditions stipulated in Article 31-2 of the Asset Securitization Law, as well as certain other requirements".


 Chart 3 Videodisc and videocassette rights
 

 

Other difficulties
A lack of secondary markets and a difficulty in valuation are recognized as the most fundamental problems for IP securitizations. Although these problems have become less severe, it is easier to start with more marketable and stable IP assets, for example licensed patents that have generated royalties for years, and movies with established reputations.

IP rights protected by Japanese laws
IP right Relevant law
Patent (Tokkyo-ken) Patent Act (Tokkyo hou)
Utility model (Jitsuyo Shin-an ken) Utility Model Act (Jitsuyou Shin-an hou)
Design (Isho-ken) Design Act (Isho hou)
Trade mark (Sho-hyo-ken) Trademark Act (Sho-hyo hou)
Copyright (Chosaku-ken), neighbouring rights (Chosaku-rinsetsu-ken) Copyright Act (Chosakuken hou)
Breeder's right (Ikuseisha-ken) Seeds and Seedlings Law (Shubyou-hou)
Circuit layout exploitation right (Kairo Haichi Riyou-ken) Act Concerning the Circuit Layout of a Semiconductor Integrated Circuit (Handoutai Syuseki Kairo no Kairo Haichi ni Kansuru Houritsu)
Business secret (eigyou himitsu), brand, domain name (added by 2001 amendment) Unfair Competition Prevention Law
Publicity rights, merchandizing rights, typeface Case law


Royalty receivables securitization

Under Japanese law, it is difficult to securitize royalty receivables without transferring IP assets and all rights and obligations under licensing agreements (keiyaku-jyo no chii). Two critical issues arise with the bankruptcy of the originator. Licences that have not been registered under the IP laws may not be asserted against the originator's trustee, and the originator's trustee may terminate the licensing agreement as an executory contract under section 59 of the Bankruptcy Act.

Section 99 of the Patent Act provides that a licensee can assert the existence of its licence against a third party who afterward obtains the patent only if such licence is registered. However, the registration system is not generally regarded as user-friendly and most licences are unregistered. Licensors hesitate to cooperate with licensees to register the license because of significant disclosure requirements as to the content of license agreements, the impossibility of registering comprehensive cross licenses, and cost of registration. Furthermore, the Copyright Act does not have any provision (except for the Publication Right; shuppan-ken) on the registration of licences. It is generally considered that the trustee under the bankruptcy procedure is a third party in this context, so the trustee may deny the existence of the non-registered licence. If the trustee rejects the licence, the licensee need not pay the future royalties even though the royalty receivables have been assigned to the SPV.

Section 59 of the Bankruptcy Act provides that the trustee has the right to terminate any executory contracts to which the originator is a party if the trustee considers them unnecessary or harmful to the bankruptcy estate. Unless a lump-sum royalty is paid in advance (where no future royalty receivables to be securitized would exist), licence agreements are deemed to be executory contracts that are subject to a trustee's termination right. If the trustee chooses to terminate the agreement, the future royalty receivables will disappear.

The Ministry of Justice (the MoJ) is considering revising the Bankruptcy Act on this point. The Ministry published a draft bill on September 10 2003, according to which the trustee's termination right under section 59 of the Act with respect to licensing agreements will be limited if the licence is registered. The MoJ also pointed out that the registration system should be modified separately. Royalty-backed securitizations may be helped if these amendments are made.

Transfer of IP assets

Non-transferable assets
Rights of inventors and authors
So-called inventors' honour rights (Hatsumeisha Meiyo ken) and authors' moral rights (Chosakusha Jinkaku ken) are considered to belong exclusively to the original inventor or author and are non-transferable. Therefore, it is necessary to obtain written consent from these inventors or authors under which the parties agree not to exercise these rights adversely to the SPV or the securitization structure.

Rights under co-ownership
Japanese IP laws provide that if an IP right is held by two or more people, no co-owner can transfer its interest unless it obtains the consent of all other co-owners. Even if consent is obtained and one or more co-owners transfer their interests to the SPV, the SPV cannot grant a licence to any third party unless it obtains the remaining co-owners' consent.

Choice of SPV
In traditional asset securitizations in Japan, the following vehicles are used as SPV(s): corporation (kabushiki kaisya; KK); private corporation (yugen kaisha; YK); TMK; and trust (shintaku).

Under the SPC law, assets a TMK could accept (specified assets; tokutei shisan) were originally limited only to monetary receivables, real estates and beneficiary interests in these assets. In 2000, the Asset Securitization Law abolished the limitation of specified assets, and a TMK is now permitted to obtain IP rights as specified assets.

A TMK has advantages over other SPVs because of its tax transparency (subject to requirements under tax laws), non-applicability of the Jigo-Setsuritsu regulation, relatively simple governance structure (only one director required), low required minimum capital (¥100,000; $913) for establishment, and treatment of its asset-backed securities as securities under the Securities and Exchange Law. But the ASL requires a TMK to submit an asset securitization plan (Shisan Ryudouka Keikaku) before starting its business. This is time-consuming and expensive to prepare. Once the asset securitization plan is submitted, it cannot be amended without the relevant corporate procedures required by the ASL. Furthermore, specified assets must be described in the asset securitization plan in accordance with the ordinance promulgated under the ASL. Although IP assets to be acquired in the future can be provided as specified assets, it is not clear how they should be described in the asset securitization plan.

For IP securitizations, Japanese trust banks cannot accept IP rights as initial trust assets. Section 4 of the Trust Business Law enumerates the assets that licensed trust corporations can accept for a business trust; IP rights are not included. There is a need for an IP trust that is a tax-transparent vehicle and avoids the defects of the TMK.

After pressure from the private sector, the Japanese Financial Services Agency is preparing a bill that will amend the Trust Business Law and abolish the restriction on acceptable assets under section 4. The bill will be considered in the ordinary Diet session in January 2004. The MoJ is also considering amendments to the Trust Law that would be made in 2005.

True sale
Difficulty of valuing IP assets
It is generally considered that the reasonableness of the transfer price is one of the most fundamental facts to be considered in a true sale issue. In an IP securitization, however, the reasonable price of the transferred IP assets cannot be quoted from an open market, and it is also difficult to estimate the fair value of IP itself, apart from the evaluation of its holding company.

Licence-back and true sale
In some cases, the originator cannot continue its business without using the transferred IP assets. In such cases, the SPV may grant a licence back to the originator. Such a licence itself will not fatally affect the true sale nature of the transaction, as long as its terms and conditions are arm's length and not too favourable for the originator.

Upside potential and true sale
It is sometimes pointed out as one of the merits and incentives for the originator to enter into IP securitizations that the originator can retain the entire upside benefit from the IP assets through the subordinated portion (usually equity) if the royalty stream exceeds the debt projection. But the degree of transfer of economic interests and risks associated with the assets is another generally accepted fundamental for considering the true sale issue. If the originator retains too much of an economic interest in the transferred assets through an equity interest, such a fact could adversely affect the true sale nature of the transaction.

As long as the portion of the equity is reasonably determined and the originator's investment decision can be recognized as that of an arm's length party, it may be argued that the originator's investment in equity interests is an independent and separate investment that should not jeopardize the true sale nature of the transaction.

However, this issue should be carefully considered, particularly if the originator is granted an exclusive (or even a non-exclusive) licence of the transferred IP assets from the SPV.

Perfection
Japanese IP laws provide various registration systems for the transfer and creation of pledges on IP rights and it is not legally difficult to obtain perfection against third parties. However, if a number of IP rights are transferred to the SPV, registration fees will be large. Furthermore, internationally exploited IP may require perfections in all relevant jurisdictions. The unpredictability of the length of registration process may be another critical issue for marketing purposes.

Which IP rights should be transferred and registered must be carefully considered. SPVs may reserve the right to complete perfection upon the occurrence of some trigger events for some of its IP assets.

An amendment to the Bankruptcy Act may facilitate royalty securitizations. If such an amendment is enacted, whether or not to transfer the IP assets themselves rather than the royalty stream from them, should be carefully determined.

Comparison of SPVs
Kabushiki Kaisha Yugen Kaisha TMK Trust
Minimum capital requirement ¥10 million ¥3 million ¥100,000 NA
Securities under the SEL? Yes NA Yes No
Tax transparency No No Yes (subject to some requirements) Yes
Jigo-Setsuritsu Yes Yes No No
Can acquire IP? Yes Yes Yes No


Disclosure

The IP assets to be securitized may include information that should be protected as the originator's trade secrets. Although disclosure regarding the underlying assets is important for an investor's investment decision, it is unreasonable to require full disclosure of this information. If such full disclosure is forced, most originators will hesitate to enter into IP securitizations.

In this early stage of the market's development, a proper disclosure regime should be set up to encourage investors to invest in this new type of asset-backed security in comfort, as well as to encourage holders of good IP to enter into, and use, the securitization market without worrying about unnecessary and unexpected leaks of its corporate secrets.

Back-up servicer

IP can generate future cash flows only if it is suitably exploited. Therefore, a suitable structure, where proper exploitation of transferred IP assets is secured even upon deterioration in the originator's creditworthiness, is an essential element for IP securitizations.

However, specialized knowledge and abilities are required to manage uniquely individual IP. No-one will use the IP assets more efficiently than the originator, and it will be quite difficult to find a proper back-up servicer. Once the IP trust is allowed, it is expected that many new trust corporations specialized in managing IP will be set up and provide some solutions to this issue.

Perspectives

Japanese IP securitizations are in the early stages of development and need to overcome many hurdles, including: standardizing a unified valuation system for IP; improving registration to a more user-friendly regime; lowering the transaction costs to enable relatively small holders of IP to obtain financing through IP securitizations; supporting the establishment of specialized trust corporations and adequately supervising them; developing secondary markets for IP assets; and creating a proper disclosure standard for IP-backed asset-backed securities. Many government and non-government bodies are trying to remove these hurdles and facilitate new transactions.

Whole business securitization is also capturing attention. While differences of legal structure (particularly in insolvency and security laws) means English whole business structures cannot be used in Japan, some pseudo-whole business transactions have been reported - for instance, a securitization of ADSL modems and all relevant rights and obligations under the rental agreements, and a securitization of a turnpike, Atami Beach-line, in which the rent of the lease-back reflects the actual earnings of the toll way. How such structures can be applied to IP securitizations will require further discussion.

Author biography

Takahiro Kobayashi

Mori Hamada & Matsumoto

Takahiro Kobayashi is an attorney at Mori Hamada & Matsumoto. He was admitted to the bar in 1998 in Japan and in 2002 in New York. He was educated at the University of Tokyo (LLB, 1995) and New York University School of Law (LLM, 2002), and worked with Debevoise & Plimpton in New York from 2002 to 2003.

He is the author of Legal and Practical Issues Associated with Securitization of Intellectual Properties, and Securitization of Royalty Receivables (2003). He is a member of the Tokyo Bar Association and the New York State Bar Association. He specializes in securitization, intellectual property finance, and private equity investment.



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