Intellectual Property Problem Collateral

August 16, 2002
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GRAND RAPIDS — Amid the welter of bad business news, there’s been little coverage of some court decisions’ implications concerning the value of intellectual property as collateral.

According to Patrick E. Mears, a lawyer with the Grand Rapids office of Dickinson Wright PLLC, recent rulings may reduce the value of such property in certain financial circumstances to zero … or worse.

The University of Michigan graduate noted that banks often take liens on intangible assets, intellectual property such as software licenses and patent licenses, to secure loans.

“The licenses are often the licensee’s most valuable assets,” he told the Business Journal.

But he said the converse isn’t necessarily true.

When the licensee begins to suffer financial distress, he asked, “Will a bank with a security interest in an intellectual property be able to foreclose upon and sell that property?”

He said it’s an issue that banks began to consider seriously two years ago when many dot-com values started becoming so wildly inflated.

“The banks started seeing what was going on, and they took appropriate steps.”

And it’s well that they did, he said, because recent developments in foreclosure and bankruptcy law suggest that foreclosures concerning intellectual property licenses sometimes may not be a realistic option for a bank.

The problem, he said, is that some recent court decisions seem to give intellectual property licensors a virtual veto over the disposition of intellectual property in foreclosures. In such cases, he said, a bank holding a security interest suddenly may learn that the assets in question have little or no value.

Mears cited two hypothetical cases to illustrate what he meant.

The first concerns a Tier II maker of precision parts for a Tier I supplier to one of the Big Three automakers.

He said the Tier II firm licenses custom software so that its complex machinery can make parts. In essence, he explained, the machines are inoperable without the software.

“The bank financing the Tier II supplier holds a security interest in the machinery and the software,” he said, and should the Tier II supplier default on its loan, the bank normally would repossess and auction both the machinery and software.

But the courts’ latest view is that the licensor can prohibit the sale of the software license when the software is not “embedded” in the machinery, as in, say, a Palm Pilot. And that leaves the bank trying to auction equipment that, absent its software, is basically scrap, “useful only as a heavy and bulky paperweight,” he said.

In the other hypothetical case, he said, a patent protects the manufacturing design of a revolutionary household appliance.

“The patent owner grants to a manufacturer an exclusive license to produce and sell the appliance for a period of 10 years in return for quarterly royalty payments,” Mears said.

Without the license, he said, the manufacturer can’t market the appliance and the patent licensor, again in this case, prohibits transferring the license to a third party without the licensor’s consent.

He said that if the manufacturer has financial difficulty and seeks Chapter 11 reorganization, it normally would try to keep the license by formally “assuming” it.

But now it appears the patent owner is in a position to torpedo that plan, potentially leaving the manufacturer in a grave position — and giving the licensor tremendous negotiating power in the Chapter 11.

“In order to realize significant value from these assets,” Mears said, “the foreclosing bank and the reorganizing business maybe forced to pay blood money to the licensor to obtain its consent to a foreclosure sale or the mere retention of the intellectual property license.”

So what’s a bank to do?

Mears says his advice for banks, no matter how florid the promise the intellectual property seems to offer, is to do due diligence just as they did traditionally — and to secure their interests in traditional assets that retain their value in foreclosures.           

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