As discussed previously in this series, there are inherent challenges in valuing intellectual property (IP) assets. Valuation requires an understanding of the marketability and commercial potential of the assets, as well as an awareness of the unique risks associated with them. This entails a more exhaustive due diligence process that can be time-intensive and challenging to complete.
In addition to valuing IP, lenders must also understand the process for registering a security interest in IP. There are different systems for provincial, federal and U.S. registrations. Each presents unique features.
Many forms of IP rights exist without any formal governmental approval or registration of the IP. As previously addressed in this series, virtually all companies in Canada have IP rights that are not registered with the Canadian Intellectual Property Office (CIPO). In particular, while some types of IP rights require registration (such as patents and industrial designs), many types do not. For example, Canadian law recognizes both registered and unregistered trademarks and copyright. Trade secrets are not registered at all.
Registering Security Interests in Ontario
In Ontario, security interests in personal property are governed by the Personal Property Security Act (PPSA). Under the PPSA, personal property includes intangibles like IP. For a security interest to be valid and enforceable under the PPSA, two things are required: attachment and perfection.
A security interest attaches to collateral only when:
- value is given;
- the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and
- the debtor has signed a security agreement containing a description of the collateral which is sufficient to enable it to be identified.
While perfection of security in other classes of collateral is achievable through registration, possession or control, perfection of a security interest in an intangible such as IP can only be achieved through registration. The law governing perfection over tangible collateral is generally the law of the jurisdiction where the collateral is located. However, for intangibles like IP, the law of the location of the debtor at the time the security interest attaches governs. Under the Ontario PPSA, location of the debtor is determined as follows:
Registering a security interest under the PPSA can be done through the Personal Property Security Registration (PPSR) system. This is done by submitting a financing statement to the Business and Personal Property Branch of the Ministry of Public and Business Service Delivery, which can be completed and submitted electronically. Under the PPSA, registration can be made even before the relevant security agreement is entered into.
Using the PPSR establishes priorities between parties with competing interests in the same personal property. It also ensures that the non-possessory lien is enforceable against third parties in the case of a claim for lien. Once registered under the PPSR system, the information can be searched by potential lenders and buyers to find out if a lien has been filed in Ontario. However, PPSR registrations are not contained in a federal register. It is therefore common for lenders, where possible, to register against IP through both the PPSR and at CIPO.
Registering Security Interests Federally in Canada
Certain types of IP rights are governed by federal statutes including: the Trademarks Act, the Patent Act, the Copyright Act and the Industrial Design Act. These federal statutes permit secured lenders to register or record transfers or assignments of applications for and registrations of patents, trademarks, copyrights and industrial designs with CIPO. Assignments may include assignments by way of security.
However, CIPO’s system can be clumsy when it comes to recording security interests in IP. In particular, recording a security interest with CIPO does not perfect that interest in the same way that registration of the security interest under the PPSA does. Rather, a note will simply be added to the applicable CIPO database entry to indicate the existence of the security agreement in respect of the particular type of registered or applied-for IP (e.g., if a security interest is recorded in respect of a particular patent, a note will appear in the entry for that patent in CIPO’s Canadian Patent Database). Therefore, recording a security interest with CIPO is typically used only as a means of providing notice of that interest to future assignees.
To record a security interest with the CIPO, the IP must first be filed with CIPO: there must be a pending application for registration of the IP with CIPO or registration in good standing with CIPO. CIPO cannot record security interests in respect of unregistered or unfiled IP rights. As a practical matter, this means that security interests cannot be recorded federally in respect of many forms of IP (including common law trademarks and unregistered copyright). Further, trade secrets are not registered in Canada. While trade secrets are theoretically captured under the PPSA as an intangible, “attachment” can be an issue. Trade secrets may or may not be reduced to a written or other recorded form. Some trade secrets are only held in the minds of company personnel. If a business is in receivership and that personnel leave, the trade secrets may not be preserved or remain in a manner that is truly available for the lender.
Registering Security Interests in the U.S.
In the U.S. context, it is critical to register security interests with the United States Patent and Trademarks Office as well as under the Uniform Commercial Code (UCC). The UCC is a uniformly adopted set of state laws that govern all commercial transactions in the U.S., with Article 9 providing the framework for secured transactions in personal property, including intangibles. The PPSA is largely based on Article 9. State laws must also be considered, as Article 9 of the UCC does not apply where a U.S. statute, regulation or treaty pre-empts it.
Use of Third-Party Escrow Services to Secure Loans
Once a security interest in the IP is registered, it is important to, where possible, set up a system that allows the lenders to access the IP if need be. IP is often the most valuable asset of many companies and, for some forms of IP (such as trade secrets), maintaining confidentiality is critical. Companies can thus be reluctant to share their IP with others in fear that it will be misused. Third-party escrow services are commonly used to secure certain types of IP, as it maintains protection of the IP while still making it available to lenders under specific circumstances.
For example, in the software space, the use of escrow services is becoming increasingly common. As security for loans, a lender can stipulate that source code be placed in a third-party escrow account with an escrow agent. The source code will be held by the escrow agent on behalf of the parties and the agent will ensure unauthorized parties do not have access. The source code will be released to the lender only in the event of default.
Placing the source code in escrow aims to ensure the lender’s access to the software as security. However, source code escrow is not a catchall solution and presents its own limitations. The source code deposited is often outdated or incomplete. Even if it is up to date, the lender may not be able to verify it.
Additionally, the source code will be of little value to the lender if it is not accessible to the employees who are familiar with it or if the company itself is no longer operating, which is often the case.
Lastly, the cost of source code escrow presents a challenging barrier as setting up and maintaining the escrow arrangement can involve substantial legal and administrative fees. While not perfect, escrow services can be a useful tool for lenders to secure their loans against tech companies.
