Summary

At first glance, patents are an attractive target for inclusion in a security package. However, inherent complexities in relation to valuation, enforceability, liquidity and regulatory capital requirements present challenges to a lender.

This article highlights key considerations in patent-backed debt finance transactions concerning UK companies, and the mechanics and formalities required to create security over their patents.

Background

Physical assets such as real estate and machinery are readily used to secure debt finance. There are greater obstacles limiting the use of intangible assets such as intellectual property (IP) rights. Lenders' aversion to providing IP-backed debt finance can limit a borrower's ability to grow. This can leave knowledge-based businesses at a disadvantage.

However, on a macro level, the ongoing shift towards intangible assets and a knowledge-based economy suggests that the debt finance market should change its attitude.

Protecting a patent

IP rights enable their owner to protect innovative products or creative ideas from unauthorised use by other people. Patents and their applications are often of great value. They give the patentee exclusivity over exploitation of an innovation for a fixed term of 20 years, in exchange for a full and detailed disclosure to the public.

In the case of patents protecting pharmaceutical products, the monopoly can be extended by up to five years under a Supplementary Protection Certificate to accommodate the necessary regulatory steps prior to product launch; and by a further six months under a paediatric extension.

In general, patent applications are first made to national offices. In the UK, the UK Intellectual Property Office (IPO) would be approached under the Patent Cooperation Treaty (PCT) route, since protection in a single country is rarely sufficient commercially.

The PCT application route provides for a 30-month window in which the applicant can consider which countries to cover, deferring the main costs associated with the specific national/regional applications until later and providing a valuable period in which the commercial aspects and need for regional protection can be considered. If granted, the result provides a bundle of national rights that may be validated in up to 38 EPC member states. These will be designated in the application.

Lender due diligence

Due diligence is essential for a lender, determining the existence and quality of a patent and/or patent portfolio. Investigating the ownership (or co-ownership), the scope, and the duration of any protection is recommended, alongside a thorough 'freedom to operate' search. This will ensure that the underlying product does not fall within the scope of earlier patents. The process can be expensive, but helps avoid infringement challenges later.

Due diligence will be more complex when a single product is protected by bundles of different IP rights at the same time, such as trademarks, copyright, design rights and patents, and when some of those rights protect more than one product.

Vulnerabilities

General

The nature of patent law dictates that the protection provided can be vulnerable to challenge both before application and at any time after registration of a patent.

Defending a patent

The validity of a patent may be challenged by a third party.

Thankfully, most patents never face such a claim. However, it is worth bearing in mind that they can be made by competitors who wish to 'clear the way' for launch of their own product, or as a counterclaim to assert the patent against an infringer. They most commonly revolve around the grounds for patent revocation, including:

• a public disclosure of the invention pre-dating the patent application which enables a person skilled in the relevant field to perform the invention ('lack of novelty')
• an absence of an inventive step over a prior public disclosure at the time of the patent application ('obviousness'), and
• insufficient enablement of the patent such that a skilled person is not enabled to perform the invention ('insufficiency').

For the patent owner or secured lender, defending patents through the courts can be at best costly and time-consuming. It may culminate in a finding of validity or sometimes a negotiated settlement. At worst, litigation can wipe out the value of the patent by holding invalidity and requiring its revocation.

Realising security

Should it come to default and enforcement of security, lenders are invariably unable to exploit the subject of the patent themselves. Immediate resale can be challenging. The absence of an established secondary market for patents is unsurprising given the infrequency of such transactions and the market's limited ability to build up an understanding of the risks involved.

Secured parties are nonetheless wise to ensure they have the power to appoint an administrator to run the business – or a receiver to sell or collect revenues derived from the patents – should enforcement become necessary.

Regulatory capital requirements

As an intangible asset class, IP does not meet the Basel III eligibility criteria for use as loan collateral (as enshrined in the Capital Requirements Regulation and the Capital Requirements Directive). This means that when a lender takes security over IP, it has no effect on the calculation of regulatory capital.

In contrast, loans secured against eligible physical and financial assets, whose default typically results in lower losses, require less capital. IP-backed loans are therefore frequently priced as if they were unsecured. The IP itself has no effect on the cost of credit for the borrower.

One proposed solution to this apparent systemic impasse encourages the transfer of risk from a banking balance sheet to an insurance balance sheet, since insurers can take a different view on IP-related risks. Whether banks and insurers will work together to develop such an approach to IP-backed loans remains to be seen.

Mechanics of creating security and formalities

If a secured lender takes security over the obligor's IP, the relevant provisions could be enshrined in a debenture, or more likely, a bespoke security document.

There are two main ways to create security over patent rights under the laws of England and Wales – a legal mortgage and a charge.

Mortgage

A mortgage over a patent necessitates assignment of the right of the obligor to the lender, subject to re-assignment on repayment of the loan. This must be in writing and signed by the obligor, whose continued freedom to exploit the patent necessitates simultaneous licensing back. This step makes the transaction more cumbersome in comparison to a fixed charge (see below) but is clearly in the interests of the assignee, who will not wish to interfere with the ability of the assignor to repay the debt. Such a licence should be exclusive to the lender in the case of an unrelated lender with no interest in exploiting the IP themselves.

The mortgage should be registered at the IPO. While there is no specific deadline for registration, assignments, licences and security interests in patents and patent applications should be registered as soon as possible after creation. To delay risks a subsequent assignee, licensee or chargee taking free of the lender's interest (if they were unaware of it).

Furthermore, if such rights are not registered within 6 months of creation, neither the assignee nor the exclusive licensee can claim costs or expenses in proceedings for infringement that precedes registration, unless the court agrees that registration was not practicable within that time frame, and that registration was completed as soon as possible afterwards.

The mortgage will also need to be registered at Companies House. Failure to register at Companies House within the 21 day timeframe renders the security vulnerable as against a liquidator, administrator and any creditor. Mortgages created by overseas companies do not have to be registered at Companies House, but local counsel should be consulted for regional registration requirements.

Charge

In contrast to a mortgage, a fixed charge requires no licence arrangements, only a contract between chargee and chargor setting out the intended security interest. To be valid, the charge must be in writing and signed by the chargor.

However, in order to protect the lender's priority against third parties, it will still be necessary to register this at the IPO – see above.

Note that in the same way as a mortgage and as outlined above, a charge should also be registered at Companies House.

Negotiating the mortgage or charge

Points that may be raised by the borrower include the following:

• In the case of a mortgage, as mentioned above, the borrower is likely to operate the patent under a licence granted by the lender. Consequently, if it requests the freedom to license the patent to a third party, a lender may consider permitting this in return for access to the resultant revenue stream, either paid directly, or by further security granted over the revenue stream.
• Obligations to maintain the value of patents and patent applications should allow for lapse or abandonment of those that are reasonably considered to be unimportant where to do otherwise would yield unnecessary costs.
• General and sweeping obligations to avoid steps that threaten the secured patent rights can in practice be very onerous for an obligor and will in all likelihood be carefully reviewed (eg an assertion of a patent against an infringer frequently prompts a validity counterclaim and litigious proceedings).