General Rules of Priority under U.C.C. Article 9
Under U.C.C. Article 9, the priority of secured creditors is generally based on the first-to-file-or-perfect (FTFOP) rules. In short, barring certain exceptions, the first secured party to file or perfect its rights related to the collateral will have priority over competing security interests held by other parties. The following common scenarios illustrate the general operation of the FTFOP rules:
- When no party perfects, the first party to have an attached security interest has priority. Thus, an unperfected security interest in IP has priority over (1) other unperfected security interests that attach later in time and (2) any unsecured claim against the debtor.
- When more than one party has an attached security interest, but only one party perfects, the perfecting party has priority over the other creditors. Thus, a perfected security interest in IP has priority over any unperfected security interest in such assets.
- When multiple parties perfect, the first party to file or perfect has priority. Thus, a perfected security interest in IP in most cases gives the creditor a prior claim over a subsequently perfected security interest in the same assets.
Of course, like many other general rules, there are always exceptions. The primary exceptions to the above FTFOP rules are:
- Purchase money financing—i.e., financing to a debtor to enable it to purchase certain property—is favored under the U.C.C. and, subject to certain notifications by the creditor providing such financing, can give such creditor priority over an earlier perfected security interest.
- Under certain circumstances, third parties acquiring collateral subject to an existing security interest, including a buyer of goods in the ordinary course of business and a “licensee in the ordinary course of business,” may take the collateral free of a prior perfected security interest.
Due Diligence Considerations for IP Collateral
Common Risk Factors of IP Collateral
In conducting due diligence on IP collateral, lenders want to confirm that such assets have value, are properly protected (and, where applicable, registered), are marketable, and can be monetized in the event of a default. Common risks associated with using IP as collateral include:
- IP rights can be lost for various reasons, for example: (1) issued patents and registered trademarks can be invalidated or canceled by competitors or other third parties; (2) fraud on the USPTO during the prosecution or procurement process could cause IP rights to be unenforceable or invalid; (3) the debtor could, wittingly or unwittingly, abandon the IP by failing to prosecute or failing to maintain the rights or registrations; or (4) the debtor could, intentionally or involuntarily, disclose trade secrets or other valuable proprietary information (e.g., source code) that should be kept in confidence.
- The debtor could harm the IP’s value by licensing or otherwise encumbering the IP without the lender’s knowledge.
- The debtor could cause leakage of assets by transferring some or all of the IP assets out of the collateral package, i.e., the so-called “J.Crew trap doors” (discussed below) or variations thereof.
- Based on recent case law, lenders’ remedies after a technical default may prevent the debtor from exercising certain IP ownership rights.
Specific IP Diligence Steps
In view of the risks of accepting IP as collateral, lenders should take specific steps during the diligence process to assess the value and risk profile of the IP assets. A nonexhaustive list of diligence items includes:
- Conduct domestic and international owner-based searches (in combination with requesting written disclosure from the debtor) to determine how much registered IP is available. Such searches should be inclusive of all databases, e.g., USPTO (patents, trademarks, applications), Copyright Office, WIPO, and WhoIs (domain names).
- Inquire as to what material nonregistered IP (e.g., trade secrets, unregistered proprietary software) is owned by the debtor and available as collateral. If there are material trade secrets or proprietary know-how, then inquire as to the debtor’s policies, procedures, and nondisclosure/confidentiality agreements protecting such confidential information. If there is proprietary software, then inquire as to any source code escrow agreement or open source license that might require disclosure of the source code to third parties.
- Inquire as to what licensed IP is held by the debtor and potentially available as collateral. Are the licenses transferrable? Are there any restrictions on the debtor’s right to use or exploit such licensed IP?
- Verify ownership and encumbrances of the identified IP assets. Who is the owner of record of each piece of the identified IP assets? Are there any chain of title issues? Are there any challenges to the ownership or claims of competing or superior interest? Are any of the IP assets already subject to security interests? Are any of the IP assets subject to any license or assignment obligations?
- Inquire as to any infringement of the IP assets by third parties or infringement of third-party IP by the debtor.
- Verify the validity and enforceability of the identified IP assets by conducting searches for any adversarial proceedings and requesting written disclosure of any third-party threats or demands challenging validity or enforceability.
- Determine the projected lifetime of the identified IP assets. If specific rights in a substantial portion of the IP assets are expiring soon, then the collateral package might lose significant value upon such expiration.
- When necessary, the lender should seek expert advice for valuation of the IP assets.
It is not uncommon for the debtor to conduct a preliminary review of its IP assets following the same steps above to anticipate and proactively address any potential issues that might arise during the lender’s diligence process. In addition, having a clear grasp of its own IP portfolio helps the debtor to evaluate what and how many IP assets to include in the collateral package.
Key Issues in Drafting the Finance Agreement
Generally, the lender would want to define IP broadly to be all-inclusive of registered, pending, unregistered, and future IP. For example:
- “Patents” would be defined to include (1) pending applications, issued patents, continuations, continuations-in-part, divisionals, substitutes, reissues or reexaminations, foreign equivalents, and improvements; and (2) any later-filed applications that are related or claim priority to any of the foregoing.
- “Trademarks” would encompass (1) trademark registrations, applications, service marks, unregistered marks, trade dress, logos, designs, fictitious business names, and any business identifiers; and (2) any “goodwill of the business” associated with any of the foregoing.
- “Copyrights” would cover both registered and unregistered copyrights.
- “Trade secrets” and “know-how” would include all confidential and proprietary business and/or technical information.
Further, the lender would want to address situations where the IP is challenged or deemed infringing or invalid, for example, by requiring the debtor to supply additional collateral. Moreover, as explained further below, the lender should also evaluate the risk of J.Crew trap doors and include mitigating blockers if necessary. In addition, the lender should also include notice and consent requirements when material IP is being transferred by the debtor.
By contrast, the debtor might want to pick and choose what IP assets to include in the collateral package. For example, it might exclude certain IP that it does not wish to be encumbered with a security interest or which might create issues during the diligence process. As another example, due to the prohibition by trademark law, the debtor might exclude from the collateral any trademark applications where no evidence of use has been filed and accepted by the USPTO, as such a pledge jeopardizes the underlying applications. Finally, the debtor should also make sure that the lender’s rights in respect of the IP collateral are not drafted so broadly as to interfere with the debtor’s ability to use such IP in its daily operations.
IP Representations and Warranties
To the extent possible, the lender would also want to get comprehensive representations and warranties from the debtor about the IP collateral, including:
- the debtor is the proper owner of or has valid license rights to each piece of its IP assets;
- there is no gap in the chain of title and the debtor has received proper assignment of IP from employees or contractors;
- there are no actual or threatened challenges to the debtor’s ownership or license rights;
- the IP assets owned by the debtor are subsisting, valid, and enforceable;
- the debtor is in compliance with the IP licenses received from third parties;
- the debtor has used commercially reasonable efforts to protect its confidential and proprietary information, including trade secrets and know-how;
- the IP owned by the debtor does not and has not infringed or otherwise violated the IP of any third party, and the debtor has not received any notice of infringement from any third party;
- the IP owned by the debtor is not and has not been infringed or otherwise violated by any third party, and there is no contemplated, threatened, or pending litigation against any third party; and
- any proprietary source code is not subject to any escrow agreement or disclosure requirement under any open source licenses.
Model Intellectual Property Security Agreement (MIPSA)
A useful resource for drafting security agreements when the collateral includes IP, especially for practitioners who are new to this subject, is the MIPSA. The MIPSA was created by a joint task force composed of the ABA’s Commercial Finance Committee and Uniform Commercial Code Committee, with the goal of bridging the gap between U.C.C. and IP lawyers by offering and, more importantly, explaining the provisions lawyers should consider in an IP security agreement. The MIPSA assumes, and is intended to work with, a separate loan agreement that will contain the more general terms relating to the secured obligations.
It should be noted that, unlike certain other model agreements promulgated by ABA groups, the MIPSA does not purport to be a fully negotiated agreement reflecting the interests of both debtor and secured party. The task force confirmed that while some model agreement provisions can be used with only minimal changes, IP assets are so varied that a one-size-fits-all approach would not work. Accordingly, the MIPSA is presented as a “teaching tool,” with over 80 explanatory footnotes containing suggested alternative approaches to commonly negotiated provisions. Nevertheless, the provisions of the MIPSA itself are clearly lender favorable. For example, the representations, warranties, and covenants are presented generally without qualification or limitation.
Other notable aspects of the MIPSA include:
- Simplification of the security interest creation language, avoiding phrases such as “assign, transfer, pledge, hypothecate,” the concern being that at least under patent and trademark laws, assignment language suggests transfer of ownership to the lender
- Adoption of broad and comprehensive granting language intended to cover all types of IP; the granting language also includes present and future rights and interest in the various forms of IP, and further includes (and requires itemization of) foreign intellectual property but does not provide for the protection or enforcement of that lien under foreign law
- Inclusion of a “savings” clause, typical in many security agreements, in the case of IP licenses—namely, that if there exists law or a contract that prohibits the grant of a security interest in such license (what it refers to as a “restrictive provision”), then the grant will not be effective if (but only so long as) such restrictive provision is effective and enforceable
Common Pitfall: J.Crew Trap Doors
From the lender’s perspective, among the most recent high-profile pitfalls involving IP collateral are the so-called “J.Crew trap doors,” which were first exploited by J.Crew and generated broad market attention.
In 2017, J.Crew made headlines for its approach to refinancing certain soon-to-mature debt. Challenging business circumstances forced J.Crew to look long and hard to find value in the company to secure indebtedness when substantially all existing assets, including IP, were already pledged as collateral for over $1.5 billion in term loans. Eventually, J.Crew carried out some then novel maneuvers to transfer the vast majority of its IP (including its well-recognized trademarks) outside the existing collateral structure to an unrestricted subsidiary and then have the unrestricted subsidiary use such IP to secure newly incurred indebtedness. These steps were referred to as the “J.Crew trap doors.”
To better understand the J.Crew trap doors, it is important to note the following definitions and roles:
- “Loan parties,” which are the debtors in respect of the original collateral (including IP) and are subject to the restrictive covenants of the original loan agreement
- “Restricted subsidiaries,” which are not loan parties or guarantors of the original loans but are subject to the restrictive covenants of the original loan agreement
- “Unrestricted subsidiaries,” which are not loan parties or guarantors of the original loans and are not subject to the restrictive covenants of the original loan agreement
The loan agreement prohibited certain investments by the loan parties and their restricted subsidiaries. There were exceptions to that prohibition in the form of permitted investment baskets. Those baskets were as follows:
A. a general permitted investment basket, which allows investments made by loan parties in any party capped by the greater of $100 million or 3.25% of total assets, plus an additional amount based on earnings;
B. a basket allowing investments made by loan parties in non-loan party restricted subsidiaries capped by the greater of $150 million and 4% of total assets, plus an additional amount based on earnings; and
C. a basket allowing investments of uncapped amount by non-loan party restricted subsidiaries in unrestricted subsidiaries if financed with the proceeds from an investment made under basket B above.
The combination of using baskets B and C above is commonly referred to as a “trap door.
So how exactly did J.Crew move some of its most valuable IP out of its existing collateral package, freeing up that collateral to secure additional financing? It involved a two-step process. First, under baskets A and B above, J.Crew transferred over 70% interest in its IP assets (including trademarks) that were part of the collateral package securing its existing $1.5 billion term loan to a restricted subsidiary named J. Crew Cayman. The transferred IP was valued at $250 million, equaling the combined cap of baskets A and B. Next, taking advantage of basket C, restricted subsidiary J. Crew Cayman then transferred the IP to J. Crew Brand Holdings, LLC, an unrestricted subsidiary, which was not subject to the terms of the original term loan facility and free to incur additional indebtedness secured by such IP. Indeed, the unrestricted subsidiary went ahead to secure additional loans using the transferred IP as collateral without having to worry about the security interest held by J.Crew’s $1.5 billion term loan lenders. In addition, the unrestricted subsidiary then licensed the IP back to the loan parties such that the loan parties would have to pay royalties to use the trademarks they once owned just to continue daily operations.
Since J.Crew, many other parties followed suit and successfully exploited similar provisions in their preexisting credit facilities, which prompted the lenders to devise blockers to mitigate the trap door risk in subsequent transactions. Commonly included blockers are:
- restrictions on the transfer of material or “crown jewel” IP;
- restrictions on investments in or by non-loan party restricted subsidiaries; and
- restrictions on investments in unrestricted subsidiaries.
Final Takeaways
First, IP is an important asset class for almost all companies, and for many companies it is the most critical asset. And the companies are leveraging the value of their IP beyond simple utilization in providing products or services.
Moreover, the interplay between U.C.C. Article 9 and the federal statutes makes the perfection of a security interest in IP potentially risky for the unwary.
Furthermore, comprehensive IP diligence needs to be a standard operating procedure for lenders in view of the various risk factors associated with accepting IP as collateral.
Finally, the lender should carefully consider whether the debtor has the ability to frustrate the lender by moving IP assets out of the collateral package without consent (i.e., J.Crew trap doors).