E-Business 101, Part 4: Security Interests.com

“Neither a borrower nor lender be.” This is obviously advice debt lenders shun, and for good reason. E-tailers have a reputation for short lifespans, and even smaller promotional budgets. But if your business needs a financial boost, what can you expect a lender to look at? The devil, it seems, is in the details.

Introduction

Debt lenders look to cash flow, character of management and collateral when lending. The secured lender wants to understand, evaluate and secure the assets that collateralize the loan. Clients will look to their counsel for assistance in these transactions.

The basic formula is deceptively simple: Perfect the security interest in the assets. The “devil is in the details” of how. And the “devil in the details” is likely to be very present in the coming years. It is axiomatic that a growing economy with low loan defaults can mask a gross magnitude of lending mistakes, and that an increase in loan defaults will shine a spot light on every error and omission.

It is now estimated that approximately half of all on line “e-tailers” will be gone by the end of this year. It also is estimated that some will be consumed by others in consolidations while others will be end up in bankruptcy court.

With the cooling of the market for e-businesses comes the realization of the risks associated with equity financing. While many businesses have recognized that their equity investment in an e-business will be subordinate to the interests of secured and unsecured creditors, a good number may be just awaking to some of the other risks associated with equity interests. For example, that preferential payments to a creditor are subject to a ninety day look back in bankruptcy, while preferential payments to an equity holder are subject to a one year look back. Further, depending upon the nature of the relationship, some equity holders may find themselves defending against claims to pierce the corporate veil of the e-business in trouble.

These factors will converge to increase the pressure on investors to cast their positions as debt rather than equity. The authors expect debt to play a larger role in those businesses that survive the current shake-out.

The Assets of a Typical Internet Company

While an e-business may have some assets that fit into the traditional categories of plant, equipment and inventory, the majority of the apparent value is likely to be in less traditional assets. Thus, the devil in the details arises when the debt financier seeks to perfect the security interests in the assets of the e-business.

In the case of most e-businesses, the primary assets will be intellectual property consisting of trademarks, trade names, copyrights, patents, customer information and general intangibles. Security interests in intellectual property are generally controlled by the Patent Act, the Copyright Act and the Lanham Act. Also relevant are state laws related to trade secrets, contracts and intellectual property.

Security Interests in Patents

One strategy that has been employed by lenders providing venture capital to e-businesses is to take an assignment of the intellectual property interests, with the lender then licensing the use of the intellectual property back to the e-business. One risk arising from this strategy is that that the Lender may be responsible for registration and maintenance of the intellectual property and enforcement of intellectual property rights against infringers.

An enforceable patent provides the owner a right to prevent others from making, using or selling the patented invention, such as a process, business method, or device, for up to twenty years. A popular means for a creditor to protect its interests in a U.S. patent is by filing a collateral assignment of the patent with the United States Patent and Trademark Office (“PTO”) and filing a financing statement under applicable state law. Filing of the financing statement, without a proper filing with the PTO may not protect the secured party from claims of subsequent purchasers.

However, cases can be found that have held that a filing with the PTO is not required to perfect a security interest in a patent, provided that there is a proper filing of a UCC-1.

Security Interests In, and Assignments Of, Trademarks

Generally a trademark is a unique name or symbol that identifies a business or product. The federal law that control trademarks is the Lanham Act. When registered with the PTO, a trademark registration remains in force for ten years and may be renewed.

To be effective, an assignment of a trademark must be recorded in the PTO. It should be noted that the Lanham Act appears to apply only to assignments and not security interests in trademarks. This fact has lead some to recommend that secured parties take an assignment of trademarks. However, some courts have held that an assignment of a trademark to a creditor who is not using the mark in business has the effect of voiding the trademark. The better practice is to perfect a security interest in a trademark by filing both in accordance with state law (Article 9 in most jurisdictions) and filing the security agreement with the PTO.

Security Interests In, and Assignments Of, Copyrights

A copyright is used to protect an ownership interest in original works of authorship and can provide rights in software, copy and graphic artwork used in an e-business. To perfect a security interest in a copyright, the lien or security agreement should be recorded at the United States Copyright Office. When taking a security interest in a copyright it is especially important to conduct proper due diligence and adequately describe the copyright and security interest. The procedure to be followed can be found at 17 U.S.C. ยง205.

When conducting due diligence it is important to ascertain that the copyright owned by the borrower matches the work in which the creditor seeks to take a security interest. In the case of software, this will require an complete comparison of the source code filed with the United States Copyright Office against the operative source code in which the creditor intends to take the interest. As we said above, the “devil is in the details.”

We continue to recommend that secured parties keep of copy of the copyrighted material either in their own possession or in the possession of an agreed escrow agent. The security agreement should cover all embodiments of the works.

A system should be implemented to insure that copyright renewals are filed in a timely manner and to enforce rights against copyright infringers. The Copyright statute does not adequately address perfection issues for royalty agreements, content licenses and other related matters.

To maximize protection for secured parties, we recommend that security interests in copyrights be recorded both with the U.S. Copyright Office and in the place otherwise required for standard UCC-1 filings.

To perfect a security interest in other general intangibles such as lease agreements, software licenses, royalty agreements, data and data licenses, we turn to Article 9 of the Uniform Commercial Code.

With regard to trade secrets that are protected by the diligence of the owner and not any particular filing, the due diligence of the creditor, should include an inspection of the systems by which the trade secrets are kept secret.

Many e-Businesses update their software, content and artwork regularly. Creditor documents should require a borrower to promptly make all necessary and desirable filings to protect its interests in its intellectual property and update the creditor’s interests.

As discussed in the first part in this series, domain names appear to have substantial value. However, the value of the domain name is inextricably linked to whether or not the owner also owns the trademark.

Recent cases have held that domain names and other intellectual property may not be garnished by judgment creditors to secure payment of debts.

Conclusion

Assuming that approximately half of the e-tailers may cease to exist, it follows that approximately half are likely to succeed or at least survive. It will be up to our clients to evaluate and manage their business risk. However, it will be up to their attorneys to help them identify and minimize legal risks.

Attorneys who represent businesses or institutions that extend credit to e-businesses or businesses with an e-commerce component should either familiarize themselves with the methods for obtaining and perfecting security interests in intellectual property, especially as it relates to assets of e-businesses, or find attorneys with that knowledge who can assist in transactions as special counsel

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