SEC's next task: disclosure of hidden loan IP collateral

This morning the SEC unanimously adopted a long delayed rule on transparency of asset-back securities (ABS). Required under the Dodd-Frank Act, the final rule turned out to be less controversial that previously proposed versions. The new rules will require collection and disclosure of certain types of information ("data points") about the underlying asset (i.e. the mortgage). This includes information such as the credit score and income of the borrower and information about the property (e.g. location, age, valuation). The earlier proposal had been held up in part because of concerns over privacy and the protection of this level of sensitive data. The SEC had re-opened the rulemaking process earlier this year to deal with these and other issues.

In adopting the new rules, SEC Commissioners mentioned that more to be done, including looking at other asset classes such as student loans. However, they did not mention nor include in the new rules disclosure of hidden loan collateral: IP.

Intangibles assets, specifically intellectual property, have always been part of the U.S. financial system. As I've noted before, the first trade secrets case in the United States involved the debt on a bond secured in part by a secret chocolate-making process in 1837. In 1884, Ara Shipman loaned Lewis Waterman $5,000 to start a pen-manufacturing business, secured by Waterman's patent.

[Note: we have discussed that role in numerous publications such as "Commercialization of University Research - Using Intangible Asset ..., "Intangible Assets in Capital Markets", "Intangible Assets: Innovative Financing for Innovation", Intangible Asset Monetization: The Promise and the Reality and Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance.]

That interest appears to be growing. Gabe Fried and David Peress recently noted that "Increasingly, ABL [asset-based lending] structures incorporate intangible assets such as trademarks, patents, customer lists and other intellectual property assets in the borrowing base" (see their article "The Continued Growth of Asset-Based Lending Secured by Intangible ... which gives a good overview of why intangibles make good collateral). William Mann found, based on USPTO filings of a creditor's security interest in a patent, "20% of patents held by domestic corporations during the 1990s had been used as collateral at some point in their lives" (see "Creditor Rights and Innovation: Evidence from Patent Collateral" - summarized as "Patents as Collateral"). Research by Maria Loumioti on "The Use of Intangible Assets as Loan Collateral" found that "twenty-one percent of U.S.-originated secured syndicated loans during 1996-2005 have been collateralized by intangibles, with intangible asset collateralization significantly increasing over this time period." Importantly, she found that "loans secured by intangibles perform no worse than other secured loans."

With this growing interest in intangible-backed lending, it is important that our financial regulatory system come to grips with this trend. As I've noted before, the failure to overtly include intangible assets in collateral analysis may have the following consequences:
•  Underestimation in the amount of collateral a lending institution has to call on in case of default (and therefore the undervaluation of the underlying loan).
•  Miscalculation of a lending institution's ability to recapture collateral if the lending institution is dealing with an asset it does not understand.
•  Improperly priced loans due to a failure to assign the correct value to the intangible assets or a tendency to apply exceedingly low loan-to-value ratios that are less a reflection of risk than of the institution's lack of knowledge about the performance of intangible assets.
•  Higher capital costs for borrowers, especially those in businesses heavily reliant on knowledge and technology.

Here we can learn from others. Our friends across "the Pond" (friends notwithstanding a nasty little incident 200 years ago) in the UK are taking steps to better utilize intangibles in the financial system. Starting with a study Banking on IP? The role of intellectual property and intangible assets in facilitating business finance, the UK Intellectual Property Office (IPO) then issued its report Banking on IP: An Active Response. As I noted in an earlier posting, one of the more important task will be to begin to standardize the process of looking at IP.
The first step will be to develop common terminology, so that lenders and businesses can talk the same language. The finance and IP worlds are both full of terms not readily understood by the lay person and which can be misused or confused. As a first step to developing a common understanding the IPO, working with businesses and the finance community, will develop a glossary of accepted definitions to be used when describing and valuing IP and intangible assets.

This common language will form a foundation on which we will develop templates and guidance which will help business accurately to document their IP assets in a way that supports the decision making of a potential lender. We recognise that most lenders already use standard templates or application forms for client businesses seeking finance. We will therefore seek to produce templates for IP related assets that can either be directly incorporated into this existing documentation or which can be used as a databank for information likely to be required by lenders.

The SEC could jumpstart a similar activity here. The databank envisioned by the UK IPO is similar in format to the data points the SEC now requires to be disclosed for ABS portfolios. Based on this experience, the next step is for the SEC to broaden the asset class covered by the new rules to include disclosure of information on intangible assets (starting with IP) used a collateral in securitized portfolio of loans. For example, an ABS using commercial loans as the underlying asset should be required to disclose information on any patents pledged as collateral on those loans. Any valuation of those patents used by the lender on those loans should also be disclosed. Such disclosures would set the template for lending institutions to use regardless of whether or not the loan is eventual part of an ABS offering. That would go a long way to helping both lenders and borrowers understand and better utilize the value of intangible assets.

(Cross posted from The Intangible Economy)

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