Use of intangibles as loan collateral might finally be at a breakthrough point. A story in today’s Financial Times (“Banks eye intangible assets as collateral“) discusses efforts to create IP recognized as collateral for purposes of Basel III bank regulation. At issue is whether these intangible assets count toward the required level of capital a bank must have. As the story notes:
Under the terms of many loans, banks have the right to seize a borrower’s patents and trademarks as part of a foreclosure proceeding. But these intangible assets cannot generally be counted towards the loan’s security for regulatory capital assets because they are considered too difficult to value.
The work around on the knotty valuation problem being proposed is insurance, where the insurance company would buy the IP at a fixed price in case of default. Details, including the pricing model, are, according to the story, still being worked out. Apparently, however, one deal may be going to regulators for approval soon. Obviously getting the pricing models right is the key step. It was the failure of those models for credit default swaps and other synthetic financial instruments that helped created the recent financial debacle.
I would note that insurance was a major player in the earlier intangibles-backed securities wave of a decade or so ago. As we described in our two working papers (Intangible Asset Monetization: The Promise and the Reality and Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance), many of those intangible-backed bonds were insured by the so-called monoline insurers. These companies originally specialized in insuring state and local government bonds, and subsequently got drawn into the financial meltdown (although intangible-backed securities were not the problem).
So guarding against abuse of the system (and a repeat of the recent crash) will be important.
Two steps might help in guarding against abuses. First is transparency. Banks don’t necessarily have an inventory of the IP collateral in their loan portfolios. Standard terms of loans are often all inclusive liens, which cover everything including the kitchen sink. IP is not necessarily explicitly listed. In some case, there may actually be a “negative pledge agreement” — where the borrower is explicitly forbidden from using their IP as collateral (a condition a VC investor might put on a company in order to protect their investment). Likewise, the IP might be already somehow encumbered by previous liens or licensing agreements. Thus, a requirement for disclosure of the IP included as collateral would be important for the market to understand the risk/reward calculation of any insurance product.
The second step is further development of the market in IP. Lenders, including the entity underwriting the insurance, need to have a place where they can dispose of the asset (the IP) at a fair price and with reasonable transaction costs. Currently, the IP market place is still evolving. One of the evolutions that needs to continue is the creation of valuation standards. Some work is being done in this area, but this is an area where the regulators could help spur faster action. For example, the SEC, in conjunction with FASB, could establish a task force on valuation to report back guidelines. And/or companies could create an intangibles reporting and valuation guideline association/group, similar to the International Private Equity and Venture Capital Valuation Group and the Enhanced Business Reporting Consortium. The International Standards Organization could step up efforts to set brand and patent valuation standards to ensure that relevant expertise and stakeholders are engaged.
In any event, the news about efforts to include intangible assets in regulatory capital for banks is heartening. We need to seize the moment and continue to efforts to better integrate intangibles into the financial system. As we know from experience, intangibles are already in the system — we need to better recognize and regularize that fact.
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For more on the issue and public policies, see various papers on the Athena Alliance website, including our two working papers: Intangible Asset Monetization: The Promise and the Reality and Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance and the following articles: “Building a Capital Market for Intangibles,” “Intangible Assets: Innovative Financing for Innovation,” and “Intangible Assets in Capital Markets.” Also see a previous posting on recent work by the OECD on the IP marketplace.