By Ellen Welsher, director, new assets group, and James Penrose, legal department, Standard & Poor's Ratings Services
In keeping with the trend of applying structured finance techniques to almost any type of "future flow" transaction, issuers and their advisers have been testing the capital markets' willingness to accept cashflow generated from intellectual property. To date, the markets' acceptance has been somewhat tentative. After the pioneering "Bowie Bond" deal in 1997, there have been other intellectual property-based transactions, but the area has hardly been the runaway success its more enthusiastic proponents once predicted. (This notwithstanding attractive assets with long-lived cash flows, good performance histories, and comfortable risk profiles that could find their way into transactions).
There are a number of possible reasons for this reticence. Some are connected with the nature of the property being securitized, others with the nature of the securitizer. As a class, intellectual property securitizations are somewhat schizophrenic. While they have the potential to be disarmingly straightforward, they often end up being highly complicated.
Intellectual property securitizations have their own peculiar analytical issues. Unlike in a "true" securitization where the asset pool is usually comprised of hundreds of loans or receivables generating a statistically predictable cash flow, intellectual property transactions run the gamut from a single-source cashflow stream under a pharmaceutical license to diverse royalty streams earned from music, record and programming fees of an artist's portfolio. The predictability of the more varied cash flows can fluctuate considerably.
The valuation of the collateral may be an issue. Worries about the diminution of collateral value in the event that catastrophe strikes an artist may be justified. Although "dying was the best career move Elvis ever made," according to one of the King's biographers, this is the exception, not the rule. Concerns about collateral value are not limited to death. In securitizations of "personality rights," for example, where an athlete attempts to monetize a stream of sponsorship payments, the contract under which those payments arise may contain provisions which purport to release the sponsor from the contract in the event of an illegal act or conscience-shocking lapse by the athlete (difficult though it may be to conceive of such extremes in this post-Lewinski era). And in securitizations of film libraries, there is a persistent concern that the lack of market liquidity in a "fire sale" scenario may well bring in a lower sale price than was envisaged by even the most pessimistic analyst.
Then there are the structural issues. Because the subject trademark or copyright may represent a considerable portion of the owner's goodwill, the owner may not be willing to part with the property in gross, but only assign particular rights in the property to the securitization vehicle while retaining the title to the property. For example, the owner of a trademark may wish to securitize a portion of the cash flow deriving from her domestic sales in the marked brand. If only the cash flows are assigned to the securitization vehicle without rights in the trademark, such cashflows could be threatened by the trademark owner's bankruptcy. While the owner of the property may be encumbered by covenant from pledging or assigning the property, he may equally be unwilling to part with the property for reasons which might best be termed "personal". One artist's company "sold" intellectual property to a securitization vehicle but, because it retained a nominal-sum purchase option, a "true sale" opinion could not be given. The rating of the securitization, therefore, was linked to that of the parent company. In other transactions where distribution rights are being securitized (film deals, for example), questions of collateral perfection in various jurisdictions may require extensive (and costly) legal diligence. The common cure for lack of perfection, a parent guaranty, may swing the transaction back across the accounting boundary from "structured finance" (i.e.: off-balance sheet) to "corporate finance" (i.e.: on). Tax issues and the provenance of the intellectual property being securitized must also be carefully researched. Private placements of intellectual property securitizations may be more numerous as investors in such transactions have traditionally been willing to undertake a good deal of the diligence required and are able to protect themselves by aggressive negotiation and pricing. Capital markets standards are different, as investors usually do not have as much of a voice in structuring transactions.
At the higher rating levels, the identity of the securitizer may also pose problems even, paradoxically, in the context where the identity of the securitizer should not be an issue. In artist-based deals (though there are, of course, exceptions) the artists themselves may be experiencing some level of economic stress or declining popularity. There is always the risk that an artist may, in a period of financial instability, attempt to renege on his sale. Even though an attack on the transaction structure by a disgruntled artist may be unlikely to succeed, the risk that the cashflows may be frozen pending judicial determination of the matter should be addressed. In trademark licenses, the very need of the owner to securitize the royalty streams may suggest a certain level of financial hardship. As the owner's goodwill is largely if not entirely bound up in the trademark, ample protection against an attack on the transaction by the owner (claiming that the trademark is necessary for its reorganization in a bankruptcy proceeding) should be considered in structuring the deal. The allure of litigation should not be underestimated. The Kingsmen (Louie Louie) case took almost as long to resolve as the Jarndyce dispute in Bleak House - and [Charles] Dickens was exaggerating for effect. In all events, a pledge of the intellectual property, be it trademark, copyright or patent, is desirable.
Experience suggests there are two stages in the development of most new financial products. The first stage is the treatment the product receives at the hands of private placement lenders. The second is the evolution of the product to the capital markets. The speed of that evolution depends on the nature and extent of the private placement-like protections in these deals that are carried over into the public sector. To the extent that those protections can be adapted to capital markets deals, their ratings can only improve. The good news is that Standard & Poor's has confidentially rated several intellectual property securitizations at investment grade. With proper structuring, there is every reason to believe that this is just the beginning of a new ratings trend.