Concept of securitization – recent trends, securitization of ipr, & overveiw of sarfaesi act 2002

EPCR-2013 Project Report

January 3

2013CONCEPT OF SECURITIZATION – RECENT TRENDS, SECURITIZATION OF IPR, & OVERVEIW OF SARFAESI ACT 2002

BY LAKSHMANAN MANIKANTAN IYER

AN OVERVIEW OF SARFAESI ACT.

The recovery of the debts due to the Bank and Financial Institutions had been a subject of great concern for the Government especially after nationalization of the major Banks. Quite a substantial share of lending to the public having emanated from the Nationalized Banks, wholly owned by the Government, the recovery of the large overdues accumulating from year to year was throwing a great challenge to the Government as ultimately, if the Banks were to write off such large overdues ,it is public money that is involved in such wastage. Finally the economy of the nation would be under setback by such large scale write off to public money endangering even big banks to go into liquidation.

The Government has adopted several methods to overcome such peril and bring in more effective recovery process and one such move was the concept of NPA. The assets which are designated as non performing assets were to be given immediately and special attention as earlier the Banks, never sensitive to the mounting overdues. The concept of NPA fixed within itself a time scale for taking a recovery action as organized by the Reserve Bank of India and the Bankers were not allowed to keep a closed eye to any account which slips into NPA finally it transpired that though the accounts had become NPA and the recovery process also started in time, but the recovery process through Civil Court were found to be more ineffective. The process of recovery through a Civil Court wherein the Bank is treated as any other litigant/plaintiff who had to invest money in litigation by paying a large amount of court fees and Advocate Fees and awaits the result of the suit for years to come as a process of civil litigation following by the Civil Court in terms of the C.P.C. was not found effective for the banks to realize their dues even within reasonable time.

Under the circumstances, the Government thought it fit to bring in the litigation known as the Recovery of the Debt due to the Bank and Financial Institutions Act of 1993 and the said law provides for creation of a Debt Recovery Tribunal which was designated to perform the functions of a statutory organization created under the said statute to be headed by a Judge of the Cadre of the District Judge or any other person qualified thereto as per the provisions of the said Act and the said Tribunal were given large powers to issue Recovery Certificates for all loans above Rs. 10,00,000/- . Other loans below Rs. 10,00,000/- were outside the purview of the said Act and the said loans were to be recovered by the banks and Financial Institutions still by instituting suits in the Civil Courts.

But as far as the other liabilities are concerned i.e over and above Rs 10,00,000/- under the Recovery of Debt Due to Banks & FIs Law which constituted the DRT’s were ordained with the jurisdiction and as and from the date of Act coming into force all suits involving a claim of more than Rs. 10,00,000/- and more were transferred to the DRT having jurisdiction over the area of operation of the receipt of banks/branches.

In this process it was expected that the Tribunals would play a very eminent role for speedy disposal of the banks ‘claims and that shall be large recoveries. The Debt Recovery Law as enacted by the Debt Recovery Tribunal Act viz. the recovery of debts due to the Banks and Financial Institutions Act 1993 was a code within itself providing for institution of applications with only a limited court fee for around 1% of the claim subject to a maximum cap of Rs. 1,50,000/- and with ample power to the DRT to take appropriate action to preserve the securities and also bring in more recoveries.

The DRT was enabled to take a constructive approach and preserve the security and also recover funds from other assets belonging to the borrowers by attaching such assets and passing orders of Injunction restraining alienation of such assets etc in other words all powers of the Courts under the Civil Law were given to the DRT but without the hurdles that you need to follow of the procedural law scrupulously and only limitation that to act according to the principles of natural justice and within its own rules and regulations. The only safeguard to the borrower viz. that Tribunal shall follow the rules and Natural Justice scrupulously.

This enactment though was a self contained law with provisions to invoke the Income Tax Recovery Rules for enforcement and recovery of Banks dues from securities and other assets belonging to the borrowers in practice did not provide the desired result as ultimately the DRT;s in their working found to be not effective at all as ultimately in the name of rules of Natural Justice to be followed as per the law, the hands of the DRTs were tied and in their functioning and they were found no way better than the civil court.

The every move of the DRT and other orders passed by the DRT shall be in the subject matter of a reasonable discretion and an order to be passed by the DRT after hearing both the sides. The hearing of both the sides by itself involves delay and cause multiple delay because multifarious applications were filed before the DRT by unscrupulous borrowers and the DRT had to hear all such applications, Court Orders, ultimately causing huge delay in the recovery process.

The Government has enacted the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act i.e. enactment enabling the Bankers and Financial Institutions to recover their dues by taking appropriate securitization measures without the intervention of Court. The validity of the SARFAESI Act 2002 which was

originally promulgated as a ordinance, was questioned before various High Courts and finally before the Supreme Court and the Supreme Court in their leading decision of M/s Mardia Chemicals –Vs- Union of India 2004 -4 SCC 311 has held that the Act is constitutionally valid and is enforceable except on certain minor issues concerning frauds played if not shown to have been played by the Bank and its Officers the matter of creating the mortgage for other securities. (ref: Para 51 and 52 of the Judgement)

Following the above decision, Hon’ble Supreme Court vide another leading decision Transcore –Vs- Union of India pronouncing by His Lordship Th S H Kapadia, the erstwhile Chief Justice of India holding that both the enactments viz. DRT Act and the NPA Act are complimentary to each other and the Banks and Financial Institutions can proceed under both the enactments simultaneously and there is no need for election of other enactments of measures therein to recover their dues as on the facts of each case the Banks and Financial Institutions can proceed against anyone or both the enactments in order to get an early and effective recovery of their dues.

The promulgation of the SARFAESI Act has been a benchmark reform in the Indian banking sector. The progress under this Act had been significant, as evidenced by the fact that during 2002-03 when the Act came into effect, there was an overall reduction of non-performing loans to 9.4 per cent of gross advances from 14.0 per cent in 1999-2000.

Currently, three legal options are available to banks for resolution of NPAs- the SARFAESI Act, Debt Recovery Tribunals and Lok Adalats. The SARFAESI Act has been the most important means for recovery of NPAs. The amount of NPAs recovered under the SARFAESI Act formed over half of the total amount of NPAs recovered in 2009-10. Banks have referred as many as 78,366 loan default cases by end march 2010 under the SARFAESI Act involving a loan amount of Rs. 14, 249 crores. Against this, banks managed to recover Rs. 4,269 crores representing 30% of the loans.

Recently the ‘Report of the Working Group on the Issues and Concerns in the NBFC Sector’ laid out recommendations to extend the coverage of SARFAESI to NBFCs as well. This move will benefit NBFCs, ensuring quicker recovery of their non-performing assets. This, in turn, could encourage NBFCs to provide access to a wider range of financial products and serve better the cause of financial inclusion.

Thus the NPA Act is a welcome change. It has created in the minds of unscrupulous borrowers as they have come to realize that by passing of the above enactments, the Banks and Financial Institutions can succeed in their recoveries and could achieve their ultimate goal of recoveries through their own efforts, come what may be the legal issues that may crop up in between the ultimate result shall be that the borrowers shall be bound to clear their dues and the bank shall be free to recover their dues after the

secured assets as also from other sources available to them. Certain of the loopholes that are found in the Securitization Act also have to be plugged by suitable legislative amendments so as to make the realization could faster and more effective so as to avoid the delay in the process and also to realize the maximum price for the secured assets.

An analysis of the NPA Act

The NPA Act has been enacted to regulate securitization and to provide for reconstruction of financial assets. It also provides for enforcement of security interest and for matters connected therewith.

Section 2(b) defines “asset reconstruction” to mean acquisition by any securitization company or reconstruction company of any right or interest of any bank or financial institution in any financial assistance for the purpose of realization of such financial assistance.

Section2 (f) defines the word “borrower” to mean the principal borrower who is granted financial assistance by any bank or FI and includes a guarantor; a mortgagor as well as a pledgor. It also includes a person who becomes a borrower of an asset reconstruction company consequent upon acquisition by it of the rights or interest of any bank of FI in relation to Financial Assistance. The word “debt” is also defined under section 2 (ha) to mean the debt as defined under the DRT Act.

Section 2 (k) defines “financial assistance” to mean any loan or advance or any debentures or bonds subscribed or any guarantees given or letters of credit established or any other credit facility extended by any bank or FI. Therefore, asset reconstruction means acquisition by asset reconstruction company or asset management company of any right or interest created in favour of any bank or FI in any loan or advance granted or created in any debentures or bonds subscribed or guarantee given to the bank or FI or rights created in favour of the bank or FI under letters of credit. This shows that the NPA Act basically deals with a crystallized liability. The NPA Acts proceeds on the basis that the asset is created in favour of the bank/FI which could be assigned to the asset management company or asset reconstruction company which, in turn, steps into the shoes of the secured creditor, namely the bank/FI.

Section 2 (l) defines “financial asset” to mean any debt or receivables. It includes a claim to any debt or receivables which may be secured or unsecured. It includes a mortgage, charge, hypothecation or pledge. It includes any beneficial interest in the property. It also includes any financial assistance.

Section 2(n) defines hypothecation to mean a charge created by a borrower in favour of a secured creditor as a security for financial assistances.

Section 2 (o) defines non-performing assets to mean an asset or account of a borrower which has been classified by a bank of FI as substandard, doubtful or loss asset.

Section 2 (r) defines the word “originator” to mean the owner of a financial asset which is acquired by a reconstruction company or asset management company for the purposes of the NPA act.

Similarly, an obligor is defined under section 2 (q) to mean a person who is liable to the originator. A borrower is an obligor whereas a secured creditor, namely, a bank or FI is the originator who is the owner of a financial asset. This section also indicates that banks/FIs are the owners of the financial assets. It is only when these assets in the hands of the bank of FI becomes substandard, doubtful or a loss then the account or the asset becomes classifiable as a non-performing asset and it is only then that the NPA act comes into operation.

Section 2(z) defines securitization to mean acquisition of financial assets by any asset reconstruction company from any originator (bank/FI),

Section 2(zc) defines secured creditor to mean any bank or FI.

Section 2 (ze) defines a secured debt to mean a debt which is secured by any security interest.

Section 2 (zf) defines security interest to mean right, title and interest of any kind whatsoever upon property, created in favour of any secured creditor and includes any mortgage, charge, hypothecation and assignment. Section 31 of the NPA Act excludes certain items of security interest from the provisions of the NPA Act.

21. Section 5 of the NPA Act deals with acquisition of rights or interest in financial assets by securitization company or reconstruction company. Section 5-A was introduced by Act 30 of 2004. It says that, if any financial asset of a borrower is acquired by a securitization company or reconstruction company and if such financial asset companies of secured debts of more than one bank of FI for recovery of which such banks or FIs has filed applications before two or more DRTs than the securitization company or reconstruction company may file an application to DRT having jurisdiction for transfer of all pending applications to any one of the several DRTs as it deems fit. Section 5-A gives a clue as to the cases in which leave is required to be obtained from DRT by banks/FIs before invoking the NPA Act. Section 5-A indicates matters which attract the first proviso to Section 19(I) of the DRT Act.

Section.6 of the NPA Act inter alia states that the bank or FI may, if it considers appropriate, give a notice of acquisition of financial assets by any securitization company or reconstruction company to the borrower and to any other concerned

person. This is also an enabling provision. The bank/FI may or may not give notice to the borrower regarding acquisition of financial assets. The reason is that assets are transferable overnight. In certain cases, the bank/FI may feel that a third party right may be created by the borrower, in which event, the bank/FI may not give notice of acquisition. In other cases, it may give such notice if it is satisfied that the financial asset is not likely to be disposed of or alienated by the borrower. The point to be noted is that the scheme of NPA Act, whose constitutional validity is already upheld, provides for various enabling provisions. It gives discretion to the bank/FI to take steps in order to protect its assets from being alienated, transferred or disposed of in any other manner. Section 9 deals with various measures which a reconstruction company is required to take for assets reconstruction. Section 10 deals with the functions of securitisation company or reconstruction company. Section 11 deals with resolution of disputes relating to securitisation, reconstruction or non-payment of any amount due between the bank or FI or Securitisation Company or Reconstruction Company. It further states that such disputes shall be resolved by conciliation or arbitration. It is important to note that the dispute contemplated under Section 11 of NPA Act is not with the borrower. Section 12 empowers RBI to give directions from time to time, on Classification of an account as non-performing asset and asset classification has to be done by the bank of FI in terms of the guidelines issued by RBI.

Section 13 falls in Chapter III which deals with Enforcement Of Security Interest. It begins with a non obstante clause. It states inter alia that Notwithstanding anything contained in Section 69 or Section 69A of the TP Act, any security interest created in favour of any secured creditor may be enforced, without the court's intervention, by such creditor in accordance with the provisions of this Act. When we refer to the word 'court', it includes DRT. We quote herein below sub-section (2) of Section 13 of NPA Act:

"13. Enforcement of Security interest.-

(2) Where any borrower, who is under a liability to a secured creditor under a security agreement, makes any default in repayment of secured debt or any instalment thereof, and his account in respect of such debt is classified by the secured creditor as non-performing asset, then, the secured creditor may require the borrower by notice in writing to discharge in full his liabilities to the secured creditor within sixty days from the date of notice failing which the secured creditor shall be entitled to exercise all or any of the rights under sub-section (4)."

On reading Section 13(2), one finds that if a borrower, who is under a liability to a secured creditor, makes any default in repayment of secured debt and his account in respect of such debt is classified as non-performing asset then the secured creditor may require the borrower by notice in writing to discharge his liabilities within sixty days from the date of the notice failing which the secured creditor shall be entitled to exercise all or any of the rights given in Section 13(4). Reading Section 13(2) it is clear that the said sub-section proceeds on the basis that the borrower is already under a liability and further that, his account in the books of the bank or FI is classified as sub-standard, doubtful or loss. The NPA Act comes into force only when both these conditions are satisfied. Section 13(2) proceeds on the basis that the debt has become due. It proceeds on the basis that the account of the borrower in the books of bank/ FI, which is an asset of the bank/FI, has become non-performing. Therefore, there is no scope of any dispute regarding the liability.

There is a difference between accrual of liability, determination of liability and liquidation of liability. Section 13(2) deals with liquidation of liability. Section 13 deals with enforcement of security interest, therefore, the remedies of enforcement of security interest under the NPA Act and the DRT Act are complementary to each other. There is no inherent or implied inconsistency between these two remedies under the two different Acts. Therefore, the Supreme Court in the case of Transcore Vs UOI held that the doctrine of election has no application in this case. Section 13(3) inter alia states that the notice under Section 13(2) shall give details of the amount payable by the borrower as also the details of the secured assets intended to be enforced by the bank/ FI. In the event of non-payment of secured debts by the borrower, notice under Section 13(2) is given as a notice of demand. It is very similar to notice of demand under Section 156 of the Income Tax Act, 1961. After classification of an account as NPA, a last opportunity is given to the borrower of sixty days to repay the debt. Section 13(3-A) inserted by amending Act 30 of 2004 after the judgment of this Court in Mardia

Chemicals (supra), whereby the borrower is permitted to make representation/ objection to the secured creditor against classification of his account as NPA. He can also object to the amount due if so advised. Under Section 13(3-A), if the bank/FI comes to the conclusion that such objection is not acceptable, it shall communicate within one week the reasons for non-acceptance of the representation/ objection. A proviso is added to Section 13(3-A) which states that the reasons so communicated shall not confer any right upon the borrower to file an application to the DRT under Section 17. The scheme of sub-sections (2), (3) and (3-A) of Section 13 of NPA Act shows that the notice under Section 13(2) is not merely a show cause notice, it is a notice of demand. That notice of demand is based on the footing that the debtor is under a liability and that his account in respect of such liability has become sub-standard, doubtful or loss.

The identification of debt and the classification of the account as NPA is done in accordance with the guidelines issued by RBI. Such notice of demand, therefore, constitutes an action taken under the provisions of NPA Act and such notice of demand cannot be compared to a show cause notice. In fact, because it is a notice of demand which constitutes an action, Section 13(3-A) provides for an opportunity to the borrower to make representation to the secured creditor. Section 13(2) is a condition precedent to the invocation of Section 13(4) of NPA Act by the bank/FI. Once the two conditions under Section 13(2) are fulfilled, the next step which the bank or FI is entitled to take is either to take possession of the secured assets of the borrower or to take over management of the business of the borrower or to appoint any manager to manage the secured assets or require any person, who has acquired any of the secured assets from the borrower, to pay the secured creditor towards liquidation of the secured debt.

Reading the scheme of Section 13(2) with Section 13(4), it is clear that the notice under Section 13(2) is not a mere show cause notice and it constitutes an action taken by the bank/ FI for the purposes of the NPA Act. Section 13(6) inter alia provides that any transfer of secured asset after taking possession or after taking over of management of the business, under Section 13(4), by the bank/FI shall vest in the transferee all rights in relation to the secured assets as if the transfer has been made by the owner of such secured asset. Therefore, Section 13(6) inter alia provides that once the bank/FI takes possession of the secured asset, then the rights, title and interest in that asset can be dealt with by the bank/FI as if it is the owner of such an asset. In other words, the asset will vest in the bank/FI free of all encumbrances and the secured creditor would be entitled to give a clear title to the transferee in respect thereof. Section 13(7) refers to

recovery of all costs, charges and expenses incurred by the bank/FI for taking action under Section 13(4). Section 13(7) provides for priority in the matter of recovery of dues from the borrower. It inter alia provides for payment of surplus to the person entitled thereto. Section 13(8) inter alia states that if the dues of the secured creditor together with all costs, charges and expenses incurred are tendered to the secured creditor before the debt fixed for sale/transfer, the secured asset shall not be sold or transferred by the bank/FI to the asset reconstruction company and no further steps shall be taken in that regard. Section 13(9) inter alia states that where a financial asset is funded by more than one bank/FI or in case of joint financing by a consortium, no single secured creditor from that consortium shall be entitled to exercise right under Section 13(4) unless exercise of such right is agreed upon by all the secured creditors. Section 13(9) provides for one more instance when permission of DRT may be required under the first proviso to Section 19(1) of the DRT Act. The agreement between the secured creditors in such cases is required to be placed before the DRT not as a fetter on the rights of the secured creditors but out of abundant caution. Generally, such agreements are complex in measure, particularly because rights of each of the secured creditor in the consortium may be required to be looked into. However, if before the DRT, all the secured creditors in such consortium enter into an agreement under Section 13(9) then no such further inquiry is required to be made by the DRT. In such cases, the DRT has only to see that all the secured creditors in the consortium are represented under the agreement. The point to be noted is that the scheme of the NPA Act does not deal with disputes between the secured creditors and the borrower. On the contrary, the NPA Act deals with the rights of the secured creditors inter se. The reason is that the NPA Act proceeds on the basis that the liability of the borrower has crystallized and that his account is classified as non-performing asset in the hands of the bank/FI. Section 13(9) also deals with Pari passu charge of the workers under Section 529-A of the Companies Act, 1956, apart from banks and financial institutions, who are secured creditors. Section 13(10) inter alia states that where the dues of the secured creditor are not fully satisfied by the sale proceeds of the secured assets, the secured creditor may file an application to DRT under Section 17 of the NPA Act for recovery of balance amount from the borrower. Section 13(10), therefore, shows that the bank/ FI is not only free to move under NPA Act with or without leave of DRT but having invoked NPA Act, liberty is given statutorily to the secured creditors (banks/ FIs.) to move the DRT under the DRT Act once again for recovery of the balance in cases where the action taken under Section 13(4) of the NPA Act does not result in full liquidation of recovery of the debts due to the secured

creditors. Section 13(10) fortifies the view that the remedies for recovery of debts under the DRT Act and the NPA Act are complementary to each other. Further, Section 13(10) shows that the first proviso to Section 19(1) of DRT Act is an enabling provision and that the said provision cannot be read as a condition precedent to taking recourse to NPA Act. Section 13(11) of the NPA Act inter alia states that, without prejudice to the rights conferred on the secured creditor under Section 13, the secured creditor shall be entitled to proceed against the guarantor/pledgor; that the secured creditor shall be entitled to sell the pledged assets without taking recourse under Section 13(4) against the principal borrower in relation to the secured assets under the NPA Act. Section 13(13) states that, no borrower shall, after receipt of notice under Section 13(2), transfer by way of sale, lease or otherwise any of his secured assets referred to in the notice, without prior written consent of the secured creditor. Thus, Section 13(13) further fortifies our view that notice under Section 13(2) is not merely a show cause notice. In fact, Section 13(13) indicates that the notice under Section 13(2) in effect operates as an attachment/ injunction restraining the borrower from disposing of the secured assets under the provision of the NPA Act.

Section 17 of NPA Act confers right to appeal. It inter alia states that any person including borrower, aggrieved by exercise of rights by the secured creditor under Section 13(4), may make an application to the DRT as an appellate authority within forty-five days from the date on which action under Section 13(4) is taken. That application should be accompanied by payment of fees prescribed by the 2002 Rules made under the NPA Act. A proviso is added to Section 17(1) by amending Act 30 of 2004. It states that different fees may be prescribed for making the application by the borrower and the person other than the borrower. By way of abundant caution, an Explanation is added to Section 17(1) saying that the communication of the reasons to the borrower by the secured creditor rejecting his representation shall not constitute a ground for appeal to the DRT. However, under Section 17(2), the DRT is required to consider whether any of the measures referred to in Section 13(4) taken by the secured creditor for enforcement of security are in accordance with the provisions of the NPA Act and the Rules made thereunder. If the DRT, after examining the facts and circumstances of the case and the evidence produced by the parties, comes to the conclusion that any of the measures taken under Section 13(4) are not in accordance with the NPA Act, it shall direct the secured creditor to restore the possession/

management to the borrower (vide Section 17(3) of NPA Act). On the other hand, after the DRT declares that the recourse taken by the secured creditor under Section 13(4) is in accordance with the provisions of the NPA Act then, notwithstanding anything contained in any other law for the time being in force, the secured creditor shall be entitled to take recourse to any one or more of the measures specified under Section 13(4) to recover his secured debt.

In our view, Section 17(4) shows that the secured creditor is free to take recourse to any of the measures under Section 13(4) notwithstanding anything contained in any other law for the time being in force, e.g., for the sake of argument, if in the given case the measures undertaken by the secured creditor under Section 13(4) comes in conflict with, let us say the provision under the State land revenue law, then notwithstanding such conflict, the provision of Section 13(4) shall override the local law. This position also stands clarified by Section 35 of the NPA Act which states that the provisions of NPA Act shall override all other laws which are inconsistent with the NPA Act. Section 35 is also important from another angle. As stated above, the NPA Act is not inherently or impliedly inconsistent with the DRT Act in terms of remedies for enforcement of securities. Section 35 gives an overriding effect to the NPA Act with all other laws if such other laws are inconsistent with the NPA Act. Similarly Section 34 bars the jurisdiction of the Civil Courts inrespect of matters falling under the exclusive purview of the NPA Act. Thus the NPA paves the way for a NON ADJUDICATORY PROCESS OF RECOVERY OF NON PERFORMING ASSETS.

CONCEPT OF SECURITIZATION AND RECENT TRENDS

‘Just as the electronics industry was formed when the vacuum tubes were replaced by transistors and transistors were then replaced by integrated circuits, the financial services industry is being transformed now that securitized credit is beginning to replace traditional lending. Like other technological transformations, this one will take place over the years, not overnight. We estimate it will take 10 to 15 years for structured securitized credit to replace to displace completely the classical lending system not a long time, considering that the fundamentals of banking have remained essentially unchanged since the middle Ages.’

Lowell L Brian

Financial Markets in the World today are replete with products that were relations at one time. Today, this relation is tradable as a commodity. Aided by derivatives, more such risks and relations are placed in the capital markets today signaling a broader trend – the trend of commoditization of securitization.

Thus securitization in its widest sense implies every such process that converts a financial relationship in the transaction more specifically in the capital market instrument. Thus it is not just a funding device or an alternative to secured funding but it is a new found way of lending a tradable character to a business relationship not limited to financial relationship.

Securitization infact was one of the earliest and by far an unequalled contribution of Corporate Law to the World of finance. In many respects, the present day concept of securitization still draws upon the concept of equity share. Conceptually , an equity share in an obligation to distribute while debt is an obligation to pay. The simplest form of securitized instruments, pass through certificates also implies an obligation to distribute and hence are closer to equity then debt.

ASSET SECURITIZATION

John Reed, the then Chairman of Citicorp defined securitization as “the substitution of more efficient public capital markets for less efficient, higher cost, financial intermediaries in the funding of debts instruments. He was obviously referring to the generic meaning of securitization as replacing intermediated funding by direct funding from capital markets by issuance of securities.

However, in the sense in which the terms Is used in present day capital market activity, securitization has acquired a typical meaning of its own, which is at times, for the sake of distinction called Asset Securitization. It is taken to mean a device of structured financing where an entity seeks to pool together its interest in identifiable cash flows over time, transfer the same to investors either with or without the support of further collaterals, and thereby achieve the purpose of financing. Though the end result of securitization is financing, but it is not financing” as such since the entity securitizing its assets is not borrowing money, but selling a stream of cash flows that was otherwise to accrue to it.

Asset securitization literally as the word implies is the process of converting something in the security i.e. to say when something that is not a security is converted into one, it is securitization. A “security” is a capital market instrument. Thus securitization is the process that transforms an asset in to a security and the security that results is typically called an “Asset backed Security”/

The security at the end of the process of securitization is an asset backed security and this security is significantly different from a usual capital market instrument. A usual capital market instrument is an exposure to in the business of the issuer. An asset backed security is simply an exposure in an asset or as the case may be on a bunch of assets. An asset backed security is not claim on an entity but an asset.

Securitization by its process creates a sort of inter creditor arrangement whereby an asset backed investor is put to two advantages. Legal preference and structural preference.

Legal preference refers to the preference that an asset-backed investor enjoys over a traditional investor as a claimant on the assets of the operator. A traditional investor essentially has a claim against the operator. If the operator were to run into financial problems, the investor’s claim is subject to bankruptcy administration, which, in most countries is a time consuming process, and might be legally preceded by other statutory

claims. An asset-backed operator has a claim over the assets of the operator as those assets have been hived off and made legal property of the investors. Therefore, these assets subserve the claims of the investors before they can be claimed by anyone else. Creating this legal preference is the key to securitization.

Structural presence refers to the qualitative attributes of the assets transferred to the investors in asset-backed securities. In other words, securitization creates a structural preference for the investors in asset backed securities by sort of de-constructing a corporation and making its specific assets exclusively available to asset-backed investors.

The Inter-creditor arrangement above is the genesis of the two preferences noted in the preceding paragraphs. A preference is understandably an advantage that one has over the other.

LEGAL PREFERENCE BY ISOLATION

Legal preference of the asset backed investor over a traditional investor is key to the very economies of securitization. Much of the need for securitization to exist would disappear if it were possible to allow a certain section of investors. A bankruptcy proofing device wherein certain assets or all assets of a corporation would first be used to pay them off. The device used for creating this legal preference is simple: transfer of assets.

In securitization parlance, this legal transfer is often referred to as “isolation” Isolation is actually nothing but a perfected, irreversible legal transfer. That the receivables are isolated from the operator means the receivables are beyond the legal powers of either the operator or the operator’s liquidator or creditors, or for that matter, any one who has a claim against the operator.

Capital Market Window

Securitzation has the law in its head, and the capital market in its heart. The very idea converting an asset into a capital market security is to raise money from the capital markets.

Securitization, as the very name implies, has a capital market window. The idea is to create a security and take the asset out into the market. In other words, the idea is to move the funding from the banking world to the investment banking world.

Use of Special Purpose Vehicles.

The twin objectives of transfer of assets to investors, and at the same time, creating a capital market instrument, can only be attained by use of a transformation device known as special purpose vehicle. The special purpose vehicle is a legal outfit, specially and solely created for the purpose of holding the assets sought to be transferred by the originator and the issuance of securities by the special purpose vehicle, such that the securities of the vehicle are no different from a claim over those assets.

SECURITIZATION OF RECEIVABLES

Much of the asset-backed securitization discussed earlier is, in fact, securitisation of financial claims, that is, receivables. Besides to be packaged as a security, the ideal receivable is one that is repayable over or after a certain period of time, and there is contractual certainty as to its payment. Hence the application was traditionally principally directed towards housing/mortgage finance companies, car rental companies, equipment leasing companies, credit cards companies, hotels etc. Soon, electricity companies, telephone companies, real estate companies, avaiation companies etc. joined as users of securitization. Insurance companies are the latest of the lot to make an innovative use of securitization of risk and receivables, though the place at which securitization markets are growing, the word :latest” is not without the risk of being stale soon.

QUICK GUIDE TO JARGON

The entity that securitizes its assets is called the originator. The originator is the one who transfers receivables to the issuing entity, discussed below. In many cases, the transferor may not be the originator, that is, original underwriter of the claim or the assets, but might simply be a re-packager, that is, one who buys assets from the market for the purpose of securitizing them.

There is no distinctive name for the investors who invest their money in the instrument; therefore, they might simply be called investors. In other words, the securitized assets could be either existing receivables, or receivables to arise in future. The latter, for the sake of distinction, is sometimes called future flows securitization, in which case the former is a case if asset-backed securitization.

In U S markets, another distinction is mostly common: between mortgage backed securities (MBS) and asset backed securities (ABS) This only is to indicate asset classes that are different: the former relates to securities based on mortgage receivables. Elsewhere in the world, the word ABS typically includes all kinds of receivables including mortgage back receivables. Since it is important for the entire exercise to be a case of transfer of receivables by the originator of the receivables, there is a legal transfer of the receivables to a separate entity.

Therefore, it is necessary to bring in an intermediary that would hold the receivables for the benefit of the end investors. This entity is created solely for the purpose of the transaction: therefore, it is called a special purpose vehicle (SPV) or a special purpose entity (SPE) that could be a trust, or a company – hence the phrase special purpose company (SPC) . The function of the SPV in a securitization transaction could stretch from being a pure conduit or intermediary vehicle, to a more active role in reinvesting or reshaping the cashflows arising from the assets transferred to it. Therefore, the originator transfers the assets to the SPV, which holds the assets on behalf of the investors, and issues to the investors its own securities. Therefore, the SPV is also called the issuer.

SECURITIZATION AND STRUCTURED FINANCE

Securitization is a “structured financial instrument.” “Structured Finance” has become a buzzword in today’s financial market. What it means is a financial instrument structured or tailored to the needs of the issuer as opposed to a generic, on tap product. From investor perspective, it also means an instrument that is structured to meet the risk-return and maturity needs of the investor, rather than a simple claim against an entity or asset. Financing instruments where the financier does not look at the entity as a risk: but tries to align the financing to specific cash accruals of the originator.

On the investors’ side, securitization seeks to structure an investment option to suit the needs of investors. It classifies the receivables/cash flows not only into different maturities but also into senior, mezzanine and junior notes. Therefore, it also aligns the returns to the risk requirements of the investor.

In practice, the word “structured finance” and securitization are almost used interchangeably, as the words “securitized instrument” and “structured product”.

SOME QUITK FEATURES OF SECURITIZATION:

What receivables are securitizable

Number of present day securitizations seems to be breaking all rules as what receivables are amenable to securitization; the traditional securitizable receivables possess the following features:

1. Substantial Investment in receivables: The entity must be having a substantial part of its assets in the form of receivables.

2. Receivables in future for value already provided : The generic form of receivables securitized is receivables already created, that is, existing right to receive over time, for something already done by the originator.

3. Reasonable predictability: To be securitisable, the receivables must have a reasonable predictability. Normally, the receivables in question are backed by payment schedule. For example, repayment of housing loans. There are cash flows, which are not based on a payment schedule, but which can be modeled based on experience – for example, rentals from real estate.

4. Diversification: This is not a necessary feature, but usually it is preferred that the receivables must be diversified both geographically as also in terms of the

obligors. No single obligor, or few obligors having correlation should be able to disrupt the payment stream substantially so as to adversely affect the investor.

CREATION OF SECURITY

A significant distinction between securitisation and asset sales is that the former results into creation of marketable securities , and hence, the name securitization. “Asset sales” is the broad name given to transfer of an asset , or portfolio of assets, usually by banks and financial intermediaries to raise liquidity or manage risks. These are mostly bilateral transactions.

On the other hand the very purpose of securitization is to ensure marketability to financial claims. Hence, the instrument is structured so as to be marketable. The concept of marketability involves two postulates (a) the legal and systemic possibility of marketing the instrument and (b) the xistence of a market fo the instrument. Securitized products are issued as transferable securities ; in certificate form or in bond or note form.

SPECIAL PURPOSE VEHICLE

A vehicle whether “special purpose” or general purpose is not required in case of asset sales in general, but is required for securitization transactions.

Creation of marketable securities is not possible without a conduit or vehicle that will house the assets transferred by the originator and create securities based on such assets. Therefore, a vehicle is required to serve as an intermediary between the originator and the investors. But for such vehicle, a transfer of assets between the originator and the investors will be a direct bilateral transfer and any further disposal thereof by the investors will be fraught with problems.

Re-distribution of risks

If there is a transfer of assets from the originator to the SPV (and from there, beneficially or indirectly to the investors), it should follow that there is a transfer of risks as well. For most financial assets, there is an element of credit risk, interest rate risk, or similar risks. So the question is, how are these risks re-distributed upon securitization.

In most securitization transactions, the risks are transferred in a structured fashion in terms of a sequence as to who will take the first hit and who will come thereafter and who will be the last one to be concerned or affected. Based on these priorities, the risks are referred to as the first loss risk, the second or subsequent loss risk and so on. The one who takes the first loss risk is a junior holder, and the one who

takes subsequent risk is a senior one. There might, of course, be one or more mezzanine security holders. If there are more than three classes, for want of a better terminology in English, these different classes may be referred to as A class, B Class, C Class and so on, the first one referring the senior most.

Rating

The need for rating of securitized products is clearly appreciated : the investors expose themselves solely on the quality of the assets with a limited right of looking back at the originator. Therefore, it is but natural that the investors must understand the quality of the portfolio. In some jurisdictions, regulations require asset-backed offerings to be rated.

Securitization as a tool of risk Management

Securitization is more than just a financial tool. It is an important tool of risk management for banks by not only allowing banks to remove substantial concentrations and value at risk , but also permits banks to acquire securitized assets with potential diversification benefits . When assets are removed from a bank’s balance sheet, with a defined recourse or first loss risk, the bank limits its loss exposure to the amount of recourse or first loss protection provided by it.

In today’s banking , securitization is increasingly being resorted to by banks, along with other innovations such as credit derivatives to manage credit risks.

Economic Impact of Securitization

o Securitization is as necessary to the economy as any organized markets

are . While this signle line sums up the economic significance of securitization, the following can be seen as the economic merits in securitization.

o Facilitates creation of markets in financial claims

o By creating tradable securities out of financial claims, securitization helps

to create markets in claims that would, in its absence, have remained bilateral deals.

o Because it makes financial assets tradable, it also reduces the liquidity

risks in the financial system o Disperses holding of financial assets

o The basic intent of securitization is to spread financial assets amidst as

many savers as possible. It results into dispersion of financial assets. One should not underrate the significance of this factor just because most of the recently developed securitizations have been lapped up by institutional investors.

o Promotes savings: The availability of financial claims is a marketable form,

with proper assurances as to quality in form of credit ratings and with double safety nets in form of trustees etc. Securitization makes it possible for the lay -investors to invest in direct financial claims at attractive rates. This has salubrious effect on savings.

o Reduces costs; As discussed above, securitization trends to eliminate

fund based intermediaries and its lead to specialization in intermediation functions. This saves the end user company from intermediation costs, since the specialized intermediary costs are service-related and generally lower.

o Diversifies risks: Financial intermediation is a case of diffusion of risk

because of accumulation by the intermediary of a portfolio of financial risks. Securitization further diffuses such diversified risk for a wide base of investors, with the result that the risk inherent in financial transactions gets very widely diffused.

o Focuses on use of resources and not their ownership: Once the entity

securitizes its financial claims, it ceases to be the owner of such resources and becomes merely a trustee or custodian for the several investors who thereafter acquire such claim. Imagine the idea of securitization being carried further, and not only financial claims but claims in physical assets being securitized., in which case the entity needing the use of physical assets acquires such use without owning the property. The property is diffused over an investor crowd. In this sense, securitization carries Gandhi’s idea of a capitalist being a trustee of resources and not the owner.

o Smoothers impact of recession: In 1991, when the US economy was

passing through recession, securitization was booming. A December 1991 article in the Institutional Investor said “The asset-backed securities market is roaring its way through the recession with record issuance and reliable performance that prove it has come of age.” In year 2001-02 , the global economy passed through multifarious problems –large bankruptcies, terrorism etc. However, securitization markets have continued to grow through all this and the growth has been widespread across different sectors. Evidently more money is being raised by credit card securitization than in the past which means consumer spending is being propped by capital markets. More auto loans have been securitized in 2002 thannin the past – once again, auto sales have been supported by securitization. All this tends to ease out the impact of economic recession.

MODUS OPERANDI OF SECURITISATION BRIEFLY EXPLAINED.

Visualise an entity having a receivable as one of its major assets, say a housing finance company or leasing company, Suppose the company has already created these receivables (that is, it has a contractual right to collect these receivables) This means the company’s working capital is tied in the receivables.

Securitization will unlock this working capital, and make it free for further asset creation. In this sense, securitization is a mode of financing, or rather refinancing.

The company will select the receivables to be securitized, following a certain criteria. See below for the criteria to be adopted for such selection. While selecting, a set of discriminants can be used but generally it is not advisable that the company cherry-picks assets, that is, select assets of the best quality leaving behind poor quality assets with the company. For understandable reasons cherry picking is frowned upon by the equity shareholders and banks having traditional loan facilities with the company.

Such selected receivables will be transferred to a special purpose conduit, which could be a trust or a special purpose corporation viz. the special purpose vehicle (SPV)

So, once the receivables are transferred by the originating company to the SPV, it is the SPV that now becomes the owner of the receivables.

The SPV now finances itself by issuing securities. These securities can be either beneficial interest certificates or debt securities similar to bonds/debentures. While the SPV holds the receivables, investors acquire either a beneficial right therein by either buying the beneficial interest certificates or by buying the debt securities of the SPV. In either case, as the SPV is merely a shell consisting of the assets of the originator, the rights of investors are collateralized by the assets transferred by the originator.

The difference between the weighted average cost of the securities issued by the SPV, and the yield transferred by the originator (depending on the discounting rate employed for selling the receivables) is called excess spread. The excess spread is normally captured as the residual profit of the originator. ‘

The originator would usually continue to act as the servicer, that is, it will continue to collect the receivables and remit the proceeds to the investors.

The transfer of the receivables to the SPV and the creation of beneficial rights therein by the SPV involves complicated legal issues in most countries. Hence there might be lengthy legal documentation and stamping involved to complete the transfer. The Financial Instrument of the New Millennium.

The transfer of receivables to the investors through the SPV may be with or with or recourse, or with limited recourse to the originator.

As the servicing is mostly done by the originating company, the debtors may often not even come to know the fact of securitization unless they are notified. The servicer continues to collect the receivables, mostly in a separate escrow account from where the collections are drawn by the SPV. The SPV uses this collection, either to pay off to the investors proportionately (as in case of pass through securitization) or reinvests the money to pay to the investors on stated intervals (as in case of pay through or bond structure securitization).

In case of pass through, since the SPV would be making a proportionate payment to investors every period, the transaction automatically comes to an end when substantially all receivables are paid off. In case of pay through securitizations, generally the originator would have provided some of his own cash, including his retained spread or an over collateralization support, or simply an equity contribution to the SPV, therefore, the residuary cash with SPV at the end of the transaction is the originator’s residual cash inflow.

If at all any enforcement is required against the debtors, the SPV as the legal owner of the receivables will bring action against the debtors, but here again, the actual physical and administrative action may be taken by the originator as an agent of the SPV.

The basic process of securitization is illustrated in the Table below.

The basic process of receivables securitization

Step 1 – The originator either has or creates the underlying assets that is, the

Transaction receivables that are to be securitized

The basic process of receivables securitization

Step 2 The originator selects the receivables to be assigned

Step 3 A special purpose entity is formed

Step 4 The special purpose company acquires the receivables at their discounted

Value.

Step 5 The special purpose vehicle issues securities to investors – either debt type securities or beneficial interest certificates. These are publicly offered or privately placed, as found conducive.

Step 6 The servicer for the transaction is appointed, normally the originator

Step 7 The debtors of the originator or obligors are/are not notified depending on the legal requirement of the country concerned. Most likely, the originator will try to avoid notification

Step 8 The servicer collects the receivables, usually in an escrow mechanism, and pays off the collection to the SPV

Step 9 The SPV either passes the collections to the investors or reinvests the same to pay off to investors at stated intervals.

Step 10 In case of any default, the services takes action against the debtors as the SPV’s agent

Step 11 When only a small amount of outstanding receivables are left to be collected, the originator usually cleans up the transaction by buying back the outstanding receivables.

Step 12 At the end of the transaction the originator’s profit, if retained and subject to any losses to the extent agreed by the originator, in the transaction is paid off.

The Securitization of Intellectual Property Assets - A New Trend

Lending partly or wholly against intellectual property (IP) assets is a recent phenomenon even in developed countries. Collateralizing commercial loans and bank financing by granting a security interest in IP is a growing practice, especially in the music business, Internet-based SMEs and in high technology sectors.

Securitization normally refers to the pooling of different financial assets and the issuance of new securities backed by those assets. In principle, these assets can be any claims that have reasonably predictable cash flows, or even future receivables that are exclusive. Thus securitization is possible for future royalty payments from licensing a patent, trademark or trade secret, or from musical compositions or recording rights of a musician. In fact, one of the most famous securitizations of recent years involved the royalty payments of a rock musician in the USA, namely, Mr. David Bowie.

At present, the markets for intellectual property asset-based securities are small, as the universe of buyers and sellers is limited. But if the recent proliferation of Intellectual Property Exchanges on the Internet is an indication, then it is only a matter of time before all concerned will develop greater interest and capacity to use IP assets for financing business start-ups and expansions. As more cash flows are generated by intellectual property, more opportunities will be created for securitization.

The World Intellectual Property Organisation (WIPO), among others, describes the securitisation of intellectual property (IP) assets as "a new trend". It has now been more than seven years since the introduction of the so-called Bowie bonds - regarded as the first ever music royalties future receivable securitisation - which gave rise to IP securitisation as a financing vehicle. In the years since the introduction of the Bowie bonds, a great deal has been written in the business and legal press and in academic journals about securitizing various IP portfolios from copyrights (particularly those associated with music and film) and patents (particularly those associated with pharmaceuticals and high technology) to trademarks and even trade secrets and domain names.

But publications on this subject seemed to have peaked between 1999 and 2002. Since then, fewer new significant articles have been published, and there has not been any significant increase in the number or scope of deals reported. The natural question then is: what happened to all of the excitement? Perhaps securitisation was caught in the wake of the financial correction following the dot.com market crash. Or perhaps risk assessment in intellectual property securitisation just has not reached sufficient maturity yet to lead to the predicted boom.

Securitisation

Securitisation transactions involving traditional financial assets have been around since at least the 1980s. In the days before the Bowie bonds, typically the assets being

securitized related to tangible receivables such as real estate leases, supply contracts and the like. Such tangible receivables have predictable revenue streams and credit rating agencies are well familiar with the associated risks. In the case of intellectual property rights, the receivables may be licence royalties or other predictable cash flows from the intellectual property.

The owner of the receivables, who is called the originator, groups receivables together and transfers them to a special-purpose vehicle (SPV) that is formed for the sole purpose of acting as an issuer of the securities based on the receivables. The SPV issues debt or equity to investors and uses the proceeds to pay the originator. Debt issued by the SPV (bonds or the like) is serviced by the receivables; equity interests issued by the SPV results in the SP passing through the revenues produced by the receivables. Recording the security interests in the property secures the commitment to pay the receivables with recourse to seize the property in the event of a default.

No matter what form of security is issued by the SPV, the SPV is created in an effort to make the securitised asset remote from the assets of the originator so that in the event of the originator's bankruptcy, the court will not include the asset as part of the originator's estate. The bankruptcy court will look at the originator's transaction with the SPV to determine whether it is, in fact, a true sale and not just a mere loan. The real transfer of the assets to the independent SPV thus also separates the originator's finances in such a way that the originator's creditworthiness ought not to be considered a risk factor that should weigh on the creditworthiness of the securities issued by the SPV.

Securitisation of tangible assets

In the realm of tangible assets, the risks are largely visible in a securitisation transaction. Take for example the securitisation of a portfolio of real estate leases. In this example, a landlord (the originator) transfers to a trust (the SPV) its lessees' rent obligations over a period of 10 years in exchange for a lump sum payment. The trust sells bonds backed by the leases with a 10-year maturity, and takes and records a security interest in the leases. The two biggest risks in this sort of hypothetical scenario are fairly plain to see, and are capable, to at least some degree, of being accounted for or mitigated:

Tenants may fail to pay rent - that may be accounted for in due diligence investigation by reviewing the lessees' creditworthiness; the tenants contracting to mitigate the damage to the lessor (or, more likely, its assign, the SPV); obtaining the lessor's right to sub-let to mitigate, etc.

The real estate could be damaged in such a way that the tenants are not required to pay rent (e.g., they are not able to inhabit the building) - that may be mitigated by insurance or at least accounted for in the predictable ways in which the damage could occur such as by fire, flood, acts of terrorism, etc.

While, like the real world, this tangible example does not provide a perfect revenue stream, it is a highly predictable revenue stream that can be assigned a reasonably accurate credit rating based upon experience with similar leases or an established history for the property at issue.

Bowie bonds

David Pullman was responsible for arranging the first securitisation of intellectual property. Musician David Bowie was looking for financing opportunities for, among other things, buying out his manager's minority share interest in his music catalogue. Bowie's objectives meant he was looking for a way to raise a lump-sum cash amount rather than to rely upon an income stream - indeed, Bowie reportedly had a regular cash flow of more than US$1 million per year from ownership rights in the copyrights in much of his music catalogue dating back to the 1960s and to the recording masters. So rather than entering into a new traditional distribution agreement at the expiration of his existing recording and distribution agreement, Pullman devised the Bowie bonds to meet Bowie's need for upfront cash.

Only limited information about the structure of the transaction is publicly available. Certainly, an SPV was formed. The assets Bowie sold to the SPV included the right to certain future royalty payments from 25 pre-1990 albums he recorded (more than 300 copyrights). The SPV issued bonds and Bowie's record distributor, EMI, provided certain credit enhancements. The bonds received a triple A investment grade rating by Moody's Investors Services.

The bonds had a 10-year average life and had a maturity of 15 years. Prudential Insurance Company purchased the bonds, netting US$55 million for Bowie. In a debt offering of this kind, the underlying copyrights would be used to secure the bonds. If the SPV defaults on its payment obligations to bondholders, the copyrights are permanently transferred to the bondholders. Until the event of default, of course, the copyright owner would retain the copyrights subject to a security interest held by the bondholders. After the bond obligations are met, the copyright owner holds the copyrights free of the security interest (just as a homeowner that has paid mortgage debt in full owns a home free of the mortgage).

The security interest in the copyrights would be perfected to allow the bondholders' claims to take precedence over most unsecured claims. The procedure used to perfect security interests in copyrights in the United States is the subject of some debate. Article 9 of the Uniform Commercial Code (UCC) does not mention copyrights and there is some question as to whether collateral interests in copyrights should be perfected by filing a UCC-1 financing statement in the appropriate states as general intangibles under the UCC or by recording a collateral assignment in the Copyright Office. Although recent case law suggests that security interests in copyrights can only be perfected in the Copyright Office, But out of an abundance of caution, most careful lenders perfect security interests in all IP rights (patents, copyrights and trademarks) at the state and federal level (Patent Office, Copyright Office and Trademark Office, as the case may be). It should be noted that perfecting security interests in property in the United States varies with the type of property and is largely a function of state law rather than, as is the case with intellectual property law, with reference to a combination of state and federal law.

Other intellectual property securitisations and the risks

The Bowie bonds are not the only example of IP securitisation. Other musicians have done similar securitisations involving their music catalogues. There also have been securitisations involving film catalogues as well. At least one securitisation involving patents for drugs has been done and publicised. Indeed, quite a few published articles have theorised that the possibilities for securitisations include portfolios of trade secrets, trademarks and domain names as well. However, if there have been such transactions, they have been kept fairly confidential and private.

When considering the intangible nature of intellectual property, perhaps it is not surprising that securitisations in this field have not become everyday, well-publicised transactions. Each type of intellectual property comes with its own peculiar set of complexities and unknown risks that are not common to commercial ventures involving tangible property.

Copyright Issues

In dealing with copyrights, there are several risk factors that need to be analysed. Even in the Bowie bond transaction, it has been reported that the examination and definition of all of the applicable revenue streams associated with the securitised music catalogue required more than a thousand pages of documentation.

Ownership of the copyright is one of the first issues to consider. The United States no longer requires registration of a post-1989 work for copyright to vest in its author(s). Determining who the author is or who the joint authors are may not always be a straightforward investigation. Certainly assignments and other encumbrances must be considered. Depending on the work, heirs may have rights in the work upon the originator's death and the creator of the work may have the right to terminate any transfer of the copyright under 17 USC §203. The Section 203 right to terminate transfers is particularly problematic because under 17 USC §203(a)(5), the termination may be effected notwithstanding any agreement to the contrary. Thus, the risk of a reversion of rights must be considered when valuing the property.

Likewise, if a work is of joint authorship, each joint author has a right to royalties derived from the work, and if less than all of the joint authors are participating in the securitisation, valuation will be effected and careful consideration will need to be paid to the joint author's or authors' rights. Of course, whether the work was a work for hire also needs to be considered, and if a work is a work for hire, where the work was created by an independent contractor rather than an employee of the purported copyright owner, the documentation of the work-for-hire agreement must be carefully considered as well.

Ownership issues can likely be resolved to at least a reasonable degree of certainty. One needs to be aware, though, that perfect certainty probably can never be achieved. Since the copyright registration process does not involve a scouring of all works to determine whether a registered work infringes another pre-existing work, there will always be at least a modicum of risk that another author will initiate a successful infringement action that not only undermines the validity of the copyright and decimates the royalty streams, but places the originator at further risk of a fraud claim by the SPV (and, perhaps the bondholders) for representations made in the initial transfer. Certainly an honest originator would be able to defend the fraud claim on the basis of lack of knowledge of the infringement, but no originator's copyright could completely escape the consequences of a successful copyright infringement action.

Assuming that ownership issues can be resolved to a reasonable degree of certainty - and with research and due diligence one would normally

expect them to be and to accept the risk of the unknown - the sources and magnitude of possible royalty streams need to be analysed and valued. Indeed, valuing the royalty stream and its reliability is of critical importance to the investors who purchase royalty-based intellectual property securities. For the originator and underwriters, these valuation issues underlie the legal disclosures required in their offerings under the securities laws and the assumptions driving the transaction. For example, in the case of Bowie's catalogue, the revenue streams were originally expected to be from traditional performance and distribution rights - such as radio play, records/tapes/discs sales, motion picture use, etc throughout different countries in the world. Today, revenue also comes from new streams such as digital distributions (e.g., iTunes(r)). The changes in the marketplace that brought new sources of revenue based on digital distribution, also brought unforeseen competition that has impaired the value of the original Bowie bonds. No one expected at the time the Bowie bonds were first offered that the demand for paid recordings of Bowie music would be threatened by illegal free peer-to-peer file sharing.

The recording industry has aggressively and publicly begun to fight widespread digital piracy on the Internet in peer-to-peer sharing networks. The estimates of lost revenue in this area are huge.

In any securitisation transaction, the threat of infringement needs to be considered. In some cases, it may be appropriate for the originator to take legal action to terminate infringement of the underlying copyrights and protect the demand for the subject works from unfair competition by infringers. The transactional documents need to explain how the infringement cases will be handled, who will control and pay for the litigation, and who will receive the benefits of settlement payments or a judgment from a successful trial.

Just as the threat of infringement can impact value, historic revenues may prove non-predictive for copyright securitizations due to other intangibles. Music and movies are part of pop culture, which has a way of changing rather rapidly. The popular music of the 1980s or even the popular films of the 1980s are not, as a whole, as popular today and how popular they may be a decade from now is really but conjecture. Tastes change.

Whether any particular music or film catalogue has any real staying power

in the marketplace is probably not predictable with a large degree of certainty. Similarly, revenues relating to copyrights in expressive works also can be subject to the personality of the artists that create them. An artist that no longer has an incentive to promote a past work - let alone produce new works that keep the artist in the public's eye - may become forgotten. Or worse, an artist that is accused of some crime of moral turpitude may see his or her works publicly shunned or treated worse.

The more predictable the revenue generated by an IP royalty portfolio, the greater the opportunities from securitisation. But no one can really successfully predict what other forms of distributions are yet to come and how they may affect future revenues (whether positively or negatively). Thus, valuation remains a main, if not the main, legal and business challenge in structuring IP securitisation transactions.

Other intellectual property

Patents, trade secrets and trademarks have also been the subject of interest for securitisation. In principle, each can generate a stream of royalty income that can be securitised in much the same way described above with respect to copyrights. Valuation of royalty income in patents and technology can present many unique challenges. Indeed, when dealing with technology, the question of obsolescence also comes into play. The promoters of eight-track players and Betamax(r) recorders all had some success for a number of years and there may still be valid IP rights owned relating to these technologies.

Though there was probably a point in time where each technology looked like the technology would produce a revenue stream for a significant amount of time into the future, one can see from today's vantage point that none of those technologies could possibly produce the revenue streams of days past.

Trade secrets are, themselves, only really recognised as a product of local state laws in the United States. (There is a Criminal Theft of Trade Secrets Act on the federal level, but for the definition of what is a trade secret, one must look to state law.) On one hand, trade secrets are very intangible property: a trade secret may be reverse engineered legally; may be purposely disclosed to the public for a business reason; and/or may be

inadvertently disclosed to the public. Thus, most trade secrets probably do not lend themselves to securitisation.

On the other hand, so long as a trade secret remains confidential and not reverse engineered, it continues to exist in perpetuity. There are certainly some trade secrets that have long established royalty streams - the secret formula to a certain popular soft drink and the secret herbs and spices for cooking fried chicken are two famous examples. There is no obvious legal reason why royalty streams from these assets could not be securitised. However, as a practical matter, the proprietors of these trade secrets may not want to part with the full control of their valuable assets or put them at risk in the event of default.

Finally, securitisation of trademarks presents many unique concerns. In the United States, a trademark cannot be assigned without its goodwill. Franchise and distribution systems are often built around trademarks (and, more recently, domain names) and the goodwill associated with them, typically in conjunction with some trade secrets. Securitising a portfolio of trademarks (or domain names) requires extreme care to avoid severing the goodwill from the trademarks and still to maintain quality control over the use of the marks in commerce. Upon default, the goodwill must pass with the marks to the secured bondholders or the value of the marks may be jeopardised.

Conclusion

IP securitisation remains a valid financing technique which allows rights holders to obtain the financial benefits of a present lump sum in exchange for the right to receive royalties from their works over the long term. For a securitisation to be successful the value of the royalty stream in question must be predictable and the risks that may undermine the demand for the goods protected by the IP must be understood. As technology evolves it may be difficult to predict how market forces (e.g., peer-to-peer file sharing) may impact intellectual property valuation and such uncertainty may temper enthusiasm for this financing technique. However, with appropriate due diligence precautions, cautious asset identifications and careful valuations, securitisation is viable and should be considered as a way to monetise intellectual property.