How to take intellectual property rights as security

By Dérick Swart on 9 April 2020
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At the time of writing, the world is in a state of distress due to the spread of the corona virus.  The world economy has been severely disrupted, and many businesses are having to seek funding to meet their cash flow requirements. 

Although most people understand the value of intellectual property as the lifeblood of an organisation, few know that intellectual property can be leveraged as an effective form of security.  This post explores at a high level how funders (owners and lenders alike) can engineer a claim over the intellectual property assets of a debtor.

A caveat

Despite all the talk of the 4th industrial revolution, South African law is unfortunately not fully settled on this topic and a short post like this cannot deal with all of complexities (nor would most readers be interested in that).  As such, my intent here is rather to provide practical guidance with the law as it stands.

What precisely is intellectual property?

Not to split hairs, but the first thing to note is that there is a difference between "intellectual property rights" and "intellectual property".  

"Intellectual property rights" typically refer to rights derived from patents, designs, trade marks, copyright and the like.  Since the term is made up of a bundle of rights, which could extend to any rights arising from creations of the mind, there is no closed list and no single, authoritative definition of the term in law or business.

"Intellectual property" on the other hand often is used to refer to assets that embody intellectual property rights, such as artworks, code, databases, blueprints, reports, analyses, moulds and so on. 
These two concepts are often conflated in drafting.  For purposes of this post, I will be looking at security by way of intellectual property rights.

Types of rights and assets

Introduction

As with the difference between intellectual property and intellectual property rights, it is necessary to understand the different categories or rights and assets used by the law as each has its own requirements for establishing security over it.

Real rights versus personal rights

Broadly speaking, a right can at law be a real right, in which case the right lies against the thing itself, or a personal right, in which case the right lies against the person having granted the right.

A real right of security is typically a stronger right in law, as it attaches to the asset itself and so is not dependent on the changing circumstances of the person having granted it.
   
Corporeal versus incorporeal assets

As the name suggests, corporeal and incorporeal assets differ in that the former can be perceived with the senses, while the latter cannot.  There can be little debate that intellectual property rights constitute incorporeal assets.  The embodiments of intellectual property rights would on the other hand mostly be corporeal in nature.

Movable versus immovable assets

There has been some debate as to whether intellectual property rights are to be considered movable or immovable.  In some cases, the legislation is perfectly clear on the matter (e.g. in respect of copyright), and in other cases the matter is left open-ended. 

Our courts have unfortunately not provided a clear, dogmatically-sound precedent to date. 

General ways to establish real rights of security

The Deeds Registry Act provides that real rights of security over immovable property can only be established by the registration of a bond with the Deeds Registry.  

In respect of corporeal and incorporeal movable assets, a notarial bond can be registered with the Deeds Registry, either a general notarial bond over unspecified movable assets or a special notarial bond be registered in respect of specific assets.

Real rights of security can also be established over corporeal movable assets by way a possessory pledge (the creditor takes actual possession of the pledged asset).  There are a few exceptions where non-possessory pledges are generally accepted to create real rights of security, such as where notional possession is given (e.g. a share certificate in respect of shares) or in the case of statutory hypothecs (i.e. a special type of pledge created by statute). 

How can security be taken over intellectual property rights?

Intellectual property rights derived from legislation with statutory hypothec 

As mentioned above, the governing legislation in respect of a few type intellectual property rights legislate a statutory hypothec as a method to securing real rights over such rights.  Examples are patents, designs and trade marks.

Accordingly, if a deed of security is executed and registered with the relevant registry, a real of right of security is established.

Intellectual property rights derived from legislation without statutory hypothec
 
Where there is no provision for a statutory hypothec, regard must then be had to the default principles of law.

It then becomes important to establish whether an asset is movable or immovable.  The question is put beyond doubt in respect of copyright, where the Copyright Act expressly states that it is a movable asset.  The drafters of other legislation however were not so clear on their intent. 

For purposes of this post, it would be fair to say that despite some unfortunate case law, the general consensus is that intellectual property rights should be treated as movable assets.  If this is the case, it follows from what was said above that a type of pledge is required to establish a real right of security. 

When dealing with intellectual property rights, a possessory pledge is obviously not possible due to the incorporeal nature of the asset.  Karjiker confirms the generally held view that our law has developed to effectively merge the concepts of cession and pledge in respect of incorporeal assets such intellectual property rights, allowing for real rights of security to be established by a so-called "security cession". 

The legislation that provides for statutory hypothecs does not expressly exclude other ways in which real rights of security may be established.  It would accordingly appear that a security cession can also be effective, even where the founding legislation provides for a statutory hypothec.  In such cases, the creditor would not be able to rely on the benefits arising from a statutory hypothec though (e.g. blocking of applications to record an assignment, for instance).  

Intellectual property rights derived from common law

Certain intellectual property rights are derived from common law, such as trade secrets and goodwill.  In principle, these rights should follow the same reasoning as discussed immediately above.

It should be noted however that these common law rights are substantially more difficult to evidence, let alone transfer in the context of execution.  That is not to say that it is not possible or useful, merely that from a commercial perspective, it is anticipated these rights would not typically be capable of easy leverage.  Where it is possible to protect such assets with an intellectual property registration (such as the registration of a trade mark in respect of goodwill), it will certainly assist.

General instruments

Finally, in addition to a security cession and statutory hypothecs (if available), it also remains possible to register a general notarial bond over intellectual property rights.

Domain names

A domain name is simply a record that translates a human-friendly name into an address which computers can find (i.e. an internet protocol address).  The commercial value of domain names in the digital economy is significant, given that the owner of a domain name can direct traffic where it chooses.  

Since domain names do not comfortably fit into any of the preceding categories, I thought to address them separately.

Having regard to the reasoning followed above, it does not take a big leap to conclude that domain names are most likely movable, incorporeal assets.  As such, a real right of security can likely be established over a domain name registration by way of a security cession or notarial bond.

Execution

It is important that a deed of security deals extensively with the rights of the creditor to execute against the collateralised assets without recourse to court as far as possible.  This applies both from a legal and practical perspective.

If a deed of security fails to provide for immediate execution (i.e. parate executie) in a lawful and legally binding manner, the creditor may be forced to approach a court to make a ruling on the matter, which will be expensive and cause a significant delay.  

Valuation and escrow arrangements can be put in place to ensure that a creditor can achieve swift access and control over intellectual property assets.  

Insolvency

Introduction

The Insolvency Act determines the manner in which a debtor's estate is to be sequestrated.  Unfortunately, these provisions are not fully aligned with the principles set out above. 

Once sequestration commences, immediate execution by way of contractual provision (i.e. parate executie) is no longer possible since all the intellectual property rights of the debtor vest in and must be 
surrendered to the trustee of the estate (or the Master of the High Court, prior to the trustee's appointment).

Secured versus preferential versus unsecured 

By way of interpretation, the Insolvency Act provides for the following ranking of creditor claims (as it pertains to intellectual property rights) in the case of winding up:
  • Secured claims:  These are claims by the holders of "security" in terms of the Insolvency Act, which are entitled to the proceeds of the assets over which they hold such rights after deduction of certain initial costs in realising the claim.  Intellectual property rights over which the creditor has a preferent right by virtue of a pledge is included.  If the holder of a general notarial bond has perfected their rights prior to sequestration, they are in the position of a pledgee.
  • Preferential claims:  These are claims by the holders of general notarial bonds which were not perfected at the time of sequestration. 
  • Unsecured claims:  These claims rank the lowest and are paid from the "free residue" after the higher-ranking claims and other statutory sequestration costs have been settled.
Perfection of a notarial bond

It is clear from the above the perfection of a general notarial bond prior to sequestration has a significant impact on the ranking of the claim.
To "perfect" a bond is generally understood to mean that the bondholder must obtain control of the bonded securities, which is often done through attachment by order of court.  The deed of security must contain effective, practical provisions that place the Creditor in a position to obtain control of the bonded securities ahead of sequestration as far as possible.  

Invalid notarial bonds

It should be noted that the Insolvency Act invalidates bonds registered 6 months prior to the debtor being sequestrated.  

Practical considerations

The trustee must seek to realise the highest value for the assets of the debtor, having regard to the order of preference set out above.  Where a creditor has a substantial claim against the debtor's insolvent estate, that claim can in certain circumstances be used to acquire the intellectual property rights by setoff. 

Other considerations

In passing, I briefly raise a few other considerations under this heading which are relevant when working with deeds of security.

Nature of obligations

Deeds of security are mostly ancillary in nature, meaning that they serve as security for a proper and timeous performance of a principal obligation.  If the security is in fact ancillary, it should be noted that it will become unenforceable if the principal obligation is extinguished or otherwise becomes unenforceable.  

Registration as credit provider

The law is not completely settled on the effect of a failure to register as a credit provider where is required by law to do so, but a compliance failure such as this could place the ancillary obligations in the deed of security at risk.

Corporate approvals

When dealing with a company, the requirements of the Companies Act come into play and failure to secure the prerequisite corporate approvals can expose the company, its directors and the creditor to risk.   

Cross-border transactions

Security over intellectual property assets can be granted in favour of foreign lender, subject to borrower seeking the prior approval of the South African Reserve Bank.

Granting of rights in the context of insolvency

The granting of any security while the debtor is insolvent exposes such transaction to possible reversal by a liquidator.  

Conclusion

Intellectual property can be used as collateral to secure obligations.Unfortunately, the legal landscape lacks a uniform treatment to collateralising intellectual property rights and expert advice is required to ensure that the anticipated rights are actually created in a legally enforceable manner.

The language of a deed of security is critical in determining whether the anticipated security is in fact established and if such rights can effectively be executed against in case of default.

Our services

The professionals at SWART practice law at the intersection of technology, intellectual property, corporate and commercial law.  

We have combined our strengths to developed turnkey instruments and services aimed at assisting clients in navigating the complexities set out in this post.  These services include:
  • Drafting of deeds of security
  • Registering intellectual property and statutory hypothecs
  • Registration of notarial bonds
  • Compliance with the National Credit Act, including registration as a credit provider
  • Managing intellectual property portfolios
  • Corporate approvals
  • Intellectual property valuation
  • Escrow services

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Please note that the legal topics informally discussed here are general discussions of certain aspects and therefore certainly not intended as legal advice.  We look forward to discussing your particular case with you.