Credit Arrangements and Loan Syndications

In today.s high-tech world, a business.s most valuable assets are often intangible, such as copyrights, patents, trademarks and other assets broadly categorized as "intellectual property". Secured lenders are consequently finding their collateral increasingly comprised of computer software, source codes, databases, films, publications, lyrics, media presentations and other "works of authorship" which derive value largely from their uniqueness and from the ability of their owners to protect that uniqueness in the marketplace.

Under the United States federal Copyright Act, a creator of a "work of authorship" is entitled, with or without registration, to protect the work against copying or other infringement and to derive the economic benefits of marketing the work to others. Specifically, the "copyright" in the work gives the owner the exclusive right to reproduce, modify, distribute and publicly perform and display the work. By registering a copyright with the Copyright Office, an owner becomes entitled to recover certain statutory damages if its copyright is infringed.

By design, the registration and notice provisions of the Copyright Act are work specific. The benefits of copyright registration, and any lien filings related to those copyrights, pertain only to the work as registered; post-registration modifications or supplements to the work are deemed to create a new "derivative" work and require a new registration.

For a copyright financier, the requirement that each work be separately registered creates significant risks that valuable items of collateral may escape its security interest. Consider, for example, a lender financing a start-up company.s development of computer software designed to monitor the use of office supplies by a multi-office corporation, cost that usage to various profit centers, compare prices among vendors and automate and manage the process of ordering and allocating new supplies. The process of creating such a program involves a number of stages, including analysis, design, coding and testing, which may go through many iterations before a salable product is produced. Moreover, after the product has gone to market, new versions containing additional functions, user-friendly improvements, etc. will almost certainly follow. The software developer might well be expected to balk at the idea that it should be required to register its copyright in each and every incarnation of the program, as well as each addition and modification, and to record the lender.s lien with each such registration. However, a recent line of cases from the 9th Circuit purports to require just that.

In In re Avalon Software, Inc., 209 B.R. 517 (D. Ariz. 1997), the United States Bankruptcy Court for the District of Arizona held that the sole method for a secured creditor to perfect a security interest in either copyrighted or copyrightable property (including unregistered copyrights, updates, modifications, amendments and enhancements) and their proceeds is to register (or cause the registration of) the copyrighted and copyrightable materials and to file a record of its security interest with the United States Copyright Office.

In re Avalon Software followed the reasoning in two other 9th Circuit bankruptcy cases, In re Peregrine Entertainment, Ltd., 116 B.R. 194 (C.D. Cal. 1990), and In re AEG Acquisition Corporation, 127 B.R. 34 (C.D. Cal. 1991). Under this trio of cases (which unfortunately for lenders represent the only apposite authority on this issue), perfection of a security interest in unregistered copyrights, in unregistered updates, modifications, amendments and enhancements to registered copyrights and in all proceeds related to the foregoing is legally impossible; consequently, a lender is left with the choice between requiring its borrower to register all material copyrightable assets and risking non-perfection.

While In re Avalon Software may provide a bright-line test for perfection, its practical implications substantially increase the costs and risks of copyright financing. There are many reasons, including the possibility that compliance with the copyright registration provisions may result in the loss of protection for trade secrets embedded in copyrightable works, why a potential borrower may prefer with good reason not to register its copyrightable assets.

Even for borrowers who register their copyrights, maintaining fully-secured status with respect to those copyrights could become difficult and costly under the Avalon precedent. Where a borrower.s business involves continual generation of works which may be or become eligible for copyright protection, a lender seeking maximum security must monitor the borrower.s activities to ensure that each copyright of material value is registered, either upon completion or, if warranted, at an earlier stage at which its value becomes significant. In addition, each material update, modification, amendment and enhancement must be promptly registered, and a notice of the lender.s lien must be recorded with respect to each registration. While the number of filings required for registration and perfection and the time and cost involved may well render copyright-secured financing prohibitively expensive for many borrowers, In re Avalon Software, et. al. leave few practical alternatives.

Although the Avalon decision comports with the two California decisions mentioned above, it may well not represent the law in other jurisdictions. We believe it may be fairly criticized. However, its existence (and that of the two California cases) cannot prudently be ignored.

In making any loan secured by copyright collateral, a lender should thoroughly review the borrower.s copyrighted and copyrightable assets to assess the value of the copyright assets as part of the overall collateral package. Where the nature of the borrower.s assets makes it important for a lender to acquire a perfected lien in copyright assets, careful attention by legal counsel to the deal structure, representations, covenants (particularly requirements to notify the lender of material changes or additions to copyright portfolios and to take the actions necessary for perfection) and loan monitoring procedures can minimize, although probably not eliminate, a lender.s risk of non-perfection. In these situations, the lender should work closely with experienced counsel to structure the collateral arrangements so as to fairly balance the lender.s need for a perfected lien in works of material value against the burdens of complying with the rules set forth in In re Avalon Software.