Securitization May Work Beyond Music Royalty Income Stream

The securitization process begins when the owner or “originator” of the IP rights sells them to a company, known as a “Special Purpose Vehicle” (SPV), specifically set up to hold the IP rights in return for an upfront cash payment to the originator. In order for this transfer of rights to be effective it must be considered a “true sale” for bankruptcy purposes. The requirements of a “true sale” are not set in stone, but generally require that the originator fully divests itself of the asset and does not retain control over its use or distribution. The SPV then issues securities creating an interest in favor of the parties who purchase the security. The SPV uses the monies raised by the issuance of the securities to pay off the debt that it incurred when it purchased the IP rights from the originator. The SPV continues to exist over a period of years for the purpose of making distributions to the holders of the securities, in accordance with the offering.

The main reason the SPV is used is to protect the IP assets from the creditors of the originator. By utilizing a “true sale” the IP asset would not be included in the originator's estate for bankruptcy purposes and therefore the security holder's interest in the revenue stream is protected from claims by the originator's potential creditors. Moreover, since the SPV is set up merely to hold the IP asset during the term of the security, it is very unlikely that it will ever become bankrupt itself. In cases where the investors still fear the possible insolvency or default of the SPV, a credit enhancement can be used, which may take the form of insurance or the creation of a reserve fund to cover payments to investors.

There are several forms of security that an SPV can issue. The most common takes the form of a debt instrument. If the SPV issues debt instruments, then it acts as a “pay-through” entity because holders of the debt instrument receive a set payment. This fixed payment is based on the anticipated cash flow that was determined at the time the debt instruments were offered for sale. Moreover, the life of a debt instrument is generally limited to the term of the offering, unless it is retired early. An SPV could also theoretically issue securities in the form of an equity (ie, stock). If an SPV issued equity securities, it would serve as a “pass-through” entity because the security holders receive payments from the cash flow that are proportionate to the amount of the securities that they hold. While the concept of an SPV issuing equity instruments is possible, it would change the nature, terms and benefits of the offering to such an extent that it would be unrecognizable from that of a debt offering. As such, while there would still be similarities to the structure and benefits of issuing debt and equity instruments, we'll focus on IP securitizations utilizing the debt instrument model.

The benefits to the originator of a securitization are potentially numerous. Instead of waiting for royalty payments from the IP assets to come in over many years, the originator receives an immediate lump sum payment. An originator can also obtain greater amounts of cash through a securitization than by a bank loan, because banks will seldom loan more than a small portion of a potential income stream. A debt instrument securitization can also provide a defined fixed rate of interest payments to be made as opposed to the uncertain fluctuation in interest rates inherent in a bank loan. Furthermore, unlike a bank loan, no personal guarantee is required in a securitization because notes are nonrecourse as to the originator. Because the securitization is considered a financing (ie, loan) and not a sale of the IP rights, taxes are not paid on the amount raised by the offering. Therefore, the originator gets a large infusion of capital and does not have to pay taxes until royalties are actually generated over subsequent years. There can also be other tax benefits depending on how the originator uses the money it raised.

Perhaps the greatest benefit to the originator is that it retains ownership of the IP rights. As opposed to selling the IP rights, which permanently divests the originator of its rights, at the end of the term of the debt instrument securitization the originator's rights in the underlying IP revert back. The originator can then choose the best manner to fully exploit these rights which may mean again arranging a securitization. Moreover, if the revenue from the IP income stream is greater than expected the security can be retired early by making full payments to the holders and the originator regains its IP rights earlier than originally expected.

Critics have raised concerns about the continued usefulness of securitization of IP rights following the Bowie Bonds. But the arguments that have been made relate mainly to the specific problems that arise in the music royalties context and not in other forms of IP rights. In the context of music royalties, there are only a few individuals that have the consistent revenue stream necessary for a securitization and these individuals may not require the infusion of cash that this type of financing creates. Moreover, the varied nature of copyright ownership that exist in music, much of which is often held jointly or separately by many different parties, has made the original Bowie Bond a difficult act to follow.

Pooling of Rights

To overcome the hurdle of the limited number of entities that have IP rights that produce a yearly seven-figure revenue stream, securitizations can be founded on a pool of IP rights. Bundling several smaller revenue streams will create the necessary elements and may eliminate the problem of various entities owning a portion of the IP rights. In using this technique, several members of a band could pool their individual rights and issue a security, when none of the members have individual rights that would be sufficient. Furthermore, pooling could be used to create a fund that embodies IP rights in several different disciplines. Writers and actors could pool their rights with musicians and designers to create a basis of revenue founded on many different types of IP rights. This would provide a greater source from which to obtain these assets and protect the underlying revenue stream from one particular individual or entity loosing public favor and its revenue stream drying up. Diversification of IP assets would also act to widen the potential investor pool and move these securitizations out of one particular niche.

In fact, some of the flaws and problems inherent in the securitization of music royalty rights do not exist to the same extent when contemplating the use of other IP rights. Actors, producers, writers and studios all have rights that can be the basis of a securitization. Many Hollywood actors receive a percentage of the income a movie or television show generates in return for their services. This income may continue long after the move has left the theater or the show has left the TV airwaves. Film and TV studios have extensive libraries of past films and shows that generate a significant amount of yearly income through licensing. The same potential exists for an author or a publishing house concerning rights to publishing royalties. An author could securitize his or her rights in a successful series of books or a publishing house could bundle the works of several authors to create a more diversified pool of IP assets. Certainly, the potential to bundle various IP interests to form the basis of a securitization is vast.

Sidebar: Bowie Bonds Formula Not Protectible

The Manhattan Supreme Court has held that the methodology used to complete the securitization of musical artist David Bowie's future royalties ' the first such securitization ' didn't constitute a protectible trade secret. Pullman Group LLC v. Prudential Insurance of America, 600772/01.

The suit was filed by David Pullman, who claimed that while at the securities firm Gruntal & Co., he developed concepts for issuing bonds secured by music royalties and then approached Bowie's management representatives, the Rascoff/Zysblat Organization (RZO). The “Bowie Bonds” transaction closed in January 1997, with Pullman's involvement when he was at Fahnestock & Co. Prudential Insurance purchased the bonds for $55 million.

In his complaint, Pullman alleged, among other things, that RZO entered into an oral agreement with Fahnestock to form a joint venture to securitize the royalty streams of other musical artists. But Pullman claimed that Fahnestock disclosed trade secrets to Prudential, which then formed a joint securitization venture with RZO that excluded Fahnestock.

The Manhattan Supreme Court dismissed an earlier complaint by Pullman on the ground that he lacked standing to sue because the alleged trade secrets were owned by Fahnestock. The New York Appellate Division affirmed. Pullman Group L.L.C., v. Prudential Insurance Co. of America, 288 A.D.2d 2, 733 N.Y.S.2d 1 (2001). After obtaining an assignment of trade secrets from Fahnestock, Pullman refilled his complaint alleging causes of action based primarily on his alleged trade secrets rights.

A trade secret gives one a competitive advantage over others who do not know or use the secret and are engaged in similar business pursuits. Pullman claimed that his trade secrets included computer programs, cash-flow-analysis grids, valuation models, interest-payment-sensitivity analyses, legal opinions, and databases of potential rights owners and investors.

In its most recent ruling, the Manhattan Supreme Court noted that articles and lectures by Pullman, as well as third-party articles, had disclosed some of the information that Pullman claimed was protected. Supreme Court Justice Ira Gammerman went on to state, “Neither the complaint, nor plaintiff's responses to defendants' discovery demands nor the instant motion papers have revealed the alleged formula. To a large extent, plaintiff appears to have plugged in numbers using pre-existing software programs, such as Microsoft's Excel spreadsheet program. I conclude that plaintiff does not possess any unique formula, and that David Pullman did nothing more than apply his business expertise to the analysis of numbers by means of previously known techniques.”

“Moreover,” Gammerman continued, “I agree with defendants that even if there had been a trade secret created in connection with the Bowie Transaction, Gruntal, Fahnestock or Pullman could not lawfully have used those trade secrets in other transactions without the consent of David Bowie. Furthermore, even if there were trade secrets and plaintiff had the lawful right to use them in other bond transactions, plaintiff has failed to specify a single bond transaction in which defendants allegedly used the trade secrets in derogation of plaintiff's rights. In other words, plaintiff has not shown that any of the defendants … have engaged in a single bond transaction in which bonds were secured by music royalties or were created using the alleged trade secrets.”

A securitization is a process whereby an individual or entity pools the right to future payments that it is owed, and sells this right as a security. The first individual to capitalize on the concept of securitization of intellectual property (IP) assets was musician David Bowie. He issued a bond offering backed by his copyright royalties in 25 of his albums comprising approximately 250 songs. Although industry experts expected a flood of music rights securitizations following the launch of the “Bowie Bonds” in 1997, this did not come to pass. However, securitization as a concept is not limited to just music copyright royalties. Any IP right with a proven revenue stream could be used as the underlying asset in a securitization. Therefore, there is a huge potential for extending the concept of IP securitizations to other areas of the entertainment industry.

Securitization of IP rights can offer a variety of financing and economic opportunities. One of the major advantages is that it allows the issuer of the security to raise money at a much lower cost than that of other conventional means of financing. There are several other benefits of securitization of IP rights as well. Among these are an immediate tax-free infusion of capital, diversification of assets and the fact that the issuer regains ultimate control over the asset following expiration of the term of the issuance. In addition, a New York court recently ruled that how the Bowie Bonds were accomplished was not a protectible trade secret. (See Bowie Bonds Formula Not Protectible).

Special Purpose Vehicle

The securitization process begins when the owner or “originator” of the IP rights sells them to a company, known as a “Special Purpose Vehicle” (SPV), specifically set up to hold the IP rights in return for an upfront cash payment to the originator. In order for this transfer of rights to be effective it must be considered a “true sale” for bankruptcy purposes. The requirements of a “true sale” are not set in stone, but generally require that the originator fully divests itself of the asset and does not retain control over its use or distribution. The SPV then issues securities creating an interest in favor of the parties who purchase the security. The SPV uses the monies raised by the issuance of the securities to pay off the debt that it incurred when it purchased the IP rights from the originator. The SPV continues to exist over a period of years for the purpose of making distributions to the holders of the securities, in accordance with the offering.

The main reason the SPV is used is to protect the IP assets from the creditors of the originator. By utilizing a “true sale” the IP asset would not be included in the originator's estate for bankruptcy purposes and therefore the security holder's interest in the revenue stream is protected from claims by the originator's potential creditors. Moreover, since the SPV is set up merely to hold the IP asset during the term of the security, it is very unlikely that it will ever become bankrupt itself. In cases where the investors still fear the possible insolvency or default of the SPV, a credit enhancement can be used, which may take the form of insurance or the creation of a reserve fund to cover payments to investors.

There are several forms of security that an SPV can issue. The most common takes the form of a debt instrument. If the SPV issues debt instruments, then it acts as a “pay-through” entity because holders of the debt instrument receive a set payment. This fixed payment is based on the anticipated cash flow that was determined at the time the debt instruments were offered for sale. Moreover, the life of a debt instrument is generally limited to the term of the offering, unless it is retired early. An SPV could also theoretically issue securities in the form of an equity (ie, stock). If an SPV issued equity securities, it would serve as a “pass-through” entity because the security holders receive payments from the cash flow that are proportionate to the amount of the securities that they hold. While the concept of an SPV issuing equity instruments is possible, it would change the nature, terms and benefits of the offering to such an extent that it would be unrecognizable from that of a debt offering. As such, while there would still be similarities to the structure and benefits of issuing debt and equity instruments, we'll focus on IP securitizations utilizing the debt instrument model.

The benefits to the originator of a securitization are potentially numerous. Instead of waiting for royalty payments from the IP assets to come in over many years, the originator receives an immediate lump sum payment. An originator can also obtain greater amounts of cash through a securitization than by a bank loan, because banks will seldom loan more than a small portion of a potential income stream. A debt instrument securitization can also provide a defined fixed rate of interest payments to be made as opposed to the uncertain fluctuation in interest rates inherent in a bank loan. Furthermore, unlike a bank loan, no personal guarantee is required in a securitization because notes are nonrecourse as to the originator. Because the securitization is considered a financing (ie, loan) and not a sale of the IP rights, taxes are not paid on the amount raised by the offering. Therefore, the originator gets a large infusion of capital and does not have to pay taxes until royalties are actually generated over subsequent years. There can also be other tax benefits depending on how the originator uses the money it raised.

Perhaps the greatest benefit to the originator is that it retains ownership of the IP rights. As opposed to selling the IP rights, which permanently divests the originator of its rights, at the end of the term of the debt instrument securitization the originator's rights in the underlying IP revert back. The originator can then choose the best manner to fully exploit these rights which may mean again arranging a securitization. Moreover, if the revenue from the IP income stream is greater than expected the security can be retired early by making full payments to the holders and the originator regains its IP rights earlier than originally expected.

Critics have raised concerns about the continued usefulness of securitization of IP rights following the Bowie Bonds. But the arguments that have been made relate mainly to the specific problems that arise in the music royalties context and not in other forms of IP rights. In the context of music royalties, there are only a few individuals that have the consistent revenue stream necessary for a securitization and these individuals may not require the infusion of cash that this type of financing creates. Moreover, the varied nature of copyright ownership that exist in music, much of which is often held jointly or separately by many different parties, has made the original Bowie Bond a difficult act to follow.

Pooling of Rights

To overcome the hurdle of the limited number of entities that have IP rights that produce a yearly seven-figure revenue stream, securitizations can be founded on a pool of IP rights. Bundling several smaller revenue streams will create the necessary elements and may eliminate the problem of various entities owning a portion of the IP rights. In using this technique, several members of a band could pool their individual rights and issue a security, when none of the members have individual rights that would be sufficient. Furthermore, pooling could be used to create a fund that embodies IP rights in several different disciplines. Writers and actors could pool their rights with musicians and designers to create a basis of revenue founded on many different types of IP rights. This would provide a greater source from which to obtain these assets and protect the underlying revenue stream from one particular individual or entity loosing public favor and its revenue stream drying up. Diversification of IP assets would also act to widen the potential investor pool and move these securitizations out of one particular niche.

In fact, some of the flaws and problems inherent in the securitization of music royalty rights do not exist to the same extent when contemplating the use of other IP rights. Actors, producers, writers and studios all have rights that can be the basis of a securitization. Many Hollywood actors receive a percentage of the income a movie or television show generates in return for their services. This income may continue long after the move has left the theater or the show has left the TV airwaves. Film and TV studios have extensive libraries of past films and shows that generate a significant amount of yearly income through licensing. The same potential exists for an author or a publishing house concerning rights to publishing royalties. An author could securitize his or her rights in a successful series of books or a publishing house could bundle the works of several authors to create a more diversified pool of IP assets. Certainly, the potential to bundle various IP interests to form the basis of a securitization is vast.

Sidebar: Bowie Bonds Formula Not Protectible

The Manhattan Supreme Court has held that the methodology used to complete the securitization of musical artist David Bowie's future royalties ' the first such securitization ' didn't constitute a protectible trade secret. Pullman Group LLC v. Prudential Insurance of America, 600772/01.

The suit was filed by David Pullman, who claimed that while at the securities firm Gruntal & Co., he developed concepts for issuing bonds secured by music royalties and then approached Bowie's management representatives, the Rascoff/Zysblat Organization (RZO). The “Bowie Bonds” transaction closed in January 1997, with Pullman's involvement when he was at Fahnestock & Co. Prudential Insurance purchased the bonds for $55 million.

In his complaint, Pullman alleged, among other things, that RZO entered into an oral agreement with Fahnestock to form a joint venture to securitize the royalty streams of other musical artists. But Pullman claimed that Fahnestock disclosed trade secrets to Prudential, which then formed a joint securitization venture with RZO that excluded Fahnestock.

The Manhattan Supreme Court dismissed an earlier complaint by Pullman on the ground that he lacked standing to sue because the alleged trade secrets were owned by Fahnestock. The New York Appellate Division affirmed. Pullman Group L.L.C., v. Prudential Insurance Co. of America , 288 A.D.2d 2, 733 N.Y.S.2d 1 (2001). After obtaining an assignment of trade secrets from Fahnestock, Pullman refilled his complaint alleging causes of action based primarily on his alleged trade secrets rights.

A trade secret gives one a competitive advantage over others who do not know or use the secret and are engaged in similar business pursuits. Pullman claimed that his trade secrets included computer programs, cash-flow-analysis grids, valuation models, interest-payment-sensitivity analyses, legal opinions, and databases of potential rights owners and investors.

In its most recent ruling, the Manhattan Supreme Court noted that articles and lectures by Pullman, as well as third-party articles, had disclosed some of the information that Pullman claimed was protected. Supreme Court Justice Ira Gammerman went on to state, “Neither the complaint, nor plaintiff's responses to defendants' discovery demands nor the instant motion papers have revealed the alleged formula. To a large extent, plaintiff appears to have plugged in numbers using pre-existing software programs, such as Microsoft's Excel spreadsheet program. I conclude that plaintiff does not possess any unique formula, and that David Pullman did nothing more than apply his business expertise to the analysis of numbers by means of previously known techniques.”

“Moreover,” Gammerman continued, “I agree with defendants that even if there had been a trade secret created in connection with the Bowie Transaction, Gruntal, Fahnestock or Pullman could not lawfully have used those trade secrets in other transactions without the consent of David Bowie. Furthermore, even if there were trade secrets and plaintiff had the lawful right to use them in other bond transactions, plaintiff has failed to specify a single bond transaction in which defendants allegedly used the trade secrets in derogation of plaintiff's rights. In other words, plaintiff has not shown that any of the defendants … have engaged in a single bond transaction in which bonds were secured by music royalties or were created using the alleged trade secrets.”