that does not create unnecessary problems for those who perceive

none.

[The prepared statement of Ms. Montgomery follows:]

PREPARED STATEMENT OF SUSAN BARBIERI MONTGOMERY, ATTORNEY AT LAW, FOLEY, HOAG & ELIOT, LLP, AND G. LARRY ENGEL, ON BEHALF OF THE AMERICAN BAR ASSOCIATION

Chairman Coble, Members of the Subcommittee:

Thank you for the invitation to testify at today's oversight hearing on intellectual property security_registration. The views we are expressing today represent those of the Section of Intellectual Property Law and the Section of Business Law of the American Bar Association. These views have not been approved by the House of Delegates or Board of Governors of the ABA, and, accordingly, should not be construed as representing the position of the Association as a whole.

We understand that one of the matters the Subcommittee will be examining this afternoon is a legislative proposal prepared and presented to you for your consideration by our two Sections of the ABA, a copy of which is attached. As co-chairs of a Joint Task Force that worked on behalf of the two Sections to develop this proposal, we appreciate the opportunity to appear before the Subcommittee to explain and speak on behalf of our proposal. We believe that this is an important law reform effort to facilitate secured financing, to clarify legal issues adversely impacting commerce, and to ensure uniform treatment of intellectual property security consistent with reasonable business practices.

Our names are G. Larry Engel and Susan Barbieri Montgomery. In addition to co-chairing the Joint Task Force, Larry Engel is also the Chair of the ABA Business Law Section's Ad Hoc Committee on Security Interests in Intellectual Property, and speaks for the Business Law Section from the perspective of commercial lawyers and clients. Business Law Section participants on the Task Force represent a wide range of Committees, such as the Uniform Commercial Code Committee, the Business Bankruptcy Committee, the Commercial Financial Services Committee, the Banking Committee, the Corporate Counsel Committee, the Corporate Practice Committee, the Cyberspace Law Committee and others. Susan Barbieri Montgomery is the chair of the ABA Intellectual Property Law Section's Committee 457, and she speaks for the Intellectual Property Section from the perspective of intellectual property lawyers and their clients, including those whose practices focus on patents, trademarks, copyrights, computer chip mask works, and trade secrets. The diverse perspectives and experiences of the two areas of specialty have been synthesized in the ABA proposal.

In order to facilitate the financing on desirable terms that is needed to fund the operations and growth of U.S. businesses, it is necessary for many businesses to borrow on a secured basis, often using all of their assets as collateral. In the technology development environment, intellectual property collateral may also be needed to secure other types of performance obligations. For technology companies, a bundle of intellectual property may be the only available significant asset. Încreasingly, for all types of American businesses, intellectual property assets are a valuable part of any collateral package.

In order to satisfy the needs of commercial lenders and other parties, a security interest in collateral must be capable of certain and cost-effective "perfection," so that the lender can establish its priority over subsequent lenders and the lender's security interest is not avoidable in the event of the bankruptcy of the borrower. See Bankruptcy Code §§ 544, 547. It is also necessary for a financier to be able to quickly and inexpensively verify the borrower's ownership and the priority of the security interest in comparison to any competing interests and transfers. Unfortunately, in the case of intellectual property collateral, the certainty and predictability required for such financing have been impaired by varying treatment in the different Federal statutes and by several controversial court decisions (discussed below). These problems are addressed and, we believe, resolved by the proposed legislation we have submitted. In addition, related reforms in the ABA proposal facilitate financing by implementing better practices involving notice filings, availability of records and other process changes (e.g. elimination of the uncertainty created by current "lookback" periods for recording of intellectual property transfers) to expedite transactions.

While parallel law reform efforts have been undertaken at the State level with respect to security interests and notice filings pursuant to the Uniform Commercial Code, the Federal intellectual property laws and filing processes have not evolved in a consistent manner. This difference exists in part because the Federal intellec

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tual property laws were designed to focus on absolute transfers of ownership, rather than upon security interests. These issues have been studied for years by the Joint Task Force, but the need for reform has accelerated because of financing realities of increasing importance for all types of businesses, whether or not considered technology companies. Every company has trademarks and trade secrets, and most now also have copyrights, although the latter are most commonly not registered. Many companies also have interests in patents and other types of intellectual property. While intellectual property is normally addressed as a part of a collateral package that includes the borrower's other assets, a problem arising with respect to the intellectual property collateral can prejudice the quality and value of the other types of conventional collateral. For example, even a lender who is primarily lending against the borrower's accounts receivables and inventory can be severely prejudiced if the lender's security interest in intellectual property is problematic. Consider, for example, the fate of a lender whose inventory collateral is copyrighted or trademarked, if the lender cannot maintain an effective security interest in such intellectual property. This is the principal focus of the Commercial Finance Association's "quick fix" for copyrights. While the CFA proposal appropriately addresses the copyright part of the problem, that narrow copyright solution may not eliminate some broader problems created by cases like Avalon Software, discussed below, which affect patents and trademarks as well.

Similarly, the lender can be disappointed if the revenue from the licensing or sale of the borrower's products is deemed to be avoidable "proceeds" of an unperfected security interest in the underlying intellectual property. As noted below, some controversial court decisions would make it legally impossible to preserve in the borrower's bankruptcy a security interest in the borrower's unregistered copyrights and their "proceeds". Such courts have defined "proceeds" to include certain ordinary revenue from disposition of the products in the borrower's inventory (e.g., revenue from the sale of hardware products is treated in part as proceeds of the unregistered copyrights in software or licenses included with the products).

These problems frustrate financing and create unnecessary risks, which decrease the availability of cost-effective financing for companies on desirable terms. Lenders (and other secured parties to technology transactions) are often either hesitant to extend credit secured by intellectual property assets or they devalue the asset to reflect the uncertainty and risk associated with this type of collateral. This problem is especially serious for software companies, whose unregistered copyrights and license revenue raise the most difficult issues under the controversial court decisions. However, since the Supreme Court has confirmed that copyrights apply to marketing materials including product packaging (e.g. shampoo labels), almost every business has unregistered copyrights at issue. Under the controversial bankruptcy court decisions described below, the lenders risk the loss of the value allocated by the bankruptcy court to at least their copyright collateral and its proceeds. Because such collateral is typically interdependent and integrated with other collateral, such bankruptcy allocations between perfected collateral and avoidable collateral impose unnecessary litigation risks and uncertainties.

As one court recently observed in invalidating a trademark security interest that was not perfected under the applicable State version of the Uniform Commercial Code,

It is, of course, unfortunate that the trademark statute is sufficiently vague to require judicial interpretation. This produced the understandable mistake made here. Security interests in patents present the same difficulty. . . . Not even the copyright statute is totally consistent with the Uniform Commercial Code. All three statutes should be amended to place them in better harmony with the Code. . . . (emphasis added).

In re Together Development Corp., 227 B.R. 439, 442 (Bankr. D. Mass. 1998).

CONTROVERSIAL COURT DECISIONS IMPACTING SECURITY INTERESTS

The Federal copyright, patent and trademark statutes provide systems for recording ownership and transfers of interests in the different types of Federal intellectual property. Over many years of continuous law reform efforts, the Uniform Commercial Code ("UCC") has created a cost-effective and uniform system of "perfecting" (and establishing priority among) security interests in most types of assets by means of a simple notice filing. Under any reasonable interpretation of the existing law, this system governs at least security interests in trade secrets and state trademarks and their associated "goodwill." Most experts contend that the UCC also governs the perfection of security interests in Federal trademarks and patents, consistent with all but one of the relevant court precedents, because those Federal laws

deal with transfers of ownership, as opposed to security interests. See, e.g., (trademarks) In re Roman Cleanser Co., 802 F.2d 207 (6th Cir. 1986); In re 1992 Z Inc., 137 B.R. 778 (Bankr. C.D. Cal. 1992); In re Topsy's Shoppes, Inc. of Kansas, 131 B.R. 886 (D. Kan. 1991); In re Chattanooga Choo-Choo Co., 98 B.R. 792 (Bankr. E.D. Tenn. 1989); In re TR-3 Industries, 41 B.R. 128 (Bankr. C.D. Cal. 1984); (patents) City Bank and Trust Co. v. Otto Fabric, Inc., 83 B.R. 780 (D. Kan. 1988); Chesapeake Fiber Packaging Corp. v. Sebro Packaging Corp., 143 B.R. 360 (D. Md. 1992); In re Transportation Design and Technology, Inc., 48 B.R. 635 (Bankr. S.D. Cal. 1985); Holt v. United States, 73-2 U.S.T.C. 19680 (5th Cir. 1973). The core of the problem addressed by the proposed legislation arises from several related, controversial court decisions, commencing with In re Peregine Entertainment, Ltd., 116 B.R. 194 (C.D. Cal. 1990). See In re AEG Acquisition Corp., 161 B.R. 50 (9th Cir. BAP 1993); In re Avalon Software, Inc., 209 B.R. 517 (Bankr.D. Ariz. 1997); The Clorox Co. v. Chemical Bank, 40 U.S.P.Q. 2d 1098 (1996).

Clearly, in the modern world the borrower's products will often involve an interaction among all types of intellectual property, such as, for example, a patented hardware product with a valuable trademark that operates using software involving registered or unregistered copyrights and that is produced with the use of valuable trade secrets. If one part of that lender's security interest in that integrated bundle of rights (e.g. the copyrights) is unperfected and therefore becomes avoidable in bankruptcy, then a wholly artificial allocation of value must occur among the functionally inseparable components of a unitary product and its proceeds.

Indeed, even a pure software product may create complex value allocation problems, since the software product typically involves far more than copyrights on the source and object codes, but can also involve trade secrets and patents, as well as trademarks. There is no clear, consistent system for establishing the priority of the secured party's interest in a technology product or process that combines different types of intellectual property. Because many financiers margin the amount of credit that they extend to their borrowers against the reliable value of their perfected and nonavoidable collateral, uncertainty about intellectual property collateral unnecessarily reduces the credit available to borrowers. This problem is particularly acute in the technology development environment, where the developer faces great difficulty in obtaining credit until its technology is sufficiently developed to permit registration under the Federal systems.

The least controversial of several debated holdings of these controversial cases is that a trustee in bankruptcy can avoid a security interest in registered copyrights, if the secured party fails to record the security interest in the Copyright Office. See Bankruptcy Code $8544, 547. At least one court and many (but not all) experts would also agree that existing law creates that same result for unregistered copyrights, although this interpretation means that it is legally impossible to perfect a security interest in unregistered copyrights. Thus, in many cases (especially involving software) friction arises between lenders and borrowers over whether to depart from the borrower's rational industry practice of not registering many types of copyrightable material that the borrower owns.

However, even when the copyright owner elects to register its copyrights in the Copyright Office so that it is possible for the lender to perfect its security interest, the result is imperfect. In many cases the borrower regularly creates derivative works that upgrade the copyrighted work, which derivative works would, therefore, require frequent and burdensome supplemental registrations and security filings for the protection of the lender under current copyright law. Even where such supplemental registrations and security filings occur, the lender may still be at risk as a result of the 90-day preference exposure under Bankruptcy Code §547.

An even more controversial decision in those disputed court cases is that certain revenue from the borrower's products constitutes "proceeds" of intellectual property. For example, license royalty payments on software operating a product sold by the buyer could be deemed "proceeds" of a copyright. If the security interest in the copyright is avoidable in bankruptcy, then so is the security interest in such proceeds. This is disputed by most legal experts, who would focus instead on the UCC status of such revenue as, for example, an "account" or "general intangible" (see UCC §9106) or as proceeds of the "inventory" being sold by the borrower (see UCC §§ 9306, 9109). There are some supporting court decisions for that UCC interpretation. See, e.g., Broadcast Music, Inc. v. Hirsch, 104 F.3d 1163 (9th Cir. 1997).

In any event, unless the lender's only collateral is a bare copyright license by itself (an increasingly smaller percentage of the total transactions in many industries), this "proceeds" issue creates uncertainty and allocation disputes. În many transactions, the revenue at issue arises from a single price paid by the customer for a combination of a trademarked or patented hardware product and licenses of various kinds of intellectual property, including software copyrights. Indeed, as a re

sult of the Supreme Court's confirmation of copyright protection for shampoo labels as recognized in Quality King Distributors, Inc. v. L'anza Research International, Inc., 523 U.S. 135, 118 S.Ct. 1125, 140 L.Ed. 2d 254 (1998), a portion of the accounts receivable from the sale of even "low tech" inventory could be argued under the disputed Peregrine theory to be proceeds of a copyright.

However, the ultimate intellectual property "heresy" is evidenced by the bankruptcy court's decision in In re Avalon Software, Inc., where the court appeared (without citing authority or offering an explanation) to "deperfect" and avoid what experts would have considered to be nonavoidable perfected security interests in trademarks, trade secrets, and software related licenses, contracts, and inventory (.e.g, user manuals, documentation, etc.). In effect, because the lender was unable to perfect the security interest in the bankrupt software company's copyrights, the lender lost the core of its tangible and intangible software-related collateral, even though the lender's interest in everything but the copyright was properly perfected under the UCC. In effect, the Court dodged the difficult allocation issue for splitting the value of the debtor's assets between (1) the software-related copyrights, and (2) everything else, by treating all of the software related assets as if they were somehow merged into the unperfected copyrights and, therefore, as also avoidable by reason of their association with the avoidable copyright security interest. The fact that the unprecedented Avalon theory is widely deemed to be incorrect by legal experts does not prevent that theory from now being regularly argued by trustees in bankruptcy across the country. While the Avalon aberration may be extreme, it illustrates why reform is essential.

We perceive no compelling policy or legal reason for making it legally impossible to perfect security interests in unregistered copyrights, or even in making it impractical to perfect security interests in registered copyrights. While some parties still attempt to address these problems by using documentation which is in form an absolute assignment of rights to the borrower's intellectual property (but is intended to be a security interest), the results can be very disappointing. See, e.g., The Clorox Co. v. Chemical Bank, 40 U.S.P.Q. 2d 1098 (1996) (transfer of rights in trademarks prior to actual registration and use is void where the secured creditor describes the transfer as an assignment rather than a security interest); Haymaker Sports Inc. v. Twain, 581 F.2d 257, 261 (CCPA 1978) (voiding an assignment under the "assignment in gross" doctrine). Proper treatment of security interests should eliminate the need to accept the risk of such results.

OTHER DESIRABLE REFORMS

The desire for certainty and uniformity with respect to the filing requirements for security interests in intellectual property goes far beyond borrowers and lenders. Clearly, many parties to commercial transactions besides traditional lenders have an interest in obtaining security interests to secure obligations of their counter-parties, including because they wish to receive the increased protections available to secured creditors in the event of the counterparty's bankruptcy. Moreover, licensees, licensors, purchasers, venture partners and other parties to strategic transactions also have an interest in being able to determine the nature and extent of competing security interests, encumbrances and other interests in intellectual property. While some transactions may only involve one type of intellectual property, increasingly multiple intellectual property rights are involved in transactions, so that lenders and others have become accustomed to searching in both state UCC filing offices and Federal registries. The burden of UCC filing and searching is not as significant as one might expect, since intellectual property is classified as "general intangibles" under UCC §9106, which need only be filed in one state under UCC §9103, not in every state where the borrower does business.

The current search process is, however, complicated by the existing "lookback" provisions under Federal intellectual property laws. These provisions require parties desiring timely closing of their transactions to assume the risk of the existence of a preceding transfer of intellectual property rights that is not yet submitted for recordation. Other complications for the due diligence process of evaluating title to intellectual property collateral under current law include varying requirements and documentation among the copyright, patent and trademark laws, as well as gaps in the records.

Given the present uncertainties, the current practice of many lenders and secured parties is to undertake dual filings: one UCC filing in the applicable state system UCC §§ 9103, 9401), together with filings in the Patent & Trademark Office for patents and trademarks and in the Copyright Office for registered copyrights and mask works. (As noted above, there is no present ability to file a security interest in the Copyright Office for unregistered copyrights, and software developers and various

other copyright owners are reluctant for costs or competitive business reasons to register all their copyrights.) The ABA proposal is consistent with that practice, with the state UCC filing perfecting the lender's security interests (and making it nonavoidable by the trustee in bankruptcy), while the Federal filing establishes priority as compared to subsequent transfers of ownership interests in the applicable Federal intellectual property.

State UCC notice filings to perfect security interests are preferred not just by lenders but by many secured parties for various reasons, including:

1. The UCC permits "floating" liens on all intellectual property of the owner, whether now existing or hereafter arising. This floating lien does not exist under Federal intellectual property law, thus, for example, creating the copyright burden described above with respect to the requirement of separate filings for each new derivative work.

2. Instead of the separate filing requirements under Federal law for each new copyright, trademark or patent, UCC notice filings can be done by general descriptions of the covered collateral, even in advance of the closing of the transaction (e.g., a security interest in all general intangibles, including all patents and applications of the debtor, now existing or hereafter arising.) 3. Instead of indexes by registration number in the Copyright Office, UCC searches can be conducted in the applicable state by reference to the debtorowner's name.

4. After decades of encouragement from commercial users, the UCC filing and search reporting systems are comparatively quick and cost effective to use, without a transaction-delaying "look back period" as exists under the Federal intellectual property laws.

The law reform contemplated by the ABA proposal introduces many of these desirable features in the proposed Federal filing system for security interests in intellectual property..

THE PROPOSED LEGISLATION IMPLEMENTS ABA JOINT TASK FORCE RECOMMENDED

REFORMS

After years of study and consultation with many client constituents of the ABA Business Law Section and Intellectual Property Law Sections, the ABA Joint Task Force has made the following recommendations:

• The establishment of a "Mixed Approach" of Federal and state law to govern recordation of security interests in intellectual property. Under this mixed approach, recordation in the relevant Federal agency of security interests in intellectual property governed by federal law would establish the secured party's priority with respect to subsequent bona fide purchasers for value and all other subsequent transferees of ownership interests, excepting only security interests. Recordation of security interests in all intellectual property in the relevant state agency under Article 9 of the Uniform Commercial Code would perfect the security interest and establish priority as against other secured parties and lien creditors.

• Provision for utilization of the same type of notice filing in the federal agencies with respect to security interests as in state agencies under the Uniform Commercial Code. This would be accomplished by amendment of the patent, trademark, copyright and mask work laws and rules to permit recordation in the respective federal agencies of notices of security interests with respect to debtors, without requiring specific identification of the properties securing the debt and without requiring recordation of the security agreement itself. Substantially the same form of notice filing as is currently employed under the Uniform Commercial Code could be utilized in the federal filing,

• Permitting the notice filing of security interests to apply to "after-acquired" intellectual property of debtors.

Making the Federal agency records concerning title to and security interests in intellectual property more useful by eliminating or substantially reducing the period for recordation of documents. This would be accomplished by amendment of the patent, trademark, copyright and mask work laws to substantially reduce the “lookback" periods for recordation of documents concerning title to and security interests in intellectual property, and requiring prompt recording and indexing by the federal agencies.

Encouraging the establishment of an electronic filing system. This would reduce the agencies' burden of handling and recording security interests and fa