the work has been created and remain protected throughout the process of development. • To accomplish this, the Copyright Act should allow filings with constructive notice effect against interested parties ("author/person index") as well as against a work. The person and work files can then be related through a relational database. This is a common approach in industry. For example, telephone contact databases ("electronic Rolodexs") are done this way. • The records should permit online, electronic filings, searches, and payment. The system also should provide filers and searches contemporaneous verification against existing records to limit typographical errors, as well as substantially immediate confirmation of filings and priority. Priority Rules-The Copyright Act must clearly define the boundaries of federal preemption of the state filing systems. • A federal filing should be required and sufficient for any transaction in which a lender attempts to acquire a security interest in a right to exercise any of the exclusive rights protected by the Copyright Act. That should be true whether the right is granted by the owner of the copyright or by some party acting under an exclusive license from the copyright owner. • A federal filing should not be required for a transaction involving trans- The 30-day and 60-day grace periods in Copyright Act Section 205(d) To: Fr: MEMORANDUM-JUNE 20, 1999 Joint Task Force of Security Interests in Intellectual Property Ad Hoc Committee on Security Interests (Business Law Section) Committee 457 (IP Section) Lorin Brennan Proposed Federal Intellectual Property Security Act EXECUTIVE SUMMARY This Memo comes in response to the fax of November 19, 1998 containing the Revised Draft of the Proposed Federal Intellectual Property Security Act. In essence, the Revised Draft continues to propose a mixed system in which federal law determines priority for the intellectual property rights, but state law determines priority with respect to royalties ("proceeds"). I led the coalition of banks, copyright owners and labor organizations that opposed this proposal when it was suggested to Congress several years ago. I also voted against the proposal in Committee 457 last year. My opinion has not changed. My objection to a "mixed system" is not that it is difficult to make such a system work; it can not work. A "mixed system" is based on a flawed data design. It will invariably lead to data anomalies, including circular liens and searching conflicts. A correct approach requires implementing a relational data model in a unified federal system with constructive notice from both the author ("entity") index and work ("object") index. The following Memo describes these issues in detail. ANALYSIS A. Why a Mixed System Will Fail Section (b)(2) of the Proposed Federal Intellectual Property Security Act contains the basic "mixed system" approach regarding what it calls "Federal IP Rights," e.g., copyrights, trademarks and patents. Under subsection (A), ". . . the priority of a security interest in Federal IP Rights or the proceeds thereof relative to all competing rights, claims and interests therein and licenses thereof" is determined by "non-federal law governing security interests in personal property," presumably Article 9 of the Uniform Commercial Code, as currently existing or as revised. As an exception, under subsection (B), a security interest in a Federal IP is "ineffective against the buyer1 of the Federal IP Right who properly recorded the document transferring ownership of the Federal IP Right to such buyer . . . before a federal financing statement. . . was filed." In other words, prior filing of a federal financing statement is effective against a subsequent transferee with regard to the rights but not the proceeds. Let us see how this would work in practice. 1. First Problem: Circular Liens Assume Copyright Owner grants a security interest to Lender A in a work and its proceeds. Lender A duly records a federal financing statement in the Copyright Office, but no where else. Seeing this, Copyright Owner grants a second security interest in the same work and its proceeds to Lender B, who only records in the state offices. Lender A forecloses and transfers its entire interest to BFP1, a bona fide purchaser without actual notice of Lender B's state recording. We can graphically illustrate this example as follows: Copyright Owner Records federally Records in State Lender A BFP1 Lender B (Proceeds) Now, what are the rights of BFP1 vis-à-vis Lender B? In particular, is BFP1 required to pay any royalties ("proceeds") to Lender B? Asked another way, if BFP1 refuses to pay royalties to Lender B, what remedies does Lender B have? There are two possible results. Case 1: BFP1 takes free and clear of the obligation to pay royalties to Lender B. That means when BFP1 exploits the work and earns income, for example by selling copies or making further sublicenses, BFP1 does not owe any payments to Lender B. The argument in favor of this approach is that BFP1 now has legal ownership of the work, and one of the basic incidents of legal ownership is the right to turn it to account. If this is the result, then Lender B did not gain much by making a state recording for the proceeds only. If a transfer to a bona fide purchaser who does not have actual knowledge of the state recording cuts off the right to proceeds, then Lender B would be well advised to record federally as to the rights as well. Case 2: BFP1 takes subject to the obligation to pay royalties to Lender B. In other words, BFP1 still gets the rights, but now must pay a portion of any income to Lender B to pay off the debt. The theory here is that BFP1 has constructive knowledge of the state recording by Lender B.2 But if that is the case, then BFP1 will 1 There is no concept of a "buyer" as such in current federal law. The Proposed Federal Intellectual Property Security Act essentially defines a "buyer" as any transferee of IP rights. Under current law, assignments and exclusive licenses are assignable, while non-exclusive licenses are not. Moreover, there is no federal recording system for non-exclusive copyright licenses. As a result, it may be appropriate to treat non-exclusive licenses differently. 2 We discuss why this assumption of constructive knowledge is not always reasonable in the next section. certainly discount its bid in the foreclosure sale based on the obligation to Lender B. That means that if Lender A wants to ensure it gets full value upon a foreclosure, it had better record in the state as well. We have discussed the example in terms of a bona fide purchaser (technically, a bona fide transferee) at a foreclosure sale, but the same reasoning applies to a bona fide transferee from Copyright Owner as well. Three observations come from this example. First, the cases are not reconcilable. You get one or the other, but not both. Second, the Proposed Federal Intellectual Property Security Act does not tell us which result is correct.3 In other words, we will have more litigation over which system prevails in case of conflict. Third, the only secure approach for either Lender is to record in both places, federal and state. Whether such a dual filing system does anything more than create a trap for the unwary will be discussed below. 2. Second Problem: Incompatible Obligations Assume the same example as in the previous case, only this time Lender B forecloses first and transfers its entire interest to BFP2, a bona fide purchaser without actual notice of Lender A's federal recording. We can graphically illustrate this example as follows: Copyright Owner Records federally Records in State Lender A Lender B BFP2 Now, what are the rights of BFP2 vis-à-vis Lender A? In particular, is Lender A required to direct any payments it receives from Copyright Owner to BFP2? Asked another way, if Lender A refuses to do so, what remedies does BFP2 have? Again, there are two possible cases. Case 1: Lender A is required to direct payments to BFP2. In this case, the payments would have been royalties and other income earned by Copyright Owner from exploiting the work, which could have been paid to Lender A either directly by Copyright Owner's licensees or through Copyright Owner. The theory is that BFP2 by the foreclosure now "owns" such royalties. If this is the result, then Lender A did not get what it thought it was getting by making a federal recording for the rights only. If Lender B's transfer to a bona fide purchaser who does not have actual knowledge of the federal recording cuts off the right to proceeds, then Lender A would be well advised to record in the state as to the proceeds as well. Case 2: Lender A is not required to direct payments to BFP2. The theory here is that the royalties come from exploitation of the work by Copyright Owner. If Lender A is deprived of the royalties, then it can foreclose for non-payment and take the work, in effect putting us back in the first situation discussed above. Again we are faced with the question: if Lender A (rights branch) refuses to pay royalties, then what remedy does BFP2 (proceeds branch) really have? BFP2 cannot foreclose on the income-earning asset (the rights), because it does not own them. In such a case, BFP2 will also certainly discount its bid in the foreclosure sale based on the obligation to Lender A, meaning that if Lender B wants to ensure it gets full value upon a foreclosure, it had better record federally as well. As in the first situation, the Proposed Federal Intellectual Property Security Act does not indicate which case prevails, so the cautious lender would be well advised to record in both the federal and state registers. Once again, the same reasoning applies if Lender A is a licensee. As these examples illustrate, a dual filing system that splits works from royalties is unstable. Invariably one system must swallow the other. 3 The same arguments as were made in Peregrine and AEG would argue for the first approach, meaning that the proposed legislation accomplishes little, if anything. 3. Third Problem: Searching As the previous examples illustrate, the only rational approach for a secured creditor under the Proposed Federal Intellectual Property Security Act is to file in both the state and federal registers. This actually makes matters worse. The sine qua non for filing is to perfect the security interest and thus obtain priority over other creditors, especially a trustee in bankruptcy. Under current law, one filing in one forum, such as filing in the Copyright Office, is sufficient. Requiring two filing now creates a trap for unwary creditors, who may find themselves unperfected as to a critical aspect of their security. Rights and royalties go hand in hand; to separate them for filing purposes invites potential disaster. Separation also creates a considerable problem when it comes to searching. A secured creditor wants to locate all prior security interests in the collateral. Under current law, that requires, at least for copyrights, one search in the Copyright Office with regard to the work. The Proposed Federal Intellectual Property Security Act would now require two searches, one at the federal level for the rights, and another at the state level for proceeds. Such a search becomes enormously difficult for many copyrighted works, often requiring searches of numerous potential debtors whose domiciles are unknown. To understand why this is so, we need to look at two different concepts of how financing of intellectual property occurs. We may term them "inventory financing" and "asset financing." Inventory Financing: In inventory financing, the creditor seeks a floating lien over all the assets of the debtor. Physical objects ("goods") come into and move from the debtor's business, and the lien attaches as the goods enter, and is released in favor of the buyer in the ordinary course as the goods leave. What the creditor looks to is the business of the debtor, not the individual objects that come and go, and so, naturally, the security interest is indexed against the debtor. This is the focus of state law recordings under Article 9. We might think of inventory financing as “horizontal financing," graphically illustrated as follows. Pre-Purchase DEBTOR'S BUSINESS Inventory Inventory Post Sale In the modern economy, a valuable component of the debtor's assets may consist of software, trademarks and other intellectual property. One would therefore like a floating lien to attach directly to the intellectual property without the necessity of separate filing in a federal register each time the intellectual property becomes part of the debtor's asset base. Note that for copyrighted works, we are really only addressing assignments and exclusive licenses, since there is no federal recording system for non-exclusive copyright licenses. This is the primary reason for the objections to Peregrine and AEG. They require additional effort for a secured creditor to perfect its interest under this model. But this is not the only financing model. There is another one in common use for which Peregrine and AEG are the right answer. Asset Financing: In this model, the primary focus is not on the debtor's business but on the protected work. We might think of it as akin to real estate financing of an office building. The key asset is the land and the building, and one files a mortgage against the property. In a building, there can be many leases that pay rents (royalties) to the owner. The lender wants to know that filing against the underlying property also gives it priority as to subsequent lease interests. Lending against copyrighted works follows the same paradigm, especially for motion pictures. The underlying property (e.g. copyright in the motion picture) can be subject to many sublicenses. A secured lender wants to ensure that filing against the underlying property gives priority as to subsequent licensees. We might think of asset financing as “vertical financing" graphically illustrated as follows. In this model, each license generates royalties ("proceeds"). By filing against any box, the secured lender gains priority over all included ("junior") boxes. Therefore, a secured creditor loaning against Sublicense A2 to needs to look up the tree to determine whether there is a filing for a prior transferee, i.e. with respect to License A or the Copyrighted Work. Notice that in the horizontal inventory model, there is only one look-up step to the immediate debtor. It is easy to search, since the creditor knows who the debtor is. But in the vertical model, the secured creditor needs to look at all prior interests. The secured creditor may know its immediate debtor, but what about prior transferees? Here is an example based on real filings for the motion picture Latino. The Producer of the picture granted certain exclusive distribution rights to Management Company Entertainment Group, Inc. The Copyright Report discloses that a Pledge and Security Interest was filed in the Copyright Office on July 13, 1989 in favor of Kidder, Peabody Group, Inc., as secured creditor, listing the following companies as debtors: Management Company Entertainment Group, Inc., Manson International, MCEG Productions, Inc., Independent Production Resources, Inc., Independent Screenplay Development Corp., MCEG Development Corp., DAHL, Înc., Go Ahead... Bore Me, Inc, Plantation House, Inc., Stroke of Luck, Inc., World Food Resources, Inc., Small Minds, Inc., I'm Nothing, Inc., Hometown Boy, Inc., Follow Your Dream, Inc., Redblood, Inc., Beyond Control, Inc., MCEG/Virgin Holdings, Inc., Virgin Vision America, and Virgin Vision, Inc. This type of filing is not unusual. Motion picture companies typically create many subsidiaries for specific purposes. For example, each picture is often produced by a newly formed company without antecedent debt so that all the capital of the company can be used to produce the picture and will not be attached by prior creditors. Thus, secured lenders often file against all companies in the corporate group. Assume Lender A now wants to make a loan to the Producer of Latino secured by the copyright in the picture including royalties payable. How can Lender A determine what interest has been granted to Management Company Entertainment Group, Inc. and its related companies through a search of the records? 4 Currently, the Copyright Report is sufficient, as it identifies the rights granted to these parties in a single listing, but since it will not be available to us under the Proposed Federal Intellectual Property Security Act, using it would be cheating. Interested parties are invited to determine for themselves what interest, if any, the listed companies have by conducting UCC searches for themselves. No, I do not know where these companies are domiciled. I will also note that there are probably hundreds of UCC-1s filed against Management Company Entertainment Group, Inc. in California alone; which one relates to Latino will require reading each one. Of course, even identifying these companies required a Copyright Search. If the Producer had grant 4 Obviously, this information can also be obtained from the debtor, but the point of searching the public records is to verify the debtor's representations rather than accepting them on blind faith. |