Factor beware: Avalon may apply to you too

Secured Lender, The, May 1999 by Prendergast, James D

Much has been written about In re Avalon Software, Inc., 209 B.R.517 (Bkrtcy.D.Ariz. 997) (Avalon), most of it informative, and none of it supportive of the decision.1

Avalon significantly complicated the financing of manufacturers which incorporate intellectual works within products. Avalon has provided the debtor-in-possession with a new and potentially powerful weapon in its fight to free up collateral from the blanket security interest of a lender.

In summary, the Avalon court, a bankruptcy court in Phoenix, extended the reasoning of the District Court in In re Peregrine Entertainment Ltd., 116 BR 194 (C.D. Cal 1990) (Peregrine), to conclude not only that it was a requirement to perfect a security interest in a copyright and any "proceeds" of a copyright, that the secured party must register the security interest with the U.S. copyright Office, but that this sole method of perfecting a security interest applied with equal dignity to "copyrightable" collateral, and the proceeds thereof, including accounts, and also to any related trade names, trade secrets and other related general intangibles.

Copyrightable property is intellectual work capable of being copyrighted and the intellectual work acquires this character when it is created2. Further, the Avalon court continued that registration with the U.S. Copyright Office "is not a condition of copyright protection", citing the U.S. Code, and therefore calling the intellectual work something else, such as a "trade secret," does not alter the requiring of filing with the U.S. Copyright Office to perfect the security interest. Calling the intellectual work a trade secret does not cause the copyrightable material to become a general intangible so that filing in the UCC records would perfect the security interest3. No such luck. According to Peregrine and Avalon, once something is copyrightable, the only avenue for perfecting the security interest in the copyrightable material and in any proceeds derived therefrom, including "accounts receivable arising from the licensing" of the copyrightable material, is registration of the copyright and the security interest therein with the U.S. Copyright Office4. The rationale behind Peregrine and Avalon is the maintenance of the comprehensive scope of the Federal Copyright Act's recording provisions5. Federal law in this area preempts state law, including the Uniform Commercial Code and its methods of perfecting security interests in copyrights and related accounts receivable6. The policy objective is the integrity of the national copyright recording system and the priority scheme for security interests in copyrights as established by Congress.

Peregrine and Avalon are clear with respect to the borrower that incorporates copyrighted and copyrightable intellectual works. Recordation with the U.S. Copyright Office is the only way to perfect a security interest in the copyright or copyrightable material itself and any proceeds derived therefrom, including license fees, royalties and accounts. Avalon involved a developer of software and Peregrine the owner of a library of film copyrights. The discussion gets more complicated and less certain where the borrower is a licensee of rights to use the intellectual work of another in its products. If dealing with a license of copyrightable material, must the lender require the borrower's licensor, over which the borrower may have no leverage (e.g., the licensor is Microsoft), to copyright first the licensed intellectual work, then require the license agreement to be recorded in the U.S. Copyright Office, and then record a collateral security agreement to perfect the lender's security interest in the borrower's license rights in the intellectual work and in the accounts receivable generated by the licensed rights? An ancillary question, beyond the scope of this article: What does the lender need to do, depending upon the rights and duties of the licensor and licensee under the license agreement, to ensure that the lender can foreclose and sell the borrower's inventory after a default by the licensee under the license agreement? If all license rights terminate upon default, the inventory may be worthless collateral to a foreclosing lender.

The Copyright Act provides, as discussed in Peregrine, that "[a]ny transfer of copyright ownership" may be recorded in the U.S. Copyright Office7. One debate turns on what constitutes a "transfer of an interest in a copyright" and whether a nonexclusive license of a copyright, which license can be repeated infinitely without diminishing the retained rights of the licensor in the intellectual work, constitutes the transfer of any property rights to a copyright which could be recorded in the U.S. Copyright Office. If not, so goes the argument, the accounts receivable generated by such a nonexclusive license should not be dragged under the Peregrine/Avalon net. Perfection of a security interest in such accounts generated by a nonexclusive license should be governed by the UCC and not the Copyright Act.