The rights of a secured creditor holding security in a debtor’s inventory may be limited by certain third-party rights.

As canvassed in one of our previous bulletins, the Supreme Court of Nova Scotia provided an example of this in its decision in Scanwood Canada Ltd., where the bankrupt manufacturing company had entered into a contract with IKEA which provided that once manufactured, items of furniture could be sold only to IKEA or one of its authorized distributors. In the event of bankruptcy, IKEA was not obligated to purchase them. Given IKEA’s refusal to purchase the debtor’s remaining furniture, the receiver asked the Court for authorization to sell it for the benefit of the mass of creditors. The Court refused to do so and ordered the furniture destroyed, pointing out that it did not have the authority to override the contract between the debtor and IKEA.

It is possible however for a creditor to protect itself against the potentially unfavourable effects of third-party rights on its security.

Due Diligence: a Crucial Step

When assessing a debtor’s file, the creditor must be thorough in performing its due diligence. It is critical to ask the right questions in order to ensure the effectiveness and enforceability of the security registered by the creditor. In particular, creditors should do the following:

  • Obtain an exhaustive list of all intellectual property rights owned by the debtor. This will allow the creditor to determine whether, and to what extent, such rights are essential for the sale of the debtor’s inventory. The creditor should also perform all necessary searches in public registries (such as those of the Canadian Intellectual Property Office and the Register of Personal and Movable Real Rights) to determine whether those rights are charged by third-party security.
  • Obtain an exhaustive list of all intellectual property rights that the debtor holds under licence from a third party. Thorough review of the licence agreements will allow the creditor to determine the extent of the rights of third parties and whether they could be an obstacle to realizing the creditor’s security in the debtor’s inventory. The creditor should also pay particular attention to the licence termination clauses and to the events giving rise to termination, as the termination of such a licence could compromise the creditor’s ability to sell the seized inventory.

Additional Security

When structuring the financing’s security package, the creditor can minimize its risk by requiring additional security to supplement that on the debtor’s inventory. For example, a hypothec charging the present and future intellectual property rights of the debtor (to the extent they are necessary for the sale of the inventory) or, in the case of software, placing the source code in escrow with a third party.

Debtor’s Undertakings

When drafting the financing documents (offer of financing, credit agreement, etc.) the creditor can reduce its risk by obtaining certain contractual undertakings from the debtor. For example, the debtor should undertake, inter alia, to:

  • In all cases
    • Inform the creditor on an ongoing basis of any new intellectual property right belonging to the debtor or a third party, so that the creditor can take appropriate measures to preserve its position, if necessary.
  • In cases where intellectual property rights are owned by the debtor
    • Obtain, from any third party holding security on an intellectual property right of the debtor, the consent to the existence of the creditor’s security, as well as an undertaking to grant the creditor any right required for the enforcement of its security. Obtaining such consent and undertakings should be a condition precedent for making credit available. 
    • Grant the creditor any necessary security in any future acquired intellectual property right that could have an effect on the sale of its inventory.
    • Not grant security in the debtor’s intellectual property in favour of any third party.
    • Not assign, let expire or otherwise compromise the debtor’s title to its intellectual property rights.
  • In cases where intellectual property rights are held under licence by the debtor
    • Not go into default pursuant to such a licence.
    • Obtain, from any third party that has licensed intellectual property rights that are essential for the sale of the debtor’s inventory, the consent to the existence of the creditor’s security, as well as undertakings to grant the creditor any right required for the enforcement of its security, and to not terminate the licence agreement in the event of a default or the debtor’s insolvency, or an agreement to transfer the debtor’s rights under the licence to a person designated by the creditor. Obtaining such consent and undertakings should also be a condition precedent for making credit available.

Legal Opinion

A creditor can also protect itself by requiring a legal opinion on the validity and enforceability of its security in light of all intellectual property rights identified as necessary for the sale of the debtor’s inventory.

Conclusion

While the enforceability of security in a debtor’s inventory can sometimes be compromised by third-party intellectual property rights, a prudent and well-informed creditor can limit their negative effects and inherent risks through thorough due diligence and by putting in place the mechanisms and safeguards discussed above.