Twenty years ago I joined the derivatives group in an investment bank with responsibility to troubleshoot problems and interface with the risk and control functions. I quickly realised that derivatives had no natural home within the bank and were poorly understood by everyone outside of the business. This was perhaps unsurprising, since the legal contracts that we devised to exchange risk between counterparties were exotic and fit none of the existing accounting treatments or risk systems. Indeed, it was this lack of standardisation that drove much of their value, since in the absence of defined rules, counterparties to the contracts could choose how to record and report these intangible assets, shielding or deferring value and creating an industry called financial engineering.

The challenge that we faced in developing valuation frameworks was to divine the most appropriate approach to bridge the gap between theoretical and market value for illiquid, idiosyncratic legal contracts that had considerable market impact. The theoretical value could be defined mathematically using an algorithm known as the 'Black Scholes' model. However, the market value often differed from this, depending on other factors such as supply/demand and the impact of the contracts on our own risk and capital position.

As the Black Scholes model became ubiquitous, the basic information asymmetry between sellers and buyers disappeared (buyers could check theoretical value themselves) and, unsurprisingly, profit margins for sellers collapsed. But the regulatory, accounting and tax treatment remained arcane and preserved the value of derivatives for financial engineering – exploiting the ambiguous treatment of derivatives on balance sheets.

In their seminal book Taxes and Business Strategy, Mark Wolfson and Myron Scholes (of Long Term Capital Management fame) examined the impact of situations that give rise to regulatory, accounting and tax arbitrage on economic returns and business strategy. Their book revealed starkly how the lack of standard frameworks for accounting and reporting for intangible assets such as derivatives distorted investor behaviour and created arbitrage opportunities.

In 2014 intellectual property inhabits a similar no man's land in terms of accounting, tax and regulatory treatment to that occupied by derivatives in the 1990s. Patents, in particular, are highly customised and therefore difficult to value out of context, and there are no universal requirements for companies to account for the balance-sheet value of these assets, except in specific situations (eg, M&A under Financial Accounting Standard 141). As a result, patents are predominantly off-balance sheet assets that boost return on equity when they are productive and conveniently disappear when they are less so. This arrangement can mask poor productivity in R&D and obscure real operating performance from shareholders.

Efrat Kasznik recently highlighted some of the consequences of the asymmetry of information in intellectual property that arises from inadequate reporting regimes. Recently she expanded on this in Google’s IP Finance Group based on research done at Stanford University Graduate Business School.

Among the issues that the Stanford research highlighted, I found three particularly pertinent given my background and area of interest:

Equity prices reflect stock analysts' views of the value of intellectual property, but only insofar as it is disclosed through mandatory filings and marketing and investor communications. 

Companies with unrecognised intellectual property (that is not disclosed due to the current poorly defined regime) provide management with preferential information. As a result, these companies are more likely to buy back their own stock and when management trade the shares, insiders make greater gains than expected.

The lack of mark-to-market valuation regimes for corporate intellectual property eliminates additional volatility in stock prices for R&D intensive companies and creates a 'file and forget' culture.

Just as I observed in the 1990s derivatives markets, any widespread information asymmetry results in material opportunities to make money across the capital structure of affected companies. For example, the Nortel bankruptcy provided significant opportunities in the complex debt structure for IP-literate investors to profit. Similarly, Kodak, Alcatel Lucent, Nokia and others have provided significant returns on well-informed capital. In an essentially unregulated market (patents are not securities), the commission levels enjoyed by patent brokers (20% to 30%) are in excess of those enjoyed by the wolf of Wall Street.

The derivatives bubble ended with many recriminations (and some incriminations), largely as a result of the inability of investors, regulators and market participants to have a clear view of the exposures they were incurring.

If the IP professionals I speak to every day are correct and intellectual property really does comprise more than 80% of market value in 2014, the current situation with intellectual property – which is effectively impossible to value in a market context with any degree of consistency or transparency – is at risk of following a similar path. 

The accounting profession eventually caught up and provided a framework for valuation of derivatives that created a level playing field. The tax and regulatory regimes are still playing catch up and, as a result of the complexity involved, have defaulted towards anti-avoidance approaches to create a catch-all, disclosure-driven approach.

Previously I have noted that intellectual property per se does not impart superior stock market performance to companies any more than other assets do. It is IP strategy and management that matters. However, the information asymmetry that currently exists between managers and investors is unhealthy. The mandatory valuation of all intellectual property held on company balance sheets could address this and should significantly affect share prices across industry sectors. Until that happens, a few smart investors will continue to make a great deal of money trading on information asymmetry in a zero-sum game.

Chris Donegan

This article first appeared in IAM magazine. For further information please visit www.iam-magazine.com.