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Unsecured financing

January 13, 2019


The writer is a lawyer with an interest in intellectual property law.
The writer is a lawyer with an interest in intellectual property law.

FORMULATING its digital policy, the PTI at the time was quick to identify the potential of the technology sector in contributing to economic growth. But since forming government, it has struggled to translate its vision into reality. Things are unlikely to change unless it addresses a key problem affecting the tech sector: restricted access to the credit market.

For the tech sector to become a primary contributor to economic growth, tech businesses would need capital — raised either through selling a part of the ownership or borrowing. The former (equity financing)has its own problems, but the issue with the latter (debt financing) is the legislative and/or executive inertia in improving the capital environment for tech companies.

What shows the government’s inability to understand the peculiarities of the sector is the widening gulf between the financial infrastructure and the existing regulatory landscape regarding secured financing. When businesses use debt to finance growth, it can either be secured where the loan is backed by collateral, or unsecured, or extended usually at a higher interest rate without collateral.

Tech ventures are mostly start-ups lacking a legal structure.

The reason why unsecured financing is a higher-risk option for lenders, and unlikely to attract investment in tech ventures, is simple: sophisticated financial analysis that allows lenders to predict the success of a venture and the likelihood of repayment of debt is not useful for tech ventures. Each time a tech venture develops a new (intangible) product — which is the case for most start-ups — the intellectual property in it is classified as an expense of the venture and is deducted from the profits the venture makes. This means the way in which accountants treat the main asset of a start-up venture paints a misleading picture of the assets of the tech company, its value, and profitability.

In such sectors, conventional wisdom dictates that a tech company’s access to the credit market will increase when the loan is backed by an asset and debt is raised through a secured transaction.

One of the main reasons for lenders relying on collateral for securing a debt is the regularisation of securities, ie the institutional recognition of arrangements between lender and debtor, their creation and enforcement. Herein lies the problem for the tech sector.

The legal and regulatory regime applicable to the creation of securities over intangible assets (eg intellectual property rights) is defective, covering some, but leaving out most financing transactions. At this time, there are two different laws permitting the creation of a security interest over intellectual property rights: the Companies Act, 2017, and the Financial Institutions (Secured Transaction) Act, 2016. But their outreach is limited and most transactions fall beyond their net.

For example, section 100 of the Companies Act, 2017, requires any company creating a collateral for any intellectual property right to be registered with the registrar designated by the SECP, failing which the security interest is not ‘perfected’ — ie it is not effective against any third party, including a liquidator or any other creditor, having the effect of converting the charge into a purely contractual right, limiting the proprietary nature of a security and denying a priority claim to the lender. But section 100 only applies in the case where the tech venture is a company registered with the SECP.

In most cases, tech ventures are start-ups lacking a formal legal structure since 1) there is a great amount of regulatory oversight of the SECP and 2) it is expensive to comply with the requirements prescribed by the law. Naturally, such ventures opt not to register as companies, and, thus, fall outside the scope of the Companies Act.

Similarly, section 14 of the Fin­a­ncial Institutions (Secured Trans­action) Act, 2016, requires registration of the security interest in intellectual property with the registry notified under the act before it can give the lender a priority claim that can be effective against any third party.

Again, there are two complications: 1) the scope of the act is limited to only those lenders that are financial institutions, which are difficult to tap for tech ventures owing to cultural scepticism about the value of intellectual property as collateral; and 2) the registry to be established for the perfection of interests is yet to be notified by the government under section 19 of the act. This issue has remained pending for the past three years.

Technically, then, the only effective means of securing debt is available to a certain category of tech ventures. For the rest, the legislature and executive must draw up a centralised, inclusive and comprehensive scheme for securing debt or the market for asset-backed financing will remain closed for most ventures, dampening growth prospects.

The writer is a lawyer with an interest in intellectual property law.
Twitter: smasood12

Published in Dawn, January 13th, 2019