Selling Innovation in Bankruptcy

Innovation is crucial for the modern economy. Financing innovation is an important but challenging task for innovative firms as innovation is associated with high degree of uncertainty. In addition, the high-risk nature of innovation makes failure highly likely and thus the bankruptcy process particularly relevant to firms’ financing policy. Ideally, to incentivize innovation, the bankruptcy system ought to provide means and tools to help innovative firms resolve the adverse situation and emerge without losing their innovative advantages. Yet the question remains open as to whether the bankruptcy system is up to the task.

In “Selling Innovation in Bankruptcy”, we provide the first systematic study on the Chapter 11 bankruptcy process of innovative firms, with a focus on patent sales in corporate bankruptcy. The study uses a sample that contains detailed patent portfolios, systematic records of patent transactions, and the characteristics and collateralization history of the individual patents of all US public firms that filed for Chapter 11 bankruptcy from 1981-2012. This novel data set is manually assembled using information from the United States Patent and Trademark Office (USPTO), New Generation Research’s bankruptcydata.com, and Public Access to Court Electronic Records (PACER).

We start our empirical analysis by documenting three stylized facts on innovation sale in bankruptcy. First, selling innovation during bankruptcy is a surprisingly pervasive phenomenon. Forty percent of bankrupt innovative firms sell at least one patent in the reorganization process, and patents transacted account for about 18% of firms’ patent stock. The intensity of selling innovation during bankruptcy is significantly higher than that of non-bankrupt innovative firms. Second, innovation sales concentrate within a short time window after the bankruptcy filing. The probability of selling increases more than six fold from the quarter before bankruptcy filing to the quarter immediately after. The increase in post-filing innovation sales concentrates in the first two quarters after the bankruptcy filing. Third, innovation sales are front-loaded in asset sales in bankruptcy. Innovation-related asset sales occur with greater intensity immediately after bankruptcy filings. In the quarter of filing, nearly 60% of asset sales are innovation-related, but by the fourth quarter after filing, this ratio drops to 17%. Overall, bankrupt firms sell a disproportionately large number of patents at the early stage of the asset reallocation process.

Using patent level regressions with a set of controls and firm fixed effects for unobservable heterogeneity, we find a surprising pattern in patent sales by bankrupt innovative firms—they are more likely to sell their core, rather than peripheral, patents during Chapter 11 reorganization. We use the measure of core patents developed and validated in Akcigit Celik, and Greenwood (2016) and Brav, Jiang, Ma, and Tian (2018). The measure is built on the technological proximity between a patent and the owning firm's core innovation expertise, and core patents are shown to be more important for firm value. Our patent-level analysis shows that patents in the highest quartile of the core measure are 2.5 percentage points more likely to be sold than those in the lowest quartile, which is equivalent to a 30% increase from the baseline selling rate of 8.3%. This pattern of giving up core innovation in bankruptcy is diametrically opposed to findings from those studies that examine patent sales in non-distressed firms. These studies use the same measure to show that non-distressed firms and firms undergoing asset restructuring under the pressure of activist equity holders sell their non-core patents—a pattern that we can replicate using non-bankrupt firms—and that divesting non-core patents creates value to the selling firm.

Why do innovative firms give up core innovation in bankruptcy? There are several explanations, which fall into two broad categories of hypotheses. On the one hand, bankrupt firms may be forced to sell due to strong control of creditors whose goal is to recover debt with minimized uncertainties, even though firms want to retain valuable core innovation for post-emergence operations. On the other hand, bankrupt firms may voluntarily sell core patents because these firms, which are on average less productive, no longer possess a competitive advantage in exploiting those technologies.

To test the role of creditor control in selling innovation, we undertake additional extensive data collection efforts using Capital IQ, PACER, SEC filings, and the USPTO, and perform an exhaustive set of heterogeneity tests across various measures of creditor control. Adopting three distinct measures for secured creditor control, including the ratio of secured debt to total debt, the amount of DIP financing, and an intertemporal measure, our heterogeneity tests show that the pattern of selling core patents is almost purely driven by firms with strong secured creditor control.

To further investigate the active role of creditors, we study an important mechanism through which creditors can uniquely exert influence on patent sales—enforcing their rights against patent collateral. We present two complementary tests to shed light on how this collateral mechanism shapes the selling of core patents in bankruptcy. First, using information on the patent collateralization of all patents in the USPTO, we show that a firm's core patents are more likely to be pledged as collateral. Second, a collateralized patent is seven times more likely to be sold by a firm in bankruptcy than by a non-distressed firm. This pattern holds particularly strongly in firms with a higher level of creditor control. These pieces of evidence together suggest that enforcing rights on collateralized patents, which are typically core to the firm and of higher quality, is an important mechanism through which creditors push bankrupt firms to give up core innovation.

In the last part of the paper, we attempt to address questions on whether the phenomenon of selling core patents is concerning and costly to the bankrupt firm. Specifically, we assess the validity of an alternative explanation: bankrupt firms may sell core patents because these firms no longer possess a competitive advantage in exploiting the technology even though they are the core assets.

Looking into several additional aspects of those patent sales, we find evidence that is largely inconsistent with the alternative view: (i) patents sold during bankruptcy are more likely to be purchased by patent trolls rather than by practicing users, mainly for litigation rather than exploitation purposes; (ii) there is a higher separation rate of patents and their inventors in the process of selling innovation in bankruptcy, suggesting buyers' lower intention to redeploy human capital associated with the technology; and (iii) patents sold during bankruptcy, compared to those sold during other time periods, experience a sharp decline of annual citations post-transaction, while there is a strongly increasing trend in the total number of citations before the sale, suggesting that the sold patents are of high quality but inefficiently used after the sale.

Additionally, we investigate the potential causes of bankruptcy filing and post-emergence performance. We find that firms suffering pure financial distress are equally likely to sell core patents. Moreover, using the sample of firms that emerge from Chapter 11, we show that when the firms sell (core) innovation in bankruptcy, secured creditors recover more at the end of the bankruptcy process. But the high recovery rate appears to come at the expense of the firms themselves—selling firms under-perform in the three-year period after emergence.

In summary, we provide the first study on the bankruptcy of innovative firms by focusing on the innovation reallocation process. Bankrupt innovative firms give up core technological innovation, and strong creditor control plays an important role in driving this pattern. These findings connect to the recent literature on creditor rights in innovative industries. A theme in this literature is that increased creditor rights and the ability to collateralize patents can enable greater debt financing for innovative firms. This paper provides supporting evidence that patent collateral protects creditors in bankruptcy. The evidence also suggests that strong creditor rights and patent collateral can be ex post costly to distressed innovative firms, highlighting the tradeoff in the process of financing innovation. These findings are closely related to the debate over the bankruptcy code reform (such as that from the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 in 2015) for a knowledge-based economy, and to the design of optimal intellectual property rights.

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