In M&A transactions, many lawyers assume that intellectual property (IP) Rights will automatically transfer with the purchase and that IP issues can be cured by general representations and warranties.
Getting strong representations and warranties covering IP Rights is useful; however, relying on damages sums from breaches of those representations as the sole means of funding the protection of that IP can sabotage the initial deal – or lead to nasty surprises after closure, including requiring significant changes to future business plans and opportunities. If the target’s IP Rights are important to the ultimate deal, then those IP Rights must be investigated thoroughly in the due diligence and fully understood.
A due diligence investigation into a company’s IP assets is, essentially, a methodical audit that will cover at least the following main areas:
• Licences and collaboration agreements
Failure to examine these areas during due diligence in a manner appropriate to the deal at hand can result in re-evaluation, repricing or structural changes to the transaction.
For example, Volkswagen outbid BMW in 1998 to buy Rolls-Royce, Bentley and their British factory from Vickers Plc for $917m. But an odd twist in the deal allowed the Rolls-Royce aerospace company, Rolls-Royce Plc, to sell rights to the Rolls-Royce trademark to BMW out from under Volkswagen for $78m. Thus, after the deal closed in 2003, Volkswagen did not have the rights to use the Rolls-Royce trademark, including both the name and the iconic ‘Spirit of Ecstasy’ emblem that adorns the bonnets of the cars.
IP due diligence in an M&A transaction should not be overlooked and should be undertaken early in the process. The following are five common IP issues that regularly impact on M&A transactions.
1. Target does not have the critical patent rights
A target company may not actually own the IP Rights that it represents that it owns.
This may be due to a failure to update the title through corporate name changes or lien releases, or a failure to ensure that employees have properly assigned to the target their rights to IP assets developed with company resources. This latter situation is particularly problematic.
For example, under US patent law, each joint inventor has the right to use and license patented technology to a competitor without accounting to the other owner in the absence of an agreement to the contrary. As a result, a non-assigning employee can license a key competitor of the buyer, the acquiring company, without notifying the target (and even keep the royalties). The problem can be more acute in the case of an independent contractor, who may not have an obligation to assign rights to the target. It is important, therefore, to review contractor agreements related to any IP relevant to the transaction, in order to confirm that the agreements address ownership of any IP created by the contractor.
Trademarks must be evaluated in terms of their goods, services and countries of registration to confirm that they cover the buyer’s intended uses in intended markets. Certain countries recognise common-law trademark rights, based on use of a mark, while other jurisdictions give priority to the first party to file a trademark application, regardless of use. Internet domain names are subject to fewer formalities, but must be investigated as well. Domain name registrations may expire and, if expired, the domain names can be bought by anyone.
It is also important to confirm that important domain names are owned by an entity relevant to the transaction, as opposed to an information technology (IT) professional within the company, a licensee or other entity.
2. Prior agreements limit IP Rights
Sometimes, the target’s IP Rights may be subject to prior agreements that restrict their use in other markets or fields of use. The target may have existing licences or agreements with respect to some or all of its IP Rights. For instance, the target may have granted a third-party exclusive in a key field of use, territory or patent, which may limit the buyer’s full and expected use of the IP Rights.
For example, when the Clorox Company purchased the Pine-Sol business and trademark from American Cyanamid in 1990, Clorox planned to leverage the strength of the Pine-Sol mark into other products. Clorox purchased the Pine-Sol assets and mark subject to a prior 1987 agreement that Cyanamid had entered into with the owner of the Lysol trademark to settle a trademark dispute years earlier. That prior agreement restricted Cyanamid (and subsequently Clorox) from expanding the use of the mark beyond the Pine-Sol pine cleaner. Clorox tried to void the terms of the settlement agreement through litigation, but was unsuccessful.
IP licensors may argue that a merger in which a licensee does not ‘survive’ as a separate corporate entity may void the licence – even if the license agreement contained no prohibition against merger, acquisition or transfer. This argument is based on an arcane line of federal cases holding that patent licences are not assignable, unless expressly made so. More recently, some US federal courts have extended this rule in ways that affect corporate mergers and have found, in effect, that certain mergers can constitute transfers that void patent licences. This is especially problematic in an acquisition of a licensee.
Additionally, in certain instances in which the US government has provided funding to an entity (usually a non-profit company, university or small business), the government may retain certain rights to any relevant patents developed from that research and any subsequent grants relating to those rights (eg, a licence or acquisition) will remain subject to the US government’s retained rights. These government ‘march-in’ rights include the right to license the invention to a third party, without the consent of the patent holder or original licensee, where it determines the invention is not being made available to the public on a reasonable basis.
3. Target is subject to infringement claims
No buyer wants to buy an expensive IP-related lawsuit through an acquisition. Any potential litigation or enforcement risks must be assessed and independently analysed, including evaluating potential indemnifications. Although others exist, two primary areas for inquiry in this context include potential patent infringement and copyright liabilities.
For potential patent liability issues, a purchaser will not want to spend a great deal of time and money to acquire rights that it will not be able to exploit because of a third party’s potential infringement lawsuit. Potential litigation and enforcement risks may be identified through the target’s legal opinions, cease-and-desist letters, freedom to operate studies and similar materials, which should be requested and analysed in the due diligence process.
As to open-source software, the GNU General Public License governs a large number of open-source products. Open-source code can be tightly integrated only into other open-source products, and a condition of using the code is that the user also publishes any modified version of the code to the public. The Free Software Foundation, a non-profit organisation to promote computer-user freedom, enforces the GNU General Public License. The latter can be problematic in an acquisition, especially when the software is a valuable piece of the assets being acquired.
There have been instances where an acquiree has been sued by the Free Software Foundation after acquiring a company that had allegedly incorporated open-source code into its software. In at least one instance, the acquirer had to release the acquired software to the public as a result. Open-source liability can kill a deal and affect the value of a transaction. In the absence of insurance, some companies will accept a reduction in deal price.
4. Barriers exist to technology exploitation
With regard to patents and the ability to exploit the acquired patented technology, significant barriers may exist. Third parties may have blocking IP Rights that prevent the buyer from exploiting the target’s IP or expanding the business as planned. Sometimes, this risk is not specifically known even to a target. Therefore, the buyer’s freedom to operate should be analysed in detail before completing the transaction, to make sure that the buyer will be able to use the assets purchased as intended in the conduct of the business operations, or as proposed to be used according to the buyer’s future plans. A freedom-to-operate analysis should be performed, which is an assessment of whether making, using, offering to sell or importation of a product in the US will infringe any third-party patents.
If third-party IP Rights are identified that may block or limit the buyer’s use of particular IP Rights, and a meaningful design-around is not possible, then it may be necessary to license or acquire ancillary rights to such third-party blocking IP Rights.
Alternatively, the target could seek to invalidate the blocking IP at the US Patent and Trademark Office (eg, through a re-examination) or in a court. The court inquiry is more complex when pending claims are published yet not issued, so the inquiry not only requires construction of the claims and infringement analysis, but also an estimation of whether the published claim(s) will issue. Evolving application of infringement under the doctrine of equivalents and other changing legal standards through judicial decisions only adds to the complexity and cost of the analysis.
Of course, this still leaves unknown barriers to the exploitation of technology. Included in this category are issues such as unpublished patent rights that could block a buyer; misappropriation of technology; reverse engineering by competitors, who have then patented improvements to a target’s trade secrets; or even competitors, who independently discover trade secrets and patent them, and the like. To the extent that these can be explored, it is wise to do so. However, there are risks in any deal, and wise IP counsel can consider the impact of potential unknowns based on the industry and technology involved in the contemplated transaction.
5. Target’s IP Rights are encumbered by liens
IP Rights may also be encumbered by liens. To record and perfect a lien against both patents and trademarks in the US, Uniform Commercial Code (UCC) filings need to be made.
Although not legally required, most lenders also record the security agreement in the US Patent and Trademark Office (USPTO). Under US copyright law, however, only a lien recorded in the US Copyright Office will perfect a security interest in copyrights. Due diligence should include reviewing reports from all of the applicable filing offices.
To sum up, early and comprehensive IP due diligence in M&A transactions is important because it can lead to a reevaluation, repricing or restructuring of the proposed transaction.
Carey C Jordan is a partner at McDermot Will & Emery LLP, based in the firm’s Houston office
THE IMPORTANCE OF DUE DILIGENCE
A surprising number of M&A transactions are concluded without any investigation into the target company’s IP, warns Emma Jones
A due diligence investigation plays a crucial role in ensuring that the buyer of a company does not end up empty-handed or overpaying for the assets of the target company. Large transactions usually involve a suite of IP items. Quite often, the investigation reveals that the target company has registered some, but not all, of the IP used in relation to its products. In addition, in some cases the IP may not have been protected in all of the territories where the company operates, and, in others, the company may simply have neglected to maintain its registrations. Over and above this, an investigation should also be designed to identify actual or potential third-party challenges which, in turn, could diminish the value attached to the target company’s IP.
Properly conducted IP due diligence can also provide the parties with a powerful negotiating tool prior to the conclusion of the transaction. For example, if the investigation shows that the target company’s IP has not been adequately protected, the scales may be tipped in favour of the acquiring company. On the other hand, the investigation could also benefit the seller where the target company is shown to have a history of having implemented proper IP-protection actions, such as identifying IP prior to implementation or disclosure, taking steps to ensure early protection, and involving all departments, from marketing to research and development, in the process. Not only will this facilitate the due diligence investigation, but it will also pay off when the company decides to capitalise on its investments.
Due diligence investigations can be expensive and time-consuming, which is off-putting to some companies. However, an experienced IP attorney would be able to assess whether, in fact, a full-scale investigation is actually appropriate as, in some cases, it is not always necessary. For example, if the target company has been in existence for a number of years, its business will probably rely on certain key IP items, such as a particular brand or trademark, patent, software or business process. Identifying these items can be quite involved, but, at the very least, the aim should be to identify those intangible assets, without which the company would not be able to continue. Once this has been done, the investigation can become more focused and cost-effective by eliminating the need to sift through voluminous, irrelevant documents.
It is also useful to have the buyer’s input prior to launching into a comprehensive investigation. It may be that the buyer is only interested in certain aspects of the target company’s IP, in which event the investigation could be scaled down considerably.
The results of an investigation may not always match the parties’ expectations. However, despite this, it is important to prepare an unbiased report of the state of affairs, clearly pointing out the strengths and weakness of the target company’s IP. If, for instance, the investigation reveals prior conflicting marks, which could potentially bar use and registration of a key trademark, the costs involved in correcting or refusing the situation should be calculated and clearly set out. Gaps in the disclosure process should also be documented meticulously so that appropriate warranties and price adjustments can be negotiated.
Given the importance of IP in M&A transactions, a thorough due diligence investigation is vital to ensure the long-term success of a deal and to avoid any nasty surprises.
DON’T LEAVE IP TO LAST
Peter Wells from McMillan explains why IP professionals need more input into M&A transactions
‘It’s not what you don’t know that causes all the trouble – it’s what you know for sure that isn’t so.’ That quote, variously attributed to Mark Twain, Walt Whitman and Satchel Paige, is true in life, but is particularly true in law, and the recent decision of the US 6th Circuit Court of Appeals, in Cincom Systems Inc v Novelis Corp (‘Cincom’), is the perfect illustration. The case provides a valuable lesson to intellectual property (IP) owners and their lawyers that assumptions about the law that may relate to a transaction have the potential to cause no end of trouble.
In Cincom, a software licensee corporation (Alcan) became part of a new entity (Novelis) through a series of mergers and internal restructurings. When Novelis continued to use certain software originally licensed by Alcan, Cincom sued Novelis for infringement, as the terms of the licence provided that it was non-exclusive and non-transferrable without prior consent from Cincom. No such consent had been sought because, under Ohio state merger laws (which the lawyers assumed was the appropriate law as all the corporations were under Ohio law), the assets of Alcan would immediately vest in (or ‘flow’ to) the surviving entity, Novelis. Surprisingly, the Court held that the transfer was impermissible and Novelis was liable for software infringement.
In formulating its decision, the Court differentiated between IP licences and other types of licences. It held that, although state contract law generally governed the interpretation of a licence and whether a merger results in a transfer, US federal common law governed questions relating to the assignment of copyright licences. The rationale was primarily a policy-driven one, suggesting that unauthorised assignability of a licence by a licensee discouraged IP creators from licensing their technology if licensees could then transfer it to third parties – such as a licensor’s competitors – without the licensor’s consent. The decision in the Cincom case, therefore, suggests that, under US law, a non-exclusive IP licence is presumed to be non-assignable and non-transferable in the absence of express provisions to the contrary.
Canadian licensees of US IP that are contemplating corporate reorganisations should closely scrutinise those agreements for anti-assignment provisions and seek the appropriate permission prior to completing a merger to ensure that licensing rights are not inadvertently diminished or lost or that unintended infringement of the licensor’s rights has not taken place as a result of the reorganisation.
More generally, where a Canadian corporation has an interest in any foreign IP, whether from the US or any other country, it should check with counsel in all the relevant jurisdictions in order to ensure that any corporate transaction that is being contemplated will not have some unexpected impact on its IP Rights.
Peter Wells is a specialist in Civil Litigation and Intellectual Property Law, and partner at leading Canadian law firm McMillan LLP
These articles first appeared in Legal Strategy Review, issue 7