INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS Editors Lanning Bryer Ladas & Parry New York, New York
Melvin Simensky Visiting Scholar in Intellectual Property Law New York Law School
JOHN WILEY & SONS, INC.
INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS
Dedication To Stuart, who has the best business instincts but also the largest heart; to Nicole and Joseph, who are always fun and wise; and to Van, who is the true academic of the family. —Lanning G. Bryer For my beautiful wife for being there for me. —Melvin Simensky
Wiley Intellectual Property Series Early-Stage Technologies: Valuation and Pricing by Richard Razgaitis Edison in the Boardroom: How Leading Companies Realize Value from Their Intellectual Assets by Julie L. Davis and Suzanne S. Harrison From Ideas to Assets: Investing Wisely in Intellectual Property by Bruce Berman Intellectual Property Assets in Mergers and Acquisitions by Lanning Bryer and Melvin Simensky Intellectual Property in the Global Marketplace, Volume 1: Valuation, Protection, Exploitation, and Electronic Commerce, Second Edition by Melvin Simensky, Lanning Bryer, and Neil J. Wilkof Intellectual Property in the Global Marketplace, Volume 2: Country-by-Country Profiles, Second Edition by Melvin Simensky, Lanning Bryer, and Neil J. Wilkof Intellectual Property Infringement Damages: A Litigation Support Handbook, Second Edition by Russell L. Parr Intellectual Property: Licensing and Joint Venture Profit Strategies, Second Edition by Gordon V. Smith and Russell L. Parr Licensing Intellectual Property: Legal, Business, and Market Dynamics by John W. Schlicher Patent Strategy: The Manager’s Guide to Profiting from Patent Portfolios by Anthony L. Miele Profiting from Intellectual Capital: Extracting Value from Innovation by Patrick H. Sullivan Technology Licensing: Corporate Strategies for Maximizing Value by Russell L. Parr and Patrick H. Sullivan Technology Management: Developing and Impelementing Effective Technology Licensing Programs by Robert C. Megantz Trademark Valuation by Gordon V. Smith Valuation of Intellectual Property and Intangible Assets, Third Edition by Gordon V. Smith, Russell L. Parr Value-Driven Intellectual Capital: How to Convert Intangible Corporate Assets Into Market Value by Patrick H. Sullivan Technology Management: Developing and Implementing Effective Technology Licensing Programs by Robert C. Megantz
INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS Editors Lanning Bryer Ladas & Parry New York, New York
Melvin Simensky Visiting Scholar in Intellectual Property Law New York Law School
JOHN WILEY & SONS, INC.
Copyright © 2002 by Lanning G. Bryer and Melvin Simensky. All rights reserved. Published by John Wiley & Sons, Inc. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ @ WILEY.COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-41437-9. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com
ABOUT THE EDITORS LANNING G. BRYER
Lanning G. Bryer is a Partner in the New York office of Ladas & Parry and is Director of the firm’s Mergers, Acquisitions, and Licensing Group. Mr. Bryer is an active committee member of several intellectual property organizations, including the Trademark Licensing Committee of Licensing Executive Society (United States and Canada) and the Editorial Board of The Trademark Reporter. He recently served on the International Editorial Board of The International Trademark Association (formerly the U.S. Trademark Association) and currently serves as co-chairman of The International Annual Review. Mr. Bryer has written and lectured extensively on foreign trademark practice and commercial transactions involving the acquisition, financing, and licensing of intellectual property. Mr. Bryer is coauthor and coeditor of a treatise titled Worldwide Trademark Transfers and the twovolume John Wiley & Sons treatise titled Intellectual Property in the Global Marketplace. He is a graduate of Johns Hopkins University and Hofstra University School of Law. MELVIN SIMENSKY
Melvin Simensky is Visiting Scholar in Intellectual Property Law at New York Law School. Prior to this engagement, he was a partner at several law firms where he both counseled and litigated trademark, copyright, advertising, and entertainment law matters. Mr. Simensky specializes in the intellectual property aspects of commercial transactions involving both mergers and acquisitions and financings. Mr. Simensky was previously adjunct professor of law at New York University School of Law, where he taught a graduate school seminar on the intellectual property aspects of the entertainment business. He is formerly a columnist on entertainment and intellectual property law issues for the New York Law Journal. Mr. Simensky has been on the Board of Editors of The Trademark Reporter and Copyright World and has been an expert witness on U.S. intellectual property law in numerous domestic and foreign court proceedings. Mr. Simensky is coauthor of both a five-volume treatise titled Entertainment Law as well as a casebook of the same name. Mr. Simensky has published many articles and has lectured at numerous conferences on intellectual property and entertainment law. He is a graduate of Yale University and New York University School of Law.
v
ABOUT THE CONTRIBUTORS Benedict Bird and Anna Carboni are partners and Deborah Lincoln is a consultant in the international law firm of Linklaters & Alliance. They are all based in its Intellectual Property and Technology Department in London. They have been assisted in writing this chapter by Steven Altham and Brian Sher, both associates in the EU/Competition Department of Linklaters & Alliance, and by their continental colleagues, Patrick Rignell based in Paris and Markus Deck and Jiri Philippi based in Cologne. Sheldon Burshtein is a partner of Blake, Cassels & Graydon LLP, and practices in the Intellectual Property Group in the Toronto, Canada, office. He is a member of the Bar of Ontario and is registered as a professional engineer in Ontario. He is also a patent agent and a trademark agent, and he has an engineering degree as well as civil law and common law degrees from McGill. He is certified as a Specialist in Intellectual Property (Patent, Trade-mark and Copyright) Law by the Law Society of Upper Canada. Andrew W. Carter is a managing director of InteCap, Inc., the largest consulting firm in the country that focuses on the economic, strategic, and valuation issues surrounding intellectual property. He assists clients with their intellectual property licensing programs and is frequently a damages expert witness in patent infringement lawsuits. He is a licensed CPA and holds an MBA in Business Policy and a BS in Chemical Engineering. Marie-Eve Cote is a lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Business Law. Her practice is mainly focused in commercial and corporate law, which includes the negotiating and drafting of commercial agreements, namely mergers and acquisitions, reorganizations, and shareholder and partnership agreements. She is also developing an expertise in due diligence. She also practices in the commercial fields of intellectual property, particularly the negotiation and drafting of license agreements, distribution agreements, transfer of technology, and related agreements. Christian Danis is a lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Commercial and Corporate Law. His practice focuses mainly on the negotiating and drafting of commercial agreements, including mergers and acquisitions, reorganizations, and shareholder agreements, as well as the commercial aspects of intellectual property, with an emphasis on licensing, transfers of technology, and research and development agreements. Patrick A. Gaughan is president of Economatrix Research Associates, Inc., an economic and financial consulting firm, located on Wall Street, that analyzes damages and conducts valuations for litigation purposes. He is a professor of economics and finance at Fairleigh Dickinson University and has authored numerous publications, including Mergers, Acquisitions and Corporate Restructurings. Louis-Pierre Gravelle, is a patent agent and lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Intellectual Property Law. His practice focuses on patent law, specifically on drafting and prosecuting patent applications, particularly in the telecommunications field. He
vi
ABOUT THE CONTRIBUTORS vii also handles infringement, validity, and patentability opinion and is involved in technology transfer, particularly in due diligence matters. He is a member of the Quebec Bar Association as well as of the Intellectual Property Institute of Canada. Tira Greene is an international lawyer specializing in intellectual property law as well as legislative reform and the drafting of intellectual property law for developing countries. She currently works as an independent consultant and also undertakes projects on behalf of the World Intellectual Property Organization. Glenn Gundersen is a partner at Dechert in Philadelphia, where he has practiced since graduating from the University of Virginia School of Law in 1980. He is the author of the book Trademark Searching: A Practical and Strategic Guide to the Clearance of New Marks, the second edition of which was published by the International Trademark Association in 2000. He is a frequent speaker on trademark, copyright, and other intellectual property issues for the major organizations in the IP field, including the American Bar Association, International Trademark Association, American Intellectual Property Law Association, and Practicing Law Institute, and has written numerous articles for the National Law Journal and other publications. William M. Heberer is an attorney with Hall Dickler Kent Goldstein & Wood LLP in New York. He practices in the areas of intellectual property, advertising, marketing, and entertainment law. Thomas G. Jackson is a partner in the law firm of Phillips Nizer Benjamin Krim & Ballon LLP. He is a member of the Clayton Act, Section 7, Intellectual Property and Internet Committees of the Section of Antitrust Law of the American Bar Association, a past member of the Antitrust and Trade Regulations Committee of the Association of the Bar of the City of New York and past chair of the Technology in the Courts subcommittee of the Federal Courts Committee of the Federal Bar Council. Panagiota (Betty) Koutsogiannis is a lawyer with Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Business Law. Her practice focuses on commercial aspects of intellectual property and technology transfers, license agreements, research and development agreements, and joint ventures. She also practices in other fields of commercial and corporate law, such as mergers and acquisitions, and has developed a particular expertise in due diligence and audits in the higher tech sectors. She is a member of various organizations such as the Licensing Executives Society (USA and Canada), Inc., and the Information, Telecommunications and Intellectual Property Section (Quebec Division) of the Executive Committee of the Canadian Bar Association. Robert B. Lamb is a clinical full professor at New York University’s Stern School of Business. He previously taught at Wharton and Columbia. He has published a number of books on corporate strategy, mergers and acquisitions, and public finance. He has also published four chapters in Intellectual Property in the Global Marketplace, dealing with Financial Valuations of Intellectual Property in Financial Transactions. Professor Lamb is a consultant to major financial institutions, corporations and to the US Government. He has often been quoted in the Wall Street Journal, and other business media. Michael Lasinski is a managing director at InteCap, Inc., a professional services firm focused on IP management issues. His focus is on IP valuation and related issues in licensing, sale, merger, acquisition, and tax-related transactions. Prior to joining InteCap, Inc., he was with Coopers & Lybrand (now PricewaterhouseCoopers) and Ford Motor Company. He holds both an MBA and BSEE from the University of Michigan, is a licensed CPA in the state of Illinois, and is co-chairman of the Valuation and Taxation Committee of the Licensing Executives Society.
viii ABOUT THE CONTRIBUTORS Scott J. Lebson is an associate in the New York Office of the international law firm of Ladas & Parry, where he specializes in commercial transactions involving the acquisition, financing, and licensing of intellectual property. David A. Loewenstein concentrates his practice on patent litigation. He has litigated cases in several technologies including: computer software patents, electromechanical devices, laser-based optical flow cytometers, nuclear magnetic resonance (NMR) instruments, pharmaceuticals, medical devices, monoclonal antibodies, electro-chromic mirrors, heart pacemakers, contact lenses, satellite spin stabilization, vehicle electronic engine controls, and nuclear power plant design. He also has significant experience with trademark and antitrust litigation, and intellectual property licensing and trademark cancellation proceedings. Theodore C. Max is a litigation partner at Phillips Nizer Benjamin Krim & Ballon LLP specializing in intellectual property law. He combines his skill and experience as a trial attorney with his knowledge of copyright, trademark. and entertainment law in servicing Phillips Nizer’s many diverse clients in the fashion apparel and accessories, music, entertainment, publishing, film, and multi-media industries. He is the author of several articles and has contributed to several books regarding intellectual property law. He is currently Editor-in-Chief of The Trademark Reporter, the official journal of the International Trademark Association. He obtained an undergraduate degree from Hobart College and a Juris Doctor from New York University Law School. Susan Barbieri Montgomery is a partner in the Boston office of Foley, Hoag & Eliot LLP. Her practice is focused on strategies for intellectual property asset development and protection, and international business transactions. She is a frequent author and lecturer on intellectual property and business transactions. She is co-editor of the treatise Worldwide Trademark Transfer Law & Practice, Clark Boardman Callaghan (1992), and an adjunct professor at Suffolk University Law School. She is currently serving on the Council for the ABA IP Law Section and is a past member of the Board of International Trademark Association and Volunteer Lawyers for the Arts. Francois Painchaud is a partner in Leger Robic Richard, Lawyers, and Robic, Patent & Trademark Agents, Business Law. His practice focuses on information technology and technology transfers in all high technology fields and includes the preparation and negotiation of transfers, license agreements, research and development agreements, and joint ventures. He also practices in other fields of commercial and corporate law such as mergers and acquisitions. He is the Montreal Local Committee Chairman and an upcoming trustee of the Licensing Executives Society (USA and Canada), Inc. (LES). He serves on the Board of Directors of various technology-driven private and public companies and is a professor (sessional lecturer) on the law faculty of McGill University on the law of trade secrets and technology transfers. Leonard Schneidman, a senior tax partner in the Boston law firm of Foley, Hoag & Eliot LLP, is a graduate of the Harvard Law School (1965) and the NYU Tax Program (1966). He has written and lectured extensively on various tax topics and is listed in the Best Lawyers in America and Euromoney Guide to Leading U.S. Tax Lawyers. Gordon V. Smith is president of AUS Consultants, Moorestown, New Jersey. He is an adjunct professor at Franklin Pierce Law Center and the founding director of the Intellectual Property Management Institute. He has authored and co-authored several well-known books on intellectual property valuation and licensing. Michael J. Ward is the company secretary of Counsel Limited, a licensed company manager based in Anguilla, British West Indies (www.counsellimited.com) that specializes in active management of client corporations. He has a reputation for designing and implementing novel and effective group structuring solutions in a fast moving and rapidly evolving legislative and regulatory environment.
CONTENTS
PREFACE
xxvii
ACKNOWLEDGMENTS
xxx
CHAPTER 1 MERGERS AND ACQUISITIONS: AN OVERVIEW
1.1
PATRICK A. GAUGHAN, PH.D. COLLEGE OF BUSINESS, FAIRLEIGH DICKINSON UNIVERSITY ECONOMATRIX RESEARCH ASSOCIATES, INC. Introduction Fifth Merger Wave Exported to Europe Fifth Merger Wave Compared to Prior Merger Periods
1.1 1.1 1.3
Types of Mergers, Acquisitions, and Corporate Restructurings Why Do Firms Merge? Growth Synergy Consolidating and Roll-Up Mergers of the Fifth Merger Wave Diversification Related versus Unrelated Diversifications Leveraged Transactions
1.4 1.5 1.5 1.5 1.6 1.6 1.6 1.6
Role of Intellectual Property in Mergers and Acquisitions
1.7
How do Mergers Turn Out and What Can Go Wrong? What Can Go Wrong with Intellectual Property Motivated Acquisitions? Trends in Deal Prices for the Fifth Merger Wave Winners and Losers in Mergers and Acquisitions Effects of Sell Offs
1.7 1.8 1.8 1.8 1.10
Conclusion
1.11
Endnotes
1.11
ix
x
CONTENTS
CHAPTER 2 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS IN MERGERS AND ACQUISITIONS
2.1
ROBERT BOYDEN LAMB NEW YORK UNIVERSITY STERN GRADUATE SCHOOL OF BUSINESS Introduction
2.1
A Firm’s IP Has Become a Major Factor in Valuing M&A Deals
2.3
3M Corporation’s Shift from Internal R&D for IP to A Mixture with External Acquisitions for New IP
2.4
The Winner’s Curse in M&A Auctions and Its Effect on New IP Creation, Transfer, and Sharing
2.5
Investment Bankers Use Four Basic Methods of Valuing Mergers and Acquisition Transactions Comparable Company Analysis Comparable Transactions Analysis Discounted Future Steps to a Valuation Option Valuation
2.6 2.6 2.8 2.9 2.9 2.12
Damodaran’s Option Valuation Procedure for a Patent Value of Underlying Asset Variance in the Value of the Asset Exercise Price of Option Expiration of the Option The Dividend Yield An Important Caveat on Investment Bankers Selection of Valuation Method
2.13 2.13 2.13 2.13 2.13 2.13 2.16
Alternative IP Valuation Methods
2.16
Today’s Compression of the Product Life Cycle and Modern Valuation Problems
2.17
Mergers and Acquisitions and the Consolidation of Market Power in Various Industries in the World
2.19
Free IP Giveaways Impact M&A Growth and Price
2.22
Bundling of Free IP Add-ons Impact M&A Prices
2.23
Impact of Rapid Technological Advance on M&A Valuations
2.24
Merger Failure Is the Norm
2.25
Failed Merger Negotiations Risk IP Losses
2.27
Impact of New Internet IPO Market on M&A Prices
2.27
Typical M&A Valuation Problems of High-Technology Firms
2.28
M&A Valuation of IP Combines Investment Banking with Strategy Consulting
2.31
CONTENTS xi
Example of a Merger Valuation of IP in an Actual Transaction
2.33
Valuation: To Believe or Not to Believe
2.34
Models of Intellectual Property Firms: Incestuous Family, Network Alliances, Winner Take All, a Wheel of Fortune
2.37
Divestitures versus Acquisitions Signal the Driving Role of IP in Today’s Businesses Wheel of Fortune
2.38 2.39
AICPA Accounting Rule Changes Impact Merger and Acquisition Transactions and Valuations
2.39
Before the Long-Term Change in Pooling Accounting Rules
2.40
Ranges of Intellectual Property Financial Valuation
2.42
Valuation of Established Intellectual Properties
2.42
Valuations of a Competitor’s Intellectual Properties
2.44
Investment Bankers’ Merger and Acquisition Valuation Problems
2.44
Endnotes
2.45
CHAPTER 3 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY ACCOMPANYING MERGERS AND ACQUISITIONS
3.1
GORDON V. SMITH AUS CONSULTANTS Introduction
3.1
The Asset Portfolio Monetary Assets Tangible Assets Intangible Assets
3.1 3.1 3.2 3.3
Business Enterprise Value in Mergers and Acquisitions Acquisition Premiums Acquiring Intangibles
3.3 3.3 3.4
Intangible Assets and Intellectual Property Rights Relationships Assembled Workforce Customer Relationships Distributor Relationships Undefined Intangibles Goodwill Going Concern Value Intellectual Property Proprietary Technology Patents
3.4 3.4 3.5 3.5 3.5 3.6 3.6 3.6 3.7 3.7 3.8 3.9
xii CONTENTS
Copyrights Trademarks Internet Domain Names Computer Software Mask Works Right of Publicity Intellectual Capital
3.10 3.11 3.13 3.13 3.15 3.15 3.15
Comment
3.16
Endnotes
3.18
CHAPTER 4 VALUATION OF INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISI4.1 TIONS
MICHAEL J. LASINSKI INTECAP, INC. Introduction
4.1
Reasons for Valuing Intellectual Property in Mergers and Acquisitions 4.2 Strategic Reasons to Value Intellectual Property Management 4.2 Transactional Reasons to Value Intellectual Property 4.2 Company Acquisition Planning and Due Diligence 4.2 Licensing Intellectual Property 4.3 Acquiring or Selling Intellectual Property (in the Absence of a Business Combination) 4.4 Establishing Equity Contributions 4.4 Corporate Spin-Offs 4.4 Tax Reasons to Value Intellectual Property 4.4 Intercompany Transfer Pricing 4.4 Intellectual Property Management Subsidiary 4.5 Charitable Donations of Patents and Related Technology 4.5 Purchase Price Allocation 4.6 In-Process R&D 4.6 Financial Reasons to Value Intellectual Property 4.6 Obtaining Financing/Raising Capital/IP Asset-Backed Securitizations 4.6 Reorganization/Bankruptcy/Loan Workouts 4.7 Legal Reasons to Value Intellectual Property 4.7 Valuation Approaches and Their Application The Premise of Value: Fair Market Value The Sources of Potential Value Valuation Approaches: Market, Cost, and Income Market Approach Cost Approach Income Approach (Discounted Cash Flow Analysis) Amount of the Income Stream Duration of the Income Stream Accounting for the Risk of the Income Stream
4.7 4.8 4.8 4.9 4.9 4.9 4.10 4.11 4.13 4.13
CONTENTS xiii
Pricing Considerations in Licensing The Range of Negotiations: The Floor and the Ceiling The Licensor’s Theoretical Floor The Licensee’s Theoretical Ceiling Industry Royalty Rates Other Pricing Factors
4.16 4.16 4.16 4.17 4.17 4.18
Conclusion
4.18
Endnotes
4.19
CHAPTER 5 ACCOUNTING FOR INTELLECTUAL PROPERTY DURING MERGERS AND ACQUISITIONS
5.1
ANDREW W. CARTER INTECAP, INC. Introduction
5.1
Accounting for Intellectual Properties in Mergers and Acquisitions Asset Recognition Objective of Accounting System Financial Reporting of Business Combinations-General The Pooling Method The Purchase Method Which Method to Use
5.1 5.1 5.2 5.2 5.2 5.3 5.3
Financial Reporting for Acquired Intangible Assets Amortization Tax Treatment Impairment of Intangibles
5.3 5.5 5.5 5.6
Proposed Financial Accounting Standards Board Changes and Recent Developments 5.6 Proposed Elimination of the Pooling Method 5.6 Goodwill and Amortization 5.7 In-Process Research and Development Charges Definition of In-Process Research and Development Charges Historical Treatment of Research and Development Potential Changes Increased SEC Scrutiny of In-Process Research and Development Write-Offs
5.8 5.8 5.8 5.8 5.9
Bibliography
5.10
Endnotes
5.11
xiv CONTENTS CHAPTER 6 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS
6.1
GLENN A. GUNDERSEN DECHERT Introduction
6.1
Acquisition Agreement Contents of the Acquisition Agreement
6.1 6.2
Other Documents Transfer Documents Obtaining Assignments of Licenses Ancillary Agreements and Obligations
6.3 6.3 6.4 6.4
Drafting the Description of Assets Identifying the Intellectual Property Being Transferred as Part of a Stock Sale Identifying the Intellectual Property To Be Transferred in an Asset Sale Determining the Disposition of Jointly Used Intellectual Property
6.5 6.5 6.5 6.7
The Substance of Intellectual Property Representations and Warranties
6.7
How Intellectual Property Law Affects Representations and Warranties Patents Trademarks Copyrights Trade Secrets Rights of Publicity Industrial Design Rights Internet-Related Assets
6.8 6.8 6.9 6.10 6.11 6.11 6.11 6.11
Negotiating Representations and Warranties
6.12
Indemnification
6.16
Endnote
6.17
CHAPTER 7 U.S. ANTITRUST AND INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS
7.1
THOMAS G. JACKSON PHILLIPS NIZER BENJAMIN KRIM & BALLON, LLP Introduction
7.1
Enforcement Agency Policies Horizontal Merger Guidelines Non-Horizontal Merger Guidelines Antitrust Guidelines for the Licensing of Intellectual Property Antitrust Guidelines for Collaborations Among Competitors
7.2 7.2 7.2 7.3 7.3
Intellectual Property Issues in Merger Cases Horizontal Mergers and Joint Ventures
7.3 7.3
CONTENTS xv
Vertical Mergers Mergers Involving Horizontal and Vertical Restraints Exclusive Licensing
7.5 7.6 7.7
Conclusion
7.7
Endnotes
7.7
CHAPTER 8 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE IN BUSINESS TRANSACTIONS
8.1
SHELDON BURSHTEIN BLAKE, CASSELS & GRAYDON, LLP Introduction Need for Intellectual Property and Information Technology Due Diligence What Due Diligence Is Identification of the Nature of Primary and Related Transactions Share Purchase Asset Purchase Purchase from Receiver or Trustee Financing Due Diligence by Parties Other than the Purchaser Due Diligence by Seller Due Diligence by Borrower Due Diligence by Issuer Scope and Cost of Work for Intellectual Property and Technology Due Diligence Time Cost Nature of the Transaction Ancillary Agreements Nature of the Business Value of Intellectual Property and Information Technology Structure of the Business Domestic Issues of Multinational Transaction Multiple Location Business International Businesses Plans for the Business The Marketplace Assistance Secrecy Agreements Representations, Warranties, and Opinions Transitional Issues
8.1 8.1 8.3 8.3 8.4 8.4 8.4 8.5 8.6 8.6 8.7 8.7 8.8 8.8 8.8 8.9 8.9 8.10 8.11 8.11 8.13 8.13 8.13 8.14 8.14 8.15 8.15 8.15 8.16
Intellectual Property Rights Overview of Intellectual Property Patents Types of Searches
8.16 8.16 8.18 8.19
xvi CONTENTS
Limitations of Searches Follow-up Designs Types of Searches Limitations of Searches Follow-up Trademarks Types of Searches Limitations of Searches Trade Dress Domain Names Follow-Up Tradenames Copyright Types of Searches Limitations of Searches Moral Rights Neighboring Rights Database Rights Follow-up Semiconductor Chip Rights Plant Rights Personality Rights Proprietary Information Foreign Rights Secured Intellectual Properties On-Site Technology Investigations Products, Advertising, and Packaging Intellectual Property Maintenance Costs
8.21 8.22 8.23 8.23 8.24 8.25 8.25 8.26 8.27 8.28 8.28 8.29 8.30 8.31 8.32 8.32 8.32 8.33 8.33 8.33 8.33 8.34 8.35 8.35 8.36 8.37 8.39 8.39 8.40
Contract Review Agreement Review Secrecy Agreements License Agreements Assignments Franchise Agreements Distribution and Supply Agreements Co-packing and Toll Manufacturing Agreements Joint Venture and Strategic Alliance Agreements Research and Development Agreements Government Agreements Sponsorship and Co-promotion Agreements Advertising Agreements Employee and Contractor Agreements Settlement Agreements Information Technology Agreements
8.40 8.40 8.42 8.42 8.43 8.43 8.43 8.44 8.44 8.44 8.45 8.45 8.45 8.45 8.47 8.47
Information Technology Issues Hardware Software
8.47 8.47 8.48
CONTENTS xvii
Data Internet Issues Electronic Commerce Computer and Information Technology Industry
8.49 8.49 8.50 8.51
Liabilities Infringement Risks Litigation
8.52 8.52 8.53
Industry-Specific Issues Franchise Industry Merchandising Industry Pharmaceutical Industry Biotechnology Industry Publishing Industry Entertainment Industry Sports Industry
8.54 8.54 8.55 8.55 8.55 8.55 8.56 8.56
Regulatory Issues Technology Transfer Restrictions Access to Information Privacy and Personal Information Issues Competition and Antitrust Issues Franchising Industry Pharmaceutical Industry
8.57 8.57 8.58 8.58 8.58 8.59 8.59
The Results of Due Diligence Interpretation Representations and Warranties Definitions Title Validity and Enforceability Noninfringement Opinions
8.60 8.60 8.60 8.61 8.62 8.62 8.62 8.62
Conclusion
8.64
Endnotes
8.64
CHAPTER 9 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST ISSUES IN MERGERS AND ACQUISITIONS
9.1
MELVIN SIMENSKY VISITING SCHOLAR IN INTELLECTUAL PROPERTY LAW, NEW YORK LAW SCHOOL WILLIAM M. HEBERER HALL DICKLER KENT GOLDSTEIN & WOOD, LLP Introduction
9.1
Understanding the Transaction Form of Transaction Parties to the Transaction
9.3 9.3 9.4
xviii CONTENTS
Due Diligence Defining the Intellectual Property Audit Components of an Intellectual Property Audit Identify the Target’s Intellectual Property Assets Confirm Ownership Rights Assess the Strength and Enforceability of Target’s Rights Review Relevant Licenses and Agreements Analyze Potential Liabilities Checklists for Specific Assets Copyrights Patents Trademarks Trade Secrets Domain Names and Websites
9.4 9.5 9.5 9.5 9.6 9.6 9.6 9.7 9.8 9.8 9.9 9.9 9.11 9.11
Representations and Warranties
9.12
Recording of Transfers Assignments Security Interests Uniform Commercial Code: Article Nine Intellectual Property and Federal Preemption Proposals for Reform
9.12 9.12 9.13 9.13 9.14 9.20
Endnotes
9.21
CHAPTER 10 PATENT OPINIONS
10.1
DAVID A. LOEWENSTEIN BROWN RAYSMAN MILLSTEIN FELDER & STEINER LLP Introduction
10.1
Legal Framework Infringement Claim Construction Literal Infringement The Doctrine of Equivalents Contributory and Induced Infringement Validity
10.2 10.2 10.2 10.3 10.3 10.4 10.4
General Considerations Concerning Opinions Patents Give the Right to Exclude Applicable Legal Principles Identify the Foundation and Scope of the Opinion Identify the Device or Process at Issue Identify the Possibility of Pending Patent Applications Identify the Intended Recipient Assessing an Opinion’s Competence
10.5 10.5 10.6 10.7 10.7 10.7 10.7 10.8
CONTENTS xix
Clearance or Right to Use Opinions Reasons Not to Get Opinions Opinions Used Against the Recipient Is Ignorance Bliss? Opinions on Applications Patentability Opinions Opinions on Technical Merit
10.9 10.10 10.10 10.10 10.11 10.11 10.12
Disqualification and Waiver Rule 3.7: The Lawyer-Witness Rule Are the Authors “Necessary Witnesses”? Scope of the Waiver/Disqualification
10.12 10.12 10.13 10.13
Endnotes
10.16
CHAPTER 11 INTERNATIONAL MERGERS AND ACQUISITIONS: THE CANADIAN PERSPECTIVE
11.1
FRANCOIS PAINCHAUD, LOUIS-PIERRE GRAVELLE, PANAGIOTA KOUTSOGIANNIS, CHRISTIAN DANIS, AND MARIE-EVE COTE LEGER ROBIC RICHARD Introduction
11.1
Duality of the Canadian Legal Regime
11.1
Overview of the Transaction: Objective, Scope, and Costs Mergers, Competition Law, and Intellectual Property The Competition Bureau and Intellectual Property Enforcement Guidelines
11.2 11.3 11.4
Intellectual Property in Due Diligence Audits Patents Co-ownership of Patents Assignment of Patents Research at the Patent Office Trademarks Introduction Rights through Use Registration Application for Registration Term of Protection Limits on Trademark Enforcement Review of Marking in Association with Trademarks Assignment of Trademarks Research at the Trade-marks Office Copyright Rights Term of Protection Registration
11.6 11.7 11.8 11.10 11.11 11.12 11.12 11.12 11.12 11.12 11.13 11.13 11.13 11.14 11.14 11.15 11.15 11.15 11.16
xx
CONTENTS
Ownership Limits Due Diligence Assignment of Copyright Insolvency Moral Rights Research at the Copyright Office Marking in Association with Copyright Trade Secrets Definition of Trade Secrets Enforcement of Trade Secret Rights Assignment of Trade Secrets Nature of the Right Industrial Designs, Integrated Circuit Topographies, and Plant Breeders’ Rights Other State-Granted Licenses Assets in Personnel Impact of Employee-Employer Relationships
11.16 11.17 11.17 11.17 11.17 11.18 11.18 11.18 11.18 11.18 11.20 11.20 11.21 11.21 11.22 11.22 11.22
Licenses, Assignments, and Other Agreements Relating to Intellectual Property Licenses Assignments in an International Context
11.24 11.24 11.26
Security Interests in Intellectual Property Legislative Context Validity and Perfection of Security Interests Security Interest Searches and the Intellectual Property Registers Enforcement
11.26 11.26 11.27 11.27 11.29
Tax Considerations Eligible Capital Expenditures Depreciation of Intellectual Property Costs and Undepreciated Capital Cost (UCC) Undepreciated Capital Cost Scientific Research and Development Advantages under the Income Tax Act Deductions-Section 37 ITA Investment Tax Credit—Section 127 ITA Withholding Tax When Purchasing Intellectual Property Assets Non-Arm’s Length Transfers Tax-Free Transfers of Property to a Corporation Divisive Reorganizations Doing the Bump during Corporate Reorganizations Liability for Unpaid Tax
11.29 11.29 11.30 11.30 11.31 11.31 11.32 11.32 11.32 11.33 11.33 11.34 11.35 11.35
Endnotes
11.36
CONTENTS xxi CHAPTER 12 INTERNATIONAL MERGERS AND ACQUISITIONS: THE EUROPEAN PERSPECTIVE
12.1
BENEDICT BIRD, ANNA CARBONI, AND DEBORAH LINCOLN LINKLATERS & ALLIANCE Introduction
12.1
Structure of the Transaction Private Acquisition of Shares Private Acquisition of Assets Private Acquisition of Part of a Business Public Offer Merger Demerger Joint Venture Scheme of Arrangement
12.1 12.2 12.2 12.2 12.2 12.2 12.2 12.3 12.3
Due Diligence Purpose and Method of Due Diligence Confidentiality and Privilege Registrable Rights Patents Supplementary Protection Certificates Trademarks Designs Utility Models Plant Breeders’ Rights Identifying Registered Rights of the Target Investigating Registered Rights of the Target Unregistered Rights Trademarks Copyright Moral Rights Database Rights Designs Semiconductor Topography Rights Confidential Information Identifying Unregistered Rights of the Target Investigating Unregistered Rights of the Target Trademarks Copyright Designs Database Rights Semiconductor Topography Rights Confidential Information Identifying Contractual Rights Investigating Contractual Rights Dealing with Issues Arising from Due Diligence
12.3 12.3 12.4 12.5 12.5 12.5 12.6 12.6 12.8 12.8 12.8 12.8 12.10 12.10 12.10 12.10 12.10 12.11 12.12 12.12 12.13 12.13 12.13 12.14 12.14 12.14 12.14 12.14 12.15 12.15 12.16
xxii CONTENTS
Warranties and Indemnities Purpose of Warranties and Indemnities Factors to Take into Account Which IPRs Are Likely to Be Relevant? Should the Warranties Be Limited to “Knowledge, Information, and Belief”? Do the Warranties Cover IPRs That Are Licensed to, as Well as Owned by, the Seller? Which Group Company Is Giving the Warranty? Updating of Warranties Disclosure Letters
12.16 12.16 12.17 12.18
Transferring the Intellectual Property Rights Intellectual Property Rights Owned by the Target or a Company in Its Group Assignment or License? Formalities for Assigning Registered IPRs Formalities for Assigning Unregistered IPRs Intellectual Property Licenses Stamp Duty and Other Taxes
12.19 12.20 12.20 12.21 12.21 12.22 12.23
The French Perspective Merger Demerger Confidentiality and Privilege Confidential Information Purpose of Warranties and Indemnities Transferring the Intellectual Property Rights The Universal Transmission Principle Formalities Required Transferring Intellectual Property Owned or Licensed by the Target or a Company in Its Group Formalities for Assigning Registered IPRs Formalities for Assigning Unregistered IP Rights Intellectual Property Licenses Stamp Duty and VAT
12.23 12.23 12.24 12.24 12.24 12.24 12.24 12.24 12.25
The German Perspective Structure of the Transaction. Due Diligence Intellectual Property (Commercial Protection Law and Copyright Laws) Patents Supplementary Protection Certificates (Ergänzende Schutzzertifikate) Utility Models (Gebrauchsmuster) Semiconductor Topography Rights (Halbleiterschutzrechte) Plant Breeders’ Rights (Sortenschutzrechte) Trademarks (Marken) Registered Design Rights (Geschmacksmuster) Copyright (Urheberrecht)
12.26 12.26 12.27 12.27 12.28 12.29 12.29 12.29 12.30 12.31 12.31 12.31
12.18 12.18 12.18 12.18 12.18
12.25 12.25 12.25 12.25 12.26
CONTENTS xxiii
Secret and Nonsecret Know-How (Geheimes und Nicht-Geheimes Know-How) Warranties and Indemnities Transfer
12.31 12.32 12.32
Competition Law Relevance to Corporate Transactions The EC Competition Rules Assessing Market Power Article 81 Agreements Having as Their Object or Effect the Prevention, Restriction, or Distortion of Competition Appreciability Exemption Modernization of EC Competition Rules Licenses of IPRs Patent and Know-How Licenses Licenses of IPRs Other Than Patents and Know-How Research and Development Agreements Guidelines on Horizontal Cooperation Agreements The Sale Agreement Article 82 The ECMR
12.35 12.36 12.36 12.37 12.37 12.38 12.39 12.39 12.40 12.41 12.41 12.44
Appendix 1
12.45
Endnotes
12.47
CHAPTER 13 INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES
12.33 12.33 12.33 12.33 12.34
13.1
SUSAN BARBIERI MONTGOMERY AND LEONARD SCHNEIDMAN FOLEY HOAG & ELIOT, LLP Introduction
13.1
Formation of the Holding Company Contribution of Intellectual Property Rights Domestic Transfer of Intellectual Property Rights Offshore Transfers of Intellectual Property Rights Business Purpose
13.2 13.2 13.2 13.3 13.3
Use of a Domestic Holding Company Delaware Investment Holding Companies Attacks on Delaware Investment Holding Companies
13.4 13.4 13.5
Use of a Foreign Holding Company Offshore Intellectual Property Rights Licensed to a Related United States Licensee Deductibility of License Royalties Royalty Rate The “Superroyalty” Provision
13.7 13.7 13.7 13.7 13.8
xxiv CONTENTS
Withholding for U.S. Tax Internal Revenue Service Enforcement
13.8 13.8
The Effect of Tax Treaties Withholding Rates Cascading Royalties Limitations on Treaty Benefits Anti-Conduit Regulations Foreign Holding Company Licensing to Its Foreign Affiliates
13.8 13.8 13.9 13.9 13.10 13.10
Endnotes
13.10
CHAPTER 14 OFFSHORE CORPORATIONS
14.1
TIRA GREENE CONSULTANT ANGUILLA MICHAEL J. WARD COUNSEL LIMITED ANGUILLA Introduction
14.1
Offshore Jurisdictions
14.1
Holding Company or Active Business?
14.2
When to Go-Before the Intellectual Property Exists
14.2
When to Go-Early in the Development Cycle
14.3
Transaction Types
14.4
Which Vehicle to Use
14.6
Conclusion
14.8
Endnotes
14.8
CHAPTER 15 ACQUISITION AND LICENSING OF FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY IN THE UNITED STATES
15.1
THEODORE C. MAX PHILLIPS NIZER BENJAMIN KRIM & BALLON, LLP Introduction
15.1
Fair Use Defense: “A Rose By Any Other Name . . . ”
15.4
Right of Publicity: What’s in a Persona The Name Must Be Identifiable and Known to Be Protected A Person’s Persona Also May Be Identified by a Photograph or Likeness Voice and Sound Are Now Protectable under the Right of Publicity
15.5 15.5 15.5 15.6
CONTENTS xxv
State and Common Laws Govern the Right to Publicity in the United States Postmortem Rights of Publicity Seventeen States Recognize Common Law Rights of Publicity Alabama California Connecticut Florida Georgia Hawaii Illinois Kentucky Louisiana Minnesota New Jersey Ohio Oklahoma Pennsylvania Tennessee Texas Utah Wisconsin
15.6 15.6 15.7 15.7 15.7 15.7 15.7 15.7 15.7 15.8 15.8 15.8 15.8 15.8 15.9 15.9 15.9 15.9 15.9 15.9 15.10
Federal Protection of the Right of Publicity under the Lanham Act § 43(a): Implied Endorsement
15.10
Defenses to Right of Publicity Claims First Amendment Parody Statutes of Limitation
15.10 15.10 15.10 15.10
Transactions Involving Famous Name Trademarks and the Right of Publicity: Assignment and Licenses
15.11
Endnotes
15.16
CHAPTER 16 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
16.1
LANNING G. BRYER AND SCOTT J. LEBSON LADAS & PARRY Introduction
16.1
Means of Acquiring Intangible Assets Mergers Purchase Agreement Supplemental Closing Documentation Sale of Assets Stock Purchase
16.3 16.3 16.3 16.4 16.4 16.4
Tax Considerations
16.5
xxvi CONTENTS
Antitrust Patents Copyrights Trademarks Grant-backs Competition Law in the European Community
16.5 16.7 16.7 16.7 16.7 16.8
Worldwide Recordal of Intellectual Property Rights Separate Documents for Each Jurisdiction Are Required Costs
16.9 16.10 16.11
Transfer of Trademarks Assignment Intent-to-Use Trademarks The Paris Convention Goodwill under the Community Trademark System Goodwill under the Madrid Agreement and Protocol Recordal of Trademark Assignments in the United States Benelux The Community Trademark Madrid Agreement and Madrid Protocol Other Multilateral Treaties
16.11 16.11 16.12 16.12 16.12 16.12 16.13 16.13 16.14 16.14 16.15
Worldwide Patent Assignment Recordal
16.15
Transfer of Patents in the United States
16.15
Transfer of Trade Secrets in the United States
16.16
Worldwide Copyright Assignment Recordal
16.16
Transfer of Copyrights in the United States
16.16
Transfer of Domain Names
16.18
Conclusion
16.19
Endnotes
16.19
INDEX
I.1
PREFACE Understanding how intellectual property rights are involved with mergers and acquisitions—the topic of this book—is essential given how merger and acquisition (M&A) activity in the intellectual property field has come to dominate, both in volume and in value, merger transactions generally. This situation was true in the 1990s, and it is true now. The driving force behind a majority of present mergers and those completed during the past decade has been the acquirer’s desire to obtain the target’s intellectual property assets. In the past 15 years, as the number of M&A transactions has exploded, a significant majority of these deals occurred because of the acquirer’s perceived need for the target’s intellectual property assets. These intangibles have included assets such as groundbreaking technologies, unique patents, mask works, Internet domain names, and significant media portfolios in the form of copyrighted movies, television programming, books, and music. The mergers of America Online (AOL) with Time Warner, Exxon with Mobil, American Home Products with Warner Lambert, and Travelers Group with Citicorp were all heavily influenced by the acquirer’s desire for the target’s intellectual properties. All of these mergers have taken place since April 6, 1998. Of these four transactions, AOL’s acquisition of Time Warner represents one of the largest M&A deals in history. AOL bid $180 billion to acquire Time Warner’s intellectual property assets, consisting of a TV cable system and its huge library of copyrighted films, TV series, and magazines. Intellectual property assets are particularly valuable because they enable firms to create and hold monopoly power on unique products and services. Key intellectual property rights can provide owners with significant business advantages by allowing, for example, the creation of “specialized” goods that are capable of generating high profit margins. This situation contrasts with competitors that can produce only “standardized” products selling at much lower margins. Today’s role of intellectual property in mergers and acquisitions favorably compares to the role such property plays in advanced economies. For example, in the United States in 1929, the ratio of intangible business assets to tangible business capital was 30 percent to 70 percent. By 1990, such ratio was nearly reversed, from 63 percent to 37 percent. Today, more than 70 percent of U.S. growth comes from intangible asset exploitation versus less than 30 percent from tangible property. An interesting feature of M&A activity is that it occurs both in boom and bust times. The boom side of the equation is amply demonstrated by the fact that recent M&A activity has accounted for a significant percentage of the world’s economy. Such a phenomenon is reflected in the ratio of recent M&A activity to the world’s largest economy: that xxvii
xxviii PREFACE
of the United States. Thus, global M&A activity in the year 2000 was valued at nearly $4 trillion, or a robust 40 percent of the estimated $10 trillion American economy in 2001. M&A transactions also occur in less economically vibrant times. Much of this activity takes place when a company, to obtain the economic benefits of consolidation in a particular industry, goes out and starts buying its competitors. In the health care industry, for instance, hospitals continue to merge to acquire the economic clout necessary to force insurers to increase their coverage payments to the hospitals. For example, in Cleveland, Ohio, two hospital organizations control more than 80 percent of the market. Due to their combined economic power, these two organizations have been able to negotiate rate increases with their insurers of more than 15 percent for some hospital services. The dominating presence of intellectual property in mergers and acquisitions coincides with the emergence of several new intellectual property-oriented M&A considerations. First, most merger and acquisition activity was once dominated primarily by the United States. This circumstance, particularly during the 1990s, changed with the sweeping globalization of intellectual property-oriented mergers. For example, in 1999 the U.S. merger volume rose to a record $1.7 trillion while Europe’s merger volume more than doubled from the prior year to $1.23 trillion. Indeed, the largest hostile takeover ever, and for intellectual property assets at that, did not occur in the United States but rather in Europe with British Vodafone’s acquisition of Hannesmann of Germany for $183 billion. Second, because of the difference between tangible assets (such as inventory and factories) in contrast to intangible intellectual property assets, methods ordinarily used to value mergers involving tangible assets do not work well when applied to acquisitions of intellectual property. Despite the fact that M&A’s involving intellectual property has dominated the merger scene for several years, merger participants are still failing to apply appropriate M&A valuation procedures. Third, it is unquestionable that Europe has newly arrived as a major player in the global M&A scene. Such a recent arrival also appears to have ushered in the new phenomenon of taking European Union (EU) competition law seriously. Such law deals with regulating the impact of mergers on their respective principles. Analogous American law is found in this country’s antitrust principles. In today’s global economy, it is critical for most companies to be capable of conducting business internationally. In other words, such companies must become knowledgeable about other nations’ competition laws or their equivalent. As this book is being readied for publication, the EU’s European Commission, which enforces EU competition law, has just rejected a proposed merger between General Electric Company and Honeywell International. Some have described this action as a “milestone.” Not only did such rejection involve the determination by European regulators of a transaction between two American companies, but more significantly, such rejection followed upon the merger’s prior approval by U.S. antitrust regulators. The preceding issues and considerations are substantially discussed in several of this book’s chapters. Patrick Gaughan sets the table in defining and explaining what makes an M&A deal unique. Robert Lamb’s contribution in his chapter on “The New Role of Intellectual Property in Mergers and Acquisitions” discusses the changing European role in world M&A activity while also considering various methodologies to value such
PREFACE xxix
business activity. Gordon Smith, in his chapter on “Intangible Assets and Intellectual Property Accompanying Mergers and Acquisitions,” and Michael J. Lasinski, in his chapter on “Valuation of Intellectual Property Assets in Mergers and Acquisitions,” provide an in-depth treatment of the valuation of intellectual property in the mergers and acquisitions context. United States antitrust principles form the subject matter of Thomas Jackson’s chapter while Benedict Bird, Anna Carboni, and Deborah Lincoln discuss the competition rules of the European Commission. Accounting issues are identified and discussed by Andrew Carter in Chapter 5, while significant M&A legal issues are covered by Glenn Gundersen in Chapter 6 and due diligence issues by Sheldon Burshtein in Chapter 8. David Lowenstein covers the critical topic of rendering legal opinions in Chapter 10. In Chapter 11, Francois Painchaud and his colleagues, Louis-Pierre Gravelle, Panagiota Koutsogiannis, Christian Danis, and Marie-Eve Cote provide the Canadian perspective on M&A transactions. The complex and unique issues of holding companies and offshore transactions are treated, respectively, by Susan Barbieri Montgomery and Leonard Schneidman in Chapter 13 and Tira Greene and Michael Ward in Chapter 14. Finally, in Chapter 15, Ted Max provides insight on the protection and transfer of famous name trademarks and rights of publicity in mergers and acquisitions. We are pleased to note that this book, like our other Wiley publications, treats its subject matter from both a legal and a business perspective, and these perspectives are interdisciplinary in nature. While we have obtained contributions from both prominent domestic and foreign legal practitioners, we have also presented the work of businesstrained professionals, including a professor of economics, a professor of management and finance, and several experts on the valuation of intellectual property assets and accountants. We hope our readers find that this book provides useful information relating to the significant business and legal issues when mergers and acquisitions take place to acquire another entity’s intellectual property assets. Lanning G. Bryer Melvin Simensky October 2001 New York, New York
ACKNOWLEDGMENTS The editors of this book owe significant debts of gratitude to many people without whose time and effort this work would not have been possible. First, we wish to thank our spouses and children who patiently endured the lost evenings and weekends during the birth, development, and publication of this work. We are indebted to our law partners and colleagues for their understanding and forbearance and for believing in the value of this project. The editors would be seriously remiss if they did not, at every opportunity, extend their deep appreciation to the many contributors who submitted chapters, and sections of chapters, to make this work what it is. The editors wish to express their sincerest appreciation to Scott J. Lebson, an associate in the New York office of Ladas & Parry and coauthor of Chapter 16, for his tireless efforts in the research, drafting, corresponding, and organization of this book. Without his skill, energy, and dedication, this work would not have been possible. The editors wish to thank their former professional and trade editor at John Wiley & Sons, Inc., Martha Cooley, who had the vision to approach us to write this book and the persistence and courage to convince us to do it. Finally, we thank the splendid professional and trade editor of John Wiley & Sons, Inc., Susan McDermott, for assuming command of this project and her encouragement and assistance in making this book a reality.
xxx
CHAPTER
1
MERGERS AND ACQUISITIONS: AN OVERVIEW1 Patrick A. Gaughan, Ph.D. College of Business, Fairleigh Dickinson University Economatrix Research Associates, Inc.
INTRODUCTION
The 1990s featured the most intense period of mergers and acquisitions in U.S. economic history. This period is now recognized as the fifth merger wave in U.S. history. Merger waves are periods of unusually intense merger and acquisition activity.2 There have been five such periods since the start of the twentieth century, with the previous one occurring in the 1980s. This wave featured many record-breaking mergers. When it ended in the late 1980s, many thought that there would be an extended period of time before another one began. However, after a short hiatus, an even stronger merger wave took hold, far eclipsing that of the 1980s. The merger wave of the 1990s was path breaking due to the dollar value of the transactions and the unusually high number of deals (see Exhibits 1.1a and 1.1b). While the fourth wave of the 1980s was known for both its megamergers and its colorful hostile deals, the fifth wave has featured far larger deals, as well as a good supply of hostile transactions. Fifth Merger Wave Exported to Europe. While the fourth merger wave of the 1980s was
largely confined to the United States, large-scale mergers and acquisitions finally made their way to Europe in the mid-1990s.3 In recent years, cross-border deals within Europe have grabbed the headlines. Even hostile takeovers, long thought to be an exclusively American phenomena, started becoming more common in Europe. This is underscored by the fact that the biggest deal of all time was the Vodafone– Mannesmann $183 billion hostile takeover. In addition to deals within Europe, transAtlantic deals, with European buyers of U.S. companies and vice versa, started to become commonplace. With the development of the European Union and the erosion of nationalistic barriers as the continent moved to a unified market structure with a common currency, companies began to see their market as all of Europe and more. It became clear that a European consolidation was in order. Although there are many indications that there will be realizable benefits from such a consolidation, only time will reveal the magnitude of these benefits. 1.1
1.2
MERGERS AND ACQUISITIONS: AN OVERVIEW
10,000
8,000
6,000
4,000
2,000
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
Exhibit 1.1a Merger and Acquisition Transaction, 1980–2000
Source: Mergerstat Review, various years
200
$ Billions
150
100
50
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
Exhibit 1.1b Dollar Value of U.S. Acquisitions of Foreign Companies, 1980–2000
Source: Mergerstat Review, various years
The main volume of non-U.S. mergers and acquisitions is taking place in Europe, with Asia well behind (see Exhibits 1.2a and 1.2b). However, the fact that corporate restructuring is taking place in nations such as Japan and Korea is reflective of their pressing need to revamp their conservative and poorly performing corporate structures
INTRODUCTION 1.3 350 300
$ Billions
250 200 150 100 50
Exhibit 1.2a
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
Dollar Value of Foreign Acquisitions of U.S. Companies, 1980–2000
Source: Mergerstat Review, various years
200
$ Billions
150
100
50
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
Exhibit 1.2b Dollar Value of U.S. Acquisitions of Foreign Companies, 1980–2000
Source: Mergerstat Review, various years
in light of their prolonged recessions. Due to the continued weak economies in Asia, many companies in Japan and Korea are not looking at acquisitions, but at sell-offs and other forms of restructuring. While this chapter primarily focuses on the U.S. merger market, most of the principles that are discussed also apply to non-U.S. mergers. Fifth Merger Wave Compared to Prior Merger Periods. The fifth merger wave began in approximately 1993 as the economy began to recover from the 1990-1991 recession. As the economy expanded, firms sought to meet the growing demand in the economy
1.4
MERGERS AND ACQUISITIONS: AN OVERVIEW
by acquiring or merging with other companies. One of the things that is unusual about the fifth merger wave is that it somewhat closely followed the fourth merger wave, which began in approximately 1984 and ended in 1989. That fourth merger wave was a period characterized by megamergers and many highly leveraged transactions. These highly leveraged transactions often relied upon the financing provided by the junk bond market that grew dramatically in the 1980s, only to collapse at the end of the decade. The three prior merger waves were at the start of the century, during the boom in the 1920s, and at the end of the 1960s. Each was different from the others. The first merger wave, which occurred between 1897 and 1904, featured a transformation of the American economy from one of many small companies to larger, sometimes monopolistic firms dominating an industry. This period of consolidating acquisitions was ironic in light of the fact that the Sherman Antitrust Act was passed in 1880—less than a decade from the start of the nation’s first merger wave. However, there are several reasons for the lack of antitrust enforcement, including the difficulty the courts had in interpreting the broad provisions of the law and the fact that the Justice Department lacked the resources, if not the mindset, to stand in the way of this first great merger wave. This changed with the passage of the Clayton Act in 1914 and the establishment of the Federal Trade Commission in the same year which, along with the Justice Department, enforces antitrust laws. The second merger wave began in 1916 and continued until the economic downturn in 1929. This wave featured many of the same types of horizontal transactions as the first wave, but also had a good percentage of vertical transactions. It has been said that the first wave was a mergers toward monopoly period while the second wave was a mergers toward oligopoly period. Like the first wave, it also ended when the market and the economy turned down. This pattern was mirrored again in the third merger, which took place between 1965 and 1969. This wave featured conglomerate acquisitions, which are acquisitions outside of the bidder’s own industry. Such deals were partly caused by the fact that bidding companies wanted to expand but were halted by the intense antitrust enforcement that prevailed in the 1950s and 1960s. The only alternative left to expansion-minded companies was to look outside their industry and buy companies that would not be considered in any way a strategic fit by today’s standards. Many of these companies paid a price for these nonstrategic deals when they sold off those diversifications in the 1970s and 1980s. As noted previously, one characteristic of merger waves is that they tend to occur during economic expansions, and they tend to end when the market and the economy slow down. This makes sense in that expansions bring about increasing economic demand, causing companies to look to grow. When the economy slows, companies are not thinking about expansion as much, and mergers play a lesser role in corporate planning. In addition, when the market turns down, deals that could have been financed by stock may become more expensive. TYPES OF MERGERS, ACQUISITIONS, AND CORPORATE RESTRUCTURINGS
Mergers and acquisitions are usually, but not always, part of an expansion strategy. They can be horizontal deals, in which competitors are combined. The 1998 $77.2 billion merger between Exxon and Mobil is an example of a successful horizontal deal.
TYPES OF MERGERS, ACQUISITIONS, AND CORPORATE RESTRUCTURINGS 1.5
They can also be vertical transactions, in which suppliers merge with buyers or distributors. The 1993 $6.6 billion merger between Merck, a pharmaceutical manufacturer, and Medco, a pharmaceutical distributor, is an example of a vertical deal. Companies may also acquire firms that are in totally different industries. These types of deals are called conglomerate mergers. Daimler Benz’s acquisitions in sectors such as the aerospace industry help convert the premium automobile manufacturer into a conglomerate and Europe’s largest industrial company. The legacy of such deals is not impressive, but some companies, such as General Electric, have shown some success (at least up to the sizable acquisition of Honeywell). When companies look to downsize, as opposed to expand, they have several alternatives available to accomplish this. They may simply sell a division through a divestiture. They may also consider a spin-off, such as when AT&T spun off different components of the overall company. When a company does this, shareholders in the original company usually become shareholders in different and separate corporate entities. Another alternative to downsizing is an equity carve-out, which is an issuance of stock in the division that is to be separated from the overall company. A less radical alternative is to issue a tracking stock that will follow the performance of the division in question. When the market is pressuring for a sell off, however, a tracking stock may not be sufficient to meet the demands of the market. Why Do Firms Merge? Growth. One of the most common motives for mergers is growth. There are two broad
ways a firm can grow. The first is through internal growth. This can be slow and ineffective if a firm is seeking to take advantage of a window of opportunity in which it has a short-term advantage over competitors. The faster alternative is to merge and acquire the necessary resources to achieve competitive goals. Even though bidding firms will pay a premium to acquire resources through mergers, this total cost is not necessarily more expensive than internal growth, in which the firm has to incur all of the costs that the normal trial and error process may impose. While there are exceptions, in the vast majority of cases growth through mergers and acquisitions is significantly faster than through internal means. Synergy. Another commonly cited motive for mergers is the pursuit of synergistic ben-
efits. This is the new financial math that shows that 2 + 2 = 5. That is, as the equation shows, the combination of two firms will yield a more valuable entity than the value of the sum of the two firms if they were to stay independent: Value (A + B) > Value (A) + Value (B) Although many merger partners cite synergy as the motive for their transaction, synergistic gains are often hard to realize. There are two types of synergy: that which is derived from cost economies and that which comes from revenue enhancement. Cost economies are the easier of the two to achieve because they often involve eliminating duplicate cost factors such as redundant personnel and overhead. When such synergies are realized, the merged company generally has lower per-unit costs. Many of the consolidating mergers of the fifth merger wave are partially based upon the pursuit of such
1.6
MERGERS AND ACQUISITIONS: AN OVERVIEW
synergistic economies. Because this is an important part of the fifth merger wave, it is discussed separately in the section that follows this one. Revenue enhancing synergy is more difficult to predict and to achieve. An example would be where each firm believes that it can sell its products and services to the other firm’s customer base. Another example would be a situation where one company’s capability, such as research prowess, is combined with another company’s capability, such as marketing skills, to significantly increase the combined revenues. Consolidating and Roll-Up Mergers of the Fifth Merger Wave. One interesting characteristic of the fifth merger wave is the trend toward consolidating, or roll-up, mergers. In certain industries, such as the printing and the funeral home industry, leading firms, sometimes called consolidators, acquired competitors across the nation in an effort to build dominant companies. Other industries, such as banking and telecommunications, spurred on by significant changes in the regulatory environment, also saw many such consolidations. Many of these acquisitions were based on the hypothetical pursuit of economies of scale and other such efficiencies. It is clear now, however, that if anything, roll-up companies got less efficient as they pursued deal after deal, not pausing to integrate the companies they had already acquired. In retrospect, it is clear that the roll-up strategy was highly questionable. Diversification. Other motives for mergers and acquisitions include diversification, whereby companies seek to lower their risk and exposure to certain volatile industry segments by adding other sectors to their corporate umbrella. The track record of diversifying mergers is generally poor with a few notable exceptions. A few firms, such as General Electric, seem to be able to grow and enhance shareholder wealth while diversifying. However, this is the exception rather than the norm. Diversification may be successful, but it seems to need more skills and infrastructure than some firms have. Related versus Unrelated Diversifications. Not all kinds of diversifications turn out
poorly. While research studies show that unrelated diversifications tend to yield poor results, related diversifications, mergers, and acquisitions into a field that is close to the acquiring firm’s main line of business tend to have a more impressive track record.4 Other studies have shown that increased corporate focus tends to be associated with higher share values.5 This result has intuitive appeal. The lesson from such research tells us that staying with what a company knows best may yield positive results, but straying into businesses that it does not know is an uphill battle that only a select few companies can manage successfully. Leveraged Transactions. The fourth merger wave featured the introduction of the leveraged buyout (LBO). This is a transaction that is financed using a significant amount of debt and often involves taking a public company private. Many of those deals relied upon financing from the junk bond market, which grew dramatically during the fourth wave. Junk bonds, bonds with a Standard and Poors rating of BB or lower, had been around for decades. However, the late 1970s featured the introduction of the original issue junk bonds—bonds that were lower rated right from the date of issuance. A combination of factors, including the willingness of market-makers such as Drexel Burnham
HOW DO MERGERS TURN OUT AND WHAT CAN GO WRONG? 1.7
Lambert to provide liquidity to this market, enabled the junk bond market to grow dramatically in the fourth wave. Unfortunately, many of the highly leveraged deals collapsed when the economy turned down at the end of the decade. Leveraged transactions continued to be conducted in the fifth merger wave. After a short hiatus, LBOs started to become more common in the 1990s, but there were a number of differences between these deals and those of the fourth merger wave. The transactions tended to be smaller and were a fraction of the size of some of the megaLBOs, such as the RJR Nabisco $24.6 billion LBO. ROLE OF INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS
Part of the fuel for the fifth merger wave was provided by the technology sector, where the attraction of merger targets was often their valuable intellectual property. The rapidly evolving high tech sector caused industry participants to rapidly seek out assets, often in the form of intellectual property, so as to keep up with the rapid pace of technological development in their industry. This helps explain why some of the more prolific acquirers of this wave were Cisco and, to a lessor extent, Lucent Technologies. Clearly Cisco accomplished this task better than Lucent. With the collapse of the market values of these companies, the currency they often used to finance acquisitions, their stock, became devalued. This, along with other troubles, led to a significant slowdown in acquisitions in this sector. HOW DO MERGERS TURN OUT AND WHAT CAN GO WRONG?
As previously noted, certain types of mergers, such as diversifications, tend to yield poor results. Unfortunately, many other acquisitions and mergers yield mediocre results, and some are outright failures. Prominent examples include the Snapple acquisition in which Quaker Oats overpaid and synergies were impossible to find. Others include the recent failed Kroll-O’Gara merger or the various failed deals in the automobile industry, such as the BMW-Rover acquisition or the Daimler Benz acquisition of Fokker and merger with Chrysler. While hindsight is omniscient, it is hard to see how Quaker Oats could justify the high premium it paid in a market that was saturated and showed limited growth potential. The adverse result in the Snapple deal is illustrative of one of the pitfalls of mergers—overpaying. The higher the price that a bidder pays, as a multiple of earnings, the higher growth in earnings that is needed to justify the price. Sometimes bidding contests can cause acquisition prices to rise well above that which can be justified by any reasonable expectation of growth. This is why successful bidders in takeover battles sometimes get inflicted with what is called the winner’s curse. Other recent examples include the failed Rite Aid acquisition program. Rite Aid’s 1996 $1.4 billion acquisition of the incompatible Thrifty Pay Less chain was one of the factors cited for the firing of the company’s chief executive. When a potentially compatible acquisition of Revco was halted by the Federal Trade Commission, the company went to a less favorable choice. Rite Aid also did not anticipate the integration problems it would have following the acquisition. This underscores another pitfall of mergers and acquisitions—post-merger integration. In spite of abundant premerger planning, it is sometimes difficult to predict all of the post-merger integration problems that will occur.
1.8
MERGERS AND ACQUISITIONS: AN OVERVIEW
What Can Go Wrong with Intellectual Property Motivated Acquisitions? Deals based upon the acquisition of intellectual property can present their own unique set of challenges. Hard physical assets are often easier to evaluate. For example, a company seeking to acquire the real estate assets of a target company can have those assets appraised individually and come up with an objective valuation. Due to the intangible nature of many intellectual property assets, they are often harder to value. This is particularly true in the rapidly evolving high-technology sector where it is often hard to anticipate both the demand for new products and technologies and the responses by competitors who may be pursuing a similar strategy. The possibility of acquiring intellectual property that may be worth much less or much more than what was originally estimated is greater than the variation that one might expect with more tangible assets. Unfortunately, the rapidly changing nature of some sectors may mean that internal development may be too slow a process and acquisitions may be the only viable route. In such cases, this may simply be a risk that companies have to assume to stay competitive. Trends in Deal Prices for the Fifth Merger Wave. As deal volume rose to record breaking
levels, deal prices also reached new heights (see Exhibit 1.3a). Several factors explain this. For one, the growth of the economy created a situation in which aggressive bidders seeking fast growth bid up the prices of target companies. In addition, the persistent decline in long-term interest rates helped lower discount rates that are used for valuation (see Exhibit 1.3b). Lower discount rates increase the present value of future cash flows and result in higher values of target companies. Between high demand for companies and lower discount rates, values reached unprecedented levels in the late 1990s and in 2000. When the economy slowed in 2001, the pace of deals also slowed with it—consistent with historical experience. This pause notwithstanding, mergers and acquisitions remain a permanent part of many companies’ corporate strategy. Winners and Losers in Mergers and Acquisitions. Various constituents are affected dif-
ferently by mergers and acquisitions. One natural group to focus on are the sharehold-
500 400 300 200 100
Exhibit 1.3a Number of Leveraged Buyouts, 1980–1999
Source: Thomson Financial Securities Data
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
HOW DO MERGERS TURN OUT AND WHAT CAN GO WRONG? 1.9 $200
Billions
$150
$100
$50
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
$0
Exhibit 1.3b Dollar Value of Leveraged Buyouts, 1980–1999
Source: Thomson Financial Securities Data
ers of the different companies involved in the deal. The shareholder wealth effects differ based upon whether the deal is friendly or hostile. These effects are summarized as follows:6 1.
2.
3.
4.
Target shareholders earn positive returns from merger agreements. Several studies have shown that for friendly, negotiated bids, target common shareholders earn statistically significant positive abnormal returns.7 These returns are a function of the premiums that target shareholders receive. Target shareholders may earn even higher significant positive returns from tender offers. Target common shareholders of hostile bids which are tender offers also receive statistically significant positive returns.8 The hostile bidding process may create a competitive environment which may increase the acquiring firm’s bid and cause target shareholder returns to be even higher than what would have occurred in a friendly transaction. Target bondholders and preferred stockholders gain from takeovers. Both target-preferred stockholders and bondholders gain from being acquired.9 Given that bidders tend to be larger than targets, the addition of the bidder as another source of protection should lower the risk of preferred stocks and bonds, making them more valuable. Thus, like the target common shareholder effects, this is an intuitive conclusion. Acquiring firm shareholders tend to earn zero or negative returns from mergers. Acquiring firm stockholders tend not to do well when their companies engage in acquisitions.10 These effects are either statistically insignificant or somewhat negative. Presumably, this reflects that markets are skeptical that the bidder can enjoy synergistic gains, which more than offset the fact that it is paying a premium for the target. The fact that the bidder’s stock response is small compared to that of the target is due to the fact that bidders tend to be larger than targets.11
1.10 MERGERS AND ACQUISITIONS: AN OVERVIEW
5.
Acquiring firm shareholders tend to gain little or no returns from tender offers. Acquiring firm shareholders also tend not to do well when their firm takes over a target through a hostile bid. There is some evidence that there may be a response that ranges from either mildly positive to zero.
Effects of Sell Offs. Sell offs are the opposite of mergers. They are a form of downsiz-
ing and are often a result of a determination that a prior acquisition did not work out satisfactorily. These sell offs can come in various forms, such as through a straight divestiture where a company simply sells off a division to a buyer. Other possibilities include a spin-off, which is when a new company is formed and shareholders in the original company become shareholders in both the original firm (which is smaller as a result of the spin-off) and the newly formed company. Another alternative is to do an equity carve-out involving a public offering of stock in a newly formed company, which is the division being separated from the parent company. Exhibit 1.4 shows that the shareholder wealth effects of sell offs are positive. It can be seen from Exhibit 1.4 that numerous research studies, covering an extended period of time, show that the decision of a parent company to sell off a division has a positive effect on the parent company. It seems to imply that the market believes that the division had a negative effect on the overall company, and separating the division from the parent company should increase shareholder value. This is due to the fact that resources would not have to be diverted to the division, as well as the fact that the parent company would receive payment in exchange for its interest in the division.
Days
Average Abnormal Returns (%)
Period Sampled
Sample Size
Alexander, Benson, and Kampmeyer (1984)
–1 through 0
0.17
1964–73
53
Hite and Owers (1984)
–1 through 0
1.50
1963–79
56
Hite, Owers & Rogers (1987)
–50 through –5
0.69
1963–81
55
Jain (1985)
–5 through –1
0.70
1976–78
1, 107
Klein (1983)
–2 through 0
1.12
1970–79
202
Linn and Rozeff (1984)
–1 through 0
1.45
1977–82
77
Loh, Bezjak & Toms (1995);
–1 through 0
1.50
1982–87
59
Rosenfeld (1984)
–1 through 0
2.33
1963–81
62
Study
Exhibit 1.4 Average Stock Price Effects of Voluntary Sell-Offs12
Source: Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons, 1999), 413.
ENDNOTES 1.11 CONCLUSION
The merger and acquisition business continued to grow in the year 2000. The economic growth of the 1980s and 1990s has fueled two major merger waves in the United States. The most recent merger wave, the fifth in U.S. history, spread to Europe as the continent was enjoying economic growth. This growth, combined with the economic impact of the European Union and deregulation, helped the fifth merger wave in the United States spread to Europe. It is unknown how these fifth-wave deals will turn out. It is hoped that deal makers learned from the mistakes of prior merger periods and crafted deals that will not be as susceptible to the flaws of past transactions. However, one can be sure that the fifth wave will have brought its share of failures. ENDNOTES 1 Many of the topics that are briefly introduced in this chapter are discussed at length in Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons, 1999). 2 Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons, 1999), 21–60. 3 Patrick A. Gaughan, “Mergers and Acquisitions in the 1990s: A Record Breaking Decade,” Journal of Corporate Accounting & Finance 11, no. 2 (January/February 2000): 3–5. 4 P.G. Berger and E. Ofek, “Diversification’s Effect on Firm Value,” Journal of Financial Economics 37, no. 1 (January 1995): 3965. 5 R. Comment and G. Jarrell, “Corporate Focus and Stock Returns,” Journal of Financial Economics 37, no. 1 (January 1995): 67–87. 6 This section is taken from Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings, 2nd ed. (New York: John Wiley & Sons 1999), 522–525. 7 Debra K. Dennis and John J. McConnell, “Corporate Mergers and Security Returns,” Journal of Financial Economics 16 (2), (June 1986): 143–187. Paul Asquith, “Merger Bids, Uncertainty and Stockholder Returns,” Journal of Financial Economics 11 April 1983: 51–83; Paul Asquith and E. Han Kim, “The Impact of Merger Bids on Participating Firm’s Security Holders,” Journal of Finance, 37, (1982), 121–139; Peter Dodd, “Merger Proposals, Management Discretion and Shareholder Wealth,” Journal of Financial Economics 8 (1980): 105–138. 8 Michael Bradley, Anand Desai, and E. Han Kim, “The Rationale Behind Interfirm Tender Offers,” Journal of Financial Economics 11 (1–4), (April 1983): 183–206. 9 Debra K. Dennis and John J. McConnell, “Corporate Mergers and Security Returns,” Journal of Financial Economics 16 (2) (June 1986): 143–187. 10 Paul H. Malatesta, “The Wealth Effect of Merger Activity and the Objective Functions of Merging Firms,” Journal of Financial Economics 11 (1–4), (April 1983): 155–182; Nikhil P. Varaiya, “An Empirical Investigation of the Bidding Firm’s Gains from Corporate Takeovers,” Research in Finance 6 (1986): 149–178. 11 Michael Jensen and Richard Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11 (1–4) (April 1983): 5–50. 12 Gailen Hite, James Owers, and Ronald Rogers, “The Market for Interfirm Asset Sales: Particial Sell offs and Total Liquidations,” Journal of Financial Economics 18, no. 2 (June 1987); Prem C. Jain, “Sell-Off Announcements and Shareholder Wealth,” Journal of Finance 40, no. 1 (March 1985); Scott C. Linn and Michael S. Rozeff, “The Corporate Sell Off,” Midland Corporate Finance Journal 2, no. 2 (Summer 1984); Charmen Loh, Jennifer Russell Bezjak, and Harrison Toms, “Voluntary Corporate Divestitures as Antitakeover Mechanism,” The Financial Review 30, no. 1 (February 1995).
CHAPTER
2
THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS IN MERGERS AND ACQUISITIONS Professor Robert Boyden Lamb1 New York University Stern Graduate School of Business
INTRODUCTION
America Online (AOL) announced its merger with Time Warner in a transaction originally valued at $180 billion, the largest in history (their combined value was $360 billion), in January, 2000. Within days the value of the merger had fallen to near $120 billion as the stock market adjusted the soaring AOL valuation as a pure Internet firm down to a hybrid blend with Time Warner’s old media and cable business. Three months later the merger’s value had risen. Yet, by December 2000, most pure-play Internet stocks’ prices had plunged, causing many to collapse, and even some of the strongest firms lost 75 percent of their market value. They continued to decline further in the first quarter of 2001. Despite this sharp decline, the surviving Internet giants’ (such as AOL, eBay, and Cisco Systems) stock prices remained higher than many traditional bricks and mortar firms. In fact, the proliferation of bricks and clicks combination firms, plus thousands of joint ventures and strategic alliances between traditional brick-and-mortar companies and high-tech Internet firms forced experts at investment banks, consultants, and academics to rethink old methods of securities analyses and mergers and acquisitions (M&A) valuation procedures. Today there is a spectrum of new business models, numerous technology dynamics, new international markets, and changing global legal and political forces that can impact M&A valuation. These can confound even experienced securities analysts and M&A experts. To date, only a minority of analysts, economists, and investment bankers admit publicly that their old tools of securities valuation, ratio analysis, or traditional discounted cash flow models may not work as well anymore. Yet, the number of underlying valuation questions and dilemmas is crucial, for most U.S. mergers in 1999–2000 involved high-tech firms, firms with complex intellectual property (IP) or intangible assets, or Internet valuation issues. Moreover, similar M&A valuation complexities are now spreading abroad. 2.1
2.2
THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
Global mergers and acquisitions continue despite the huge stock market decline, and in many industries the digital revolution and use of the global Internet are becoming vital mechanisms for new business-to-business communications, reverse auction suppliers’ bidding, comparative pricing transparency, actual transactions commitments, and final delivery terms. By 2000, more than 100 industry-wide Internet exchanges had been announced. GM, Ford, Daimler-Chrysler, Toyota, and other manufacturers launched Covisent (the largest such exchange) to try to capture the $240 billion per year in auto manufacturers’ purchases, plus a percentage of the additional $500 billion in auto suppliers’ purchases and a share of the billions in many auto-related services transactions.2 While only a few of these industry-wide online exchanges were actually operational by the first quarter of 2001, many corporations were using the Internet increasingly for procurement of their supplies. GE purchased $20 billion in orders over the Internet in one year. Many of the old economy industries realize they must try to embrace today’s digital revolution, including the Internet, in one way or another in order to drastically cut excess costs; speed their systems and processes; and link suppliers, producers, and buyers. Other important factors beside the high-tech digital revolution and the Internet are driving recent M&A valuations and causing merger waves to sweep across the global business landscape. Many foreign governments have deregulated key industries, resulting in the introduction of new laws impacting the volume of M&A transactions, valuations, and auction prices paid and affecting who controls key assets and intellectual properties that governments owned or funded. As a direct result, frantic mergers of giant oil companies, utilities, defense, drug, financial services, communications, aerospace, rail, shipping, auto, and media firms have caused massive global industry consolidations. The United States took the lead both in deregulating many industries and in spearheading consolidation. In fact, The New York Times stated that “A major legacy of the Clinton administration will be that it encouraged one of the greatest periods of industrial concentration in American history, affecting old and new sectors ranging from oil and pharmaceuticals, to telecommunications, broadcasting and the Internet. Call it the Age of Oligopoly. Corporate mergers have grown so frequent and so large, said Robert Pitofsky, the chairman of the Federal Trade Commission, that ‘there’s not a week that goes by that we’re not called upon to review a big merger that has significant implications for the marketplace.’”3 This global merger wave also fostered greater international competition of foreign businesses inside many countries’ economies. In fact, today’s merger wave is global, racing faster abroad than in the United States. From 1992 to 2000, every year rewrote the record for merger volume. United States merger volume totaled $6.5 trillion in the 1990s. In 1999, world merger volume jumped 36 percent to $3.4 trillion. United States merger volume rose to a record $1.75 trillion, while Europe’s merger volume more than doubled to $1.23 trillion. More than half this volume increase occurred in 1998 and 1999.4 Global mergers in 2000 alone grew to almost $4 trillion. There are many causes of this latest global wave of mergers and acquisitions. As a result of the stock market boom of the last decade, acquisition-hungry companies had an inflated stock value, which could be used as merger currency. Due to the increasing interdependence of global markets, the M&A revolution not only affected the United States, but also the
A FIRM’S IP HAS BECOME A MAJOR FACTOR IN VALUING M&A DEALS 2.3
growing markets of Europe and Asia. For example, the drive to achieve global wireless and Internet connections is what led Britain’s Vodafone to acquire Airtouch of the United States for $62 billion, then Mannesmann of Germany for $183 billion, in the largest hostile takeover ever. That merger’s success depended directly on Vodafone’s separate side deal with Vivendi, a French conglomerate possessing wireless technology along its original water utility routes and major stakes in media. In fact, these and other giants and alliances in Europe, the United States, and Asia are fighting simultaneously for the fastest broadband access to the Internet and access to digital media and information. A FIRM’S IP HAS BECOME A MAJOR FACTOR IN VALUING M&A DEALS
For 15 years, the prime cause of the majority of mergers has been many firms’ urgent desire to acquire valuable technological assets that were being developed by the fastest growing companies. In many cases, these assets are ground-breaking technologies, unique know-how, trade secrets, patents, trademarks, copyrights, databases of information, rare customer lists, unique corporate reputations, and new business models, which collectively are known as intangible assets and intellectual properties. Battles for these rare assets have often driven what some called merger mania. The Internet has sped up the race for these rare assets, but it has also been forcing radical changes in many nations’ old laws and accounting rules on IP rights and intangible assets. The attraction of these intangible assets and intellectual properties is financially driven by the value added to the firms who possess them and their ability to create superior products and services, which generate the highest profit margins. These assets are often unique and difficult to imitate. Firms that possess them can sometimes achieve a longterm sustainable competitive advantage over competitors who can produce only commoditized products or services at razor-thin margins. In many cases the acquisitions are preceded by intense auction bidding where several companies fight to acquire the target firms that possess these rare intangible assets and intellectual properties. For example, on November 4, 1999, Warner Lambert announced its $67 billion merger with American Home Products. That same day, Pfizer, Inc., proposed a $72 billion acquisition of Warner Lambert in a hostile bid to prevent its merger with American Home Products. Ultimately the bidding war, which was won by Pfizer, reached $93 billion. Pfizer stated why it had rushed in and bid so high: The company was desperate for Warner Lambert’s teams of scientists and their know-how, their labs, and their portfolio of patents to help propel the creation of many breakthrough drugs. Twin revolutions in genetics and computerized testing of millions of medical compounds are fast overturning the way drug companies do business. A frantic race (which requires armies of scientists) is on among firms to sort through all the gene discoveries and pinpoint a few new blockbuster drugs.5 These multi-billion dollar merger fights among drug firms are literally wars for talent and battles for the best pipelines of proven patents. The vital importance of these drug patents has grown in the recent past as many of the major pharmaceutical companies are losing the exclusive rights to their products. In response, many drug giants merged, bought out, or allied with biotech firms or joint ventured with cosmetic, health food, or competitor drug firms. To add to the maelstrom, new regulations under the Hatch Waxman Act are unclear about possible extensions for many
2.4
THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
future-generation drugs. In the fight for drug rights, companies not only see the current drug, but also the franchise. Although a 20-year drug patent often has a useful life of only 10 years, the next-generation drugs based on this first one can be protected under patent extensions of up to 7 years. This franchising of a drug’s future generations could extend a company’s hold on the drug almost indefinitely. Likewise, with giant drug firm mergers, joint ventures, or alliances the companies have recently succeeded in combining two firms’ blockbuster drugs (each with expiring patents) into a so-called blended drug to attack two sides of the same illness together, and thus extend patent life. Across many high-technology industries, not just biotech, this same merger war for cutting-edge knowledge assets is occurring both to capture top innovators and scientists and to buy a collection of legal rights. Often these merger fights are really battles to obtain and retain rare or unique know-how, product patents, and process patents, or to patent new business models, new forms of matter, and new forms of life. These are also contests to control copyrights, trademarks, trade secrets, or other legal monopolies of intangible assets that provide firms with their most secure means to ensure a sustainable competitive advantage. 3M CORPORATION’S SHIFT FROM INTERNAL R&D FOR IP TO A MIXTURE WITH EXTERNAL ACQUISITIONS FOR NEW IP
This use of M&A to acquire the IP of other firms is not restricted to high-tech firms, but has spread rapidly to many traditional companies. Even firms that had grown for decades by their internal culture of constant innovation and new product development found they simply could not keep pace with the explosion of new IP creation among countless startup companies across the United States and the globe. It has become more cost efficient for companies to acquire technology rather than attempt to recreate the IP internally. For example, during the past 100 years the 3M Corporation became legendary as one of the most innovative companies in the world, filing for more new patents each year than most firms would in their entire lifetimes. The entire corporate culture of 3M was also famous for allowing employees to use 15 percent of their work time to create new IP that developed literally 60,000 new products. However, by 1998, 3M concluded that it could not continue to meet its firm’s target requirement of creating 30% of its profits from products less than four years old. Nor could 3M guarantee to continue to achieve its 10 percent financial rate of growth, simply by its own internal research and development (R&D) and by sharing its central bank of thousands of patents, to develop new products. The company could hope to achieve only a 7 percent rate of return from its internal growth engine, well below its long established 10 percent minimum. Therefore, 3M changed its legendary corporate strategy to require each of its many business division heads to constantly recommend potential acquisitions of companies whose cutting edge IP and creative R&D teams could jump-start 3M’s overall total rate of corporate financial growth well beyond what it could achieve internally.6 So far this acquisition strategy (aimed at buying companies for their R&D and IP creation machines) is succeeding. Securities analysts credit this new blend of 3M’s acquisitions of IP from acquired companies and its internally generated IP each year with enabling the corporation to regain its financial pace of growth. 3M’s highest performing corporate divisions are in key new target acquisition fields like health care, Internet equip-
THE WINNER’S CURSE IN M&A AUCTIONS 2.5
ment, and fiber-optic cable businesses. 3M now is forecasting internally and externally that its future growth must be “driven by three engines:” bolt-on acquisitions to existing businesses; brand-new cutting-edge IP bought in mergers; and the continuing IP being created by 3M’s traditional businesses.7 In short, IP growth continues to be the central core of 3M. It is now generally acknowledged that IP can only be generated from the combination of internal R&D plus many acquired companies’ IP resources. 3M is not alone among traditional companies in reaching the wrenching realization that their past highly successful engine of growth is simply no longer sufficient to guarantee survival nor to achieve past yardsticks of corporate growth. Most top managers now realize they must reach out via mergers, acquisitions, joint ventures, strategic alliance partnerships, or licensing for new IP just to survive or remain competitive. As a result, thousands of traditional companies, partially deregulated government firms (such as Deutche Post Office’ acquisition of DHL), and countless high-tech and startup companies are all joining in today’s huge wave of global mergers and acquisitions. THE WINNER’S CURSE IN M&A AUCTIONS AND ITS EFFECT ON NEW IP CREATION, TRANSFER, AND SHARING
The bidding wars in many M&A battles are so intense that frequently what is known in M&A financial theory as The Winner’s Curse occurs. In short, whichever buyer wins an M&A auction has usually paid too much for the target firm and will probably not be able to achieve even its minimum hurdle rate of return on its investment. The combined entity will not achieve the necessary synergies to be more profitable than the individual companies prior to the merger. According to experts, taking various metrics into consideration, over the last 50 years up to 80 percent of all mergers and acquisitions have failed to achieve their required rates of return.8 While there are many causes of merger failures, the most common cause of failure is the payment of excess premiums over the stock market price of the target company. Although the winner’s curse phenomenon occurs in many M&A situations, it is most frequently a problem in auctions for new economy companies whose key resources are their intangible assets and intellectual properties. This is a result of the difficulty in accurately valuing these assets. Companies whose unique strengths and financial growth potential are their knowledge assets, social capital, IP, and intangible assets are often overvalued. This was particularly apparent during the technological bull market of the 1990s. When investment bankers value a firm whose key assets are its intellectual properties and intangible assets in a merger, they often have difficulty using financial accounting measures of performance, such as return on sales, return on assets, or return on equity. These are often based on the firm’s past performance, and they don’t accurately measure the future potential value of the merger or acquisition. Many assumptions are required to justify any future valuation. Even investment bankers who estimate financial returns from strong firms with huge R&D expenses, creating hundreds of new patents, trademarks, copyrights, know-how, and new technology, must work cautiously with the company’s management to forecast realistically expected future free cash flows. These bankers must use assumptions determined through the due diligence process. Although often financial assumptions may appear reasonable, they may not be based on any fundamental analysis. Such assumptions have proved false, leading to incorrect projections of future revenues, profits, or cash flows from these intangible
2.6
THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
assets. Many of the most famous failed mergers and acquisitions were based on estimates and key assumptions that were wrong or unrealistic. A classic example of these M&A valuation problems was Quaker Oats’ $1.7 billion purchase of Snapple, which later was sold for only $300 million. Snapple was a fledgling beverage firm with unique patents, trademarks, trade secrets, company reputation, and very fast growth-rate, which Quaker Oats thought would be similar to the success of Gatorade. Snapple had all the IP and intangible assets, but its primary distribution channels were small convenience stores that could charge expensive prices but were much harder to supply than supermarkets, which sold Gatorade. These small stores could not support the huge volume of sales that Quaker Oats and its bankers forecast for Snapple. Price competition from other beverages in supermarkets inevitably forced the profit margins for Snapple down from what convenience stores could charge. Snapple’s valuable and unique new brewing technique was reverse engineered, or copied, by many other beverage companies. Also, the market niche it had pioneered became so overcrowded with competitors selling copies of Snapple that the original Snapple’s forecasted growth rate, on which investment banks’ valuation forecasts had been based, could not be sustained. Quaker Oats sold Snapple, after additional large yearly investments, for a bargain price of only $300 million to a small beverage company that served convenience stores. It was highly profitable immediately. While the Snapple acquisition by Quaker Oats remains a classic blunder, its valuation mistakes remain quite common. A far worse case was Mattel, the leading toy producer that bought The Learning Company, a youth-focused interactive media firm, for $3.4 billion, and less than two years later sold it for a zero dollar payment. The old toy firm was completely out of its depth in the new interactive media world. The CEO Jill Barad was fired, but with a multi-million dollar exit payment. Mattel is hugely burdened by this total loss. Another factor that some experts argue is significant in driving the Winner’s Curse in systematic M&A auction overbidding is “agency costs,” or self-interested motives of CEOs and investment bankers to enlarge their own personal bonus or firm’s fee by completing the larger transaction at whatever cost it takes. In fact, some observers have suggested that these “agency costs” (including CEO pay scales pegged to size of firm, incentive bonus payments, and investment banking firm’s fee structures based on the larger size of the merger transaction) is an important reason for what has been called the recent “merger mania.” To complete the merger, the CEO of the acquiring firm, caught up in the heat of the M&A auction process, may seriously consider any conceivable synergies of this deal that will justify a higher final valuation offer. INVESTMENT BANKERS USE FOUR BASIC METHODS OF VALUING MERGERS AND ACQUISITION TRANSACTIONS
There are four types of technical valuations that are most commonly used by investment bankers. The following pages outline these methods and some of their pluses and minuses. Comparable Company Analysis. Comparable company analysis requires the investment
banker or internal corporate finance team to carefully identify as many comparable companies to the target firm as possible (normally between 2 and 20). Then they mea-
INVESTMENT BANKERS USE FOUR METHODS 2.7
sure each of these comparable firms in terms of their stock market value, P/E ratio, Enterprise Value/EBITDA, or (more common with new economy companies that don’t have positive cash flows) Enterprise Value/Revenue. In theory, the comparable analysis provides the buying firm with a range of fair equity market prices as a guide to determine an offering price for the target. 1.
2.
The first problem is that the equity stock market, which in past decades was relatively stable, is so volatile today that the price of many comparable companies can easily move up or down by more than 40 or 50 percent during the 6 to 22 months that a merger deal is being completed. In fact, the spike or plunge in value of the stock price (volatility) of several of the companies that investment bankers deemed comparable can range from 10 or 15 percent in one week or even one day. This means that M&A professionals are forced to create bands of high-to-low stock market price ranges for each separate company included in the comparable company index or average they use in their price comparisons for the client buyer in their so-called Pricing Book. Although price volatility can be problematic, the use of a large enough universe of comparable companies should diversify most of the outliers. For example, in Spring, 2000, AT&T planned to spin-off its wireless business as a separate tracking stock to take advantage of recent huge wireless firms’ valuations (reaching $62–$350 billion) including the following: Airtouch of the United States, Vodafone of the United Kingdom, Mannesman of Germany, and DoCoMo of Japan. After April, 2000, the sudden plunge of most Internet and high-tech stock prices by 50 to 80 percent negatively impacted the price for AT&T’s wireless company despite its potential for future Internet access. AT&T only raised $10.5 billion and was lucky to find buyers even in the lowest range for its large wireless firm’s spin-off sale in that very bad market. AT&T’s wireless firm had the same assets that it had six months earlier, but its potential for market cap had suddenly shrunk. Because comparable company analysis is based on market valuation, the equity value can vanish with the falling market, as in this case. The second key problem is that frequently there are no truly comparable companies to the target firm. This is especially true if the firm’s key assets are its intellectual properties and intangible assets. The greatest asset new high-tech, biotech, Internet, or knowledge-based companies (those that have the potential for the fastest growth) have is their uniqueness. The real potential economic and financial power of these firms, if they succeed, is founded upon the originality of their concept, new materials, new technology, or innovative business model. Today’s startup firms’ future value is founded on their breakthrough scientific genome tests, discoveries of light waves, and other path-breaking science, or their new image trademark products, trade secrets, know-how in process improvements, or their new entire business model. A firm’s originality is often its critical competitive strength, but is also a difficult financial stumbling block in its valuation if based on comparables.
Comparable Transactions Analysis. The second classic method used by investment bankers to value mergers and acquisitions is to carefully identify a cluster of compara-
2.8
THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
ble merger transactions done during the current period. Investment bankers attempt to select recent mergers in which the structure of the deal, nature of the companies, size, total sales, total profits, total scope of operations, line of business, type of customers, and growth rate are similar to those of the firm in the pending deal. Although it is impossible to find past deals that are exactly the same, the more closely matched the comparable factors, the more accurate the analysis will be. Once again, the global volatility of stock markets has made it far more difficult to identify with reasonable certainty what is truly comparable. For example, AT&T paid twice as much for Media One, a TV cable company, in 1999 as it paid in 1998 for Telecommunications, Inc. (TCI), which was a significantly larger cable company. This is a critical example because when AT&T bought TCI, cable companies were out of favor and expensive to install. After Microsoft invested in Comcast and AT&T’s bid for TCI was accepted, suddenly it was widely realized that cable TV lines were a major broadband into 73 percent of U.S. homes, and their cables passed by 90 percent of all U.S. homes. They could be used for local telephone connections and Internet connectivity on a major scale because cable lines were already installed across the United States, and each had a monopoly in its region. In short, the tangible TV cable lines were now seen to have enormous potential for delivering intangible asset value by distributing a vast range of intellectual properties. These include all kinds of specific information on health, transportation, business or scientific data, video, music, voice telephone calls, sports, education, testing services, electronic games, financial transactions, security services, gambling, and pornography. One result of AT&T’s $110 billion spent on acquisitions of cable systems was AOL’s fear that it would be prevented by the cable monopolies from gaining access to broadband already connected to the Internet. Thus, AOL rushed to bid over $180 billion originally for Time Warner, which owned both the second largest TV cable system in the United States and a vast range of the most valuable intellectual properties in huge libraries of copyrighted movies, TV series, magazines, books, and music. AOL’s initial bid was 70 percent above current market price. Time Warner did not negotiate a collar, or valuation price floor, on AOL’s stock price change, and AOL’s price for Time Warner by the date the deal closed was $108 billion.9 Even if TV cable firms had been similar, all these merger transactions were done at huge variances in relative price because of high- or low-valuation perceptions of the market and of the range of intangible assets and intellectual properties that complement, or add functional uses to, that basic cable line. It was often the commercial potential of complementary products and services that dramatically expanded the perceived financial acquisition value of Internet firms, high-tech firms, biotech firms, or virtual firms completed in a six-month to one-year period. As a result of this, January 1999 to May 2001 witnessed 50 to 250 percent price differences in acquisition prices paid for relatively similar firms. In each case, investment bankers and firms’ Chief Financial Officers (CFOs) could point to supposed comparable transactions to justify the wildly inflated or deflated acquisition prices they decided to pay for other companies. While there is nothing unique in today’s acquisition price swings, the height of the spike, whether up or down in value, is new. Discounted Future Cash Flows. The third, and most intrinsic, method of merger valua-
tions is the discounted cash flow model (DCF). The DCF analyzes the forecasted free
INVESTMENT BANKERS USE FOUR METHODS 2.9
cash flows to be achieved by the new firm formed from the combination of the two merged entities. It is largely the widespread recognition of the inherent valuation problems in using comparable company analysis and comparable transactions analysis mentioned above that has resulted in the continual reliance on discounted cash flow analysis of M&A transactions. This valuation method, like the others, is subject to various problems, inadequacies, and misuse. This is due in part to DCF analysis’ reliance on a range of “assumptions” about future growth in sales, profit, market share, stock price, technology innovation, brand-name value, inflation, old laws, and enforcement of regulations. Financial analysts at M&A departments of investment banks and consulting firms and finance professors in most business schools prefer this valuation method for more traditional companies because it is considered to be more widely applicable in all sorts of industries and all stages of growth. The DCF also provides a valuation of a firm’s intrinsic value based on performance, rather than the market’s perception of the firm’s value. While this is normally true, DCFs have proven inaccurate in valuing knowledge companies whose primary future financial value is based on intangible assets, know-how, innovative technology, or new business systems. The basic difficulties result from discounted cash flow analysis’ dependence upon the interrelation among numerous assumptions about when knowledge assets will generate sales, cash flows, profits, or future streams of income, or in which future years particular amounts of revenues, profits, or future stock price levels will be achieved. Such assumptions are often just as inadequate as if based on unrealistic extrapolation of growth rates from noncomparable companies or noncomparable transactions. Steps to a Valuation. After understanding that there are three main valuation methods, it is important to remember that the investment banker does not use only one. Bankers use a combination of the three techniques to arrive at a valuation that they—as well as the company—believe is fair. The bankers will have an understanding of where the market values the company under the current market conditions, as well as what the intrinsic value of the company is, considering its future forecasted cash flows and using both types of comparable analysis and a discounted cash flow analysis. Although admittedly not a perfect science, the use of all three methodologies is widely considered the most accurate measure of a company’s value. Without citing a specific transaction, the following steps provide a basis for corporate valuation of a target company in an M&A transaction in practical terms:
Comparable Company Analysis 1.
2.
Find a peer group to use in the analysis. The larger the universe of companies, the more accurate the analysis. A large, diversified sample within the comparable universe provides more statistically accurate data, as outliers carry less weight. Research analysts within most major investment banks can provide the comparable universes for most industries. Whenever possible, companies with similar characteristics, such as industry, size, scope, and geographic location, should be used. When you don’t find a company publicly traded in that sector, you may have to look at a company with a similar operating structure. Determine which metrics will be used to compare all of the companies. It is important, especially with new economy/technology companies, to determine
2.10 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
3.
what the comparison will be based on. Many technology companies, whose assets include high percentages of IP, do not have positive earnings or even EBIT.10 Without these traditional comparative line items, bankers have gone to alternatives such as revenues or hits to a website for the dotcom companies. A fairly simplistic spreadsheet will provide the analyst with a low, base, and high range of price valuation for the company once these steps have been completed.
Comparable Transaction Analysis 1.
2.
3.
Find similar transactions that have occurred in the recent past. It is important to use recent transactions because the underlying market condition is the determining factor in valuation. Using transactions that occurred during different market trends will skew the metrics and provide an unsupportable company value. Once again, a larger sample will provide more accurate data for the analysis. In addition, investment bankers also do sensitivity analyses by taking snapshots of the market at three different economic levels. Determine what metrics will be used in the comparison. It is important, especially with new economy/technology companies, to determine what the comparison will be based on. Many technology companies (whose assets include high percentages of IP) don’t have positive earnings or even EBIT.10 A fairly simplistic spreadsheet will provide the analyst with a low, base, and high range of price valuation for the company once these steps have been completed.
Discounted Cash Flow The DCF analysis is the most involved and most time consuming of the three, and it often requires a number of assumptions about changes in a firm’s growth rate and number of years of growth. 1.
2.
Working with management, bankers determine the future cash flows of the company. Is this firm in a period of stable growth or high growth, or is its growth declining? Is this firm now in a high-growth period, but expected in five years to decline to only a stable growth rate? Bankers first take management’s forecasts for growth rates during this process. An extensive due diligence process is undertaken once the bankers have an idea about management’s projections, during which revised projections are developed. It is of utmost importance that the investment bank and any outside experts feel comfortable with the forecasts, considering the name and reputation of the bank will be placed on the fairness opinion. Determine the growth rates for the stable period for which a terminal value is to be computed. This terminal value represents the present value of the free cash flows the firm may generate beginning with the last year of its stable growth period and lasting the remainder of its life. The terminal value is usu-
INVESTMENT BANKERS USE FOUR METHODS 2.11
3.
4.
ally calculated as a growing perpetuity of a single cash flow projected with the growth rates of the stable period. Alternatively, one can compute the terminal value of a comparable financial ratio with the stable period growth rates based on the projected values. Because the terminal value represents the vast majority of the company’s value, it is important to find an appropriate multiple of the firm value or a perpetuity rate. Determine an appropriate discount rate to present value the cash flows of the high-growth period, stable period, and the terminal value. Use the Weighted Average Cost of Capital (WACC) as the most accurate approximation of what the next dollar of capital will cost the company to raise. The WACC is generally a weighted average of the firm’s cost of equity and after-tax cost of debt. When the company has preferred stock, WACC is computed as a weighted average of cost of equity, after-tax cost of debt, and cost of preferred stock. Discount the cash flows to present day or a defined point in time using the WACC.11
These steps will provide the firm’s value in present dollars. It is necessary to subtract the total debt of the company and add back any cash on the balance sheet to find the equity value. (The amount of cash added back depends on how you define the free cash flows.) The investment banker divides the equity value by the number of outstanding shares to find a per-share value. (In some cases they divide by the number of diluted shares outstanding.) In general, comparable transactions analysis leads to a higher company value than comparable company analysis because the prices you use in comparable transactions include both the premiums and the fair market values. From 1980 to 2000, the average control price premium paid for a firm in a merger was 40 percent above the market price for that firm two months before the merger announcement. DCF analysis is based more on the expected future cash flow, assumptions about potential growth rates of the firm, and future financial performance of the business being valued than on the firm’s stock market prices or transaction prices of other mergers. As a result, DCF analysis of a merger often produces the highest financial valuation of a company in a merger of these three methods of valuation. When a firm has high capital expenditures, its cash flow could be negative. It is important to have a positive Net Present Value (NPV). Even though one’s firm might show a loss in its accounting statements, when one converts the accounting earnings into free cash flows by adding back non-cash charges like amortization, the firm may have a positive cash flow. It is important to be clear on exactly what inputs each valuation model requires. (Be aware that certain factors are not required as inputs.) Option Valuation. The three traditional M&A valuation methods (comparable companies, comparable transactions, and discounted cash flows) do not work well when analyzing bankrupt firms, financially-troubled companies, startup firms, or innovative companies whose major assets are currently unprofitable technologies, patents, copyrights, trademarks, or trade secrets. This is because such firms often lack profits, net
2.12 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
income, or even sales revenue and ongoing positive cash flows that traditional valuation models usually require as inputs. Therefore, a fourth method known as Option Valuation, or Real Option Valuation, has begun to be used in M&A valuation for these types of currently unprofitable firms that could generate significant financial value in the future. For example, Real Option Valuation can be applied to companies whose assets are comprised of nothing more than patents for as yet unutilized products. Based on the option-pricing model, this method, which is applied to value both biotech companies that hold a number of patents and each individual patent, is described in detail in Aswath Damodaran’s book Damodaran on Valuation. A potential acquirer can determine the possible value of the products protected under the patents and the value of the biotech firm by using this general technique. Martha Amram and Nalin Kulatilaka refine the general Real Option Valuation model more specifically in the chapter “Developing a Drug” in their book Real Options.12 They show that biotech firms are examples of a “sequence of learning options” that frame or affect the next drug business option choices by reducing risky outcomes, because these companies learn to select better success paths. David Kellogg, John Charnes, and Riza Demirer go into even more depth on the importance of tracking a drug firm’s learning options from each phase in FDA clinical trials in their paper, “Valuation of a Biotechnology Firm: An application of real-options methodologies.”13 These clinical trial stages of success, or learning options, are vital to giving the acquiring firm critical information necessary for deciding which specific biotech firms to buy and at what price. Learning options that biotech and pharmaceutical firms consider go beyond the ones noted in both the Amram-Kulatilaka book and in the Kellogg, Charnes, and Demirer paper. They include not only the choice to invest or abandon the project at different drug trial phases, but also options to seek joint-venture partners or to apply for “orphan drug status” to the U.S. government for vital funding of new drugs that were originally deemed not commercially viable. First, the basic Real Options Valuation method for a patent and for valuing a biotech firm in an acquisition will be outlined. This is followed by a review of actual drug companies’ “sequence of learning options” and an analysis of the stages of choices in firm growth as a series of option decisions: which drugs to research, which to develop, which to keep funding, and whether to buy a firm, joint venture, or strategically ally with biotech companies. This range of real option valuations is stressed, because many giant pharmaceutical firms must spend more than $500 million on each successful new drug to make up for all those that failed to pass the required tests. Now their old blockbusters are losing their patents, so they are forced to make a decision based on different options: whether to invest, acquire, merge, make strategic alliances, buy equity stakes in biotech firms, or pay licensing fees. DAMODARAN’S OPTION VALUATION PROCEDURE FOR A PATENT14
It is assumed that each product will be developed only if the net present value of the free cash flows generated by the sales of this product is greater than zero. In this way, the patent acts in a similar manner to a call option on a stock—the option will be exercised only if the cash flows are positive. With that in mind, the inputs for the valuation
DAMODARAN’S OPTION VALUATION PROCEDURE FOR A PATENT 2.13
of the patent as an option on the future product will consist of the “underlying asset or product, the variance in value, the time to expiration on the patent option, the exercise price of the patent option or the cost to develop the product, the risk-free rate, and the patent equivalent of the dividend yield or yearly payoffs from the patent, once developed, until its patent life expires.” Value of Underlying Asset. This value is derived, once the product is introduced, from
the determination of cash flows for the life of the patent. Because patents are for products that don’t exist, this determination can be difficult at times. This fact, however, is exactly what gives the option value. If the cash flows are certain, there is no need to use an option valuation. Variance in the Value of the Asset. Considerable uncertainty [variance] is likely to be
associated with the cash-flow estimates and the present value, which measures the value of the asset now—partly because the potential market size for the product is unknown and partly because technological shifts can change the cost structure and profitability of the product. One of two methods can be applied to determine this variance. First, one can use a comparison of similar existing product’s cash flows. Second, one can perform a sensitivity analysis using various scenarios to determine a range of probable cash flows on the product to be developed. The value of a product patent will gain value in an environment where high-technology, competition, and markets all change rapidly, just like a traditional option on a stock gains value with stock price volatility. This is in contrast to the value in a stable industry. Exercise Price of Option. The cost of developing the product can be seen as the exer-
cise price. If the present value of the cash flows is higher than the exercise price, the product will be developed. Expiration of the Option. The expiration is the legally permitted life of the patent.
(While in some cases, such as pharmaceuticals, it may be possible to extend the expiration date on the life of the original drug patent, assume the standard patent life expiration date for this case example.) The Dividend Yield. The yield for a patent is equivalent to the yearly payoffs from the
product—once it has been developed from the patent—until its patent expiration date. Because patents have a limited life, there is a real cost associated with waiting to complete development of the new product. Because the number of years of its potentially useful life with patent law protected monopoly profits years is reduced, Damodaran assumes that excess profits from the patented product disappear when the patent expiration date approaches because new competitors, who are selling nearly identical products, emerge. He also assumes that if the cash flows from the product are evenly distributed over time, and the life of the patent is n years, then the annual cost of delay of the product launch is 1/n. Once its development is complete, care must be taken to accurately estimate both the number of years and the expected yearly payoffs for this product until its patent expiration. Damodaran analyzes it this way:
2.14 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS Assume that a firm has the patent rights for the next 20 years to a product that requires an initial investment of $1.5 billion to develop and that it has a present value (PV), right now, of cash inflows of only $1 billion. The technology is rapidly evolving, however, and there is a possibility that this will become a valuable project in the future. Assume that a simulation of the project under a variety of technological and competitive scenarios yields a variance in the PV of inflows of 0.03. The current risk-less 20-year bond rate is 10%. The inputs to the option-pricing model are as follows: Value of the underlying asset = PV of inflows (current) = $1, 000 million. Exercise price = PV of cost of developing product = $1, 500 million. Time to expiration = Life of patent = 20 years Variance in value of underlying asset = Variance in PV of inflows = .03 Risk-less rate = 10% Based upon these inputs, the Black-Scholes model provides the following value for the call: d1 = 1.1548
N(d1) = 0.8759
d2 = 0.3802
N(d2) = 0.6481
Cash value = $1,000 million exp(–0.05)(20)(0.8759) – $1,500 million exp(–0.10)(20)(0.6481) = $190.66 million.15
What Damodaran concludes is that the product, although presently unprofitable, has value if seen as an option over the lifetime of the patent. This value can be added as an asset to the acquiring company. The valuation of a company whose primary assets are its patents starts by adding together the values of each of its individual patents. However, Tom Copeland and Vladimir Antikarof, in their book, Real Options: A Practitioner’s Guide, say that we must keep technological or product market uncertainties separate in option valuations of a patent, and track how they interact on value. For example, a drug firm’s stages of “learning options” may gradually reveal that certain breakthrough patents of a biotech firm (for the tetracycline family of drugs, for instance) could really be the foundation blocks for whole new clusters of follow-on pharmaceutical patents. Key strategic mergers or acquisitions of firms possessing such potential breakthrough intellectual properties may cause a chain reaction of financial growth. Therefore, scientists and bankers analyze whether this firm’s patent is for one drug or for a key family of drugs. Often, an acquiring firm making its strategic investment cannot know with any certainty if its Option Valuation of a patent or potential breakthrough new business model is worthless, worthwhile, or truly invaluable. This Option Valuation estimation uncertainty leads some M&A experts to recommend the use of an earn out method of payment structure for the purchase of both a patent and a firm whose key assets are their patents. In short, the Real Options model is being transformed from a simple mathematical calculation of expected value to concrete provisions within the merger or acquisition deal structure. This means that the final price for a patent or for the firm with that patent will be determined only once the drug or technology comes to market or achieves specific milestones. For example, the seller of a pharmaceutical patent can initially receive a modest payment for selling the rights to the patent, but can retain some
DAMODARAN’S OPTION VALUATION PROCEDURE FOR A PATENT 2.15
form of carried interest, or equity ownership, in the patent if it really produces results. Thus, if the drug passes phase I, the seller will receive $1 to $3 million; at the end of phase II, he will receive $5 to $7 million; if it passes phase III, he will receive $10 to $20 million, and so on. This will ensure both that the buyer does not overpay and that the seller does not miss out on a huge future financial opportunity. This earn out acquisition plan may be used for M&A Real Option Valuation of firms that have several patents in different stages of the FDA drug approval process—as in the case of pharmaceutical firms in their purchase of various biotech companies, for example. Of course, many argue that it is much better to have cash now rather than later, but again, how can you define the real potential cash value of a drug at such an early stage? If the two parties align their interests, through such acquisition deal “earn out” Real Options structured into contract agreements, they may have higher chances of success, because both parties have to contribute to the lengthy process, and both share in the risk and the rewards. This particular deal structure of an earn out for Real Option Valuations in biotech firm acquisitions is an extremely clear example of the commercial importance of “learning options” at each milestone (phase I, phase II, phase III) stage of FDA drug testing approval. In the absence of such an earn out Real Option structure for most acquisitions of early stage IP firms, the buyer or seller will more than likely incorrectly measure the firm’s potential financial value, because its collection of patents is often very hard to estimate with any reasonable degree of accuracy.16 An example of this type of uncertain option valuation situation existed with Napster, the hugely popular peer-to-peer free file-sharing company that had 60 million users in 2000. Bertelsmann, the world’s third largest media corporation, in November 2000, made a $50 million loan to Napster to enable the company to develop a new profitable business model based on all subscribers paying a $5 to $10 monthly fee for downloading music from many file sharers. Market research studies of Napster users had shown that customers might well be willing to pay up to $15 per month for that music file sharing service. Bertelsmann’s $50 million investment in Napster was buying an option, or purchasing the future financial possibility that the company would survive its current legal problems. The chief executive of Bertelsmann, Thomas Middelhoff, stated publicly that he intended to use a Napster-like file-sharing, or peer-to-peer business model, for all of Bertelsmann’s media and information products and services in music, books, magazines, television programs, movie videos, and data with many new Internet distribution channels. Because there is no way to determine whether Napster will even exist in the future, or whether other companies and new technology will capture the market, any valuation of Napster is highly speculative. However, only some version of the Real Option Valuation model could perhaps provide a reasonable way to analyze Napster’s file-sharing business model’s potential financial payoffs and figure them to be derived from specific business opportunities in Bertelsmann’s segments of each media industry. Securities analysts viewed Bertelsmann’s $50 million investment in Napster purely as a speculative option. To have any value, Bertelsmann would need to convince major music firms to join this experiment. By April 2001, Napster’s legal case looked very bleak, as the U.S. federal judge issued her injunction.17 Nevertheless, two new Napster alternatives sponsored by the five giant record labels were announced to be ready for launch by early fall of 2001. Bertelsmann, AOL-Time Warner’s Warner Music, EMI, and Real Networks formed a joint venture called Music
2.16 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
Net that would market their digital music to online companies. Likewise, Sony Music Entertainment and Vivendi Universal’s Universal Music group said they would roll out Duet, a music licensing operation online. Yahoo has signed up both of these online music joint ventures. Finally, many Internet experts still believe that the peer-to-peer model is potentially immensely powerful, and someday teams of corporations and networks of individuals will use it. An Important Caveat on Investment Bankers Selection of Valuation Method. Financial experts agree that one of the most important tasks of investment bankers is the careful determination of what the most appropriate valuation methodology is for each particular company. Most professionals realize that if they use the wrong methodology, false assumptions, and incorrect inputs, it will result in baseless valuations for M&A transactions. Nevertheless, standard but inappropriate valuation methods are commonly used in M&A deals, and they have been blamed for the resulting failure of a number of attempted mergers. Although a top manager may suggest a ballpark number he or she would like the firm to sell for, true professionals should not start in advance with an estimated financial value of what the final price could be and then select a valuation method most likely to lead to that number.
ALTERNATIVE IP VALUATION METHODS
The previous section was a simplified explanation of the four basic valuation processes. There are many variations and iterations that can be applied. Most investment bankers and consultants in M&A will agree that the DCF and comparable analyses are the most widely used methods to determine the value of a target company’s IP, with Real Option Valuation being used for special situations. But according to a September 25, 2000, research report by Dresdner Klienwort Benson, other measures can be used, such as: Proxy Valuation: A large number of companies do not value their own internal IPR (IP Rights) separately and simply assign a value as a percentage of market capitalization as a proxy for individual project valuations. However, this assumes that the IPR have no value above their book value and that the value of the property changes with share price movement. Calculated Intangible Value (CIV): In one method developed by NCI Research, the industry’s average return on tangible assets is multiplied by the company’s tangible assets (can be historical, but can also be based on forecast data). This number is subtracted from the company’s profit before tax giving the excess return. This return is multiplied by the tax rate and then subtracted from the excess return giving the post tax premium. The net present value of this premium can then be calculated giving the CIV of the IPR IP Rights. Return on Investment (ROI): The ROI for each individual project can also be calculated. This looks at the average return being generated each year on a particular project or set of IPR (IP Rights). To do this, the analyst needs to be able to break out the original cost and investments in the project and either forecast the return or already have revenues that can be separated out. This requires a significant amount of information that may not be readily available and ignores the time value of money invested in the project. This technique can be extended and combined with a DCF to give the cash flow ROI (CFROI). This allows companies to value the present value of the net cash return at the investor’s dis-
TODAY’S COMPRESSION OF THE PRODUCT LIFE CYCLE 2.17 count rate. In other words, it attempts to restate the investment in current returns. To be able to calculate the CFROI four key inputs are needed: life of asset, the amount of total assets, periodic cash flows and release on non-depreciating assets. Payback Period: Other performance measures examine the payback period for the investment in the IP Rights, i.e. how long it takes for the IPR to cover the costs for all its R&D” of a prototype model, batch production and first profitable sales in a commercial rollout. TODAY’S COMPRESSION OF THE PRODUCT LIFE CYCLE AND MODERN VALUATION PROBLEMS
Many experts are now deeply engaged in studying these current financial valuation problems from different perspectives. Aswath Damodaran has concluded The value of a firm is based upon its capacity to generate cash flows and the uncertainty associated with these cash flows. Generally speaking, more profitable firms have been valued more highly than less profitable ones. There seems to be, at least from the outside, one more key difference between technology firms and other firms in the market. Technology firms do not make significant investment in land, buildings or other fixed assets, and seem to derive the bulk of their value from intangible assets. The simplest way to illustrate this divide [between high tech firms and traditional bricks and mortar firms] is by looking at the ratio of market value to book value at both technology and non-technology firms. Like the price earnings and the price to sales ratios, the price to book value ratio at technology firms is much higher than it is for other firms. [Exhibit 2.1] compares the price-to-book value ratio for technology sectors to that of nontechnology sectors.18 (It shows a 700% difference between them.)
18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00
Exhibit 2.1 Price-to-Book-Value Ratios by Sector
Internet
Specialty Retailers
Chemicals
Auto & Truck
Semiconductors
Computer Software & Svcs
Computer & Peripherals
0.00
2.18 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
Damodaran criticizes those who argue for new financial methods or new metrics to evaluate new technology firms and new business models. “This search for new paradigms is misguided. The problem with technology firms, in general, and new technology firms, in particular, is not that they lose money, have no history or have substantial intangible assets. It is that they make their initial public offerings far earlier in their life cycles than firms have in the past, and often have to be valued before they have an established market for their product. In fact, in some cases, the firms being valued have an interesting idea that could be commercial but has not been tested yet. The problem, however, is not a conceptual problem but one of estimation. The value of a firm is still the present value of the expected cash flows from its assets, but those cash flows are likely to be much more difficult to estimate.”19 There is often a wide range in the financial valuations of the same IP or intangible assets. For example, a particular IP’s financial value often would be quite different if it were owned by a firm that had no sales or production facility yet, but only a patent, trademark, or copyright with potential for future income, than if it were owned by a functioning company with a track record of sales, profit, and cash flow. In fact, there was a wide spectrum of different valuations that investment bankers, venture capital firms, mezzanine capital firms, and providers of seed capital or angel investment would attribute to the very same intellectual properties. That valuation spectrum stretches over six different valuations: 1. 2. 3. 4.
5. 6.
The totally untested patent stage held by one independent inventor The fully tested prototype product A fully developed production process for the one product A fully developed production-distribution-marketing process for various products stemming from the original patent, which is held by a fledgling company that has sales, but is not yet returning a profit A company with a proven track record of one to five years of profit earnings and actual cash flows A well-known product with brand recognition
Each of these six valuations of the same new technology is based both on the stage of its actual commercialized development into a real and successful business and the greater degree of certainty of the future cash flows that technology IP can reasonably be expected to deliver. It is vitally important to realize that today mergers and acquisitions can take place— and increasingly do take place—at every single one of these different stages of that IP’s development. Literally thousands of single inventors’ innovations and countless fledgling start-up firms with no fully tested product yet, no FDA approved drug, no profits, or few sales have been bought in acquisitions in this decade for many millions or (in a few cases) billions of dollars. In short, because of a new realization of the potentially huge financial value of a variety of intellectual properties in the global business environment—especially in high-technology, biotechnology, or the Internet—aggressive corporations are often moving in earlier and earlier to buy up any highly promising IP firm. Because of today’s urgent needs for speed to market and setting new technology industry standards in what are known as winner-take-all markets, corporations believe
M&A AND THE CONSOLIDATION OF MARKET POWER 2.19
they cannot wait for a fledgling IP startup firm to reach its full business potential before entering a bidding war to buy it. For example, in early 2000, Cisco Systems (near its high) purchased Cerent, a private start up company that had, as yet, no profits, and less than $300 million in sales, for $6.9 billion. It was an example of the huge acquisition value that a unique, essential IP owned by one small firm can have at a particular moment in time to another unique, but giant firm that controlled the backbone of the Internet. Corporations like Cisco, Intel, Microsoft, and the giant pharmaceutical firms all increasingly want early IP ownership options, or major early investments for, key IP access rights. Thus, a very wide range of staged investment and acquisition deals is structured by investment bankers to make sure the maximum number of new highpotential intellectual properties is available for corporate clients to use as and when they are needed, or they pay to lock up IP ownership options to prevent competitors’ access to them. MERGERS AND ACQUISITIONS AND THE CONSOLIDATION OF MARKET POWER IN VARIOUS INDUSTRIES IN THE WORLD
At the other end of the spectrum from these small, unique start-up firms, bought up early because of their future potential, are giant corporations and their multiple acquisitions of already famous brands. These are really consolidations of market power. In 1998, the big three auto firms controlled 70 percent of the United States industry. The big three beverage firms controlled 90.3 percent of the industry, and the big three tobacco firms controlled 88.4 percent of the industry. Trademarked brand-name recognition was probably the most powerful anchor for the continued dominance of these giants in each of these industries. Each of these giant firms uses its well-known and high-priced stock, its surplus free cash flow from high-profit margins, or its superior debt capacity to do mergers and acquisitions to capture other top brand-names to add to its stables.20 For example, Ford bought Jaguar and Volvo, Daimler-Benz bought Chrysler and control of Mitsubishi, and Volkswagen bought Nissan. Each of these companies did this to extend their global brand-name auto product lines. Similarly, Coke bought Minute Maid, PepsiCo bought Tropicana, and both Coke and PepsiCo are buying famous bottled waters to extend their brand-name control in beverages. Waves of M&A transactions have eliminated many competitors from various markets. For example, the big eight accounting firms bought each other out to become the Big Five. In pharmaceuticals, the largest 20 became the giant seven via mergers. Due to mergers, there are now six media giants in the world. The 30 largest U.S. military contractors became the giant four in recent mergers. These many industry-wide merger waves, although launched for cost-cutting efficiencies, became oligopolies that enabled the surviving giants to act more as profit magnets in creating a circle of tightly interconnected networks of overlapping or closely complementary businesses. For example, in mid-2000, a General Motors’ subsidiary, Hughes Corporation Direct TV, was the largest satellite firm in the United States. It had 10 million customers and a tracking stock market value that was higher than GM’s entire automotive business.21 The Board of GM and securities analysts expected that Direct TV could be sold for over $20 billion. However, by May 2001 (after the sharp tech stock decline) GM and Hughes Direct TV announced they were in negotiations with Rupert Murdock’s News
2.20 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
Corporation, which has over 100 million viewers globally, at a merger price of under $9 billion. This merger would create by far the largest global TV satellite empire, and be a serious competitor to all cable and media giants. No other serious bidders were reported for Hughes Direct TV except News Corp.22 This was in large part because Murdock was the only potential major buyer who could fully leverage all his own intellectual properties: Fox TV, 20th Century Fox film, global media, news and data streams over Direct TV, and join his global 100 million viewers to 10 million Hughes customers to achieve large economies of scale in satellite equipment purchases. Like AOL-Time Warner, this News Corp.-Direct TV merger is important because it is a working example of global market power derived from combining dominant ownership of distribution channels with powerful IP media libraries, streams of new content, and networks of key alliances. Microsoft’s CEO, Steve Balmer, was reported in the Wall Street Journal to have implicitly warned the CEO of Hughes Direct TV not to sell his firm to any corporation but News Corp.23 Microsoft instantly pledged to invest at least $3 billion in a Direct TV-News Corp. entity in order to have a major role in all its commercial opportunities, from home banking, investing, shopping, travel services, to set-top boxes for phone and Internet services.24 Microsoft was signaling to the market that this News Corp.-Direct TV merger was a unique marriage of dominant giants that made significant opportunities for value creation and value capture by its network of corporate allies possible. What made News Corp.’s merger offer so powerful, despite its relatively low market price, was that no other buyer could exploit so many different financial and operational synergies by controlling Direct TV. For example, in 2000 News Corp.’s British subsidiary, B-Sky-B, already had 5 million satellite TV customers who do home banking, order pizzas, and make other purchases via two-way satellite communications technology, which was more advanced than U.S. satellite TV companies, and News Corp. stated it would be made available quickly across the United States.25 News Corp. could reduce fees that Direct TV paid to certain companies by selling its own films, major sports events, and global TV shows on Pay-Per-View Direct TV. Securities analysts in media, telecommunications, and retail and the Internet experts stated that if News Corp. succeeded in this deal to control Hughes Direct TV, it could quickly and significantly drop prices in competition with cable TV companies and steal cable customers and other satellite firms’ customers via a lower cost of customer acquisition than many other firms. Although Murdock’s forecast that the combined firm would double Direct TV’s customers to 20 million in a short span of time may be overly optimistic, this is another clear example of global industry consolidation.26 These M&A industry consolidation patterns are deliberate, strategically planned initiatives. They are not an accident, but are targeted by corporations in order to achieve specific market share dominance goals; rank number one, two, or three in an industry; or hit what is called critical mass—the minimum size currently thought necessary to be a viable player in a key industry sector. As a result, many mergers and acquisitions that are targeted to buy firms with specific IP or intangible assets are not really single one-off deals but are often part of an ongoing strategic acquisition program to build that critical mass in a chosen business field. This is the most crucial fact in understanding the clustered patterns of acquisitions by specific corporate buyers. It also helps explain the bidding valuations they offer, or will ultimately pay, for specific firms whose IP or intangible assets fill their firm’s crit-
M&A AND THE CONSOLIDATION OF MARKET POWER 2.21
ical gap or provide links with 5 to 10 other current products or services sold by their firm. Before he became chairman of Cisco Systems, John Chambers laid out a large grid showing a number of vital new technology mergers, acquisitions, or intellectual properties that were all directly in Cisco’s path to future success in dominating the backbone of the Internet for Cisco’s Board of Directors.27 Chambers stated that Cisco must either buy those specific firms or provide seed capital to startup firms currently pioneering in each of the key technologies on that large grid and help advise or direct their paths of growth until they were ready for Cisco to acquire them. Cisco Systems did carry out that major acquisition program and seed those many technology startups before buying them, often at huge prices. As a result, at one point in 2000 it became the most valuable company in the world ($550 billion) before its stock fell by 80 percent in 2001. While Cisco’s 10-year acquisition program was more unique, and much more expensive, than that of most other firms, it was also similar to many companies. Hundreds of famous brand-name firms acquired by Kraft, Nabisco, General Foods, CocaCola, PepsiCo, and Heinz were bought to continually strengthen their existing mass of foods, snacks, or beverages that could be sold through each firm’s existing distribution system to its existing major corporate client retailers. Proctor & Gamble, Colgate Palmolive, and Gillette did the same in buying many famous brand-name personal product firms to enlarge their lines and reap economies of scale and economies of scope in cross-selling many closely related products directly through their preestablished marketing, merchandising, and distribution channels. These corporations’ acquisition bid price for each new famous brand-name firm automatically presupposed their corporation would quickly achieve major cost synergies, especially in huge reductions in the acquired firm’s existing cost structure, by using the acquiring firm’s existing managerial staff, systems, style, structures, skills, and current bureaucratic infrastructure. For decades a number of these giants succeeded in buying countless name-brand firms and achieving the targeted cost reductions and revenue enhancements. Over time, the giants’ mergers became a cookie-cutter formula. These ever-growing organizations, whose mergers copied the over-priced valuations paid by competitors, led the corporate parents to become less productive and more wasteful. Their acquisition machines became static stocks in the market while they continued to gain market share. These acquiring corporations took it for granted that their giant firms’ huge resources and existing tailor-made customer base and their broad and deep current systems and business practices, would more efficiently exploit the brand-name equity value of the target firm. In theory, this strategy was reasonable. However, in fact, often the excessive acquisition price paid, the incompatibility of the giant firm’s distribution channels to those used by the target firm, or the giant’s organizational layers of bureaucracy led to underperformance by the acquired brand-name firm. An analysis of the major brandname acquirers demonstrates that while their market share dominance grew, their profitability and efficiency ratios gradually tended to erode.28 Newell Rubbermaid provides an example of nearly 30 years of virtually nonstop acquisitions (often in related product categories clustered around kitchen utensils, window dressings, and writing instruments) to be sold to Wal-Mart, Kmart, or Home Depot mass discounters, which Newell had targeted for its entire business career. This way,
2.22 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
Newell captured more shelf space for new name-brand product offerings for its corporate growth and became and remained the category managers for Wal-Mart and other giant discounters. The company’s standard mode of acquisition was to acquire famous brand-name firms at inexpensive prices when they were doing poorly and were badly managed. The company would immediately install new management, tighten financial systems, cut nonselling items, and push the newly acquired products through the same mass-discount clients. By not paying excess price premiums for these brand-name firm acquisitions and turning them around quickly, Newell was able to rank 24th in the entire S&P 500 for 10 years. This string of acquisition successes stopped when Newell finally bought Rubbermaid (a famous brand-name firm as large as Newell, but terribly managed) at an inflated price premium and spent three years turning it around. Once again, even the most successful firms doing multiple acquisitions of famous brandname firms at low or no premium prices for years will stumble and erode their value if they buy large, badly managed companies at premium prices that require long, intense merger integration work.29 FREE IP GIVEAWAYS IMPACT M&A GROWTH AND PRICE
A vitally important business strategy is that many companies give away a key initial IP, new technology, or a key trade secret in order to capture a wide range of customers early so they will buy that company’s future add-ons and later product developments. This initial product or service giveaway strategy has become standard practice in a number of industries: from free packs of cigarettes, free computer software, free mobile telephones, free new food products, free music CDs, free new financial services, and a year’s free rent for commercial real estate to no payments for a year on furniture. Many corporations’ global growth strategy is to lock in as many potential customers to their basic system, product, or technology as rapidly as possible, so that their company’s IP becomes the basic industry-wide standard from which all others must work. However, this giveaway strategy is expensive and risky. Dangerous financial consequences are inherent in adopting this free giveaway strategy, although it achieves the fastest possible global dissemination of a company’s key initial IP for both the first mover firm that pursues it and the competitors who imitate it. Free open source code computer operating systems have become one of the most interesting global competitive movements against Microsoft’s dominance of the computer operating system market. Open source code has been adopted by almost all major computer manufacturers (including IBM, Compaq, and so on) launching ongoing new product lines based on Linux, the free open source computer operating system whose continued development has been fueled by an army of volunteers and computer hackers along with serious firms who compete with Microsoft. Microsoft largely ignored Linux and its inroads into the market until May 2001, when it began a national campaign to vigorously warn firms using open source code operating systems and their open source code software derivatives that this could seriously threaten the patent protection and copyright protection of their own products, which could now be claimed to be open to public domain misappropriation. While Microsoft’s argument in favor of its own proprietary software systems is inevitably self-serving, it has pointed to a potentially serious business strategy issue that a number of firms may need to address. IBM
IMPACT OF RAPID TECHNOLOGICAL ADVANCE ON M&A VALUATIONS 2.23
immediately stated that its lawyers had carefully researched its adoption of open source code operating systems, but other firms may face risks. Free computers, free telephones, and free Internet service are only a few of the many major industry examples that are forcing the speed of change in corporate strategy worldwide and forcing investment bankers and corporate financial analysts to rethink their valuation models of many M&A transactions. For example, European analysts believe it was partly the rapid global growth in free Internet service providers and firms offering free phones or free computers to customers who contracted to watch ads that helped pressure AOL to sign its deal with Time Warner to add new media and information content to its basic $19.95 a month Internet subscribers, to prevent them from defecting. AOL’s soaring stock price was highly vulnerable to a sudden plunge from another key threat: cable TV regional monopolies like AT&T’s TCI and Media One or Time Warner. AOL lacked its own TV cable or other Internet distribution and might be held hostage by cable, phone, satellite, or wireless firms via extortionate price increases. Merging AOL with Time Warner not only solved these two key strategic threats of free Internet and cable hold-up, but also let AOL raise its monthly fee by over 10 percent to $21.95, added one million new subscribers in six months, locked in many long-term bundled advertising contracts across all its media and Internet services, and squeezed ad revenue from its many media and Internet equipment suppliers who had never advertised before.30 Offers of free Internet service and free phones continue, but AOL-TW’s bundling is more powerful. BUNDLING OF FREE IP ADD-ONS IMPACT M&A PRICES
Microsoft competitors view its many giveaways of new IP in its bundle of Internet offerings as the latest gambit in that company’s long-term market-dominance strategy of bundling giveaways to lock in each new generation of customers to its expanding range of software and closely interrelated products or services. Investment bankers have been forced to analyze the key threat of free bundled services and products in their valuations of mergers and acquisitions of stand alone companies that lack the deep pockets of financial giants. Microsoft’s new “.Net” giveaways and cheap bundles of software for Internet devices, Internet business services, TV cable set-top boxes, wireless phone software, or financial systems software are widely considered by investment bankers to impose a financial cap on the M&A price of other companies possessing new intellectual properties that compete in Microsoft’s ever-increasing space. The U.S. Justice Departments’ monopoly judgment against Microsoft did not prevent it from making billions of dollars of niche acquisitions in all kinds of Internet and cutting-edge businesses for new IP giveaways or bundles in each next-generation MS product. M&A experts cannot avoid factoring this free-bundling threat into their valuations of many firms. IMPACT OF RAPID TECHNOLOGICAL ADVANCE ON M&A VALUATIONS
This problem by no means rests exclusively with Microsoft Corporation. George Fisher, former CEO of Kodak and Motorola, warns, “Companies have to project out: ‘How will I be competitive in a world [in which] technology will be virtually free?’”31 The speed at which each new technology leapfrogs its predecessors, making them
2.24 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
obsolete, is the most crucial problem facing many corporations. More than 97 percent of the firms that originally entered these technology markets ultimately went out of business. What are the best competitive strategies and best M&A options for different companies to adopt when confronted with competitors willing to use industrial espionage? Especially in high-tech industries, this geometric rise in the power of new generations of technologies is matched by an almost equally dramatic decline in the price they can charge for many of their recent technologies. In 1997 Intel had 90 percent of the world microprocessor market. In 2001 Intel and AMD became locked in a brutal price war and high stakes technology innovation giveaway battle as they both continually launched newer, more powerful microprocessor and network devices at ever-lower competitive prices. What is perhaps not widely realized is that this current Intel versus AMD technology and price war was made possible by AMD’s becoming a “Virtual Gorilla” in the words of AMD’s CEO, Jerry Sanders.32 For four years, AMD made crucial strategic alliances with Intel’s enemies, Motorola and Fujitsu, to share technology and plants. Also, AMD made crucial acquisitions of firms to help it leapfrog Intel in crucial capabilities. Finally AMD was literally given a new $1 billion fabrication plant by the Government of Saxony in former East Germany to provide their highly educated workforce with cutting-edge technology jobs in the new AMD factory. One key result of this Intel versus AMD price and technology war of leap frog is that the profit margins of both firms will shrink significantly, and the market value of both firms may shrink as well, which could make it much more difficult and expensive for them to do the mergers and acquisitions they will need to do to keep up in this brutal battle. Another important fact is that the new molecular-level chemical research is creating breakthrough innovative circuits on the tiniest of scales. Their developers claim these tiny molecular circuits could take the place of large current microprocessors made of silicone, copper, gallium arcinide, or indinium, and in 2000 they publicized that they would have fully workable prototype models in less than four years. Once complete and ready for commercial production, these potent new molecular circuits could be made in small, inexpensive labs at a fraction of the cost of the current multibillion dollar fabrication plants that make microprocessors today. This could make many current plants obsolete. Rapid technological advance inevitably leads to a problem called stranded investment, in which new technology makes old investments obsolete. Literally hundreds of billions of dollars of stranded investments have been incurred over the last two decades in telecommunications, computers, electronic video devices, power plants, energy distribution systems, and biotechnology industries. Much of this may be a total write-off. Most companies must first spend huge amounts of money to develop intellectual properties; then more on plants and facilities to build, ship, market, and provide service and support for all the products based upon those intellectual properties—only to have those products made virtually worthless by the on-rush of technological advances. Investment bankers and corporate financial analysts today know they cannot afford to be oblivious to the brutal reality of rapid technological leapfrogging by innovation, which John Maynard Keynes called “gales of creative destruction.” To cope with this widespread problem, investment bankers doing mergers and acquisitions today have developed more sophisticated financial valuation modeling techniques in order to more accurately measure the useful life of each asset bought in a merger. These computerized
MERGER FAILURE IS THE NORM 2.25
simulations of multifactor valuations provide a step in the right direction, but are frequently proved wrong because key assumptions built into their models turn out to be rigid, static, or insufficiently realistic when confronted by actual corporations’ conditions in specific M&As. This M&A valuation problem is not easy because, as Business Week concluded, “High tech has its own inverted logic ever since the invention of the transistor at AT&T Bell Laboratories in 1948: Power goes up and prices come down in lock step. In the past few years, though cheap technology has crossed an invisible threshold to assume a central role in economies around the world.”33 This constant technology change is probably one of the most critical facts confronting investment bankers and corporate financial planners doing mergers and acquisitions, primarily of knowledge-based companies possessing various intellectual properties and intangible assets. Because of the digital revolution, speed of new telecommunications, and world economic power of the Internet we now have truly interdependent global markets and competitors. As a result, the inherent value of a corporation’s intellectual properties has vastly expanded to be exploited in almost every country. However, in valuing a merger or acquisition of that corporation, the investment banker must consider the huge scale of global piracy of all intellectual properties and the very high and prohibitive cost of protecting them.34 It is not sufficient or professionally realistic today to simply value the potential financial free cash flows that might be derived from the intangible assets, intellectual properties, and business model of the firm. Too many of these potential financial synergies forecast to be derived from hundreds of mergers fail to be achieved because of many hard realities of actually integrating two companies or theft, copying, or reverse engineering of technologies or IP assets by many aggressive competitors. MERGER FAILURE IS THE NORM
For over 50 years, there has been between a 70 and 80 percent rate of failure of mergers and acquisitions to pay back the money invested in them. Often they don’t achieve even the minimal hurdle rate of return that the investment bankers and corporate financial analysts forecast in advance. These high rates of merger failures have been measured using a range of different criteria by investment bankers, consulting firms, and professors. Overwhelmingly negative results remained consistent for that entire 50year period. For example, in 1999 KPMG International analyzed 700 of the most expensive deals from 1996 to 1998 and found that 83 percent failed to boost shareholder wealth—in fact, 53 percent reduced shareholder wealth.35 In 1999 Arthur Anderson Consulting analyzed all large mergers completed between 1994 and 1997 and found that 70 percent did not achieve the benefits they sought to accomplish.36 In 1999, Mark Sirower studied 100 large deals from 1994 to 1997 and found that two-thirds of the deals met with negative market reactions, and most remained underperformers a year later.37 In 1999 Right Management Consultants studied 179 mergers and found that less than one-third of the mergers had successfully combined cultures. In 1999, the Hay Group analyzed 65 mergers and found that 75 percent failed to place employees in the right roles in the first six months after merging. In 1998 Daimler-Benz studied cross-border business combinations and found
2.26 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
that 70 percent of all cross-borders mergers fail to thrive. In 1998, J.P. Morgan analyzed 116 acquisitions of more than $1 billion by European companies since 1985 and found that 44 percent added no value after three years.38 In 1998 A.T. Kearney studied 115 mergers from 1993 to 1996 and found that 58 percent did not add value. In 1996 Coopers & Lybrand studied 125 companies during their post-merger period and found that 66 percent were financially unsuccessful.39 In 1987 Michael Porter analyzed 3,788 acquisitions by 33 leading U.S. companies from 1950 to 1986 and found that acquired companies were divested at a rate that ranged from over 50 to 74 percent.40 In 1987 Mc Kinsey & Co studied 116 acquisitions and found that 77 percent did not cover the costs incurred in the deal.41 The former head of Lehman Brothers, Warren Hellman, stated, “So many mergers fail to deliver what they promise that there should be a presumption of failure. The burden of proof should be on showing that anything really good is likely to come out of one.”42 The latest tidal wave of merger activity is doing exactly what past tidal waves have done—hide the cold, hard reality that most mergers fail to achieve any real financial returns. The most commonly cited cause of M&A failure is the excessive control price premium paid by acquiring companies, which their future management efforts cannot earn back. Key reasons for paying excessive premiums center on their necessity to complete acquisitions, the synergies that the two combined companies can achieve together, the acquiring CEO’s ego, and the winner’s curse in M&A auction bidding that inflates the bidding price beyond its reasonable payback limit.43 A second cause of merger failure is that in 80 percent of all cases the managers failed to make post-merger integration plans for successful integration of the two former companies into one.44 Integration failure is often a direct result of management’s inability to execute the synergies assumed during the valuation process. Although often blamed for a lack of foresight after mergers fail, bankers argue that they base their synergistic forecasts on management’s projections. A third cause of merger failures is the lack of understanding of the acquired firm’s IP and intangible assets or their practical uses, growth potential, or inherent limits. Inflated pricing of the acquired firm’s IP and intangible assets is common. In-depth M&A planning is often difficult, because valuable IP and knowledge assets are hard for acquiring firms to grow, enhance, or retain. Despite the fact that each acquisition had originally passed many types of tests and financial forecasts, between 50 and 74 percent of corporate acquisitions often had to later be divested.45 Although a number of investment bankers blamed a firm’s poor merger integration or radically changed market circumstances, most professionals agreed that one of the key reasons for such high failure rates and divestitures was that overzealous bidders, or their investment bankers, had allowed an inflation of financial projections that it could never sustain for the merger. However, more in-depth and longer-term analyses of failed mergers showed that even when M&A price premiums were low, most corporations failed to fully exploit many of the intellectual properties or intangible assets in their acquired businesses because they often failed to test the future opportunities they held. They frequently divested these firms at bargain prices to specialists who profited. One such classic industry case involved the 1999–2000 bargain basement divestitures of many specialty chemical subsidiaries of petroleum or
IMPACT OF NEW INTERNET IPO MARKET ON M&A PRICES 2.27
large chemical companies who had acquired them and gone nowhere. In less than 18 months these specialty chemical companies were soaring in value, now owned by their prior managers who exploited the unique chemical technologies, know-how, and other intellectual properties that were unseen or not funded by their prior corporate parents’ chiefs. FAILED MERGER NEGOTIATIONS RISK IP LOSSES
Many announced mergers fail to be completed for a wide variety of reasons. It is important to remember that a large amount of vitally important secret proprietary information about each company is shared during the intense merger negotiation periods, as the two firms perform their due diligence investigations of the other firm prior to final merger. The vital information learned about the proposed merger partner company includes the way that firm researches, designs, and develops new products. That firm’s specific production processes, how it manages its procurement, designs its organizational systems, the production methods for its goods and services, how it controls quality, how it organizes its distribution, and how it manages its sales and foreign operations are often examined in detail by its potential merger partner. All of this constitutes the potential merger partner’s intangible assets or IP. Both firms originally signed explicit written confidentiality agreements to be shown or told all this secret proprietary information about the other firm; however, if that merger fails to be completed, all the secret information divulged in those merger negotiations is now in the heads of the entire team of that other firm’s negotiators. As a result, the very firm that would have been your partner now has a much stronger ability to compete against you once the merger has failed to be completed. This is because it understands more about your firm’s crucial IP and what the real range and depth of your intangible assets are. IMPACT OF NEW INTERNET IPO MARKET ON M&A PRICES
Another key factor in recent merger failures, even by giant corporations, was the high IPO price inflation. There was a huge value inflation in the past decade, which was a direct result of the decade-long bull market on Wall Street. In 1987, the idea of valuing a company at two times its yearly revenues was considered unrealistically high. By 2000, Wall Street firms were rating companies as a “strong buy” because their trading was at only 21 times the estimated revenue.46 What is most important to understand is that this inflation spread from many new Internet companies’ IPO stock prices, to overvaluation of the entire NASDAQ stock market, to the inflation in the pricing of most M&A transactions. Investment bankers often showed each client corporation lists of new Internet IPO valuations of recent high-priced merger transactions, and those of comparable companies, to justify recommending increasingly-inflated estimates for proposed M&A deals. As a result, the separate markets for IPOs and M&A deals had high inflation rates that were continually mutually reinforcing each other. While circular patterns of value inflation often occurred in the past, they never happened on such an enormous international scale, nor so fast, as today. Although each
2.28 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
market’s proponents attributed this equity value growth to a “virtuous circle,” critics derided it as simply a “vicious cycle” of excessive equity pricing. As soon as many Internet companies went public at highly inflated prices, they rushed to do mergers and acquisitions using their inflated stock as currency. The central point, however, was not just that their high IPO price made them willing to overpay in M&A deals, but that their need for growth and speed was so intense that companies looking to enter the market had to keep making larger deals in order to remain relevant. One part of this was simply an Internet land grab for growth in firm size. “The gorilla wins in every market,” stated Paul Deninger, CEO of Broadview International, summarizing accepted wisdom. Different competing technologies are all reaching critical mass. Each has its own IP roots, trunk, branches, and leaves of new products and services.47 However, the much more important driving force was the position of firms at critical juncture points, where key future business innovation must pass. This combination of the nonstop pace of deals, the explosion in deal size, and the compulsion to achieve breakthrough technological innovations was the hallmark of M&A momentum. TYPICAL M&A VALUATION PROBLEMS OF HIGH-TECHNOLOGY FIRMS
Because a majority of companies that completed M&A transactions in the last five years were high-technology firms, it is important to realize that the accounting measure of operating earnings for high-technology firms is skewed by the treatment of R&D expenses as operating expenses. According to valuation expert Aswath Damodaran, this understates operating earnings of the technology firms whose primary assets are intellectual properties and intangible assets. It also understates how much technology firms are reinvesting into assets, the free cash flow produced by many high-technology firms because of operating expenses, and the total capital invested in these high-technology firms due to lack of capitalization of R&D expenses.48 Investment bankers, who are aware of the accounting problem faced by hightechnology firms, make adjustments to the financials of merging firms in order to reverse the accounting treatment of R&D. A key question raised is whether R&D expenses for high-tech firms are really an operating expense or a capital expense. As Damodaran notes, accounting standards require us to consider R&D as an operating expense, even though it is designed to generate future growth and it is more logical to treat it as a capital expenditure. Investment banking valuation experts therefore engage in a series of assumptions that adjust the financials of a high-tech firm in order to capitalize its R&D. While there are significant justifications for criticizing many of our archaic accounting conventions, the result of investment bankers’ method of capitalizing the high-tech firms’ R&D is to add over a billion dollars a year as an upward adjustment to the operating income of a firm like Compaq Computer. When this same upward adjustment of the operating income is made to many of the high-tech firms engaged in merger transactions, it makes their performance look significantly more positive than they reportedly were and tends to justify paying a higher acquisition premium to acquire such firms. It enables the high-tech acquiring firm to view its own adjusted operating income in a much more positive light so that it can justify increasing its bid for a target company.49 Either way, this issue is fraught with valuation adjustments that
TYPICAL M&A VALUATION PROBLEMS OF HIGH-TECHNOLOGY FIRMS 2.29
in the name of clarity serve collectively to justify higher bids in M&A deals, which ultimately the combined companies usually are unable to pay off. These widespread practices of financial revaluation and incorrect valuation often impact the failure rate of mergers. Rampant M&A transactions occur among high-tech firms because technology innovations can create brand new products, improve existing product performance, or lower their costs. Many firms seek process innovations by M&A high-tech deals because they cut waste, skip intermediary stages, shrink time requirements, use new substitute materials, streamline production, innovate designs, and build worker team empowerment. The most successful firms, such as Microsoft, Oracle, GE, and Vodaphone-Mannesman, continually combine strategic M&A for technological product innovations, process innovations, and service innovations to create a virtuous circle. Each innovation sparks other innovations in a chain reaction not only at their firm, but also with their suppliers, customers, and allies. For 100 years, 3M Corporation continually improved upon these two parallel R&D innovation tracks in new products and new processes, and now they have become world leaders in what they call “the process of micro-replication.” It is clear that 3M’s new chief executive, who came from being one of the three CEO finalists at GE, is inculcating the highly successful GE process of extending the virtuous circle of innovation beyond 3M itself to interrelate closely with innovations by its suppliers and customers. While successful mergers by firms to acquire ever-newer technologies have often been led by a stellar company which became the standard, the glaring fact is that the majority of high-tech firms acquired went bankrupt. Whether bought by non-high-tech firms or by significantly different technology firms, most have destroyed huge amounts of shareholder value. This is partly because so many firms are pouring investments into a wide range of competing high-technology firms that it is physically impossible for more than a few to become the generally accepted standard technologies of their specific sector. The “winner-take-all” pattern of single technological dominance in a sector has been repeated frequently. This has often led to a herd instinct among many firms who invested simultaneously in multiple competing technologies so they would not be excluded from the single winning standard that ultimately prevailed. These multiple follow-the-leader patterns result in excessive funding of many competing technologies that for the most part become stranded investments, when only one definitive technology becomes the standard that most complementary product firms decide they must adopt in order to ensure their own company’s survival and success. In this century there has been a dramatic transformation in what economists call the production functions of companies—the major assets that create value and growth.50 Intangibles are fast becoming substitutes for physical assets. John Kendrick, a wellknown economist who has studied the main drivers of economic growth, reports that there has been a general increase in intangible assets contributing to U.S. economic growth since the early 1900s. In 1929, the ratio of intangible business capital to tangible business capital was 30 percent to 70 percent. In 1990, that ratio was 63 percent to 37 percent.51 Today, more than 70 percent of U.S. growth is contributed by intangible assets, versus less than 30 percent that is contributed by tangible assets. For the sake of clarity, we will distinguish between intangible assets and IP, but in reality they frequently go together. While IP is generally legally considered to include patents, trademarks,
2.30 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
copyrights, trade secrets, know-how, new business processes, new technology, and customer lists; intangible assets are said to be corporate reputation, worker loyalty, and organizational designs and systems. NYU Stern Business School professor Baruch Lev has gathered intangible capital together, including both IP and intangible assets. He groups them into four categories: “First are assets that are associated with product innovation, such as those that come from a company’s R&D efforts? Second, assets that are associated with a company’s brand, which let a company sell its products or services at a higher price than its competitors. Third are structural assets — not flashy innovations or new inventions but better, smarter, different ways of doing business that can set a company apart from its competitors. And forth are monopolies: companies that enjoy a franchise, or have substantial sunk costs that a competitor would have to match, or have a barrier to entry that it can use to its advantage.”52 Professor Lev provides a very useful example of the value of intangible assets. AMR Corp owns American Airlines and most of the SABRE computer reservation system. Whereas American is one of the largest airlines in the world, with roughly 700 jets in its fleet, nearly 100,000 employees, and exclusive and valuable landing rights in the world’s most heavily trafficked airports. On the other hand you have SABRE a computer reservation system. How can a computer reservation system be as valuable as all the remainder of American Airlines’ assets? The reason is that when dealing with tangible assets, your ability to leverage them—to get additional business out of them—is limited. You can’t use the same airplane on five different routes at the same time. You can’t put the same crew on five different routes at the same time. And the same goes for the financial investment that you’ve made in the airplane. But there’s no limit to the number of people who can use AMR Corp.’s SABRE system at once: it works as well with 1, 5 or 10 million people. The only limit to your ability to leverage a knowledge asset is the size of the market. Economists call physical assets ‘rival assets’ meaning that users act as rivals for the specific use of an asset. With an airplane, you’ve got to decide which route it’s going to take. But knowledge assets aren’t rivals. Choosing isn’t necessary. You can apply them in more than one place at the same time. With many knowledge assets, the more areas you apply them the greater your return. This is because, with many knowledge assets, you get what economists call ‘increasing returns to scale.’ These ‘increasing returns to scale’ on a firm’s IP fixed cost network like the Saber system, works as well with 1, 5, 10 million customers, which is crucial to the financial power of IP and intangible assets. The larger the network of users is, the greater the benefit everyone gets from using it (to everyone using it, and the greater value it has as a whole). Knowledge assets are very expensive to acquire, to develop and extremely difficult to manage. For example, it is important to consider the extremely high prices that high-tech companies are paying to acquire smaller companies, as they look for knowledge assets that they can leverage. November 1, 1999, Cisco announced that it had acquired Cerent Corp. for $6.9 billion, yet, for the first six months of 1999, Cerent’s sales totaled roughly $10 million. That’s what it can cost to acquire a knowledge asset. The cost to develop a new pharmaceutical is $500 million. Finally, America Online spent nearly $1.5 billion on customer acquisition when it was creating its franchise. That’s what it can cost to create a high barrier to entry. There’s another downside of knowledge assets: Property rights are fuzzy. When it comes to a
M&A VALUATION OF IP
2.31
tangible asset, such as an airplane, American Airlines doesn’t have to worry much about ownership. No one is going to steal an airplane. But American Airlines definitely has to worry about someone stealing Saber System’s [computerized software yield management models for maximizing total profit from every passenger seat and every square foot of cargo space.] The proliferation of thousands upon thousands of very costly patent-infringement lawsuits attests to the difficulty of defining and keeping property rights when you’re dealing with knowledge assets of companies. And while the benefits that come with knowledge assets can be enormous, they are much more uncertain than the benefits of tangible assets. When you invest in tangible assets such as an office building you almost always can get some return. But when you’re building knowledge assets you could quite possibly wind up with nothing.53 M&A VALUATION OF IP COMBINES INVESTMENT BANKING WITH STRATEGY CONSULTING
By 1975, investment bankers and strategy consultants involved in mergers and acquisitions were developing new methodologies to value intellectual properties. Whereas traditional financial valuation models, including Damodaran’s, assumed that the financial value of a patent ended with its expiration date, because competitors rushed in to compete away any excess profits, strategy consultants tracked the lowered, but continued, superior profit margin earned by certain original patented products after expiration because of their brand-name recognition and loyal customers. Two intellectual properties, the patent and brand-name, could be combined to extend the original patent value. Strategy consultants have learned to integrate the original patent-protected monopoly earnings and the later residual earnings from loyal customers after patent expiration with their analysis of patterns of continual cost reductions from economies of scale and experience curve effects to model the range of comparative profit margins achievable by different direct competitors in each market during each year. (However, some strategy consultants and investment bankers doing M&A valuations at that time did not realize that if brand-name was built into the growth rate of the firm’s Cash Flow estimation, they might well be double counting it.) By the 1980s, investment bankers and corporate strategy analysts became more aware of the wide variance in total earnings projections, or rates of return, caused by different rigid valuation models because they could only be as good as the basic assumptions on which they were calculated. Thus, if one or two key assumptions in the original model were incorrect, the financial valuation of a patented product’s future earnings and future growth rate would be way off the mark. For example, new competitors using more advanced technology would not be on the same experience curve of cost reductions as the largest producer or original patent holder, but might suddenly achieve dramatically cheaper production than did the market share leader or original patent holder. Each year as certain new technology leapfrogged old, the useful life and forecasted financial value from many past patents were suddenly cut short. As a result, a wide variance of technology forecasts and other critical factors forced the creation of multiple scenarios with differing assumptions behind each separate valuation model. By 1990, simple multiple-scenario financial forecasting of best case, average, and worst case in M&A valuations became normal for investment bankers and corporate
2.32 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
financial analysts. Many key problems still remained with these supposedly more sophisticated financial valuation models, however. This was because many of the most powerful growth companies are driven today by the knowledge assets inside their key employees, their know-how, commitment to quality, systems of teamwork, human incentives, social architecture (as GE calls it) or social capital. The knowledge assets of today’s firms, such as eBay, are often structured using new virtual business models, which dramatically leveraged the value and growth rate of firms’ total intangible assets (including their corporate reputation) by outsourcing most of their basic functions. No typical financial valuation model was capable of accurately estimating the inherent value of these knowledge assets inside the employees of these growth companies, such as Nokia, the key to their innovativeness, or the social capital of their methods of teamwork that added significant productivity enhancements each year to their specialized businesses, such as Southwest Airlines. A crucial fact that was not realized in standard financial valuation was that these knowledge assets and the social capital embedded in new methods of teamwork appear as less costs in year cash flow projections, but somehow these intangible assets are capable of generating huge growth in a firm’s income. Although traditional financial valuation experts sought to focus solely on discounted cash flows of the business, they kept running against a wall; many, if not most, of the core assets in today’s M&A deals were not on the balance sheet or the income statement, or accurately measured in past or current cash flows, but existed only in projections, estimations, or forecasts of future cash flows. These forecasts, estimations, and projections were simultaneously contingent on a range of future events, new technology breakthroughs, new business model patents, or collateral developments in several new industries and the timing of regional or foreign national adoption. A new valuation process required a number of innovative types of business development assumptions. The problem of the new valuation process is two-sided because it requires crucial changes in accounting and finance. Accounting faces the most glaring transformation because it has resisted the changes in our 500-year-old financial accounting rules, terms, practices, and procedures for decades. Most importantly, it needs a new focus on what is truly important for accountants to measure, because these knowledge assets— not book value, fixed assets, depreciations, amortization, and so on—were the key drivers of the financial value of firms. Until the recent work of Baruch Lev and his accounting institute, there was no clear understanding of the nature and depth of the problem that the accounting profession faced in regaining its relevance.54 Even today, few accountants make the first steps to try to understand knowledge assets and intangible resources and why these are powerful creators of financial value in firms but very easily evaporate in M&A transactions. The other side of the valuation problem lies in the often rigid, limited, or traditional valuation practices and metrics that investment banks believe their corporate M&A clients expect to see or are capable of understanding. It is not unusual for new MBA and Ph.D. graduates who have been trained in the latest financial analysis tools to enter the M&A department at an investment bank and find their analysis of M&A deals is often strictly limited to “crunching numbers” for iterations of discounted cash flow analysis, comparable companies, or comparable transactions analysis. Most of their indepth work in business schools into the more sophisticated financial analysis of real
EXAMPLE OF A MERGER VALUATION OF IP IN AN ACTUAL TRANSACTION 2.33
options—for valuing patents on biotech genomic breakthrough drugs, new business models, new technologies, or copyrights on innovative software—is rarely put to use in the M&A department’s continual rush to complete each new deal. At certain strategy consulting firms (McKinsey, Booze Allen, Ernst & Young, Cap Gemini), cutting-edge valuation boutiques (Intellectual Capital), and Valuation Services at AUS Consulting, more interest is shown in exploring innovative valuations of social capital and knowledge assets and combinations of intangible resources in the multiplication of firm value. However, a need for far more significant development work on innovative valuation methods still exists, especially for understanding the dynamics of rapidly evolving new business models and the growth of the multiplier effects of intangible assets in firms. EXAMPLE OF A MERGER VALUATION OF IP IN AN ACTUAL TRANSACTION
A major U.S. investment bank was appointed by a major European health care corporation to assist the company in the sale of one of its divisions, which is a leading European medical device company. The division is an autonomous unit that is not very integrated with the rest of the corporate medical device company, thus causing a conglomerate discount on the corporation’s overall stock price. The main objective of the divestiture is to unlock the IP value of the core business. Another goal of the company may be to capture some of the synergies that the next owner may gain in this acquisition.55 In this European firm, the R&D investments and potential for IP breakthroughs are the key drivers of its financial valuation’s rapid growth. A wide range of possible values exist for this firm, however. The investment bank valued the company to be only between 275 to 320 million euros on a standalone basis. In an auction transaction to European corporate bidders, the company’s potential value rose to between 320 and 375 million euros. Yet, the highest financial valuation possible, the investment bank said, would result only if that very same European company were sold at a global auction to one of the three most powerful U.S. medical devices firms willing to pay a price over 500 million euros. However, the corporate board felt pressed to forego this highest financial value achievable for fear of jeopardizing its corporate reputation by selling to a U.S. firm that would seek to close key EU plants. The European company is a leading cardiovascular device manufacturer with R&D, brand franchise, manufacturing plants, sales force, and market position as its main assets. The company is known for its technology, breadth of product range, and reliability. Although a small player compared to its peers, the company has consistently passed its competitors in achieving key milestones in the industry. This success is due, among other things, to its clinical research program and excellent relationships with physicians in the major markets around the world. Furthermore, this is the only company in the industry that has never faced a recall, which is important to value assessment in this industry because of the outstanding litigation issues. The company’s weaknesses are derived from its past poor performance. As is typical, at least in Europe, because this company division belonged to a wealthy corporation, it had poor procedures for requiring its profitability independent of the corporation’s. During the last two years, the corporate parent had also been spending heavily on this company’s sales network, which prevented the company from showing good financial results. The company expects to boost the firm’s total sales by leveraging
2.34 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
the productivity of the sales representatives hired. It normally takes two years in this particular sector of the medical devices market before a new salesperson is considered totally trained and fully productive. VALUATION: TO BELIEVE OR NOT TO BELIEVE
Investment bankers’ valuation of the intellectual capital of this company for its acquisition, as in many startups, is based not as much on the scientists or their technology as on the experience and industry credibility of the management. Will the management be able to maintain the timing and high quality product introductions it has demonstrated in the past? Clearly, when looking at the past results to extrapolate in the future, no investment banker could find any source of value from the company’s bottom line figures for the last five years. Instead, they had to look for another source of value. To do so, they first performed an in-depth evaluation of the cardiovascular medical devices industry landscape. They next assessed the company management’s business plan against its competitors in both its top line sales and cost structure. From this information, the investment bankers derived a detailed three-year forecast of the company’s future performance, plus a seven-year projection. In a detailed valuation such as this one, it is required to consider the market size and market growth rate for each of the countries in which that company operates. The base reference point for the investment bankers was the current sales by each firm in each national market for cardiovascular devices. The next step was to study the strategic advantage of each competitor, their current market share and growth forecast in terms of units to be sold and potential prices to be charged in each region for the years of the projection. For competitive advantages in a high growth sector, it is relevant to measure the firepower of the company’s R&D in terms of its capacity to generate a continuous flow of products ahead of the general trends and before its competitors. It was also necessary, however, to estimate the current pipeline of the company’s new cardiovascular devices that would likely result from all past efforts, and the time spent to fully implement and produce the projected range of anticipated products. In the valuation, relationships with the many heart disease specialists were crucial in the speed with which the company could obtain the license to introduce a product in the regulated areas: the United States, European Union, and Japan. The company had been consistently able to implement the new findings from its R&D research into the old products by leveraging the tool’s original investment for as long as three years for its line of products. At that point, a new platform was built from scratch to enable the company’s base to grow successfully the next few years. Growth was planned to be leveraged by outsourcing noncore production. But what growth rate was most likely? Because of growing competitive intensity in cardiovascular medical devices, each company’s base cost structure in this sector would be its most vital competitive tool. This was because the products became so quickly commoditized that the capacity to squeeze every cost, compress each stage of production, and shrink needed materials to achieve higher productivity became critical for survival.
VALUATION: TO BELIEVE OR NOT TO BELIEVE 2.35
Finally, the investment bank’s valuation analysis included a systematic assessment of potential technologies that could eventually substitute or complement/bundle a product from one industry to another. In this case, the cardiovascular drugs represented a weak threat to the medical device industry because of the side effects in their treatment of the same heart problems. On the other hand, some complementary medical device products existed that could impact the company’s overall revenue line. After their preliminary valuation analysis and due diligence, the investment bankers determined that, on the one hand, this company’s management had been conservative in its assessment of the growth of market, new products, and complementary products and the price and projection of its profit. On the other hand, the company had been aggressive in its estimation of its U.S. penetration, sales for the year 2000, cost structure and containment, projected market share growth, and the weak competitors’ reaction. Before the investment bankers could begin to project the quarter-by-quarter product introductions, they had to visit the factory and R&D facilities and get to know their respective managers to be sure that the managers would be capable of reaching their projected target milestones and deadline timetables. After visiting the company’s facilities, the investment bank, valuing the firm for its merger or acquisition auction, decided to introduce more realistic assumptions about all the aggressive issues. Overall, however, the investment bank gave credit to the company’s R&D capability of rolling out a series of new products. This would provide most of the company’s financial value. The acquisition bidders, who receive the investment bank’s Information Memorandum, prepared for the company’s valuation in its acquisition auction, typically do not have access to all the detailed information the bank gathered to back up numbers, especially if the key value driver is intangible. As a result, the bidding firms and their bankers must carefully estimate what they believe the target firm’s IP and intangible assets are truly worth to their corporations (including all real or imagined synergies) and decide what price to offer. The value of the firm’s intellectual capital is most significantly impacted by proof of its legal right to the patents for various cardiovascular devices. The legal legitimacy of the patents and the number of national jurisdictions in which the patents are legally upheld and can be judicially protected, is the single most important and relevant factor that could erode the value of the company. The number and quality of cross-licensing agreements and the relevance of pending lawsuits against competitors are used in this industry as strategic weapons to increase a firm’s bargaining power in similar situations. In the medical device industry, product prices of companies erode quickly because of the high degree of intense competition. Sources of growth in value, therefore, can often result from the range of new, rapidly launched, closely related products that this company is able to introduce to the market in a relatively short and definite time. If the product is deemed unique, rare, or in hot demand, another potential source of growth can come from the company’s ability to raise its prices. To a large degree, both of these key potential means of enhancing the company’s value are derived directly from its capacity of key innovations from the R&D department. The race to develop new medical devices is so rapid in this industry, however, that companies that can’t innovate fast enough by themselves are forced to introduce small variations of the market leader’s products. This immediately triggers the legal machinery
2.36 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
that all the companies have in place. Because no company can innovate everything by itself, all the companies eventually copy something from the others. As a result, all the companies have actual or potential legal issues, as well as cross-licensing agreements in a number of cases, against each other. Although some court decisions are finally reached in these patent battle zones, most of the time, the pending legal actions are used to force bargaining compensations from the patent-infringing parties because of the sluggish nature of the judicial system and complexity of the cases. For example, in the case of an acquisition, where the target had a cross-licensing agreement in place with one of the acquirer’s competitors, it was necessary to negotiate compensation in order to enable the competitor to use the technology it had cross-licensed. In such merger crises, all the pending legal issues with many companies would be laid out for settlement. Otherwise, the merger or acquisition would be illegal or would fail to close. Each competitor bidding to capture the company’s valuable IP has knowledge about the product’s introductory track record and its own perception of the credibility of the investment bank backing the projected financial numbers of the company’s product for three to seven years. The value of the intellectual capital, therefore, partly reflected in all these factors, not just in the sales or profit forecast relative to various competitors’ forecasts. Yet, other factors affected the valuation of the European company. These factors included the company’s WACC, taxes and tax credits, and range of synergies that the bidders, currently competitors of this company, would expect to derive from combining its resources with their own. In the end, however, the investment bankers invited the giant U.S. firms into the first round of bidding with the European firms in an attempt to raise the auction bids significantly but not truly maximize the final acquisition price. This forced the European firms to bid higher than they would have if no U.S. firms had been invited. In the final round of bidding, however, the parent corporation of the division being auctioned feared that the giant U.S. bidders would try to close the European plants and operating facilities if they won. That situation, the parent feared, could very seriously damage this corporation’s solid, long-standing reputation in various European countries. The parent company did not want to risk this reputation, so did not include the U.S. firms in the final round of bidding and chose to accept a lower selling price than it could have received for the subsidiary. Had this been a U.S. corporation selling its subsidiary, it probably would not have restricted itself to prevent the highest bidders from the final round, nor would it have decided to accept a less than maximum sale price. The European firm decided not to take another step that a United States firm would probably have taken to retain a carried interest in the medical device subsidiary. This carried interest could take the form of payments if the firm hit future earning targets or could require a percentage payment of a later sale price if this subsidiary was flipped or sold to a different buyer within the next three years. Noticeably, the European M&A negotiations are far more likely to be influenced by the stake holder interests of workers, job security, local communities the firm impacts, or local governments than would M&A auctions originated in the United States for an equivalent business. Although this type of practice is contrary to what many U.S. financial professionals believe management’s fiduciary duty to its shareholders is, it is common in Europe.
MODELS OF INTELLECTUAL PROPERTY FIRMS 2.37 MODELS OF INTELLECTUAL PROPERTY FIRMS: INCESTUOUS FAMILY, NETWORK ALLIANCES, WINNER TAKE ALL, A WHEEL OF FORTUNE
There is an important relationship between the explosive growth of many intellectual properties and the proliferation of new businesses by entrepreneurs working with their financial backers and mergers and acquisition dealmakers. This clustering of innovators with their financiers is a common pattern in the economic history of the fastest growing industrial regions of many countries. My father’s research (1928–1952) traced this crucial pattern of family and social networks of simultaneous technological and capital accumulation in various nations. The clearly linked development of various specific intellectual properties in new technologies for the growth paths of new business models required the critical mass of science, technical, and financial expertise in one place in one period. For example, key high-tech centers grew over the last 30 years in Silicone Valley, California, Route 128 around Boston, the Internet center in Northern Virginia, Triangle Park, North Carolina, and Silicone Alley in New York City. These tightly knit creative regions’ explosive growth stemmed not from new IP but from innovators all learning from each other during the continual interaction in family networks of new businesses in those regions. This phenomenon is sometimes termed the “agglomeration effect” and has been studied for decades by business historians, anthropologists, sociologists, and technology experts. In the case of Silicone Valley in California, the way that the creative technology IP innovators joined with new venture capital groups and startup investment banks of San Francisco like Hambrect & Quist has become a legendary case study. This incestuous extended family relationship between inventors, who create new intellectual properties, and their entrepreneurial financial backers and mergers and acquisition advisors acted as the lightning rod that sparked networks of innovations. What outsiders often did not realize, but insiders knew all too well, was that the first successful inventors and their entrepreneurs became the key advisors, mentors, board members, and vital angel investors in most second generation clusters of new innovative companies. In short, a chain reaction of new intellectual properties development and spinoff expansions came from these creative new business experiments of scientists and their financial backers, often feeding off of one another’s breakthrough ideas. In fact, by adding layer upon layer of new technologies and financing structures, those teams kept the IP chain reactions moving forward. It is important to recognize the extended family IP links and intergenerational pass-along roles that these scientific–business partnerships played in developing new industries such as transistors, microprocessors, personal computers, cellular and wireless phones, the Internet, and key biotechnology industries. Two key examples will help illustrate this network effect between the scientific innovators and the financial architects of the new industries. In case after case of business innovations, the old riddle comes up: Which came first, the chicken or the egg? When America Online pioneered highly user-friendly Internet connectivity from its primitive startup in Northern Virginia, it launched a new cottage industry of Internet firms based there. Within three years, Fortune Magazine provided a map of new online companies in the region and the “incestuous relations” among the founders and financial backers of all these pioneers. The same phenomenon took place with the key scientists
2.38 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
and financial backers who founded Digital Equipment Corporation, Wang and its offspring near Boston, and Texas Instruments and its offspring in Austin, Texas. In the North Midwest region, National Semiconductor, Control Data, Cray Research, and others joined. Likewise, the IP development via a clearly linked heritage from Xerox Park, Apple, Microsoft, Oracle, Silicone Graphics, Netscape, Cisco Systems, and Amazon.com from Northern California to Seattle, Washington, has by now, become legendary. Countless biotechnology companies have also clustered geographically. In an extraordinarily large number of cases, the first successful entrepreneurs not only helped fund the next generation with angel investing, but also helped arrange for their own firms’ original venture capital firms to do several rounds of private financing or mezzanine capital. These same successful biotech pioneers then took those new firms to their own investment bankers to either do initial public offerings or arrange for pre-IPO acquisitions of the private companies. Business historians, economic historians, growth economists, and business strategists have explored several classic models of dynamic explosive business growth periods linked to various scientific and technological pioneering developments and their networks of financial backers. By providing live, real-time, and continual global linkages, today’s Internet is exploding the number of these creative relationships between clusters of businesses based upon innovative intellectual properties and their inventors, entrepreneurs, and financiers. Japan’s “Softbank” has been the godfather of new ventures clusters’ rounds of financing and its M&A transactions in the United States, Asia, and Europe. DIVESTITURES VERSUS ACQUISITIONS SIGNAL THE DRIVING ROLE OF IP IN TODAY’S BUSINESSES
Divestitures, according to a McKinsey and Company study, comprised 40 to 50 percent of all M&A corporate financial transactions for two decades.56 A central part of the global merger waves of the past 40 years has been the divestitures of unrelated businesses. Since the 1960s, financial experts have pointed at thousands of divested firms as examples of conglomerate corporations selling off their numerous unrelated businesses. However, when lists of all the companies divested are compared to the core business of all those companies acquired, it is clear that the majority of those sold off tend to lack unique intellectual properties, intangible assets, and knowledge assets. In short, the core businesses of a majority of firms acquired were purchased because they possessed these unique, rare, or higher value-producing assets. Many corporations have sold off divisions and companies whose lack of high-value intellectual properties made them appear as not only having lower long-term potential ROI for the corporation, but also financially draining the other high-potential IP businesses the firm retained. The familiar pattern of firms making an acquisition and then divesting those noncore businesses has repeatedly demonstrated the shedding of the bland commodity-type businesses that lack unique brand equity value, strong patent portfolios, and valuable trade secrets, or which have only outmoded technology. Wheel of Fortune. In contrast to these wholesale divestitures, the patterns of mergers and acquisitions of IP firms repeatedly shows that they are often bought not only in
AICPA ACCOUNTING RULE CHANGES 2.39
focused clusters, but also as the central core assets of corporations, from which other key business functions are linked specifically to exploit that core. In its cover story, “Wheel of Fortune,” Economist Magazine stated, “Intellectual Properties form the hub of a giant global Wheel of Fortune of the New Business Model in today’s Entertainment Industry.” From that central IP hub extend ever-increasing numbers of new spokes of the entertainment distribution channels and subsector technological innovations wheel, which multiply the value of IP content into a universe of new media. A very similar M&A pattern of purchasing biotech and new breakthrough medical device firms as IP core assets can be seen in the rapid growth of giant pharmaceutical and healthcare firms. Among communications companies, the acquisition of firms doing most advanced transmission development with different colored light waves, optics, and new materials form the IP core of technology pioneers. AICPA ACCOUNTING RULE CHANGES IMPACT MERGER AND ACQUISITION TRANSACTIONS AND VALUATIONS
Despite the importance in M&A of buying firms with the most valuable intellectual properties because they can produce the most sustainable profits over time, tax law was another critical driver of many deals. Hundreds of billions of dollars of U.S. M&A deals from 1998 to 2001 were quickly completed to take full advantage of the pooling of interest accounting method for mergers and acquisitions before it was phased out. This rush was due to the fact that pooling of interest accounting for M&A deals enabled firms to avoid dragging down their yearly earnings by recording goodwill (the excess dollar value of their buyout price above the book value of the target company) in their public accounting statements for up to 40 years, which the traditional purchase accounting method for mergers and acquisitions set by the AICPA would have required. Although the Accounting Standards Board has adopted new rules that will end pooling of interest accounting, the AICPA was ultimately persuaded, after intense lobbying by investment banks and many corporations, to create new and very flexible accounting rules to permit firms to continue mergers and acquisitions without huge goodwill amortization writeoff costs each year. Although the final details of the new rules have yet to be worked out, firms will have the flexibility to determine when their goodwill is impaired and to amortize it at that time if the need is clear and obvious. This essentially means that firms can keep goodwill on their books, but need to amortize it only when the assets related to that goodwill are impaired. Intangible assets—such as patents that have a fixed useful life until their ultimate expiration date—would be amortized over the remaining years of each patent’s life. Traditional goodwill such as brandnames and strong firm reputation would not have to be amortized or written down in a yearly charge against the firm’s earnings. The new accounting rules, although substantial, should have no effect on the actual valuations of firms. Because the changes are only in accounting on paper, they will have no effect on a company’s cash flows. It is not certain, however, as to how the market will react to the new rules. In past M&A deals, the value paid above the book value of the firm has been split into three separate accounts: In-Process R&D, Identified Intangible Assets, and Goodwill. The percentage breakdown among the three accounts was, as one M&A banker
2.40 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
said, “like putting your finger in the wind.” The arbitrary allocation of these expenses has led to no uniform standard across the market or within industries. Because InProcess R&D and Identified Intangible Assets can be immediately written off, most companies try to allocate as much as possible to these accounts rather than submit to the resulting drag on earning of goodwill amortization. With the new standards, there will be tiny amortization of goodwill and, as a result, tiny effect on earnings. Firms with large amounts of goodwill, then, will at times realize substantial increases in earnings. This is when the dilemma arises: If reported earnings increase, shouldn’t the value of the company also increase? The professionals answer no. The problem is that the increase in earnings will have an immediate effect on a company’s P/E ratio. Because many industries such as health care trade directly on metrics such as P/E, it has not been determined if the market will immediately adjust for the changes. Although most people realize that no fundamental change will be made to the company’s value, some analysts still think there could be a price effect in the market. Merrill Lynch analyst Phua Young wrote about Tyco shares, which had earnings of $2.70 before the proposed change and $3.00 after: “In our view, the shares of Tyco International were inexpensive before the proposal. However, the FASB would make the shares even more attractive.” This sentiment assumes the market perception is more relevant than reality. Another analyst, UBS Warburg’s chief strategist Edward Kerchner, wrote in a report outlining companies that would most benefit from the rule change: “In theory there is no economic impact. But, certainly on the margins, this has to make some stocks look more attractive.” At this point, the probable reaction of the market has not been determined. BEFORE THE LONG-TERM CHANGE IN POOLING ACCOUNTING RULES
One key factor spurring the growth in the total merger volume and dollar value in the 1990s was the use of the pooling of interest method of accounting for mergers. This was because the pooling of interests permitted merging companies to simply combine the two companies’ total assets without being required to amortize, or writeoff, the goodwill or excess of the high merger deal price premium above the target firm’s accounting book value. The pooling of interest method gave acquiring firms a perceived benefit of no goodwill. In the majority of cases involving high-tech firms, the key resource was the IP and intangible assets they had created, innovated, broadly developed, or uniquely marketed. In fact, most joint ventures, strategic alliances, and mergers and acquisitions now hinge on obtaining access to the intellectual properties and intangible assets owned by other companies. Correctly valuing those intellectual properties is now a vital task of investment bankers. This was not usually the case. For decades, the acquiring company in most merger and acquisition transactions lumped together all the intellectual properties of the acquired company in one amorphous, undifferentiated combination, which was listed in the financial documents as goodwill according to United States accounting rules. Less than 20 years ago, many companies thought of most of their IP as a costly writeoff expense. At the same time, investment bankers valuing a merger often valued their client firms’ patents, trademarks, copyrights, ancillary rights, and potential for exploiting all other media rights as a pittance. Their IP valuation numbers were virtualy picked out of the air.
RANGES OF INTELLECTUAL PROPERTY FINANCIAL VALUATION 2.41
Today, most advanced investment bankers and strategy consultants involved in mergers and acquisitions treat IP very differently because they realize that these intangible assets and intellectual properties are often a fast-growth firm’s most unique, vital, and valuable assets. IP and intangible assets are valuable because they often allow firms to create rare or difficult-to-duplicate products or services. Key intellectual properties often provide sustainable competitive advantage such as high margins lasting over a decade or more to companies that own them. Firms that lack unique IP often sell only commodity products at razor-thin margins and compete in continual price wars. While most experts who analyze these values call them IP or intangible assets, others now call them knowledge assets or intellectual capital. The range of terms for these valuable intangibles proliferate as experts explore deeper into new business models demonstrating new potential for generating economic power and future wealth that traditional business assets do not. Although most valuation experts often use various financial theories of discounted future cash flows, some will now use the Black Scholes options theory, real options theory, or new valuation tools, as well, for measuring knowledge assets, knowledge earning, or intellectual capital that are not based on traditional accounting measurements. Merger analysts have developed an elaborate series of new valuation models for assessing each of the different intellectual properties of target firms for acquisitions, joint venture partners, or strategic alliances separately. Before the transaction, investment bankers use valuation models to perform a strategic audit of a firm’s various intellectual properties and intangible assets. Bankers and analysts are now able to better measure the dollar value of each patent, trademark, or copyright in each separate existing or potential market distribution channel. For example, Intellectual Capital in California and the Marketing Corporation of America in Connecticut work with hundreds of corporations and investment banks to create equity-valuation model grids, in which firms and bankers are provided the ability to compartmentalize, into a matrix of up to 200+ cells, elaborate cross-referenced valuations of each IP’s potential future worth, and discounted present value in dozens of distribution channels. Moreover, detailed market survey research and multiple-scenario financial models back these equity-valuation grids. Equity-valuation grids and other new financial and strategic tools help give investment banks the ability to analyze the combined value of several patents, trademarks, or copyrights owned by a target company. When three potential corporate acquirers examine a target company with the intent of capturing its various intellectual properties, investment banks and strategy consultants can provide a thoroughly documented range of valuations representing three or more potential scenarios. In short, investment bankers and analysts can provide pricing or auction bidding models that forecast future years’ net income streams and future cash flow projections for the different values for each corporate acquirer. RANGES OF INTELLECTUAL PROPERTY FINANCIAL VALUATION
A wide range often exists in the financial valuation of the same intellectual properties or collection of intangible assets. This is largely because many IP-centric companies have no sales or production facility but only a patent, trademark, or copyright with
2.42 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
potential for future income when compared to when those intellectual properties are owned by a functioning company with a record of sales, profit, and cash flow. In fact, a wide spectrum of quite different valuations exists, which investment bankers, venture capital firms, mezzanine capital firms, and providers of seed capital would attribute to the same intellectual properties. That valuation spectrum encompasses the following: • • • •
Totally untested patent stage held by one independent inventor Fully tested prototype product Fully developed production process for the one product Fully developed production-distribution-marketing process for various products stemming from the original patent held by a fledgling company, which has sales but is not yet returning a profit • Company with one to five years of profit earnings and actual cash flows • Well-known product with brand recognition Not all companies followed this traditional valuation spectrum step-by-step from fledgling start-up to major company. In 2000, many financial experts concluded that technology stocks accounted for a larger percent of the market capitalization of all stocks than ever, mirroring the increasing importance of technology in the economy. Aswath Damodaran went so far as to admit in his book, The Dark Side of Valuation, that as more and more technology firms became listed on financial markets, often at very early stages of their life cycles, traditional valuation methods and metrics often seemed ill suited to them. Damodaran also noted that although more profitable firms tend to be more highly valued than less profitable ones, this proposition had seemed to be turned on its head concerning new technology and Internet firms from 1997 to 2000. Although the Internet firms’ valuation bubble was said to have burst by 2001, the valuations of new technology companies, is significantly higher than traditional valuation experts would expect, even after the sharp stock market decline. VALUATION OF ESTABLISHED INTELLECTUAL PROPERTIES
The first and simplest financial analysis is of well-established intellectual properties. For example, many investment bankers and market analysts have done hundreds of brand-name equity studies in which properties or products were evaluated so their acquisition price for a potential buyer or their sale price to a potential seller could be established. Alternatively, many financial analysts do brand-name equity valuations for the corporate owner to realistically assess its inventory of patents, trademarks, or copyrights. This can be done for strategic management purposes; to help decide which products to keep, build upon, or sell off; or to decide which separate businesses a company should fund first, or how much of each of several businesses internal IP should be funded as part of a capital budgeting decision. Alternatively, these IP audits reveal which of a corporation’s businesses is lacking critical current IP and requires acquisitions of outside firms for its IP to fill vital gaps. The corporation is conducting these firm-wide IP inventory assessments with increasing frequency—often yearly, semiannually, or even quarterly—to keep current on what its real options are for current market valuations.
VALUATION OF ESTABLISHED INTELLECTUAL PROPERTIES 2.43
Investment banks and financial analysts often do valuations of licensing rights for each of the intellectual properties held by one firm if the properties are being offered to other firms as part of a company acquisition. A corporation’s potential to grow its future rate of return on its own resources and its ability to leverage its future growth rate off the combined IP portfolios of its cross-licensing partners, strategic allies, joint venture, or network partners are assessed in investment banks’ valuations of the existing network of cross-licensing contractual agreements and operational joint venture arrangements. Gene D’Ovideo, president of Intellectual Capital, has done two thousand of these brand-name equity valuations, plus licensing and cross-licensing valuations for investment banks managing corporations’ mergers, acquisitions, divestitures, or IP selfassessments. Like the vast majority of investment bankers, who do not yet usually use “Real Option Valuation,” D’Ovideo uses two standard methods of valuation in most cases for a patent, trademark, or copyright: first, a discounted cash flow analysis, and second, the valuation of the combined stream of yearly net income projections and future terminal value. The first method of valuing a particular trademark assesses how much incremental cash flow will be earned by a particular branded product compared to its generic counterpart; then their Net Present Values can be compared. If the brand-name is already well known and the product has generated known amounts of cash flow for a period of years, it is common to extrapolate—for three, five, or ten years into the future—the amount of cash flow likely to be earned with stable, rising, or falling sales. This brandname’s estimated cash flow figures are compared to those likely to be generated by a generic brand of the same product sold at a cheaper price during those same years. The two cash flow projections—for the brand-name versus the generic product to a set term of years—are then discounted back to their Net Present Values with one or more financial discount rates. The discount rates used represent a combination of an estimate of the time value of money or rate of inflation over that term of years, plus the relative risk of the overall market for the product or the uncertainty about sales forecasts. By subtracting the Net Present Value of the generic product from that of the brand-name product, the analyst can compute the brand-name’s value. In cash flow forecasts and options valuations, brand-name equity studies, and measurements of licensing rights to other firms, investment bankers are fairly certain of the financial figures of the company’s historic cash flows specifically derived from this product, year-by-year. In developing the cash flow valuations (or estimations of a yearly net income stream of a company with an established brand-name), an investment banker may benefit from calculating the rates of return on sales, return on investment, or return on assets with the historical financial figures supplied by the company for the brand-name product’s growth in sales, gross margin, and net profits. From these figures of historical financial growth, the financial analyst can estimate the product’s relative contribution to the firm’s overall net income over the past five years. It is not difficult for corporations to lay out reasonably defensible estimates of the net income forecasts attributable to this brand-name product by using this data with comparative financial ratio analysis, and making certain assumptions about the likely overall market changes during the next five years.
2.44 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS
A similar situation existed when, during a merger, the investment banker was asked to do a financial valuation of an established patent that is incorporated into a successful product. It is not difficult to do both a present value cash flow valuation and a future net income and terminal value calculation of the patent’s value, assuming that 10 years are left to run of the original 20-year patent life. The calculation is done by taking the year-by-year cash flows and profit margins of the last five years and extrapolating a reasonable forecast of future cash flows and profit margins for each year remaining of the patent life (while making varying assumptions about changes in supply, demand, demographics, alterations in the overall market, and the level of interest rates). The investment banker usually again provides the company with a sensitivity analysis that provides three or more scenarios and shows which factors might cause the variance in three financial forecasts for the value of the patent, collection of patents, or product streams possibly generated by the patent. VALUATIONS OF A COMPETITOR’S INTELLECTUAL PROPERTIES
When the investment banker is called on to value a patent, trademark, or copyright owned by a competitor because it is a target company for a hostile acquisition, accurate information about that company’s specific cash flows, profits, or the portion of its entire net income derived from just one of its many products is more difficult to obtain. This task requires far more estimation and in-depth research study by strategic, financial, and market analysts. Even industrial espionage has been used in trying to obtain reasonably accurate figures on the target company’s intellectual properties and separate businesses, lines, product cash flows, profit, and contribution to net income. Only from such data, estimates, or clandestine sources can bankers develop forecasts of future cash flow and net income contributions to evaluate the probable benefit and price of an acquisition. INVESTMENT BANKERS MERGER AND ACQUISITION VALUATION PROBLEMS
The chief executive of a company commonly comes to an investment bank with a specific price for which he is willing to sell his company. He may also tell the bankers the exact terms and conditions under which the company can be acquired by or merged with another firm. This often sets the acquisition floor price and fixes the key deal terms that get done. This practice is logical, prudent on the surface and deemed justifiable by the CEO and board of the selling company. Nevertheless, this valuation practice has important consequences that are rarely considered carefully by the bankers or the firms who employ them. The CEOs view this preemptive declaration of their valuation price and deal terms as their right and proof of their fulfillment of fiduciary duty to maximize shareholder value. They see this as not much different from a seller of a house setting the highest conceivable price hoping that someone will pay it. The investment bankers usually go along with this suggested price, acting as agents for the client company to maximize deal terms and earn the highest possible fee for their firms. The bankers may agree that this is in the company shareholders’ best interests and conclude that the price offered by bidders will be negotiated to its current market price if the selling firm’s declared price is ultimately not reasonable. A competitive auction for the company will force the final actual transaction price to be what a willing buyer would pay. A valua-
ENDNOTES 2.45
tion problem inherent in many mergers and acquisitions is that investment bankers sometimes, in effect, rubberstamp the price that the selling company’s CEO arbitrarily dictates as fair and reasonable. At times, investment banks do little independent, exhaustive, or thorough financial analyses for objective valuation of a number of merger or acquisition transactions. They may simply sign their firm’s name and reputation to lend legitimacy to the price paid in the deal and the fairness of the valuation process. This is not to say that this type of valuation is an evil, illegal, or immoral act, however. Instead, this is simply noting a number of the key facts that are apparent in the valuation practices of firms. In many M&A deals—especially friendly transactions—there is only one real bidder; little or no competitive price bidding exists in the majority of cases—only the original asking price. As a result, investment bankers, who were trained in corporate finance valuation techniques in business school and investment banking training programs, employ these tools in a number of cases only to the extent that they tend to legitimize the original price that the selling company’s CEO suggested as acceptable. ENDNOTES 1
This chapter was written with the research assistance of John M. Huerta and Daniel Cervantes, both MBA graduates of New York University’s Leonard N. Stern School of Business. 2 The Wall Street Journal (Nov. 20, 1999), B1. See also The New York Times (Nov. 20, 1999), C1. 3 The New York Times (June 11, 2000), A2. 4 Thomas Grubb and Robert Lamb, JP Morgan Securities, Transaction Values Computed by Securities Data Corporation, Capitalize on Merger Chaos (2000), 10. 5 “Pfizer Gets Its Deal to Buy Warner-Lambert,” The New York Times (Feb. 8, 2000), C1 & C5. See also “Pfizer Covets Warner’s Labs, Research Staff,” Wall Street Journal, Nov. 19, 1999; “Pfizer & Warner Lambert Merger for Labs & Scientists,” The New York Times (Feb. 9, 2000), C1. 6 Merrill Lynch Research Report on 3M Corporation, Oct. 24, 2000. See also Salomon Smith Barney Research Report on 3M, March 2000. 7 Ibid. 8 Capitalize on Merger Chaos, ibid., 155–159. 9 “Showtime for AOL,” Business Week (Jan. 15, 2001), 57–64. 10 Aswath Damodaran, Damodran on Valuation (New York: John Wiley & Sons, 1994), 360. 11 Damodaran on Valuation, ibid., 363. 12 Martha Anram and Nalin Kultilaka, “Developing a Drug,” Real Options (Boston: Harvard Business School Press, 1999). 13 David Kellogg, John Charnes, and Riza Demirer, “Valuation of a Biotechnology Firm: An Application of Real-Options Methodologies,” conference paper. 14 Damodaran on Valuation, ibid., 360–363 summarized. 15 Ibid., 364. 16 Ibid., 340–341, “A Few Caveats on Applying Option-Pricing Models.” See also Tom Copeland and Vladamir, Real Options: A Practitioner’s Guide (Texere, 2001). 17 Jack Eqing, “A New Net Powerhouse,” Business Week, Nov. 13, 2000. See also “Napster US Federal Court Injunction in Barnes&Noble.Com Joint Venture Case,” New York University Stern School of Business. 18 Aswath Damodaran, The Dark Side of Valuation, Financial Times/Prentice Hall (Upper Saddle River, NJ, 2001), 11. 19 Ibid.
2.46 THE ROLE OF INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS 20 For consolidation of market power, also see Thomas Grubb and Robert Lamb, Appendix C, Capitalize on Merger Chaos (2000), 143. 21 The Wall Street Journal (May 2, 2001), A1 & A8 22 Ibid. 23 Ibid. and The New York Times (May 7, 2001), C1 & C14. 24 The Wall Street Journal (May 2, 2001), A8. 25 Ibid., A1 & A8, and The New York Times (May 7, 2001), C1 & C14. 26 Ibid. and see Thomas Grubb & Robert Lamb, Capitalize on Merger Chaos (2000), 143, Appendix C. 27 Grubb and Lamb, 19, 41, 88, 90. 28 Ibid., 38, example: Procter & Gamble’s acquisition of Noxell Cosmetics. 29 Prudential Securities Analysts Report on Newel Rubbermaid, Jan. 23, 2001. 30 “Show Time for AOL Time Warner,” Business Week (Jan. 15, 2001) and The Wall Street Journal (May 2, 2001). 31 Neil Gross and Peter Coy with Otis Port. “The Technology Paradox: How Companies Can Survivie as Prices Dive,” Business Week (May 6, 1995), 77. 32 “How to Compete with an 800 Pound Gorilla,” speech by Jerry Sanders, CEO of Advanced Micro Devices. Reprinted in a Robertsons Stephens’ Co. report, July 29, 1998. 33 Neil Gross and Peter Coy, 77. 34 Robert Lamb and Randy Rosen, “Global Piracy and Intellectual Property,” The New Role of Intellectual Property in Commercial Transactions, M.Simensky and Lanning Bryer, eds. (New York: John Wiley & Sons, 1997). Reprinted in M. Simensky, Lanning Bryer, and Neil Wilcoff, eds., Intellectual Property in the Global Marketplace (New York: John Wiley & Sons, 1999). 35 Nikhil Deogun, “Merger Wave Spurs More Sock Wipeouts,” The Wall Street Journal (Nov. 29, 1999), C1. 36 Neil Gross and Peter Coy with Otis Port. “The Technology Paradox: How Companies Can Survive as Prices Dive,” Business Week (May 6, 1995), 77. See also Bhushan Bahree, “Oil Mergers Don’t Live Up to the Hype,” The Wall Street Journal (July 23, 1999), A10. See also Saikat Chauduri and Behnam Tabrizi, “Capturing the Real Value in High Tech Acquisitions,” Harvard Business Review (Aug.–Sept. 1999), 124. 37 Mark Sirowar, “What Acquiring Minds Need to Know,” The Wall Street Journal (Feb. 22, 1999), A18. 38 Jeffery Liday, “Most Mergers Fail to Add Value, Consultants Find,” The Wall Street Journal (Oct. 12, 1998), B9. 39 Ibid. See also Alexandra Reed Lajoux and J. Fred Weston, “Do Deals Deliver on Post Merger Performance?” Mergers & Acquisitions (Sept./Oct. 1998), 34–37. See also Capitalize on Merger Chaos, 155–158. 40 Ibid. 41 Michael Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review (May–June, 1987), 45. 42 Jeffery Liday, “Most Mergers Fail to Add Value, Consultants Find,” The Wall Street Journal (Oct. 12, 1998), B9. See also Mark Sirowar, A18, and “The Synergy Trap,” The Free Press (1999). 43 Ibid. 44 Anne Fisher, “How to Make a Merger Work,” Fortune (Jan. 24, 1994), 66. 45 Michael Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review (May–June, 1987), 45. 46 Paul Deninger, CEO of Broadview International, interview.
ENDNOTES 2.47 47
C.K. Prahalad and Gary Hamel, “The Core Competence of the Corporation,” Harvard Business Review (May–June 1990). 48 Aswath Damodaran, The Dark Side of Valuation, 11. 49 Ibid. 50 John Kendrick, interview. 51 Ibid. 52 See Baruch Lev, Intangibles, (Brookings Institution, 2001), 5–7, 22–27 and 46, 47, note 61. Professor Lev’s original quotations are from an interview. 53 Ibid. 54 Ibid. 55 It is important that the European firms in this M&A bidding situation did not consider this type of “carried interest” or “flip fee,” which investment bankers in the United States would have focused on in any similar situation in which the seller feels constrained to demand top auction price at this moment from the buyer. 56 Tom Copland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, 2000).
CHAPTER
3
INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY ACCOMPANYING MERGERS AND ACQUISITIONS Gordon V. Smith AUS Consultants
INTRODUCTION
When a business enterprise is acquired, whether by purchase of assets or by purchase of stock, a portfolio of assets is included in the transaction. This is also true when a subsidiary or product line is acquired. This chapter examines the nature of one portion of that portfolio—intangible assets. THE ASSET PORTFOLIO
It is useful to first place these assets in the context of the entire portfolio. The creation of a business enterprise can be visualized as the act of turning cash and a concept into other types of assets that, in turn, will attract more cash. It is hoped that the value of these assets will, in time, be greater than the cash invested. As a business grows, new cash is required. Its source may be the original owner, outside investors in the company’s stock, earnings of the business itself, or lenders, but whatever the source, the same process is involved—converting cash into assets. The assets formed in this process fall into three classifications. Every business enterprise, from a pushcart vendor of hot dogs on the street to the largest multinational corporation, comprises three basic elements: monetary assets, tangible assets, and intangible assets. The composition of an acquired enterprise can be depicted as shown in Exhibit 3.1. Monetary Assets. Monetary assets, or net working capital, are defined as current assets
less current liabilities. Current assets include: • • • • •
Cash Short-term investments such as marketable securities Accounts receivable less reserves Inventories, including raw materials, work in process, and finished goods Prepayments
3.1
3.2
INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
Working Capital
+
Business Enterprise
=
Fixed Assets
+
Intangible Assets
+
Intellectual Property
Exhibit 3.1 Composition of a Business Enterprise
Current liabilities include: • Accounts payable • Current portion of long-term debt • Income taxes and other accrued items In most cases there is an excess of current assets over current liabilities, so net working capital is a positive amount. The value of these assets is usually reflected in the amounts shown on the balance sheet. Tangible Assets. Tangible assets are usually shown on an accounting balance sheet as “Plant, Property, and Equipment.” Typically included in this asset category are the following classifications of property:
• Land • Land improvements such as paving, fencing, landscaping, yard lighting, sewerage and fire protection • Buildings, including building construction and services • Improvements to leased property, which may comprise structural improvements, building services, power wiring, and piping • Machinery and equipment, including machinery, power wiring, plant piping, laboratory equipment, and tools
BUSINESS ENTERPRISE VALUE IN MERGERS AND ACQUISITIONS 3.3
• • • • •
Special tooling, such as dies, jigs, fixtures, and molds Drawings Office furniture and equipment Licensed vehicles Construction in progress
The value of these assets must be independently estimated. Book values from the balance sheet are at best an imprecise surrogate for fair market value. Intangible Assets. Intangible assets and intellectual property usually do not appear on
a company’s balance sheet, but they are present in any case. Accounting theory defines intangibles as assets that do not have physical substance, that grant rights and privileges to a business owner, and that are inseparable from the enterprise. We define intangible assets as all the elements of a business enterprise that remain after monetary and tangible assets are identified. After working capital and fixed assets, they are the elements that make the business work and contribute to the earning power of the enterprise. Their existence is dependent on the presence of complementary assets and on the expectation of earnings. They usually appear last in the development of a business and very often disappear first in its demise. BUSINESS ENTERPRISE VALUE IN MERGERS AND ACQUISITIONS
One could infer from the previous discussion that the valuation of a business enterprise in a transaction is accomplished by adding the values of the underlying assets in the business portfolio. This is rarely done, however, and the purchase price in an acquisition is usually the result of valuing the entire portfolio based on its present or anticipated earning power. As an example, recently, when the share price of Yahoo! was $236.94, the value of that enterprise was $47.2 billion (199 million shares times $236.94 per share). That is, buyers and sellers in the marketplace, by coming to an agreement that a fair price for a share of common stock was $236.94, also concluded that the Yahoo! enterprise was worth $47.2 billion. They did this without any calculation of the individual values of the monetary, tangible, and intangible assets of Yahoo! If we were, however, to value the monetary, tangible, and intangible assets of Yahoo!, the sum of those values would have to be $47.2 billion, because, absent unusual circumstances, the value of the whole is equal to the sum of the values of its parts. Acquisition Premiums. An additional complexity can be added to this equation in the
case of a merger or acquisition. To continue the example, most of the present stockholders of Yahoo! are content with their investment and are not motivated to sell their shares. If another entity wished to purchase a majority of Yahoo! shares and gain control of the company, the offer to purchase would likely be in an amount higher than that at which the shares are currently trading. Acquiring companies may do this for a number of reasons.1 These may include the need to motivate all (or at least a majority) of shareholders to sell their holdings, to obtain control of the target’s assets, to exploit potential synergies, or to thwart competition for the transaction. The end result may be a value indication for the acquired company that exceeds that formerly in evidence in
3.4
INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
the marketplace. This increased business enterprise value may be ascribable to specific underlying assets, or may be an increase in the value of goodwill represented by a residual. Whatever the allocation of value to underlying assets, the sum of the parts is still equal to the whole. Acquiring Intangibles. One reason for this discussion is that when mergers and acquisitions take place, the parties to the transaction (especially the buyer) become very sensitive to the nature and quality of the underlying assets of the subject enterprise. For that reason, they must be aware of the nature of intangible assets and intellectual property: how these assets contribute to the earning power of the target enterprise and how these assets will affect the operations and earnings of the combined enterprise. This has become critical, because the value of intangible assets and intellectual property often represents most of the enterprise value. An acquirer of the Yahoo! business, as an example, would be extremely sensitive to the fact that of the $47.2 billion total value (or more, if a premium were to be paid), $46.7 billion, or nearly 99 percent of that total value, is intangible assets and intellectual property!
INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
Intangible assets are categorized as: • • • •
Rights Relationships Undefined intangibles Intellectual property
Rights. Every business enterprise acquires rights through establishing contractual agreements with other businesses, individuals, or governmental bodies. A large enterprise may have a bundle of rights comprising thousands of elements. These rights usually exist according to the terms of a written contract that defines the parties to the agreement; the nature of the rights, goods, or services transferred; the transfer consideration; and the duration of the agreement. Of most interest are the 12 types of contracts that are important because they enable a business to obtain goods or services at an advantageous price:
1. 2. 3. 4. 5. 6.
Leases of premises that are at rates or terms better than would be available in the current market. Such an advantageous lease is called a leasehold interest. Advantageous distribution agreements for the sale, warehousing, and movement of products Employment contracts that act to retain key personnel Financing arrangements that result in capital being available at more favorable terms or at lower rates than otherwise Insurance coverage at better-than-market rates Contracts for the supply of raw materials or purchased products at advantageous terms
INTANGIBLE ASSETS 3.5
7. 8. 9. 10. 11. 12.
Contracts for services such as equipment maintenance, data processing, or utility services Licenses or governmental certifications that are in short supply or are costly to obtain Rights to receive goods or services in limited supply, such as radio or television network affiliations or film distribution rights Covenants by a former owner or employee not to compete Contractual rights of a franchisee to an exclusive territory or product line License contract for the use of intellectual property that provides reduced costs or a profit opportunity
Some contractual rights are important because they afford the business the opportunity to provide goods or services to others at a profit: • Mortgage servicing rights to collect, process, and manage escrow and insurance matters on a portfolio of mortgages for a fee • Loan agreements purchased as part of a business enterprise on which there will be a future return of principal and interest • Agreements to provide food service, health care, data processing, advertising, or consulting services • Agreements to provide goods under contract for future delivery • Student enrollments or subscriptions that are prepaid • Licenses granted to another for the use of intellectual property in return for royalties • Franchises that protect a territory or product line and produce fee income
Relationships. Every business establishes relationships with outside agencies, other companies, and other individuals. These are often noncontractual but can be extremely important to the enterprise. They include assembled workforce, customer relationships, and distributor relationships. Assembled Workforce. One of the most obvious relationships of an enterprise is with its
employees. It can be very costly to locate, hire, and train a workforce, as evidenced by the expenditures made to retain employees and reduce turnover. The more specialized the workforce, the greater the cost of its assemblage and the larger its importance to the enterprise. Customer Relationships. Every business has customers, but not every business has customer relationships. For example, a newsstand in a large city probably has a number of customers who habitually purchase a daily newspaper. The newsstand proprietor does not know the identity of his customers or where they work, maintains no customer account records, and could not contact them to discover their interest in other publications. If the proprietor moved the newsstand to another location these customers would probably not seek him out, but rather would patronize another stand. This is not a customer relationship in the sense used here.
3.6
INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
The most important customer relationships are those which have a high level of inertia (relative difficulty for the customer to migrate to another source of goods and services). Another important factor is that meaningful information is known about the customer, which enables a strategic exploitation of the relationship. Strong customer relationships are those that would persist through a change in ownership, change in personnel, or even a relocation. Distributor Relationships. A business that depends on others to distribute and/or sell its
products may have established relationships of considerable importance. Many companies have representatives that sell cosmetics, cookware, and cleaning products in the residential market, for example. These companies have no retail stores, so the relationship with their representatives is extremely important. Other businesses may sell complex products in a highly technical market through manufacturers’ representatives. Locating, hiring, training, and maintaining such representation can be a very costly process. Once accomplished, however, the relationship is an asset of importance to the enterprise. Undefined Intangibles. In spite of the fact that in recent years appraisers have analyzed, identified, and valued many intangible assets, there often remains a residual. That residual is commonly referred to as goodwill and/or going concern value. These concepts are distinct; the following discussion will separate them. Goodwill. Business people, attorneys, accountants, and judges have all had a try at
defining the concept of goodwill. Some of the more common explanations are: • Patronage. Many equate goodwill with patronage, or the proclivity of customers to return to a business and recommend it to others. This results from superior service, personal relationships, advertising programs, and business policies that meet with favor in the marketplace. • Excess Earnings. Another common aspect of a goodwill definition is the presence of excess earnings. That is, a business that possesses significant goodwill is likely to have earnings that are greater than those required to provide a fair rate of return on the other assets of the business. • Residual. Goodwill represents the residual between the value of the enterprise as a whole and the value of the other identifiable assets. This is a permutation of the excess earnings concept because the value of the enterprise will only exceed the value of the identifiable assets (and create room for the residual) if there are excess earnings. We cannot rely entirely on one definition to the exclusion of the others. Can there be goodwill in a business that is losing money (no excess earnings)? Of course. A temporary escalation of expenses, a casualty loss, the opening of a new plant, or the development of a new product line can temporarily eliminate earnings, but goodwill can remain. Can there be excess earnings and no goodwill? Certainly. Suppose a business has a single customer who is locked in for several years under a lucrative contract. There might well be excess earnings, but they are attributable to the contract, not to goodwill.
INTANGIBLE ASSETS 3.7
The accounting profession has long grappled with the question of how to reflect goodwill and other intangible assets in financial statements. In the previous example concerning Yahoo!, we noted that the value of the intangible assets of that enterprise was $46.7 billion, or nearly 99 percent of the market value of the entire business. We came to that conclusion by reference to the price of Yahoo! common stock as set in the marketplace by investors. By observing the financial statements of Yahoo!, however, one would only see the $500 million of monetary and tangible assets in the business. Yahoo! has spent billions of dollars developing customer relationships, partner alliances, and its brand. Obviously, investors feel that those expenditures have created intangible assets of value. However, accounting rules preclude reflecting the value of those self-developed intangible assets on the balance sheet. If, however, Yahoo! were to acquire another business that was a mirror image of itself, it would allocate its total purchase price to all of the assets acquired, tangible as well as intangible, and Yahoo’s! balance sheet after the transaction would reflect the value of those acquired intangibles, but not its self-developed intangibles. These issues are developed more fully in other chapters of this book. Going Concern Value. Going concern value has been defined as “the additional element
of value which attaches to property by reason of its existence as part of a going concern.” 2 To illustrate this concept, suppose one were to assemble all of the tangible and intangible assets for a business that was not yet in operation. These would include the following: • • • • • • • • • •
Employees (standing around) Machinery (in crates) Furniture and office machines (on the loading dock) Computer and peripherals (boxed) Cash (in bags) Computer software (on disks and tape) Office supplies (scattered about) Vendors (waiting to be seen) Customers (waiting in the lobby) Advertisements and radio/television commercials (ready to be placed)
Much is needed before this aggregation of assets is an organized business ready to sell its product. Nearby is an identical business that has legalized itself; established relationships with financial, banking, legal, and accounting firms; contracted with suppliers; designed a product; obtained an inventory; developed a business plan; readied its advertising program; written operating procedures; and is poised and ready to go. However, it has yet to make a sale, so it has no goodwill. The difference between the value of these two enterprises is “going concern value” or, as we prefer to describe it, the elements of a going concern. Intellectual Property. The final element of the intangible asset category is intellectual
property. This classification of property includes patents, proprietary technology, copyrights, trademarks, computer software, mask works, and the right of publicity. Intellectual
3.8
INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
property is unique in that it is protected by law from its unauthorized exploitation by others. Proprietary Technology. The term proprietary technology refers to trade secrets and
know-how. Proprietary technology is very often more valuable to an enterprise than its patents. Karl F. Jorda3 describes this: “Patents are but the tips of icebergs in a sea of trade secrets. Over 90% of all new technology is covered by trade secrets and over 80% of all license and technology transfer agreements cover proprietary know-how, i.e. trade secrets, or constitute hybrid agreements relating to patents and trade secrets.” Jorda also opines that the decision as to which type of protection to seek is not simply a “patent or padlock” question, but one in which the inventor must decide “. . . what to patent and what to keep a trade secret and whether it is best to patent as well as padlock, i.e. integrate patents and trade secrets for optimal protection of innovation.” The owner of proprietary technology is relieved of the necessity of administering registrations (perhaps internationally), including legal costs and filing fees. A trade secret does not have to be reduced to some tangible form in order to be protected. In fact, some trade secrets are such that they cannot be so captured. An increasingly common reason not to patent is that the subject technology or information may be changing so rapidly that obsolescence may occur before a patent is granted. There are situations, as well, in which a company does not wish to reveal even the direction of its research program. All of this is, however, counterbalanced by the risk of having valuable information subject to being inadvertently divulged or independently developed by another. Trade Secrets have been defined in several ways: . . . information, including a formula, pattern, compilation, program, device, method, technique, or process that: (i) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and (ii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.4 . . . any formula, pattern, patentable device or compilation of information which is used in one’s business and which gives an opportunity to obtain an advantage over competitors who do not know or use it. It may be a formula for a chemical compound, a process of manufacturing, treating or preserving materials, a pattern for a machine or other device, or a list of customers . . . or it may . . . relate to the sale of goods or to other operations in the business such as a code for determining discounts, rebates, or other concessions in a price list or catalog; of bookkeeping; or other office management5 . . . any information not generally known in the trade. It may be an unpatented invention, a formula, pattern, machine, process, customer list…or even news.6
State laws govern one’s rights in trade secrets. Proprietary technology can take many forms, such as an extremely technical process or a formula. Collections of data are one form of trade secret. In order to be of material value, compilations of data should be organized, accessible, and (with the exception of historically significant information) should pertain to or be useful in current and future operations. Some examples of proprietary technology include the following:
INTANGIBLE ASSETS 3.9
• Management or technical experience and judgment that is embedded in the decision logic of computer software • Technical trial-and-error experience that is captured in drawings, operation manuals, tooling, fixtures, machine settings, or process designs • Formulas, recipes, specifications for ingredients, methods of combination, mixing times, and temperatures • Accounting procedures, personnel practices, marketing strategies, and sales techniques • Formations and plays of a sports team or its training regimen • Knowledge of materials or processes that do not work (negative knowledge can be valuable) • Artistic techniques for mixing or applying pigment, preparing a musical instrument, or exposing and processing film • Research and development information such as laboratory logs, experiment designs, and results • Results of product or material tests • Results of market surveys or consumer testing • Job files (such as for consulting engagements) and construction projects Information is not classified as a trade secret simply because it is not generally known outside of a business organization. It must be used in the business and provide its owner with some competitive advantage and be treated as secret. It is therefore necessary that procedures be in place to protect trade secret security. That is, documents should be safeguarded, access restricted, and confidentiality agreements in place with employees who must have knowledge for their work. The most valuable proprietary technology possesses some essential characteristics: • It produces an economic advantage. • It raises barriers to competition. • It creates a strong market position.
Patents. A patent is the legal process whereby technology is turned into controllable
property with defined rights associated with its ownership. A patent is the grant of a property right by the U.S. government to the inventor (or his or her heirs and assigns) by action of the United States Patent and Trademark Office (USPTO). The right conferred by the patent grant is the right to exclude others from making, using, or selling the invention. Burge describes a patent as a “negative right.” He explains: “While the right of ownership in most personal property is a positive right, the right of ownership in a patent is a negative right. It is the negative right to exclude others from making, using, or selling the patented invention . . . Indeed, in making, using, or selling his own invention, the inventor may find that he infringes the patent rights of others.”7 The following description refers to a utility patent that has a term of 20 years from the date of filing the application. Section 101 of the Code states, “Whoever invents or
3.10 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
discovers any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, may obtain a patent therefor . . .” The word “process” typically refers to industrial or technical processes. “Manufacture” refers to articles which are manufactured, and “composition of matter” relates to mixtures of ingredients or to new chemical compositions. Patents are also issued for plants. “Whoever invents or discovers and asexually reproduces any distinct and new variety of plant, including cultivated spores, mutants, hybrids, and newly found seedlings, other than a tuber propagated plant or a plant found in an uncultivated state, may obtain a patent therefor . . .” 8 Plant patents also have a protection term of 20 years. Design patents are issued for a term of 14 years and are described as follows: “Whoever invents any new, original and ornamental design for an article of manufacture may obtain a patent herefor . . .”9 Design patents protect only the appearance of an object, not its structure or utilitarian features. The U.S. Supreme Court found that living matter that owes its unique existence to human intervention is patentable subject matter in a 1980 decision.10 After some delay the USPTO has granted several patents on transgenic animals. When a patent application has been received by the USPTO, the applicant may identify products containing the invention with the words, “Patent Pending,” or “Patent Applied For.” This action does not provide any protection against infringement, either intentional or unintentional, because until the patent issues its validity is not known. It may, however, discourage copying since if and when a patent is issued, protection will ensue from the date of issuance and the copying will change from an annoyance to legal infringement. To obtain foreign patent protection, an inventor must apply for a patent in each country. The laws under which a patent may be granted differ considerably, as might be expected. Maintenance fees may be required, licensing may be compulsory to anyone who applies, and a patent may become void if manufacturing in the country does not occur. United States patent laws make no discrimination relative to the nationality of the inventor or applicant, so a foreign inventor can obtain patent protection for an invention by the same procedures as described previously. Copyrights. A copyright protects the expression of an idea, not the idea itself, just as a patent does not protect an idea, rather its embodiment in a product or process. Copyright protection commences from the time when that expression is fixed in some tangible form, even prior to its publication, not the time at which an application is accepted by the federal government. In fact, full copyright protection is present whether the work is registered with the Copyright Office of the Library of Congress or not. A copyright owner may reprint, sell, or otherwise distribute the copyrighted work; prepare works that are derived from it; and assign, sell, or license it. An increasingly important issue concerns the ownership of copyrightable works when they are created by someone for use by another. Such works might include, for example, computer software, written materials, or photographs, which are created by independent contractors or consultants. It is important to establish the ownership of such works. This issue has been the subject of litigation in recent years. Unless there
INTANGIBLE ASSETS 3.11
are specific arrangements between the parties, the copyright is the property of the creator. The fact that the creator was paid for the work does not automatically vest ownership with the buyer. Copyrights are protected for a period of the life of the author plus 70 years for works created after January 1, 1978. Copyright protection on “works for hire” extends for 95 years from date of publication or 120 years from the date of creation, whichever expires first. In December 1990, the Copyright Act was amended to include protection for “architectural works:” . . . the design of a building as embodied in any tangible medium of expression, including a building, architectural plans, or drawings. The work includes the overall form as well as the arrangement and composition of spaces in the design, but does not include individual standard features.11
In October 1992, the Copyright Office published final regulations for the registration of architectural works, which included some definitions and registration instructions. As with other registrable works, the issue of ownership can be very important because the design and ownership of a building are most often separated. While this has not always been so, it is now clear that computer programs are copyrightable. This is true whether the program is in the form of source code and intelligible to humans or in object code understandable only to a computer. Copyright is available for operating system or applications programs and extends to a program’s structure and organization as well as its coding. Computer databases are considered “literary works,” just as are dictionaries and catalogs. Further defined as a “compilation,” computer databases are protected primarily to the extent of what the author of the work created or contributed to the finished product. This may only be in the arrangement or order of presentation of data, but some degree of creativity must be evident. There has been a considerable amount of litigation over the degree of protectibility that the Copyright Act provides to computer screen images. The images are, of course, caused by software coding, and the problem was made more difficult by the fact that the same-appearing screen could be the result of different coding within a program. The question has been which element of the process is copyrightable, or are both? This seems to have been resolved in the courts and screen images are protected as “audiovisual works.” Trademarks. Trademarks can be extremely valuable business assets. Large amounts of
money are spent to create and nurture them, and when they are threatened large amounts of money are spent to defend and protect them. Trademarks are both longlived and ephemeral, powerful and delicate. A trademark as defined in the Trademark Act of 1946 “includes any word, name, symbol, or device, or any combination thereof adopted and used by a manufacturer or merchant to identify his goods and distinguish them from those manufactured by others.” Exclusive rights to trademarks are obtained by continued use, and when that use includes trade regulated by the federal government, the trademark may be registered by the Patent and Trademark Office.
3.12 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
Registration remains in force for 20 years and may be renewed for additional 20year periods as long as the trademark is in use in commerce. An affidavit must be filed between the fifth and sixth years following the registration date stating that the mark is still in use, how it is being used, and include a sample. If this is not done, registration will be cancelled automatically. Continued improper use of a trademark can result in its being found to be generic, and its protection will be lost. Many trademarks have followed this unhappy (for their owners) path, including “escalator,” “nylon,” “linoleum,” and “trampoline.” Technically, trademarks are used to identify goods, while service marks identify services. They are identical except for this; in common usage, both are referred to as trademarks or marks. The most common trademarks are some form of company name, usually in distinctive type style, or a logo. Trademarks can also apply to shapes (such as the distinctive shape of the Coca-Cola bottle), designs (such as the Ralston Purina “Checkerboard Square”), a building style (such as the “Golden Arches” of McDonald’s Corporation), a slogan, a color combination, or even a number, such as “4711” toiletries. The trade dress of a product describes its total image and includes its size, shape, color, or texture. Trade dress has typically referred to packaging, though more recently it has been used to describe the appearance of the product itself. A tradename is the name of a business, association, or other organization used to identify it. It may or may not be the same as the trademark used to identify the company’s products, such as IBM, which represents both. It cannot be registered at the federal level unless it is also a trademark. Ownership would be governed by common or state law. A tradename is typically not an asset of material value because the buying public recognizes goods and services by their trademark and, in many cases, can be entirely unaware of the actual name of the producing company. Some people use the term “brand” interchangeably with trademark. A brand shares some characteristics with a trademark, but the two are not entirely synonymous: Many think of a brand as being synonymous with a trademark. From the literature, it seems to us that a brand is more of a marketing concept, or a way that marketing professionals have developed to describe an asset that differs from the strictly legal concept of a trademark. Martin12 describes brands by contrasting them with “commodities”—soap vs. IVORY, pianos vs. STEINWAY, and breakfast food vs. KELLOGG’S Cornflakes. We think that a useful way to conceptualize a brand is as an aggregation of assets which includes, but is not limited to, a trademark. A brand also comprises a particular product, or more than one product, perhaps a formula and/or a recipe, trade dress, a marketing strategy, an advertising program, and/or promotional activities.
For the purposes of the tasks that accompany an acquisition or merger, one can assume that the trademark carries with it a full complement of all the ingredients necessary to also be recognized as a brand. One must understand that the distinction between a brand and a trademark can be important when one considers the economic life of each. Visualize how the economic life of a brand (comprised as it is of many elements) could be quite different from that of a trademark. Within the brand, there may be a constant turnover of its constituent parts as advertising programs and marketing strategies come and go. The economic life of a trademark can even be independent of a particular product if it is sufficiently strong and versatile and if the transition is carefully managed.
INTANGIBLE ASSETS 3.13
Federal registration of a trademark is not necessary to obtain protection. One can simply begin using the mark on goods or services and can, if other confusingly similar marks subsequently appear, enjoin their owner from using them. Federal registration does, however, provide some advantages. The owner of a federally registered mark can enjoin all subsequent users anywhere in the United States and can be awarded treble damages, infringer’s profits, and sometimes attorney fees in successful infringement litigation. The Trademark Law Treaty Implementation Act of 1998 brought some aspects of U.S. trademark law into conformity with international law. The primary change was the right to file a trademark application with the intention to use, with a period (three years) during which a lack of direct use will not invalidate the mark. Trademark registrations remain in force indefinitely, as long as the proper renewals are made, fees paid, and the trademarked goods or services remain in commerce identified by the mark as registered. With regard to foreign trademark rights, the Paris Convention affords benefits to trademark owners seeking non-United States protection. Member countries provide to foreigners the same trademark protection available to their own citizens. Under the Madrid Protocol, the World Intellectual Property Organization accepts a single international trademark application that provides protection in several jurisdictions. Since the United States is not a party to the Madrid Protocol, only U.S. companies with subsidiaries in relevant countries can use this option. In 1996 the European Community inaugurated the Community Trade Mark (CTM) system, which permits a single registration system for the 15 countries of the EC. The CTM registration system is administered by the Community Trade Mark Office. The system differs from the U.S. system, for example, by allowing registration of a mark prior to use and in allowing the owner five years to use the mark in commerce. Internet Domain Names. This subject is introduced here because even though Internet
domain names are not trademarks in the legal sense, they share important property characteristics with trademarks. This sharing has led to some very difficult international disputes and equally complex efforts to resolve them. From the standpoint of this book, however, there is no question that the Internet has enabled the creation of intellectual properties of great value. Some domain names have been taken as company names by their owners (amazon.com, for example). A website that receives thousands of hits per day becomes a prime location for advertising, like a billboard on a well-traveled highway. A website can be the core of a worldwide distribution system for products and services or can, in some cases, be an entity’s only place of business. Computer Software. Computer software is included here because it is subject to patent, copyright, or trade secret protection. Trademark protection is also becoming very important in the computer software industry. Revenue Procedure defines computer software to include:
. . . all programs or routines used to cause a computer to perform a desired task or set of tasks, and the documentation required to describe and maintain those programs. Computer programs of all classes, for example, operating systems, executive systems, monitors, compilers and translators, assembly routines, and utility programs as well as application
3.14 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY programs are included. Computer software does not include procedures which are external to the computer operations, such as instructions to transcription operators and external control procedures.13
The Copyright Act defines a computer program as: “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.”14 Consider computer software to include the project description and research, source code, object code, program documentation, user instructions, and operating manuals. This form of intellectual property can be extremely important to a business enterprise, and it is categorized as either product or operational software. Product Software is developed for resale as a product. It can be individual, standalone programs or more complex modular systems that interface with one another, such as a general ledger system. The software may be sold with or without consultant support and related services. Operational Software is used by a company in its own internal operations. It may have been purchased, be used under license, developed by an outside firm under contract, or developed internally. The types of operational software include system software and applications software. System Software, sometimes called “the operating system,” is required by the computer hardware to operate. Usually obtained from the hardware vendor as part of the computer system, it is rarely developed—though it may be modified—by the user. Applications Software is used for the specific functions of the business. This might include: • Basic accounting functions such as general ledger; payroll; accounts payable and receivable; material, supply, and inventory control; and fixed asset accounting. These systems are often purchased and may be extensively modified. • Company-specific accounting systems for areas such as sales and commissions, product costing, purchasing, and customer billing. These would usually be developed in-house. • Management systems for functions such as personnel functions, property taxes, database systems for management information, property lease systems, word processing, or financial models. • Production systems for functions such as manufacturing scheduling, CADCAM (computer-aided design—computer-aided manufacturing), design models, engineering calculations, numerically controlled machines, and robotic operations. Recalling the previous discussion of proprietary technology, note that when computer software is designed in-house, and when it becomes more company-specific in its design and function, it is likely to embody more proprietary features. That is, it is likely that more time was spent by users in development to design the system and test the results. When the users of the system are heavily involved in the design, there will be more of their knowledge embodied in the system.
INTANGIBLE ASSETS 3.15 Mask Works. Standing somewhat in between computer hardware and software are
semiconductor chip products that embody circuitry and logic. The essence of a chip is the mask work, defined as: A series of related images, however fixed or encoded: (A) having or representing the predetermined, three dimensional pattern of metallic, insulating, or semiconductor material resent or removed from the layers of a semiconductor chip product; and (B) in which series the relation of the images to one another is that each image has the pattern of the surface of one form of the semiconductor chip product.15
Mask works are eligible for protection under the Copyright Act if certain conditions are met. Generally, these conditions require that the owner be a U.S. citizen or domiciled here or in a country that also protects mask works, or that the mask work is first commercially exploited in the United States. Protection lasts for 10 years from the date of registration. A copyrighted mask work must be marked “mask work” and have the symbol M. Right of Publicity. The right of publicity emerged from the long-existing protection granted primarily by state statutory or common law concerning the right of privacy. It addresses the right of a person to control and benefit from commercial exploitation of his or her identity. Since this is an age of celebrities, the commercial exploitation of that celebrity can be an extremely valuable right. In general, the right of publicity extends to a person’s name and likeness, as well as to voice or even identifiable robots. The right can even extend to those to whom a name or likeness has been licensed. Many states have adopted right-of-publicity laws. These and federal trademark statutes have afforded celebrities new means to protect their images and their markets. It is rather unlikely that the right of publicity would emerge as an important element in a corporate acquisition or merger. Rather than being an asset of the business, it is more likely that this concept might emerge in terms of litigation underway in which the corporation is a defendant. Many of the more notable cases involving the right of publicity resulted from the overzealous use of sounds and styles in advertisements for which proper permission had not been obtained from the creating personality. Intellectual Capital. A new term, Intellectual Capital, has entered the business lexicon.
This has been an outgrowth of the attention that has been given to intangible assets and intellectual property as managers of businesses seek to maximize their creation and contributions to the enterprise. Intellectual capital has been variously defined as “…what walks out the door at the end of the business day…” and “knowledge that can be converted to value.”16 Intellectual capital is not a new category of business assets, but rather a different way of classifying assets in order to focus on their management. Intellectual capital is a combination of Human Capital, Intellectual Assets, and Intellectual Property.17 An examination of the elements of these categories reveals that they comprise the intangible assets and intellectual property already discussed, with perhaps an additional, more detailed breakdown of human capital (what is termed the assembled workforce). Exhibit 3.2 depicts a more detailed business enterprise having many of the intangible assets and intellectual property previously discussed.
3.16 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY Business
=
Working Capital
+
Fixed Capital
+
Intangible Assets & Enterprise Intellectual Property
- Inventory
- Offices
- Patents
- Cash
- Warehouses
- Trademarks
- Accounts Receivable - Manufacturing - Mineral Reserves
- Research Labs
- Copyrights - Technological Know-how - Designs - Formulae - Trade Secrets
Intellectual Property
- Distribution Networks - Supply Contracts - Licenses - Customer Lists
Intangible Assets
- Manufacturing Practices - Trained Work Force - Research Capabilities
Exhibit 3.2 Business Enterprise Assets
COMMENT
There is no question that in the world of international business bricks and mortar are giving way to intangible assets and intellectual property. Therefore, one must expect that these assets will loom large in the thinking of buyers, sellers, lenders, and investors when merger and acquisition transactions take place. Looking at the value of Bristol-Myers Squibb during April 2000, one sees that more than 90 percent of the value of this pharmaceutical company belongs to intangible assets and intellectual property. The market value of equity of Bristol-Myers Squibb was $125 billion in April. Long-term debt totaled another $3 billion. As such, the value of invested capital (debt plus equity) totaled $128 billion. The balance sheet of this business enterprise showed that net working capital equaled $3.7 billion; fixed assets totaled $4.6 billion; and other long-term assets were reported to be valued at another $3.2 billion. The remaining $116.5 billion of value is comprised of the intangible assets and intellectual property discussed in this chapter. The pie chart in Exhibit 3.3 shows the significant value of the intangibles possessed by Bristol-Myers Squibb.
COMMENT 3.17
Bristol-Myers Squibb Allocation of Value Net Working Capital
Fixed Assets Other LT Assets
Intellectual Property & Intangible Assets Exhibit 3.3 Bristol-Myers Squibb Intangibles Values
The significant value of intangibles is not limited to pharmaceutical companies or even other types of high-tech companies. The same relationship shown for BristolMyers Squibb is true for food companies, apparel companies, and manufacturers of household products. A similar analysis for Heinz, Nike, Philip Morris, and Procter & Gamble shows that more than 85 percent of their invested capital values are intangible. In each case, the character of the valuable intangibles may be different. For BristolMyers Squibb patented technology is a significant portion of the intellectual property. For Heinz, Procter & Gamble, Nike, and Philip Morris trademarks dominate. Regardless of the type, intangible assets and intellectual property dominate. Buyers are looking to acquire assets that they may not have the ability or resources to create themselves. They are looking to acquire intangible assets and intellectual property with speed; acquiring an entire enterprise may be the appropriate vehicle for that strategy. Buyers are also looking to fill gaps in their own technological expertise. At the same time, due diligence cannot be forgotten. Buyers must carefully investigate the existence and quality of the intangible assets they seek to acquire. The business press has highlighted the dire consequences of a headlong rush into an acquisition without sufficient attention to this due diligence. Sellers, however, need to receive fair value for their intellectual assets. That judgement may rest on a careful evaluation of how those assets will provide benefits and synergies with a potential acquirer.
3.18 INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY
Lenders are increasingly willing to accept intangible assets and intellectual property rights as collateral for debt. Intangible assets and intellectual property are more inextricably linked to a business enterprise than are most monetary and tangible assets. This means that much of the importance in value of intangible assets and intellectual property depends on a viable business enterprise. The liquidation value traditionally depended upon by lenders can be dramatically different for these types of assets. Lastly, investors who may stand to profit or lose money in corporate mergers and acquisitions are concerned with a proper evaluation of intangible assets and intellectual property. As this is written, a significant market correction is going on in the technology sectors. Investors are obviously re-evaluating the intangible assets and intellectual property rights that support the stock prices of these companies. ENDNOTES 1 For further discussion of this subject, see Gordon V. Smith and Russell L. Parr, Intellectual Property: Licensing and Joint Venture Profit Strategies (New York: John Wiley & Sons, 1998), Supp. 1999, Chapter 2A. 2 VGS Corp v. Commissioner, 68 TC 563,569 (1977). 3 David Rines, Professor of Intellectual Property Law and Industrial Innovation, Franklin Pierce Law Center, Concord, New Hampshire, in Germeshausen Center Newsletter (Spring 1999). 4 Uniform Trade Secrets Act, 1(4) (Drafted by the National Conference of Commissioners on Uniform State Laws as amended, 1985). 5 Restatement of Torts §757 Cmt.b. (1939). 6 E.I. Dupont de Nemours & Co. v. United States, 288 F.2d 904 (Ct. Cl. 1969). 7 David A. Burge, Patent and Trademark Tactics and Practice (New York: John Wiley & Sons, 1984), 27. 8 35 U.S.C. §161. 9 25 U.S.C. §171. 10 Diamond v. Chakraberty 447 U.S. 303, 206 USPQ 195. (1980). 11 17 U.S.C. section 102(a)(8). 12 David N. Martin, “Romancing the Brand: The Power of Advertising and How to Use It,” American Management Association (New York, 1999). 13 Revenue Procedure 69–21 (1969-2 CB 303). 14 The Copyright Act, 17 U.S.C. Section 101. 15 17 U.S.C. Section 901, Semiconductor Chip Protection Act of 1984. 16 Russell L. Parr and Patrick H. Sullivan, Technology Licensing-Corporate Strategies for Maximizing Value (New York: John Wiley & Sons, 1996), Chapter 14. 17 See note 16, 255.
CHAPTER
4
VALUATION OF INTELLECTUAL PROPERTY ASSETS IN MERGERS AND ACQUISITIONS Michael J. Lasinski InteCap, Inc.
INTRODUCTION
Business development and licensing executives have, on numerous occasions, entered into agreements that give away their intellectual property (IP) assets. Alternatively, they often walk away from transactions that would have resulted in significant value for their companies. This happens because the underlying value of the subject IP assets in the transaction is often unknown. For those involved in IP-intensive transactions who are willing to spend a little time and effort understanding the IP, analyzing the markets in which the IP will be commercialized, and crunching the numbers, the economic rewards can be significant. This chapter is intended to provide business development and licensing executives, as well as other senior management, with the theoretical foundations of IP valuation. It also provides guidance on the practical application of an IP valuation and highlights some of the analytical tools and data sources that may be used in the valuation process. With those objectives in mind, the chapter has been organized into the following sections: • Reasons for valuing intellectual property in M&A transactions • Valuation approaches and their application (including useful data sources) • Other pricing considerations This chapter is to be used for discussion purposes only and is not intended to be allinclusive on the topic of intellectual property valuation. The concepts and considerations presented do not represent those that InteCap, Inc. would necessarily apply in any particular case. The data to be relied upon, the theories employed, and the weight given to various factors will vary depending on the specific facts and circumstances of each valuation situation.
4.1
4.2
VALUATION OF INTELLECTUAL PROPERTY ASSETS
REASONS FOR VALUING INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS
Skeptics often argue that because of its intangible nature, IP cannot and should not be valued. This is because assigning a number to IP assets in the abstract is of little or no use. However, when considering the best methods of extracting value from a company’s intangible assets, negotiating mergers and acquisitions, or other transactions, a valuation can be critical. In fact, it is even more critical to perform a valuation for IP assets than for tangible assets. This is because the variety of ways a company can exploit its IP is often far greater than its tangible assets. Intangible assets can be bought and sold (like tangible assets); however, they can also be shared (for example, licensed), used in financing, used for legal purposes (for example, infringement litigation), used for tax planning (for example, donated), and for other purposes. To understand the importance of valuing IP in mergers and acquisitions, it is necessary to understand how IP is used and valued in the normal course of business. Reasons to value IP include the following: strategic, transactional, tax, financial, and legal. Strategic Reasons to Value Intellectual Property Management. For the most part, senior
business executives spend very little time thinking about IP matters. However, they do care a great deal about extracting maximum value from corporate assets, protecting current markets, and executing corporate strategy (for example, achieving revenue growth and financial targets). A thorough valuation analysis can provide senior management with information related to the importance of IP in achieving these corporate goals. In a recent survey of corporate Licensing Executive Society members, 12 percent of the 198 respondents indicated that they were using valuations to report IP performance to senior management. Unfortunately, it is often impossible due to time, resources, and other constraints to perform a full valuation analysis of a corporation’s entire IP portfolio. That is why companies such as Dow Chemical Company have developed processes to systematically and efficiently value corporate IP assets. Processes such as Dow’s help the company identify and highlight the value and risks presented by the IP. For example, the valuation process can highlight the value of expected price premiums or market share premiums that a company can expect by including a patented technology in its products. Alternatively, it may highlight the value of licensing a technology outside of the corporation’s scope of products. In many cases, the questions asked during the valuation process are often as enlightening as the final value. Transactional Reasons to Value Intellectual Property. A proper valuation helps ensure
prudent decisions in M&A transactions. However, valuations are also used in a variety of other transactions, such as licensing-out, licensing-in, IP acquisitions or sales, spinouts and joint ventures, and combinations of the transactions listed here. The following sections discuss the role of IP valuation in each of these contexts. In today’s society, an acquisition target’s IP (as well as that of its competitors) is a critical element of any transaction.
Company Acquisition Planning and Due Diligence.
REASONS FOR VALUING INTELLECTUAL PROPERTY 4.3
This is especially true within the pharmaceutical and e-commerce markets, where IP can result in significant price premiums and can provide a barrier to entry. However, because of current financial reporting and tax accounting standards, companies are not always required to explicitly value the IP acquired. This, combined with the fact that many current valuation methods used in business acquisitions do not account for the way in which IP assets differ from tangible assets, can result in inappropriate purchase prices or nonoptimal deal structures for either the seller or the buyer. As this book goes to print, the Financial Accounting Standards Board has issued FASB 141 and FASB 142 which supercede APB 16. These standards affect the way the value of intangibles and IP is reported (accounted for) in certain types of business transactions (combinations). See Chapter 5 for a more detailed discussion of these accounting changes. The acquiring company should be aware of both the reliance a potential acquisition candidate places on its IP and the strength and composition of its IP portfolio. In addition, the acquiring company may want to determine the value of the post-merger IP. For example, if the acquisition candidate relies heavily on trade secrets held by employees, the acquiring company must analyze confidentiality and noncompetition agreements, as well as its ability to retain the acquiree’s key employees. Finally, a company may need to analyze the strength, breadth, and life of key patents that protect top revenuegenerating products (for example, top 10 products based on revenues). This should be done for both the acquiree’s and the competitors’ IP. Remember, just because a company hasn’t been sued by its competitors for patent infringement doesn’t mean it won’t be in the future. This is especially true when the acquirer has deep pockets. Licensing Intellectual Property. The economic objective of a license agreement is to
establish a royalty amount that permits both the licensee and the licensor to earn a higher return than would be achieved by pursuing some alternative to licensing. Blind reliance on industry standard royalty rates or rules of thumb may result in forgone licensing income (by charging too low of a royalty) or ignoring profitable opportunities because they appear to fall short of required economic objectives. An independent valuation of the property can be helpful to both parties in setting royalties that are economically justified. A proper valuation helps to isolate and quantify key variables affecting the underlying economics of the transaction. Such variables may include product pricing and profitability, potential market penetration, required capital expenditures, inflation, required rates of return, functional life, technological life, and economic life. After quantifying the economic risk factors associated with the licensing transaction, both parties can negotiate license terms to shift risks from one party to the other. Also, basic financial modeling (for example, discounted cash flow analysis) aids in the evaluation of alternative payment structures, such as running royalties versus fixed payments. In addition to the above benefits, a valuation can be useful in monitoring actual license payments versus expected payments. A license that produces royalty income significantly less than that expected can be highlighted during annual license reviews and investigated for underpayment or other problems.1
4.4
VALUATION OF INTELLECTUAL PROPERTY ASSETS
Acquiring or Selling Intellectual Property (in the Absence of a Business Combination). The
valuation of intellectual property is important in the context of a sale for many of the same reasons previously discussed. However, there may be valuation considerations in a lump-sum compensation received from a technology sale that differ from the running income stream commonly generated by a license. For example, in a lump-sum transfer it is important to consider the after-tax cash flows and time value of money effects. It is also important to account for the tax treatment surrounding the acquired asset (for example, the amortization benefit available to the new owner). Further, although the useful life of a technology may be of less importance during a running royalty negotiation, it may be very important in the context of a lump-sum transfer. If one were to choose an improper period over which to value the technology, the negotiated price could be orders of magnitude different than the actual value. Establishing Equity Contributions. In joint ventures or company formations, it is relatively common for one partner to provide technology and IP assets while the other partner provides tangible assets and capital. Valuation of contributed intellectual property is important to determine the value of equity shares to be issued to each party. This not only is important for both tax and financial purposes but also may become critical in situations requiring buyout of equity shares. Corporate Spin-Offs. As companies face mounting pressure to focus on their core busi-
ness, many are spinning off noncore operations. Such spin-offs may involve the divestiture of entire divisions of the existing company. Alternatively, the company may choose to spin off embryonic technology into a startup company. In both cases, valuation of the intellectual property can substantially impact the structure of the transaction and the consideration that is exchanged. Tax Reasons to Value Intellectual Property. Although there are a number of proactive
reasons for valuing IP, many IP valuations are performed in order to comply with federal and state tax regulations. The following sections discuss IP tax strategies and how valuation plays a role in such strategies. Please remember certain tax strategies may not be appropriate for all companies; therefore, tax counsel should be sought prior to implementing any of the strategies discussed. Intercompany Transfer Pricing. Under the Internal Revenue Code (I.R.C.) Section 482, pricing for intercompany transfers of intangible assets may be adjusted by the IRS to reflect arm’s-length income levels. While Section 482 has been around for quite a while, the Tax Reform Act of 1986 added new teeth to the provision. The Code requires that payments for a licensed or transferred intangible asset be commensurate with the income attributable to the intangible. This is commonly known as the Super Royalty provision. Even though the Super Royalty provision was implemented in 1986, the final Section 482 regulations were not issued until July 8, 1994. These regulations discuss various methods to use in the valuation of intangibles and require the taxpayer to select the best method on an individual transaction basis. The best method is the method that “. . . under the facts and circumstances, provides the most reliable measure of an arm’slength result.” Factors that may be considered in determining the best method include:
REASONS FOR VALUING INTELLECTUAL PROPERTY 4.5
comparability, completeness and accuracy of data, reliability of assumptions, sensitivity of results to deficiencies in data and assumptions, and confirmation of results by the use of another method. In addition, the current regulations compel taxpayers to substantiate intercompany royalty rates with contemporaneous documentation. Taxpayers may risk substantial penalties by waiting until the time of an audit to justify intercompany royalty rates. A proper valuation can play an important role in satisfying the documentation requirements under Section 482.2 Intellectual Property Management Subsidiary. Some states, such as Delaware and Michigan, do not tax intangible asset royalty income when appropriate corporate structures are established. Because of this, one strategy that may allow a company to decrease its state income tax is the formation of a holding company. Intangible assets such as patents or trademarks are transferred to the holding company, which subsequently licenses them back to the operating companies. The license fees paid to the holding company by the operating companies decrease the operating companies’ taxable income and reduce their state tax liabilities. Conversely, the royalty income earned by the holding company is exempt from state taxes. An independent valuation is important to establish for state tax authorities the fair market value of the assets transferred and intercompany royalty rates that are consistent with the arm’s-length standard. In assessing the validity of the transaction, a key factor that states may consider is the presence or absence of legitimate business activities by the holding company. In other words, the transaction is less likely to be disallowed if the IP holding company actively participates in the management of the company’s IP. This requirement is actually a blessing in disguise, as it encourages the establishment of an IP holding company that seeks to proactively manage the company’s IP. Proactive measures such as creating a Board of Directors for the IP subsidiary and creating a business plan for managing the IP serve the dual purpose of reducing tax risk and improving the company’s management of its IP.3 Charitable Donations of Patents and Related Technology. In a number of recent news articles, DuPont indicated that it donated $64 million in IP assets to three universities in 1998.4 While these articles seemed to indicate that this was a new way for companies to give, it was not. Section 170 of the Internal Revenue Code allows companies to realize a tax deduction for the value of property donated to a qualified organization. Revenue ruling 58–260 appears to classify a patent as property that may be donated: “The fair market value of an undivided interest in a patent, which is contributed by the owner of the patent to an organization described in section 170(C) [charitable organizations] of the Internal Revenue Code of 1954, constitutes an allowable deduction….” Regulations require that the fair market value of the patent be determined through an independent appraisal. In addition to the tax deduction that results from the donation, a number of advantages result from the donation. First, a donation allows the company to make a contribution that benefits society. Second, donating the IP allows the company to avoid the cost of maintaining the patent(s). Finally, charitable donations assist companies in strengthening their ties with nonprofit research organizations such as universities.5
4.6
VALUATION OF INTELLECTUAL PROPERTY ASSETS
Purchase Price Allocation. Prior to the enactment of Section 197 of the Revenue
Reconciliation Act of 1993, significant tax incentives existed for acquiring companies to allocate the purchase price to certain amortizable intangible assets as opposed to goodwill. Under Section 197, the cost of most intangible assets, including goodwill and going concern value, is amortizable over a 15-year period. Therefore, the need to allocate the purchase price between various types of intangible assets for tax purposes may have been reduced.6 As mentioned previously, FASB 141 and FASB 142 are newly issued. These standards supercede APB 16 and affect the need to value certain identifiable intangible assets (including IP) in certain, if not all, types of business combinations. See Chapter 5 for a more detailed discussion of accounting trends and financial/IP reporting requirements in business combinations. In-Process R&D. In the context of normal business, the great majority of research and development costs are recorded as expenses in the period in which these costs are incurred. Therefore, research and development expenses typically appear on the income statement rather than the balance sheet. In certain business combinations, accounting standards have required capitalization of what is known as In-Process R&D. Because the In-Process R&D must be capitalized in certain business transactions (e.g, those accounted for under the purchase method), it must be valued. See Chapter 5 for a more complete discussion of this topic. Financial Reasons to Value Intellectual Property. As intangible assets grow in importance, traditional accounting principles fail to capture an increasingly large portion of the value of many companies. As a result, IP valuations are becoming more common in the world of corporate finance, as the following sections highlight. Obtaining Financing/Raising Capital/IP Asset-Backed Securitizations. One of today’s hot topics in IP management is using IP assets to obtain financing through raising capital, securing debt, or issuing asset-backed securities. Although using IP to raise capital or secure debt is not new, the use of royalty income to issue bonds is. The most prominent example of using an IP royalty stream for securitization of bonds is the now-famous Bowie Bonds. These are bonds that were issued using the royalty stream that David Bowie was receiving as security. This transaction was unique for a number of reasons. First, it gave David Bowie access to his future cash flows today. Second, it gave investors a unique vehicle in which to invest their money. Since the success of the Bowie Bonds, a number of financial institutions have become interested in the securitization of other IP-related cash flow streams. These institutions have raised or are in the process of raising funds for future securitizations. The paramount question facing most of these institutions is how to value cash flow streams from intangible assets.7 Reorganization/Bankruptcy/Loan Workouts. In cases of corporate reorganization or bank-
ruptcy, creditors and bankruptcy courts require an accurate representation of corporate asset values. In this context, intangible asset valuations can be used for purposes of
VALUATION APPROACHES AND THEIR APPLICATION 4.7
determining liquidation values or estimating the value of the remaining business interests. In loan workout situations, lenders may obtain a security interest in intellectual property as collateral for underlying debt instruments. A proper valuation can assist lenders in identifying marketable intellectual property and maximizing its value in liqui-dation. An example helps to highlight this point. In 1992, Orca, a disk drive manufacturer, filed for bankruptcy. The company had claims against it for more than $2.5 million, and assets valued at $1.3 million. The company (in bankruptcy) and legal counsel decided to auction off the company’s patent portfolio, for which it had paid approximately $500,000. Although the company had hopes of realizing as much as $600,000 for the portfolio, the bidding started at only $225,000. When the auction was completed, Samsung Electronics Co. had purchased the portfolio for approximately $3.65 million, or $1.15 million more than the total claims against the company!8 Legal Reasons to Value Intellectual Property. In addition to strategic, transactional, tax, and financial reasons, there are often legal reasons for valuing intellectual property. The Federal and Tax court system has recognized the value of intellectual property rights by granting substantial awards for compensatory damages in infringement and tax-related suits. Arguably, the most famous IP damages case was Polaroid versus Eastman Kodak, in which Polaroid was awarded more than $873 million. These types of awards and the volume of patent litigation highlight the significant value put on IP in today’s business world. Calculation of intellectual property damages (most often lost profits and reasonable royalty) is similar in many respects to valuation in other contexts outside of litigation. This is because damages attempt to compensate the harmed party for the economic benefit that it would have enjoyed had its IP not been infringed. Quantifying damages requires attention to variables such as sales volumes, prices, market share, profitability, and royalty rates for products that embody or utilize certain IP assets. Because of the high costs of litigation (average patent lawsuits through trial now exceed more than $1 million in legal fees and other costs), progressive companies have begun to perform valuations prior to the initiation of litigation. To determine the expected economic benefit of litigation, these valuations consider the potential damage awards that may be granted, the economic value of an injunction, and the costs of litigation. These valuations are then used to determine whether to pursue an infringer in litigation and to support settlement discussions.
VALUATION APPROACHES AND THEIR APPLICATION
Just as many reasons exist for valuing IP, numerous methods exist to value IP. IRS Revenue Ruling 59–60 acknowledged this diversity, stating that, “no formula can be devised that will be generally applicable to the multitude of different valuation issues . . . a sound valuation will be based upon all relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”9
4.8
VALUATION OF INTELLECTUAL PROPERTY ASSETS
Although one formula cannot be derived to apply to all situations, a few fundamental principles exist that apply to most IP valuations. The first is the premise of value, the second is the source (or sources) of value, and the third is the valuation approach. In many ways, the valuation of intellectual property is similar to other valuations; however, the nature of intellectual property sometimes requires unique application of these valuation principles. The Premise of Value: Fair Market Value. Before value can be estimated, the premise, or
theoretical basis, of value must be considered. Often, this premise is defined as fair market value. Fair market value is “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”10 The Sources of Potential Value. Those attempting to value intellectual property can lose
sight of the forest for the trees. In attempting to calculate how much someone would pay for the IP, analysts often neglect the issue of why someone would pay for it. Regardless of which quantitative valuation approach (market, cost, or income as is discussed in the next section) is used, it is important to focus on the issue of exactly how the IP may create value for its owner. There are numerous ways in which IP can create value. The following categories provide an overview of some of these sources of value: • Exclusivity Value. Exclusivity value derives from the legal right to exclude others from manufacturing, using, or selling products that incorporate the subject IP. This exclusive position may allow a company to charge a premium price, increase unit market share, or reduce manufacturing costs. Exclusivity may also provide more subjective benefits such as enhanced customer satisfaction. Finally, exclusivity may provide value by simply stopping a competitor from practicing a technology that the owner is unable to practice himself because of other IP that is blocking the owner’s ability to practice in the same field. • Defensive Value or Freedom to Operate. Legally, a patent provides the owner with the right to exclude. It does not provide the owner with the right to practice. This is because others may have IP that blocks this right as previously discussed. However, in business, a significant IP arsenal, or even one key patent, can create a détente situation in which competitors are wary of asserting their own patents for fear that the defendant may countersue. • Transfer Value. Another potential source of value is transfer value. A company may wish to buy or sell certain IP assets for any number of reasons. While these reasons are too numerous to discuss here, please note that patent licensing revenues have increased more than 700 percent from $15 billion in 1990 to $100 billion in 1998.11 This indicates not only that transfer value can be signifi-
VALUATION APPROACHES: MARKET, COST, AND INCOME 4.9
cant, but also that a number of companies are participating in the technology transfer arena. • Option Value. Patented inventions are sometimes made before their time. At the time they are made, marketing the invention may be infeasible due to technological, manufacturing, or market limitations. It may also not be desirable because of current investments in alternative technology. While such inventions may seem to have little value initially, they can possess a substantial option value. In other words, the current technology and protection may provide an avenue for future projects and products that may be very profitable. Real-option pricing theory can be used to evaluate these situations.12
VALUATION APPROACHES: MARKET, COST, AND INCOME
Once the premise of value and the source(s) of potential value have been determined, the appropriate valuation approach or approaches must be selected. The cost, market, and income approaches are well documented in the literature and are currently used by valuation professionals for both intangible and tangible assets. Market Approach. The Market Approach determines the fair market value of an asset based upon the price at which parties with comparable assets have previously transacted under similar conditions. In other words, the price paid in a similar transaction for similar assets should be similar to the price for the assets in the current transaction. The degree of reliance on comparable transactions depends on an assessment of whether the past comparable transactions are sufficiently similar to provide an indication of fair market value for the assets in question. Some of the factors that may be considered in assessing comparability include the nature of the assets transferred (e.g., patents versus trade secrets); similarity of products, industry, market size and characteristics; profitability; barriers to market entry; and so forth. By their very nature, IP and IP-related transactions tend to be unique; therefore, it can be difficult to find closely comparable transactions. However, inexact comparables may serve as a guide or indication of value, and adjustments can sometimes be made to account for the differences in transactions. In some cases, the Market Approach is useful for determining inputs to use in other valuation approaches, particularly the Income Approach. For example, if you are trying to estimate the lump-sum value of a portfolio of patents, it can be very difficult to find a transaction in which a similar portfolio of patents was sold. However, it may be possible to identify license agreements for similar patents that specify running royalty rates. These market-based rates could be used as an input into a valuation model created using the Income Approach, as discussed later. Cost Approach. The Cost Approach values assets based on the cost that would be incurred in the development of assets similar to those being valued. This valuation method is based on the premise that no party involved in an arm’s length transaction would be willing to pay more for a license than the cost to develop an alternative. Of
4.10 VALUATION OF INTELLECTUAL PROPERTY ASSETS
course, such an analysis is based on the assumption that an alternative could be developed. Although this assumption is almost always valid in other valuation contexts such as machinery or real estate, it may not be in the case of intellectual property. For example, it may be difficult to envision an alternative to a basic or pioneering patent. On the other hand, some patents may be minor improvements, in which case the development of an alternative would be relatively straightforward. Assuming that the development of an alternative appears possible, the next task is to develop an estimate of the cost of the alternative. Depending on the circumstances, one may choose to base the cost to develop the technology on historical development costs or current projected costs to develop an asset of similar value. In the case of technology, some of these costs may include materials used in development and testing, engineering, prototype production, factory overhead, consulting fees, and so forth. It is also important to consider the amount of time required to develop the alternative and the opportunity costs (such as lost sales and profits) of this delay. It may also be necessary to incur incremental marketing or promotional expenses in order to secure a comparable market position for the replacement product. The Cost Approach may be very useful in certain situations such as the valuation of embryonic technology where the market applications have not yet been defined and other approaches are difficult to use. However, in other circumstances, the Cost Approach may have certain limitations that suggest the use of another approach. These limitations include a lack of consideration for elements of future income streams, market conditions, useful life, and the risks associated with receiving future economic benefits. Income Approach (Discounted Cash Flow Analysis). While the Cost Approach determines an asset’s value by calculating the avoided cost of developing an equivalent alternative, the Income Approach focuses on quantifying the expected future income that the buyer may generate using the assets. The Income Approach values assets based on the present value of the future income streams expected from the asset under consideration. In finance terms, it is a discounted cash flow (DCF) model. This approach is often used in the context of one of a few theoretical constructs. Two constructs will be discussed in more detail:
1.
2.
Relief from Royalty. Under this construct, it is assumed that ownership of the subject intellectual property relieves the owner of the burden of paying a royalty to license it. The Income Approach is used to quantify this relief from royalty. Postulated Loss of Income. This construct is based on the assumption that the loss of the subject intellectual property would reduce the owner’s income. This loss could result, for example, from decreased market share, reduced prices, or increased costs. The Income Approach is used to quantify this loss of income.
It should be noted that these valuation constructs or approaches are not mutually exclusive, nor should one be used without consideration of the other. In fact, a recent appellate tax court opinion found that the use of the Relief From Royalty Approach under the facts of the Nestle Holdings, Inc. v. Commissioner of Internal Revenue
VALUATION APPROACHES: MARKET, COST, AND INCOME 4.11
Service necessarily undervalued certain trademarks. The appellate court found that the IRS’ valuation expert erred in the use of the Relief From Royalty Approach because it did not capture all of the economic benefits an owner generally derives from using a trademark. Because the Income Approach requires the user to quantify the expected future benefit from the asset, it is sometimes considered the most rigorous of the three methods. As a result, the Income Approach is useful not only for the value estimate that is ultimately developed, but also for the exercise itself. One of the primary benefits of the DCF model is its ability to measure alternative opportunities and transactions on an equivalent basis (i.e., net present value of cash flows). Another benefit of a DCF analysis is its ability to isolate and test the sensitivity of certain key variables. For example, a DCF model would help to answer the question: What market penetration rate must be achieved in order to yield a reasonable return on this acquisition? In addition, Monte Carlo analyses can be performed that can test the sensitivity of multiple variables at once and, therefore, identify expected best and worst cases, as well as a likely range of outcomes. There are three primary parameters that should be quantified in order to use the Income Approach: 1. 2. 3.
The amount of future income from the asset The timing and duration of the income stream The risk associated with the realization of the income stream
Amount of the Income Stream. Determination of the income stream is generally a twostep process. First, the user must determine the sales and profitability of products that incorporate the intellectual property. Second, the user must determine what portion of this income is attributable to the subject intellectual property because of a number of other factors that create value, such as the distribution channel or manufacturing knowhow. The following sections describe alternative approaches for achieving these two steps. Step 1: Determination of the Sales Base and Profitability. The size of the sales base is determined by a number of factors, including the overall market size, segmentation and share considerations, growth rate, product pricing, and other considerations. Once the sales base has been determined, profits can sometimes be forecasted by deducting relevant expenses such as additional development costs, manufacturing costs, operating expenses (e.g., advertising and promotion), the cost of required capital investments, taxes, and others. While many intellectual properties may produce an incremental stream of sales and profits, occasionally the intellectual property enhances profits only through manufacturing (or other) cost savings that accrue to the user of the property. In such cases, the cost savings may be an appropriate pool from which to apportion value to the IP. Step 2: Apportioning the Profit. The following discussion presents a number of alterna-
tive methods for attempting to determine what portion of the total profit is attributable to the subject IP.
4.12 VALUATION OF INTELLECTUAL PROPERTY ASSETS
• The Excess Earnings Method is based on the premise that a property’s value can be measured by the incremental earnings achieved by products that embody unique intangibles (e.g., intellectual property protection) relative to the profitability of similar benchmarks. Examples of benchmarks, as used here, may include profit margins on similar products without intellectual property protection, or more general measures of industry profit levels. The excess earnings may result, for example, from the proprietary product commanding a price premium, delivering certain manufacturing cost savings, or achieving larger sales quantities. Part or all of these excess earnings (depending on the circumstances) represent the portion of total profits attributable to the intellectual property, exclusive of other factors. • The Residual Income (Rate of Return) Method is another way to isolate the value of intellectual property. It is similar to the Excess Earnings Approach in that both attempt to quantify the incremental benefit of the subject IP. The difference is that the Excess Earnings Approach analyzes incremental profit, while the Residual Income Method examines incremental return on assets. Under the Residual Income Method, the user begins by identifying the tangible assets required to produce and distribute the products that incorporate the subject IP. The required return on these tangible assets is then computed by applying appropriate costs of capital to the tangible assets. This required return is then subtracted from the actual rate of return earned by selling the subject products. The residual return or income stream may be considered representative of the income attributable to the intellectual property. While theoretically attractive, this approach is often difficult to implement in situations where multiple, interrelated intangibles are employed in a business. • The Rules of Thumb are sometimes used to apportion the profit attributable to the subject intellectual property. These rules of thumb attempt to divide the anticipated profits in a manner that is commensurate with the nature of the intellectual property and the functions performed and risks assumed by each party to the transaction. The need to divide the profit pool has been recognized and endorsed by licensing practitioners, intellectual property infringement case law, Tax Court case law, and Internal Revenue Service regulations. An often discussed rule of thumb in licensing transactions is the 25% Rule, in which the licensor receives 25% of the profit generated by the licensed invention. A common question, however, is the definition of profit and whether it represents the total profit generated by the product embodying the licensed invention or the incremental profit generated by the specific IP.13 Comparables-Based Royalty Rates. The three previous methods (Excess Earnings,
Residual Rate of Return, and Rules of Thumb) represent alternatives for apportioning profit once the total profitability of the subject products has been determined. While each of these approaches is theoretically appealing, the two-step process of estimating profits and apportioning value to the IP is sometimes a difficult or impossible task in practice. A potential alternative in some cases may be to compute the income stream attributable to the IP using royalty rates specified in comparable agreements.
VALUATION APPROACHES: MARKET, COST, AND INCOME 4.13
Under this comparables-based royalty rates method, the royalty rate is determined using comparable agreements as discussed in the Market Approach section. Then the royalty rate is applied to the appropriate sales base. This method can be appealing for two reasons. First, it eliminates the need to forecast future profits. Second, because the royalty is determined using market comparables, the royalty rate may represent a de facto, market-based apportionment of profits. Duration of the Income Stream. In tandem with the estimation of the annual amount of
the income stream, it is necessary to forecast the duration of the income stream. There are three components to the duration of the income stream: 1. 2. 3.
The timing of market introduction for products incorporating the subject IP The adoption rate and life cycle of the products The length of the useful life of the IP
Timing of Market Introduction. The timing of market introduction may depend on a
number of factors, including perfection of design, development of manufacturing capacity, and the launch of advertising and promotional efforts. Interviews with personnel in various functions may be useful for estimating the timing of the market introduction. It may also be useful to analyze previous product introductions to identify potential obstacles and confirm the reasonableness of launch estimates. Adoption Rate and Life Cycle. In order to estimate the annual cash flows attributable to
products incorporating the subject IP, the analyst must consider the adoption rate and life cycle of the products. Different markets vary widely in their eagerness to adopt new technology. These differences should be reflected in the cash flow estimates. Length of the Useful Life. The useful life of intellectual property can be influenced by
a number of factors. The following points describe several alternative definitions for the life of IP. • Statutory or legal life is determined by the duration of legal protection, such as the life of a patent. • Functional or technological life represents the period before which technology is succeeded by superior developments, thereby becoming technically obsolete. • Market life refers to the length of time for which the market demands products incorporating the subject IP. For example, the consumer market, not technical obsolescence or patent expiration, ended the useful life of Sony’s Betamax technologies. • Economic life represents the period during which the property is producing an adequate return on invested assets. Accounting for the Risk of the Income Stream. The income stream attributable to intel-
lectual property is risky, as just about any future cash flow stream would be. In employing the income method, it is critical to account for this risk. Uncertainty, or risk, can impact the analysis in two ways. First, uncertainty might need to be reflected in the
4.14 VALUATION OF INTELLECTUAL PROPERTY ASSETS
estimated cash flows attributable to the intellectual property. That is, the cash flow estimates likely should reflect the expected outcome, not simply the most optimistic outcome. Second, once the analyst has developed estimates of the cash flows attributable to the IP, she must discount these cash flows at a rate that reflects the risk of the cash flows. The following sections describe methodologies for accounting for these risks. Computing the Expected Income Stream. A common pitfall when using the Income Approach is to create a model that computes the cash flows under the best-case scenario and then apply a discount rate to the flows. Such an analysis may inadequately account for the risk inherent in the cash flows. Consider the example of a company valuing a patented drug that it has recently developed. Using the Income Approach under the Relief from Royalty construct, the analyst may first forecast the estimated sales of the drug given successful completion of clinical trials and subsequent FDA approval. To this sales estimate, he or she applies a royalty rate based on comparable agreements in order to estimate the cash flows attributable to the patented invention. The analyst then discounts these cash flows to compute the present value of the IP. Unfortunately, the analyst has neglected a critical step—adjusting the cash flows for the risks that the drug faces during development and prior to commercialization. In this case, the drug may not be approved by the FDA; therefore, it may never generate any income. Risks such as this can seriously reduce the expected value. Decision trees may be a good tool for evaluating intellectual property with an uncertain future such as the previous drug example. The decision tree in Exhibit 4.1 illustrates a portion of the tree that might be created in response to the scenario outlined in the previous paragraph. Each branch of the tree, ending at the far right with a hollow left-pointing arrow, represents one potential outcome. Each outcome has an associated value, which reflects the forecasted cash flows, assuming that the particular outcome occurs. Note that the cash flows are zero if FDA approval is not received. Each node of the tree reflects an uncertainty or risk, and the probability that the outcome will take one branch as opposed to the other branch is assigned.
Patent Issues
$5,875
0.70 FDA Approval Received 0.40 Patent App. Denied
Expected Value of a License
0.30 FDA Approval Denied 0.60
Exhibit 4.1 Sample Decision Tree
$0
$1,909
VALUATION APPROACHES: MARKET, COST, AND INCOME 4.15
In order to compute the expected value, the value for each outcome is rolled back through the tree from right to left. Mathematically, the value for each outcome is multiplied by the cumulative probability of its occurrence. The cumulative probability of a given outcome is computed by multiplying together each probability on that particular branch. The expected value is essentially the weighted average outcome, in which the weights reflect the probability that a given outcome will occur. Please note that, depending on the data available and circumstances surrounding the valuation, the size (number of decision nodes) of the decision tree may be vastly different. Therefore, a valuation expert may have a decision tree with just one node (e.g., expected cash flows) or hundreds of nodes. In analyses where there are decision trees with many nodes, the analyst may wish to consider employing a real options approach to IP valuation. This decision to use real options will obviously be based on the information available as well as the circumstances of the valuation.14 Discounting Cash Flows to Their Present Value. Once the expected annual cash flows
have been forecasted, the cash flows must be discounted to their present value. The discounting process serves two purposes. First, it adjusts the cash flows to account for the time value of money, a principle that states that a dollar received today is more valuable than a dollar received at some point in the future. Second, the discounting process reduces the value of the cash flows to account for the risk that they may not occur. If the time value of money were the only discounting concern, cash flows would be discounted at a risk-free rate. Interest rates, or yields, on U.S. government securities are considered a reasonable proxy for the risk-free rate. The maturity of the securities used should correspond to the length of time prior to receipt of the cash flows (e.g., cash flows expected to be received in 10 years would be discounted using yields on longterm government bonds). Unfortunately, the discount rate must also reflect the inherent risk of the cash flows. That is, the rate should include a risk-free rate plus a premium to account for risk. Unfortunately, there is no textbook answer for how to compute this risk premium or how to directly calculate a rate that accounts for both the time value of money and the risk of the cash flows. The following list outlines a few alternative approaches for computing the latter. • Weighted Average Cost of Capital (WACC). A company’s weighted average cost of capital is defined in almost any finance textbook. In short, however, the WACC reflects the blended amount of return investors require for providing capital (in the form of debt or equity) to a company. Investors in firms that entail greater risk demand higher returns as compensation for undertaking the increased risk. The advantages of WACC are that (1) it can be estimated using stock market data and the company financial statements, and (2) WACC is widely accepted and generally understood in the financial community. Unfortunately, WACC has its disadvantages. First, it may not reflect all of the risk associated with IP assets. It is based on a number of assumptions that may prove unrealistic. Its computation is complicated and subject to discretion. Finally, a relatively large body of empirical research questions its validity.
4.16 VALUATION OF INTELLECTUAL PROPERTY ASSETS
• Hurdle Rates. Many companies have one or more hurdle rates, or rates of return, that new projects must be able to earn in order to receive funding. Depending on how they are determined, these rates may be useful in IP valuations, particularly when performing quick and dirty analyses. It should be noted that, like WACC, many hurdle rates are applied across projects at a company. However, each project must be discounted at a rate that captures the risk of the specific project. If the project’s risk level is significantly different from the firm overall risk level, use of the corporate hurdle rate is inappropriate. • Venture Capital Required Rates of Return. Venture capitalists (VCs) invest money in high-risk, early stage ventures with the hope of realizing returns on their investments that are commensurate with the risks undertaken. Because of the substantial risk of their investments, venture capitalists sometimes expect annual return on investment rates of 30 percent to 70 percent. The risks undertaken by VCs are often parallel to the risks of commercializing emerging technologies and IP. (In fact, venture investments increasingly entail investing funds in companies specifically formed to bring new technologies to market.) As a result, the rates of return required by VCs—30 percent to 70 percent, depending on the state of development—may be used as an appropriate discount rate in the context of IP valuations.15 PRICING CONSIDERATIONS IN LICENSING
The premise of value (fair market value), valuation approaches (market, cost, and income), and the sources of value are generally applicable to a number of situations in which IP is to be valued. There are also a number of considerations that are more specific to licensing transactions. (Please note, however, that some of the these considerations may be relevant in other contexts.) The following sections discuss a number of pricing considerations in licensing. In a licensing situation, the parties can reach an agreement only if there is overlap in the ranges of their acceptable outcomes. That is to say, a fair price will be reached if the licensor’s theoretical floor is below that of the licensee’s theoretical ceiling. Within this range, both parties can reach a price that allows them to be better off by entering a license compared to other alternatives. The following sections briefly describe the considerations that influence the licensor’s floor and the licensee’s ceiling.16 The Range of Negotiations: The Floor and the Ceiling.
The Licensor’s Theoretical Floor. The theoretical floor the licensor or transferor of intellectual property may be willing to accept is the cost to transfer the property plus the opportunity cost forgone by the transfer. The cost to transfer the property may include the out-of-pocket costs incurred by the licensor/transferor, such as legal fees during the negotiation. Opportunity costs may include forgone profits if the technology was to be commercialized by the licensor or foregone royalties that may have been earned from another willing licensee. The R&D costs to develop the technology may be considered in determining the licensor’s floor; however, they are often considered sunk costs that do not affect the licensing decision. Strategic reasons may also play a role in deter-
PRICING CONSIDERATIONS IN LICENSING 4.17
mining a licensor’s potential floor. For example, a licensor may accept a lower royalty to encourage market adoption of a new technology. The Licensee’s Theoretical Ceiling. The theoretical ceiling that a licensee may be willing to pay includes the potential costs avoided by licensing the technology and the additional profits received due to the license. Potential avoided costs include costs to design around the IP, costs to acquire a similar license, and the costs and risks associated with infringement litigation. Additional profits over alternatives may result from increased volume or market share, selling price premiums, manufacturing cost savings, and convoyed or derivative sales. Strategic reasons may also play a role in determining a licensee’s potential ceiling. For example, the licensee may pay a higher royalty to obtain an exclusive license that prevents entry of competition into the market place. Industry Royalty Rates. As discussed, negotiations sometimes rely on industry royalty
rates as a starting point because they are easy to apply and are perceived to be in the ballpark. A licensing survey conducted by IPC Group in 1991 asked companies to assess the relative weight they place on established royalty rates in their industries versus profit-based analyses. The results are summarized in Exhibit 4.2. Interestingly, when licensing-out, respondents placed a greater weight on established royalty rates than on a detailed profit review. However, when licensing-in, survey participants emphasized profit analysis over established rates. That licensees should focus more on profitability is not surprising, since they will be making investments to prepare a technology for market and bearing risk in the process. Licensors, on the other hand, may view licensing-out transactions as low-risk, incremental sources of revenue, and therefore, may not feel the need to perform profit analyses. In addition, licensors may feel that they do not have the data to perform useful profit analyses.
Weight 160
Established Rates
140 Licensor Profit Analysis
120 100
Licensee Profit Analysis
80 60 40 20 00
•Relative weight importance on a scale of 30 Licensing-Out
Licensing-In
Exhibit 4.2 Established Rates versus Profit Analysis
Source: “Licensing Practices, Business Strategy, and Factors Affecting Royalty Rates: Results of a Survey,” by McGavock, Haas and Patin, Licensing Law and Business Report, March/April 1991, Vol. 13, No. 16. For a more recent survey, see “A Survey of Licensed Royalties,” les Nouvelles, June 1997.
4.18 VALUATION OF INTELLECTUAL PROPERTY ASSETS Royalty Rate Category
Primary Industry Aerospace Automotive Chemical Computer Electronics Energy Food/Consumer General Mfg. Gov’t/University Health Care Equip. Pharmaceuticals Telecommunications Other
0–2%
2–5%
90.0% 52.5% 16.5% 62.5%
90.0% 45.0% 98.1% 31.3% 90.0% 66.7% 100.0% 28.6% 25.0% 51.7% 32.1% 37.3%
45.0% 25.0% 3.3% 23.6% 40.0%
5–10% 10–15% 15–20% 20–25% Over 25%
2.5% 24.3% 6.3% 25.0%
0.8%
0.4%
25.0% 33.3%
12.1% 90.0% 45.0% 20.3% 23.6%
14.3%
12.5% -
1.1% -
0.7% -
0.7% -
Exhibit 4.3 Licensing—in Royalty Rates—by Industry
While industry rates may be a guide, they should be used with caution. First, negotiators must recognize that there can be significant variation in royalty rates within an industry. Exhibit 4.3, compiled from the results of the previously mentioned IPC Group survey, illustrates the range of royalty rates within industries. Because of this variation in industry royalty rates, negotiators must ensure that comparable royalty rates are not blindly relied upon. Participants must consider the unique circumstances of the transaction at hand and adjust the industry rates accordingly. Other Pricing Factors. In a licensing negotiation, a number of qualitative considera-
tions may affect the ultimate pricing decision. Specific agreement terms and conditions (e.g., exclusivity) can be used to shift risk from one party to another, thereby affecting pricing. The scope of this chapter does not allow comprehensive discussion of each pricing factor.17 CONCLUSION
Valuation of IP in mergers and acquisitions is still often considered an overwhelming task. However, a valuation that focuses on the IP of the target company can help to identify key assets (or the lack thereof) that could make or break even the best deals. Further, with a significant portion of Fortune 100’s market capitalization represented by intangible assets, IP valuations will become more commonplace during M&A deals in the not too distant future.
ENDNOTES 4.19 ENDNOTES 1
For a more in-depth analysis of the benefits of licensee investigations see Burgis and Koppel, “Getting the Most for Your IP,” les Nouvelles (December 1996). 2 See The Federal Register, July 8, 1994 edition or the Tax Management Transfer Pricing Report, July 6, 1994 edition, for a copy of the full text of the Final 482 Regulations. 3 For a more detailed discussion on this topic, see Robert Carney and Daniel McGavock, “Tax Strategies for Protecting the Value of IP,” les Nouvelles (March 1997). 4
DeAnn Christinat, “The Benefits of Donating Patents,” CFO (May 1999). See note 3. 6 See Michael Douglass, “Tangible Results for Intangible Assets: An Analysis of New Code Section 197,” Tax Lawyer 47, no. 3 for a more complete discussion of this topic. 7 For a more detailed discussion on the Bowie Bonds, or asset-backed securitizations in general, please go to www.fahnestocksas.com. 8 See Bruce Rubenstein, “Patent Auction: The Property Isn’t Real but the Money Is,” Corporate Legal Times (July 1995). 9 Revenue Ruling 59-60, Section 2031, Sec. 3.01. 10 Revenue Ruling 59-60, Section 2031, Sec. 2.02. 11 Kevin G. Rivette and David Kline, “Rembrandts in the Attic: Unlocking the Hidden Value of Patents,” Harvard Business School Press (1999). 12 For a discussion of this topic, see Avinash K. Dixit, “The Options Approach to Capital Investment,” Harvard Business Review (May-June 1995). 13 For a more detailed discussion of this topic, see Marcus B. Finnegan and Herbert H. Mintz, “Determination of a Reasonable Royalty in Negotiating a License Agreement; Practical Pricing for Successful Technology Transfer,” The Business of Licensing (Clark Boardman Company, Ltd., 1978), p. 3D–17. 14 Razgaitis, Early Stage Technology Valuation (New York: John Wiley and Sons, 1999). 15 For additional information about required rates of return in the venture capital industry, see Blaine Huntmann and James P. Hoban, Jr., “Investment in New Enterprise: Some Empirical Observations on Risk, Return, and Market Structure,” Financial Management (Summer 1980). 16 See note 11. 17 For a more detailed discussion of factors that may affect the IP pricing decision, see Arnold, White, and Darkee, “100 Factors Involved in Pricing the Technology License,” The 1988 Licensing Law Handbook (1998), Appendix C. 5
CHAPTER
5
ACCOUNTING FOR INTELLECTUAL PROPERTY DURING MERGERS AND ACQUISITIONS Andrew W. Carter InteCap, Inc.
INTRODUCTION
Intellectual property currently enjoys a position of great significance to many businesses and industries—in fact, it is often a primary factor leading to many of today’s business mergers, acquisitions, and joint ventures. While the financial markets and dealmakers recognize intellectual property as a key driver to many businesses and business combinations, current accounting and financial reporting requirements in the United States poorly reflect these assets in a company’s financial statements. This chapter discusses three main topics. First, a general overview of how intellectual property is accounted for in mergers and acquisitions is given. Second, several proposed changes are discussed, as the accounting treatment of mergers and acquisitions in general is currently in flux. Third, the current hot topic in this area—the treatment of inprocess research and development costs—is discussed in depth. ACCOUNTING FOR INTELLECTUAL PROPERTIES IN MERGERS AND ACQUISITIONS
Intellectual property is an asset. When a business combination occurs, all assets must be accounted for in some fashion. In order to understand the accounting treatment of intellectual property in mergers and acquisitions, it is fundamental to understand the accounting nature of assets, the objectives of the accounting system, and the accounting for business combinations in general. Asset Recognition. Financial Accounting Standards Board (FASB) Statement of Concepts, No. 6 states that “assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” An asset has three essential characteristics:
1.
It embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows. 5.1
5.2
ACCOUNTING FOR INTELLECTUAL PROPERTY
2. 3.
A particular entity can obtain the benefit and control others’ access to it. The transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred.
There are two broad types of assets—tangible and intangible. Intellectual property is considered an intangible asset—that is a nonmonetary asset lacking physical substance that is held for the continuing benefit of the business. There are two types of intangible assets: those that are specifically identifiable and those that are unidentifiable. For specifically identifiable assets, costs associated with obtaining a given intangible asset can be identified as part of the cost of that intangible asset. In general, intellectual property, such as patents and copyrights, is grouped into this class. Before recognition of an asset as such, U.S. accounting standards require that there be an ability to measure the asset and provide information that is both relevant and reliable. FASB Statement of Concepts, No. 5 states that to be reliable, information must be “sufficiently free of error and bias to be useful” to financial statement users. This need for both relevancy and reliability quite often, as acknowledged in FASB Statement of Concepts, No. 6, requires some tradeoff if the perceived relevance warrants a tolerable amount of uncertainty. It is this balance between relevance and reliability that must be weighed carefully when the recognition of intellectual property is considered. Objective of Accounting System. The accounting system for intellectual property has the same objectives as that for financial reporting in general—to provide readers of financial statements with useful and reliable information to facilitate their investing and lending decision-making processes. In order to facilitate the investing and lending decisions of potential investors, accounting information must be relevant, understandable, and reliable. Moreover, its usefulness is almost always enhanced if the information is prepared consistently with comparable information of similar enterprises. However, identification and measurement uncertainties surrounding intangibles have made it difficult to develop accounting information that reflects all these attributes. Financial Reporting of Business Combinations—General. The accounting treatment of
business combinations can vary, depending on the deal; therefore, the accounting for intellectual property can also vary. Accounting Principles Board (APB) Opinion No. 16 (APB 16), issued in August 1970, governs the accounting treatment for business combinations. APB 16 currently provides for two methods of accounting for business combinations: (1) the pooling-of-interests method (pooling method)1 and (2) the purchase method. From the standpoint of accounting for intellectual property in mergers and acquisitions, the pooling method is relatively easy, but the purchase method can be complex. The Pooling Method. Under the pooling method, the financial records of the combin-
ing entities are pooled together to create the financial records of the resulting combined company. The income statement of the combined entity for the year of combination is compiled and presented as if the entities had been combined for the full year. No other assets or liabilities are recorded as a result of the combination, and the excess of the purchase price over the book value of the net assets acquired is not recognized in the financial statements. As will be discussed later, use of the pooling method does not result in any changes to the accounting expression of intellectual property for either company.
FINANCIAL REPORTING FOR ACQUIRED INTANGIBLE ASSETS 5.3 The Purchase Method. Under the purchase method, the fair market values of all assets and liabilities, including those that may not have been recorded on the financial statements of the acquired entity, are recognized by the acquiring entity. Any excess of the cost of the acquired entity over the fair value of the net assets acquired is recognized as goodwill and is capitalized as an asset on the balance sheet. The income statements do not include the results of the acquired entity until after the acquisition. As noted later in this chapter, use of the purchase method can have an impact on the accounting treatment of current intellectual property. Which Method to Use. These two methods of accounting for business combinations are
not alternatives or substitutes for one another. Rather, APB 16 specifies 12 conditions that must be met in order for a business combination to be accounted for under the pooling method. Recently, however, creative lawyers and investment bankers have been structuring transactions so that the 12 criteria for using the pooling method have been met. Why? Because using the purchase method often results in a significant amount of goodwill, or purchase price in excess of fair value of net assets acquired. This goodwill is amortized over a specified period of time, which results in an expense that lowers reported earnings.2 Generally speaking, companies desire higher, rather than lower, reported earnings and, if possible, would like to avoid amortizing goodwill charges associated with an acquisition. Therefore, the use of the pooling method has increased significantly over time. FINANCIAL REPORTING FOR ACQUIRED INTANGIBLE ASSETS
Acquisition of intangible assets can be either direct (e.g., cash for a patent) or indirect (e.g., cash for an entire company that holds land, equipment, and patents). APB Opinion No. 17 (APB 17), issued in August 1970, governs the accounting treatment for the acquisition of intangible assets, even when acquired as part of a business combination. Intellectual property is a form of intangible asset and, therefore, falls under APB 17. When intangible assets are acquired directly, the cost is measured by “the amount of cash disbursed, the fair value of other assets distributed, the present value of amounts to be paid for liabilities incurred, or the fair value of consideration received for stock issued.” In other words, what someone pays is what the asset costs. Indirect acquisition of intangible assets typically occurs as the result of a merger or acquisition. How the merger or acquisition is accounted for has a significant impact on the accounting treatment for the acquired intangible assets. If the pooling method of accounting is used, balance sheets of the two companies are combined, and no changes are made to the way the acquired intellectual property is accounted for. If the purchase method of accounting is used, then several rules govern the accounting of the acquired intangible assets. APB 17 requires that all intangibles acquired as a result of a business combination be recorded as assets. APB 17 also requires that the costs recorded for intangible assets, including goodwill, be amortized over the economic useful life of the asset. Exhibit 5.1 is a flowchart that provides a general overview of the treatment of intangibles under APB 17. According to U.S. accounting standards, similarly to long-lived assets, intangibles— including goodwill—are required to be recorded at cost on the day of acquisition. Costs
5.4
ACCOUNTING FOR INTELLECTUAL PROPERTY Is the intangible object identifiable?
No
Recognize as part of goodwill
Amortize over useful economic life, ≤ 20 years
Yes Can it be reliably measured?
No
Yes Recognize as separate intangible asset
Estimate useful economic life
Amortize over useful economic life
No
Is the useful economic life > 20 years?
Yes Is it exchangeable or based on contractual/ legal rights?
No
Yes No
Amortize over 20 years
Clearly identifiable cash flows for > 20 years?
Yes Amortize over finite useful economic life > 20 years
No
Is the useful economic life finite?
Yes No
Is there an observable market?
Yes Do not amortize unless the useful life becomes finite
Exhibit 5.1 Treatment of Intangibles under APB 17
should be assigned to all specifically identifiable assets. Thus, the cost of unidentifiable intangible assets, or goodwill, is “measured by the difference between the cost of a group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired, less liabilities assumed.”3 For
FINANCIAL REPORTING FOR ACQUIRED INTANGIBLE ASSETS 5.5
example, assume that Company A pays $10 million for Company B, and the purchase method of accounting is used to account for the acquisition. If Company A can specifically identify only $8 million in assets (property, plant, patents, etc.), the remaining $2 million is termed goodwill. One significant result of using the purchase method is that a valuation of the intellectual property of the acquired firm is frequently performed. As a result of that valuation, the intellectual property of the acquired firm is often carried at a greater value (higher asset value) on the accounting books of the new or acquirer firm. For example, trademarks, which are often carried at $0 on the accounting statements of the firm that develops them, often have value. If a firm with valuable trademarks is purchased, those trademarks can be specifically valued, then accounted for on the books of the acquiring company. The end result is the creation of an accounting asset where there was none previously. Amortization. U.S. accounting standards require companies to systematically amortize
the cost of each type of intangible asset (which includes intellectual property) over the period of estimated future benefit or its economic useful life. This useful life is dependent on a number of the following factors: • Legal, regulatory, or contractual provisions may limit the maximum useful life. • Provisions for renewal or extension may alter a specified limit on useful life. • Effects of obsolescence, demand, competition, and other economic factors may reduce a useful life. • A useful life may parallel the service life expectancies of individuals or groups of employees. • Expected actions of competitors and others may restrict present competitive advantages. • An apparently unlimited useful life may, in fact, be indefinite, and benefits cannot be reasonably projected. However, the Financial Accounting Standards Board states that goodwill should never be written off immediately or amortized for a period greater than 40 years. The 40-year requirement is based on the assumption that few intangible assets last forever. Goodwill amortization should be computed using a straight-line method unless another method is deemed more appropriate. Tax Treatment. The amortization lives of intangibles are different for taxation than for
financial reporting purposes. The Financial Accounting Standards Board favors a shorter life for purposes of accuracy and integrity, but the IRS prefers a longer amortization life to increase the amount of taxable income. Under Section 197 of the Internal Revenue Code, all intangibles acquired in connection with a business combination may be amortized over a 15-year period using the straight-line method beginning the month the asset is acquired. Section 197 includes, but is not limited to, goodwill and intellectual property of various types. Section 197 contains a provision with respect to claiming an intangible asset as worthless. Even if an intangible that falls under Section 197 is deemed worthless, it cannot be written off
5.6
ACCOUNTING FOR INTELLECTUAL PROPERTY
before the 15-year period unless all other Section 197 assets that were acquired in the same transaction are deemed worthless. For example, if a patent expires and was acquired in connection with a customer list, it cannot be written off prior to the 15-year period unless the patent and customer list are deemed to have no value. Impairment of Intangibles. Impairment, or loss of value, applies to all types of intangi-
bles, including intellectual property and goodwill. APB 17 states that companies “should evaluate the periods of amortization continually to determine whether later events or circumstances warrant revised estimates of useful lives.” A change in useful life should be coupled with a change in the resulting yearly amortization value. FAS (Financial Accounting Standard) 121, Accounting for the Impairment of LongLived Assets and For Long-Lived Assets to be Disposed of, also applies to intangibles. According to FAS 121, “An entity shall review long-lived assets and certain identifiable intangibles to be held and used for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.” For example, if a company has a patent, and competitors design around that patent, the patented technology may be unprofitable, and the recoverability should be analyzed. In order to evaluate the recoverability, the company would estimate the future cash flows expected to result from the use of the asset and its disposition. If the future net cash flows (not discounted and before interest) were less than the book value of the asset, an impairment loss would be recognized. The impairment loss is the amount by which the carrying amount of the assets exceeds the fair value of the impaired asset. Goodwill is unique in that it can be identified only with the business as a whole. Because goodwill is a going concern, valuation cannot be separated from the entire business entity. Thus, goodwill impairments involve a grouping of net assets. In situations where goodwill is associated with assets that are subject to impairment loss, the Financial Accounting Standards Board requires the carrying amount of the associated goodwill to be eliminated before the carrying amounts of impaired long-lived assets and identifiable intangibles are reduced to their fair values. FAS 121 is effective for financial statements for fiscal years beginning after December 15, 1995. Earlier application was encouraged; however, restatement of previously issued financial statements is prohibited. PROPOSED FINANCIAL ACCOUNTING STANDARDS BOARD CHANGES AND RECENT DEVELOPMENTS
There are currently a number of proposals pending before the Financial Accounting Standards Board that will alter the landscape for the treatment of intellectual property in a merger or acquisition. The most important of these are (1) the proposed elimination of the pooling method for business combinations, and (2) the proposed elimination of the amortization of goodwill. A brief outline of each of these follows. Proposed Elimination of the Pooling Method. In August 1996, the Financial Accounting
Standards Board began to reconsider APB Opinions No. 16, Business Combinations, and No. 17, Intangible Assets. In addition to wanting to improve international comparability, the Financial Accounting Standards Board and the Securities and Exchange
PROPOSED FINANCIAL ACCOUNTING STANDARDS 5.7
Commission (SEC) have received several inquiries about the APB Opinions in question as a result of the increase in merger activity. In September 1999, the Financial Accounting Standards Board issued an exposure draft of a proposed statement, Business Combinations and Intangible Assets. The proposed amendment to APB 16 would require all business combinations to be accounted for under the purchase method, thus eliminating the use of the pooling method. In January 2001, the Board voted to accept this proposal, and a final ruling on the subject is anticipated in late June. Companies can continue to elect the pooling of interests method for mergers, including those mergers announced but not completed by the final date, until the final ruling. The Financial Accounting Standards Board contests that the pooling method provides investors with less relevant information than does the purchase method. Members argue that the pooling method ignores the value of the business combination from a financial reporting perspective, which makes it increasingly difficult for users of financial statements to identify the amount invested in the acquisition. Those hesitant to eliminate the pooling method are concerned about how the markets for mergers and acquisitions will be affected. Respondents argue that eliminating the pooling method will discourage the beneficial consolidation occurring in the nation’s economy. For certain industries, intangibles are a significant part of a deal value, which results in a significant writeoff. Corporate executives argue that goodwill is not always a depreciating asset and that it truly is the basis for products and services that create future cash flows. Others advocate that the purchase method would damage financial statement comparability because internally developed intangibles are not recognized on the balance sheet, whereas purchased intangibles are. Regardless, the Board’s final decision will have significant ramifications for how future mergers and acquisitions in general are accounted for. The decision will also significantly impact the accounting for intellectual property if the pooling method of accounting is eliminated. Goodwill and Amortization. In response to concerns that the elimination of the pooling
option could have an adverse effect on the market for mergers and acquisitions, the Financial Accounting Standards Board reconsidered its position on the treatment of purchased goodwill. In January 2001, the Board reconfirmed that goodwill should be initially recognized as an asset and should be measured initially as the excess of the cost of the acquired enterprise over the sum of the amounts assigned to the identifiable assets acquired, less liabilities assumed. Second, the Board proposed the elimination of the amortization of goodwill, instead allowing the asset to remain at cost on the balance sheet until such time when the asset was impaired. If goodwill was determined to be impaired, the asset would be reduced to the impaired value. Determining the impairment value of goodwill could prove troublesome, however, as companies would be required to conduct an impairment review whenever their market value fell below book value for an as-yet unspecified period; whenever their stock price decreased significantly relative to overall economic or market changes; or when one of several other indicators pointed to an impairment. Final adoption of these decisions was expected to occur in the summer of 2001.
5.8
ACCOUNTING FOR INTELLECTUAL PROPERTY
IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES
A trend that has developed recently is the immediate writeoff of purchased R&D. Inprocess research and development is an intangible asset, as no hard, physical assets have yet been derived (which is why the research is “in-process”). The average charge has grown from $101 million in 1991 to $382 million in 1998. Acquisitive companies favor this charge, as the immediate deduction lowers the company’s earnings, creating the illusion of greater earnings growth in the future. Definition of In-Process Research and Development Charges. Financial Accounting Standards Board Interpretation, No. 4 (“Applicability of FASB Statement, No. 2 to Business Combinations Accounted for by the Purchase Method”) defines in-process research and development as costs assigned to assets to be used in a particular research and development project and that have no alternative future uses in a current product or other ongoing R&D activities. These costs include materials and supplies, equipment and facilities, and specific research projects in process. As with other assets acquired, costs allocated to in-process research and development should be based on an appraisal of the fair value of these assets, not their original cost. Obviously, recording in-process research and development is very attractive to corporations because it reduces the amount of goodwill recorded in an acquisition and the drag on future earnings that accompanies the amortization of goodwill. Attracted by the ability to avoid goodwill’s drag on earnings, corporations are allocating increasing amounts to in-process research and development. Historical Treatment of Research and Development. Historically, costs identified with
research and development activities would be expensed during the time period in which they occurred. Disclosure of these costs would be made in the financial statements under total research and development expense each time an income statement is prepared. Potential Changes. The Financial Accounting Standards Board announced its intentions in February 1999 to enforce gradual writeoffs of purchased R&D, rather than immediate writeoffs at the time of acquisition. Although this new method of accounting would decrease the use (and some say abuse) of in-process research and development writeoffs, some say it may have an adverse affect on investors and acquisitive companies. In this regard, one possibility is that investors would be less inclined to invest in a company with lower earnings for a longer period of time. In addition, companies who purchase research and development in an acquisition would be treated differently than companies who generate their own research and development internally. A company that purchased another company with large in-process research and development costs would then be expected to gradually write off this purchased research and development, but a company with only internally generated research and development charges could immediately write off these charges. Despite the Financial Accounting Standards Board and Securities and Exchange Commission support of a new method for writing off purchased in-process research and development, there has been no final action taken as of this writing.
IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES 5.9 Increased SEC Scrutiny of In-Process Research and Development Write-Offs. In recent years, both the frequency and magnitude of in-process research and development writeoffs have increased dramatically. For example, in the WorldCom/MCI merger, MCI Worldcom planned to write off as much as $7 billion of the $37 billion purchase price as in-process research and development. In addition, examples exist in which the entire purchase price of an acquisition was allocated to in-process research and development. Due to this heightened activity, the Securities and Exchange Commission (SEC) has significantly increased its scrutiny of in-process research and development writeoffs, believing that amounts that exceed its fair value are being allocated to in-process research and development. In the WorldCom example, the in-process research and development writeoff was reduced to $3.1 billion, partly to win SEC clearance. The Securities and Exchange Commission has focused on two areas—the allocation of the purchase price to in-process research and development and the determination of the fair value of in-process research and development. First, the SEC is scrutinizing the allocation of the purchase price among in-process research and development costs that are expensed, core technologies that are capitalized and amortized over the life of the technologies, and other assets that are also capitalized and amortized. In determining this allocation, the value of other acquired intangibles such as patents, the engineering workforce, and licensing agreements, must be considered. Consistent with the FASB, the SEC has stated that only amounts with no alternative uses may be expensed as inprocess research and development. In addition, the SEC has discussed at length the treatment of rights to enhance or embellish an existing product or technology that has alternative future uses. The SEC maintains that these rights are not separable from the product or technology itself and should therefore be capitalized and amortized over the life of the technology. The SEC gives the following example to illustrate the proper treatment of research and development costs:
Assume that at the time of acquisition, an acquired company had developed and released Version 1 of a product. In addition, it had completed 10% of the research on Version 2. The acquiring company also received the rights to develop all future versions of the product. According to the SEC, only the costs associated with the 10% research completed to date on Version 2 can be classified as in-process R&D and expensed. All other amounts, including the rights to develop all future versions of the product, should be classified as assets and capitalized.
The second area of SEC scrutiny is the determination of the fair value of in-process research and development. The SEC has stated that in-process research and development should be recorded at its fair value, which represents the amount that would be exchanged in an arm’s length transaction. The investment value to a particular investor does not represent fair value. Both the Income Approach and the Relief from Royalty Method (both discussed in Chapter 4) are deemed to be acceptable methods of valuing in-process research and development. The SEC believes that, under the Income Approach, the discounted cash flows expected from the research project, net of estimated costs to complete the project, should be calculated. These cash flows should then be reduced based on the percentage of completion of the research project. The SEC has expressed that the
5.10 ACCOUNTING FOR INTELLECTUAL PROPERTY
assumptions used in these analyses must be carefully reviewed for reasonableness, with consideration for factors such as stage of completion, complexity, difficulty of completion, costs incurred to date, and projected costs to complete the project. The Securities and Exchange Commission has also expressed concerns regarding the Relief from Royalty Method. Although it views this approach as an acceptable valuation method, it does not view the use of an “industry” royalty rate in this analysis as acceptable. The SEC has explained that it views research and development projects as being highly unique and specific in nature. Therefore, the SEC believes it is difficult to support the application of an industry, or average, royalty rate to these projects. Finally, the Securities and Exchange Commission expects companies to disclose more information about the calculation of in-process research and development writeoffs. Specifically, the SEC expects disclosure of the material assumptions and estimates used in the in-process research and development valuation. Along with these efforts, the SEC is increasing its policing of merger and acquisition consulting work performed by accounting firms for audit clients. Specifically, the SEC has expressed concerns regarding accounting firms completing valuations used in mergers and acquisitions, then subsequently reviewing these calculations as part of the audit process. These valuations include areas such as in-process research and development. BIBLIOGRAPHY “Acquisitions of In-Process R&D,” Journal of Accountancy (February 1999): 8. “APB Opinion No. 16: Business Combinations,” Accounting Principles Board, August 1970 “APB Opinion No. 17: Intangible Assets,” Accounting Principles Board, August 1970 Arthur Andersen LLP, “SEC to Increase Scrutiny of In-Process Research and Development Charges in Business Combinations,” 1998. “Arthur Levitt Addresses ‘Illusions’,” Journal of Accountancy (December 1998): 12–13. “Current Projects of the Office of the Chief Accountant,” Remarks by Lynn Turner, Chief Accountant, U.S. Securities and Exchange Commission, to the Colorado State Society of Certified Public Accountants, 1998 SEC Conference, December 3, 1998. “FASB Interpretation No. 4: Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method,” Financial Accounting Standards Board, February 1975. “FASB Statement of Concepts, No. 5: Recognition and Measurement in Financial Statements of Business Enterprises,” Financial Accounting Standards Board, December 1985. “FASB Statement of Concepts, No. 6: Elements of Financial Statements—a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2),” Financial Accounting Standards Board, December 1985. Financial Accounting Standards Board, “Business Combinations,” from website (http://www.rutgers .edu) “Financial Accounting Standards No. 121: Accounting for the Impairment of Long-Lived Assets and For Long-Lived Assets to be Disposed of,” Financial Accounting Standards Board, March 1995. Garver, Rob, “FASB Closes the Window on Pooling,” American Banker (New York, January 25, 2001). MacDonald, Elizabeth, “Merger Write-Offs Prompt SEC Drive For Full Disclosure,” Wall Street Journal (January 13, 1999): A8.
ENDNOTES 5.11 MacDonald, Elizabeth, “SEC Steps Up Scrutiny of Accountants: Agency Warns Major Firms About Possible Conflicts Over Merger Consulting,” Wall Street Journal (January 8, 1999): A3. MacDonald, Elizabeth, “SEC Weighs Wide Review of Write-Offs,” Wall Street Journal (January 22, 1999), A2, A7. “The ‘Numbers Game.’” Remarks by Chairman Arthur Levitt, Securities and Exchange Commission, New York University Center of Law and Business, September 28, 1998. Roberts, Ricardo, “How Will FASB Ring in the New Year?: M&A Tax Experts Sound Off on Upcoming Changes to Accounting Rules,” Mergers & Acquisitions Report (New York, January 1, 2001). “Section 197 Intangibles,” Internal Revenue Code. Securities Exchange Commission, “Letter from the Office of the Chief Accountant Regarding the 1998–1999 Audit Risk Alerts,” October 9, 1998. Shaffer, Leslie. “High-Tech Firms Are Upset Over an SEC Crackdown,” Wall Street Journal (February 1, 1999): B4. “Statement of Financial Accounting Standards No. 2: Accounting for Research and Development Costs,” Financial Accounting Standards Board, October 1974. “Statement of the AICPA in Response to SEC Chairman Arthur Levitt’s NYU Address,” September 28, 1998, AICPA website. Weil, Jonathan, “Goodwill Hunting: Accounting Change May Lift Profits, But Stock Prices May Not Follow Suit,” The Wall Street Journal (January 25, 2001).
ENDNOTES 1 On July 5, 2001, the Financial Accounting Standards Board (FASB) formally moved to eliminate the pooling-of-interests method of accounting for most business transactions. The final rules are expected to contain certain exclusions for the combination of two or more mutual enterprises, formation of joint enterprises, and potentially other types of transactions. The final rules are not expected to be published until sometime later in 2001. 2 The FASB has voted to eliminate the requirement to amortize goodwill. Under the proposed regulations, goodwill will remain on the purchaser’s balance sheet at the purchase price until its value is in some way impaired, at which point it would be written down to the impaired value. 3 Laymen often refer to goodwill as what is “left over” after everything else has been accounted for.
CHAPTER
6
INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS Glenn A. Gundersen Dechert
INTRODUCTION
Every business uses some form of intellectual property, and the buyer of a business will typically need to acquire the intellectual property used in the business along with other types of assets. Lawyers who specialize in mergers and acquisitions usually take the lead role in these transactions, but intellectual property counsel are often called upon to assist transaction counsel in drafting and negotiating the documents that relate specifically to intellectual property. This chapter is designed to allow intellectual property specialists to understand their mission in the context of the overall transaction and to analyze the issues that IP specialists and nonspecialists encounter in these negotiations. ACQUISITION AGREEMENT
Almost any acquisition of a business involves an agreement between buyer and seller that spells out the terms of the transaction. Occasionally very short, often more than 100 pages long, this document is usually captioned either as a “stock purchase agreement” (the stockholders of a corporation are selling the stock of the corporation that conducts the business) or “asset purchase agreement” (a corporation sells the assets it uses in operating the business). The agreement details the terms and conditions under which the stock or assets will be sold and is usually negotiated and signed weeks or months in advance of the actual sale. It is the central focus of counsel’s activity in the course of the transaction and the “bible” that both parties will consult after the transaction is done. The acquisition agreement will usually include provisions that relate specifically to intellectual property. In fact, as patents, trademarks, copyrights, trade secrets, and other forms of intellectual property have become more important to businesses, they have received greater scrutiny from buyers in acquisitions. As a result, the intellectual property provisions of these documents have grown in length and complexity and can be the subject of extensive negotiation.
6.1
6.2
INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS
Contents of the Acquisition Agreement. The acquisition agreement is intended to comprehensively detail all of the terms and conditions of the transaction. Such agreements typically include provisions that cover the following issues:
• The date on which the transaction will be consummated. The closing date is usually weeks or months in advance of the signing of the agreement but sometimes simultaneous with signing. • The consideration. These provisions detail the price to be paid for the business (which, depending on the circumstances, may consist of cash, stock, the assumption of liabilities, and other considerations), the timetable for payment (all at closing or in installments), and any adjustments to be made to the purchase price for contingencies determined after closing. • A description of the property (stock, assets, or a combination of both) to be transferred at closing. This language can be relatively simple in a transaction in which the buyer acquires the stock of a company: The agreement specifies the stock to be acquired, and by acquiring that stock, the buyer, in effect, takes control of all of the assets of the corporation. Buyers need to be careful, however, that the corporation does, in fact, own all of the assets relative to the business. In some cases, certain assets are held by particular shareholders or affiliated companies, and the buyer will need to make sure that the stock purchase agreement calls for the buyer to acquire or license those other assets. The description of the property being transferred is likely to be considerably more complex in an acquisition of assets, especially when the buyer is only buying one division or line of business and the seller is retaining other businesses and assets. In such situations, the definition of assets to be sold (and those that the seller will retain) is sufficiently precise to avoid confusion and dispute about what is intended. The parties usually negotiate a fairly detailed description of the assets (e.g., “all of the assets used or held for use by Seller and its Affiliates in the manufacture of spatulas”) that is supplemented by detailed lists of specific assets (e.g., spatula manufacturing plants and equipment, patents on spatula technology, etc.). • An allocation of the existing liabilities of the business. In stock acquisitions, the buyer takes on all of the company’s liabilities by acquiring its stock. In asset acquisitions, the parties must negotiate which liabilities the buyer will assume and which the seller will retain. • The representations and warranties about the business. In either type of agreement, the seller is typically called upon to make certain representations and warranties about the assets of the business. Buyer and seller negotiate the nature of these disclosures and representations, often at length. • The seller’s indemnification of the buyer. If the buyer discovers, after closing, that one of the seller’s representations about itself, the business, or the assets was inaccurate, the acquisition agreement sometimes allows the buyer to seek indemnification from the seller to compensate for the diminished value of the business or the unexpected liabilities the buyer incurred. • The covenants of the parties. Buyer and seller typically promise to do certain things and refrain from certain acts before and after the closing. Some of these
OTHER DOCUMENTS 6.3
covenants are fairly standard (e.g., seller agrees not to engage in any asset sales between signing and closing the deal except in the ordinary course of business). Other covenants will only arise in particular transactions (e.g., a seller agrees not to compete with the buyer in the acquired business for a period of time after the deal closes). • The conditions to closing. Buyer and seller typically specify conditions that must be present or events that must occur before they are obligated to consummate the deal. A seller makes representations about the business as of the date that the acquisition agreement is signed, but that date may be weeks or months prior to closing, especially if antitrust or other regulatory approvals are required in order to close the transaction. The buyer will typically require that at closing, the seller warrant that the representations are still true. If certain statements are no longer true, the buyer might have the option of declining to go through with the transaction as specified. Other conditions of closing may reflect issues that come to light during the negotiation of the agreement. For example, in a stock sale, if the buyer learns certain intellectual property is not owned by the corporation whose stock is being acquired, it may require that those assets be either transferred to the corporation before closing or directly to the buyer at closing. If the seller does not comply, the buyer will not be obligated to buy the stock of the corporation. OTHER DOCUMENTS
In most cases, the acquisition agreement does not actually effectuate a transfer of stock or assets from seller to buyer. Instead, it merely embodies the seller’s promise to sell stock or assets to the buyer under certain terms. The consummation of the transaction takes place at the closing on a later date when the parties execute transfer documents and any ancillary agreements and take other steps. Transfer Documents. If the buyer is acquiring stock, the seller typically effects the transfer by signing stock powers and delivering stock certificates. An asset transaction is more complicated. While most assets will be transferred via the seller’s execution of a bill of sale at closing, a buyer will usually require that separate assignments be prepared for all patents and patent applications, trademark registrations and pending applications, and U.S. copyright registrations and applications. The buyer will usually want to record these assignments in the applicable offices in each of the jurisdictions where the patents have issued or are pending, marks have been registered, or applications are pending. Patent, trademark, and copyright assignments each require different transfer language, and the parties will typically prepare a different assignment document for each type of intellectual property. It is also preferable to prepare and record separate assignment documents for each country jurisdiction because each country has particular language, format, and signature requirements for the assignment form. In addition, special considerations apply when assigning patent applications that have been filed under the Patent Cooperation Treaty or trademark registrations issued under multicountry registration systems such as the Madrid Agreement. In transactions involving the transfer of intellectual property
6.4
INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS
rights in multiple countries, the parties may agree that master patent, trademark, and/or copyright assignments will be executed at closing and that the preparation and execution of individual country assignments will occur as part of the post-closing cleanup. The bill of sale is usually not recorded because it is likely to be lengthy, contain confidential information, and not contain language necessary to comply with various national recording requirements. Transfers of domain names pose special issues. A bill of sale is insufficient to fully effect the transfer of a domain name since it does not effect a change of title in the domain name registrar’s records. Counsel for the buyer first needs to determine which domain name registration organization (Network Solutions, Register.com, or another) registered the name, then determine how to comply with that organization’s requirements for transferring the domain name. Such transfers are an aberration from the M&A lawyer’s expectation that all transfers can be effected by the execution of hard copy documents in a conference room on closing day because domain transfers may also require the electronic filing of domain name transfer instructions. In addition, from a practical standpoint, if the buyer is not acquiring the seller’s servers or other hardware and software used to operate the website, the buyer will need to make plans prior to closing for a smooth technical transition to its own facilities on closing day or for having the seller provide transition services until the buyer’s facilities are operational. The transfer of intellectual property is discussed in greater detail in Chapter 16. Obtaining Assignments of Licenses. Many businesses use intellectual property, such as computer software, trademarks, and technology, that is licensed from third parties. In most acquisition agreements, the seller provides the buyer with a list of intellectual property licenses used in running the business. As part of its due diligence, the buyer will obtain and review copies of these licenses. Often, such licenses are not readily assignable. This is not a problem in a stock deal (unless the license prohibits a change of control of the licensee) since the identity of the licensee does not change. However, it causes headaches in an asset purchase in which the buyer must step into the seller’s shoes as licensee. The buyer will need to determine whether it wants to assume these licenses and, if it does, whether it can obtain the licensor’s consent to the transfer without a renegotiation of its terms. As a general rule, intellectual property licenses are not transferable from one licensee to another without the licensor’s consent. Some licenses permit transfer, but most do not. The buyer and seller will need to determine whether the obligation to negotiate and obtain such consents falls on the buyer or the seller. The acquisition agreement may even provide that the buyer is not obligated to close the transaction if consents from key licensors cannot be obtained or cannot be obtained without considerable expense. Ancillary Agreements and Obligations. The acquisition agreement often specifies other
obligations of the parties related to the acquisition. In the intellectual property area, the most common type of ancillary agreement is a license from the seller to the buyer, or vice versa. This is commonplace in situations in which the seller is parting with one of its businesses but has certain intellectual property that is used in that business and the businesses it is retaining. In such situations, the buyer either retains the shared intellectual property and licenses it to the buyer post-closing or sells it to the buyer and
DRAFTING THE DESCRIPTION OF ASSETS 6.5
takes a license back. The parties may also conclude that short-term licenses are needed to allow a party to phase out its use of certain intellectual property post-closing. Examples would be a license to the seller to allow it to use up packaging or materials bearing the marks it has sold or a license to the buyer to allow it to continue using a mark the seller has retained until the buyer adopts a new mark and deletes the seller’s mark from packaging and advertising. DRAFTING THE DESCRIPTION OF ASSETS
The first task for buyer’s and seller’s counsel in an acquisition is to agree on the definition of what property will be transferred. This is obviously an easy task if the seller is selling itself, lock, stock and barrel. It can be considerably more difficult if the seller is selling only a portion of its assets. Following are several possible scenarios. Identifying the Intellectual Property Being Transferred as Part of a Stock Sale. When the
stock of a corporation is sold, the assets of the corporation do not change hands—they remain with the corporation. The buyer of the stock, in effect, acquires the intellectual property owned by the corporation because it has acquired the corporation. However, the buyer should not assume that all of the intellectual property used by the corporation is, in fact, owned by that corporation. With smaller companies, in particular, it is not uncommon for individual shareholders to own patents on the inventions they developed, copyright registrations on software they wrote, or trademark registrations of marks they coined. To the extent feasible, the buyer should make sure that the seller’s disclosure schedules indicate which intellectual property is owned by the corporation and which is owned by other entities and licensed to the corporation. To the extent that ownership is public record (in the case of issued patents and trademark registrations and applications), the buyer will want to conduct its own independent due diligence search to verify that the seller’s schedules are accurate. Identifying the Intellectual Property To Be Transferred in an Asset Sale. When all the assets
of a business are sold and the parties neglect to specify that trademarks are being transferred, the general rule is that the seller is nevertheless presumed to have transferred the marks of that business to the buyer. However, it is not always clear which marks relate to the business being sold and which do not. Moreover, this rule does not necessarily apply to other forms of intellectual property. The Copyright Act, for example, requires that a transfer of copyright ownership be in a written instrument executed by the copyright owner unless the transfer occurs through operation of law.1 A bill of sale that neglects to reference copyrights or include other catch-all language arguably fails to effect a transfer of copyrights. Domain names definitely cannot be transferred by the same implied grant. Thus, to avoid doubt about what the buyer has acquired and what the seller has retained, the parties typically list or otherwise define which intellectual property assets are being transferred and which are not. From a drafting standpoint, the typical agreement will begin by defining “Intellectual Property” along the following lines:
6.6
INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS
All patents, industrial design rights, trademarks, service marks, trade names, trade dress, copyrights, mask works, inventions, technology, know-how, industrial design registrations, formulae, trade secrets, confidential and proprietary information, computer software programs, domain names, and other intellectual property, and all registrations and applications for registration of any of the foregoing.
Although such definitions sound comprehensive, by their nature they leave some ambiguity. For example, if the seller agrees to transfer “all Intellectual Property used exclusively in the Business,” the buyer will not necessarily know whether particular patents or trademarks fall within that definition or are used in other seller businesses as well. Thus, the parties rely in large part on schedules that list identifiable items of intellectual property being transferred. Thus, the agreement would specify that the previous definition of “Intellectual Property” includes, but is not limited to, the items listed on an attached schedule. Thus, in most transactions, both parties’ counsel should recognize that schedules are not all-inclusive, but a subset of all of the intellectual property to be transferred. The buyer can reasonably expect such schedules to include issued patents and pending patent applications, registered trademarks and pending applications, registered copyrights and applications, and domain name registrations. The buyer will also want the schedules to list unregistered marks and tradenames, although most sellers will be reluctant to characterize any such list as comprehensive. The seller and its counsel prepare these schedules, and newcomers to M&A transactions are often surprised to discover that they are frequently incorrect, incomplete, or out of date. A buyer will want to conduct its own due diligence search to verify that the seller’s schedules are accurate. Buyers should not expect that schedules will list every item of intellectual property, in part because it is virtually impossible to exhaustively list (or even accurately describe) certain categories of intellectual property, such as trade secrets and unregistered copyrights. The larger the company, the more cautious counsel should be about the comprehensiveness of schedules. Even if a company has sophisticated in-house intellectual property lawyers, chances are that they are not aware of every brand or slogan used in the company and that some errors, even if slight, have found their way into docket lists of patents and trademark registrations over time. The Internet domain name is a new kind of property right, combining elements of trademark, property right, and vanity phone number. As such, it will not appear in formbook asset purchase agreements as part of the list of intellectual property assets that are typically transferred in M&A transactions. Most asset purchase agreements would call for the transfer of the seller’s trademarks to the buyer, but that does not necessarily cover domain names. This is for two reasons. First, the registration of a domain name, in and of itself, does not create trademark rights in that name, and as a result, one cannot assume that the terms “trademark” and “domain name” are interchangeable or synonymous. Many domain names do consist of a trademark followed by “.com,” “.net,” or the like, and if a buyer neglects to list domain names among the assets to be transferred, an agreement that calls for the sale of trademarks could reasonably be interpreted to also contemplate the sale of the corresponding domain names. However, some domain names consist of generic terms followed by .com. These, arguably, don’t fall within the definition of trademarks (especially if they do not lead to an active website). Moreover, the courts disagree over whether a domain name is a
THE SUBSTANCE OF INTELLECTUAL PROPERTY REPRESENTATIONS 6.7
property right at all or merely ancillary to a contract with a domain name registrar. Thus, a buyer will want to make certain that “domain names” are listed among the assets to be transferred in the sale of a business. The buyer will want the seller to provide a comprehensive list of all Internet domain names held or used by a company (if the entire company is being purchased) or all Internet domain names used or held for use by a business (if only one of the company’s businesses is being acquired). The buyer will want to do its own due diligence review of whether the domains are registered in the company’s name or that of another party (e.g., an employee, website developer, or web-hosting firm). Determining the Disposition of Jointly Used Intellectual Property. In many cases, certain intellectual property may be used both in the business being sold and in the business that the seller is retaining. For example, the seller may sell its products using the seller’s overall house mark in combination with individual product line brands. Similarly, the same patented technology or manufacturing know-how may be used in both businesses. If both parties will need or want to continue using certain intellectual property after the sale, they will need to negotiate whether the seller will retain such intellectual property and license it to the buyer post-closing or whether the buyer will acquire it, subject to an obligation to license it back to the seller. They will also need to decide whether the license will be a short-term transitional arrangement, long-term (but terminable) license, or perpetual, and whether it will be royalty-free.
THE SUBSTANCE OF INTELLECTUAL PROPERTY REPRESENTATIONS AND WARRANTIES
As with the other assets of the business being sold, the buyer in an acquisition will want information about the intellectual property needed to conduct its operations. The buyer’s checklist will typically include the following questions: • What intellectual property is necessary to operate the business? Does the seller own all the intellectual property necessary to operate the business? If so, does the seller own it free of any liens, security interests, and other encumbrances? • If the seller does not own all the intellectual property necessary to operate the business, does it have sufficient licenses from third parties? • With respect to intellectual property that the seller owns, is the seller in a position to transfer to the buyer all of the intellectual property used in the business, or does the seller need to retain some of it for use in the seller’s other businesses? With respect to intellectual property that the seller licenses from third parties, can the seller freely assign those licenses to the buyer, or must consents be obtained? • Has the seller granted licenses of any of the intellectual property to third parties? If so, what are the terms of those licenses? Do they contain exclusivity provisions or other terms that would restrict the buyer’s ability to use the intellectual property? • Has the seller entered into settlement agreements or consents, or is it bound by judgments or consent orders restricting the use of its intellectual property?
6.8
INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS
• Would the buyer’s use of the intellectual property infringe any third party? Have any infringement or dilution claims been made against the seller with respect to the intellectual property? Has the seller made any infringement or dilution claims against third parties? Is there ongoing litigation involving the intellectual property? Are there interferences, oppositions, or similar proceedings pending in patent and trademark offices at home or abroad? • Have any pending applications for patents, trademarks, or copyrights been rejected or refused registration? A buyer has two ways of getting answers to these questions. One is to conduct its own due diligence review of the seller’s intellectual property (see Chapter 8). The other is to request that the seller make representations and warranties about the intellectual property. Depending upon the language negotiated by the parties, these representations will answer some or all of the previous questions. In some cases, the seller will be able to provide a clean representation, for example, that no infringement claims have been made with respect to its use of the intellectual property. More often, however, the seller will be unable to honestly make an unequivocal representation as to every aspect of its intellectual property, especially if the buyer has proposed language that makes sweeping generalizations. Thus, the seller will either attempt to modify the representation so that it is accurate or will make the representation subject to exceptions, which are typically set forth in a disclosure schedule. In entering into the acquisition agreement at a given price, the buyer will be relying on the accuracy of these representations. What if they prove to be inaccurate? The agreement often provides that the seller will partially or fully indemnify the buyer if the seller’s representations and warranties prove to be inaccurate, as discussed later in this chapter. HOW INTELLECTUAL PROPERTY LAW AFFECTS REPRESENTATIONS AND WARRANTIES
The complexity of intellectual property law poses challenges to sellers in making representations for several reasons. First, it is difficult to make simple, broad-brush statements about intellectual property in general because different rules apply to the different categories of IP. What is true for patents is not necessarily true for trademarks, copyrights, trade secrets, industrial designs, mask works, or rights of publicity; and what is true in one country is not necessarily true in another (despite the worldwide trend toward harmonization of IP laws). Internet domain names raise an entirely different set of issues. Following are some examples of how differences in legal principles between categories of intellectual property law and between jurisdictions can complicate what sellers can say, and what buyers want sellers to say, about an intellectual property portfolio. Patents. Patents create the single biggest concern for buyers in today’s environment because of the uncertainty about exposure for infringement. The contents of patent applications are kept secret for at least a portion of the prosecution process, such that other companies have no knowledge of what an applicant is claiming as patentable.
HOW INTELLECTUAL PROPERTY LAW AFFECTS REPRESENTATIONS 6.9
However, any unlicensed users of that technology become liable for patent infringement at the point that the patent issues. Thus, users of technology are generally in the dark about what others may be seeking to patent. The advent of protection for business methods has created substantive uncertainty about what can and cannot be patented under the law. All of this doubt is exacerbated by the fact that a plaintiff’s patent infringement victory, unlike a trademark infringement claim, often results in a significant damage award. Similarly, patent suits that are settled rather than litigated often result in the defendant entering into a royalty-bearing license for the life of the patent. Therefore, potential exposure for patent infringement can carry a substantial financial risk. The representations in an acquisition agreement allocate this risk. Companies considering the purchase of a multinational business must be aware that patent protection is acquired on a country-by-country basis and that the monopoly afforded by a patent exists only in those countries in which the seller has obtained or is likely to obtain patent protection, and then only if the seller has paid the requisite patent annuities. This makes disclosure schedules critical to understanding where a seller enjoys exclusivity with respect to an invention, and where it does not. Trademarks. Trademark infringement claims pose a different set of risks than patents
and raise different concerns for buyers about the exposure they may inherit. Like patents, a trademark user lives with uncertainty because it can be liable for infringement of a third party’s mark, even if it was completely unaware of the mark. A trademark user can conduct a search to attempt to identify these risks, but searching is not foolproof. One cannot simply search a single database and discover all relevant thirdparty rights. In the United States and some other countries, trademarks exist at common law and need not be registered to be protected. Occasionally, such marks leave no footprint in the databases that are commonly used for searching. In addition, such databases have inherent blind spots. The primary goal of most plaintiffs in trademark litigation is to enjoin the infringing use. Also, damages tend to be less frequently awarded and of lesser gravity. This means, however, that defendants are less likely to settle litigation by taking a license of the plaintiff’s mark and face the prospect of business disruption from having to change or modify an existing mark and discard all of the marketing materials used with the mark. The parties to an acquisition must determine who bears the risk of these uncertainties. Trademark claims are complicated by the fact that owners of famous marks can allege two different grounds for relief—infringement (asserting that the defendant’s mark is likely to cause confusion) and dilution (asserting that the defendant’s mark causes dilution of the distinctive quality of the famous mark). Dilution is relatively new as a federal claim, and confusion exists about the standards for relief, most notably about what constitutes a famous mark. Compounding the confusion is the fact that more than half the states have dilution statutes that set different (and sometimes more lax) standards for relief. The concept of dilution is also more inherently amorphous than infringement, and one can determine more intuitively whether two marks are confusing than whether one mark dilutes another. Therefore, sellers are likely to have less comfort in making representations about dilution, and buyers more likely to have anxiety about their potential exposure.
6.10 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS
Companies that are considering the purchase of a multinational business must be aware of the differences between patent protection (which either exists or does not exist in a country, depending on the issuance of a patent) and trademark protection, the existence of which is less obvious. Like patents, protection is acquired on a country-bycountry basis, and the fact that a seller has registered a mark in the United States does not mean that the mark will be afforded protection anywhere else. Moreover, the requirements for protection vary significantly between types of legal systems. Unregistered common law trademarks are recognized in the United States, United Kingdom, Canada, and other countries with legal systems based on British law. Other countries do not afford trademark protection unless the mark is either registered locally or protected as a famous mark under international treaties. These differences mean that trademark rights are more difficult for a seller to comprehensively schedule because rights in marks and trade dress and rights that the seller has never attempted to catalog and are unregistered may exist. Copyrights. Copyright law inspires less fear about being blindsided by a hitherto-
unknown claimant than patent or trademark law because liability for copyright infringement arises only if the author had access to the copyrighted work and copied it. Nevertheless, companies can be liable for copying done by individual employees, even if their bosses are unaware of the copying. However, copyright law raises a wealth of peculiar title issues, and the rules of copyright ownership are unique and sometimes counterintuitive. For example, if someone commissions a copyrighted work, he or she does not necessarily own it. Copyrighted works created by regular, full-time employees belong to an employer without the need for a written agreement, but a freelancer retains copyright in his or her work unless he or she executes a written assignment. Many companies have the mistaken notion that they own computer software, advertising, photography, website designs, and other works that they have paid free-lancers to create, but in fact, have only a license on undetermined terms. Even if a copyright owner makes a valid and outright transfer of copyright, the assignee may not receive irrevocable and complete title to the work. Some works can be subject to a reversion to the original author. Authors of works created under some foreign legal regimes can retain “moral rights,” restricting the new owner’s freedom to modify the work. U.S. copyright law underwent a major revision in 1976 and has seen several major amendments since then. The rules surrounding works created under the new act can differ significantly from those governing older works. The most significant example is that older works may have been lost to the public domain for failure to comply with statutory formalities, such as copyright notice and renewal, that no longer exist. The term of copyright is not uniform for all U.S. works, nor is it uniform between U.S. and foreign copyright laws. For U.S. works created on or after January 1, 1978, copyright protection is calculated based on the death of the last surviving author. In the case of anonymous works or works made for hire, copyright protection lasts for 95 years after publication or 120 years from the date of creation, whichever expires first. The term of copyright for older works was originally 28 years followed by an equal renewal term, but the renewal term for works still under copyright has been repeatedly extended by Congress.
HOW INTELLECTUAL PROPERTY LAW AFFECTS REPRESENTATIONS 6.11
Copyright law recognizes the concept of coauthorship by two otherwise unrelated parties. A company that believes it is the sole owner of a mark may be subject to a claim that a contributor to that work is a coauthor, and therefore, a co-owner. A seller needs to take all of these principles into account in making representations, and a buyer needs to understand these principles in order to ask the right questions. Trade Secrets. Trade secret protection in the United States is a creature of state law,
although the enactment of model laws provides some uniformity. Some countries outside the United States provide little or no protection for trade secrets. Thus, multinational companies will have to consider carefully what representations they can make about trade secret protection. Rights of Publicity. The right of an individual to prevent the commercial use of his
name and likeness is also a creature of state law in the United States, with considerable variance in scope from state to state. Some states provide no protection for the deceased, and those that do provide it for varying terms after death. Laws outside the United States can be very different. Multinational companies that have endorsement licenses from celebrities or may use celebrity names and likenesses in some markets without permission are dealing with multiple conflicting legal regimes in making representations about compliance with right of publicity law. Industrial Design Rights. Many countries afford protection for the appearance of products in the form of industrial design registration, which is analogous in some ways to a U.S. design patent. For some businesses, this type of protection can be important, but because it does not exist in the United States, American lawyers sometimes neglect to include it in the definition of intellectual property or to ask for a schedule of the seller’s design registrations. Internet-Related Assets. The advent of websites has raised new complications for the
drafting and negotiation of representations and warranties. While most websites began as static, electronic versions of a company’s hard copy brochure, today’s sites contain sophisticated features, graphics, and audio-visual content. As the content has become increasingly complex, the amount of intellectual property used in creating and operating a website has increased dramatically, and the potential for infringement disputes has grown. For example: • The high-tech features of state-of-the-art sites require sophisticated software, which may be protected by both copyrights and patents. If the software was not developed in-house, the buyer will require licenses sufficient to permit current and intended uses. • Certain aspects of the way a website business operates may be sufficiently innovative to merit patent protection, and the seller’s website may inadvertently infringe upon an existing patent or may later be discovered to infringe upon an invention that, at the time of the sale, appears only in a pending, nonpublic patent application.
6.12 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS
• Music, photography, text, graphics, and other creative website content are protected by copyright. Some companies take inadequate measures to acquire the third-party permissions necessary to incorporate such material into the website. • Websites that incorporate chat room or bulletin board features may create opportunities for users to post infringing or defamatory content. While many of these potential challenges will be covered under the traditional representations that a seller makes about whether its business is infringing upon the intellectual property rights of others, such language does not cover all the potential claims. Many domain name disputes are framed as trademark dilution claims or administrative proceedings rather than trademark infringement claims, which means that disclosures or representations that refer only to “infringement” may be incomplete. Real-time use of hot news information compiled by others may even draw a claim of misappropriation. Finally, the global nature of the Internet creates new hazards. Offering goods for sale in all 50 states, and beyond the United States, creates exposure under state and foreign consumer protection, tax, and obscenity laws. Buyer and seller will need to negotiate responsibility for those past liabilities. NEGOTIATING REPRESENTATIONS AND WARRANTIES
The parties’ lawyers typically spend more time in negotiating representations and warranties than in any other part of the acquisition agreement. From the buyer’s standpoint, this language is important because the buyer has made certain assumptions about the business, and the wisdom of entering into the transaction hinges on those assumptions being correct. If those assumptions prove wrong, the buyer may discover that it cannot make money at the business, or at least that it overpaid. From an intellectual property standpoint, the buyer may be making a whole range of assumptions about the extent to which it can use the acquired technology, trademarks, and copyrighted works without interference from others. The due diligence process will help shed light on the limitations of the seller’s intellectual property portfolio, but the reps and warranties are often used to smoke out the problems that require further investigation. The list of questions that buyers want answered is fairly standard, but the manner in which those questions are answered via representations varies considerably from transaction to transaction. The clarity and detail of the answers depends upon the structure of the transaction, the parties’ relative bargaining power, and counsel’s negotiating and drafting skills. For example, in an auction situation where a seller puts itself or its business up for bid, the potential buyers may have very limited opportunities to negotiate disclosures. In contrast, reps and warranties are likely to be more hotly contested in a one-on-one negotiation. The typical transactions lawyer has two standard form agreements to be used as the starting point in negotiating the sale of a business—one form whose terms are favorable to the company selling the business and another, which favors the buyer of the business. In general, the buyer will want blanket statements that give it comfort that, among other things, (1) it will be acquiring all of the intellectual property it will need to run the business going forward; (2) the seller has good title to the intellectual property and can convey title to the buyer free of any encumbrances; (3) the seller has provided complete
NEGOTIATING REPRESENTATIONS AND WARRANTIES 6.13
and accurate lists of all intellectual property; (4) the seller’s use of the intellectual property does not violate any third-party rights, and the seller has not received any claims to that effect; (5) the buyer’s use of the intellectual property will not violate any thirdparty rights; and (6) there are no licenses, consents, judgments, settlements, or other constraints on the use of the intellectual property. If life were so simple, lawyers would have nothing to do. For a variety of reasons, the seller will often want to modify or qualify the representations that the buyer proposes, including the following: • Intellectual property law has become an increasingly contentious field. For large companies in particular, it will be rare that a seller has nothing to disclose in terms of claims, disputes, licenses, consents, judgments, or settlements. • Intellectual property is often subject to liens, and the seller typically discloses that such encumbrances exist, linked with the condition that the debt will be satisfied at closing and the lender will release the lien. • The buyer’s proposed language may be so sweeping that it does not accommodate the quirks and inconsistencies in intellectual property law. • The seller may not wish to become the buyer’s guarantor as to the soundness of the intellectual property portfolio and may resist making certain representations on that principle. Sellers sometimes try to qualify the content of representations either by limiting them to the client’s knowledge or by limiting them as to materiality. For example, rather than asserting that its use of certain intellectual property does not infringe, a seller may offer to qualify the fact by representing that no infringement exists to the best of its knowledge. A materiality qualification can be used in two different ways. A seller may resist a representation that a schedule of trademarks or license agreements is complete and accurate, and offers, instead, to provide a list of marks or licenses that are material to the business. A different type of materiality standard is applied to representations involving breach or liability. For example, rather than stating that it is in complete compliance with all licenses, a seller may represent that it has not committed any material breach (or perhaps even limit that statement to material licenses). The reps and warranties in a buyer-oriented agreement are, needless to say, often over-reaching and likely to be more extensive than in the seller-oriented form. However, they sometimes contain serious omissions, failing to ask the right questions about the intellectual property being acquired. Many commonly used representations fail to take into account the substantive differences between the different types of intellectual property assets, asking the buyer to make broad-brush statements about intellectual property that may be relevant to patents, for example, but not trademarks or copyrights. Thus, some seemingly innocuous representations in acquisition agreements are in fact, wildly overbroad and impossible for a seller to make. Other representations, which appear at first glance to be adequate, are in fact deceivingly narrow and fail to elicit important information about particular types of intellectual property. The following are examples of provisions from acquisition agreements that are not what they seem at first glance. First are examples of those that are over-reaching.
6.14 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS The attached schedule sets forth an accurate and complete list of all of Seller’s intellectual property.
As noted, if a buyer is acquiring the assets of a particular business rather than the entire corporation, it will want as exhaustive and detailed a list of those assets as possible in order to avoid future disputes about what was acquired and what the seller retained—thus, the request for an “accurate and complete list.” It is virtually impossible, however, for a seller to make this representation if the acquisition agreement defines “intellectual property” to include such categories as trade secrets and copyrights. Few, if any, companies could define and catalog every item of confidential information and business know-how that they consider to be proprietary. The same goes for copyright, which protects every work of authorship created by an employee, including such prosaic items as internal memoranda, and therefore applies to countless works at the typical company. (Corporate lawyers sometimes assume that this representation is easy to make because they mistakenly assume that copyright protection only attaches when the copyright is registered). Even trademarks can be difficult to exhaustively schedule, since a company may use minor brand names and advertising slogans that it has not bothered to register or catalog. In addition, the appearance of products, packaging, and perhaps even retail facilities may constitute trade dress that is difficult to describe on a schedule. Thus, among these traditional categories of intellectual property, only patents can be exhaustively listed, since patents only come into existence when issued by a governmental office. In contrast, copyrights, trade secrets, and trademarks are products of the user’s creation or use, at least in the United States, without the need for registration. What is the typical solution? The seller represents that the schedule contains a complete list of all patents, registered trademarks, copyrights (including pending applications for registration), and perhaps material unregistered marks, as well. Even with patents and trademark registrations, however, many very large companies whose portfolios number in the thousands are reluctant to present their records as precisely and accurately cataloging every issued patent and registered trademark, and are willing to represent only that the list contains material patents and trademarks. The use of the intellectual property in the business does not infringe upon any patent, trademark, copyright, or other intellectual property of a third party.
In order to infringe upon another party’s copyrights or trade secrets, a company must first have access to those copyrighted works or secret information. This is not so with patents and trademarks. A company could infringe upon a third party’s trademarks or patents without even being aware that such rights exist. Most companies do conduct searches of prior third-party rights as part of the process of adopting a new trademark, and searches are an integral part of the process of securing a patent. However, such searches have significant blind spots at the time they are conducted and can rapidly become obsolete, making it impossible to know for certain whether a patent or trademark infringement claim is lurking. Even with copyright and trade secret claims, a company cannot be certain whether an employee has engaged in copyright or trade secret infringement without management’s knowledge.
NEGOTIATING REPRESENTATIONS AND WARRANTIES 6.15
Finally, a determination of infringement inevitably involves subjective determinations. Thus, a seller that is asked to represent that its intellectual property does not infringe is, in effect, issuing a guarantee to the buyer. The seller instead seeks to represent that it has not received any claims or that it is not aware of the basis for any claims. Seller has taken such actions as are necessary to ensure full protection of the intellectual property under any applicable laws.
The fundamental problem with this representation is that it does not define what actions the seller must have taken “to ensure full protection,” leaving the potential for future dispute about what was required. A logical interpretation is that this phrase means that the seller has registered its trademarks in every jurisdiction in which they are used, obtained patents wherever it sells, and registered its copyrights in the United States. This is seldom likely to be true for any seller, for several reasons. Trademark registration is discretionary in the United States and other common law countries. While registration confers certain benefits, a company could reasonably conclude that the expense of registering every mark is not commensurate with the benefits. Registration can be much more important in countries that afford little or no protection for unregistered marks, such that it will be important for the buyer to know if a mark is unregistered in major markets such as continental Europe or Southeast Asia. Similarly, since no patent protection is available except where a patent has issued, the buyer will want to know where the seller has obtained such protection. However, few companies have chosen to shoulder the expense of registering every mark and extending every patent to every country. Copyright registration is a creature of U.S. law and is discretionary—whether to register is very much a judgment call, depending upon the nature of the work and the nature of the business. A publishing or media company might be expected to have a large number of copyright registrations, but other types of businesses might reasonably have none. In sum, a seller should refuse to give this representation on the grounds that it is ambiguous and highly unlikely to be accurate, and the buyer will want to tailor it more precisely to reflect the nature of the business and its geographic scope. The following are examples of provisions that appear to provide the buyer with broad assurances, but in fact fail to elicit important information. Seller owns or possesses licenses or other rights to use all intellectual property necessary to conduct its business.
Most companies are not in a position to create and develop all of the intellectual property required to operate the business and must license some of it from third parties. Most standard-form warranty language recognizes this, but it does not always require the seller to clearly distinguish between what is owned and what is licensed. The buyer will want detailed disclosure of what is licensed so that it can determine which of those licenses are transferable to the buyer without the licensor’s permission, how long each license lasts, what royalties are required, and what limits are imposed on use. The seller may have been asked elsewhere in the agreement to disclose certain contracts and agreements, but that warranty may not necessarily encompass all of the company’s licenses of intellectual property.
6.16 INTELLECTUAL PROPERTY ASPECTS OF ACQUISITIONS Immediately after the closing, Buyer will own or have the exclusive right to use all of the intellectual property free from any liens, mortgages, or similar encumbrances.
Intellectual property often comes with strings attached, and those strings aren’t just liens or other encumbrances on title. As previously discussed, intellectual property that is licensed to the seller has various limitations. While this representation seeks to uncover any restrictions on assignability of licenses, it misses the sometimes significant strings attached to the intellectual property that the seller owns. For example, in order to resolve disputes, companies often enter into settlement or consent agreements that restrict the use of intellectual property. A company may have agreed to refrain from using a mark in a particular geographic or product market, only with a particular logo, or in combination with another mark. Similarly, the company may only have the right to use a licensed patent in connection with the manufacture or distribution of certain specific goods. This warranty does not require the seller to disclose such restrictions. Though the acquisition agreement most likely contains a separate section calling for disclosures on litigation, asking the seller to disclose court judgments, it may not call for documents such as trademark consent agreements, which often result from trademark prosecution, rather than litigation. Seller has not received any claims from third parties alleging that its use of any intellectual property infringes upon the rights of any third party.
This clause requests information on “incoming” infringement claims but fails to ask about “outgoing” infringement claims (i.e., third parties who are allegedly infringing upon the seller’s intellectual property rights). These claims sometimes can be as troublesome as claims against the seller, and often as expensive. In addition, using the term “infringe” is too limiting, since it does not encompass other types of incoming intellectual property-related claims such as trademark dilution. Finally, by focusing only on third-party claims, this representation fails to seek the disclosure of problems that may have arisen in patent or trademark prosecution (e.g., refusals to register marks on the grounds that they are not protectible or are confusingly similar to other marks). The buyer will need this information to get a complete picture of the intellectual property portfolio it is acquiring. INDEMNIFICATION
What happens if the seller’s representations turn out to be inaccurate? Often, but not always, the acquisition agreement provides that the seller will indemnify the buyer if the seller’s representations and warranties prove inaccurate. Although the typical indemnification clause does not specifically refer to intellectual property issues, counsel should be aware of the terms of the indemnification provision when negotiating intellectual property representations and warranties, since this provision will determine the consequences of breach. Although indemnification obligations can be mutual, the buyer generally stands to lose much more from the other party’s misrepresentations, so the buyer depends more heavily on the protection afforded by an indemnification clause.
ENDNOTE 6.17
Broadly speaking, a misrepresentation by the seller can injure the buyer in two ways. First, the buyer may not receive an asset specified in the acquisition agreement, such as a scheduled trademark that was previously sold to a third party. Second, the buyer may inherit a liability that was not disclosed, such as a royalty due on an inbound patent license. Although contract law may provide a remedy even in the absence of an indemnification provision, the buyer will likely insist on an indemnification clause in order to specify the duration of the seller’s representations, to ensure that the seller’s liability extends to expenses such as attorney’s fees, and otherwise to define the scope of the seller’s obligations. In negotiating representations and warranties, intellectual property counsel need to understand the nature of the transaction and the indemnification provisions, if any. There is no indemnification in acquisitions of public companies, and the representations evaporate after closing. The significance of the buyer’s preclosing due diligence (discussed in Chapter 8) is thus magnified. In other transactions, the seller may continue to be liable, but subject to various types of limitations. In negotiating the indemnification clause, the seller typically looks to include a basket that will limit its liability to material misrepresentations. The term “basket” can refer to one or both of two distinct types of arrangement, so it is important to examine the indemnification provision carefully to understand the seller’s obligation. In one type of arrangement, the buyer is not obligated to indemnify the seller unless damages reach a certain threshold amount. When the threshold is exceeded, the seller is liable for the first dollar of damages and every dollar thereafter. By contrast, if the parties structure the basket as a deductible, the seller will be liable only for damages in excess of the specified amount. On the other end of the liability spectrum, the seller may request a cap or ceiling that sets a maximum amount of liability under the indemnification clause. Because the agreement may specify that baskets and caps apply to certain types of claims but not to others, misrepresentations relating to intellectual property may have different consequences than misrepresentations in other areas. Just as the seller will seek to limit liability with a basket and cap, it will also try to negotiate a cut-off time to limit the period during which the indemnification obligation endures. If, for example, the seller remains liable for third-party intellectual property infringement claims arising prior to closing, it will want to limit the time during which the buyer can assert an indemnification claim. In addition to terms defining the scope of the indemnification obligation, the acquisition agreement may include provisions for ensuring collection, including escrows and procedures for offsetting against a deferred purchase price. The agreement may also specify which party controls the defense of a third-party claim covered by an indemnification obligation. ENDNOTE 1
17 U.S.C. § 204(a).
CHAPTER
7
U.S. ANTITRUST AND INTELLECTUAL PROPERTY IN MERGERS AND ACQUISITIONS Thomas G. Jackson Phillips Nizer Benjamin Krim & Ballon LLP
INTRODUCTION
The intellectual property laws—in particular, the patent and copyright laws and trade secrecy protection—and antitrust laws share a common purpose: namely, to promote innovation and enhance consumer welfare.1 Yet, as former Federal Trade Commission Chairman Robert Pitofsky recognized in a recent address, the relationship between antitrust policy and intellectual property is very much an unresolved issue “at the heart of the ‘New Economy.’”2 Although antitrust policy has made significant progress in understanding the New Economy and taken into account the need to protect incentives and opportunities to innovate, Pitofsky acknowledged in his address that “much remains to be done.”3 He noted that products and services based on intellectual property are typically characterized by large initial investments (fixed costs) and relatively low costs associated with producing goods or providing services (variable costs), thereby encouraging sellers to reduce price to acquire additional sales. This, in turn, requires potential competition to acquire intellectual property and increase sales beneficial to consumers. Despite this, however, the fundamental nature of competition in markets based on intellectual property often tends toward single firm dominance and, possibly, monopoly. This is largely a result of the patent and copyright protections provided for intellectual property, which preclude competition for a period of time, and the fact that individual demand for a particular product or service is often driven by its use by others, making the product or service more useful as a greater number of individuals begin to use it.4 A central theme given increasing emphasis over at least the past decade in antitrust policy, generally, and merger regulation, in particular, is the need to balance efforts aimed at protecting incentives to innovate with policies directed toward ensuring that consumers are given a reasonable range of choices in the marketplace and are protected to the extent practical from higher prices. Summarizing the principles governing antitrust policy in the area of intellectual property, former Assistant Attorney General, Antitrust Division, Anne Bingaman said: 7.1
7.2
U.S. ANTITRUST AND INTELLECTUAL PROPERTY
The intellectual property laws and the antitrust laws share the common purpose of promoting “innovation, industry, and competition.” The intellectual property laws provide incentives for innovation by establishing enforceable property rights for the creators of new and useful products and more efficient processes. The antitrust laws promote innovation and consumer welfare by ensuring that owners of intellectual property rights do not abuse those rights, for example, to suppress competition in alternate technologies and adjacent markets. . . . The bedrock principle of our policy towards intellectual property is that we treat it as we treat any other form of tangible or intangible property. Intellectual property is not exempt from the application of the antitrust laws, nor particularly suspect under them. While an owner of intellectual property is given certain rights to exclude competitors by intellectual property law, the right to exclude is bounded by the prohibitions of the Sherman and Clayton Acts, which can prohibit the owner from using those rights to suppress competition from alternative technologies. This limiting of rights is no different than the case for any other property owner. We will not presume monopoly power solely from the existence of an intellectual property right. If a specific form of intellectual property does confer a significant competitive advantage on its owner, that advantage is no more in conflict with the antitrust laws than one created by any other asset that enables its owners to earn supracompetitive profits. Judge Leamed Hand’s statement in Alcoa made more than fifty years ago that the Sherman Act is not violated by the attainment of power solely through “superior skill, foresight and industry”5 remains apt today with respect to the types of innovation protected by intellectual property rights.6
Although a variety of efforts have been made to address these often-competing interests, the concern still exists that a considerable degree of uncertainty that may, in itself, at times create a disincentive to innovate, remains as to the application of antitrust policies to intellectual property rights.7 ENFORCEMENT AGENCY POLICIES Horizontal Merger Guidelines. The U.S. Department of Justice and Federal Trade
Commission Horizontal Merger Guidelines issued in 1992 were reissued in revised form in 1997 to give a greater degree of importance in merger analysis to the potential of generating significant efficiencies resulting in the development of new and improved products and the ability to introduce innovative products more efficiently. At the same time, the guidelines recognize that efficiencies relating to research and development, although potentially significant, are inherently less susceptible to verification and may be the result of anticompetitive reductions in output.8 Under the Horizontal Merger Guidelines, the less likely anticompetitive effects are found to be, in the absence of efficiencies, the greater the weight that is likely to be given to potential efficiencies in the merger analysis. Non-Horizontal Merger Guidelines. Originally issued in 1984 as section 4 of the U.S. Department of Justice Merger Guidelines, all other sections of which were superceded by the Horizontal Merger Guidelines, the Non-Horizontal Merger Guidelines, dealing with the prospective harm to actual or perceived potential competition of the merger of a firm in a relevant market with a potential entrant to the market, recognize that expected efficiencies will be considered in determining whether to challenge a vertical merger. Also, because a substantial degree of vertical integration may be indicative of
INTELLECTUAL PROPERTY ISSUES IN MERGER CASES 7.3
resulting efficiencies, claims of such efficiencies will generally be given greater weight in determining whether to challenge a vertical merger than in analyzing a horizontal merger.9 Antitrust Guidelines for the Licensing of Intellectual Property. Unlike nonexclusive licensing arrangements, complete or exclusive acquisitions of intellectual property rights are analyzed under the U.S. Department of Justice and Federal Trade Commission Guidelines for the Licensing of Intellectual Property (Intellectual Property Guidelines), issued in 1995, by applying the principles and standards of the Horizontal Merger Guidelines.10 On the other hand, where a nonexclusive licensing arrangement is found to have, or be likely to have, an anticompetitive effect, the enforcement agencies will first consider whether the restraint is reasonably necessary to achieve procompetitive efficiencies, and, if the restraint is found to be reasonably necessary, will balance the procompetitive efficiencies and anticompetitive effects to determine the probable net effect on competition in a relevant market.11 Antitrust Guidelines for Collaborations Among Competitors. In nonmerger contexts, the
U.S. Department of Justice and Federal Trade Commission Antitrust Guidelines for Collaborations Among Competitors issued in 2000 recognize that most joint research and development agreements are procompetitive and “[t]hrough the combination of complementary assets, technology or know-how, an R&D collaboration may enable participants more quickly or more efficiently to research and develop new or improved goods, services, or production processes.”12 INTELLECTUAL PROPERTY ISSUES IN MERGER CASES Horizontal Mergers and Joint Ventures. Horizontal mergers and joint ventures between companies with overlapping or complementary intellectual property are typically defended on the ground that the combined entity will be able to introduce innovative products more efficiently. The argument is most effective where levels of concentration and barriers to entry are relatively low, and the potential anticompetitive effects are therefore limited. Where market shares and levels of concentration are high, effects on innovation are far less likely to justify the proposed combination. For example, in Lilly-Sepracor, Eli Lilly, the manufacturer of the widely used antidepressant Prozac, sought an exclusive license to the rights to R-fluoxetine, a followon and allegedly superior product, to which Sepracor, a relatively small pharmaceutical company, holds the patent. Among the concerns with the transaction was the possibility “that Lilly could introduce R-fluoxetine shortly before its own patent is due to expire in 2004, and attempt to shift its Prozac market share to the new antidepressant drug, on which the patent is not due to expire until 2015, thereby reducing the potential effect of generic competition on Lilly’s overall market share.” A second concern was the potential effect on competition of a market leader such as Lilly acquiring the exclusive rights to a similar, potentially competing product that would otherwise be marketed by a separate, smaller firm. Following a lengthy investigation, the Commission ultimately voted not to authorize a complaint.13 Largely based upon the uncertainties as
7.4
U.S. ANTITRUST AND INTELLECTUAL PROPERTY
to whether the follow-on drug would receive FDA approval, when it would come to market, whether and to what extent Lilly’s patent on Prozac would have blocked marketing of the follow-on drug, and whether it represented a meaningful advance over Prozac, the arrangement was not challenged. Not only did Prozac face other competitors with significant market shares, but other generic manufacturers were ready to challenge Prozac when Lilly’s patent on the drug expired in 2004, and Lilly’s distribution resources and scientific expertise made it likely that it would bring this new drug to the market more promptly than would otherwise be the case. Therefore, the proposed transaction was not challenged.14 In another case, Ciba-Sandoz,15 Ciba-Geigy and Sandoz, the two leading developers of gene therapy products, agreed to merge to form Novartis A.G. Although at the time of the proposed merger, no gene therapy products were on the market, potential treatments were being evaluated in clinical trials. In one of the relevant markets, the Commission alleged that Ciba and Sandoz controlled the intellectual property rights needed to commercialize gene therapy products and asserted that the four other relevant markets were highly concentrated; that entry into the relevant markets was costly, timeconsuming and difficult, requiring patent rights, significant capital, and FDA approval; and that Ciba and Sandoz were the dominant developers. The majority of the Commission concluded in these circumstances that preserving long-run innovation was critical and that the development of potentially life-saving therapies could be hindered if the combined firm were permitted to control virtually all of the intellectual property rights needed to commercialize the products. In the settlement agreement that was reached, Ciba and Sandoz were required to license gene therapy technology, knowhow, and patents to another firm, Rhône-Poulenc Rorer, to ensure that it would be able to compete against Novartis, thereby resolving the agency’s antitrust concerns. In Glaxo-Wellcome,16 another case involving the research and development of pharmaceuticals, the Commission challenged a proposed acquisition in what it alleged was the highly concentrated market for a specific type of treatment of migraine headaches. It alleged that the acquisition would eliminate competition between the two companies in the research and development of migraine remedies. In a settlement with the agency, the two companies agreed that the combined firm would divest patents, technology, manufacturing information, testing data, research materials, and customer lists relating to the research and development of migraine remedies to a third firm, Zeneca Pharmaceuticals, to ensure continued research and development of Wellcome’s potential product in the same manner as if the proposed acquisition had not taken place. In United States v. Compuware Corp.,17 the Antitrust Division sued to enjoin Compuware—the leading producer of mainframe production testing and debugging software and fault management software—from acquiring Viasoft—Compuware’s closest rival in the testing/debugging software market and a recent entrant in the fault management software market. The complaint alleged that at the time of the proposed acquisition, Compuware had a market share of over 80 percent of the fault management market and approximately a 60 percent share of the testing/debugging software market. Viasoft’s SmartTest software, which generated approximately $20 million in revenues, was one of only two competitors to Compuware in the testing/debugging software market, with total revenues from its XPEDITER software of approximately $33 million. Compuware’s Abend-AID fault management software accounted for over $230 million in revenues and, according to the complaint, Viasoft’s SmartQuest fault management
INTELLECTUAL PROPERTY ISSUES IN MERGER CASES 7.5
product, which had been introduced earlier the same year, had begun to attract customers away from Compuware. In addition, Viasoft was preparing to integrate its testing/ debugging and fault management products to compete with Compuware for customers who prefered integrated testing/debugging and fault management software. The complaint alleged that the proposed acquisition would eliminate the closest of Compuware’s only two significant competitors in the testing/debugging software market and the only rival posing a potentially significant competitive threat in the fault management software market, lessening competition and resulting in higher prices, lower levels of service and support, and less innovation in product development. In addition, the complaint alleged that the markets for mainframe systems software are mature with relatively static demand, dominated by an entrenched incumbent. A new entrant, therefore, would require substantial time and money to develop and test competitive products and acquire a sufficient reputation to overcome user reluctance to switch to an unproven vendor, which would make new entry unlikely, untimely, or insufficient in scale to prevent an increase in prices or reduction in service, support, or product development in the relevant markets. The parties abandoned the merger approximately three months after the action was commenced, shortly before the date when the trial was scheduled to begin. Vertical Mergers. In Silicon Graphics,18 the Commission challenged the proposed acqui-
sition by Silicon Graphics—the largest producer of entertainment graphics workstations, which according to the Commission’s complaint had a 90 percent share of the market—of Alias Research and Wavefront Technologies, two independent producers of entertainment graphics software. The two companies, with a combined market share of a highly concentrated market in excess of 90 percent, had only one competitor—a subsidiary of Microsoft. The Commission’s primary concerns were the foreclosure of rival workstation manufacturers in competing effectively if Alias and Wavefront designed their software to be compatible with Silicon Graphics’ workstations, and the foreclosure of rival entertainment graphics software producers from 90 percent of their market if Silicon Graphics closed its open software interface so that only Alias and Wavefront were permitted to design compatible software. The Commission was also concerned that if Silicon Graphics continued to permit Alias and Wavefront to work with rival workstation manufacturers to develop complementary products, Silicon Graphics could use proprietary information disclosed in the course of product development to obtain an unfair competitive advantage over its rivals. The Commission also recognized that there was strong evidence that the proposed combination of companies with complementary offerings would lead to important innovation. To permit these potential efficiencies to be achieved while, at the same time, maintaining competition, the Commission negotiated a consent order allowing the merger to proceed, subject to the conditions that: (1) the merged entity would be required to enter into an approved porting agreement with a rival workstation manufacturer and use its best efforts to ensure optimal interoperability of Alias’ software programs with the rival’s workstations; (2) Alias and Wavefront would be prohibited from transferring proprietary information from rival workstation manufacturers to Silicon Graphics; and (3) Silicon Graphics would be required to maintain an open architecture, publish its application programming interfaces (APIs) for its workstations, and refrain from discriminating against Alias’ and Wavefront’s rivals.
7.6
U.S. ANTITRUST AND INTELLECTUAL PROPERTY
Mergers Involving Horizontal and Vertical Restraints. In AOL-Time Warner,19 the
Commission challenged the proposed merger of America Online (AOL)—the largest Internet service provider (ISP), with a share of approximately 50 percent of dial-up (narrowband) subscribers—and Time Warner—a media conglomerate that operates cable television systems serving approximately 20 percent of U.S. cable households. Through a controlling interest in its partially owned Road Runner subsidiary, Time Warner provided broadband Internet access service to subscribers in areas served by its cable television systems. The Commission’s complaint alleged that Time Warner was a significant competitor in each of those areas. AOL also provided broadband Internet access, primarily over noncable broadband transmission facilities using digital subscriber line (DSL) technology to connect its broadband subscribers to the Internet. AOL was also a recent entrant in the Interactive Television (ITV) market, which blends data with video signal for display on televisions to combine Internet functionality with television and cable programming. AOL was perceived by many industry observers and regulators as likely to become the leading provider of broadband Internet access and positioned well to become a leading provider of ITV services. The Commission alleged that the proposed merger would lessen competition in the residential broadband Internet access market, undermine AOL’s incentive to promote DSL broadband Internet service as an emerging alternative to cable broadband in areas served by Time Warner’s cable television systems, and restrain competition in the delivery of ITV services. The merger was permitted to go forward, subject to the terms of a consent order that (1) required AOL-Time Warner to open its cable systems to competitor ISPs; (2) prohibited it from interfering with content delivered by nonaffiliated ISPs and the ability of nonaffiliated providers of ITV services to interact with signals, triggers, and content carried by AOL-Time Warner; (3) prevented it from discriminating on the basis of affiliation in the transmission of content; (4) prohibited it from entering into exclusive arrangements with other cable companies with respect to ISP or ITV services; and (5) required it to offer and market AOL’s DSL services in areas served by Time Warner’s cable systems where affiliated cable broadband ISP service is made available in the same manner and at the same retail pricing as it does in those areas where affiliated cable broadband ISP service is not available. Under the terms of the order, AOL-Time Warner was required to make the competing cable broadband service of Earthlink, the second largest ISP, available to subscribers in its largest cable markets before it could make AOL’s cable broadband service available to those subscribers. AOL-Time Warner was also required to enter into agreements with at least two other nonaffiliated ISPs within 90 days of making AOL’s cable broadband service available to subscribers in those markets on terms comparable to its agreement with Earthlink or any other agreement between AOL and a nonaffiliated cable company to provide AOL’s broadband service over that company’s systems. Another requirement was that AOL-Time Warner negotiate in good faith and enter into arms’ length agreements with other ISPs seeking to provide cable broadband service on its systems. These agreements would be subject to refusal only on the basis of capacity, business, and technical constraints, other than the potential decrease in AOL’s subscribers that might result from adding competing ISPs. Other provisions require AOL-Time Warner’s noninterference with competing ITV services and its charging the same or comparable prices for its DSL service in areas
ENDNOTES 7.7
where it provides cable broadband service to areas where it is not offering cable broadband service, subject to pricing differences that reflect actual differences in its transmission costs. A particularly striking aspect of the settlement is the limited duration of the consent order—five years—which is believed to be the shortest duration of any consent order entered into by either the Commission or the Antitrust Division.20 Taking into account both the actual and the likely future increase in competitive offerings, the fact that ITV is largely in its infancy, and the uncertainty of the competitive effects of future developments in these markets, the Commission attempted to strike a balance between protecting incentives to innovate and providing consumers with a degree of protection from higher prices while ensuring consumers a reasonable range of choices in the marketplace. Exclusive Licensing. Under the Intellectual Property Guidelines, exclusive licensing agreements and transfers of intellectual property rights are analyzed under standards similar to the analysis of the actual and potential anticompetitive effects of mergers and acquisitions.21 The acquisition of an exclusive license—one that precludes all other persons, including the licensor, from using the intellectual property—is treated as the acquisition of an asset for purposes of the reporting and waiting period requirements of the Hart-Scoft-Rodino Antitrust Improvements Act of 1976, if the other requirements of the statute are met.22 The Intellectual Property Guidelines state that, absent extraordinary circumstances, the Antitrust Division and Commission will not challenge a nonexclusive licensing arrangement if (1) the actual or potential restraint is not of a kind that always or almost always would tend to reduce output and increase prices (i.e., “facially anticompetitive”) and (2) the licensor and its licensees account for no more than 20 percent of each relevant market significantly affected by the restraint. Under this rule, the so-called antitrust “safety zone” does not apply to exclusive licenses and outright transfers of intellectual property rights.23
CONCLUSION
As global economic and regulatory pressures continue to mount, and the importance of technology in driving economic growth continues to grow, the attention given by antitrust enforcement agencies to intellectual property issues continues to increase while the treatment of intellectual property in merger analysis continues to evolve and mature. ENDNOTES 1
U.S. Department of Justice and Federal Trade Commission, Antitrust Guidelines for the Licensing of Intellectual Property § 110, n. 8., citing Atari Games Corp. v. Nintendo of America, Inc., 897 F.2d 1572, 1576 (Fed. Cir. 1990). 2 Robert Pitofsky, “Antitrust and Intellectual Property: Unresolved Issues at the Heart of the New Economy,” Address at the Antitrust Technology and Intellectual Property Conference of the Berkeley Center for Law and Technology, University of California, Berkeley, March 2, 2001. 3 Ibid. 4 Ibid.
7.8 5
U.S. ANTITRUST AND INTELLECTUAL PROPERTY
United States v. Aluminum Co. of America, 148 F.2d 416, 430 (2d Cir. 1945). Anne K. Bingaman, Report from the Antitrust Division, Spring 1994, Address at the American Bar Association Antitrust Spring Meeting in Washington, D.C. (April 8, 1994). 7 Anne K. Bingaman, “Competition and Innovation: Bedrock of the American Economy,” Address at the University of Kansas Law School, Lawrence, Kansas (September 19, 1996). 8 U.S. Department of Justice and Federal Trade Commission, Horizontal Merger Guidelines § 4 (Rev. 1997). 9 U.S. Department of Justice, Non-Horizontal Merger Guidelines § 4.24 (1984). 10 U.S. Department of Justice and Federal Trade Commission, Antitrust Guidelines for the Licensing of Intellectual Property § 5.7 (1995). 11 Intellectual Property Guidelines, § 4.2. 12 Federal Trade Commission and U.S. Department of Justice, Antitrust Guidelines for Collaboration Among Competitors § 3.31(a) (2000). 13 “FTC Completes Review of Lilly Agreement With Sepracor; Votes to Allow Transaction to Close,” PRNewswire, Apr. 13, 2000)
. 14 Pitofsky “Intellectual Property and Antitrust.” See also Sheila F. Anthony, “Riddles and Lessons from the Prescription Drug Wars: Antitrust Implications of Certain Types of Agreements Involving Intellectual Property,” Address at the American Bar Association “Antitrust and Intellectual Property: The Crossroads” Program, San Francisco, California (June 1, 2000). 15 In re Ciba-Geigy, Ltd., 123 F.T.C. 842 (1997). 16 In re Glaxo P.L.C., 119 F.T.C. 815 (1995). 17 United States v. Compuware Corp., No. 1:99CV02884 (D.D.C., filed Oct. 29, 1999). 18 In re Silicon Graphics, Inc., Dkt. No. C-3626 (Nov. 14, 1995). 19 In re America Online, Inc. and Time Warner Inc., Dkt No. C-3989 (Dec. 14, 2000). 20 Pitofsky “Intellectual Property and Antitrust.” 21 Intellectual Property Guidelines, § 5.7. 22 See Edward G. Beister, III, Overview of Intellectual Property and Antitrust American Bar Association Section, Antitrust Law Intellectual Property Committee Newsletter 7 (Spring 2000); American Bar Association Section, Antitrust Law, Premerger Notification Practice Manual, Interpretations 49, 129 and 151, 2d ed. (1991). 23 Intellectual Property Guidelines, § 4.3, 5.7 n. 38. 6
CHAPTER
8
INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE IN BUSINESS TRANSACTIONS Sheldon Burshtein Blake, Cassels & Graydon LLP
INTRODUCTION
This chapter discusses intellectual property and technology, including information technology due diligence in business transactions.1 This chapter is meant to provide an overview of the types of issues that should be considered in relation to intellectual property and technology during the due diligence process in a commercial transaction. There is no legal analysis; instead, the focus is on assembling a summary of the considerations that arise in the two most typical types of commercial transaction purchases: share and asset. More specific types of transactions require special consideration. This chapter does not consider transactions in which intellectual property and technology are the primary focus, such as license and technology transfer agreements, although many of the considerations discussed also apply to those arrangements. The chapter looks at intellectual property and technology due diligence from a broader, more international approach, without focusing on issues in any particular jurisdiction (although in some cases reference is made to U.S. statutes). A brief checklist of issues to be considered in the due diligence process is presented at the end of most sections. Need for Intellectual Property and Information Technology Due Diligence. There are an
increasing number of corporate divestitures, acquisitions, and reorganizations. Divestitures are now an accepted way to reduce overhead, remove stagnant business lines, restructure a company to avoid hostile takeovers, and increase the value of a company’s stock. Acquisitions diversify businesses, expand product lines, reduce competition, expand markets, and reduce the possibility of a hostile takeover. Reorganizations of corporate groups may be effected either before or with other transactions to satisfy creditors, for tax reasons, or to ready an entity for a subsequent deal. The sale or purchase of a business or product line can be complicated and costly, with tens or hundreds of millions, or even billions, of dollars of shares or business assets changing hands. Often, the seller prepares information packages, due diligence 8.1
8.2
INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
briefs, and even draft documentation for a purchaser in preparation for a sale. After the parties have agreed on the basic terms of the agreement, including the price, the purchaser often has a fixed period of time in which to review all the assets, liabilities, and any other information pertinent to the business prior to execution of the share purchase or asset purchase agreement. This activity is typically referred to as due diligence. (See the legal definition in the next section.) The situation may be the same in a borrowing or share issuing situation. The borrower or issuer, in anticipation of seeking financing or issuing equity, may prepare information packages, due diligence briefs, offering circulars, and prospectus materials. Once a lender or underwriter agrees to pursue the loan or the issue, the lender or underwriter often has a limited time to do due diligence. The due diligence period is usually 30 to 90 days. Therefore, lawyers representing the seller, borrower, or issuer often seek to anticipate the questions and needs of the purchaser, lender, or underwriter. Lawyers for the purchaser, lender, or underwriter must decide which assets and liabilities require the most thorough review. Since the lawyers who are negotiating the transaction on behalf of the parties are usually merger and acquisition and corporate and securities lawyers, their expertise leads them to focus on matters most familiar to them. They often do not appreciate the value or complexity of intellectual property and technology. However, front and center in many of these deals are intellectual property and technology issues with a very visible and important role to be played by the intellectual property and technology lawyer. Historically, minimal, if any, effort was spent reviewing the intellectual property and technology assets and liabilities of the acquired business. This was due primarily to the short duration of the due diligence period, the unfamiliarity of many corporate and securities lawyers with intellectual property and technology matters, and the very subjective nature of assessing such assets and liabilities. Further, in many historical instances, a detailed review of intellectual property and technology rights would be too time-consuming, expensive, and cumbersome for the value received. However, intellectual property and technology rights are often among the most important assets of the acquired business in technology-driven industries (electronics, telecommunications, biotechnology, and pharmaceuticals); brand namebased businesses (food, clothing, and other consumer products); and copyright-based enterprises (software, publishing, entertainment, and the Internet). Intellectual property and technology rights have importance in virtually every other business, too. A hot dog stand on the corner uses a trademark to distinguish its goods and services from those of its competitors on the street and to encourage return trade. A medical clinic licenses a computer program to maintain patient records and to keep track of billings and payments. A Web-hosting business operated by an individual in a basement or a garage may involve not only domestic, but also foreign intellectual property and technology rights. It is not appropriate, and perhaps negligent, to say a business has no intellectual property or technology rights or to give it a too-short shrift in a commercial transaction. Further, the legal liabilities that may result from the infringement of intellectual property or violation of technology rights of others can directly and materially affect the long-term profitability of the business and thus the eventual purchase price, loan value, and share value. This may also affect the liabilities to the seller or borrower under its representations and warranties, the liabilities of the issuer under its offering document, or the ability of the lawyers to sleep at night.
INTRODUCTION 8.3
As the value of intellectual property and technology increases, both inherently and as a percentage of the value of a business’s assets, the significance to business persons and the responsibilities of lawyers related to intellectual property and technology due diligence in a commercial transaction increase. Therefore, purchasers, lenders, and underwriters, as well as advisors to the parties, are increasingly focusing on both the value and strengths and the weakness of the intellectual property and technology portfolio. For this reason, sellers, borrowers, and issuers are also focusing on these issues. What Due Diligence Is. Due diligence may be defined as the “measure of prudence,
activity, or assiduity, as is properly to be expected from, and ordinarily exercised by a reasonable and prudent [person] under the particular circumstances; [Due diligence is] not measured by any absolute standard but depending on the relative facts of this special case.”2 The term has different meanings depending upon the context in which it is used. In the sense used in this chapter, due diligence refers to the process of investigation into the business, legal, and financial affairs of a business sufficient to permit parties to make informed decisions. In the context of acquisitions, for example, it is the process in which the purchaser verifies the claims made in relation to the business, allowing the purchaser to determine whether to make the acquisition. Due diligence also serves to assist the lawyer in drafting or negotiating the agreement of purchase or sale. Identification of the Nature of Primary and Related Transactions. The first step in the due
diligence process is to identify and understand what the deal is. The two most useful questions an intellectual property and technology lawyer can ask a client when first retained on transaction are simple: “What are you doing?” and “Why are you doing it?” The answers to those questions will reveal the client’s perception of the transaction; the value, assets, liabilities, and perceptions of the business being sold, purchased, or financed; and will guide the due diligence inquiry. Sometimes there are a series of transactions. The primary transaction may have related and post-closing transactions. It is important to identify and understand the structure and motives for these. For example, a sale of shares of target company T from seller company S to purchaser company P may be followed by a sale of the assets of T to subsequent buyer company B. The sale of assets, including intellectual property such as trademarks, may be done simultaneously with a license back from B to T to use a key trademark for a transitional period. Lender company L may finance all or some of these transactions as well. If the overall deal is considered only from the perspective of a single transaction, the full picture may not be appreciated and difficulties may result. Therefore, the intellectual property and technology lawyer should request, and the client or commercial lawyer should provide, a complete overview of the whole series of transactions so the intellectual property and technology due diligence strategy can be developed with the big picture in mind. • • • •
Identify the deal. Determine the primary transaction. Determine whether there are related transactions. Determine whether there are post-closing transactions.
8.4
INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
Share Purchase. In a share or stock purchase agreement (a share deal) the purchaser purchases most or all of the shares of the acquired business (the target) from the current shareholders. The agreement is usually between the seller and the purchaser. In a share deal, it may appear that it is not crucial to identify all of the intellectual property and technology assets because they are not changing hands. However, there may have been an intimate flow of technology, proprietary rights, and employees between the target and the seller (as often occurs in large corporate families with interrelating technology). Similarly, the target may have operated using the intellectual property and information technology of a related company without a formal license agreement in place. A careful review should be conducted to assess which intellectual property and technology assets are comprised within the assets of the target. Sometimes, asset transfers or licenses flow from the due diligence findings. It is also crucial to ensure that all contractual relationships survive the transaction, because many intellectual property and technology agreements have provisions that terminate or otherwise affect the relationship upon a change of control.
• Determine whether there is a flow of technology, proprietary rights, and employees between the target and the seller. • Determine whether the target operates using the intellectual property and technology of a related company without a formal license agreement in place. • Determine whether the contractual relationships of the target and the seller will survive the transaction. The other common avenue for acquiring a business is through purchase of assets (an asset deal). In an asset deal, either all or a portion of the assets of the acquired business is transferred to the purchaser. The identification and listing of specific intellectual property and technology assets and liabilities must be complete and accurate. It is crucial to ensure that all contractual relationships can be assigned without termination or other adverse consequences. If not, the agreement may not provide for the transfer of all the assets and rights. Because of this, due diligence becomes even more crucial to identifying all intellectual property and technology assets, rights, and liabilities, whether of record in a public office, contractual, or otherwise. Comprehensive appendices identifying all intellectual property and technology assets and liabilities to be transferred therewith usually accompany the asset purchase agreement.
Asset Purchase.
• Identify and list all specific intellectual property and technology assets and liabilities. • Prepare comprehensive appendices to accompany the purchase of assets agreement. • Determine whether the contractual relationships of the target are assignable. Purchase from Receiver or Trustee. In the case of an intellectual property and information technology purchase from a receiver or trustee, all the issues inherent in an asset deal are present, with a few additional complicating factors. First, one deals with an intermediary and must ensure that the receiver or trustee has title in the assets it pur-
INTRODUCTION 8.5
ports to sell. Second, the deal is usually on an as is, where is basis so that the purchaser buys without any, or with very few, representations and warranties. Third, there are usually a number of creditors to whom money is outstanding who seek any opportunity to grab some asset, right, or value. Fourth, if there is a rare opportunity for due diligence, there is usually very little information or assistance forthcoming because of the state of the financial affairs of the insolvent or bankrupt debtor business. The trustee or receiver may sell all of its rights to the intellectual property and information technology. However, the trustee or receiver may not have all, or even any, rights in the intellectual property or the information technology. One should take particular care if the purchaser expects to obtain an assignment of, or interest under, license or similar agreements. Such agreements frequently do not survive insolvency, bankruptcy, or even the appointment of a receiver or manager. Accordingly, a purchaser may not be getting what it thinks it is. A purchaser must take special care to confirm what portion of the intellectual property and information technology, if any, is covered by the transaction. Otherwise, a purchaser may be in for a nasty surprise, especially if the intellectual property or information technology is an important part of what the purchaser assumes it is getting. When a purchaser buys the assets of a financially troubled, insolvent, or bankrupt business, a review of all the contracts of the insolvent company should, if possible, be done to confirm that the trustee or receiver has the right to sell the assets which are purportedly for sale. • Determine whether the receiver or trustee has title in the assets it purports to sell. • Determine whether there are any representations or warranties, or if the deal is on an as is, where is basis. • Determine whether there is an opportunity for due diligence. • Determine whether there is any information or assistance forthcoming. • Determine whether the agreement has survived insolvency, bankruptcy, or the appointment of a receiver or manager when the receiver or trustee is selling interests under a license or similar agreements. Financing. A financing transaction involves the loan of money to finance an acquisi-
tion of shares or assets. The lender must be concerned about a number of different aspects of the overall transaction. First, it must view the transaction from the perspective of the purchaser to ensure that the purchaser gets the assets it intends in an asset deal or that the target has the assets the purchaser anticipates in a share deal. In addition, the lender must ensure that its interests are protected through both contractual arrangements governing the borrowing and repayment of money and the taking, recordal, and perfection of security interests against the collateral. This ensures that the lender is adequately protected in the event that the borrower defaults on repayment. Financings involving securities also often raise intellectual property and technology due diligence issues. In order to circulate an offering memorandum or a prospectus or to apply for a stock exchange listing, securities legislation requires that the offeror or applicant conduct reasonable investigations into the affairs of the business. Further, the memorandum, prospectus, or application must set out information about the business. Where such assets as brands and technology are material to the business, the position
8.6
INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
of the business must be assessed and reported. In many cases, such as new technology businesses involved in an initial public offering, forecasts and projections (sometimes termed future-oriented financial information) may be relevant. In such cases one must assess not only legal issues, but also business issues related to the intellectual property and technology, such as the true value of the technology, the market environment, the timetable for product introduction, and revenue projections. If the projections turn out to be incorrect, liability for misrepresentation may attach to the issuer, its directors and officers, and their advisors. A defense to such liability is that reasonable investigations were conducted and reasonable projections were made. Therefore, when an intellectual property and technology lawyer represents a lender or an issuer, he or she must look at the transaction from multiple perspectives, including those of a borrower, underwriter, securities regulator, and purchaser of equity. He or she must ensure that the intellectual property and technology assets of the business are properly dealt with and then, if acting for a lender, must ensure that the lender has the appropriate security interests in them. • View the transaction from the perspective of the purchaser to ensure that the purchaser gets the assets it intends. • Check that the lender’s assets are protected through contractual arrangements governing the borrowing and repayment of money. • Check that the lender’s interests are protected through security interests against the intellectual property and technology collateral. • Check that the lender’s interests are protected through the recordal and perfection of security interests against the intellectual property and technology collateral. Due Diligence by Parties Other than the Purchaser Due Diligence by Seller. Intellectual property and information technology due diligence
is increasingly imposed on the seller’s counsel and starts even before a deal is made. Except in those instances where the purchaser approaches the seller offering to purchase a business or product line, the process may begin when the seller decides that it is time to shed a particular business. Often the seller begins by preparing an offering memorandum, which is a document that provides prospective purchasers with an overview of the business. Although preparation of an offering memorandum is principally the responsibility of the commercial lawyers, this is where an intellectual property and technology lawyer may first become involved. Because many companies have discrete businesses operated as divisions or components within divisions, much of the technology and intellectual property supporting these businesses may have migrated into other divisions or businesses. Thus, an accurate definition of the business—and its intellectual property and technology—is needed before the offering memorandum is made available to avoid overlaps with the businesses of other divisions or components being retained by the seller. The intellectual property and technology lawyer needs to carefully review the offering memorandum. For instance, many offering memoranda refer to the intellectual property and technology assets of the business (such as patents, key trade secrets, trademarks, and copyright) and important licensing arrangements. Also, since confidential
INTRODUCTION 8.7
information is sometimes set forth in the offering memorandum, the intellectual property and technology lawyer should advise the seller to require a secrecy agreement from prospective recipients prior to the offering memorandum being sent. The intellectual property and technology lawyer should make certain that there are adequate disclaimers concerning the intellectual property and information technology information disclosed to protect the seller. • Check that any offering document has accurate information on intellectual property and technology issues. • Check that the seller has enough information to support representations and warranties in the agreement. Due Diligence by Borrower. A financing transaction involves the loan of money to
finance an acquisition of shares or assets, or for general business purposes. Where intellectual property or technology is a key asset of the business, these rights will be an important part of the collateral for the loan. Therefore, if it is prudent, the lender will do due diligence on the intellectual property and technology assets. Where the loan is for the purpose of financing an acquisition, the lender must also be concerned about a number of different aspects of the overall transaction. First, it must view the transaction from the perspective of the purchaser to ensure that the purchaser gets the assets it intends in an asset deal or that the target has the assets the purchaser anticipates in a share deal. In addition, the lender must ensure that its interests are protected through both contractual arrangements governing the borrowing and repayment of money and the taking, recordal, and perfection of security interests against the collateral. This ensures that the lender is adequately protected in the event that the borrower defaults on repayment. To facilitate the lending transaction, it will clearly be in the borrower’s interests to have its intellectual property and technology house in order. • Check that the lender has enough information to properly and in a timely fashion effect its intellectual property and technology due diligence. • Check that the representations and warranties in the loan agreement have accurate information about intellectual property and technology. Due Diligence by Issuer. Financings involving securities often raise intellectual prop-
erty and technology due diligence issues. In order to circulate an offering memorandum or a prospectus or to apply for a stock exchange listing, securities legislation requires that the issuer conduct reasonable investigations into the affairs of the business. Further, the memorandum, prospectus, or application must set out information about the business. Where such assets as brands and technology are material to the company, the position of the business must be assessed and reported. In such cases, not only must legal issues be assessed, but also business issues related to the intellectual property and technology (such as the true value of the technology, the market environment, the timetable for product introduction, and revenue projections). If the projections turn out to be incorrect, liability for misrepresentation may attach to the issuer, its directors and officers, and their advisors. A defense to such liability is that reasonable investigations
8.8
INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
were conducted and reasonable projections were made. When an intellectual property and technology lawyer represents an issuer, he or she may also have to consider the perspectives of underwriters, securities regulators, and purchasers of equity. He or she must ensure that the intellectual property and information technology assets of the business are properly dealt with. • Check that any offering document has accurate information about intellectual property and technology issues. • Check that the underwriter has enough information to properly and in a timely fashion effect its intellectual property and technology due diligence. Scope and Cost of Work for Intellectual Property and Technology Due Diligence.
Determining the scope of due diligence is often one of the most difficult decisions but it may be appropriate to a specific transaction. The quantity and quality of review of the intellectual property, technology assets, and liabilities depend on the length of the due diligence period, the financial resources of the client, the importance of intellectual property and technology assets to the business, and other issues. • Determine the value of the transaction. • Determine the importance of intellectual property and technology assets to the target or other client. • Determine the financial resources of the purchaser or other client. • Determine the time period for due diligence. • Determine the scope of due diligence. Time. An obvious constraint in the due diligence process is time. Time is generally not on the side of the purchaser’s counsel. Someone has already decided it wants the business, and most likely wants it yesterday. The seller wants to expedite matters, too. Not only does a fast deal get the seller its money sooner, it reduces the uncertainty among employees and the parties and also exposes the target and the seller to less probing. If the intellectual property and technology lawyer is brought in during the early stages of a 30- or 90-day due diligence period, the type of activity and the quality of due diligence will obviously be very different from that which would be expected when one receives a call for a closing on the same day.
• Determine the time period for due diligence. Cost. The cost of due diligence is usually the most important constraint. The cost of
due diligence is most often dictated by the value of the transaction. For example, if the total legal fee for a transaction is not to exceed $100,000, it would be difficult to argue that the value of the intellectual property and technology component of the work should be $50,000 unless the nature of the business or the transaction is heavily dependent on intellectual property or technology. A few factors should be kept in mind when establishing a budget for due diligence in addition to those discussed in the following sections. One is that intellectual property and information technology due diligence is
INTRODUCTION 8.9
often highly dependent on searches, both locally and abroad. Therefore, disbursements comprise a significant component of the cost in most cases. A second consideration is that intellectual property and technology is, in most cases, likely to be viewed by anyone but the intellectual property and technology lawyer as an annoying factor in the transaction and as relatively unimportant until a problem arises. • Determine the importance of intellectual property and technology to the target and the client. • Determine the value of the transaction. • Consider the expected value of total legal fees. • Consider the high expense of disbursements for intellectual property searches, both domestically and abroad. Nature of the Transaction. The nature of the transaction plays a major role in determin-
ing the approach that should be taken in due diligence. For example, if the transaction involves a management buyout the purchasers presumably know, or at least should be aware of, what the strengths and weaknesses of the target are. The type of transaction may also affect the type and quantum of due diligence. In a share deal, the assets are not being transferred, so one may be interested in determining what the intellectual property and technology of the target is to avoid problems and set value. In an asset deal it is essential to ensure that all of the intellectual property and technology is captured by the transfer. Of course, these are general propositions that do not apply to every situation. • • • •
Determine the nature of the transaction. Determine if the transaction is a share deal. Determine if the transaction is an asset deal. Determine if the transaction involves a management buyout, and if so, what management knows. • Determine if the transaction is another type of deal. Ancillary Agreements. A major transaction may also have a series of ancillary arrange-
ments, some of which relate to intellectual property or technology. They may have been foreseen by the parties at the time of the original negotiations or may come up as a consequence of the due diligence review. The following examples illustrate the types of issues that may arise. The seller may want to keep ownership of certain intellectual property and technology assets that are essential to the target because the seller’s other businesses will use them in continuing operations. This will necessitate licenses of shared assets so that the purchaser can run its business without having the benefit of ownership. A second example is the need for an operating secrecy agreement, where the purchaser will lease or purchase a portion of the seller’s facilities. Having a tenant operate a plant-within-a-plant can give rise to a host of problems, confidentiality being only one of many. Another example of an ancillary agreement is a transitional license. For example, a purchaser of a portion of the seller’s assets may want to have the right to continue using
8.10 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
the seller’s trademark until it can develop its own and effect a smooth transition. In the absence of a license, the purchaser would have no right to use the seller’s mark and will have no market recognition for its business after closing. A fourth example is the need for the seller to continue processing data for the purchaser, or vice versa. This raises licensing and confidentiality issues. There are many other situations that call for different types of ancillary agreements. Defining the need for these ancillary agreements is part of the due diligence process. In an asset deal there are typically a host of intellectual property-related implementing agreements. The most significant and common ones are short agreements for recording the assignment of intellectual property rights to the purchaser. • Determine whether ancillary arrangements relating to intellectual property and technology are considered part of the original negotiations. • Determine whether ancillary arrangements relating to intellectual property and technology have been identified as a consequence of the due diligence review. • Determine whether there are any shared assets that are essential both to the target or purchaser and to the seller. • Determine whether the target or the purchaser will lease or purchase a portion of the seller’s facility so that the parties will share facilities. • Determine whether there is a need for a transitional license, such as for trademarks or confidential information. • Determine whether there are ongoing information technology services provided by one party to the other. • Determine whether there is a need for agreements for recording the assignment of intellectual property rights of the purchaser. • Determine whether there is a need for agreements for recording security interests. Nature of the Business. Transaction lawyers often take comfort from the assumption that all businesses are more or less the same. All businesses are not more or less the same. Each business is different, and there are different issues associated with each. Businesses in which intellectual property and technology play a key role or form key assets are less the same than others. Pharmaceutical companies, for instance, work within a highly regulated industry. Many of the products are covered by patents and licensed, but in some countries compulsory licenses may be available to competitors. Electronics companies may not patent all new technology because it changes so quickly. Consumer product companies, of course, rely heavily on brand names. Publishing and software businesses are heavily dependent on copyright. Financial services businesses are heavily dependent on data processing and software. Furniture manufacturers may rely on design protection. One must find out what businesses the target is in and what reliance it places, or should place, on intellectual property and technology, including information technology.
• Determine the business of the target. • Determine how important a role intellectual property and technology plays in the business of the target and the industry.
INTRODUCTION 8.11 Value of Intellectual Property and Information Technology. One must try to get a sense of
why it is that the purchaser wants a particular business and what it sees as the real value in the business. The investigation and analysis have to concentrate on the valuable assets and aspects of the business. By way of illustration, suppose you are acting for a lender contemplating a loan to the purchaser of a manufacturing business. In answer to your first question, your client responds that the target company is desirable because it holds down a 50 percent market share in a product line which is synergistic to that of the purchaser. This is valuable information, but it is not the end of the inquiry. Why does the target hold a predominant market share? Is it a low cost producer? Does it offer a superior product? Why can’t the competition compete? In answer to these subsidiary questions you learn that there are two further elements to the answer: 1. Brand name loyalty is a powerful element in the particular marketplace and the target has the most well-recognized brand name. 2. No one can compete because the target has a lock on some element of its product design and on the production process for the product. In that bright and shining moment you come to see the transaction in a dramatically different legal light. This is not a bricks and mortar business turning out commodity widgets by the gross. Now you understand that the key to value lies not in the real estate and fixed assets, but in the status and extent of its intellectual property. You understand that your client’s foremost interest is in taking a real and effective security interest over the intellectual property assets of the target business. While a first charge over the physical assets will be a necessary part of the security package, it will prove to be pyrrhic unless the [Intellectual Property] security package carries with it the right to use trade names and patents after the appointment of a receiver.3
Therefore, you must identify why the purchaser wants the particular business and what it sees as the real value. Structure of the Business. It is essential to determine the structure of the business, as that will play an important role in determining what and how much intellectual property and technology due diligence may be required. By way of illustration, issues that arise when the target is one of a series of related companies, a small business, or a partnership are discussed.
• Determine the structure of the business of the target. Related Companies. Because of its intangible nature and the fact that so few people understand intellectual property and technology, it is not uncommon for the intellectual property and technology rights belonging to or used by a target to be owned by, or of record in the name of, a related company. For example, in some corporate families it is a policy that all intellectual property and technology is owned by the parent company or by a holding company specifically set up for such purposes. In some cases, the holding company may be located in a tax haven jurisdiction so that a standard search of corporate records in the United States or any other major commercial jurisdiction may not even reveal the existence of the holding company. The more multinational in nature the
8.12 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
corporate family is, the more likely the diversity in arrangements will be in respect to ownership and licensing of intellectual property and technology. Because of the relationship between the target and the owner, it is often the case that there is no written license authorizing the target to use the intellectual property and technology when intellectual property and technology is owned by a holding company. Therefore, where a transaction involves one of a related group of companies, it is essential to identify all of the related companies. It may be necessary to conduct intellectual property and technology due diligence for all of them and their intercompany arrangements. • Determine whether the intellectual property and technology rights owned or used by the target are owned by—or are of record in the name of—a related company. • Determine whether it is a policy or a practice of the target or its corporate family that all intellectual property and technology is owned by a parent company. • Determine whether it is a policy or a practice of the target or its corporate family that all intellectual property and technology is owned by a holding company. • Determine whether there are any written licenses authorizing the target to use the intellectual property or technology of its related companies. • Identify all of the related companies. • Conduct intellectual property due diligence for all of the related companies and their intercompany arrangements. Small Business. A small business or one dominated by its founder or other key executive presents peculiar issues. Often the key player is also a key source of intellectual property and technology in that the business may be based on an invention that he or she made or a computer program that he or she has authored. Such individuals usually do not conceptually separate the rights of the target from their own personal rights so that a key patent may, for example, be on record in the name of the individual, as opposed to the target.
• Determine whether the target is dominated by its founder or other key executive. • Determine whether the intellectual property of the target is on record in the name of the founder or other key executive. • Determine whether an assignment of intellectual property and technology rights from an individual to the target or purchaser is necessary. Partnership. If the target is a partnership, there are important issues that must be
resolved to ensure proper transfer or ownership of the intellectual property and technology. When an individual operates a business using his or her own intellectual property and technology and then enters into a partnership, title to the intellectual property and technology developed prior to entry into the partnership may remain in the individual in the absence of an express transfer of the intellectual property and technology by the individual partner. A determination of whether a partner or the partnership owns the intellectual property and technology should be made prior to the acquisition of a partnership or its assets.
INTRODUCTION 8.13
• Determine whether the target is a partnership. • Determine whether the intellectual property and technology of the target is owned by one or more individual partners. • Determine whether an express transfer of the intellectual property and technology to the partnership by one or more partners is necessary. Domestic Issues of Multinational Transaction. Lawyers in one jurisdiction are often
called upon to perform the domestic component of a multinational transaction. If the transaction is being driven locally, the local lawyer usually quarterbacks the deal and has control and coordination responsibilities. However, where the local component is a small part of a transaction being driven from abroad, the local lawyer is frequently instructed to do very specific tasks and to conduct very specific searches. This can be misleading and is worthy of careful attention by both local counsel and the coordinating counsel. For example, a target in the United States may have a wholly-owned Canadian subsidiary, Canco. A commercial lawyer in New York may ask that intellectual property searches be conducted in Canada for Canco, never thinking that the target or an intellectual property holding company may own all or most of the organization’s intellectual property and technology in Canada. Similarly, nobody in the United States may consider that Canco owns intellectual property and technology there or in other countries. Other similar investigative cracks may arise in such transactions. One must identify and raise potential issues like these with the client or the commercial lawyer. • Determine whether the intellectual property and technology in a particular jurisdiction is in the name of a local subsidiary or a foreign parent. • Determine whether a local subsidiary owns intellectual property or technology abroad. Multiple Location Business. A target having a head office in one location and plants or other significant premises elsewhere presents different problems for intellectual property and technology due diligence than for most other aspects of the due diligence process. For example, although all of the target’s corporate and tax records are likely to be centralized in the head office, widgets may be produced or services performed in the other locations. In fact, different types of widgets may be produced in each plant or different services performed in each location. Local places of business may have developed and may use technology that has not been communicated to, and may not be known at, the head office. Therefore, it may be necessary to sometimes visit each significant place of business of the target to properly conduct intellectual property and technology due diligence.
• Determine whether local offices or local plants have developed technology that has not been communicated to the head office. • Visit each significant place of business of the target. International Businesses. It is rare that any business does not have, or at least intend to
have, sales outside the local jurisdiction in this era of globalized trade. Exceptions,
8.14 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
though few, may include domestic service and retail companies—however, even they may sell products on the Internet or have long-term goals of expansion. If the target is based in one country and conducts all its manufacturing operations there, a commercial lawyer may not appreciate the need to conduct intellectual property and technology due diligence investigations in foreign countries. However, it would be awkward for a purchaser in an asset deal not to capture foreign intellectual property assets. It would be disastrous for a target to learn that it could not export its products to another country because, for instance, someone held a foreign patent that would be infringed by the sale of the products there. Therefore, it is necessary to identify all foreign jurisdictions that may be relevant to the target’s present and future operations and sales for intellectual property and technology due diligence. • Determine whether the target sells goods or performs services outside its local jurisdiction. • Determine whether the target intends to sell goods or perform services outside its local jurisdiction. • Determine whether the target owns intellectual property or technology outside its local jurisdiction. • Determine whether there is intellectual property or technology owned by a third party in a foreign jurisdiction that would be material to the target’s ability to sell goods or perform services in a foreign jurisdiction. Plans for the Business. In reviewing the nature of the business, one should have in mind the plans for that business. For example, the purchaser may plan to drop certain brands and emphasize others. Similarly, a purchaser may intend to introduce a new product line embodying recently developed technology. The purchaser may wish to revive a dormant trademark or product line, or it may wish to expand geographically and sell goods or services in new markets. If the business is currently a traditional bricks and mortar business, it is important to determine the purchaser’s plans with respect to ecommerce. Being aware of such plans is essential and should assist in targeting more important investigations and downplaying others in due diligence. The same issues arise where a business is borrowing money or issuing stock to expand its operations.
• • • •
Determine whether the purchaser intends to drop certain brands or products. Determine whether the purchaser intends to introduce new brands or products. Determine whether the purchaser intends to expand sales to new jurisdictions. Determine whether the purchaser is involved or intends to expand into e-commerce.
The Marketplace. One must also have an appreciation for the market, who the target’s
competitors are, and, in a general way, what challenges they pose to the target. • Identify the target’s key competitors. • Identify the key intellectual property and, where possible, technology of the target’s competitors.
INTRODUCTION 8.15 Assistance. It is crucial to identify at a very early stage those contacts on both sides of the transaction who may have information that one needs or who may assist in obtaining it. The process by which the necessary understanding can be achieved starts with the client. There may be a number of different people to speak to when dealing with the client. It may be necessary to speak to the business people driving the deal; in-house technology people; in-house general counsel; in-house intellectual property and technology counsel (if the client has them); and those who will be concerned with the marketing, technology, and other operational aspects of the target. In many instances, the questions will go beyond the purchaser’s knowledge. One needs to ask the seller a lot of questions. One may have to speak with the seller’s business people, in-house technology people, in-house counsel, marketing people, technology and operational people, contract administrators, and people in different plants and related companies. In the case of some businesses, it may be necessary to work with a technical expert. In an e-commerce business, it is important to speak with the chief information officer or the chief technology officer. In some cases, it may be possible to get information on record in government files through access of information legislation.
• • • • • • • •
Identify contacts who may have relevant information. Meet with in-house counsel. Meet with key marketing management. Meet with technology and operational people. Meet with information technology officers. Meet with contract administrators. Meet with people in different plants. Consider the relevance of information on record in government files through access of information legislation.
Secrecy Agreements. Prior to providing any oral or documentary assistance, the seller, borrower, or issuer may require execution of a nondisclosure agreement to protect any confidential information that may be disclosed, especially in the event that the transaction is never closed. A reciprocal secrecy agreement may be advisable if the purchaser intends to disclose any of its confidential technical and business information. A nondisclosure agreement should be executed by the parties well before the due diligence period and prior to disclosure of any confidential information, be it financial, technical, marketing, or otherwise.
• Consider the need for a nondisclosure agreement prior to due diligence activities. Representations, Warranties, and Opinions. Sometimes the representations and war-
ranties contemplated by the purchase or other agreement, as well as the opinions to be delivered on closing, serve to define and focus due diligence activities. For example, if the negotiated representations and warranties are narrower than what the purchaser originally hoped for, additional due diligence may be required. If the representations and warranties specifically exempt certain issues, that should be a red flag that there
8.16 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
may be a problem or that the seller does not have specific knowledge of those issues. If the intellectual property and technology lawyer knows that he or she will be required to give an opinion in a certain form, it is necessary for the due diligence to be sufficient to put the lawyer in a position to provide the requested opinion. • Consider the representations and warranties contemplated by the agreement as a basis for due diligence. • Consider the opinions to be delivered on closing as a basis for due diligence. Transitional Issues. The due diligence review should also assess whether or not any
actions or fees relating to the target’s intellectual property portfolio become due during the due diligence period. This will assist in avoiding any abandonment of rights during the review period. Sometimes there is a need for bridging services, especially in those deals where the seller may be transferring assets, such as patent and trademark applications, or proceedings like trademark oppositions that have responses or fee payments due during the transitional period or shortly after closing. The payment of maintenance fees, outstanding agent and counsel bills, and the like also needs to be addressed. These issues should be raised to facilitate the smooth transfer of the business. • Consider whether or not any actions or fees relating to the target’s intellectual property portfolio will become due during the due diligence period. • Consider who is responsible for looking after management of the intellectual property portfolio of the target pending closing. • Determine who is to look after payment of government and legal fees during the period prior to closing.
INTELLECTUAL PROPERTY RIGHTS Overview of Intellectual Property. It is important that one understand the different types of intellectual property in order to conduct intellectual property due diligence properly. Different aspects of the same product may sometimes be protected by various types of intellectual property. This is illustrated with reference to a table lamp with an ornamental base:
• A patent protects any new and unobvious functional features of the lamp or its electrical circuitry. • Copyright protects any original design drawings of the lamp. • The author of such design drawings has moral rights to prevent certain types of modifications to the drawings in some countries. • A design patent in the United States, or an industrial design registration elsewhere, protects any novel and unobvious (original in some countries) aesthetic design of the lamp. • A trademark protects a distinctive word or design denoting the brand of the lamp on the lamp itself or on a label, tag, or package.
INTELLECTUAL PROPERTY RIGHTS 8.17
• Trade dress protects the shape of the lamp or its packaging if distinctive of the source. • A tradename is the corporate name, partnership name, or business name under which a corporation, partnership, individual, or other entity conducts business, and may appear on the lamp or its packaging to identify its source. • A semiconductor chip registration protects any original topography of a semiconductor chip in the lamp’s circuitry. • The method of making the lamp is proprietary information or a trade secret if that method is known only by its manufacturer. • Personality rights protect the right of publicity of any celebrity whose persona is used to market the lamp. • A performing right would protect the performance of a jingle used to advertise the product in some countries. • The producer of a sound recording of the commercial has a producer’s right in some countries. • In some countries, a broadcaster has a broadcaster’s right in the communication of its signal if the commercial is broadcast. • In some countries, database rights protect the database of lamp customers and their pertinent information. • Plant rights are not applicable. Often, clients and commercial lawyers assume that all intellectual property rights are on record and that all that needs to be done to get a handle on a target’s intellectual property is to conduct searches in one or more key jurisdictions. However, in many cases pending applications to acquire such intellectual property rights are not available for searching, and in many cases even important intellectual property rights that should be registered or otherwise formally protected are not. There are a number of other intellectual property rights for which searches of public registers are of no assistance, because they need not be registered. These include moral rights, personality rights, and proprietary information. Therefore, while searches of public records will provide some very important information, they are by no means reflective of the whole picture. Through corporate name changes, mergers, acquisitions, and other transactions, the records relating to title of intellectual property in the public offices are not always up to date. This is especially true for jurisdictions other than the one that the target is based in. This is because, either through ignorance or indifference on the part of clients or commercial lawyers or in a desire to save costs, the somewhat expensive task of recording changes in names, structures, and ownership of companies in intellectual property offices is often not done. Also, intellectual property rights are not uniform from country to country. For example, copyright covers different bundles of rights in different jurisdictions. The trade dress of a product may be protectable under the law of one country, but not under the law of another. It may be harder to get a patent in one country than in another, so that the scope of a patent in one country may be somewhat narrower than in another, or there may not even be a patent in one country corresponding to a patent granted in another.
8.18 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
Searches are time-consuming and expensive. Therefore, it is preferable for a company to have good current records of its own intellectual property, whether formally protected or not. A prudent seller, borrower, or issuer will organize and maintain a compilation of all intellectual rights. However, in any intellectual property due diligence in a commercial transaction, at an absolute minimum one must check publicly available records of intellectual property in the Patent, Trademark, Copyright, and other offices in those countries that are material to the target’s business or rights. With the foregoing general concerns in mind, and subject to the specific limitations identified later in connection with each of the different types of searches, a search strategy should be planned that will develop a meaningful response. For example, if the target is Acme, Inc., but you are aware that there are a dozen or so companies within the corporate family having “Acme” in their names, you may wish to conduct intellectual property searches for all companies having the word “Acme.” The incremental costs of doing broader searches are generally not significant, but the potential cost of missing some key intellectual property, especially in an asset deal, may be significant. The following discussion considers each of the forms of intellectual property in turn. First, a brief summary of the relevant rights is provided. Second, a summary of available searches for each significant type of property, where appropriate, is set out. Third, the limitations of each of these searches are set out so that one can be aware of where the gaps are in the information. Finally, some comments are made on follow-up. • Remember that searches do not tell the whole story. • Remember that intellectual property rights are not uniform from country to country. • Develop a search strategy. • Consider searches in the names of predecessors. Through corporate name changes, mergers, acquisitions, and other transactions, it is often the case that records relating to title of intellectual property in public offices are not up to date. • Consider rights that are not on record in intellectual property offices. Patents. A patent issued by the government grants the right to exclude others from
making, using, or selling an invention in the relevant country.4 It can only be obtained for certain classes of new, useful, and unobvious inventions. These include methods, such as a process for refining petroleum; devices, such as a motor; and compositions of matter, which include chemical compounds like a plastic. In some countries, like the United States, computer software and business methods may now be patented. In order to be patentable, an invention must have a useful purpose5 and be novel. Novelty is measured against certain criteria in the patent legislation, which differs from country to country.6 A patentable invention must also be inventive—that is, it must not be obvious to a person having ordinary skill in that field.7 A patent is always susceptible to attack on the basis that it is invalid for failing to satisfy any of these criteria. Patent applications may only be filed within narrowly prescribed time limits. In almost all countries, an application must be filed prior to any availability of the invention to the public. In the United States and Canada there is a one-year grace period.
INTELLECTUAL PROPERTY RIGHTS 8.19
Patent applications are rigorously examined and may be pending for a long period of time.8 In many countries, recently including the United States, the application is made available to the public 18 months after the filing date of the first application for the invention.9 The terms of patents vary in each country. In most countries, the term of a patent expires 20 years after the date of filing the application from which the patent was granted,10 but this should always be verified because of numerous variations to this general rule. In some countries, for example, the United States, the term of patents may be extended to compensate for regulatory delays in approvals for certain products like pharmaceuticals.11 It is also possible for one to file an international patent application pursuant to the provisions of the Patent Cooperation Treaty (PCT). Such an application is filed through the World Intellectual Property Organization (WIPO) in Switzerland,12 and well over 100 PCT member countries may be designated.13 The application first passes through an international phase before the applicant chooses to enter the national phase in some or all of the member countries designated in the application. The national phase may be entered before either the 20- (or 21-) or 30- (or 31-) month anniversaries of the original filing, depending on whether or not the international application is examined. The application is treated as an ordinary national application within the country it chooses to enter in the national phase.14 It is also possible to file an application for a European patent, which covers one or more European countries that are members of the European Patent Convention. It is important to appreciate that many valuable inventions may not be the subject of patent protection in any or all countries. The most common reasons are that the invention does not satisfy the criteria to obtain a patent, the target that developed the invention did not want to make the investment to seek a patent, the target pursued patents only in selected countries, the target missed the very limited window in which a patent application must be filed, a patent application or a patent was not maintained through the payment of fees, or a patent has expired. Types of Searches. Several types of searches may be done in the Patent Office (the Patent and Trademark Office in the United States) records of each relevant jurisdiction. An index search is the most common in a commercial transaction. It seeks to determine what patents and, where available, published applications, have been granted to, filed by, or transferred to a particular person. An index of inventors, applicants, patentees, and recorded owners is kept by the Patent Office. Again, if there is a series of related companies, it may be prudent to conduct such a search in the names of all of the relevant companies. An inventor search is made to locate all patents and published applications granted in the name of a certain inventor. Such a search is often advisable in the case of a small business where there is a single directing mind or key technical person. It may also be helpful in the case of a major business where all or most of the technology derives from the work of one or few key people. If information on the patent position of one or two key competitors is desired, it may also be worthwhile to conduct an index search in the names of the competitors or an inventor search for the competitors’ key technical people.
8.20 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
A PCT application that has not yet entered the national phase in a particular country will not be found in a search of records of that country. A European application may not be identified in a search of a national patent office. One may conduct PCT index and inventor searches for pending international applications that have not yet entered the national phase and for European applications. Most patent laws require the recordal of all exclusive licenses and permit the registration of other licenses. In some countries the patent law also provides for compulsory licenses, particularly for pharmaceuticals. A license search against certain patents may provide insight into important contractual or compulsory arrangements affecting key patents. A state-of-the-art search is made to find the current technology in a particular field quickly and relatively economically. Such a search is often done once a business has identified a need and wants to begin product design. However, such a search may also be conducted to determine whether a target is developing technology that may already be obsolete or to identify potential patent impediments in getting that technology to market. This is sometimes done prior to a decision being made in a financing deal, especially when equity is being injected into a recent startup business. The problem with this type of search is that, in certain industries like electronics and biotechnology, developments occur very quickly and the information available through Patent Office searches may be out-of-date. A novelty search is a preliminary search made prior to filing a patent application to determine whether the invention is patentable. Such a search may be appropriate when the target has developed new key technology on which future business prospects depend and one wishes to determine the patent prospects for that invention. For new inventions that are not yet the subject of a patent application, it must be borne in mind that all countries have statutory deadlines or bars within which patent applications must be filed. Most bars are triggered by the public availability of the invention. The United States15 and Canada have limited grace periods before a deadline within which an application must be filed, but most other countries do not. An infringement search seeks to locate patents and potential patents that might be infringed by the proposed manufacture, sale, or use of a device, composition, or method. It is limited to patents that have not expired and, in those countries where available, published applications. A patent only provides a negative or exclusionary right, not a positive right. Even if one has a patent, exploitation of a patented invention may still infringe other patents. This search is often impractical because of the expense involved, but if a particular product line—especially a new or proposed one—is material to the success of the target, it might be advantageous to conduct such a search. A validity search seeks to locate patents and published applications that may affect the validity of claims of a specific patent. The results are used to assess the strength of a patent. Because private resources are usually greater, the patents and other documents found in a validity search often include some not found by the Patent Office examiner during the application process. Such a search might be conducted when the strength of a target’s patent is crucial to the success of the business because the target relies on that patent to maintain its dominance of the market or competitive position.
INTELLECTUAL PROPERTY RIGHTS 8.21
In some countries, one may also conduct a search to identify grants of security interests against patents and published applications. • • • • • • • • • • • • • • •
Consider an index search. Consider an inventor search. Consider an index search in the names of competitors. Consider a search in the name of an inventor who is one of the competitors’ key technical people. Consider a search of recorded voluntary licenses. Consider a search of compulsory licenses, where appropriate. Consider a state-of-the-art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search for pending applications, where published. Consider a search for pending applications that have not yet been published. Consider a PCT index search for pending international applications that have not yet entered the national phase. Consider a PCT inventor search for pending international applications that have not yet entered the national phase. Consider a search to identify grants of security interests against patents and published applications.
Limitations of Searches. There are many limitations to patent searches. First and fore-
most, a search of the records of the U.S. Patent Office will not reveal reference to any inventions for which a patent has not been issued. In many countries, including the United States,16 a search will not reveal an application that has not been published. If the application was withdrawn or refused, the application would never become available to the public. Even if a country is designated in an international application at the time of filing, until the application enters the national phase there is usually no ability to locate the application in the local Patent Office. Therefore, it may also be necessary to search for international PCT applications or regional applications in Europe. It is possible to obtain information on expired patents in an index search. Information on expired patents may be relevant in a number of situations. An example is when a patent has recently expired and the market position of the target has been dependent on the monopoly afforded by the patent. The fact that the patent has recently expired may be a reason why the seller is interested in selling the target. In most countries pending applications and patents are subject to the payment of annual maintenance fees. In the United States, only granted patents are subject to periodic maintenance fees. It is possible that an application or patent that is key to the target has lapsed due to failure to pay such fees. It is sometimes possible to reinstate such applications and patents within certain time limits. Therefore, it might be helpful to expand the search to cover recently lapsed patents and published applications.
8.22 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
An index search will only reveal the issued patents and published applications on record in the name being searched. Therefore, the search may reveal rights that are still in the name of the target but have since been assigned, or may not reveal rights actually owned by the target but for which assignments or other documentation may not have been recorded. In the case of state-of-the-art, novelty, infringement, and validity searches, there is much subjectivity that goes into the search and any resulting analysis. In conducting any such searches, the searcher must rely on the classification system maintained by the Patent Office, and the classification of each application as it is filed in the Patent Office within the system. If an application is incorrectly classified and does not appear in those classes in which one would expect that technology to appear, it is possible to miss a relevant reference. The records of the Patent Office are also known to contain many errors and omissions that may affect the reliability of all searches. • Understand the limitations of patent searches. • Understand the PCT filing regime and the limitations as to accessibility of international applications that have not yet reached the national phase. • Understand that pending patent applications may not be available for searching in some circumstances. Follow-up. It is necessary to correlate the information obtained in patent searches with
that obtained through meetings with people who are familiar with key technology in the target. If there are other key inventions and proprietary information of the target that might be patented, or major problems are posed by a patent of a competitor, they should be identified. All relevant information about the key technology, its inventors, and the relationship of the inventors, whether through employment or consulting contract, should be identified. It is important to note that, at least in the United States, patent applicants have a duty of candor to the Patent Office to disclose all relevant prior art known to them.17 The target’s files should be considered in relation to this duty. One should try to work from the bottom up and find out how the target handles new ideas, whether it has a research and development department, and where that is. One should attempt to identify what kind of documentation is produced when an employee or consultant comes up with a new idea. It is essential to tour the research and development facilities, plant, warehouse, stores, systems control centers, and other locations where the real business is done to see, in a general way, what technology the company is using. No plant or other premises tour can ever totally familiarize an intellectual property and technology lawyer with the details of technology. It will give one a general idea of the processes used in the plant and elsewhere, and it may also give one an idea as to which technology is home-grown and which is licensed-in. All relevant inventions, patented or unpatented, should be listed with all pertinent related information, including dates of invention and deadlines for the filing of applications, the prosecution of applications, and the payment of maintenance fees for applications and patents. • Correlate the information obtained in patent searches with that obtained through meetings with people who are familiar with key technology in the target.
INTELLECTUAL PROPERTY RIGHTS 8.23
• Consider other key inventions and proprietary information of the target that might be patented. • Consider major problems posed by a patent or application of a competitor, if identified. • Determine if the target has complied with its duty of candor to the U.S. Patent Office. Designs. A design patent, or in many other countries a design registration, may pro-
tect certain reproducible shapes and patterns that have a new and unobvious (or, in some countries, original) shape, configuration, or ornamentation applied to a useful article.18 The design must have an aesthetic affect—entirely functional features may not be the subject of a design protection. Examples of designs that may be registered are furniture designs and telephone casings. A design application may only be filed within narrowly prescribed time limits. In almost all countries, an application must be filed prior to any availability of the design to the public. There is a one-year grace period in the United States and Canada.19 A design patent or registration grants the right to exclude others from making, selling, or using a product embodying a design. The terms of corresponding protection vary by country. In the United States, a design patent extends for a term of 14 years.20 It is important to understand that many valuable designs may not be the subject of design protection in any or all countries. The most common reasons are that the design does not satisfy the criteria to obtain a patent or registration; the target pursued design protection in selected countries; the target that developed the design did not want to invest in an attempt to patent or register the design; the target missed the very limited window in which a design application must be filed; a design application, patent, or registration was not maintained; or the patent or registration has expired. Types of Searches. Several types of searches may be done in the Industrial Design
Office (the Patent and Trademark Office in the United States) records. An index search, done to determine what patented or registered designs have been transferred to a particular person, is the most common in a commercial transaction. Again, if there is a series of related companies, it may be prudent to conduct such a search in the names of all of the relevant companies. If information on the design position of one or two key competitors is desired, it may also be worthwhile to conduct an index search in the names of the competitors. An inventor (or author) search is made to locate all patents or registrations and published applications granted in the name of a certain inventor. Such a search is often advisable in the case of a small business where there is a single directing mind or key design person. It may also be helpful in the case of a major business where all or most of the designs derive from the work of one or a few key people. In many countries, the laws require the registration of exclusive licenses and permit the registration of other licenses. A license search may identify any such licenses on record against particular registrations. A state-of-the-art search is made to find the current design art in a particular field quickly and relatively economically. Such a search is often done once a business has identified a need and wants to begin product design. Such a search may also be conducted
8.24 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
to determine whether a target is developing designs that may already be obsolete or to identify impediments in getting that design to market. A novelty search is a preliminary search made prior to filing a design application to determine whether the design is patentable or registrable. Such a search may be appropriate where the target has developed a new key design and one wishes to determine the patent or registration prospects for that design. An infringement search seeks to locate design patents or registrations that might be infringed by the proposed manufacture or sale of a product embodying a design. It is limited to design patents and registrations that have not expired. If a particular product line embodying a design—especially a new or proposed one—is material to the success of the target, it might be advantageous to conduct such a search. A validity search seeks to locate design patents and registrations that may affect the validity of a patent or registration. The material located is used to assess the strength of a patent or registration. The patents, registrations, and other materials found in a validity search often include some not found by the examiner during the application process. Such a search might be conducted if the strength of a target’s design patent or registration is crucial to the success of the business because the target relies on that patent or registration to maintain its dominance of the market or competitive position. In some jurisdictions, one may conduct a search to identify grants of security interests against design applications, patents, and registrations. • • • • • • • • • •
Consider an index search. Consider an inventor search. Consider an index search in the names of competitors. Consider a search in the name of an inventor who is one of the competitors’ key design people. Consider a search of recorded licenses. Consider a state-of-the-art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search to identify grants of security interests against applications, patents, and registrations.
Limitations of Searches. There are many limitations to design searches. A search of the records of the Patent Office or, outside the United States, the Industrial Design Office, will not reveal reference to any design for which an application has not been filed. A search will generally not reveal reference to any application that is still pending because in most countries, all applications are kept confidential throughout prosecution until a patent or registration issues. If an application is withdrawn or refused, the application would never become available to the public. As in the case of patent and trademark searches, an index search will only reveal the patents and registrations on record in the name being searched. Therefore, the search may reveal rights still in the name of the target but which have since been assigned, or may not reveal rights actually owned by the target but for which assignments or other documentation may not have been recorded.
INTELLECTUAL PROPERTY RIGHTS 8.25
It is possible to obtain information on expired patents and registrations in an index search, but this information must generally be specifically requested by the searcher. Information on expired patents and registrations may be relevant in a number of situations. An example is when a patent or registration has recently expired and the market position of the target has been dependent on the protection afforded by the patent or registration. In the case of state-of-the-art, patentability, registrability, infringement, and validity searches, there is much subjectivity that goes into the search and any resulting analysis. In conducting any such searches, the searcher must rely on the classification system maintained by the Patent or Design Office, and the classification of each application as it is filed within such a system. If an application is incorrectly classified and does not appear in those classes in which one would expect that art to appear, it is possible to miss a relevant reference. The records are also known to contain many errors and omissions that may affect the reliability of all searches. • Understand the limitations of the searches. • Understand that pending applications are not available for searching. Follow-up. It is necessary to correlate the information obtained in design searches with
that obtained through meetings with people who are familiar with key products and product and packaging configurations in the target. If there are other key designs that might be patented or registered, they should be identified and carefully considered. All relevant information about the key designs, its inventors or authors, and the relationship of the creators, whether through employment, consulting, or other contract, should be identified. All relevant designs, whether or not patented or registered, should be listed with all pertinent related information, including deadlines for the filing of applications, the prosecution of applications, and the maintenance of patents and registrations. • Correlate the information obtained in design searches with that obtained through meetings with people who are familiar with its key products and product and packaging configurations in the target. • Consider other key designs that might be patented or registered. • Consider relevant information about the key designs, their creators, and the relationship of the creators, whether through employment or consulting contract. Trademarks. A trademark is a word, symbol, shape, or a combination of them used by a person to distinguish his or her goods or services from those of others.21 Trademarks include word marks such as Coke, design marks such as McDonald’s Golden Arches, shapes such as the familiar Coca-Cola bottle, characters such as Mickey Mouse, and getups such as the well-known Howard Johnson Orange Roof.22 Trademarks may identify goods, such as Crest for toothpaste; services23 such as Holiday Inn for hotel services; or both, such as McDonald’s for hamburgers and restaurant services. The goods or services themselves are not protected by a trademark. Rather, the trademark may not be used by others in a way that would confuse the public into thinking that the goods or services of the trademark owner were being obtained. For instance, anyone may sell film, but only the owner of the Kodak trademark may identify it as
8.26 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
Kodak film. Every business has some type of trademark right, even if it is only in the name under which it does business. In a consumer-based business the value of trademarks will be even higher, but one should not discount the value of trademarks in businesses that cater to other businesses. For example, a very sophisticated manufacturer of electronic equipment may distinguish its components in the marketplace by a trademark, as opposed to referencing the component by its technical specifications. In the United States and some other countries, trademark rights can be acquired through use of the mark with goods or services.24 In such countries a trademark need not be registered, but registration usually ensures protection throughout the country. A prior user of a mark may have superior rights to a person who subsequently uses or registers the mark. However, in other jurisdictions, such as many European countries, trademark rights must be registered to be enforceable. In such countries, the superiority of rights is generally determined by the first filing of an application and trademark use is less important in establishing rights. The term of a registration varies from country to country. In the United States, the term is 10 years25 and is renewable indefinitely.26 The rights granted by a registration are generally limited to a national jurisdiction. It is possible for one to file so-called international applications to register trademarks through conventions such as the Madrid Agreement or regional trademark applications through the European Community Trademark Office. These applications cover a group of regional national jurisdictions. They first are treated as international or regional applications, and then become a series of national applications or registrations, depending on the rules of the specific arrangement. Types of Searches. There are a number of different types of searches one can conduct
in the Trademark Office of each relevant country (the Patent and Trademark Office in the United States). An index search is the most common type of search and the usual starting point in a commercial transaction. This search is made to determine what trademark registrations and pending applications for registration of trademarks are on record in the name of a particular person. An index search should be conducted in the name of the target and all relevant predecessor and related companies. In the case of an index or name search, a search strategy should be planned to get a meaningful response. For example, if the company is called Acme, Inc., but you are aware that there are a dozen or so companies within the corporate family having in their names the word “Acme,” you may wish to conduct your searches for all companies having the word “Acme.” An application that has not yet been made of record in a specific national jurisdiction will not be found in a search of records in that country. One may conduct searches of regional indices for such international and regional applications and registrations. If after investigation it becomes apparent that an important trademark of the company has not been registered, it may be advisable to conduct a registrability search. This search will identify prior filed applications and issued registrations for trademarks similar to the mark for which the search is made. This will provide some idea as to whether the particular trademark may be registrable in a particular jurisdiction. In a business where there is a significant major competitor and one wishes to assess the trademark rights of that competitor, one may conduct similar searches in the name of the competitor and its related companies for its key trademarks.
INTELLECTUAL PROPERTY RIGHTS 8.27
One may conduct an opposition search to locate pending oppositions in which the target is opposing applications of third parties. One may also conduct a search for cancellation proceedings which may lead to possible expungement of a registration. In some countries it is also possible to look for documentation relating to security interests recorded against trademark registrations and applications. All trademarks of public record, all other trademarks which are identified during the process, and their various script and design versions should be listed together with the goods and services with which they are used, the dates of first use in each jurisdiction, and all relevant deadlines for the prosecution of applications and the renewal of registrations in each relevant jurisdiction. • Consider an index search in the name of the target and all relevant predecessor and related companies. • Consider a registrability search. • Consider a search of trademark rights of major competitors. • Consider an opposition search. • Consider a search for cancellation proceedings. • Prepare lists of all relevant registrations and applications. • Consider a search for documentation relating to security interests recorded against trademark registrations and applications. Limitations of Searches. It is just as important for one to understand what information is
not revealed in a search as what is revealed. There are a number of important limitations on the information that one may obtain in a search of the records of the Trademarks Office. A search normally will not reveal cancelled registrations but can be expanded to identify these. A registration may be cancelled for a variety of reasons. This includes the failure to file an affidavit of use prior to the sixth anniversary of the registration in the United States27 or the failure to renew a registration. Therefore, a registration of a valuable trademark may have been lost due to administrative inattention. This is common. A search may be expanded to identify cancelled registrations. A search will normally not reveal abandoned applications. An application may have been abandoned for a number of reasons, including voluntarily in response to an adverse examiner’s report, as a result of an opposition by a third party, or as a result of overlooking a deadline. A search can be expanded to identify abandoned applications as well. A search will also not reveal recently filed pending applications. This is because there is a brief period between the time an application is actually filed and the time when it first appears in the indices of the Trademark Office or in any commercial database. It is also possible for persons in other countries to file an application in one country within six months of the date of an earlier application abroad and obtain the benefit of that earlier date in the former country. In some countries licensees of trademarks must be registered as users. In such countries, a search of user registrations may reveal important contractual arrangements regarding key trademarks. Obviously, a search is only as good as the data. A search of the records of the Trademark Office will not reveal any information on trademarks that may have been
8.28 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
extensively used but are not the subject of a pending application or issued registration. It is possible that a very material trademark of the target has not been registered, either because no one has made the decision to file an application or because the trademark may not be registrable. When conducting an index search, it is important to understand that the search will only reveal trademark registrations and applications of record in the name of the party for which the search is conducted. In other words, if the trademarks are currently owned by party B through an assignment from party A but that assignment has never been recorded in the records of the Trademark Office, it will not be possible to locate those marks merely by doing a search in the name of B. Similarly, it may identify a mark in the name of A which A assigned to B long ago, but for which B did not record the transfer. The records of the Trademark Office and the related commercial databases are known to contain errors and omissions. Therefore, even in respect of rights that are properly recorded, the information available for searching is not always accurate. This may affect the reliability of all searches. It may be advisable to conduct a more comprehensive search by specific trademark. It is possible to search trade directory, telephone directory, tradename, domain name, and other trademark and tradename uses through private databases. It may be prudent to conduct a search of this type for the most important trademarks of the target. • • • •
Consider the limitations of each type of search. Consider a trade directory search. Consider a telephone directory search. Consider a corporate name search.
Trade Dress. Trade dress is the distinctive getup of goods, packaging, and other materials which function as a trademark to distinguish the source of goods or services. Examples are the Coca-Cola bottle design for beverages and the Howard Johnson Orange Roof design for restaurant services. Not all countries recognize rights in trade dress and of those that do, some limit the scope of rights in trade dress. Rights are often based on use where trade dress is recognized. However, in some countries, rights may be based on registration. Any registered trade dress rights will usually be identified in trademark searches. It is important to attempt to identify unregistered trade dress rights where they exist.
• Consider conducting trademark searches for trade dress. • Understand that different countries treat trade dress differently. • Consider identifying unregistered trade dress rights where they exist. Domain Names. Domain names are the pseudonyms given to alphanumeric combinations that represent addresses on the Internet. An example is targetcompany.com. Because of the way the commercialization of the Internet has evolved, domain names have become very important identifiers and are often based on important trademarks of the target. A domain name itself is probably not a property right because the registrant holds the domain name subject to a contract with the domain name registry, much as a
INTELLECTUAL PROPERTY RIGHTS 8.29
business uses a telephone number subject to a contract with a telephone company. However, it is clear that trademark rights will arise if the domain name or the telephone number is used as a trademark. A search should be conducted for all domain names registered by the target. In addition, searches should be conducted for all domain names which include important trademarks of the target. Searches should be conducted through all top-level domain (TLD) registries. In addition to the .com registry, these generic TLDs include specialized TLDs, like .org and .net. Searches should be conducted in all national TLD registries like .ca for Canada and .uk for Britain. These searches should also look for domain names that may tarnish the target such as targetcompanysucks.com and typo variations, such as targettcompany.com. In each case, the website of a registrant other than the target should be visited to determine how the domain name is used, the location(s) of the business, and the nature of the business, wares, and services offered. In some cases, third-party domain names comprising similar marks will not be an issue. In other cases, either cybersquatters who have registered the target’s domain names in advance of the target, or legitimate businesses with similar marks in different industries or in other countries, may pose issues. • Consider a search for all domain name registrations of the target in all generic top-level domain registries. • Consider a search for domain name registrations of the target in key national top-level domain registries. • Consider a search for domain name registrations incorporating, or similar to, key trademarks and tradenames of the target. • Identify those registrants of relevant domain names who may be cybersquatters. • Identify those registrants of relevant domain names in unrelated businesses. • Identify those registrants of relevant domain names that are actual or potential competitors. • Identify those registrants of relevant domain names with websites directed to criticizing the trademarks, website, goods, services, or business of the target. Follow-Up. It is important to compare the results of the trademark and domain name searches with the activities of the target to identify any inconsistencies between the trademarks that are being used and those that are of public record, and to determine what additional marks are of value to the company. During this exercise, one should focus on the manner in which trademarks are used. For example, there may be registrations for old logos or design versions of word marks. Those marks or versions may no longer be in use, and their registrations may be susceptible to attack while currently used versions may not be properly protected. A preliminary discussion with the target’s marketing and personnel is helpful in discerning the trademark position for key products. During the market review, one should also inquire about the role of trademarks of the target in the markets it participates in for the purpose of assessing competitiveness in those markets. One should also attempt to identify those countries in which registered trademark rights may be subject to cancellation for nonuse. In a few specific industries there are prohibitions or limitations against the use or registration of some trademarks. These should also be considered.
8.30 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
One should differentiate between house marks, which are used with most or all goods and services, and specific product marks. Each product that is material to the target’s business should be considered from the perspective of trademarks, trade dress, packaging, and advertising. It is helpful to obtain specimen advertising materials, including video and audio tapes, print advertising, and website pages. It is advisable to obtain and review copies of product packaging and labeling to identify any regulatory issues and all relevant trademark rights that may not have been revealed in the course of Trademark Office searches. Each of the relevant domain names registered by the target or by a third party should be assessed in light of the target’s business. These materials may also suggest contractual arrangements that should be carefully considered in the contract review. Before the preparation either of formal assignment documentation in an asset deal or of schedules relating to representations and warranties in a share deal, all trademarks of public record, all other trademarks that are identified during the due diligence process, and their various script and design versions should be listed. The assignment of trademarks often presents particular problems. In some countries, such as the United States, trademarks must be assigned together with the goodwill.28 In many countries where a division of a business is to be sold, the difficulty in splitting ownership of a trademark when both the vendor and the purchaser wish to own the trademark for their respective activities is more problematic. In many of these countries, trademark rights cannot be split in this way. • Compare the results of trademark and domain name searches with the activities of the target to identify any inconsistencies. • Determine what additional marks and domain names are of value to the target. • Consider the manner in which the trademarks and domain names are used. • Prepare lists of all relevant marks and domain names. • Consider assignment issues. Tradenames. A tradename is the name under which any business is carried on, includ-
ing the name of a corporation, a partnership, or an individual. In most countries, absent use of a tradename or registration of a trademark, the mere registration of a business name, a fictitious name, or the incorporation of a company whose name includes a trademark provides no positive trademark rights. In some countries, trademark rights may be acquired through the use of tradenames or portions thereof. The information obtained through a corporate or tradename search will identify names under which the business or particular divisions thereof operate. A search of incorporated companies and business names familiar to all commercial lawyers will generally identify all tradenames of record that are identical or similar to a key tradename. The information contained in such a search is minimal. It may be necessary to order corporate or business name records to obtain additional information. An important limitation of a tradename search is that in some jurisdictions it is not possible to search business names by registrant. Another important limitation is that a target may not have registered a key tradename under which it operates. Investigations should be conducted to determine what other tradenames are of value to the target. All tradenames of public record and all other tradenames that are identified during the process
INTELLECTUAL PROPERTY RIGHTS 8.31
should be listed together with all relevant deadlines for the renewal of registrations in each relevant jurisdiction. • Consider a tradename search of incorporated companies and business names. • Understand the limitations of the searches. Copyright. Copyright29 is the exclusive right, among other things, to reproduce or dis-
tribute copies of, and display or publicly perform, certain works.30 These works include literary, musical, dramatic, artistic, choreographic, audiovisual, and architectural works.31 In some countries, including the United States, copyright protects other works such as sound recordings.32 The essential concept of copyright is that only the form of expression is protected. Copyright does not protect the idea, concept, or subject matter of a work.33 For example, if a physicist writes an article on lasers, anyone else can use the information contained in the article to write an article on lasers, among other things. However, no other person is entitled to copy the words, or any other form of expression, used by the original author. The moment a copyrightable work has been created and fixed in a tangible form such as writing, it has copyright protection. Notice is not necessary for this protection to automatically extend to many other countries of the world. However, in some countries, including the United States, there are advantages to having copies of the work which are distributed to the public bear the familiar copyright notice “©, year of first publication, the name of the owner of the copyright.”34 Copyright automatically exists on an original work without the need for registration. Some countries, such as the United States, operate a registration system. Registration often perfects rights or adds to remedies that arise automatically.35 However, very few businesses actually register copyright unless the work is particularly valuable, there is a need to register in light of a financing (such as for a film), or in anticipation of litigation. This is especially true of works, such as technical drawings, catalogues, and manuals, that are used on a day-to-day basis. Copyright is a fundamental asset in certain industries, such as the publishing, music, motion picture, television, and software businesses. However, the value of copyright in most other businesses should not be overlooked. Copyright protects databases, such as those relating to suppliers and customers; manuals, such as those containing operational, sales, and technical information; technical drawings; software; catalogues and advertising materials; and trademarks, labels, and character designs. Therefore, copyright is usually a material asset of any business. In most countries, copyright protection generally extends for the life of the author plus 50 years thereafter.36 In many countries, including the United States, there are numerous variations from and exceptions to that general rule for certain types of works.37 In the United States, there are also different terms for older works.38 The rules on authorship and ownership of copyright are not uniform. In most countries, the person who created the work is the author.39 The United States has its work made for hire doctrine that governs the authorship and ownership of certain types of works authored by those in certain types of relationships.40 There are numerous variations to these rules from jurisdiction to jurisdiction, often based on the nature of the work.41 What further complicates an assessment of title in copyright is the fact that
8.32 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
copyright statutes around the world generally provide for an automatic reversion of title to the heirs of the author(s), at a specified time after the death of the author(s) despite any assignment.42 The terms and conditions of such reversions vary from country to country. Types of Searches. Several types of searches may be done in the Copyright Office
records. An index search is made to determine what copyright registrations have been granted to or transferred to a particular person. One may conduct a title search to identify licenses on record and grants of security interests against copyright. Such documents are recorded in the Copyright Office. A work search seeks to identify whether a certain work has been the subject of copyright registration or not. This may be relevant if a certain work is material to the business. An author search seeks to locate all works for which copyright has been registered in which a particular author has been named. This is often of assistance when, for example, a particular individual has been responsible for developing most or all of the computer software in the company. • • • •
Consider an index search. Consider a title search. Consider an author search. Consider a work search.
Limitations of Searches. While copyright searches are necessary from the lawyer’s perspective, they often yield very little information, except in particular copyright-dependent industries because copyright is rarely registered. Because of the additional advantages given to a copyright registrant in the United States, there is more incentive to register copyright there than in most other countries, so searches in the U.S. Copyright Office may be of some assistance. In the case of an index search, as in the case of patents and trademarks, the search will only identify registrations on record in the name of the person for which the search is conducted. A work search can only identify works by title, and the titles used are often misleading or vague (like “Computer Program 1”). Applications for registration are not available for searching during their pendency. This is not generally a significant problem, as applications usually pass through to registration within a few weeks in most countries. The Copyright Office search records are also known to contain errors and omissions that may affect the reliability of any search.
• Understand the limitations of these searches. • Understand that most copyrights are not on record in the Copyright Office. • Understand that applications for registration are not available for searching. Moral Rights. In some countries, authors have moral rights that may restrict the modification or exploitation of a work after it has been sold or licensed.43 In some countries these rights are broader and stronger than in the United States, where they apply only to
INTELLECTUAL PROPERTY RIGHTS 8.33
works of visual art.44 For example, in Canada, moral rights apply to all works (including computer software, technical specifications, compilations of data, and advertising copy). In some countries, unlike other intellectual property rights, moral rights may not be assigned, but may only be waived.45 Therefore, any assessment of the rights in literary, artistic, and other copyright-protected works of a target must consider the impact of authors’ moral rights. Of primary importance is the issue of whether or not an author’s moral rights could interfere with the future modification or exploitation of those works (such as software) and if appropriate waivers have been obtained. • Consider the impact of moral rights. Neighboring Rights. There are a number of so called neighboring rights that are related
to copyright. These rights vary significantly from country to country and relate to works such as broadcast signals and performers’ performances.46 These rights are usually not susceptible to registration and, therefore, are generally not revealed in searches. When these rights are relevant in businesses, one must carefully consider them on a country-by-country basis. • Consider neighboring rights. • Identify relevant rights on a country-by-country basis. • Consider title issues. Database Rights. In some jurisdictions, there are separate rights governing the use of databases that are in addition to those rights in compilations that are provided by copyright.47 For example, Europe has legislation governing the selection and arrangement of data in databases. In other countries like the United States, legislation has been contemplated. Registration is not required to acquire rights under these laws. Therefore, searches of intellectual property offices will be of no assistance. Databases are relevant to most businesses in many ways but present the most issues when they are licensed or shared, in whole or in part, with others.
• Consider relevant databases of the target. • Consider application of relevant database laws in relevant jurisdictions. Follow-up. In light of what was said previously, the key limitation on a copyright
search is the fact that copyright is registered in so few works, and related rights generally cannot be found in searches. Therefore, one must generally rely on discussions with the target’s personnel and other investigations to identify works that are material to the business. For such works, authorship and all other relevant particulars should be identified and listed. • Consider discussions with the target’s personnel and other due diligence activities to identify key works, including databases, that are material to the business. Semiconductor Chip Rights. A mask work 48 is a three-dimensional pattern embodied in
silicon chips. The resulting chip is a semiconductor chip product.49 In some countries,
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creators of such chip designs may, through registration, protect either a mask work or a chip embodying the mask work against reproduction and commercial exploitation.50 The rights granted prohibit even a substantially similar mask work. A topography must be original to be protected. These types of rights are obviously of concern to only specific types of businesses. If one is dealing with a business for whom semiconductor chip rights are important, one must conduct appropriate searches in the appropriate offices in relevant countries and relate the findings of these searches to the actual activities of the target. • • • • • • • • • • • •
Consider an index search. Consider a search of recorded licenses. Consider a state-of-the-art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search to identify grants of security interests against issued registrations. Understand the limitations of the searches. Understand that pending applications may not be available for searching. Correlate the information obtained in semiconductor chip right searches with that obtained through meetings with relevant people in the target. Consider other key mask works that might be registered. Consider relevant information about key semiconductor chips, their authors, and the relationship of authors, whether through employment or consulting contract.
Plant Rights. Plant rights protect certain new varieties of plants in certain countries.51
In the United States, one can obtain a plant patent. In many other countries, a plant breeders’ right may be registered. These rights are of relevance only to very specific businesses. If one deals with one of these businesses, appropriate searches should be conducted and related to the activities of the target. • • • • • • • • • • •
Consider an index search. Consider a search of recorded licenses. Consider a state of the art search. Consider a novelty search. Consider an infringement search. Consider a validity search. Consider a search to identify grants of security interest against issued patents and registrations. Understand the limitations of the searches. Understand that pending applications may not be available for searching. Correlate the information obtained in plant right searches with that obtained through meetings with relevant people in the target. Consider other key varieties that might be registered.
INTELLECTUAL PROPERTY RIGHTS 8.35 Personality Rights. Celebrities, including political, athletic, and entertainment figures have rights in their personas, which are commonly referred to as personality rights. These include their names, their representations, and other distinctive features associated with them. The unauthorized commercial use of such features may be prohibited. A number of jurisdictions, including some countries, a number of states in the United States,52 and a number of provinces in Canada, have statutes prohibiting the commercial use of certain distinctive attributes of individuals without authorization. In other countries, such uses may be protected under more general laws. Creators of fictitious characters such as Mickey Mouse may have rights of a different type. Personality rights may be material to a business in one of two general situations. The first is when the business is based primarily on personality rights (such as a film, music, or sports business) where significant revenues are generated as a result of the use, direct or indirect, of the attributes or other indicia of famous real or fictitious personalities. The other situation arises when a business uses a personality as a spokesperson for the business or a particular product. There is no central registry in any federal jurisdiction to obtain information on personality rights. A few states maintain registries, such as California. If the participation of a personality on a continuing basis is seen as a significant asset of the business, these issues should be addressed. If a use is made of a personality’s indicia without consent, this should also be addressed.
• Determine whether the business is based primarily on personality rights. • Determine whether the target uses a personality as a spokesperson for the business or a particular product. • Identify relevant personality rights. • Review all contractual arrangements relating to personality rights. Proprietary information is any information that gives the possessor an advantage over those who do not know it. While the terms trade secrets and know-how are generally used to refer to technical information, proprietary information is not restricted to technical information. Business and sales techniques, customer and supplier lists, databases, sales manuals that are distributed on a restricted basis, franchise manuals and such all constitute proprietary information that may be of great value to a business. Rights in proprietary information may be enforced in some jurisdictions by statute.53 Either alternatively or in addition, the general law of many jurisdictions provides recourse against the misappropriation or the unauthorized disclosure or use of proprietary information. Contractual rights restricting disclosure may supplement these rights. It is not possible to obtain information on proprietary information through searches of public records. Proprietary information by its very nature is not documented or recorded. Rather, one must derive knowledge of the proprietary information of the business, its value, and the care taken to protect it from meetings with representatives of the target. In order to identify the proprietary information that is material to the target, one must probe all aspects of the business. Key areas are financial, record keeping, and data processing operations; supplier, distributor, and customer lists; operational procedures and manuals; and most importantly research, development, processing, and manufacturing operations. In assessing trade secret protection, one should consider information Proprietary Information.
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(such as specifications) that may have been provided to governments and may be available to third parties under access to information legislation. In an asset deal, provision must be made, either in the asset purchase agreement or in an ancillary technical assistance agreement, for full disclosure of the trade secrets to the purchaser. However, one must be careful to avoid violating statutory, contractual, or other obligations by such disclosure. In a share deal, obligations may be violated through the change of control of the target. In some cases, consent may be required. • Consider all information that might be proprietary, including technical information, business and sales techniques, customer and supplier lists, databases, sales manuals, franchise manuals, and so on. • Determine all relevant proprietary information from discussions with the target. • Determine whether it is necessary to obtain disclosure of the trade secrets to the purchaser by way of an ancillary technical assistance agreement. • Consider financial, record keeping, and data processing operations. • Consider supplier, distributor, and customer lists. • Consider operational procedures and manuals. • Consider research and development operations. • Consider processing and manufacturing operations. • Consider information that may have been provided to governments and may be available to third parties under access to information legislation. • Consider statutory, contractual, and other legal obligations that may be violated by disclosure to the purchaser or a change of control of the target. Foreign Rights. Most businesses have some interest in foreign markets. Many already
have commercial interests or rights in other jurisdictions. At the very least, most now advertise on the Internet. As trade becomes more globalized, intellectual property rights in foreign countries become more important as a method of acquiring and preserving competitive positions. Depending on the nature of the target’s business, it may not be sufficient merely to conduct intellectual property searches or identify intellectual property rights in the United States, or even in a few select countries. It is also important to understand that intellectual property rights may automatically arise in multiple jurisdictions. For example, through various international treaties (commonly referred to as conventions), as soon as a work is created in the United States or any other country that is a member of the convention, copyright in that work automatically is generated in the country of origin and all other countries that are members of the convention (for example, the Convention for the Protection of Literary and Artistic Works—the Berne Convention). International rights arise differently in the case of other intellectual property. To obtain patents or design protection in other countries, formal applications must be made, and those applications prosecuted until grant of a patent or a registration. Absent such an application in a particular country, there is no protection for the invention or design in that country. In the case of trademarks, rights are acquired in some countries merely through performance of a service or the sale of goods in association with the mark in that country without any formal application having been made; in other countries registration of the mark is necessary to acquire rights. Therefore, if the target exports widgets, performs
INTELLECTUAL PROPERTY RIGHTS 8.37
services in foreign countries, or advertises abroad, it may have acquired trademark rights in those countries. Conversely, if someone else has obtained rights in the same trademark in those countries through registration or prior use (depending on the nature of the country’s trademark system), the sale of such widgets, performance of such services, or advertising in such countries by the target may constitute an infringement or other violation of the trademark rights of a third party. In certain countries there are different forms of intellectual property. For example, many European countries have protection (with no equivalent in the United States) for what is known as a utility model. An invention that may not meet the stringent criteria for patent protection may qualify for utility model protection. The scope of intellectual property rights also varies from country to country—for example, the rights included within copyright vary significantly from one jurisdiction to another. There are also terminology differences. For example, many countries do not have a design patent system. Instead, their systems grant registrations for designs with different criteria, rights, and terms for designs. One should be careful about foreign rights, as their rules can be quite different in many other ways. If there are significant foreign rights, it is advisable to retain local counsel to find out what questions one should be asking and what searches should be conducted. Here are three of many examples: 1. 2.
3.
In some countries, a holding company cannot own trademarks. In some countries, there is no examination of trademark applications against previous registrations. The application is filed and the registration issues unless there is some formal defect. Thus, the registrations themselves may be less reliable than registrations in countries with substantive examination. In some countries, inventions must be worked in order for patent rights to be maintained beyond an initial period.
Therefore, when dealing with foreign rights, focus on the following: • Consider the effect of international treaties. • Consider the effect of international and regional applications. • Consider searches in those countries in which the target sells or advertises goods or advertises or performs services. • Consider different forms of intellectual property in different jurisdictions. • Consider peculiar foreign rights and rules. Secured Intellectual Properties. The existence of security interests granted against the
intellectual property of the target will obviously be of vital concern to any potential purchaser or lender. There may be general security arrangements governing all assets of the business (bank financing, for instance). There may also be specific security interests directed to some or all of the intellectual property of the target. This is particularly true where the intellectual property and technology assets of a target are among the most important assets. An example is a software development company that operates through leased premises, has no inventory, and very little equipment or cash. The key assets of the business are the know-how of the employees and copyright or patent rights in the software that they develop. In such cases, a lender may have obtained and
8.38 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
recorded a security interest against all assets, against specific intellectual property rights, or both. It is also possible to take security in agreements relating to intellectual property. For example, lenders often take security in the proceeds pursuant to a license. These should also be considered. National intellectual property statutes generally do not expressly contemplate the granting of security against intellectual property. The intellectual property statutes define the rights of creators and owners of certain types of intellectual property. They also establish registration systems and govern the priority of conflicting claims of applicants rather than creditors. They also provide for the recordal of assignments and licenses. However, the intellectual property laws of most countries usually do not adequately define the types of assignment or interest governed by their recordal provisions and leave much to be desired as systems for governing security interests in intellectual property. The legal situation is complicated by the fact that security interests in intellectual property are generally subject to the same regime as other intangible property. In some countries, commercial personal property security laws, such as the Uniform Commercial Code (UCC) in the United States,54 legislate with respect to intangibles (including intellectual property rights) as if the intellectual property statutes do not exist. Even in the context of intellectual property, personal property security laws generally fail to distinguish between security interests in intellectual property that are subject to application and registration from intellectual property (such as trade secrets) that is protected in other ways. Over these are layered issues regulated by the banking, bankruptcy55 and insolvency, reorganization, and related laws of each jurisdiction. In some countries it is not even possible to record a security interest in intellectual property, either under the intellectual property laws or the personal property security laws. In many jurisdictions there is some doubt about which system governs in the case of conflicting priorities governing the security interests that have been recorded in the intellectual property offices and the personal property security regimes. For these reasons, some feel it is necessary to register security interests in intellectual property under both the intellectual property regimes and the applicable personal property security regimes. Lenders who are cautious sometimes record the same interests under both systems. Others feel that this is not necessary. In some cases, commercial lawyers who are more familiar with the personal property security regimes choose to record security interests under that system. Intellectual property lawyers, who are more familiar with the intellectual property statutes, when possible, only record interests in the intellectual property offices. These different approaches obviously impact on decisions about where to look for such recorded interests. For the purposes of due diligence, one must look in both locations in those jurisdictions where it is possible to record security interests in both systems. When it is procedurally possible to record a security interest against intellectual property in intellectual property offices, there are limitations, as previously discussed, in searching some pending applications to identify them for the purpose of listing the collateral and in locating recorded security interests. A creditor, when identifying the relevant collateral in its security agreement, may not have identified then-pending applications. As a result, there may appear to be a patchwork of patents, registrations, and applications, some of which may or may not be identified in the grant of the secu-
INTELLECTUAL PROPERTY RIGHTS 8.39
rity. In other cases, even when the rights are identified in the security agreement, recordals may not have been made against all properties or in all jurisdictions. The usual personal property security searches, such as under the UCC and other equivalent foreign types of searches familiar to all commercial lawyers, should, of course, be conducted, and the results of those should be reconciled with the information obtained through the searches for security interests in intellectual property offices. • Consider conducting searches under the UCC and other personal property security legislation. • Consider conducting searches in relevant intellectual property offices. • Reconcile the information in these searches. On-Site Technology Investigations. Once the searches have been ordered, one should go to the premises of the target to try to find out what intellectual property and technology rights it uses and owns. With respect to technology, one should try to work from the bottom up by determining how the target handles new ideas, if it has a research and development department, and where that is. One should attempt to identify what kind of documentation is produced when an employee or a freelance contractor comes up with a new idea. It is essential to tour the plant, warehouse, stores, and other locations where the real business is done to see, in a general way, what technology the target is using. No plant or other premises tour can ever familiarize a lawyer with the details of technology. It will, however, provide a general idea of the processes used in the plant or other premises, and it may also give one an idea about which technology is homegrown and which is licensed-in. It is often helpful to tour the plant with the purchaser and the seller’s counsel so that all parties can see the issues at the same time and in the same setting.
• Determine how the target handles new ideas. • Determine whether the target has a research and development department. • Determine what kind of documentation is produced when an employee comes up with a new idea. • Tour the plant, warehouse, stores, and other locations. • Consult with the technical and marketing executives of the target. Products, Advertising, and Packaging. A preliminary discussion with the seller’s marketing and technology personnel is helpful in discerning the proprietary position, if any, of key products and identifying the intellectual property associated with these key products. During the market review, the intellectual property lawyer should also inquire about the proprietary position of the target in the markets in which it participates for the purpose of assessing competitiveness and exclusivity in those markets. Each product that is material to the target’s business should be considered from the perspective of manufacture or other production, brand names, packaging, advertising, and electronic commerce. It is helpful to obtain specimen advertising materials, including video and audio tapes and print and Internet advertising. It is advisable to obtain and review copies of product packaging, labeling, and copies of website materials in order to identify any regulatory issues and all relevant trademark rights that may not
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have been revealed in the course of Trademark Office searches. These materials may also suggest violations of the rights of third parties or contractual arrangements that should be carefully considered in the contract review. It is during the review of these materials that one obtains a real sense of the target’s business, and can hopefully reconcile real-life activities with the information obtained from intellectual property office searches to identify and fill in the gaps. • • • • • • • •
Determine the proprietary position, if any, of key products. Inquire about the proprietary position of the target in the marketplace. Meet with the target’s marketing and technology personnel. Consider each product that is material to the target’s business from the perspective of manufacture or other production, brand names, packaging, and advertising. Obtain specimen advertising materials, including video and audio tapes, print advertising, and website materials. Obtain and review copies of product packaging and labeling to identify any regulatory issues and all trademark rights. Consider these materials in the context of violations of the rights of third parties. Consider these materials in the context of contractual arrangements.
Intellectual Property Maintenance Costs. One should also assess the costs of maintaining the company’s intellectual property portfolio. It is helpful to review prior costs and consider what major expenses (such as those relating to litigation) are anticipated in the future in addition to more routine expenses. One should focus on government fees, local counsel costs, and the costs to coordinate maintenance.
• Inquire about intellectual property maintenance costs and foreign agent and outside counsel expenses. • Assess routine annual expenses for maintenance of the intellectual property portfolio. • Identify anticipated major expenses relating to intellectual property. CONTRACT REVIEW Agreement Review. One must identify, obtain, and review copies of all contracts that
involve intellectual property and technology. Agreements are usually available from the target but may also be referenced in other sources, such as filings made pursuant to securities laws. One should also have an understanding of the important products of the target. The essential thing is to concentrate on the business relationships that are built around intellectual property and technology and try to find the contracts that govern those relationships. In doing so, one should attempt to identify all schedules, appendices, and side letters. Intellectual property and technology assets can be uncovered in contracts such as license, joint venture, consulting, joint development, manufacturing, and sales agreements. Contractual review should not be overlooked as a source of identifying relevant owned or licensed intellectual properties. All relevant agreements should be reviewed sufficiently to determine whether they contain a restrictive assign-
CONTRACT REVIEW 8.41
ment provision preventing transfer to the purchaser in a sale of assets or whether they will be materially affected by a sale of the shares of the target. One will also need to assess how diverse the target’s technology and other intellectual property rights have become—for instance, if the target has licensed most of the technology to its competitors and under what terms (such as exclusivity). An evaluation of the grants both into and out of the target needs to be undertaken to understand if the business of the target will have the freedom to grow or whether it is contractually boxed into its present form. This may shed some light on whether the target is a net developer or acquirer of technology or not something that may prove useful if the purchaser is considering retaining key research and development personnel and facilities. It will be necessary to find out whether the agreements are in good standing, how long they run, what happens when they end, and whether or not they can be terminated earlier. In the case of copyright, statutory reversions may effect automatic terminations.56 Agreements should also be considered from the perspective of problems in the context of the transaction as a whole. For instance, if the target will be wound up into the purchaser, the purchaser may not be happy with the trade secret restrictions because they may be unworkable. Contracts should also be considered from the point of view of provisions providing for indemnification of intellectual property infringement. These may potentially involve significant liabilities. The intellectual property and technology lawyer must also pay attention to the money flow to identify the royalties to be paid out and received annually for the foreseeable future. • Review relevant contracts to identify intellectual property and technology. • Obtain copies of all contracts that involve intellectual property and technology. • Concentrate on the business relationships that are built around intellectual property and technology. • Identify all schedules, appendices, and side letters to contracts relating to intellectual property and technology. • Review all relevant agreements to determine whether they contain a restrictive assignment provision preventing transfer to the purchaser in an asset deal. • Review all relevant agreements to determine whether they will be materially affected by a share deal. • If there are restrictive covenants or consent is required, request appropriate waivers. • Consider how diffuse the target’s technology and intellectual property has become. • Evaluate all license grants into the target to determine how reliant the target is on licensed intellectual property and technology. • Evaluate all the grants out of the target to determine whether the business of the target will have the freedom to grow. • Determine whether the target is a net developer or acquirer of technology. • Determine the money flow to identify amounts to be paid out and received annually for the foreseeable future. • Determine whether the agreements are in good standing, how long they run, what happens when they end, and whether or not they can be terminated earlier.
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• Determine these questions from the perspective of problems in the context of the transaction as a whole. • Consider the agreements from the point of view of provisions providing for indemnification of intellectual property infringement. Secrecy Agreements. One also needs to review all secrecy agreements to determine
whether they also contain provisions that prohibit the assignment of rights and obligations. Most secrecy agreements restrict assignment unless written permission is first obtained. Therefore, the purchaser must request that the seller obtain written waivers prior to transferring confidential information to the purchaser. These agreements should be reviewed to ascertain whether information disclosed is already in the possession of the purchaser. If so, the agreement may be terminated. Assignments, waivers, and terminations should be executed before the confidential information is passed from the seller to the purchaser. • Review all secrecy agreements to determine whether they also contain provisions that prohibit the assignment of rights and obligations. • Review these agreements to ascertain whether information disclosed thereunder is already in the possession of the purchaser. • Determine whether any agreements should be terminated. • Determine whether assignments, waivers, or terminations should be executed before the confidential information is passed from the seller to the purchaser. License Agreements. A review of license agreements is crucial in any commercial transaction. License agreements will often reference intellectual property and technology that may not be located in searches of public registers. In certain businesses, license agreements may be material: for example, a key product line may be based on a trademark or patent license. The financial and other terms of such license may be crucial to the financial viability and success of the target. When the core or a material aspect of the target’s business is dependent on licenses, either as licensor or licensee, the need to carefully review and consider the material aspects of the license agreements, such as exclusivity grants, financial considerations and restrictive covenants, becomes even more important. One should carefully review the quality control provisions in trademark license agreements. In an asset deal, one must be sure that the agreement is assignable without the need for consent or one must obtain the consent of the other party. This is because most licenses, unless otherwise specified, are personal to the licensee and therefore cannot be assigned without the consent of the licensor. This is different from the rule for most contracts. In certain competitive situations, depending upon the wording of the assignment provisions in the license agreement, it may be possible for consent to be refused or for the other party to extract some concession, financial or otherwise, in exchange for a consent. In a share deal, one must carefully examine the change of control provisions of license agreements to ensure that, in each case, a change of control or other material share transfers do not terminate or otherwise affect the agreement. Restrictions on
CONTRACT REVIEW 8.43
assignments and termination for improper assignments and changes of share control are quite common in licensing arrangements. • Review all license agreements. • Determine whether a key product line or service of the target is based on a license. • Determine whether a license agreement is assignable without the need for consent in an asset deal. • Determine whether a change of control or other material share transfers will terminate or otherwise affect the agreement in a share deal. • Consider quality control provisions in trademark license agreements. Assignments. A review of intellectual property and technology assignments and other transfers is crucial in any commercial transaction. Assignments will often reference intellectual property and technology that may not be located in searches of public registers. In certain cases an assignment may be very material. For example, a key product line may be based on a trademark or patent purchased from someone else, but the assignment was not recorded in the relevant intellectual property office. The financial and other terms of such assignment may be crucial to the financial viability and success of the target. Determine if goodwill has been assigned with trademarks where required.
• Review all intellectual property assignments. • Determine whether a key product line or service of the target is based on the assignment of an intellectual property right. • Determine whether goodwill has been assigned with trademarks where required. Franchise Agreements. Franchise agreements present many of the same issues as do license agreements, with some twists. In the case of a franchisee, the company’s business is totally dependent on the franchise agreement. There are usually a variety of ancillary agreements relating to a franchise agreement. These may include lease or sublease arrangements, guarantees, and so on. Restrictive covenants in franchise agreements are usually far more onerous than in license agreements. The assignment and change of control provisions in franchise agreements are also typically more onerous than in ordinary license agreements because the franchisor wishes to ensure that the franchisee or its principals are capable of running the franchise.
• Review all franchise agreements. • Identify all ancillary agreements relating to franchise agreements, including lease or sublease arrangements, guarantees. • Carefully consider restrictive covenants. • Carefully consider assignment and change of control provisions. Distribution and Supply Agreements. Distribution and supply agreements present many of the same issues as license agreements. While distribution and supply agreements
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may be characterized more as commercial agreements, they often include provisions relating to intellectual property and technology rights that may make them more like license agreements. • Review distribution and supply agreements in the same way as license agreements. Co-packing and Toll Manufacturing Agreements. A co-packing or toll manufacturing
agreement authorizes a manufacturer to manufacture and package a product in the name of some other entity so that, as far as the outside world is concerned, the product is manufactured and packaged in the name of the other entity. A co-packer or toll manufacturer is a contract manufacturer who packages and labels the product for the ultimate seller. Co-packing and tolling arrangements, like distribution and supply arrangements, often also include intellectual property and technology provisions and restrictive covenants. These should be carefully reviewed for the same issues as license agreements. • Review co-packing and toll manufacturing agreements in the same way as license agreements. Joint Venture and Strategic Alliance Agreements. Joint venture and strategic alliance agreements usually involve many aspects of commercial arrangements. However, most joint venture arrangements include some reference to intellectual property rights and often include specific licensing arrangements. The other party to the arrangement may enjoy a very good relationship as a joint venturer or alliance member with the target, but the possibility that this party may have no interest in continuing that relationship with the purchaser for competitive or other reasons may be a particular concern in a joint venture or strategic alliance arrangement. Therefore, the other joint venturer or alliance member may look at ways to terminate the joint venture relationship. These agreements should be reviewed in the same way as license agreements.
• Review joint venture and strategic alliance agreements in the same way as license agreements. Research and Development Agreements. It is important to review both current and terminated research agreements. Terminated agreements are important because the target may have contracted for research or other development work with third parties and such agreements may not have properly dealt with the transfer of intellectual property rights from those third parties to the target. Therefore, while the target may be operating on the assumption that it owns such intellectual property rights, in fact, it may not. Current research agreements are of importance for the same reasons. In addition, all of the issues discussed in respect to license agreements are material.
• Review current, expired, and terminated research agreements in the same way as license agreements.
CONTRACT REVIEW 8.45 Government Agreements. Government procurement contracts and government-funded
research and development agreements may provide for ownership or rights in favor of the government or a government agency. In addition, all of the issues discussed in respect to license agreements are material. Further, there may be relevant statutes and regulations that govern such rights.57 • Review current expired and terminated research agreements. • Consider any statutory or regulatory overlay. Sponsorship and co-promotion agreements should be reviewed for all the same types of issues as those to be considered in license, distribution, and personality rights agreements.
Sponsorship and Co-promotion Agreements.
• Review sponsorship and co-promotion agreements in the same way as license agreements. Advertising Agreements. There are many different types of agreements relating to
advertising. One key type comprises agreements with advertising agencies. These should be reviewed to ensure that all intellectual property, including copyright, is transferred to the target by virtue of those agreements. Without a written transfer of copyright, in some jurisdictions the target may not own copyright in the works (such as television commercials, radio commercials, jingles, copy, and so forth) developed for it. Because advertising agencies often subcontract portions of campaign development out, it is also essential to check that the advertising agency has itself obtained those rights from third parties in order to be in a position to effectively transfer them to the target. It is advisable to assure oneself that these agreements adequately deal with intellectual property issues. They should also be considered for those issues referenced in the discussion of licensing agreements. • Ensure that all intellectual property, including copyright, is transferred to the target. • Review advertising agreements in the same way as license agreements. Employee and Contractor Agreements. Often overlooked in a target’s contractual
arrangements, and therefore in the due diligence process, are employee and independent contractor agreements. Policy manuals should also be reviewed as many policies are set out in manuals and incorporated in the terms of employment by reference. Generally, intellectual property or technology developed by an employee in the course of his or her duties is owned by the employer. However, in some countries employees may retain some rights to the intellectual property or technology. Alternatively, if the intellectual property or technology derives from activities not directly related to an employee’s activities, there may be an argument that it is not owned by the employer. Further, in most countries, there is no automatic waiver of moral rights in a work by an author merely by virtue of the employment relationship. Therefore, it is advisable to have, at least from all employees who are involved in work
8.46 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
that is likely to yield intellectual property or technology rights, an assignment of all intellectual property or technology resulting from their activities and a waiver of moral rights in all copyright works. In light of increased mobility among employees, it is also advisable to have very clear restrictions on the disclosure or use of confidential information, restrictive covenants, and continuing obligations to assist in the protection of intellectual property and technology rights, such as in the case of patent applications. It is equally necessary to determine whether any material intellectual property or technology has been developed by current or recently departed employees or by independent contractors who have not signed intellectual property transfer agreements and to assess the consequences of such gaps in the documentation. Contractor agreements have taken on even more importance as more companies have retained third parties to do contract work in order to keep their payroll and fixed costs relatively low. It is necessary to review these documents to ensure that they deal with the transfer of all relevant intellectual property or technology rights, have appropriate confidentiality and restrictive covenant provisions, and contain waivers of moral rights. These agreements should also be reviewed from the perspective of all the issues discussed with respect to licensing agreements. It is also possible that former employers of current employees of the target may be in a position to assert rights in proprietary technology on the basis that the technology was developed while the employees were employed by the former employer. Such employees may be bound by nondisclosure agreements or restrictive covenants. Nondisclosure provisions and restrictive covenants are material to a consideration of these rights in a commercial transaction. Many purchasers of businesses often terminate a number of employees immediately after the acquisition, or in anticipation of the acquisition they require the target to terminate the employees. If this is done in the absence of a clear transfer of intellectual property and technology rights and restrictions on what can or cannot be done with intellectual property, this may leave the target exposed. These agreements should be looked at from the perspective of this possibility as well as for continuing employees. • Identify and review all employee and independent contractor agreements. • Identify and review policy manuals. • Determine whether such employees or contractors have signed intellectual property and technology transfer and confidentiality agreements, and assess the consequences of any gaps in the documentation. • Determine whether any material intellectual property and technology has been developed by current or recently departed employees. • Review all contractor agreements relating to intellectual property and technology. • Obtain assignments of all intellectual property and technology and waivers of moral rights from all relevant employees. • Obtain restrictions on the disclosure or use of confidential information, restrictive covenants, and continuing obligations from all relevant employees. • Obtain assignments of all intellectual property and technology and waivers of moral rights from all relevant independent contractors. • Obtain restrictions on the disclosure or use of confidential information, restrictive covenants, and continuing obligations from all relevant independent contractors.
INFORMATION TECHNOLOGY ISSUES 8.47 Settlement Agreements. All agreements relating to the settlement of intellectual prop-
erty and technology disputes should be reviewed. Such agreements often include licenses, payment obligations, limitations on the right to use or protect intellectual property, limitations on the right to challenge the use or protection of intellectual property of the other party, acknowledgements of the intellectual property rights of others, agreements to co-exist, and various other provisions that may be material from a financial perspective or may limit the value of the target’s intellectual property and technology. Such agreements arise out of both threatened and actual litigation and administrative proceedings such as patent interferences and trademark oppositions. Often such agreements are in letter form and may, therefore, be difficult to identify. • Review all agreements relating to the settlement of intellectual property and technology disputes. • Consider such agreements from the perspective of licenses, payment obligations, limitations on the right to use or protect intellectual property and technology, limitations on the right to challenge the use or protection of intellectual property, acknowledgements of the intellectual property rights of others, and agreements to co-exist. Information Technology Agreements. These are discussed in detail in the next section.
INFORMATION TECHNOLOGY ISSUES
Every business uses computer and information technology in some form. Common examples include accounting systems, inventory control, manufacturing processes, word processing, telecommunications systems, websites, other Internet activities, and electronic commerce. The following briefly discusses each of the most relevant areas for information technology due diligence. Hardware. One should prepare a complete inventory of equipment to be transferred,
including: personal computers, minicomputers, mainframes and servers; peripherals such as terminals, printers, and scanners; and telephone systems, including handsets, facsimile machines, and switching equipment. A determination should be made as to whether the equipment is owned or leased. Lease agreements must be reviewed to determine whether the consent of the lessor is required to assign the equipment. Similarly, maintenance contracts for the equipment must be reviewed to determine whether they are assignable or if a transfer of control of the company will trigger a termination or penalty. These agreements often contain intellectual property provisions. • Prepare a complete inventory of equipment to be transferred. • Determine whether the equipment is owned or leased. • Review lease agreements to determine if the consent of a lessor is required to assign the equipment. • Review service and maintenance contracts for the equipment to determine whether they are assignable or if a transfer of control of the company will trigger a termination or penalty.
8.48 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
• Review these agreements for intellectual property issues in the same way as license agreements. Software. Copyright in most general-purpose software used by a company is licensed by the company and not owned. Copyright in software that has been custom developed for the target may be owned by the target or thought to be owned by the target but actually owned by the developer. A complete inventory of software should be completed and an audit conducted to ensure that all software other than that developed in-house and owned by the target is properly licensed. One should also review accounting procedures, since those are most often done by computer. This may also lead to software that is used in the accounting process. Bank agreements may involve information technology and software licenses. Examples include payable and cash management systems. In some cases, accounting and data processing may be done by a related company or an independent service provider. The same approach should be followed for all other computer-driven activities, such as manufacturing processes. Many companies are very lax about the use of software and have many illegal copies of personal computer software. All copies should be verified as licensed. All of the software licenses should be reviewed to verify compliance and to determine whether the consent of the licensor is required to assign in an asset sale or if a sale of shares will trigger a termination or penalty. Software support agreements should be reviewed for the same issues. These agreements should also be reviewed for restrictions relating to specific sites and prohibitions against off-site removal and use. If there is any custom-developed software, it should be determined whether it was created by employees or independent contractors. In both cases, because modifications may have been met in the past or may be made in the future, moral rights issues should be considered. In addition, if the software was developed by an independent contractor, the contract should be reviewed to ensure that all rights, especially copyright, have been assigned to the target. One must also find out if the target has safeguards for its source code. All source code escrow agreements should be identified and reviewed. Careful attention should be paid to the importance of the use of software and hardware in the operations of the business. If, as is the case for most businesses, it is virtually impossible to function without operational software or in the event of data loss, it is important to identify what plans there are for disaster recovery. Often businesses have contracts with disaster recovery service providers. These should be reviewed and assessed in the context of the target’s business. Copyright law provides that only a computer program is protectable and that the underlying ideas and processes are not. However, courts have had a great deal of difficulty in articulating a workable method of separating protectable expression from the unprotectable elements. This is particularly the case where software is designed to have the same “look and feel” or “structure, sequence, and organization” as a competitive product. Such programs and their origins should be carefully considered.
• Prepare a complete inventory of software. • Conduct an audit to ensure that all software other than that developed in-house and owned by the target is properly licensed.
INFORMATION TECHNOLOGY ISSUES 8.49
• Determine whether any software used by the target is unlicensed. • Review all software licenses to verify compliance. • Review all software licenses to determine whether the consent of the licensor is required to assign in an asset deal or if a share deal will trigger a termination or penalty. • Review maintenance and service agreements. • Determine whether the target has safeguards for its trade secret rights and its source code. • Review all source code escrow agreements. • Review all software support agreements for the same issues. • Determine whether any custom-developed software has been generated by employees or independent contractors. • Review disaster recovery plans and contracts. Data. If the company makes extensive use of databases, the source of the information should be reviewed. If the data is licensed from third parties, the agreements should be reviewed in the same way as other license agreements. If the data is internally developed, ownership, copyright, and moral rights issues should be considered and assessed. One should determine whether data is processed by a related company or independent service provider and review all relevant agreements. As previously discussed, some jurisdictions (such as Europe) have separate laws governing databases. Other jurisdictions have privacy laws that regulate the use of personal data. (See the section on Privacy and Personal Information Issues.) Privacy issues in data compilation, protection, use, and disclosure should be considered along with the potential liability for the content and use of the data.
• Determine the source of information for all databases. • Review all relevant agreements when data is licensed from third parties. • Consider ownership, copyright, and moral rights issues when data is internally developed. • Consider issues relating to data protection legislation where relevant. • Consider issues relating to privacy. • Review data processing agreements. Internet Issues. The Internet is becoming increasingly important as a business tool. One should first identify all the servers on which the target’s website(s) reside(s). It is important to describe the servers, their location, and who owns and operates them. All other material equipment and software used in website hosting and operation should be identified. One should obtain copies of all contracts with equipment lessors, server providers, Internet backbone or bandwidth providers, Internet service access and hosting providers, and telecommunication companies. Domain names were discussed previously. If there are any technological limitations on the access to the target’s website, they should be identified. One should review the website development and agreements with website designers and those who maintain the website to ensure that copyright and other rights in all relevant materials have been assigned or licensed. People frequently assume that information
8.50 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
may be uploaded or downloaded from a website without regard to the rights of copyright owners. The website should be reviewed carefully to ensure that it does not contain or permit access to materials that would violate the intellectual property rights or would defame others. All agreements relating to linking other websites should be reviewed. It is often helpful to identify all search engines, files, databases, hyperlinks, browsers, and tools used on the website or by the target. It is important to obtain copies of all current and prior website legal notices and disclaimers, Internet and website use policies, including privacy policies, and online agreements, including the dates of posting and implementation of each. One should identify all products and services offered or provided on the target’s website. If the website is viewed as a significant aspect of the target’s business, it is helpful to obtain information about the number of visitors to the website, tracking methods, and information about how revenues are generated through the website. For sales through the website, it is important to understand the payment mechanisms and the contractual relationships with credit card companies, third-party payment agencies, outsourcers, certification authorities, and customers. All relevant contracts should be reviewed. If the target is an Internet service provider, one should focus even more on the services provided, including forum/bulletin board access services and posting/chat room services. One should obtain copies of all contracts relating to the development, supply, or use of these services. • Identify Web servers on which the target’s website resides, including description, quantity, where located, and who owns it. • Identify all material equipment and software used in website hosting and operation and review all contracts relating thereto. • Review copies of all contracts with server providers, Internet backbone or bandwidth providers, Internet service access and hosting providers, and telecommunications companies. • Consider any technological limitations on access to the target’s website by Internet users. • List all hyperlinks, search engines, and databases. • Consider all text, art, graphics, and sound used on the website and the intellectual property rights therein. • Review copies of all contracts relating to the development, maintenance, supply, acquisition, assignment, distribution, or use of the site and its content. • Identify all products and services provided on the website, including the ability to download images, content, or software; forum/bulletin board access, services and posting; and chat room services; review all contracts relating thereto. • Review copies of all current and past website legal notices and disclaimers, Internet/website use policies (including privacy policies), online agreements, and dates of implementation. • Review all linking agreements authorizing the target to link to other sites or others to link to the target’s site. Electronic Commerce. Today, much business is conducted by way of electronic data
interchange (EDI) and electronic commerce (e-comm). E-comm may be business-to-
INFORMATION TECHNOLOGY ISSUES 8.51
business (B2B) or business-to-consumer (B2C). Transactions are paperless in many cases. Therefore, a careful review should be made of all electronic trading agreements and practices. For B2B applications, one should determine whether there is a formal trading partner agreement where orders, invoices, and possibly payments are processed electronically. If there is not such a formal agreement, the legal basis for such transactions should be determined. One should carefully identify all payment procedures and the contractual trail of responsibility. For B2C transactions, compliance of agreements with consumer protection legislation should be checked.58 • Review all EDI and e-comm agreements and practices. • Determine whether there is a formal trading partner agreement where orders, invoices, or payments are processed electronically. • Where there is no agreement, determine the legal basis for such transactions. • Review accounting procedures, including software used in the accounting process, bank agreements that may involve information technology, data processing, and software licenses. • Determine whether data processing or accounting services are performed by a related company. • For Internet sales, review all payment mechanisms and copies of relevant contracts with all credit card and financing companies, outsource providers, certification authorities, security controls, and customer contracts. • For online consumer transactions, verify compliance with consumer protection legislation. Computer and Information Technology Industry. When information technology is a core
business asset, such as in the case of a hardware manufacturer, a software publisher, a data compiler, an Internet business or a service provider, or where website or e-comm activity is material to the business, even more careful attention must be paid to a number of key issues. If the target sells or leases hardware, it must be determined whether the products were developed internally. Intellectual property for the equipment should be assessed. Supply, co-packing, and distribution agreements should be reviewed. Related agreements such as software licenses and maintenance contracts must also be reviewed. The representations and warranties in such agreements must be considered. If the target distributes software, one must assess who has developed the software and related documentation. If it has been done internally, employee contracts relating to intellectual property must be reviewed. The review process is even more important when the rights have been acquired from outside the company. One should consider copyright and trade secret protection and, in some circumstances, patent protection. Related agreements such as distribution agreements, user licenses, and support contracts should be reviewed for issues similar to those in hardware agreements. Interface and protocol issues must be addressed. If the target markets information in the form of data, whether in electronic or printed form, a number of considerations arise. The sources of the data should be determined. If databases are created internally, one must determine whether steps have been taken to ensure copyright protection and review employee agreements relating to, among
8.52 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
other things, nondisclosure. If, on the other hand, the data is obtained from other sources, the rights to use, manipulate, or supply the data should be assessed. Contracts and license agreements should be reviewed to ensure that the business has the necessary rights to use, modify, and distribute the data. This should also be considered from the point of view of laws relating to accuracy, privacy, and database use in various jurisdictions. If the data is ultimately distributed by others, the distribution and end-user contracts should be reviewed to ensure that the rights to data will remain protected, among other things. If the business provides services relating to information technology, whether hardware, software, or data, a number of other issues should be considered. One issue is if the business has contractual rights with the owners of the intellectual property rights in the products that are necessary to provide the services. This is because maintaining the equipment or software may infringe the intellectual property rights of others in certain cases. Contracts with manufacturers or publishers and customers should be carefully reviewed for proprietary rights, confidentiality, termination, and change of control provisions. If e-comm or website aspects are crucial to the business of the target, particular emphasis should be placed on the issues discussed in the earlier section. • • • •
Review intellectual property issues and agreements relating to hardware. Review intellectual property issues and agreements relating to software. Review intellectual property issues and agreements relating to databases. Review intellectual property issues and agreements relating to information technology. • Focus on these issues for an electronic commerce based business. LIABILITIES Infringement Risks. The intellectual property liabilities of a company usually stem
from violation of the intellectual property rights of third parties. Attempting to assess all of the known and unknown potential liabilities could take a lifetime. However, there are very good reasons for reviewing intellectual property liabilities. The primary reason is to avoid the seller unwittingly breaching a representation or warranty to a purchaser of the shares or assets of a target whose long-term profitability or market position may be jeopardized by the infringement of the target’s or a third party’s proprietary rights, or invalidity of the target’s intellectual property rights. Similarly, a review will help avoid the failure to disclose a material risk to an issuer’s business in a prospectus or to avoid the breach of a representation or warranty to a lender in a loan transaction. Although a determination of future infringement or invalidity of intellectual property rights is extremely difficult, identifying red flags can assist in identifying truly imminent liabilities, in which good business judgment can be exercised in deciding how to deal with any issues that may arise. Intellectual property liabilities can be identified through infringement searches. Liabilities also surface in license agreements, other agreements of the type previously discussed, and those containing indemnification provisions. The indemnification provisions in all such agreements of the target should be reviewed to assess the potential
LIABILITIES 8.53
liabilities posed by them. Sufficient information needs to be gathered to explain to the purchaser where the known risks are, what products or processes are involved, and what dollar amounts and business activities are at stake. This may require more information than any schedule or backup material provides. The intellectual property and technology lawyer’s objective is to avoid having the purchaser acquire a target whose very viability is jeopardized by present or future litigation against the target or by aggressive third parties encroaching upon the target’s market share. A sensible approach is to conduct interviews with the target’s intellectual property counsel, general counsel, and internal administrator (who is primarily responsible for the intellectual property and technology of the target). The interviews should focus on any current or anticipated lawsuits and on letters, memoranda, and opinions regarding the actual or potential infringement or validity of any intellectual property asset of the target, or of a third party that would directly affect the target’s business. Attention should also be given to administrative proceedings, like trademark oppositions, nonuse cancellation proceedings, patent interferences, and so on. The discovery of any infringement or validity issue involving key products or important intellectual properties raises a red flag and must be reviewed in detail. Lawyers for both the purchaser and seller should be careful to disclose to each other all actual and potential liabilities concerning the infringement of intellectual property that may affect the target. Disclosure by the seller may satisfy many of the warranty provisions in the purchase agreement, thereby preventing any redress other than that specified in the agreement itself. Disclosure of infringement liabilities uncovered by the purchaser’s lawyer may prevent a catastrophic event for the target, allow for the negotiation of better terms and conditions in the purchase agreement, or reduce the eventual selling price. Liability for ongoing infringement litigation may be left with the seller or protected by an escrow arrangement. • Review the files of the target and speak with its lawyers. • Consider intellectual property liabilities and indemnification obligations in license and other agreements. Litigation. The intellectual property and technology lawyer should determine whether
it is worthwhile conducting a search in the courts of relevant jurisdictions to see if the target is a party in any intellectual property proceedings. In addition to litigation in the courts, one should check to see whether or not there is any administrative litigation in the Patent and Trademark Offices. One should not overlook material foreign jurisdictions when conducting such searches. Usually, though, one can get a good idea of what actions the target is involved in through discussions with the target’s lawyers and a review of its files. • Consider a search in the courts of relevant jurisdictions. • Consider a search to determine whether there is any administrative litigation in the Patent and Trademark Offices. • Consider a search in the courts and Patent and Trademark Offices of material foreign jurisdictions.
8.54 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
• Conduct interviews with the target’s intellectual property counsel, general counsel, and internal administrator (who is primarily responsible for intellectual property of the target and litigation). • Inquire about administrative proceedings with the target’s lawyers. • Focus on current or anticipated lawsuits and memos and opinions directed to intellectual property issues. INDUSTRY-SPECIFIC ISSUES
Certain industries are very dependent on intellectual property and technology rights. The following are some brief comments on intellectual property and technology due diligence issues in a few such industries. Franchise Industry. In theory, the purchase of a franchisor’s business should be no dif-
ferent than any other business. However, in practice, the franchisees, who are fundamental to the franchisor’s business but may have very different priorities, can have a major impact on the transaction. There is nothing inherent in the relationship between franchisee and franchisor that prevents the franchisor from transferring its rights and obligations to someone else. Most franchise agreements expressly reserve the franchisor the right to assign the agreement. However, franchisees are naturally apprehensive when they learn that the franchisor may be sold. There are concerns over whether or not the franchise system will continue to operate successfully. A sale may also bring long-simmering disputes between the franchisor and franchisees to a boil. In some situations, one or more franchisees may want to buy the franchisor and seek to frustrate the deal for their own benefit. Franchisees can cause serious problems for both the purchaser and the seller of the business. It may be advisable to meet with a representative group of franchisees. There are three basic strategies that may be undertaken by franchisees to impede a transaction. First, they may try to obstruct the deal by relying on the terms of the franchise agreement itself or on laws against anti-competitive transactions. Second, the franchisees may claim damages for fraud or misrepresentation arising out of the dealings between purchaser and seller, or between either of them and the franchisees. A third approach of franchisees is based on allegations of improper conduct by the franchisor prior to the sale, such as not disclosing its intent to sell the business. The potential purchaser of a franchisor must be concerned about the past conduct of the seller. A purchaser will try to ensure that it does not assume any unexpected liabilities to the franchisees. The first step will be to verify that all of the liabilities are disclosed by the seller. The second is to check representations and promises made in disclosure documents, copies of which are filed in those jurisdictions having franchise legislation. Lawyers for the seller should anticipate these issues and review those materials in advance. • Consider interests and rights of franchisees. • Consider interests and rights of franchise associations. • If acting for a franchisee, consider the restrictions on transactions involving the franchise.
INDUSTRY-SPECIFIC ISSUES 8.55
• Consider compliance with disclosure requirements. • Consider related agreements. Merchandising Industry. A number of industries now have as their primary aspect, or as a material collateral aspect, the merchandising of intellectual properties. Certain industries are particularly dependent on the merchandising area; these include the sports, entertainment, and toy industries. The merchandising aspect of a target’s business should be considered and all license agreements in that area reviewed for the strength of the underlying intellectual property and contractual terms.
• Consider license agreements. Pharmaceutical Industry. Companies in the pharmaceutical industry present specific issues for a variety of reasons. First and foremost is the regulatory environment they function within.59 Second is the fact that such businesses are strongly reliant on patent protection. Third, in some countries, is the effect that the compulsory license regimes have. Fourth, in a number of countries, such as the United States, there is what is commonly referred to as patent term extension or restoration legislation.60 When a portion of the monopoly granted by a patent has not been available to a patentee because the manufacture and sale of the patented product has been held up by regulatory approvals, it is possible to extend the patent monopoly to offset the delays encountered by the regulatory process, subject to certain limitations. Finally, it is necessary to check carefully supply agreements because of the importance of the supply of raw materials for pharmaceuticals. Because of the patchwork of patents and compulsory license regimes around the world, there may be only limited supply sources for certain raw materials necessary to the production of a pharmaceutical. Therefore, losing a supply agreement as a result of a transaction may prove to be material to a pharmaceutical company’s business.
• Consider a search for compulsory licenses. • Consider the effect of patent term extension and restoration. • Consider supply and license agreements. Biotechnology Industry. The biotechnology industry presents specific issues relating to
the ownership of living organisms. For example, there may be questions regarding ownership of tissue samples and blood by-products obtained from patients and organisms developed as a result of research. These should be considered. • Consider issues relating to living organisms in the biotechnology industry. Publishing Industry. Among the most crucial assets in any publishing business are the
copyrights that are owned by the publisher, copyright licenses through which the publisher is entitled to publish and distribute works, and licenses to local and foreign publishers and distributors in other media. Careful attention should be given to copyright and moral rights issues in this industry, particularly those of employees and freelancers.
8.56 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
In some countries, employees of periodicals have a right to restrain use of their works authored for such periodicals for any other use than as part of periodicals. Defamation issues are also of major importance. Computer databases and electronic and Internet publishing are generally important to publishers today. License agreements should be reviewed for any restrictions relating to online or website activities. • • • • • • •
Consider copyright ownership issues. Consider moral rights issues. Consider defamation issues. Consider licenses with authors and others. Consider other licenses. Consider database issues. Consider online and website activities.
Entertainment Industry. The entertainment industry presents difficult issues in connec-
tion with intellectual property. First, intellectual property rights in this industry tend to be layered. Using an example of a motion picture, an author may own copyright in an underlying novel. Someone else may have adapted the novel into a play for theatrical purposes. A third person may have adapted the play into a screenplay for a motion picture. The director, producer, cinematographer, soundtrack composers, arrangers, and many others may have contributed to the final movie. Often the agreements dealing with the ownership or licensing of the intellectual property rights created by each “author” are less than satisfactory. Different authors may have retained and given up different components of their rights. For example, the author of the original novel may have assigned or licensed to his or her publisher not only the book rights, but also all other rights on an exclusive basis. It may be necessary for the movie’s producer to obtain rights from the publisher. Second, exploitation of any property in the industry usually involves a number of licenses, sublicenses, and other agreements. Again using a motion picture as an example, there will be a series of agreements relating to domestic theatrical exhibition, foreign exhibition, television performance, satellite distribution, home video release, merchandising, and other issues when the movie is finally produced. There are often complicated intervening agreements to take advantage of tax sheltering and, in many jurisdictions, government grants. Guilds and other unions may also have rights. There is now an additional overlay of online activities. The music, television, and similar businesses pose similar, but slightly different issues. As intellectual property and, increasingly, technology are crucial to the music, television, motion picture, and related businesses, these complex situations cannot be ignored. • Consider layering of intellectual property. • Consider division of rights, for example, movie, television, and music, through multiple licenses. • Consider the rights of guilds and other unions. • Consider online activities. Sports Industry. The sports industry presents different types of layering issues. One
must first consider the rights relating to franchises in a peculiar type of franchise
REGULATORY ISSUES 8.57
arrangement. However, one must also consider the multitude of rights of different persons in relation to broadcasting, merchandising, and endorsement arrangements. The team sports industry has a number of different components. These components include the relevant league or other central organization, the individual team franchises, often a players’ association, and the rights of individual players and player groups. One must assess first the inherent rights of each component of the industry, and then the contractual arrangements in place among them to organize exploitation. For example, there will usually be agreements governing the interface between national or international broadcast rights held by the league and local broadcast rights that might be held by an individual team. Similarly, with merchandising, one must determine whether the league, the individual teams, the individual players, or the players’ association has or have the right to exploit various insignia and personality rights relating to the sport. Often, various agreements (including individual player contracts and league-wide collective bargaining agreements) deal with these issues on a compromise basis so that certain rights are retained by individuals, others are transferred from individuals to the players’ association and exploited by them, and still others are transferred to the league or its member teams. The teams’ rights to merchandise their own trademarks, logos, and other identifying indicia may be licensed or assigned to the league or an arm of the league specially set up for licensing purposes. The issue of websites and other online activities is now layered above these issues. All of these rights and related agreements must be considered. • • • • • •
Consider franchise issues. Consider league issues. Consider team issues. Consider player issues. Consider collective bargaining agreements and players’ association issues. Consider online activities.
REGULATORY ISSUES
Many industries today are heavily regulated. In addition to ones that one might identify most easily, such as utilities and financial institutions, there are a number of regulated industries that rely to a great extent on intellectual property and technology. In addition, there are general regulatory provisions that may affect intellectual property and technology transfers. Technology Transfer Restrictions. Most countries have legislation restricting the export
to or import from certain defined countries of goods, services, or technology. The United States probably has the most restrictive of such laws.61 Such legislation restricts, among other things, exports of certain types of sensitive technology and exports to certain jurisdictions of broader types of technology. The motive for this legislation is political. As a result, the legislation is frequently amended. If the target conducts or anticipates conducting business in jurisdictions that have sensitive political relations, or if the target is involved with sensitive technology like encryption software or atomic energy, such legislation should be considered. Some countries have boycott provisions
8.58 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
pursuant to which one must certify that one does not do business in or with those in select other countries. • Consider the impact of legislation on the export and import of products and technology of the business. • Consider the impact of boycott provisions in some countries. Access to Information. Under access to information legislation in some jurisdictions, it is possible for any person to obtain copies of documents in the possession of the government unless they fall within the specific exemptions to disclosure in the legislation.62 If the target has significant government dealings, this valuable information may not be protected against disclosure to third parties. Appropriate precautions should be taken when filing materials with governments, and lists of these filings should be compiled. In some cases, it is possible to benefit from this right of access during the due diligence process.
• Consider the impact of access to information legislation in various jurisdictions on materials filed by the target. • Consider accessing information filed by the target under access to information legislation. Privacy and Personal Information Issues. A number of jurisdictions have legislation that
strictly limits the use and transfer of data relating to individuals. Europe is one example. Recent federal legislation to the same effect has been enacted in Canada, and the Province of Quebec has for some time had very limiting statutory protection for individual data. Several bills were pending in the United States at the time of this writing.63 The use of personal data by the target in customer and mailing lists, employment records, and otherwise should be carefully considered against the relevant statutory limitations. This is especially true for those businesses that are highly dependent on dealing with and transferring this type of information. It should be borne in mind that this information may often be easily transferred across borders within corporate groups or to and from service providers electronically without much effort or thought by those who make these arrangements. Therefore, it is important that the full geographical scope of the activities with this information be assessed, then compared against the legislation in relevant jurisdictions. In some industries, such as health care, there is specific legislation.64 In other industries, such as the financial services industry, standards and codes of practice have developed with respect to the handling of this personal information. Copies of these codes and guidelines should be obtained and reviewed. • Identify all personal information that is relevant or material to the target’s business. • Consider the use, movement, and geographical reach of this personal information. • Review the activities of the target with this information against relevant privacy industry codes and legislation. Competition and Antitrust Issues. The laws of some countries impose restrictions for
competition or antitrust law purposes on the leverage that one can obtain through intellectual property.65 Most often, these restrictions are based on licensing practices that
REGULATORY ISSUES 8.59
offend the local competition laws of the jurisdiction. For example, in a number of jurisdictions it is improper to attempt to extend the term or scope of patent or other intellectual property rights through an agreement. In many countries it is similarly inappropriate to engage in various other practices, such as tied selling (in which one conditions the grant of a license of one intellectual property right to the taking of a license under another, perhaps less desirable, intellectual property right). All license and similar agreements of the types discussed previously should be considered from these perspectives. • Consider the impact of competition and antitrust issues in various jurisdictions on relevant license and other intellectual property agreements. Franchising Industry. Many state governments within the United States and a few other
countries have franchise legislation requiring the filing of franchise disclosure requirements.66 These disclosure documents often contain relevant and complete financial information. One should ensure that all regulatory approvals have been obtained and maintained through the filing of updated information or that any exemption obtained earlier is still effective in order to avoid the need for filing or further filings. • Consider the impact of disclosure legislation. • Consider publicly available materials. • Ensure that all filings have been made and are accurate. Pharmaceutical Industry. The pharmaceutical industry is very heavily regulated.67
Careful attention must be paid to regulatory approvals, or applications for regulatory approvals, in countries where there is a significant market for particular products. Because requests for approval and approvals may be obtained at different times and subject to different requirements in different countries, they must be considered on a product-by-product and country-by-country basis. In some cases, a proposed transaction or a relocation may trigger the need to reapply for approvals or registrations. When, for example, a pharmaceutical company sells off a product line, it may be necessary for the purchaser to apply for a new registration number. Approvals must be obtained to manufacture a pharmaceutical at a specific plant in certain countries. Therefore, it is necessary to carefully consider regulatory approvals for specific plants. Any plans to relocate production of a pharmaceutical will be impacted by these regulatory considerations. As part of the regulatory approvals, searches should be made among the records of the Food and Drug Administration (FDA) and equivalent bodies of other jurisdictions to determine what information may be publicly available. Much of the information that is submitted to such bodies is kept confidential, but significant portions are available. In some countries, such as Canada, patented drugs may be subject to price controls. These may directly impact the prices at which products may be sold. These issues should also be considered. Drugs that are in the course of development or clinical trial stages may also present specific issues. • Consider compliance with regulatory legislation. • Consider the impact of price controls on patented medicines. • Consider drug registration issues.
8.60 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE THE RESULTS OF DUE DILIGENCE Interpretation. After having considered all of the issues in the foregoing sections and
having taken those steps in the due diligence process appropriate to the deal, an evaluation of the target’s intellectual property and technology position can be undertaken. At this stage, the intellectual property and technology lawyer should have an overview of the intellectual property and technology assets, the rights and liabilities of the target, and some knowledge about where the important problems and gaps lie. Then it is necessary to assess the results of these investigations in light of the real world and the needs of the client and to report the results of your assessment. For example, if there is a major potential patent infringement action looming that may prove to be disastrous to the target, the transaction might be postponed; the representations, warranties, and indemnities strengthened; the price adjusted; or a certain portion of the selling price in a sale held in escrow pending resolution of the potential liabilities. However, it is only in a rare situation that there will be such a material problem. More often, imperfections or gaps in the intellectual property and technology and the contractual portfolio can be overcome through efforts before or after the closing of a transaction or the filing of a prospectus. The intellectual property and technology lawyer should raise these issues and the need for rectification or clarification, but in a manner that does not suggest that each point poses a fundamental problem with the transaction. In other words, the report of the intellectual property and technology lawyer on the due diligence procedure should clearly set out the findings of that process, but should highlight those problems that are truly material to the target’s business both now and in the foreseeable future. The intellectual property and technology lawyer should focus on what the purchaser is really buying and how the defects in the intellectual property and technology position may affect the purchaser’s acquisition. He or she should focus on material problems and their solution. When problems are identified, the seller’s intellectual property and technology lawyer should recommend ways that they can be cured. In some cases, the seller may be able to satisfy the purchaser’s anticipated concerns through some remedial action prior to closing or shortly thereafter, or through indemnities or other contractual obligations in the purchase agreement. The intellectual property and technology lawyer should also review the acquisition and related agreements or the prospectus to ensure that the provisions concerning the intellectual property and technology rights of the target have been properly dealt with. This includes the schedules listing the intellectual property and technology assets, other agreements that affect those assets, intellectual property and technology liabilities, and the provisions warranting the transfer of such intellectual property rights. Representations and Warranties. Representations and warranties are generally matters
for the asset purchase or share purchase agreement and therefore are another subject. However, they often provide a framework for the due diligence process, so something should be said about their role. In the intellectual property and technology context, representations and warranties have two main purposes. They allocate risk between the seller and the purchaser or the lender and the borrower, and they provoke disclosure by the seller or borrower, thus assisting in the due diligence process. The consequences of a breach of representation may be that the transaction does not close, as the accuracy
THE RESULTS OF DUE DILIGENCE 8.61
of the representation is usually a condition of closing. The consequence of a breach of warranty is a claim for damages. The seller will also usually indemnify the purchaser against the consequences of any breach of warranty—thus, there is real exposure to the seller if it should give one that is not correct. The risk factors that representations and warranties allocate may well include issues that are discovered in the due diligence process. Although the basic warranties may be settled at the letter of intent stage, the exact representations and warranties negotiated should depend on the results of the due diligence investigations. To do proper due diligence, one must review the representations and warranties. One’s view of the contents of those representations and warranties will depend on whom one represents because the purchaser usually wants more than the seller wishes to give. If there are specific problems that are disclosed during the due diligence process, it is often in this area that they have to be addressed. Sometimes they are addressed by way of opinions from lawyers, but it is preferable to deal with a specific problem through a warranty or a representation. The key is to focus due diligence on the representations and warranties, and then address the results of due diligence in the representations and warranties. • Consider the representations and warranties in the agreement in light of the information revealed by due diligence. • Carefully consider certain definitions in the agreement, including “business” and “intellectual property.” • Consider representations and warranties about title in light of the information revealed by due diligence. • Consider representations and warranties relating to validity of intellectual property in light of due diligence and other unknown potential third-party rights. • Consider representations and warranties relating to enforceability in light of the information revealed by due diligence. • Consider representations and warranties relating to noninfringement in light of the information revealed by due diligence and potential third-party rights. Definitions. The definition of the “business” in the agreement is usually crucial to
these representations and warranties. In a purchase agreement, it should be broad enough to cover all of the purchaser’s interests and narrow enough to protect the seller’s interests. A narrow definition of the business will preclude the purchaser from acquiring some assets and may limit the protection the purchaser has from the seller’s activities. It may also restrict the scope of the representations and warranties. The business and technical personnel involved for both parties must understand and agree with the scope of this definition. With a broad definition of intellectual property, the seller will have more difficulty in giving the warranties. The seller may instead wish to limit the warranties to listed intellectual property. This may, in turn, lead the purchaser to ask for a warranty that the list is a complete description of all the intellectual property used by the target. The target will not be able to identify each property, such as every work for which it owns copyright or each trade secret. The target will prefer to refer only to registered rights. In this way, the seller may restrict its representations and warranties to the rights that it can easily identify. However, this may not be sufficient for the purchaser.
8.62 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE Title. Warranties on title are common. A simple one says that the seller is the owner of
the intellectual property. The difficulty with this from the seller’s point of view is that it may not know if it owns the intellectual property itself. For example, the seller may have used a trademark for some period of time and may be confident that it can use it. It may even have a registration for it. Yet, there is always the chance that someone will come out of the woodwork and successfully contest that ownership. Similarly, the seller may not be able to present the chain of written assignments that are necessary to pass copyright from a nonemployee. Another pitfall is that ownership is an indefinite term. It may mean that there is no lien or encumbrance, no co-owner, or no license granted in respect to the intellectual property. The seller will, therefore, wish to be specific in its representations. Validity and Enforceability. The purchaser will want to make sure that the intellectual
property that it is buying is valid and that it can enforce rights against third parties. The seller, on the other hand, will not know and have no practical way of determining whether the rights are invalid or unenforceable. It may be willing to say that, to the knowledge of the seller, the listed intellectual property rights are valid and enforceable. Sometimes there is a question of what “enforceable” means. If the seller warrants that a patent is enforceable, it may be saying that only one claim, but not necessarily all other claims, of the patent may be enforced. For a registered trademark, it may be saying that it is enforceable against third parties using the same mark for at least some wares or services covered by the registration. If the patent or trademark rights are important, the warranty should be specific as to how enforceable the rights are. The seller should keep in mind that it will not control the strategy in litigation for infringement of the rights. The purchaser may choose to assert a broad interpretation of the patent claims, for instance, with the result that the patent is held infringed but invalid. For these reasons, representations and warranties may be subject to intensive negotiation after the due diligence process. Noninfringement. The seller may be asked to give a warranty that the conduct of the
seller’s business does not infringe any intellectual property rights of any third party. The seller may wish to say that, to the best of its knowledge, the conduct of the seller’s business does not infringe the intellectual property rights of any third party. Alternatively, the seller may prefer to say that it has not received any notice, claim, or threat of any claim that the conduct of its business has infringed the intellectual property rights of any third party. Opinions. Legal opinions in commercial transactions are a subject in and of themselves. As a general point, it is essential that the intellectual property lawyer have input into any opinion on due diligence or the transaction that may be issued by the purchaser’s commercial counsel. This is because commercial lawyers use terms like “valid” and “enforceable” (whose meanings are well known to them in commercial practice) in statements relating to intellectual property when they may not be appropriate. Similarly, the language generally used by commercial lawyers to summarize due diligence activities and the effect of the purchase agreement may be broader than it should be in intellectual property and technology aspects of the transaction.
THE RESULTS OF DUE DILIGENCE 8.63
When intellectual property and technology counsel is retained by counsel to the purchaser, seller, borrower, or issuer, intellectual property and technology counsel may be asked to provide an opinion on the intellectual property and technology aspects to be appended to or incorporated into the broader opinion. When the intellectual property and technology counsel is within the same firm as the commercial counsel of the purchaser or borrower, the intellectual property and technology counsel may be asked to prepare a memorandum that may be appended to or incorporated in the opinion on the broader commercial transaction. In both of these situations, it is advisable for the intellectual property and technology lawyer to see a draft of the final opinion to ensure that the opinion has all appropriate limitations and does not opine on matters not dealt with in due diligence or covered in the purchase agreement. Every opinion authored by counsel is expected to meet the minimum standards of a reasonable lawyer in the jurisdiction. Some jurisdictions hold the view that intellectual property and technology counsel, as specialists, may be held to a relatively higher standard. However, there should be no liability for an incorrect opinion when the opinion giver has conducted a reasonable investigation and has reasonable grounds for the conclusions. When there are issues that have not been investigated, they should be expressly noted. The preferred standard is one that is established through communications between the intellectual property and technology lawyer and the commercial lawyer or the client. These discussions should focus on budgetary, time, and other constraints imposed by the transaction as a whole and the due diligence process in particular. The substance of these discussions (the relevant constraints and all external limitations discussed in the preceding sections) should be articulated in any opinion. It is essential to define the purpose for which any opinion is given. For example, an opinion given to a client with respect to whether a product infringes a patent of another or whether a patent is invalid, is very different from an opinion that may be given in the context of an initial public offering or a commercial transaction. In some transactions, the intellectual property and technology lawyer’s only role may be to ensure that assets being acquired or secured are on record in the name of the company and are unencumbered. In other situations, the lawyer may be required to conduct all or some of the searches previously discussed and to consider all or some of the other issues discussed elsewhere. When the intellectual property and technology lawyer will not be giving an opinion or formal report to the client, the intellectual property and technology lawyer should consider using an engagement letter. If the matter is not discussed, the client may assume that the intellectual property and technology lawyer has done everything that was necessary to ensure that the purchaser acquired good title to, or security in, all of the intellectual property and technology relating to or used in the business, that such rights are broad enforceable rights, and that there is no actual or potential liability. When the client wants to restrict the scope of due diligence, the intellectual property and technology lawyer must advise the client of the potential consequences and confirm the client’s instructions in writing. In reporting to a client after a transaction, it may be impossible to list all the searches and investigations that have been conducted in the opinion. However, it is advisable to reference these, at least in summary fashion, in an appended memorandum. In listing the types of searches and other investigations that have been conducted, for all the reasons discussed earlier in this chapter, it is perhaps more essential that one
8.64 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE
set out investigations that were not conducted for time, budgetary, or other reasons, and the limitations of the investigations that were. For example, if one is specifically asked to confine activities to searches in the U.S. Patent and Trademark Office, one should specifically state that no searches were conducted in any other jurisdictions. CONCLUSION
The valuation of intellectual property and technology assets, contracts, and liabilities, while steadily increasing, is very subjective. However, an intellectual property and technology lawyer’s review of these issues can at least provide the following information: the proprietary position of key goods and services; the strength and longevity of certain intellectual property and technology rights; the amount of internally developed intellectual property and technology versus licensed-in intellectual property and technology; the dilution of intellectual property and technology assets via license and other agreements; contractual rights and liabilities; an assessment of potential intellectual property and technology violation liabilities; and a look at key regulatory issues. No two deals are identical and no two clients or commercial lawyers have the same expectations. Thus, the best way to pursue the task is with a solid understanding of what the client or the instructing principal wants to accomplish. Until such an understanding is reached, the choice of routes to get to a successful closing will elude even the most experienced intellectual property and technology lawyer. Commercial and securities transactions will keep the intellectual property and technology lawyer fairly active. There is a lot to accomplish in a short period of time and, given the sums of money that may be involved, it is imperative to get it done right. Hopefully, this chapter will assist in the process. ENDNOTES 1
This chapter is based on a number of earlier papers and articles of the author: “Intellectual Property Due Diligence in Commercial Transactions,” “Intellectual Property in Business Transactions: A Practical Course,” Infonex, November 1993; “Intellectual Property Due Diligence: Asset and Share Purchases: What, Why and How,” “Business Transactions Involving Intellectual Property,” The Canadian Institute, September 1994; “Intellectual Property Due Diligence in Commercial Transactions,” Spring Meeting, Patent and Trademark Institute of Canada, March 1994; “Intellectual Property Due Diligence in Commercial Transactions” (1994), 11 C.I.P.R. 91; “Intellectual Property Due Diligence in Commercial Transactions,” Licensing Executives Society USA-Canada Annual Meeting, October 1994; “Intellectual Property Due Diligence in Commercial Transactions,” Licensing Executives Society Annual Meeting, April 1995; “Intellectual Property Due Diligence for Financing Technology Businesses,” Licensing Executives Society Canadian Regional Meeting, May 1995; “Intellectual Property Due Diligence For Transactions in Converging Businesses,” “Financing Convergence,” The Canadian Institute, September 1995; “Intellectual Property Due Diligence in Commercial Transactions,” “Intellectual Property in Business Transactions—A Practical Course,” October 1995, Insight; “Intellectual Property Due Diligence in Commercial Transactions,” “Due Diligence,” Federated Press, September 1997; “Intellectual Property and Technology Due Diligence in Business Transactions,” “Trademarks in Business Transactions,” International Trademark Association, September 1999; “Intellectual Property and Technology Due Diligence in Business Transactions,” Licensing Executives Society USA/Canada Annual Meeting, September 2000; “Intellectual Property and Technology Due Diligence in Business Transactions,” Osgoode Hall Law School E-Business LL.M. Program, February 2001; and “Intellectual Property, Technology and E-Commerce Due Diligence in Business Transactions,” “Critical Intellectual Property Issues for the
ENDNOTES 8.65 Corporate Lawyer,” Osgoode Hall Law School of York University, May 2001. Another version is being included in a text on Canadian Electronic Commerce Law to be published in 2001 by Carswell. Yet another version is being included in a text on Canadian Biotechnology Law to be published in 2002 by Caswell. The author is a Canadian lawyer and the earlier papers were written with a focus and more detail on Canadian legal issues. 2 Black’s Law Dictionary, 6th ed., (West Publishing Co., 1990), 457. 3 Douglas Kneebone, “Examining Key Transactional Issues,” “Business Transactions Involving Intellectual Property Issues,” Insight (September 25, 1991). 4 35.U.S.C. 5 35.U.S.C. 101. 6 35.U.S.C. 102. 7 35.U.S.C. 103. 8 35.U.S.C. 102(b). 9 35.U.S.C. 122. 10
35.U.S.C. 154. 35.U.S.C. 155–156. 12 35.U.S.C. 361. 13 35.U.S.C. 363–364. 14 35.U.S.C. 371–376. 15 35.U.S.C. 102(b). 16 35.U.S.C. 122. 17 37 C.F.R. 1.56. 18 35 U.S.C. 171. 19 35 U.S.C. 102(b). 20 35 U.S.C. 173. 21 15 U.S.C. 22 15 U.S.C. 1052. 23 15 U.S.C. 1053. 24 15 U.S.C. 1051. 25 15 U.S.C. 1058. 26 15 U.S.C. 1059. 27 15 U.S.C. 1058(b) and 1065. 28 15 U.S.C. 1060. 29 17 U.S.C. 30 17 U.S.C. 106. 31 17 U.S.C. 102. 32 17 U.S.C. 101(a)(7). 33 17 U.S.C. 102(b). 34 17 U.S.C. 401–405. 35 17 U.S.C. 408–412. 36 17 U.S.C. 302(a). 37 For example, 17 U.S.C. 302(b–c). 38 17 U.S.C. 303–305. 11
8.66 INTELLECTUAL PROPERTY AND TECHNOLOGY DUE DILIGENCE 39
17 U.S.C. 201(a). 17 U.S.C. 201(b). 41 For example, 17 U.S.C. 201 (c). 42 For example, 17 U.S.C. 203. 43 17 U.S.C. 106A. 44 17 U.S.C. 106A(a). 45 17 U.S.C. 106A(e). 46 17 U.S.C. 1101. 47 17 U.S.C. 103. 48 17 U.S.C. 901(a)(1). 49 17 U.S.C. 901(a)(2). 50 17 U.S.C. 905. 51 35 U.S.C. 161. 52 For example, New York C.L.S. Civ. R.50. 53 For example, 18 U.S.C. 1832. 54 For example, S.N.Y. c.553. 55 11 U.S.C. §1–§1330. 56 For example, 17 U.S.C. 203. 57 For example, 15 U.S.C. 3701 ff; 42 U.S.C. 2181 ff; 42 U.S.C. 2457; and 42 U.S.C 5908. 58 For example, New York C.L.S. Article 22-A. 59 For example, 21 U.S.C. 355. 60 35 U.S.C. 155-155A. 61 For example, 35 U.S.C. 184-188. 62 Freedom of Information Act, 5 U.S.C. 552. 63 For example, Online Privacy Protection Act of 2001, H.R. 260. 64 For example, Pub. L. 104–191, Section 263(2). 65 For example, 15 U.S.C. 1ff. 66 For example, 16 C.F.R. 436.1. 67 For example, see note 59, supra. 40
CHAPTER
9
INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST ISSUES IN MERGERS AND ACQUISITIONS Melvin Simensky Visiting Scholar in Intellectual Property Law New York Law School
William M. Heberer Hall Dickler Kent Goldstein & Wood LLP
Increasingly, the attractiveness of a potential acquisition target or merger partner is due not only to such traditional factors as the value of its tangible assets, cash flow, or market niche, but also to the value of the entity’s intellectual property assets. These assets raise several unique issues in the context of mergers and acquisitions in terms of strategies for conducting due diligence and perfecting security interests. These issues will be explored in this chapter. INTRODUCTION
The term intellectual property is used to broadly encompass several distinct assets including, among others, patents, copyrights, trademarks, and trade secrets. Other assets not traditionally classified as intellectual property, but increasingly considered as such, are domain name registrations. A patent is a monopoly granted to the inventor of a useful process, machine, or composition of matter that is both novel (i.e., not previously known or used by others) and nonobvious to a person having ordinary skill in the relevant art.1 This monopoly allows the patent owner to exclude others from making, using or selling the invention.2 In the United States, patents are governed exclusively by federal law3 and are obtained by filing a patent application in the United States Patent and Trademark Office (PTO). For U.S. patents filed after June 8, 1995, the term of protection is 20 years from the earliest deemed filing date. For U.S. patents filed prior to that date, the term of protection ends after the greater of 17 years from issuance or 20 years from the earliest deemed 9.1
9.2
INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
filing date.4 The term of protection for foreign patents varies, but, in most countries, also ends 20 years from the application filing date.5 Copyrights, which are also governed exclusively by federal law, are granted to creators of original works of authorship—including literary works, audiovisual works, and dramatic works—upon the fixation of those works in a tangible medium of expression.6 Copyright ownership provides the creator with certain exclusive rights, including the right to display, distribute, reproduce, and publicly perform the copyrighted work.7 Registration is not required in order for copyright protection to attach; however, copyright owners obtain additional benefits and protections by registering their works in the U.S. Copyright Office. For example, registration allows the owner to institute a copyright infringement action in federal court and seek statutorily set damages rather than having to establish actual damages.8 The duration of a copyright varies depending upon the number of authors and whether the initial author is an individual or a corporate entity. For single author works created after 1989, the copyright term is the life of the author plus 70 years. For works created by more than one author (i.e., works of joint authorship), the copyright term is the life of the last surviving author plus 70 years. For a work made for hire,9 the term is 95 years from the date of publication or 120 years from the date of creation, whichever is earlier.10 Unlike patents and copyrights, trademarks are subject to protection under both state and federal law. A trademark is any word, phrase, symbol, emblem, device, or design that identifies the goods and services of a particular person or entity, and distinguishes them from the goods or services of others. Trademark rights are obtained by use of the trademark in commerce and continue in effect for as long as the mark remains in use. Once used in interstate commerce, a trademark may be federally registered under the Lanham Act.11 Applications for federal registration may be filed on one of two bases—prior use of the mark in interstate commerce or a bona fide intention to use the mark in commerce (an intent-to-use application) in the future.12 When an intent-to-use application is filed, the application may not mature into registration until the mark is actually used in interstate commerce and an amendment to allege use or a statement of use to that effect is filed in a timely manner with the PTO. Upon registration, the owner will obtain the benefit of the earlier intent-to-use application filing date (rather than the actual first use date) for priority purposes.13 Though not required to obtain protectible trademark rights, federal registration affords the mark owner with several procedural and substantive advantages, including: (1) a presumption of the validity of the trademark and the registrant’s ownership of and exclusive right to use the mark; (2) constructive notice nationwide of the registrant’s rights in the mark; and (3) the ability to bring an infringement action in federal court in which damages, profits, and costs are recoverable and treble damages and attorneys fees may be sought.14 A federal trademark registration remains in effect for 10 years, but may be continually renewed as long as the mark is in use.15 Trademarks may also be registered at the state level. A trade secret is “any formula, pattern, device or compilation of information which is used in one’s business and which gives [the business owner] an opportunity to obtain an advantage over competitors who do not know or use it.”16 Factors to be considered in determining if particular corporate information qualifies as a trade secret include: (1) the
UNDERSTANDING THE TRANSACTION 9.3
extent to which others already know the information or the ease with which they could learn it; (2) the steps taken by the company, if any, to keep the information confidential; and (3) the value of the information.17 Trade secrets are protected under state law. Finally, a domain name (e.g., acme.com) can be thought of as the alphabetical equivalent of an Internet Protocol (IP) address representing a particular location on the Internet. The domain name is made up of two different levels—a top-level domain (TLD) and a second-level domain. The information to the left of the “dot” is the second-level domain, frequently the company’s name or trademark (i.e., “acme”), and is the portion of the domain name selected by the user.18 The TLD is the designation to the right of the “dot.” There are two basic types of TLDs—generic TLDs such as “.com,” “.net,” and “.org,” and country-code TLDs such as “.co.uk,” which are controlled by national registries in various countries. There are currently over 250 country-code TLDs in which domain names can be registered. These domain names are registered by companies and individuals to identify the location of their Websites. A single domain name (e.g., acme.com) may only be registered to a single entity. However, the same name may be registered as a domain name by different parties in different TLDs. For example, Company A may own the domain name “acme.com,” Company B may own “acme.net,” and Company C may own “acme.co.uk.” Due to the tremendous growth in the Internet as a method of advertising and selling a company’s goods and services, domain names have also become important and valuable assets.19 The existence of these intellectual property assets raises unique issues both as to the due diligence to be conducted in connection with any merger or acquisition, and as the assignment of, and granting of, security interests in said assets. UNDERSTANDING THE TRANSACTION
In order to properly assess the scope of an intellectual property due diligence inquiry and the manner in which it will be conducted, one must first have a clear understanding of both the structure of and parties to the proposed transaction. Form of Transaction. The proposed transaction can be structured in a number of dif-
ferent ways. In an asset purchase, the acquiring company purchases only particular assets and liabilities of the target company20 and leaves the remaining assets and liabilities behind.21 In a stock purchase, shares in the target are sold to the acquirer, resulting in both entities remaining intact with the target becoming a subsidiary of the acquirer. In contrast, a merger of the target and acquirer results in one company surviving as the identified company while the other one disappears. The surviving company can be either the target or the acquirer.22 The deal structure selected will impact upon the focus of the intellectual property due diligence inquiry. For example, as asset purchases and mergers involve the assignment of intellectual property and other assets from one entity (typically the target) to the other, issues concerning the validity and enforceability of these assignments are of critical importance. Conversely, in a stock purchase transaction, the target remains a going concern and retains ownership of the intellectual property at issue, making it unlikely that there will be any significant issues concerning intellectual property assignments.23
9.4
INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
There are also significant differences concerning the target’s potential liabilities with respect to due diligence. In a stock purchase, the acquirer will succeed to the target’s liabilities subject to any indemnification or representations and warranties by the target at closing. Likewise, the surviving company in a merger assumes all obligations of the constituent companies, whether they are known, unknown, or contingent at closing.24 Thus, due diligence with respect to the target’s liabilities is critical in these transactions. In an asset purchase, however, since only selected assets and liabilities are assumed by the acquirer, due diligence concerning potential unknown liabilities of the target is less important.25 Parties to the Transaction. An understanding of the parties to the transaction and the industries in which they operate will also shape the intellectual property due diligence audit.26 For example, technology companies often count their patent portfolios and proprietary trade secrets among their most valuable assets. Thus, when the target is a technology company, the due diligence inquiry will typically focus on these assets, examining both the manner in which they have been protected in the past and the ability of the acquirer to exploit them in the future without interference from others.27 Alternatively, an entertainment company may have a sizable copyright and trademark portfolio but few, if any, patent or trade secret assets. For these entities, the inquiry might emphasize the copyright and trademark protection and registration programs that the target has in place. Other companies may derive substantial value from the uniqueness of their information database and their ability to control the dissemination of that information. For these targets, a key issue will be the extent to which the database information has been or can be protected by copyright or trade secret.28 Other relevant inquiries relate to a determination of the target’s pretransaction structure. For example, if the target is a public company, its annual report and other required filings will be available to the public, thereby providing a reliable source of information concerning its intellectual property portfolio. When the target is the subsidiary of a larger parent company, certain assets such as trademarks may be held in the name of the parent or another subsidiary, then licensed to the target for use. Thus, the existence of such a parent/subsidiary relationship will call for a close examination of the ownership of intellectual property assets and the licensing of those assets between the target and its related companies.29 Finally, it is helpful to gain some understanding of the acquirer’s motivation in entering into the transaction. For example, if the primary objective is to acquire a particular technology, the intellectual property inquiry will focus on the steps taken to protect that technology and the risks that the technology infringes upon the rights of others. Alternatively, if the primary objective is to increase market penetration or enter new markets by acquiring the target’s goods or services, the intellectual property investigation would likely focus on the steps taken to enforce and protect the target’s trademarks.30
DUE DILIGENCE
The purpose of a due diligence inquiry in connection with a merger or acquisition is to determine the extent of the target’s assets and identify and reduce the risk of potential liabilities that could result in significant losses to the acquirer post-closing.31 Due diligence prevents last minute surprises and arms the acquirer with information that will
DUE DILIGENCE 9.5
aid in determining if, and on what terms, it should proceed with the deal. In this way, the due diligence inquiry differs somewhat from the due diligence investigation conducted with a securities offering, which is intended to demonstrate that the participants in the offering “had, after reasonable investigation, reasonable ground to believe and did believe” that the offering materials provided to potential purchasers were accurate and free of material omissions.32 In the merger and acquisition context, the due diligence inquiry should include a thorough investigation of the history of the target and should seek to uncover all liabilities, claims, liens, pending litigation, and obligations that the target’s business may have, as well as any limitations or restrictions on the target’s ability to exploit its assets. Defining the Intellectual Property Audit. As previously suggested, the comprehensiveness and focus of the intellectual property audit may vary with the goals of the parties, types of businesses involved, and form of the transaction.33 The intellectual property audit seeks to identify and inventory the target’s portfolio of intellectual property assets, assess the strength and enforceability of those assets, and analyze any potential liabilities associated with their continued use and exploitation.34 It also benefits the target by allowing it to determine the extent to which it can make representations and warranties at closing about its ownership of the intellectual property assets at issue.35 Components of an Intellectual Property Audit Identify the Target’s Intellectual Property Assets. A comprehensive inventory of the tar-
get’s intellectual property assets should be taken. This information may be compiled from a number of sources. As a preliminary, a list of intellectual property assets may be obtained from the target. This list should encompass, among other assets, U.S. and foreign patents and patent applications; trademark registrations and applications; copyright registrations and applications; intellectual property licenses and agreements; domain name registrations; website development and hosting agreements; and trade secrets.36 The target should also be asked to provide a list of all upcoming docket deadlines for the filing of documents necessary to maintain and protect recorded assets such as patents, trademark registrations, and copyright registrations. For example, the target should identify upcoming deadlines for the payment of patent maintenance fees and the filing of patent and trademark office action responses,37 trademark statements of use,38 and renewal applications and copyright renewals (if any).39 One effective method of obtaining this information from the target is to have the acquirer’s intellectual property counsel prepare and send a due diligence letter. This letter will typically contain a list of questions and document requests similar in nature to discovery requests that itemize the desired information and documentation.40 Some of the information sought from the target may be confidential in nature. For example, U.S. patent applications are not publicly available until the patent issues. Likewise, trade secret information, by definition, is confidential, and by disclosing the information to the acquirer, the target could run the risk of losing trade secret protection.41 Accordingly, in order for the acquirer to have access to the target’s files about these assets, a signed nondisclosure and confidentiality agreement will likely be required. Under this agreement, the acquirer would agree not to disclose or use the information revealed during the due diligence review pending the closing of the transaction.42
9.6
INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
Other information is available publicly and may be obtained from outside sources if necessary. For example, file histories for U.S. trademark and copyright applications and registrations are available from the PTO and Copyright Office, respectively. In addition, outside search companies can perform searches of U.S. and foreign trademark and copyright registries, and provide lists of all pending applications and registrations owned by the target on those particular registries. There are also companies that now perform worldwide searches for domain name ownership. Again, note that trademarks and copyrights do not require registration to be valid and enforceable. As such, the acquirer must be sure to identify and schedule any common law trademarks and unregistered copyrights.43 Confirm Ownership Rights. Once an inventory of intellectual property assets has been cre-
ated, the acquirer should review the assets’ chain of title and confirm the ownership status of all known recorded rights such as patents and patent applications, copyright applications and registrations, trademark applications and registrations, and domain name registrations. As previously noted, United States patent and trademark filings are recorded in the PTO, but copyright filings are recorded in the Copyright Office. However, the review of the ownership status of particular assets should encompass both United States and foreign filings.44 By undertaking such a review, the acquirer will be able to discover, prior to closing, any gaps or discrepancies in the recorded chain of title (e.g., unrecorded assignments) as well as any prior liens or security interests placed on a particular asset.45 In addition to determining ownership and current status of the target’s intellectual property portfolio, the acquirer should evaluate the target’s patents and trademarks to determine whether they are valid and enforceable against others and whether the target is potentially vulnerable to thirdparty infringement claims.46 This evaluation is typically performed by intellectual property counsel with the requisite technical expertise. The acquirer should also obtain copies of any opinions of counsel provided to target with respect to the validity of any of its intellectual property assets, the infringement of any of these assets by third parties, or the freedom to use the assets without objection or interference from third parties.47 Assess the Strength and Enforceability of Target’s Rights.
Review Relevant Licenses and Agreements. All of the target’s existing intellectual property licenses—both as licensor and licensee—must be analyzed, since these agreements may well restrict the target’s (and subsequently, the acquirer’s) ability to exploit particular assets. Moreover, the licenses will identify the other parties to these agreements, parties with whom the acquirer may well be entering ongoing business relationships. In reviewing these licenses, the acquirer should take note of (1) any exclusivity provisions; (2) the duration and geographic scope of the license; (3) royalty and performance provisions, including if the license calls for, any minimum royalties or minimum sales targets; (4) the extent of the quality control provisions in the case of trademarks; and (5) the ability of the target to assign and/or sublicense the license.48 Many license agreements provide that an assignment by the licensee without the prior written approval of the licensor will lead to the automatic termination of the agreement. Nevertheless, in light of the imminent enactment of Revised Article Nine of the Uniform Commercial Code (UCC),49 a review of the target’s licenses should
DUE DILIGENCE 9.7
include an assessment of the enforceability of any antiassignment provisions or other limitations contained therein. As discussed in greater detail later in this chapter, Article Nine governs the granting and enforcement of security interests in various types of personal property, including accounts.50 Under the current version of Article Nine, accounts are defined as payment obligations arising out of the sale or lease of goods or the provision of services.51 However, Revised Article Nine broadens this definition to include the right to receive payments (i.e., royalties) under intellectual property (and other) licenses, thereby subjecting the right to receive such payments to Revised Article Nine.52 Moreover, under Revised Section 9–406, any restriction in a license agreement that would prohibit the creation or enforcement of a security interest in the right to receive payment thereunder will be rendered ineffective.53 Thus, Revised Article Nine permits the creation and enforcement of security interests in a licensor’s right to receive royalty payments under a license, even if the license itself restricts the licensor’s ability to assign or otherwise transfer its right to receive payment.54 The revisions to Article Nine also impact the ability of licensees to obtain financing secured by their right to perform under an intellectual property license by “render[ing] ineffective a[ny contractual or other legal] restriction on the transfer of a licensee’s rights under an intellectual property license. . . to the extent the restriction would interfere with the creation, attachment, or perfection of the security interest.”55 Of course, a licensee’s ability to grant a security interest is limited only to its rights as licensee. It has no ability to grant a security interest in the underlying collateral owned by the licensor.56 Moreover, Revised Article Nine does not permit a secured party to enforce its security interest in the licensee’s rights under the license if other law prohibits enforcement or would enforce a contractual restriction on enforcement.57 Analyze Potential Liabilities. In any transaction in which the acquirer will be assuming
the obligations and liabilities of the target, a thorough assessment of potential liabilities associated with the use of the target’s intellectual property assets should be made. In this regard, the acquirer will want to review the files of any pending litigations or administrative proceedings (United States or foreign) involving the target’s intellectual property assets or related agreements.58 For such actions, the acquirer will want to ascertain the nature of the claim, dollar value of the claim, likelihood of injunction, and likelihood of settlement before the closing of the transaction.59 Any opinions of counsel about the likelihood of success in the pending actions and administrative proceedings should also be requested. However, due to potential concerns regarding waiver of the attorney-client privilege, review of such opinions may require the execution of a nondisclosure and confidentiality agreement. Alternatively, the acquirer may request that its own intellectual property counsel evaluate the likelihood of success regarding any pending actions.60 It is also helpful to determine whether the target carries any errors and omissions or other insurance policies covering intellectual property infringement claims. The acquirer should also review any office actions61 or oppositions62 filed in trademark proceedings, office actions or interferences63 filed in patent application proceedings, protest or cease and desist letters involving the target’s intellectual property, and any relevant opinions of counsel. Moreover, the acquirer will want to obtain and review copies of
9.8
INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
any judgments, decrees, or settlement agreements from prior litigations or proceedings involving the target’s intellectual property assets because these documents may contain provisions restricting the target’s or acquirer’s ability to use certain intellectual property assets.64 Checklists for Specific Assets. Apart from the general considerations previously dis-
cussed, there are issues specific to each particular type of intellectual property asset. Following are checklists of information to be obtained and issues to be considered regarding each type of asset. Copyrights. When compiling a list of the target’s copyrights, the following information
should be obtained:65 • • • • • • • • •
Country of registration Registration number Date of issue Date of publication or, if not published, creation Initial author(s) and prior owners Duration of copyright Presence or absence of any security interests Copyright notices66 Renewal periods67
Of these, a review of the initial author and any prior owners of the work is critical to the issue of copyright ownership and duration. Typically, the author and owner of a copyrighted work are the same person or entity. If, however, the initial author differs from the target (owner), a valid assignment of copyright must be provided. Moreover, the acquirer must ensure that the assignment was properly recorded to establish an accurate chain of title.68 In instances when the work was jointly created by multiple authors,69 each author would have an ownership interest in the work and a right to license the work, subject only to an obligation to account to the other for economic benefits received from the license.70 If the target were assigned rights in the work from only one of multiple joint owners, the acquirer’s ability to exercise complete control over the work would be compromised.71 Moreover, copyrighted works created by employees within the scope of their employment may be considered “works made for hire” whereby the employer is deemed the author and owner of the work.72 The acquirer should determine whether the target has any agreements with employees about the ownership of works created in the workplace. In contrast, subject to limited exceptions, works created for the target by a freelancer or independent contractor are unlikely to be deemed works for hire, and the target will not be viewed as the copyright owner absent an assignment of copyright.73 Finally, as previously noted, registration in the U.S. Copyright Office is not required to obtain copyright protection.74 Thus, the target may have unregistered copyrights in its portfolio. The acquirer should determine whether the target owns any important unregistered copyrighted works and require that these copyrights be registered before closing.75 Due to the uncertainty surrounding the perfection of security interests in unregistered copyrights,
DUE DILIGENCE 9.9
which will be discussed in detail in later sections, lenders may also require that copyrights be registered as a condition to extending loans.76 So as to identify any unregistered copyrights, the acquirer may wish to review all of the target’s sales brochures, catalogs, Websites, software programs, and any computer programs the target uses under license.77 Patents. A list of all patents and patent applications—United States and foreign—
should be compiled containing the following information: • • • • • • •
Patent number Inventor’s name(s) Date of application Date of issue for issued patents Any prior owners and how the patent was obtained by the target78 Remaining patent term Presence of any liens, security interests, or other encumbrances
In addition, periodic governmental fees (maintenance fees in the United States and annuities elsewhere) must be paid with patents and patent applications.79 Failure to pay these fees can cause patent rights to lapse. As such, the acquirer should ensure that all fees have been paid and ascertain any upcoming fee deadlines.80 Each patent should be checked to verify that the claims of the issued patent cover the products, processes, or methods to be acquired. For issued patents, the official prosecution file should be obtained from the PTO and analyzed to determine if any representations made to the PTO during the patent’s prosecution limit the scope of the patent’s claims. For patents of critical importance to the acquirer, a validity search should be conducted to determine if the claims of the patent are valid over prior art.81 Since any potential liability in connection with the target’s patent portfolio must be explored, any third-party protests or allegations of infringement and all opinion letters concerning the patent’s validity or enforceability should be reviewed. If the target has licensed any patents, the license agreements should also be reviewed to determine if there is any risk of patent misuse. Patent misuse is a defense to infringement that precludes the patent owner from enforcing the patent when the owner has improperly attempted to impose restrictions on its patent licensees that exceed the scope of the patent grant.82 Provisions that might give rise to a patent misuse defense include requiring royalty payments after the license term, requiring the licensee to license a bundle of patents rather than a single desired patent, or granting a license on the condition that the licensee refrain from dealing in products that compete with the patented product.83 Finally, the acquirer should determine if the target has entered into any agreements not to assert its patents against third parties, which might restrict the acquirer’s ability to enforce the patent(s) at issue. Trademarks. When compiling an inventory of U.S. and foreign trademark applications
and registrations, the following information should be included: • Country of registration or application • Registration or application number
9.10 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
• Goods or services included in the registration or application • Date of application and (if applicable) registration • For pending United States applications, whether the application is based upon use or a bona fide intent-to-use the mark • Any prior owners and how the trademark was obtained by the target84 • Any recordation of the mark with United States Customs • Presence of any liens, security interests, or other encumbrances To aid in gathering this information, the target should provide the acquirer its trademark prosecution files for review. In addition, file wrapper histories for U.S. trademark applications and registrations may be obtained from the PTO.85 Finally, for the most important marks, it is often a good idea to perform a trademark search or scan86 that will provide essential information about the target’s applications and registrations, especially the recorded chain of title and existence of any prior encumbrances.87 In addition, trademark rights in the United States may be obtained at common law without the filing of a trademark application.88 Thus, the target’s trademark portfolio may also include unregistered marks. A review of the target’s catalogs, price lists, brochures, Websites, advertising, promotional material, and annual reports should be performed to identify any common law (unregistered) marks that do not appear on the schedule of registered marks and pending applications.89 Moreover, when compiling a list of the target’s marks, the acquirer should confirm that all marks are still in use. In the United States, failure to use a mark for three consecutive years without an intent to resume use is prima facie evidence of the mark’s abandonment.90 In addition, the PTO requires that affidavits be filed between the fifth and sixth years after registration evidencing continued use of the mark.91 Failure to file these affidavits in a timely way can lead to cancellation of the registration.92 All upcoming deadlines for the filing of these documents should be specified. Likewise, imminent deadlines for the prosecution of pending applications (e.g., deadlines for responding to office actions or filing statements of use) and renewal of trademark registrations should be identified. For pending applications, any PTO office actions93 and relevant search reports should be reviewed to determine the likelihood of the applications maturing to registration. For the same reason, all files of pending PTO proceedings aimed at preventing or canceling trademark registration (opposition and cancellation proceedings, respectively) should also be reviewed. As with all other types of intellectual property assets, any protest or cease and desist letters or allegations of infringement should be analyzed. This also applies to all opinion letters concerning the availability of any marks, the strength of the target’s marks, or any potential infringement claims. The acquirer should also ensure that any prior assignments of material trademarks were proper. Trademarks cannot be assigned without the underlying goodwill of the business that they symbolize.94 Any assignment of a trademark apart from the goodwill of the business it represents constitutes an assignment in gross and will render the trademark abandoned.95 Special attention should be paid to any assignment of intentto-use applications. These applications may not be assigned prior to the filing of a statement of use96 with the PTO except to a successor to the business to which the trademark
DUE DILIGENCE 9.11
pertains, provided such business is ongoing and existing.97 Thus, for all pending intentto-use applications, the acquirer should determine if the mark is in use and, if so, if a statement of use has been filed with the PTO. If the target has licensed its marks to third parties, those licenses should be reviewed to ensure that the target has maintained adequate control over the use of its mark. Trademark law requires that a trademark owner control the nature and quality of the goods and services sold under its mark, including those sold under license.98 Failure to properly exercise control over the manner in which an owner’s mark is used by its licensees represents another ground for abandonment of a trademark.99 Finally, the acquirer should determine if the target has entered into any consent or co-existence agreements with other trademark owners, whereby the parties have agreed that their respective marks can coexist in the marketplace without confusion. These agreements frequently contain limitations regarding the geographic area or product lines in which a mark can be used. Trade Secrets. The value of any trade secret will depend upon the extent to which the target and its employees have protected the secret information.100 Therefore, the acquirer must investigate the practices and procedures implemented by the target to maintain the confidential nature of such information. In particular, the acquirer should examine the target’s internal security procedures, policies, or guidelines (e.g., employee entrance or exit interviews covering intellectual property issues), any confidentiality or nondisclosure agreements with employees, and any confidentiality or nondisclosure agreements with third parties who have been provided access to the secret information.101 In addition, the acquirer should determine if any key employees with knowledge of the trade secret information have recently left the target to join or start a competing business. Further, the acquirer should assess if the target has recently hired any employees from a competitor who may have knowledge of that competitor’s proprietary information, thereby raising the possibility of the target’s liability for misappropriation of the competitor’s trade secrets.102 Domain Names and Websites. The acquirer should obtain a list of all registered domain names and Websites owned or operated by or on behalf of the target. For domain name registrations, the acquirer should determine how each was obtained (i.e., directly from registration with a domain name registrar or via assignment from a prior registrant). For all third-party transfers, copies of the relevant assignment documents should be provided. For each domain name, the acquirer should note the registry with which the name is registered (e.g., Network Solutions or Register.com), the date of registration, and the deadlines for the payment of renewal fees to maintain registration. If the target owns registrations in any foreign country code TLDs (e.g., “www.target.se” in Sweden or “www.target.es” in Spain) the acquirer should review the requirements of the local country registry to determine whether assignment of a domain name registration by the target to the acquirer is possible.103 Finally, the acquirer should determine whether the target has received any communications from third parties challenging its use of its domain names or alleging that said domain names infringe upon third parties’ trademark rights.104
9.12 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
With respect to any target websites, the acquirer should identify the developer of the sites and verify ownership of the site content. Any website development or hosting agreements should be reviewed. The acquirer should also ensure that any websites are, in fact, operational.105 REPRESENTATIONS AND WARRANTIES
A schedule of the intellectual property assets owned by the target will typically be incorporated into the closing documents of a transaction, and the target will be called upon to make various representations and warranties at closing regarding the validity, ownership, strength, and transferability of the scheduled intellectual property. The scope of these representations and warranties will be dictated by the due diligence audit and any problems that it uncovers. The following are examples of the types of representations and warranties that a target might typically make: • The target is the exclusive owner of the scheduled intellectual property. • The scheduled intellectual property assets are valid and enforceable. • The target is not aware of any claim of invalidity or infringement respecting the scheduled intellectual property. • The target has not infringed upon, diluted, or misappropriated the intellectual property rights of third parties. • All PTO or Copyright Office recordings and filings necessary to maintain and enforce the target’s intellectual property rights have been made. • There are no pending suits, actions, or other proceedings that threaten or otherwise involve the scheduled intellectual property. • The target is not subject to any judgment, decree, injunction, or court order that limits or restricts its ability to use the scheduled intellectual property. • The target has not entered into any agreement that impairs or limits its rights regarding the scheduled intellectual property.106 Because the acquirer and target will often merge into a single entity or other business combination after the closing, the issue of whether the acquirer will have any recourse post-closing should the target breach its representations or warranties frequently remains. One method used to address this issue is to require placement of a portion of the purchase price in escrow for a specified period of time. This circumstance allows the acquirer to recover against the escrow in the event of a breach of a representation or warranty by the target.107 Alternatively, the acquirer may seek to require that certain large shareholders agree to personal liability for the target’s intellectual property representations and warranties.108 RECORDING OF TRANSFERS Assignments. In the majority of merger and acquisition transactions, the target’s intel-
lectual property assets will be assigned to the acquirer at closing. In the case of registered copyrights, patents, and trademarks, assignments must be publicly recorded to put the world on constructive notice of the acquirer’s rights.
RECORDING OF TRANSFERS 9.13
For example, Section 205(a) of the Copyright Act provides that “any transfer of copyright ownership or other document pertaining to a copyright may be recorded in the Copyright Office.”109 In the event of two conflicting transfers, priority will be given to the first party to record its interest in the Copyright Office, provided the recording is made within one month of its execution in the United States or two months of its execution outside the United States.110 Similarly, both patent and trademark assignments will be deemed void against any subsequent purchaser or mortgagee without notice, unless recorded in the PTO within three months from the date of assignment or before the date of the subsequent purchase or mortgage.111 Security Interests. Like many commercial transactions, corporate mergers and acquisitions frequently require that the acquirer borrow funds to finance the transaction. In these instances, the lender providing the funds will seek collateral—property offered by the borrower (acquirer) to secure the loan—as protection against the risk of default. This collateral frequently takes the form of a security interest in the assets of the target, which allows the lender to foreclose on those assets should the acquirer default. Uniform Commercial Code: Article Nine. The granting and enforcement of security inter-
ests in personal property is governed by Article Nine of the UCC.112 Before the drafting of Article Nine, a number of different nonstatutory or common law devices (e.g., chattel mortgages, conditional sales, trust receipts) provided creditors with recourse against specific personal property assets in the event of a debtor’s default. Each of these devices was governed by a separate set of rules and applied to only a limited range of commercial transactions.113 This multiplicity of security vehicles and governing rules added unnecessary complexity to commercial transactions. Article Nine was drafted to simplify the process of securing commercial loans by enveloping the various common law security devices in a single comprehensive security interest, which is defined broadly as “an interest in personal property or fixtures which secures payment or performance of an obligation.”114 In contrast to certain pre-UCC security devices (such as a chattel mortgage) that required the title for the collateral transfer to the creditor during the term of the loan and then revert back to the debtor upon satisfaction of the debt,115 Article Nine does not distinguish between security devices involving a transfer of title and those that comprise a lien on the underlying assets.116 Under the UCC, a security interest is created when a party having rights in the collateral grants a security interest to a creditor in exchange for value (consideration), pursuant to a signed written agreement.117 When these elements are present, the security interest is said to attach (i.e., it is enforceable by the creditor against the debtor). However, in order for the creditor’s security interest to be given priority over the interests or claims of third parties, it must also be perfected.118 Perfection is achieved by filing a financing statement (a UCC–1) in the appropriate state office.119 This UCC–1 is recorded under the debtor’s name and identifies the creditor and the collateral in which a security interest has been taken.120 In this way, the world is put on notice of the creditor’s security interest so that subsequent lenders, creditors, and assignees will be able to search the UCC filings in a particular state(s) to determine if, and the extent to which, the assets of a potential borrower are subject to prior security interests.121
9.14 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST Intellectual Property and Federal Preemption. Among the types of personal property subject to Article Nine are general intangibles, which are defined in Section 9–106 to include any personal property other than goods, accounts, chattel paper, documents, instruments, investment property, rights to proceeds of written letters of credit, and money.122 Copyrights, patents, and trademarks are expressly identified in the Official Comments of this section as examples of general intangibles.123 Moreover, because trade secrets and domain name registrations do not fall within any of the categories of personal property expressly excluded from the statutory definition,124 they, too, appear to constitute general intangibles. As such, the creation and perfection of security interests in each of the intellectual property assets addressed in this chapter—copyrights, patents, trademarks, trade secrets, and domain name registrations—would appear, at first blush, to be governed by Article Nine. However, the drafters of the UCC recognized that there could be instances in which Article Nine would be supplanted by federal law with respect to certain types of collateral. Thus, two provisions were included in Article Nine that render it inapplicable in certain circumstances when federal law governs. Section 9–104(a) states that “this Article does not apply to a security interest subject to any statute of the United States, to the extent that such statute governs the rights of parties to and third parties affected by transactions in particular types of property.”125 A second provision, Section 9–302(3), contains a more limited exclusion—relating solely to perfection of security interests—which states that
the filing of a financing statement otherwise required by this Article is not necessary or effective to perfect a security interest in property subject to. . . a statute or treaty of the United States which provides for a national or international certificate of title or which specifies a place a filing different from that specified in this Article for filing of the security interests.126
Section 9–302 further states that compliance with the filing requirements of such a federal statute or treaty “is equivalent to the filing of a financing statement” under Article Nine.127 Thus, filing a UCC–1 financing statement is not required (or effective) to perfect a security interest in any asset subject to a federal statute which provides its own mechanism for perfection. Three of the intellectual property assets addressed in this chapter—copyrights, patents, and trademarks—are governed, to varying degrees, by federal law.128 Thus, Article Nine appears to be internally inconsistent with respect to its applicability to these assets. On the one hand, copyrights, patents, and trademarks are expressly identified as examples of general intangibles subject to Article Nine.129 On the other hand, each of these assets is subject to federal law, thereby raising the possibility of preemption under Section 9–104. Moreover, to the extent any of the relevant federal statutes contain alternative methods of perfecting security interests, the possibility of partial preemption under Section 9–302 also exists. The applicability of Article Nine to these assets has been subject to much debate and is discussed further in the following sections. Copyrights. The Official Comment of Section 9–106, which identifies a copyright as an example of a general intangible, contains the caveat “except to the extent that [copy-
RECORDING OF TRANSFERS 9.15
rights] may be excluded by Section 9–104(a).”130 This suggests that the drafters of Article Nine believed that the Copyright Act may sufficiently govern “the rights of parties to and third parties affected by transactions in [copyrights]” to preempt Article Nine.131 The Official Comment of Section 9–104(a), however, takes the position that “the Federal Copyright Act. . . would not seem to contain sufficient provisions regulating the rights of the parties and third parties to exclude security interests in copyrights from the provisions of this Article.”132 Thus, the comments appear to be somewhat contradictory about the possibility of Copyright Act preemption. The Official Comment of Section 9–302 further muddles the analysis by identifying the Copyright Act as an example of a statute with filing provisions adequate to supercede the Article Nine filing system for perfection of security interests.133 It must be noted, however, that the current Copyright Act of 1976 was not in effect at the time of the drafting of the Official Comments to Article Nine. Rather, the comments relate to the prior 1909 Copyright Act, which differed from the current law in several material respects. Thus, the relevance of these Official Comments to the issue of preemption by the current Copyright Act is dubious, at best. Despite the lack of clarity in the provisions of Article Nine, the question of Copyright Act preemption has been addressed by the courts in In re Peregrine Enter. Ltd.134 and its progeny. As previously noted, Section 205(a) of the Copyright Act provides that “any transfer of copyright ownership or other document pertaining to a copyright may be recorded in the Copyright Office.”135 A “transfer of copyright ownership” is defined in the Copyright Act as an assignment, mortgage, exclusive license, or any other conveyance, alienation or hypothecation of a copyright or of any of the exclusive rights comprised in a copyright, whether or not it is limited in time or place of effect, but not including a non-exclusive license.136
The Peregrine court determined that the terms “mortgage” and “hypothecation” include a pledge of security or collateral for a debt—in other words, a security interest.137 Moreover, the Copyright Office has defined “a document pertaining to copyright” as one that has a direct or indirect relationship to the ownership, division, allocation, licensing, transfer, or exercise of rights under a copyright.138 Thus, the court held that the recording provisions of Section 205(a) encompass security interests in copyrights and specify a place for recording those security interests that differs from that provided in Article Nine, thereby triggering the Section 9–302 exclusion for perfection of security interests.139 Therefore, based upon Peregrine, security interests in copyrights are perfected by filing in the Copyright Office, not via a UCC–1 filed in the state where the debtor is located.140 In addition, the Peregrine court found that the Copyright Act sufficiently governed the rights of parties to, and third parties affected by, transactions in copyrights to fall within the broader preemption language of Article Nine Section 9–104(a).141 Thus, the court held that the Copyright Act not only provided for the proper method of perfecting security interests in copyrights, but also governed priority disputes between conflicting transfers of interests in copyrights.142 Under Article Nine, priority between competing security interests in intangibles is governed by a “first to perfect” rule.143 In contrast, the Copyright Act provides that the first security interest executed will be accorded priority so long as it is properly
9.16 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
recorded within one month of execution in the United States or two months of execution outside the United States or at any time before the proper recordal of the later security interest.144 Thus, in the context of due diligence, the acquirer should be cognizant not only of recorded security interests, but also of the possibility of recent grants of security interests in copyrights that may not yet be recorded, but that may have the possibility of posing priority problems. While the holding of Peregrine appears straightforward, there remain two unsettled areas with respect to copyright perfection: copyright accounts receivable and unregistered copyrights. Copyright Accounts Receivable. The creditor in Peregrine had obtained security inter-
ests in the copyrights in several films, as well as the accounts receivable generated by distribution of these copyrighted films. With respect to the accounts receivable, the Peregrine court held that “because a copyright entitles the holder to receive all income derived from the display of the creative work, an agreement creating a security interest in the receivables generated by a copyright” is also properly recorded in the Copyright Office.145 The appropriateness of this holding has been the subject of much debate. On the one hand, it has been argued that the value of a federal filing would be reduced if it did not encompass such receivables because the receivables represent at least some of the value of the copyright itself. Moreover, to hold otherwise would require a federal filing to perfect a security interest in a copyright and a state filing to perfect a security interest in the copyright receivable, thereby requiring parties to search under both systems to identify related security interests, leading to unnecessary confusion, delay, and expense.146 On the other hand, at least one commentator has noted that, while the Peregrine court determined that the Copyright Act preempted Article Nine due, in part, to the comprehensive nature of the Copyright Act’s recording system, there is little evidence to suggest that the Copyright Act was intended to occupy the field of accounts receivables in copyrights.147 Indeed, the Copyright Act is generally silent with respect to copyright receivables and licenses. Thus, because there is no direct conflict between the Copyright Act and Article Nine with respect to accounts receivable, it can be argued that security interests in these receivables are more properly filed under Article Nine. A recent New York state court case adds further support to this position. In MCEG Sterling, Inc. v. Phillips Nizer Benjamin Krim & Ballon,148 a creditor obtained a security interest in the home video royalties generated by three copyrighted films. These security interests were perfected by the filing of a UCC–1 with the California Secretary of State. Subsequently, a legal malpractice action was brought against the creditor’s law firm on the grounds that the security interests were not properly perfected, because they were not recorded in the Copyright Office. The court noted that Peregrine and its progeny were the only legal authority cited for the proposition that security interests are properly perfected under the Copyright Act.149 However, it found the Peregrine holding to be “somewhat questionable” with respect to security interests in copyright receivables as the collateral in question was not the copyrights themselves.150 The court went on to state that copyright receivables appeared to be analogous to installment notes for the sale of land that are perfected under the UCC, rather than under the real property recording statutes. So, too, the court felt that copyright receivables could be perfected by a state UCC filing. Thus, the malpractice claim was dismissed on summary judgment.
RECORDING OF TRANSFERS 9.17
In sum, the scope of Peregrine is somewhat in doubt. While security interests in copyrights themselves have been held to be subject to the Copyright Act, the applicability of the federal statute to security interests in related licenses and receivables is less clear. Thus, prudence would appear to dictate a belt and suspenders approach whereby filings are made pursuant to both the Copyright Act and Article Nine. Unregistered Copyrights. As noted previously, registration is not required in order to
obtain a copyright. Rather, a copyright in a particular work will subsist upon the fixation of that work in a tangible means of expression.151 While the Peregrine court held that federal filings perfect security interests in copyrights, it made no distinction between registered and unregistered copyrights. At least two subsequent cases, In re AEG Acquisition Corp.152 and In re Avalon,153 followed the Peregrine holding and concluded that security interests in unregistered copyrights could only be registered in the Copyright Office. However, a more recent decision, In re World Auxiliary Power Co.,154 reached the opposite conclusion, with the court holding that a security interest in an unregistered copyright may be perfected by the filing of a UCC–1 in the appropriate state office.155 In so finding, the court noted that the recording of a security interest in the Copyright Office provides third parties with constructive notice of that security interest only where the copyright at issue is registered.156 The statute provides no method for the perfection of security interests in unregistered copyrights. Thus, the court reasoned that the Copyright Act’s recording provisions are not comprehensive as applied to unregistered copyrights and that the perfection of security interests in such copyrights under Article Nine is appropriate.157 Much like the copyright accounts receivable previously discussed, the split of opinions among the courts with respect to perfection of security interests in unregistered copyrights mitigates in favor of a belt and suspenders method of federal and state filing. Patents. The creation of patent rights is governed exclusively by the federal Patent
Act.158 This statute does not, however, contain extensive provisions relating to priority and recording of patent conveyances or liens. The sole recording provision of the statute is Section 261, which merely states that any “assignment, grant or conveyance” of a patent is void as against a subsequent purchaser or mortgagee without notice of the assignment, unless the assignment has been recorded in the PTO within three months from its date or prior to the date of the subsequent purchase or mortgage.159 Until recently, there was some dispute among the few district courts addressing the issue as to if this “assignment” recording provision encompassed security interests in patents and therefore required a filing in the PTO in order to perfect such security interests. The earliest cases on point, In re Transportation Design & Technology, Inc.160 and City Bank & Trust Co. v. Otto Fabrics, Inc.,161 both involved disputes between a secured creditor and a bankruptcy trustee, with the trustee arguing that the creditor’s UCC–1 filing was an ineffective method of perfecting its security interest in the debtor’s patents. In both cases, the court found the state filing to be a sufficient method of perfection for two reasons. First, Section 261 does not address the issue of perfection as against lien creditors (which include bankruptcy trustees)—only subsequent purchasers or mortgagees.162 Moreover, a UCC security interest does not require the transfer of title and, therefore, cannot be deemed an “assignment, grant or conveyance” within the meaning
9.18 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
of Section 261.163 Thus, the courts concluded that Section 261 was inapplicable to the recording of security interests in patents and that Article Nine provided the proper method of perfection. The reasoning of Transportation Design and Otto Fabric was subsequently criticized by the Peregrine court, which argued that the prior opinions had confused two distinct issues: perfection of security interests and priority in the event of competing security interests.164 According to the Peregrine court, the relevant inquiry is whether a federal statute provides for a national system of recordation or specifies a place of filing different from that in Article Nine. [If so,] the methods of perfection specified in Article Nine are supplanted by that national system; compliance with a national system of recordation is equivalent to the filing of a financing statement under Article Nine.165
The Peregrine court appeared to be of the view that, in light of the national recording system for patent assignments set forth in Section 261, security interests in patents should be properly perfected by federal filings. It should be noted, however, that the comments of the Peregrine court were made in dicta, as that case involved security interests in copyrights and related receivables, not patents. Nevertheless, any lingering uncertainty with respect to the propriety of perfecting security interests in patents pursuant to Article Nine appears to have been removed by the U.S. Court of Appeals for the Ninth Circuit in In re Cybernetic Servs., Inc.,166 in which the court affirmed a lower court determination that perfection of a security interest in a patent did not require a filing in the PTO.167 The Cybernetic court concurred with the view posited in Transportation Design and Otto Fabric that “the extent to which the Patent Act regulates the perfection of security interests depends on whether the term ‘assignment’ in the Act includes the grant of a security interest and whether every secured party and lien holder is a ‘mortgagee.’”168 The court found (as did the earlier courts) that the term assignment as used in the Patent Act involves the transfer of title, but UCC security interests in personal property are not dependent on which party has title to the property.169 In addition, the Patent Act says nothing about the creation or perfection of security interests, and the administrative rules regulating the function and operation of the PTO make no reference to security interests or liens.170 As such, the Cybergenics court determined that Section 261 is not a secured transactions statute in the modern sense of the word, but is concerned only with ownership or title transfers. Therefore, it concluded that the Patent Act does not preempt state regulation of security interests in patents.171 Having thus determined that no broad Patent Act preemption applied, the court next considered if the recording system for patent assignments under Section 261 was adequate to supercede state UCC filings in accordance with Article Nine Section 9–302(3). In this regard, the Court again noted that security interests in patents are not subject to the mandatory recording provisions of Section 261. Rather, the PTO records such security interests on a discretionary basis that is insufficient to provide constructive notice of the security interest. As a result, the Court found that the Patent Act is “not sufficiently comprehensive to exclude state methods of perfecting security interests in patents.”172 In short, in contrast to copyrights, it appears fairly clear that security interests in patents are properly perfected by filing a state UCC–1 financing statement.
RECORDING OF TRANSFERS 9.19 Trademarks. As noted, trademarks are subject to protection under not only federal
statutory law, but also state statutory and common law. To the extent that security interests are granted in common law trademarks and/or state trademark registrations, federal law would not be implicated, and Article Nine would apply. For security interests in federally registered trademarks, the analysis is similar to that provided in Cybergenics about the Patent Act. Section 10 of the Lanham Act provides that: A registered mark. . . shall be assignable along with the goodwill of the business in which the mark is used. . . An assignment shall be void as against any subsequent purchaser for a valuable consideration without notice, unless it is recorded in the Patent and Trademark Office within three months after the date thereof or prior to such purchase.173
The statute makes no direct reference to the recording of security interests. Thus, the issue is whether the term assignment as used in Section 10 is sufficiently broad to encompass security interests, thereby mandating a federal filing to perfect such security interests. Assignment is not defined under the Lanham Act; however, several courts have concluded that a trademark assignment does not include a security interest.174 In order for a trademark assignment to be valid and enforceable, the trademark must be assigned together with the goodwill of the business in connection with which it is used.175 As there is no transfer of the goodwill in the debtor’s business to the holder of a security interest, this prerequisite for a valid assignment under the Lanham Act is lacking. Moreover, in contrast to the recording provisions of the Lanham Act, “Congress has expressly included consensual liens in the copyright recording system, thereby demonstrating its awareness of the possibility of such liens and its inclination to make manifest an intention to require their recording when that intention is present.”176 The absence of any concomitant mention of security interests in the recording provisions of the Lanham Act has been viewed as further support for the position that security interests in trademarks are subject to Article Nine.177 Intent-to-Use Trademark Applications: Security Interest versus Collateral Assignment. As
noted, in instances which an intent-to-use trademark application is filed, the applicant must commence actual use of the mark and file a statement of use with the PTO before a registration can issue.178 Moreover, an intent-to-use application may not be assigned before the filing of a statement of use, except to a successor to the business to which the mark pertains.179 This prohibition has been held to apply to not only outright title transfers, but also to conditional assignments (i.e., security devices intended to secure collateral for a loan but involve a transfer of title).180 In The Clorox Co. v. Chemical Bank,181 USA Detergent, Inc. (USA) filed an intentto-use application for the trademark SCRUB. It later filed a statement of use, and a registration issued. Prior to filing the statement of use, however, USA entered into a loan agreement with a bank, secured by various assets, including the SCRUB intent-to-use application.182 The agreement, entitled “Trademark and Tradename Security Assignment and License Agreement,” expressly provided for USA to assign all right, title, and interest in certain trademarks, including the SCRUB intent-to-use application,
9.20 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST
to the bank to secure its loan obligations. Subject to USA’s fulfillment of its repayment obligations, the bank would license back to USA the right to use the trademarks during the pendency of the loan, then assign the trademarks back upon repayment of the loan.183 Clorox, a USA competitor, subsequently petitioned the PTO to cancel the SCRUB registration on the grounds that USA had improperly assigned the underlying intent-touse application to the bank prior to filing a statement of use, thereby rendering the registration invalid.184 USA responded by arguing that, while the loan agreement may have used the term assignment, the parties’ intent was to create a security interest in the intent-to-use application and, thus, the application was not “assigned” within the meaning of the Lanham Act. The PTO’s Trademark Trial and Appeal Board rejected this argument, holding that although the agreement was entered into to secure a loan, the bank was, in fact, granted an outright assignment of all right, title, and interest in the intent-to-use application and was not a successor to the business in connection with which the mark was to be used. Thus, the registration was deemed void and invalid.185 In recent years, the American Bar Association (ABA), American Film Marketing Institute (AFMI)186 and Commercial Finance Association (CFA)187 have each advanced proposals for reforming the current system of recording ownership and security interests in intellectual property assets, particularly copyrights.188 The ABA’s Joint Task Force on Security Interests in Intellectual Property has drafted proposed legislation entitled the “Federal Intellectual Property Security Act” (FIPSA)189 that would provide for a dual system of perfecting security interests in copyrights, patents, and trademarks. Under FIPSA, a state UCC–1 filing would be required to perfect a security interest and establish priority as against secured parties and lien creditors (including bankruptcy trustees), that a federal recording would be required to perfect and establish priority, as against subsequent purchasers and all others. FIPSA also includes conforming amendments to the relevant federal statutes regarding timing and other filing particulars.190 In early 1999, the ABA presented the proposed FIPSA legislation to the Subcommittee on Courts and Intellectual Property of the Committee on the Judiciary of the United States House of Representatives. The Subcommittee held an oversight hearing on June 24, 1999, at which it solicited comments on FIPSA. Representatives of the ABA and CFA (among other groups) testified in favor of the proposed bill. Other groups, including the AFMI, testified against the proposal, arguing that FIPSA’s dual recording scheme would be burdensome and costly in that parties would still be required to search and file at both the federal and state levels. In addition, neither of the relevant federal offices—Copyright Office or PTO—testified in favor of the bill. Both, however, noted that the current systems are in need of reform.191 The 106th Congress took no action on FIPSA following the June 24, 1999, hearing, leaving its future in doubt. The ABA may, however, revisit the issue with the House Subcommittee during the 107th Congress.192 In addition to testifying in favor of FIPSA, the CFA proposed an interim measure, aimed at reversing Peregrine, that would be implemented while long-term reform proposals were studied. Under this interim measure, the Copyright Act would be amended to allow for the perfection of security interests in copyrights through a UCC–1 filing.193 Proposals for Reform.
ENDNOTES 9.21
Much like FIPSA, the state filing would only affect the rights of secured parties and lien creditors, not outright transferees of a copyright. These bona fide purchasers would continue to take free and clear of any security interest recorded only at the state level. Thus, both FIPSA and the CFA’s proposed interim measure take the position that the UCC should “govern the creation, attachment, perfection, priority and enforcement of security interests, while federal law should govern the rights of a person other than a secured party or lien creditor who acquires any other right or interest in intellectual property.”194 In contrast, the AFMI has advocated a purely federal solution to the problem and has put forth its own proposed legislation—the Copyright Filing Modernization Act (CFMA). Under the CFMA, a facility would be created within the Copyright Office to maintain constructive notice filings against both persons and works.195 Copyright owners would be able to file “personal registration statements” in the Copyright Office similar to the registrations currently available for copyrighted works. Security interests and other recorded transfers could then be filed with respect to either a particular copyrighted work in a works registry, or a particular person in a person registry. The two registries would be linked in a computerized database, and a filing in either registry “would impute constructive notice, create priority, and be necessary for perfection.”196 One criticism leveled at the proposed CFMA is the practical difficulties and administrative burdens it would place on the Copyright Office in implementing and maintaining the new “person” registry and database. While there continues to be much debate regarding how best to reform the current methods of perfecting security interests in intellectual property, it is widely recognized that such reforms are needed and, perhaps, inevitable. Parties engaged in intellectual property due diligence should monitor the legislative landscape to ensure that they are aware of future proposals for reform. ENDNOTES 1
35 U.S.C. §§ 101-103. U.S. CONST. Art. 1, § 8, cl. 8. 3 Patent Act, 35 U.S.C. §§ 1–376. 4 35 U.S.C. § 154. 5 Diane Wilkins Savage, Intellectual Property Due Diligence in Acquisitions of Technology Companies, at 221 PLI Corporate Law and Practice Course Handbook, Series N. 945 (June 1996). 6 Copyright Act of 1976, 17 U.S.C. §§ 101 et seq. Under the prior 1909 Copyright Act, copyright protection arose upon publication of a work. Prior to publication, the work could be protected under a state common law copyright theory. Under the current statute, however, protection is obtained upon fixation of the work in a tangible medium of expression, regardless of whether publication has occurred. This change, coupled with the broad preemption language of 17 U.S.C. § 301, puts the existence of state copyright rights in considerable doubt. 7 17 U.S.C. § 106. 8 17 U.S.C. §§ 411, 412. 9 A work made for hire is defined as “(1) a work prepared by an employee within the scope of his or her employment; or (2) a work specially ordered or commissioned as a contribution to a collective work, as a part of a motion picture or other audiovisual work, as a translation, as a supplementary work, as a compilation, as an instructional text, as a test, as answer material for a test, or as an atlas, 2
9.22 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST if the parties expressly agree in a written instrument signed by them that the work shall be considered a work made for hire.” 17 U.S.C. § 101. 10 17 U.S.C. § 302. 11 15 U.S.C. §§ 1051 et. seq. 12 See 15 U.S.C. § 1051(a), (b). 13 15 U.S.C. § 1051(b). 14 See 15 U.S.C. §§ 1057(b),1072, 1117; J. Thomas McCarthy, McCarthy on Trademarks and Unfair Competition, § 19:9 at 19–20 to 19–21 (3rd ed. 1995 rev.). 15 15 U.S.C. § 1058. 16 Restatement (First) of Torts § 757, cmt. B at 5 (1939); Melvin Simensky and Howard A. Gootkin, “Liberating Untapped Millions for Investment Collateral: The Arrival of Security Interests in Intangible Assets,” in 2 Intellectual Property in the Global Marketplace, 3rd ed. (2000) at 454. 17 Simensky and Gootkin, supra note 18 at 455; Restatement (First) of Torts § 757, cmt. B. 18 See Michael S. Denniston and Margaret Smith Kubiszyn, www.yourclient.com: Choosing Domain Names and Protecting Trademarks on the Internet, 61 Ala. Law. 40 (January 2000). 19 Recent domain sales include business.com for $7,500,000, asseenontv.com for $5,000,000, loans.com for $3,000,000, and autos.com for $2,200,000. 23yr old mogul seeks offical.com dollars for MAD.COM!, M2 Presswire, February 22, 2000, available at 2000 WL 12935340. 20 For ease of reference, we will refer to the parties to a merger or acquisition transaction as the “acquirer” and “target” throughout this chapter. 21 Judith L. Church, Resolving Intellectual Property Issues in Mergers and Acquisitions, at 135, PLI Patent, Copyrights, Trademarks and Literary Property Course Handbook Series No. 559 (May 1999). 22 Ibid. at 142. 23 See Church, supra note 21 at 137; Savage, supra note 5 at 215–16. 24 Byron E. Fox and Eleanor M. Fox, Corporate Acquisitions and Mergers, ch. 2A § 2A.03[2] (1999) (hereinafter, “Fox & Fox, Corporate Acquisitions and Mergers”), Matthew Bender & Company, Inc. 25 Church, supra note 21 at 137; Savage, supra note 5 at 207. It is recognized that, while this is the general rule, the “de facto merger” doctrine provides that an asset or stock purchase may, despite efforts to the contrary, be treated as a merger under certain circumstances. See Fox & Fox, supra note 24 at § 2A.03[2]. A discussion of this doctrine is outside the scope of this chapter. 26 Savage, supra note 5 at 210–11. 27 Ibid. at 214–15. 28 David A. Gerber et al., The Role of Intellectual Property in Mergers and Acquisitions, at 537, PLI Corporate Law and Practice Course Handbook, Series N. 609 (July 1988). 29 Church, supra note 21 at 138. 30 Savage, supra note 5 at 211. 31 Ibid. at 209–10. 32 Securities Act of 1933, Section 11(b)(3), 15 U.S.C. § 77(k); Savage, supra note 5 at 209. 33 See supra Section II. 34 See Catherine H. Stockell, A Primer on Due Diligence Reviews of Intellectual Property Assets, at 1122, PLI Corporate Law and Practice Course Handbook, Series N. 441 (May/June 1999); Savage, supra note 5 at 208. 35 See Stockell, supra note 34 at 444. Typically, the intellectual property audit is completed prior to closing. In certain instances, however, a deal may close subject to completion of “satisfactory” due diligence. Savage, supra note 5 at 219. 36 See Sandra Edelman, Intellectual Property Aspects of Corporate Acquisitions, SE12 ALI-ABA 293 (1999); Stockell, supra note 34 at 447.
ENDNOTES 9.23 37 In the federal patent and trademark application processes, applications are assigned to an examining attorney. This examiner will review the applications in light of any relevant prior patents or trademark registrations (as the case may be), then issue an “office action” to the applicant. The office action identifies any defects in the application and any grounds for refusal to issue the patent or register the trademark. The applicant then has six months to respond to the office action. See 15 U.S.C. § 1062(b); 35 U.S.C. §§ 132, 133. 38 As noted previously, a federal trademark application may be filed on the basis of a bona fide intentto-use the mark. In such cases, the application must either be amended to allege use or a so-called “statement of use” must be filed prior to obtaining registration. The statement of use must be filed within six months of receiving a notice of allowance (i.e., a notice that the mark is entitled to registration) from the examiner. 15 U.S.C. § 1051(d). 39 Stockell, supra note 34 at 451. 40 William A. Tanenbaum, Intellectual Property Due Diligence in Structuring, Negotiating & Implementing Strategic Alliances, at 195, 204, PLI Corporate Law and Practice Course Handbook, Series N. 1132 (July/August, 1999). 41 See Gerber, supra note 28 at 566. 42 Stockell, supra note 34 at 447–48. 43 Ibid. at 448. 44 See Stockell, supra note 34 at 449; Tanenbaum, supra note 40 at 204. 45 Edelman, supra note 36 at 297–98; Stockell, supra note 34 at 449–50. 46 Stockell, supra note 34 at 452. 47 Ibid. at 462. 48 Ibid. at 452. 49 Revised Article Nine has a uniform effective date of July 1, 2001. 50 See infra Section V.B.1. 51 U.C.C. § 9–102. 52 See Rev. U.C.C. § 9–102; Steven O. Weise, The Financing of Intellectual Property Under Revised UCC Article 9, 74 Chi-Kent L. Rev. 1077, 1087 (1999). 53 Rev. U.C.C. § 9–406; Weise, supra note 52 at 1088. 54 Weise, supra note 52 at 1089. 55 Ibid. at 1092; see Rev. U.C.C. § 9–408. 56 See Rev. U.C.C. § 9–203 cmt. 6 (“a security interest attaches only to whatever rights a debtor may have, broad or narrow as those rights may be”). 57 Weise, supra note 52 at 1095; Rev. U.C.C. § 9–408(d). 58 See Edelman, supra note 36 at 299; Stockell, supra note 34 at 454; Tanenbaum, supra note 40 at 206. 59 Savage, supra note 5 at 236–37. 60 Stockell, supra note 34 at 454. 61 As noted in note 37, supra, an office action is a document issued by the PTO patent or trademark examiner, that identifies any defects in the application and any grounds for refusal to issue the patent or register the trademark. See 15 U.S.C. § 1062(b); 35 U.S.C. §§ 132, 133. 62 An opposition is a proceeding that may be brought before the PTO’s Trademark Trial and Appeal Board by any person who believes that he or she would be damaged by the registration of the appliedfor trademark. 15 U.S.C. § 1063. 63 A patent interference is a proceeding before the PTO’s Patent Board of Appeals and Interferences, which is instituted by the PTO for purposes of establishing invention priority when, in its opinion, a patent application has been filed that would interfere with any pending patent application or unexpired patent. 35 U.S.C. § 135.
9.24 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST 64
See Edelman, supra note 36 at 299; Savage, supra note 5 at 236-37; Stockell, supra note 34 at 454. Savage, supra note 5 at 227–29. 66 For works created prior to 1989, failure to include a copyright notice on each copy of the work might have resulted in loss of copyright protection. See 17 U.S.C. § 10 (1909 Act). 67 Works created prior to 1978 have both initial and renewal periods. 17 U.S.C. § 304. For any such works, the Acquirer should determine if renewals have been obtained. 68 See infra Section V.A. 69 A “joint work” is defined as a “work prepared by two or more authors with the intention that their contributions be merged into inseparable or interdependent parts of a unitary whole.” 17 U.S.C. § 101. 70 See H.R. Rep. No. 94-1476, 94th Cong., 2d Sess. 121 (1976) (“[C]o-owners of a copyright would be treated generally as tenants in common, with each co-owner having an independent right to use or license the use of a work, subject to a duty of accounting to the other co-owners for any profits.”); Weissman v. Freeman, 868 F.2d 1313, 1318 (2d Cir.), cert. denied, 110 S. Ct. 219 (1989) (“The only duty joint owners have with respect to their joint work is to account for profits from its use.”). 71 Edelman, supra note 36 at 301. 72 See supra note 9. 73 Edelman, supra note 36 at 301. As noted in note 9, a work that is specially ordered or commissioned as a (a) contribution to a collective work, (b) part of a motion picture or other audiovisual work, (c) translation, (d) supplementary work, (e) compilation, (f) instructional text, (g) test, (h) answer material for a test, or (i) atlas will be considered a work made for hire, provided that the parties expressly agree to the same in a signed, written instrument. 17 U.S.C. § 101. 74 17 U.S.C. § 102. 75 Although not required, copyright registration provides numerous advantages, including the ability to bring an infringement action in federal court and eligibility for statutory damages in such an action. 17 U.S.C. § 412. Moreover, as discussed infra, unregistered copyrights pose additional difficulties with respect to the perfection of security interests. 76 See In re AEG Acquisition Corp., 127 B.R. 34 (C.D. Cal. 1991). 77 Edelman, supra note 36 at 300. 78 As with copyrights, the acquirer must ensure that any assignments were properly recorded to establish an accurate chain of title. See infra Section V.A. 79 Maintenance fees for United States patents are due 3, 7, and 11 years after the issuance of the patent. 35 U.S.C. § 41(b). Most foreign countries require that annuities be paid annually. See Savage, supra note 5 at 222. 80 Tanenbaum, supra note 40 at 205. 81 Ibid. at 206. In general, the term “prior art” refers to any relevant knowledge, art descriptions, or patents that pertain to, but predate, the invention at issue. See 35 U.S.C. § 102; Mooney v. Brunswick Corp., 663 F.2d 724, 733 (7th Cir. 1981). 82 See Morton Salt Co. v. G.S. Suppiger, 314 U.S. 488 (1942); Tanenbaum, supra note 40 at 210–11. 83 See B.B. Chem. Co. v. Ellis, 314 U.S. 495 (1942); Koratron Co. v. Lion Uniform, Inc., 409 F. Supp. 1019 (N.D. Cal. 1976); Tanenbaum, supra note 40 at 210–11. 84 Again, the acquirer must ensure that any assignments were properly recorded to establish an accurate chain of title. See infra Section V.A. 85 A “file wrapper” refers to the official PTO file relating to a particular trademark application. Trademark file wrappers are available to the public and may be obtained from the PTO. 86 A trademark availability search involves a search of federal and state trademark applications and registrations, common law trademark uses, and domain name registrations for prior uses the same or similar trademarks by third parties. A trademark scan refers to a streamlined search that focuses only on federal and state registries and does not encompass common law or domain name uses. 65
ENDNOTES 9.25 87
See Edelman, supra note 36 at 298–99. See supra Section I. 89 Edelman, supra note 36 at 297. 90 15 U.S.C. § 1127. 91 15 U.S.C. § 1058. 92 Ibid. 93 See supra note 37. 94 15 U.S.C. § 1060; see Marshak v. Green, 746 F.2d 927 (2d Cir. 1984) (“A trade name or mark is merely a symbol of goodwill; it has no independent significance apart from the goodwill it symbolizes . . . [A] trademark cannot be sold or assigned apart from the goodwill it symbolizes.”); Mister Donut of America, Inc. v. Mr. Donut, Inc., 418 F.2d 838 (9th Cir. 1969) (“there are no rights in a trademark alone and. . . no rights can be transferred apart from the business with which the mark has been associated”). 95 Ibid.; J. Thomas McCarthy, 2 McCarthy on Trademarks and Unfair Competition §§ 18.01-18.12 (3rd ed. 1995 rev.). 96 See supra note 38. 97 Clorox Co. v. Chemical Bank, 40 U.S.P.Q.2d 1098 (T.T.A.B. 1996). 98 See Gorenstein Enters., Inc. v. Quality Care-USA, Inc., 874 F.2d 431 (7th Cir. 1989) (“The owner of a trademark has a duty to ensure the consistency of the trademarked goods or services”). 99 AmCam Enterprises, Inc. v. Renzi, 32 F.3d 233 (7th Cir. 1994); Kentucky Fried Chicken Corp. v. Diversified Packaging Corp., 549 F.2d 368 (5th Cir. 1977). 100 Savage, supra note 5 at 229; Tanenbaum, supra note 40 at 207. 101 Tanenbaum, supra note 40 at 207. 102 Ibid. 103 As previously discussed, several countries have eligibility restrictions for ownership of domain names in their registries. For example, several countries (e.g., France, Germany) require that the registrant be locally registered to do business in that country. Others (e.g., Spain, Sweden) further limit each registrant to a single domain name registration that must match the registrant’s company name. Thus, it is unlikely that acquirer would be able to directly own the domain name “www.target.es” or “www.target.se.” For strategically important domain name registrations, companies have been able to get around these restrictions by setting up subsidiary companies in the relevant jurisdictions for the sole purpose of owning the desired domain name in that country. 104 Edelman, supra note 36 at 300. 105 Ibid. 106 Edelman, supra note 36 at 305–06; Gerber, supra note 28 at 591. 107 Savage, supra note 5 at 238–39; Fox & Fox, supra note 24 at § 2A.03[5][d]. 108 Gerber, supra note 28 at 591; Savage, supra note 5 at 239. 109 17 U.S.C. § 205(a). 110 17 U.S.C. § 205(d). 111 15 U.S.C. § 1060; 35 U.S.C. § 261. 112 Article Nine has been enacted into law in each of the fifty states. Gregory E. Maggs, Karl Llewellyn’s Fading Imprint on the Jurisprudence of the Uniform Commercial Code, 71 U. Colo. L. Rev. 541, 548 (2000). 113 See Simensky & Gootkin, supra note 16 at 457. 114 U.C.C. § 1-201(37). 115 Ibid. 88
9.26 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST 116 See Alice Haemmerli, Insecurity Interests: Where Intellectual Property and Commercial Law Collide, 96 Columbia L. Rev. 1645, 1648 (1990). Nevertheless, today, one typically thinks of a security interest as involving a lien rather than a transfer of title. Thus, for purposes of this discussion, we will use the term “security interest” to refer to liens and the term “assignment” to refer to transfers of title. 117 U.C.C. § 9-203(1)(a)–(c). 118 Under Article Nine, priority among competing security interests in a particular collateral is governed by a “first to perfect” rule. U.C.C. § 9–312(b). 119 The proper state in which to file the UCC–1 in a given transaction will vary in accordance with the type of collateral at issue (i.e., general intangibles, goods, accounts). For intangible assets, such as the intellectual property assets at issue here, the filing is typically made in the state where the debtor’s principal place of business is located. U.C.C. § 9–103. 120 U.C.C. § 9–302. Perfection may also be accomplished by taking possession of the assets at issue. However, as intellectual property assets are, by their very nature, intangible, they are incapable of being possessed physically. Thus, this method of perfection will not be addressed herein. 121 The state filings are searchable by debtor name. 122 U.C.C. § 9–106. 123 Official Comments, U.C.C. § 9–106. 124 Goods are defined to include “all things which are moveable at the time the security interest attaches.” U.C.C. § 9–105(1)(h). An account is “any right to payment for goods sold or leased or for services rendered which is not evidenced by an instrument or chattel paper.” U.C.C. § 9–106. Chattel paper means “[a] writing or writings which evidence both a monetary obligation and a security interest in or a lease of specific goods.” U.C.C. § 9–105(1)(b). Documents means documents of title as defined in U.C.C. § 1–201 such as bills of lading, warehouse receipts, and dock receipts. U.C.C. § 9–105(1)(f). Instruments are negotiable instruments subject to UCC Article 3 or as certified securities under UCC Article 8, while money is defined as “a medium of exchange authorized or adopted by a domestic or foreign government.” U.C.C. §§ 1–201(24), 9–105(1)(i). An investment property refers to a security, securities account, commodity contract, or commodity account. U.C.C. § 9–115(1)(f). Trade secrets and domain name registrations do not meet any of these definitions. The remaining exclusion, rights to proceeds of written letters of credit and money, is likewise inapplicable to these assets. 125 U.C.C. § 9–104(a). 126 U.C.C. § 9–302(3)(a). 127 U.C.C. § 9–302(4). 128 See the Copyright Act of 1976, 17 U.S.C. §§ 101 et. seq.; the Patent Act of 1952, 35 U.S.C. §§ 1 et. seq.; the Lanham Act of 1946, 15 U.S.C. §§ 1051 et. seq. 129 Official Comments, U.C.C. § 9–106. 130 Ibid. As noted, Section 9–104(a) states that “this Article does not apply to a security interest subject to any statute of the United States, to the extent that such statute governs the rights of parties to and third parties affected by transactions in particular types of property.” 131 U.C.C. § 9–104(a). 132 Official Comments, U.C.C. § 9–104. 133 Official Comments, U.C.C. § 9–302. 134 116 B.R. 194 (C.D. Cal. 1990). 135 17 U.S.C. § 205(a). 136 17 U.S.C. § 101. 137 116 B.R. at 199. 138 37 C.F.R. § 201.4(a)(2); see In re Peregrine Enter. Ltd., 116 B.R. at 199. 139 In re Peregrine Enter. Ltd., 116 B.R. at 203.
ENDNOTES 9.27 140
Ibid. Ibid. at 205. 142 Ibid. 143 U.C.C. § 9–312(5). 144 17 U.S.C. § 205(d). 145 116 B.R. at 199, 203. 146 Peter F. Coogan et al., 1C UCC Secured Transactions, ch. 25, § 25.08[3][b][iii] (1999). 147 Haemmerli, supra note 116 at 1683. 148 646 N.Y.S. 778 (Sup. Ct., New York City. 1996). 149 Ibid. at 780. 150 Ibid. 151 17 U.S.C. §§ 102(a), 302(a); see supra notes 8–9. 152 127 B.R. 34 (C.D. Cal. 1991). 153 209 B.R. 517 (D. Ariz. 1997). 154 244 B.R. 149 (N.D. Cal. 1999). 155 Ibid. at 153. 156 See 17 U.S.C. § 205(c). 157 244 B.R. at 155. 158 35 U.S.C. §§ 1–376. 159 35 U.S.C. § 261. 160 48 B.R. 635 (C.D. Cal. 1985). 161 83 B.R. 780 (D. Kan. 1988). 162 In re Transportation Design & Technology, Inc., 48 B.R. at 639; City Bank and Trust Co. v. Otto Fabric, 83 B.R. at 782. As noted by the courts, a lien creditor is not a mortgagee within the meaning of Section 261 because, under the Patent Act, the term “mortgage” refers to a chattel mortgage, which involves a transfer of title rather than a lien. Simensky & Gootkin, supra note 16 at 467; see Waterman v. Mackenzie, 138 U.S. 252 (1891) (holding that a patent mortgage was an “assignment” where the mortgage at issue involved the transfer of title to the patent). 163 In re Transportation Design, 48 B.R. at 639; Otto Fabric, 83 B.R. at 782; see Simensky & Gootkin, supra note 16 at 467. 164 166 B.R. at 104; see Simensky & Gootkin, supra note 16 at 468. 165 116 B.R. at 203. 166 239 B.R. 917 (9th Cir. 1999); aff’d, 2001 U.S. App. LEXIS 11750 (9th Cir. 2001). 167 Ibid. at 918. 168 Ibid. at 920. 169 Ibid.; see U.C.C. § 9–202 (providing that Article 9 applies to secured transactions involving personal property regardless of “whether title to collateral is in the secured party or the debtor”). Indeed, the court noted that the majority of UCC security interests do not involve title transfers. 239 B.R. at 921. 170 239 B.R. at 922. 171 Ibid. at 922. 172 Ibid. at 923. 173 15 U.S.C. § 1060. 174 See In re Together Development Corp., 227 B.R. 439 (D. Mass. 1998); In re 199Z, Inc., 137 B.R. 778 (C.D. Cal. 1992); In re Roman Cleanser Co., 43 B.R. 944 (E.D. Mich. 1984); In re TR-3 Indus., Inc., 41 B.R. 128 (C.D. Cal. 1984). 141
9.28 INTELLECTUAL PROPERTY, DUE DILIGENCE, AND SECURITY INTEREST 175
15 U.S.C. § 1060; see supra note 94. In re Together Development Corp., 227 B.R. at 441. 177 Ibid. 178 See supra notes 12, 38. 179 15 U.S.C. § 1060. 180 The Clorox Co. v. Chemical Bank, 40 U.S.P.Q.2d 1098 (T.T.A.B. 1996). 181 Ibid. 182 Ibid. at 1100. 183 Ibid. at 1102–03. 184 Ibid. As noted, the Lanham Act prohibits the assignment of an intent-to-use application prior to the filing of a statement of use, except to the successor of the business of the applicant to which the mark pertains. In Clorox, the bank was not a successor to USA’s business, but rather had taken a conditional assignment as collateral for a loan. 185 Ibid. 186 The AFMI is a trade association of almost 200 independent film and television production and distribution companies and affiliated financial institutions. See Ara A. Babaian, Comment, Striving for Perfection: The Reform Proposals for Copyright-Secured Financing, 33 Loy. L.A. L. Rev. 1205, 1231 n.156 (2000). 187 The CFA is a trade group for the asset-backed financial services industry. See id. at 1232 n.166. 188 Ibid. at 1226–27. 189 A copy of FIPSA may be located on the ABA Website at www.abanet.org/intelprop in the legislation section of the site under the 106th Congress. Additional information concerning FIPSA can also be obtained at the Intellectual Property Law Section portion of the ABA Website. 190 See 1999–2000 Annual Report of ABA Intellectual Property Law Section, Special Committee on Security Interests, on ABA Website (hereinafter, “ABA Annual Report”); Babaian, supra note 186 at 1228. 191 ABA Annual Report, supra note 190. 192 Ibid. 193 Babaian, supra note 186 at 1233. 194 Ibid. at 1233–34 (Quoting the statement of Charles G. Johnson, President and Chief Executive Officer, Allstate Financial Corporation, on behalf of the CFA at the June 24, 1999, House subcommittee hearing.) 195 Ibid. at 1231–32. 196 Ibid. at 1232. 176
CHAPTER
10
PATENT OPINIONS David A. Loewenstein1 Brown Raysman Millstein Felder & Steiner LLP
INTRODUCTION
Intellectual property in general, and patents in particular, have become considerably more valuable assets in the past decade and have taken on an increased role in corporate finance and planning. Intellectual property, once the “backwater” of the law and corporate decision making, has now moved to the forefront. Recent Patent Office statistics show that the number of utility patent applications filed has increased from 152,750 in 1989 to 270,187 in 1999, with a corresponding increase in issued patents.2 Protecting one’s intellectual property and avoiding patent conflicts has, therefore, become a key issue. Recent decisions that award large damages and injunctions highlight the importance of seeking and obtaining a competent opinion before any potential liability accrues. No one is quite sure why patents have become more valuable. Some suggest the creation of the Federal Circuit in 1983 strengthened patents when it created uniformity in patent law. Others point to the increased prominence of technology in society, perhaps caused by decreased prices of computers, chips, and so on. Some recent increased patent activity undoubtedly has been caused by the State Street Bank3 decision, which settled an ongoing dispute (or confirmed a long-standing policy), holding that business methods are patentable. This, together with developments in the Internet, created an entirely new arena for patents. Scholars can debate the cause of this phenomenon, but statistics seem to support the observation that patents have become extremely valuable corporate assets. This chapter addresses opinions related to patents, although some of the observations may also be applicable to other forms of intellectual property. Opinions related to patents can serve several functions. In litigation, opinions of counsel may help avoid a finding of willful infringement, a finding that could result in an award of treble damages and attorneys’ fees. Most of the relevant case law addresses opinions of this sort. Patent owners can obtain opinions to evaluate the strengths of their patents before filing suit. Prospective investors can obtain opinions to estimate the value of patents or pending applications owned by another enterprise to determine whether there is a risk of infringement from the investment or to quantify the value of the intellectual property before consummating a venture. Another frequent use of opinions is a so-called clearance 10.1
10.2 PATENT OPINIONS
opinion. These types of opinions are obtained before a company begins to sell a new product or service, and generally involve a search of the prior art (e.g., existing patents) to determine if there is any danger of infringement. LEGAL FRAMEWORK
To better understand how opinions relate to substantive patent law, I provide the following brief primer on patent infringement and validity. Infringement. Under 35 U.S.C. § 271(a), whoever makes, uses, offers to sell, or sells
a patented invention in the United States or imports in the United States without authority from the patent owner infringes a patent. A person may also be liable for inducing infringement or as a contributory infringer under 35 U.S.C. § 271(b) and (c) if he provides a component for an infringing system. However, there can be no contributory or induced infringement unless there is direct infringement.4 Determining whether an accused product infringes is a two-step process. First, the Court must determine what the claims mean. The Supreme Court has held that interpretation of patent claims is to be decided by the District Court judge, not a jury.5 This procedure is thought to increase the uniformity and predictability of patent claims. Second, the properly interpreted claims must be compared to the accused product.6 After the claims are interpreted, the second step requires patentees to prove all elements in the asserted claims are in the accused device.7 Absence of a single element precludes a finding of infringement.8 Patentees bear the burden of proving infringement by a preponderance of the evidence.9 There are generally two types of claims, independent and dependent. A dependant claim cannot be infringed upon unless the independent claim from which it depends is also infringed upon.10 Therefore, an opinion that concludes no independent claim is infringed implicitly also recognizes that no dependent claim is infringed. Claim Construction. If a claim’s meaning is disputed, and it usually is, the judge must
consider intrinsic evidence of record (i.e., the claims, specification, and prosecution history) to determine what the claims mean.11 “Such intrinsic evidence is the most significant source of the legally operative meaning of disputed claim language.”12 Patent claims must be read in light of the specification.13 “For claim construction purposes, the description may act as a sort of dictionary, which explains the invention and may define terms used in the claims.”14 Also, “the descriptive part of the specification aids in ascertaining the scope and meaning of the claims inasmuch as the words of the claims must be based upon the description.”15 Thus, “the specification is always highly relevant to the claim construction analysis. Usually, it is dispositive; it is the single best guide to the meaning of a disputed term.”16 In its discretion, the Court may consider extrinsic evidence such as the testimony of experts and dictionary definitions “to aid the court in coming to a correct conclusion” to determine the meaning of the claim.17 However, extrinsic evidence generally should not be used to interpret claims.18 Claims are frequently expressed in means-plus-function language, authorized by 35 U.S.C., which provides:
LEGAL FRAMEWORK 10.3 An element in a claim for a combination may be expressed as a means or step for performing a specified function without the recital of structure, material, or acts in support thereof, and such claim shall be construed to cover the corresponding structure, material, or acts described in the specification and equivalents thereof.19
In Pennwalt Corp. v. Durand-Wayland, Inc., the Federal Circuit held that, to determine whether a means-plus-function claim limitation is literally met, one “must compare the accused structure with the disclosed structure, and must find equivalent structure as well as identity of claimed function for that structure.”20 [Emphasis in original.] If the accused device fails to perform a single claimed function or its equivalent, there can be no infringement either literally or under the doctrine of equivalents. In Pennwalt, the Federal Circuit held: [S]ection 112, ¶ 6, rules out the possibility that any and every means which performs the function specified in the claim literally satisfies that limitation. While encompassing equivalents of those disclosed in the specification, the provision, nevertheless, acts as a restriction on the literal satisfaction of a claim limitation. [Emphasis in original]21
The restrictive nature of means-plus-function claim language was emphasized again by the Federal Circuit in Johnston v. IVAC Corp.: Section 112, ¶ 6 provides direction with respect to how the part of a claim framed in meansplus-function language must be interpreted within an infringement analysis . . . [It] does not . . . expand the scope of the claim . . . . [It] operates to cut back on the type of means which could literally satisfy the claim language . . . [It] has no effect on the function specified—it does not extend the element to equivalent functions . . . [Emphasis in original.]22
Literal Infringement. In Lantech,23 the Federal Circuit stated the well-recognized legal
principle underlying any infringement claim: “All limitations in a claim must be considered meaningful . . . . [E]ach limitation of the claim must be met by the accused device exactly, any deviation from the claim precluding a finding of infringement.”24 (“It is also well settled that each element of a claim is material and essential, and that in order for a court to find infringement, the plaintiff must show the presence of every element or its substantial equivalent in the accused device.”)25 Thus, many opinions seek a claim element that is missing from the product or service at issue and readily conclude there is no danger of infringement. The Doctrine of Equivalents. If a claim is not literally infringed (i.e., there is not an identical, one-to-one correspondence between the claim and the accused device) the device may nevertheless infringe under the doctrine of equivalents. Infringement under the doctrine of equivalents is a question of fact.26 Equivalence is to be applied as an objective inquiry on an element-by-element basis, not to the invention as a whole.27 Infringement under the doctrine of equivalents may be assessed by determining the substantiality of the differences between the claimed invention and the accused device as viewed by one of ordinary skill in the relevant art.28 Substantiality of the differences may be measured by the function-way-result test, under which infringement exists if
10.4 PATENT OPINIONS
the accused product performs substantially the same function, in substantially the same way, to produce substantially the same result as claimed.29 Other factors, such as evidence of copying or “designing around” the claims, while not required, may play a role in an equivalence analysis.30 The range of equivalents may vary, depending on the nature of the invention. When the patent concerns a pioneer invention, it is given a broader range of equivalents. On the other hand, if the invention is in a crowded field, the patent is only entitled to a narrow scope of equivalents.31 The definition of a “pioneer” invention is, of course, debatable, and there is no precise definition. In Wallace London v. Carson Pirie Scott & Co., the Federal Circuit emphasized: Application of the doctrine of equivalents is the exception, however, not the rule, for if the public comes to believe (or fear) that the language of patent claims can never be relied on, and that the doctrine of equivalents is simply the second prong of every infringement charge, regularly available to extend protection beyond the scope of the claims, then claims will cease to serve their intended purpose. Competitors will never know whether their actions infringe a granted patent.32
Even if the doctrine of equivalents is used to prove infringement, the accused device must have each claim element.33 Contributory and Induced Infringement. A person can induce or contribute to infringement if he supplies a component of a system that, when completed, infringes a patent.34 The person must know of the patent and must specifically intend to cause another to infringe.35 However, there can be no contributory infringement or inducement unless there is direct infringement.36 Additionally, there is no contributory infringement if the assembled system is capable of noninfringing uses.37 Validity. Issued patents can be, and frequently are, invalidated during litigation. A
patent is invalid if it was anticipated by an earlier discovery of the same invention.38 Anticipation requires an exact one-to-one match between the patent claim and the prior art. A claim is anticipated, and therefore invalid, if the claimed invention is “known or used by others in this country or . . . described in a printed publication” that discloses every limitation of the claimed invention.39 Anticipation is a question of fact.40 If there is not a one-to-one correspondence between a patent claim and the prior art, a patent can nevertheless be invalid for obviousness if the difference between the prior art and the claimed invention would have been obvious to a person of ordinary skill in the art when the invention was made.41 A patent is invalid for obviousness if: the differences between the subject matter sought to be patented and the prior art are such that the subject matter as a whole would have been obvious at the time the invention was made to a person having ordinary skill in the art to which said subject matter pertains.42
The ultimate question of obviousness is a question of law.43 Despite this fact, factual inquiries underlie the conclusion the Court must consider: • The scope and content of the prior art • The differences between the claimed invention and the prior art
GENERAL CONSIDERATIONS CONCERNING OPINIONS 10.5
• The level of skill in the art • The secondary considerations such as commercial success, failure of others to discover the patented invention, and long-felt need.44 These factual inquiries are made using the patent’s filing date as the reference point, building into the inquiry the required assumption that the hypothetical person of ordinary skill in the art is aware of all relevant prior art.45 GENERAL CONSIDERATIONS CONCERNING OPINIONS
When an accused infringer learns about a patent, it has “an affirmative duty to exercise due care to avoid infringement.”46 To satisfy its obligation of due care, an accused infringer can, but is not required to, obtain an opinion of counsel about the validity or infringement of the patents at issue.47 However, obtaining an opinion is not a guarantee that willful infringement will not be found at trial, nor is it a guarantee that treble damages will not be awarded. A willful infringement finding can, but does not necessarily, lead to increased damages under 35 U.S.C. § 284 and attorney fees.48 Damages can be increased up to three times at the Court’s discretion.49 These cases require a party to act reasonably once it knows about a patent and to obtain an opinion before it begins the allegedly infringing activity.50 It is, of course, possible to obtain an exculpatory opinion after the infringement begins or after the decision to enter the market is made—but there is a natural skepticism about post hoc opinions.51 Liability for willful infringement turns on considerations of intent, state of mind, and culpability,52 inherently factual questions,53 the outcome of which is always difficult to predict. A timely, competent opinion is likely to prevent treble damages, but a conclusory late opinion is, at best, irrelevant. These basic rules underlie issues related to the efficiency of opinions in patent litigation and should be instructive to persons considering investing in a company that has either been given notice of alleged infringement,54 is considering practicing its own patented inventions, or is simply concerned about potential infringement charges. Patents Give the Right to Exclude. There is a common misperception that patents give a person a right to practice a given invention. This is wrong and may lead a company to put too much faith in an opinion and in the ownership of patents. Patents give a right to exclude, only. That means a patent owner has the right to prevent another person from practicing a patented invention, but the patentee may be precluded from practicing an invention that he has patented. This counterintuitive result can be better understood with an example. Suppose A has a patent on cars, and B has a later patent on an improvement—cars with radios. B would not be able to sell cars with radios because A had a preexisting patent on cars. B’s patent could be perfectly valid, and someone might infringe it, entitling B to damages and an injunction, but B itself might be blocked from selling a product that it invented. An opinion in this example that B’s patent was valid might be correct and might have some value vis-à-vis a third party, but that would only be part of the story. B would be enjoined by A from selling its product. The value of B’s patent might be nil.
10.6 PATENT OPINIONS
How to avoid that problem? A typical way to learn about preexisting patents is to do a prior art search. Any competent clearance opinion must have a search done. There are several ways to do a search. The easiest is on the Internet. The U.S. Patent and Trademark Office (PTO) website (USPTO.Gov) has a search engine that allows prior art searches to be conducted. There are other services available. IBM has a website that has patent searching capabilities. Lexis also has a searchable patent database. There are also private searching firms that will conduct a search for a fee. Searches, however, are imperfect and could miss a critical patent. The thoroughness and accuracy of a search could depend on the search terms used. Therefore, it is advisable to do several different types of searches. One search could be a subject matter search with several different keywords, and another could be an assignee search, looking for companies active in the field. If a potential investor, for example, knows the identity of competitors, it is advisable to search for patents owned by the competitor, regardless of the subject matter of the patents. This will help ensure that patents with unconventional titles or nomenclature will not be overlooked. One limitation to an opinion is that it may be only as good as the search. A search that fails to uncover a critical patent may yield an opinion with an incorrect conclusion. If the opinion’s conclusion is critical, independently conducted searches might be advisable. Searches also suffer from an unsolvable problem. There is at least an 18month period during which patent applications are confidential in the PTO, and a search will not discover these pending applications (discussed in more detail in a later section). A preliminary step to reduce the cost of opinions is to determine if a patent’s maintenance fees have been paid. Maintenance fees are required 4, 8, and 12 years after a patent is issued to keep it in force.55 If, for example, a search locates a potentially problematic patent, a relatively simple solution might be found by first determining whether maintenance fees have been paid and the patent is still in force. At this point, the PTO Website does not identify patents that have expired due to failure to pay maintenance fees. There is, however, a PTO automated telephone line that identifies expired patents. Applicable Legal Principles. The threshold question jurors and courts must resolve when an opinion is used to rebut willfulness charges is whether it is competent.
An opinion is competent if it is thorough enough, as combined with other factors, to instill a belief in the infringer that a court might reasonably hold the patent is invalid, not infringed, or unenforceable.56
What makes an opinion “thorough” is difficult to define in absolute terms. Some guideposts are as follows: the analysis must be predicated on review of the accused device; the patent offers proof; the prosecution history and any prior art references under the relevant legal principles; and unsupported conclusory statements should be avoided.57 In this way, if the opinion is incorrect (and it would not be relevant in litigation unless it were incorrect) and infringement is proven, the infringer may still be insulated from a charge of willful infringement if the opinion is deemed competent and was in fact relied upon by the infringer.58 Issues frequently analyzed and addressed in infringement opinions are discussed in the following sections.
GENERAL CONSIDERATIONS CONCERNING OPINIONS 10.7 Identify the Foundation and Scope of the Opinion. Opinions should state any limitations and assumptions upon which they are based, and relevant facts should be identified. For example, the claims at issue—prosecution history, any relevant prior art, affidavits, reports, drawings, and the like—that convey relevant factual information should be identified. Sources of information, including persons interviewed, should be identified to avoid any improper inferences. It is obviously important to address all the patent claims. Omitting claims can lead to finding that the opinion was not competently drafted.59 Identify the Device or Process at Issue. The accused device or process should be identified precisely, if necessary, using drawings and other information. The author, however, should be cautious not to rely exclusively on information provided by the client and should, if necessary, verify factual statements independently. This is particularly true if information provided is suspect or if the opinion author questions its reliability.60 The author should request additional information regarding changes made to the product, and new opinions should be written that take into account any design changes.61 A competent opinion of counsel that the patent in suit would be held invalid, unenforceable, or not infringed can provide a defense to a willful infringement charge.62 Accordingly, opinions, especially those that suggest design changes, will help, although not ensure, that a product will not infringe any valid and enforceable patent, and may protect against the possibility of treble damages in litigation.63 Successful design changes may prevent an award of damages and an injunction that would shut down an entire manufacturing operation. Identify the Possibility of Pending Patent Applications. Typically, opinions are rendered on issued patents. The recipient should be told about the possibility of pending U.S. patent applications that might later issue and present potential infringement problems. Patent applications are confidential in the PTO. Recent statutory changes, however, provide that applications filed after November 29, 2000, will be published within 18 months of their earliest priority dates.64 There are some exceptions to this rule, but for the most part, one can expect recent patent applications to be published within 18 months of their earliest filing dates (which could be a foreign filing date). The obverse is that new patent applications (ignoring the exceptions) can only expect 18 months of secrecy. Before this rule change, opinions, in general, were inherently imprecise because the party could not be sure if the opinion had overlooked a pending application. Patent applications filed before November 29, 2000, remain confidential indefinitely within the PTO until the patent issues. Even with the rule change, a clearance opinion has an 18-month blind spot, which means a party could obtain an opinion that its activity did not infringe any patent, invest considerable resources in a product, and learn that its sales were blocked by a recently issued patent. There is no absolute way to avoid this problem. Opinion recipients should understand that there is a gap in the author’s knowledge that could change the opinion’s conclusion. Identify the Intended Recipient. In an effort to limit the author’s liability to third parties,
the opinion should identify the recipient for whom the opinion has been prepared and
10.8 PATENT OPINIONS
should state that the opinion is being provided for the recipient. These boilerplate clauses are useful but may not prevent the author from incurring third-party liability, particularly if the author knows that persons other than the recipient have obtained copies of the opinion.65 If the author knows the opinion will be shared with third parties, or acquiesces when he becomes aware that third parties have obtained information in the opinion, he exposes himself to the possibility of third-party liability.66 (See the discussion on Cellpro). The author and recipient should take precautions to maintain the attorney-client privilege and work-product immunity. The opinion should identify the intended recipient of the opinion and instruct the recipient that disclosure and distribution of the opinion should be carefully monitored. Assessing an Opinion’s Competence. As previously mentioned, a critical inquiry about
opinions is their competence. In preparing an opinion, keep in mind the following seven factors: 1.
2.
3.
4.
5.
The timing of an opinion is a significant factor in assessing the opinion’s competence. An opinion should be prepared prior to commencing any potential infringing activity, preferably before significant funds have been invested into the development of the product and prior to obtaining substantial venture financing.67 The underlying reason is to avoid the inference that the opinion was for ulterior reasons (e.g., to obtain venture capital financing and provide protection from enhanced damages),68 rather than to determine if a proposed product infringed a patent. This means the opinion must be relied on, and not be pro forma window dressing. Ordinarily, the opinion should be received and analyzed before a go ahead decision is finalized. An independent patent attorney should be selected to draft the opinion. Cases suggest the opinion is considered more objective if drafted by outside counsel.69 Competent opinions drafted by in-house lawyers, however, are preferable to conclusory opinions drafted by outside lawyers. Cellpro intimates that an opinion drafted by a former partner of in-house counsel will be viewed less favorably. To the extent an opinion about the validity of one’s own patent is at issue, it might be preferable to obtain an opinion from a lawyer who did not draft the patent. Written opinions fare better in litigation than do oral opinions.70 A written record is simply a more reliable record of what the infringer was told, and when. The opinion should contain a well-researched, legal, and factual underpinning, including current legal principles—particularly burdens of proof related to invalidity and unenforceability71—and sufficient factual foundation, including review of the file history and prior art, to support the legal conclusions. For infringement opinions, the opinion should individually address each claim of the patent at issue and should also consider the doctrine of equivalents. The author should, where possible, verify facts supplied by the client and, if feasible, conduct his or her own factual research.72
CLEARANCE OR RIGHT TO USE OPINIONS
6. 7.
10.9
The opinion should avoid unsupported conclusory statements.73 A new opinion should be drafted when there has been a relevant change in the accused product or method.74
The Cellpro case demonstrates the importance of obtaining a competent, independent opinion before the decision to sell the product at issue is reached.75 In Cellpro, the defendant had already made the decision to sell the product and had reserved funds as a contingency in the event of litigation. The firm that wrote the rather short opinion had been affiliated with Cellpro’s in-house counsel. The opinion did not address infringement allegations of all the claims or consider the burdens of proof associated with various defenses. Additionally, Cellpro’s defenses at trial differed significantly from the defenses set out in the opinion letter. Cellpro was aware of John Hopkins’ patent from its inception. It obtained an opinion on Johns Hopkins’ patents that stated they were invalid and unenforceable. It then entered the market. A short time later, as expected, Cellpro was sued. The jury determined that infringement was willful, and the court awarded treble damages and attorneys’ fees. The District Court also issued an injunction (an eventuality the opinion apparently did not consider). The Federal Circuit affirmed and explained that the opinion was nothing more than an attempt to whitewash the company’s decision to enter the market. After losing the suit, Cellpro declared bankruptcy and terminated its activities (which created spinoff shareholder derivative litigation). The lack of a timely, credible opinion was critical to the company’s demise. Another illustration of the importance of opinions is the Polaroid76 case. In Polaroid, Kodak was aware of the thicket of patents Polaroid owned on instant photography, but nevertheless, wanted to enter the market. Together with its patent attorneys, who had analyzed over 250 patents, Kodak embarked on a research and development program to design around the patents and develop arguments that Polaroid’s patents were invalid, not infringed, or both. Kodak obtained lengthy opinions of counsel, which ultimately turned out to be wrong, on the few patents that were eventually litigated. Kodak spent hundreds of millions of dollars on research and development on its product line and was later enjoined from selling its products. Polaroid was awarded just under one billion dollars in damages. The entire experience cost Kodak well over one billion dollars. The opinions, however, prevented Kodak from being found to be a willful infringer, and the Court did not award enhanced damages. On one hand, this case illustrates a textbook example of proper, competent opinions that, to some extent, accomplished their aims—there were no enhanced damages awarded—but on the other hand, the case shows that even the best opinion can be wrong and demonstrates the often drastic consequence of an incorrect opinion. CLEARANCE OR RIGHT TO USE OPINIONS
In an effort to quantify a company’s value, financial professionals often seek counsel’s opinion on issued patents or pending applications. For an acquiring or investing company, the opinion serves several functions. It can provide guidance on the validity and
10.10 PATENT OPINIONS
potential infringement of an adversely held patent and may provide some information about the company’s competitive posture. However, there are a number of pitfalls, some of which can be avoided, but others that cannot. Reasons Not to Get Opinions Opinions Used Against the Recipient. Consider a situation where A is considering a joint venture with B. Suppose A wants an opinion on B’s patents and pending applications. A hires a firm that concludes the patents are valid and that the pending applications would yield valid patents. The opinion could also conclude that B’s patents covered A’s products. Armed with these opinions, A decides to invest in B. The joint venture (or investment) proceeds amicably for several years; in the meantime, B’s patent applications mature into issued patents. Then the deal terminates for one reason or another, or B goes bankrupt. B’s patents are then asserted against A either by B or a third party that purchased them at a bankruptcy auction. A now has opinions in its files that say the patents are valid (and are infringed). Whether these opinions might be discoverable in litigation is difficult to predict with certainty. Nevertheless, the risk is worth considering before commissioning opinions. It is also difficult to predict the likelihood of this scenario, but joint ventures and investments typically do not last indefinitely. An opinion requestor could find itself on the wrong end of an opinion. Ways to avoid this problem include provisions in the joint venture or purchase agreement that prevent suits on the patents or that prevent the patentee (and transferees) from seeking an injunction if suit is brought. Another suggestion is a provision that limits damages to a fixed amount or reasonable royalty. These provisions will obviously be easier to obtain during a presumably amicable business negotiation than in a litigation context. Is Ignorance Bliss? As previously discussed, once a party learns about a patent, it is obligated to act with due care. The converse is that if a party does not know about a patent, it cannot be held to be a willful infringer and would avoid the consequence of that finding. The danger of seeking a comprehensive opinion with a diligent prior art search is that it may turn up patents that a party had previously not known about, and the expense can spiral out of control. For example, consider a situation in which a party conducts a prior art search for half a dozen patents owned by various competitors, and each search locates a dozen patents. There are now 72 patents at issue. The question for these new 72 patents, then, is: should searches be conducted (with the possibility of finding hundreds of patents) and opinions written on all of these patents? This example shows that opinion costs can increase geometrically with no easily definable end point. Although ignoring these patents obviously entails some risks, at some point, a costbenefit analysis will have to be conducted, and the risk of suit on each patent will have to be evaluated. Otherwise, the clearance exercise can become an enormous and unpredictable expense. The related, but unanswerable, question is: Was the party better off before it knew about all these additional patents? As previously discussed, a party cannot be a willful infringer if it does not know about a patent. However, a company can be enjoined and forced to pay damages even if it did not know about a patent until it was sued. This paradox creates another dilemma that has no easy answer for companies.
CLEARANCE OR RIGHT TO USE OPINIONS
10.11
Many of these decisions are business decisions that depend on the amount of the investment, potential profitability of the ventures, flexibility of the design, ability to design around patents, and importance of the venture to the enterprise (i.e., the potential harm of an injunction). A related issue, particularly for in-house patent attorneys, to consider is whether patent solicitors should also write opinions. If a large number of patents that are relevant to a pending application are located during a prior art search, the applicant may have an obligation to disclose them to the PTO. Because patent applicants are required to disclose all noncumulative, material prior art, the safest course is to disclose all relevant references. But if the applicant knows about a large number of references and is required to make some judgment calls about which are relevant and which are not, he or she might be criticized for not disclosing them all. On the other hand, if an applicant submits a large number of references to the PTO, he or she might be criticized for that too, because he or she might be accused of burying more relevant references in the large submission to the PTO. In an effort to avoid these potential difficulties, it may be advisable to segregate these responsibilities. Opinions on Applications. Sometimes clients seek opinions on pending U.S. patent applications or on pending foreign counterparts to a U.S. application. These opinions can be important to investment decisions because an investor may want to know the value of the inchoate patent right. However, there are a number of important principles to keep in mind. First, a patent application, as distinguished from an issued patent, gives the owner no right to exclude. To the extent an application’s value is fixed at the moment in time before it is issued, the value is zero. The value is an expectant value of an issued patent, which could range from zero to some large value. The additional problem with rendering an opinion on a pending application is that there is no assurance that any patent will issue. Typically, the PTO will reject a patent application. The applicant may have to amend the claims to overcome the PTO’s rejection. This process can go on for several years before a patent issues. Alternatively, the patent may never issue. Ultimately, if a patent is issued, it may have very different claims (which measure the right to exclude) than the pending application. Also, because patents only give a right to exclude, it is often difficult to predict if any competitor will have a product on the market that would be covered by the issued claims (whatever they turn out to be). If there is no competitive product on the market, or one waiting in the wings covered by the claims, the value of the patent may be nil because there will be no one willing to pay a licensing royalty, and there will be no one to sue to collect damages. Patentability Opinions. Clients occasionally ask for patentability opinions. These types
of opinions have problems similar to those regarding pending applications. Here, too, the author is being asked to predict (to guess, to some extent) what the PTO will do. A patentablity opinion essentially asks the author to opine on whether a given discovery would be patentable. One view of these opinions is they are a waste of money. In all likelihood, it will be cheaper to file an application and let the PTO determine if the subject matter is patentable. However, if time is important (and money is not), a party will get a much faster view of patentability from an opinion than it will get waiting for the PTO.
10.12 PATENT OPINIONS Opinions on Technical Merit. Sometimes a client will ask for an opinion about the value of a potential acquisition or venture partner. For example, they have been told that the company is a leader in field X and has patents or pending applications on that technology. This type of opinion shares many common issues with opinions previously discussed. Additionally, the patent applicant may have moved away from the technology set out in the patent or pending application. The company’s value may be in its current technology, and its patents may not cover it. This scenario is quite likely in fast-moving technologies in which a company filed patent applications on its then-current state-of-the-art technology, but improved on it and abandoned what turned out to be an inferior solution. The pending applications may not be worthless, however, because a competitor may still practice the old technology. Thus, the patents may have value even though the patent owner does not use the patented invention.
DISQUALIFICATION AND WAIVER
Another factor to consider is the potential for disqualification of the opinion’s author if the underlying patents are later litigated. This issue can arise if a party has produced exculpatory opinions.77 There are cases that hold that an opinion’s author should not be trial counsel because of a potential violation of the lawyer-witness rule.78 Thus, there is a threshold determination to make: Who should write the opinion? Disqualification and scope of waiver can be some of the most contentious issues litigated in patent disputes and can be extremely disruptive and costly. Rule 3.7: The Lawyer-Witness Rule. Disqualification arguments are based on the socalled “lawyer-witness rule” that bars a lawyer (the opinion’s author, for example) from also being an advocate. Rule 3.7(a)(3), however, bars disqualification if it “would work substantial hardship on the client.” There is a natural skepticism when a party seeks to disqualify an adversary’s counsel. For example, in Freeman v. Chicago Musical Instrument Co.,79 the Seventh Circuit cautioned District Courts about the drastic, and often irremediable, consequences of disqualification:
[O]rders granting disqualification requests have immediate, severe, and often irreparable and unreviewable consequences upon both the individual who hired the disqualified attorney or law firm as well as upon the disqualified counsel. * * * [T]he losing party with the tainted counsel is immediately separated from the representation of his choice. The effect of this is immediate and measurable. The party who has had his counsel disqualified is abruptly deprived of his legal advisor, and, provided the affected party desires to proceed with his action, the litigation is disrupted while he secures new counsel. * * * Moreover, it may also be difficult, if not impossible, for a new attorney to master ‘the nuances of the legal and factual matters’ late in the litigation of a complex case. * * *
DISQUALIFICATION AND WAIVER 10.13 Proof of the often subtle ramifications of an order disqualifying counsel may be impossible at times to adequately present. * * * [S]uch motions should be viewed with extreme caution for they can be misused as techniques of harassment.80
Therefore, to disqualify counsel, a movant bears “a ‘heavy burden’ and must meet a ‘high standard of proof’ before a lawyer is disqualified.”81 In Bristol-Myers, the District Court refused to disqualify patent counsel, Baechtold, who had authored an opinion letter, six months before trial: [A]s this Court has pointed out, the issues are limited to whether the Baechtold opinion letter is a competent opinion and what Bristol’s [the client-recipient’s] state of mind was when it decided to rely on it. In other words, was there reasonable reliance by Bristol? Bristol’s management witnesses are the proper parties to be examined on that subject, not Mr. Baechtold.82 Are the Authors “Necessary Witnesses”? Disqualification under Rule 3.7(a) is only
appropriate if counsel is likely to become a necessary witness at trial. In a nonpatent context, one Court explained what a necessary witness is, and is not: A necessary witness is not the same thing as the ‘best’ witness. If the evidence that would be offered by having an opposing attorney testify can be elicited through other means, then the attorney is not a necessary witness.83
The Court in Bristol-Myers also held that an attorney/author was not a necessary witness because the client/recipient’s employees and expert witnesses could testify on the same subject.84 Therefore, if an attorney/author’s testimony is cumulative or irrelevant, that person is not a necessary witness.85 Additionally, the Federal Circuit and District Court cases just cited explain that the proper inquiry in evaluating an alleged infringer’s reliance on an opinion of counsel centers on the state of mind of the alleged infringer. Where the opinions themselves are sufficiently detailed to evidence good faith reliance on their face, the necessity of the author’s testimony is even more attenuated.86 Scope of the Waiver/Disqualification. Typically, the proponent of the waiver will urge a
broad waiver of the attorney-client privilege, and also possibly the work-product immunity, and ultimately disqualification. The opponent obviously will argue the opposite. There is a wide split of authority on the scope of the waiver. Some courts narrowly limit the waiver temporally, to limited subject matter to information that was communicated to the client, or to the attorney-client privilege, but not the work-product immunity. The Federal Circuit has held that focus of the willfulness determination is on the accused infringer’s state of mind. Thus, Ortho’s [the infringer’s] intent and reasonable beliefs are the primary focus of a willful infringement inquiry.87
10.14 PATENT OPINIONS
Some District Court cases have relied on this holding to limit the scope of the waiver.88 In Steelcase Inc. v. Haworth, Inc. the Court held the following: The Federal Circuit has made it clear that the infringer’s intent, not that of counsel, is the relevant issue.89
Some cases hold that the inquiry about the competence of the opinion is objective; therefore, the author’s subjective views are irrelevant. Following this line of authority, these and other cases resolve the scope of the waiver dilemma by limiting the waiver to information that was communicated to the client preserving the work-product immunity and protecting trial strategies. For example, in Bristol-Myers,90 the Court explained the narrow issue the jury must decide—without considering the author’s subjective intent or any uncommunicated work-product information: The issues for the jury are whether that opinion was a competent legal opinion and whether Bristol reasonably relied on it. As stated in Westvaco Corp. v. Int’l Paper Co.; (991 F.2d 735, 743-744 (Fed. Cir. 1993)). ‘This court stated that objective evidence must be considered to determine whether a defendant was justified in relying on patent counsel’s advice, i.e., whether patent counsel’s opinion was competent. Opinion letters should be reviewed to determine whether they evidence an adequate foundation based on a review of all necessary facts or whether they are conclusory on their face. “Counsel’s opinion must be thorough enough, as combined with other factors, to instill a belief in the infringer that a court might reasonably hold the patent is invalid, not infringed, or unenforceable.’91
The court in Steelcase reached the same conclusion—only the client/recipient’s state of mind is relevant: Counsel’s mental impressions, conclusions, opinions, or legal theories are not probative of that [the infringer’s] state of mind unless they have been communicated to that client92
In Thorn, supra, the court held the following: To the extent, [the law firm] has information or documents on the subject [validity or infringement under the doctrine of equivalents] that were not communicated to Micron [the client], nor received from it, that information is probably not probative of Micron’s intent, is probably not relevant to the matters in issue, and is not discoverable.93
According to Thermos Co. v. Starbucks Corp.,94 “Any documents defense counsel relied upon but did not communicate to Defendants are not probative of Defendants’ state of mind.” This line of authority is consistent with some non-patent cases. In Harter v. University of Indianapolis, the Court reached the same conclusion and denied a motion to disqualify counsel: The better-reasoned cases hold, however, that when a client files a lawsuit in which his or her state of mind (such as good faith or intent) may be relevant, the client does not implic-
DISQUALIFICATION AND WAIVER 10.15 itly waive the attorney-client privilege as to all relevant communications unless the client relies specifically on advice of counsel to support a claim or defense. * * * There is no apparent reason why testimony from Keller [the attorney] about her subjective motives, purposes, or thoughts would be essential in this inquiry. There is a long paper trail in this case. Keller said what she said and wrote what she wrote. Her testimony is not necessary to prove that those communications occurred. Questions about why she wrote what she wrote are at best only marginally relevant except to the extent that she communicated her reasons to the university.95
It is also important to recognize that attorneys’ opinions are irrelevant to any issue until the privilege is waived and only become relevant to the narrow issue of alleged willful infringement. Typically, counsel’s advice to a client on whether or not the client may be infringing a valid patent is not relevant to the claims in an action for patent infringement. Evidence of that advice would not tend to make the existence of any fact of consequence to the determination of the action more or less probable and would not, therefore, fall within the definition of relevant evidence under Federal Rule of Evidence 401.96
There are several cases that hold that intent cannot be influenced by information that was never communicated to the recipient.97 Indeed, the “legal correctness” of the opinion is irrelevant because the opinion only becomes relevant if it was wrong, (i.e., the defendant infringed).98 Ortho, supra, 959 F.2d at 944. Therefore, the recipient’s intent does not turn on the veracity of these opinions. In Steelcase, the Court held: Steelcase [the patentee] is not entitled to ‘audit’ attorney Theil’s opinion to determine whether it was actually correct.99
One case, Rohm and Haas Co. v. Lonza, Inc., reached the opposite conclusion.100 In that case, the defendant intended to rely on counsel’s opinion, and counsel was disqualified. This case is relatively thinly reasoned. There are several cases—FMT,101 Handgards,102 and Mushroom Associates103—that hold that once a party has waived this privilege, the waiver is broad. However, these cases have all been criticized. In Steelcase, the Court, held: I find this line of authority [Mushroom Associates, FMT and Handgards] unpersuasive. Remarkably, these cases do not attempt to divine from Federal Circuit authority any controlling principle grounded in substantive patent law. In fact, these cases do not cite Federal Circuit authority at all, but rely upon district court opinions in patent cases or in general civil litigation. Furthermore, as Judge Rowland pointed out, the Mushroom Associates case is based on faulty analysis under which the attorney’s state of mind, and not that of the client, becomes paramount.104
Finally, many Rules of Professional Conduct limit disqualification, and will not require disqualification of the entire firm, if an attorney at the firm wrote the opinion (see, e.g., Model Rule 3.7(b)).
10.16 PATENT OPINIONS ENDNOTES 1
Partner, Brown Raysman Millstein Felder and Steiner LLP. This chapter represents the author’s thinking and does not represent the view of his firm or of any client. 2 USPTO. Gov. 3 State Street Bank & Trust Co. v. Signature Financial Group Inc., 149 F.3d 1368 (Fed. Cir. 1998). 4 Aro Manufacturing Co. Inc. v. Convertible Top Replacement Co. Inc., 377 U.S. 476, 483 (1964); Universal Electronics Inc. v. Zenith Electronic Corp., 846 F. Supp. 641 (N.D.Ill. 1994), affirmed without published opinion, 41 F. 3d 1529 (Fed. Cir. 1994). 5 Markman v. Westview Instruments Inc., 517 U.S. 370, 390–91 (1996). 6 Southwall Technologies Inc. v. Cardinal IG Co., 54 F.3d. 1570, 1575 (Fed. Cir. 1995); Markman v. Westview Inc., 52 F.3d. 967 (Fed.Cir. 1995) affirmed, 116 S.Ct. 1384 (1996). 7 Lantech Inc. v. Keip Mach Co., 32 F.3d 542, 546–47 (Fed. Cir. 1994). 8 Laitram Corp. v. Rexnord Inc., 939 F.2d 1533, 1535 (Fed.Cir. 1991); see also American Permahedge, supra, 105 F.3d 1441. 9 Phillips Petroleum Co. v. United States Steel Corp., 673 F. Supp. 1278, 1344 (D.Del. 1987) affirmed 865 F. 2d 1247 (Fed. Cir. 1989). 10 Carroll Touch Inc. v. Electro Mechanical systems Inc., 15 F.3d 1573, 1576 (Fed. Cir. 1993). 11 Markman, supra, 116 S.Ct. at 1995–96. 12 Vitronics Corp. v. Conceptronic Inc., 90 F.3d 1576, 1582 (Fed. Cir. 1996). 13 Autogiro Co. of America v. United States, 384 F.2d 391, 397 (Ct.Cl. 1967). 14 Markman, 52 F.3d at 1970. 15 Standard Oil Co. v. American Cyanamid Co., 774 F.2d 448, 452 (Fed. Cir. 1985). 16 Vitronics, 90 F.3d at 1582. 17 Markman, 52 F.3d at 980. 18 Bell & Howell Doc. Mgmt Prods. Co. v. Altek Sys., 132 F.3d 701, 706 (Fed. Cir. 1997); Vitronics, supra, 90 F.3d 1576. 19 35 U.S.C. § 112 ¶ 6. 20 Pennwalt Corp. v. Durand-Wayland Inc., 833 F.2d 931, 934, 936 (Fed. Cir. 1987) (en banc), cert. Denied, 485 U.S. 1009 (1988). 21 Pennwalt, supra, 833 F.2d at 934. 22 Johnston v. IVAC Corp., 885 F.2d 1574, 1580 (Fed. Cir. 1989). 23 Lantech, supra, 32 F.3d at 546–47. 24 Unique Concepts Inc. v. Brown, 939 F.2d 1558, 1562 (Fed Cir. 1991); Lemelson v. United States, 752 F.2d 1538, 1551 (Fed. Cir. 1985). 25 Southwall, supra, 54 F.3d at 1575. See also, American Permahedge, Inc. v. Barcna, Inc., 105 F.3d 1441, 1443 (Fed. Cir. 1997). 26 Warner-Jenkinson Co. Inc. v. Linde Air Prods. Co., 520 U.S. 17, 1053 (1997); Graver Tank & Mfg. Co. Inc. v. Linde Air Prods. Co., 339 U.S. 605, 609–10 (1950). 27 Warner-Jenkinson, supra, 117 S.Ct. at 1054. 28 See, e.g., Valmont Indstries Inc. v. Reinke Mfg. Co., 983 F.2d 1039, 1043 (Fed. Cir. 1993). 29 Graver Tank, supra, 339 U.S. at 607–10. 30 Warner-Jenkinson, supra, 117 S.Ct. at 1054. 31 Slimfold Mfg. Co. v. Kinkead Indus. Inc., 932 F.2d 1453, 1457 (Fed. Cir. 1991). 32 Wallace London v. Carson Pirie Scott & Co., 946 F.2d 1534 (Fed. Cir. 1991).
ENDNOTES 10.17 33
K-2 Corp. v. Salomon S.A., 191 F.3d 1356, 1367 (Fed. Cir. 1999). 35 U.S.C. § 271. Joy Technologies Inc. v. Flakt, Inc., 6 F.3d 770, 774 (Fed. Cir. 1993). 35 Manville Sales Corp. v. Paramount Systems, Inc., 917 F.2d 544, 553 (Fed. Cir. 1990). 36 Joy Technologies, supra, 6 F.3d at 774. 37 C.R. Bard, Inc. v. Advanced Cardiovascular Sys. Inc., 911 F.2d 670, 674, 15 USPQ2d 1540 (Fed. Cir. 1990). 38 35 U.S.C. § 102. Title 35, section 102 states in pertinent part: “A person shall be entitled to a patent unless— (a) the invention was known or used by others in this country, or patented or described in printed publication in this or a foreign country, before the invention thereof by the applicant. * * * (e) the invention was described in a patent granted or an application of patent by another filed in the United States before teh invention thereof by the applicant.” 39 In re Schreiber, 128 F.3d 1473, 1477 (Fed. Cir. 1997); Hazani v. United States International Trade Commission, 126 F.3d 1473, 1477 (Fed. Cir. 1997). 40 Schreiber, supra, 128 F.3d at 1477. 41 Sakraida v. Ag Pro, Inc., 425 U.S. 273, 281–82 (1976). 42 35 U.S.C. § 103. 43 Richardson-Vicks Inc. v. Upjohn Co., 122 F.3d 1476, 1479 (Fed. Cir. 1997) citing Graham v. John Deere Co., 383 U.S. 1, 17 (1966). 44 Ryko Mfg. Co. v. Nu—Star, Inc., 950 5.2d 714,719 (Fed. Cir. 1991). 45 Union Carbide Corp. v. American Can Co., 724 F.2d 1567, 1576 and n. 6 (Fed. Cir. 1984). 46 John Hopkins University v. Cellpro, Inc., 152 F.3d 1342, 1364 (Fed. Cir. 1998); Read Corp. v. Portec, Inc., 970 F.2d 816, 826–829 (Fed. Cir. 1992) (modified on related ground); Ortho Pharmaceutical Corp. v. Smith, 959 F.2d 936, 944 (Fed. Cir. 1992); Underwater Devices, Inc. v. Morrisen-Knudsen Co., Inc., 717 F.2d 1380, 219 U.S.P.Q. 569 (Fed. Cir. 1983). 47 Rolls-Royce Ltd. v. GTE Valeron Corp., 800 F.2d 1101, 1109 (Fed. Cir. 1986). 48 See, e.g., Cellpro, supra, 452 F.3d 1342. 49 Rite-Hite Corp. v. Kelley Co., 819 F.2d 1120, 1126 (Fed. Cir. 1987); King Instrument Corp. v. Otari Corp., 767 F.2d 853, 866 (Fed. Cir. 1985); see also, State Industries, Inc. v. A.O. Smith Corp., 751 F.2d 1226, 1238 (Fed. Cir. 1985). District Courts have discretion under 35 U.S.C. § 284 to increase the awarded damages up to three times, SRL Int’l, Inc. v. Advanced Tech. Lab., Inc., 127 F.3d 1462, 1464, 44 U.S.P.Q. 2d 1422 (Fed. Cir. 1997), and under 35 U.S.C. § 285 to award attorneys’ fees to the prevailing party in exceptional cases. Strattec Sec. Corp. v. General Auto. Specialty Co., 126 F.3d 1411, 1419, 43 U.S.P.Q. 2d 1030 (Fed. Cir. 1997); S.C. Johnson & Son, Inc, v. Carter-Wallace, Inc., 781 F.2d 498, 200 (Fed. Cir. 1986) (upholding the trial court’s grant of attorney fees when willful infringement was proven). 50 Cellpro, supra; Underwater Devices, supra, 717 F.2d at 1390. 51 See, e.g., Cellpro, supra, 152 F.3d at 1342. 52 Cellpro, 152 F.3d 1342. 53 National Presto Indus., Inc. v. West Bend Co., 76 F.3d 1185, 1192–93 (Fed. Cir. 1996). 54 A patent owner is not entitled to collect damages unless it has provided constructive notice to the alleged infringer by marking its products with patent numbers, or by giving actual notice. Amstead Industries Inc. v. Buckeye Steel Castings Co., 24 F.3d 178 (Fed. Cir. 1994). 55 37 C.F.R.§ 1.362. 34
10.18 PATENT OPINIONS 56 Cellpro, supra, 152 F.3d at 364 (citing Ortho Pharm Corp. v. Smith, 959 F.2d 936, 944 (Fed. Cir. 1992)). 57 Ortho, supra, 959 F.2d 936; Underwater, 717 F.2d 1380. 58 Cellpro, supra, 152 F.3d at 1364. 59 Cellpro, 152 F.3d at 1364. 60 C.F. Kline v. First Western Government Securities, Inc., 24 F.3d 480 (3rd Cir. 1993); Ackerman v. Schwartz, 947 F.2d 841 (7th Cir. 1991). 61 Critikon, 120 F.3d at 1259 (rejecting defendant’s advice of counsel defense to a charge of willful infringement where the client withheld relevant information, regarding design changes, from the drafting attorney preparing the opinion used in the defense). 62 127 F.3d at 1464. 63 Critikon, Inc. v. Becton Dickinson Vascular Access, Inc., 120 F.3d 1253 (Fed. Cir. 1997), cert. denied, 118 S. Ct. 1510 (1998); Cellpro, supra, 152 F.3d 1342. 64 35 U.S.C. § 122(b). 65 Kline, supra, 24 F.3d 480; Ackerman, supra, 947 F.2d 841. 66 Kline, 24 F.2d 480; Ackerman, 947 F. 2d 841. 67 John Hopkins University v. Cellpro, Inc., 978 F. Supp. 184 (D.Del. 1997). 68 SRI, supra, 127 F.3d 1462 (infringers received the opinions after the infringing activity started); Cellpro, 152 F.3d 1342, 47 U.S.P.Q. 2d 1705; Critikon, 120 F.3d 1253; Cellpro, 978 F.Supp. at 188–189. 69 But see Minnesota Mining & Mfg. Co. v. Johnson & Johnson Orthopedics, Inc., 976 F.2d 1559, 1582 n.13, 24 U.S.P.Q. 2d 1321, 1340 n. 13 (Fed. Cir. 1992) (The Master found that this opinion, a case analysis prepared by outside counsel representing the infringer in this law suit, was “inherently suspect”). 70 Cellpro, supra, 152 F.3d 1342. 71 Cellpro, supra, 152 F.3d 1342. 72 Comark, supra, 156 F.3d at 1190 (upholding a jury’s finding of willful infringement where the defendant was found to have withheld information, e.g., design change, relevant to preparation of a competent and reliable opinion). This may be important in defending against third party actions against the author. Kline, supra, 24 F.3d 480; Ackerman, supra, 957 F.2d 841; Ultramares Corporation v. Touche, 255 N.Y. 170 (1931) (Cardozo, J.). 73 Comark, supra, 156 F.3d 1182. 74 Critikon, supra, 120 F.3d at 1259. 75 Cellpro, supra, 978 F.Supp. 184. 76 Polaroid Corp. v. Eastman Kodak Co., 16 U.S.P.Q.2d 1481 (D. Mass. 1990). 77 This text does not address the issue of the inadvertent waiver. 78 See, e.g., ABA Model Rules of Professional Conduct, Rule 3.7. 79 Freeman v. Chicago Musical Instrument Co., 689 F.2d 715, 719–21 and 722 (7th Cir. 1982). 80 “Where one party argues that an opponent’s attorney is a necessary witness and moves to disqualify that attorney, however, courts view the opponent’s asserted need to call the attorney more skeptically and must be concerned about the possibility that the motion to disqualify is an abusive tactic to hurt the opponent’s ability to pursue his case.” Harter, supra, 5 F.Supp.2d at 663. 81 Bristol-Myers Squibb Co. v. Rhone-Poulenc Rorer, Inc., 55 U.S.P.Q.2d 1662, 1663 (S.D.N.Y. 2000). 82 Bristol-Myers, supra 55 U.S.P.Q.2d at 1666. 83 Harter, supra, 5 F.Supp.2d at 665. 84 Clintec Nutrition Co. v. Baxa Corp., 1998 WL 560284 *5 (N.D. III. August 26, 1998).
ENDNOTES 10.19 85 Bristol-Myers, 55 U.S.P.Q.2d at 1664; Clintec, supra, at *5; Harter, supra, 5 F.Supp.2d at 664; see also Gaull v. Wyeth Laboratories, Inc., 687 F.Supp. 77, 80 (S.D.N.Y. 1988). 86 Bristol-Myers, supra; Harter, supra, 5 F.Supp.2d at 665–666; see also, Clintec, supra; cf. Gusman v. Unisys Corp., 986 F.2d 1146, 1148 (7th Cir. 1993). 87 Steelcase Inc. v. Haworth, Inc., 954 F.Supp. 1195, 1198 (W.D. Mich. 1997) citing Ortho, supra, 959 F.2d at 944; Thorn EMI North America, Inc. v. Micron Technology, Inc., 837 F.Supp. 616, 622–23 (D.Del. 1993). 89 Steelcase, supra, 954 F.Supp. at 1198. 90 Bristol-Myers, 55 U.S.P.Q.2d at 1665–66. 91 Id. At 743 quoting Ortho, supra 959 F.2d at 944. 92 Steelcase, supra, 954 F.Supp. at 1199. 93 Thorn, supra, 837 F.Supp.621; at 622–23. 94 Thermos Co. v. Starbucks Corp., 1998 WL 781120 at *4 (N.D.III. November 3, 1998). 95 Harter v. University of Indianapolis, 5 F.Supp. 657, 664–66 (S.D. Ind. 1998). 96 Thorn, supra, 837 F.Supp. at 620–21. 97 Thermos, supra, at *4–5; Steelcase, supra, 954 F.Supp. at 1199; Thorn, supra, 837 F.Supp. at 621–22. 98 Ortho, supra, 959 F.2d at 944. 99 Steelcase, supra, 954 F.Supp. at 1200. 100 Rohm and Haas Co. v. Lonza, Inc., 1999 WL 71814 (E.D.Pa. September 7, 1999). 101 FMT Corp. Inc. v. Nissei ASB Co., 24 U.S.P.Q.2d 1073 (N.D. Ga. 1992). 102 Handgards Inc. v. Johnson & Johnson, 413 F.Supp. 926 (N.D. Cal. 1976). 103 Mushroom Associates v. Monterey Mushrooms, Inc., 24 U.S.P.Q.2d 1767 (N.D. Cal. 1992). 104 Handgards Inc. v. Johnson & Johnson, 413 F.Supp. 926 (N.D.Cal. 1976), an antitrust case, decided six years before the Federal Circuit was created, is not on point. In that case, defendant intended to call lawyers as witnesses to rebut testimony that it had conspired to restrain trade, allegedly by asserting patent infringement suits in bad faith. Because lawyers’ state of mind was a central issue in Handgards, the Court found a broad waiver. The Court reasoned that the plaintiff could “demonstrate the bad faith of the defendants only through the discovery of information in the hands of the defendants and their attorneys.” (At 931). Accordingly, the Court held the attorney’s work product was “directly at issue and the need for production is compelling.” (At 933). However, as previously explained, the lawyers’ states of mind are not relevant here, and Thomson has no intention of calling the opinion’s authors as witnesses.
CHAPTER
11
INTERNATIONAL MERGERS AND ACQUISITIONS: THE CANADIAN PERSPECTIVE1 Francois Painchaud, Louis-Pierre Gravelle, Panagiota Koutsogiannis, Christian Danis, and Marie-Eve Cote Leger Robic Richard
INTRODUCTION
Economic prosperity in Canada, just as in other industrialized nations, has come to rely more and more on nontraditional manufacturing sectors based primarily on information and biotechnology. In this environment, intellectual property continues to take on an ever-increasing role in the valuation of a corporate enterprise. In Canada, the existence of a right in intellectual property is generally a creature of statute. Such statutes include the Patent Act,2 Copyright Act,3 Trade-marks Act,4 and Industrial Design Act,5 and more esoteric forms such as the Integrated Circuit Topography Act,6 and Plant Breeders’ Rights Act7. There are also a number of nonstatutory intellectual property rights, including rights with respect to trade secrets, know-how, and confidential information. These are subject to provincial laws, which vary from one province to the other; this may have an impact on the manner in which the intellectual property in question may be dealt with. As many high-tech startup companies consist of virtually no fixed assets, but primarily of a small number of technological assets and a handful of key people,8 a diligent and accurate evaluation of an enterprise’s intellectual property is an invaluable tool when seeking to reduce risk in the course of a corporate merger or acquisition. Furthermore, when the real worth of a company is thought to reside in an important intellectual property asset, the prospective investor may often be so overwhelmed by this asset and its potential market that general business caution is suppressed. DUALITY OF THE CANADIAN LEGAL REGIME
Canada has inherited from two distinct legal systems within the private law sphere: the English Common Law from the United Kingdom and the French Civil Law from France. The Civil Law governs private relations in Quebec, and the Common Law 11.1
11.2 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
applies to private relations in the other nine provinces. The two systems have been firmly entrenched in the provinces they respectively cover and have managed to coexist while evolving parallel to one another. As a result, there are some variations between the two systems, notably in the classification and treatment of property rights, that may have an impact in the course of transactions involving intellectual property. Fortunately, since Canada is a confederation, most of the statutes related to intellectual property are to be found at the federal level, which applies to all provinces, irrespective of their legal system. Throughout this chapter, where relevant, a distinction will be made between the common law and civil law approaches for a given situation, in order to take into account this duality of the Canadian legal regime. OVERVIEW OF THE TRANSACTION: OBJECTIVE, SCOPE, AND COSTS
The potential parties to a merger or an acquisition are interested in ensuring themselves of seven very basic facts: 1. 2. 3. 4. 5. 6.
7.
Defining the relationship between the target company and the subject technology to make sure that it is the sole owner or licensee of such technology Ensuring that protection has been properly secured Ensuring that all of the delays inherent in the various national and regional juridictions have been respected Ensuring that inventions have not been disclosed publicly to the extent that patent protection is lost Evaluating the extent to which other parties may already have had access to the target’s technology Evaluating the extent to which secrecy has been maintained on nonpatentable or nonpatented technology and the potential risks of maintaining the secrecy of such information Evaluating the possibility that future use of the technology of the target company may violate the prior existing rights of third parties
One of the goals of a due diligence investigation is to ensure that a business has been managed in an orderly fashion. There are three issues at the center of any due diligence concerning intellectual property:9 1. 2. 3.
Establishing a chain of title or rights with regard to the property Identifying any potential infringement Ensuring that there are no outstanding claims against the intellectual property, including demands, judgments, security interests, contractual restrictions, or current or pending litigation
When intellectual property is not the main asset, but only one type of asset among others in a transaction, there is a risk of underestimating both its value and, consequently, the time and money that should be devoted to proper due diligence in that area. Since the legal fees are often dependent on the value of the transaction, there is no practical means to estimate how many resources should be allocated to the intellectual property part of the due diligence. In many cases, if 10 percent of the legal fees are devoted
OVERVIEW OF THE TRANSACTION: OBJECTIVE, SCOPE, AND COSTS 11.3
to it, it would be considered appropriate, but this greatly depends on the particular circumstances of the transaction. Obviously, disbursements related to searches at the national and international levels may represent a relatively large portion of those costs, since intellectual property rights often rely heavily on registration. It is important to remember that ownership of the technology is one of the most important issues in a due diligence audit concerning intellectual property.10 When there is only one owner of a patent, for example, one can more easily determine the rights of such owner and trace the rights granted by such owner to third parties. However, when intellectual properties are held jointly by several persons, these issues become more difficult. Mergers, Competition Law, and Intellectual Property. IP and competition laws comple-
ment each other in promoting an efficient economy. IP laws provide incentives for innovation and technological diffusion by establishing enforceable property rights while competition laws may be invoked when these rights are used in anticompetitive practices that create, enhance, or maintain market power or otherwise harm competition. In Canada, the competition aspects of any merger are governed by the Competition Act,11 which is administered by the Competition Bureau of Canada12 (hereinafter: the Bureau). Private cases are limited to section 36 of the Competition Act, which provides for civil damages if a person suffered damages as a result of a breach of Part VI (offences in relation to competition) or for violation of an order of the Competition Tribunal. However, this provision has rarely been used. Remedies or injunctive relief may be ordered by the Competition Tribunal for breaches of the Competition Act’s Part VIII reviewable practices provisions, but no civil action may be based on a breach of those provisions. Parts VIII and IX of the Competition Act and associated regulations govern the competitive effects of a merger. A merger is defined at section 91 as: the acquisition or establishment, direct or indirect, by one or more persons, whether by purchase or lease of shares or assets, by amalgamation or by combination or otherwise, of control over or significant interest in the whole or a part of a business of a competitor, supplier, customer or other person.
According to the Merger Enforcement Guidelines,13 the principal issue to be considered in a merger proposal is the interpretation of the words significant interest. The Merger Guidelines state that the acquisition or establishment of a significant interest in the whole or a part of a business of another person is considered to occur when a person acquires or establishes the ability to materially influence the economic behavior of the business of a second person. Pursuant to subsection 92(1) of the Competition Act, if it is found that a merger prevents or lessens, or is likely to prevent or lessen, competition substantially in a trade, industry, or profession, or among the sources from which a trade, industry, or profession obtains a product, amongst others, the Competition Tribunal may order the merger not to proceed or to be dissolved, order assets disposed of as it directs, prohibit the doing of any act or thing the prohibition of which the competition Tribunal determines to be necessary to ensure that the merger does not prevent or lessen competition substantially, or take any other action.
11.4 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
Section 93 of the Competition Act goes on to provide a number of factors that may be used in determining whether a merger prevents or lessens competition substantially. For example, the Tribunal may have regard to, among others, the extent to which acceptable substitutes for products supplied by the parties to the merger or proposed merger are, or are likely to be, available; the extent to which effective competition would remain in a market that is affected by the merger; or the nature and extent of change and innovation in a relevant market. In this regard, the Merger Guidelines hold that mergers generally will not be challenged on the basis of concerns relating to the unilateral exercise of market power where the post-merger market share of the merged entity would be less than 35 percent. The Merger Guidelines further state that in a similar fashion, mergers generally will not be challenged on the basis of concerns about interdependent exercise of market power, where the largest four firms in the market post-merger would share less than 65 percent. In some cases, prenotification of a merger to the Director of the Bureau is required. The necessity of prenotification is determined as a function of the aggregate size of the merging companies’ assets or annual gross revenues, including affiliates (section 109 of the Competition Act, $400,000,000 in Canadian funds) and, in general terms, the size of the proposed transaction (section 110 of the Competition Act, $35,000,000 in Canadian funds, or $70,000,000 in the case of an amalgamation), unless exempted.14 In such cases, a mandatory waiting period exists, in which the Director has the opportunity to challenge the merger after the required information has been received by the Director.15 However, even if prenotification is not required, a merger may still be challenged on the basis of section 92 of the Competition Act. Section 102 of the Competition Act also provides for the possibility of binding advance ruling certificates upon application. The Competition Bureau and Intellectual Property Enforcement Guidelines. Traditionally,
the Bureau is not very severe in reviewing IP transactions unless those transactions fall into the merger category. The Competition Tribunal may apply the general provisions of the Competition Act to anticompetitive practices incidentally involving IP such as conspiracy, bid-rigging, market allocation, or mergers. However, the mere exercise of an IP right will not give rise to an anticompetitive practice captured by the general anticompetitive provisions. To counter any abuse that may arise, given the statutory grant of exclusion for a large portion of IP, subsection 32(1) was enacted, which reads as follows: 32. (1) In any case where use has been made of the exclusive rights and privileges conferred by one or more patents for invention, by one or more trade-marks, by a copyright or by a registered integrated circuit topography, so as to (a) limit unduly the facilities for transporting, producing, manufacturing, supplying, storing or dealing in any article or commodity that may be a subject of trade or commerce, (b) restrain or injure, unduly, trade or commerce in relation to any such article or commodity, (c) prevent, limit or lessen, unduly, the manufacture or production of any such article or commodity or unreasonably enhance the price thereof, or
OVERVIEW OF THE TRANSACTION: OBJECTIVE, SCOPE, AND COSTS 11.5 (d) prevent or lessen, unduly, competition in the production, manufacture, purchase, barter, sale, transportation or supply of any such article or commodity, the Federal Court may make one or more of the orders referred to in subsection (2) in the circumstances described in that subsection. (2) The Federal Court, on information exhibited by the Attorney General of Canada, may, for the purpose of preventing any use in the manner defined in subsection (1) of the exclusive rights and privileges conferred by any patents for invention, trade-marks, copyrights or registered integrated circuit topographies relating to or affecting the manufacture, use or sale of any article or commodity that may be a subject of trade or commerce, make one or more of the following orders: (a) declaring void, in whole or in part, any agreement, arrangement or license relating to that use; (b) restraining any person from carrying out or exercising any or all of the terms or provisions of the agreement, arrangement or license; (c) directing the grant of licenses under any such patent, copyright or registered integrated circuit topography to such persons and on such terms and conditions as the court may deem proper or, if the grant and other remedies under this section would appear insufficient to prevent that use, revoking the patent; (d) directing that the registration of a trademark in the register of trademarks or the registration of an integrated circuit topography in the register of topographies be expunged or amended; and (e) directing that such other acts be done or omitted as the Court may deem necessary to prevent any such use.
A number of different acquisitions of property that may raise concerns under subsection 32(1) of the Competition Act exist. Concerns may be raised when:16 • A firm with a dominant market position acquires the intellectual property rights of the only commercially viable alternative product • A firm acquires exclusive rights to use a complementary technology or product that allows the firm to leverage its market power into a related market • A firm obtains rights in future intellectual property developed independently by others (e.g., a “grant back” clause) • A dominant firm acquires exclusive rights to improvements on its own technologies or products that have been developed by others Similar to that in the United States, the time of assessing a potentially anticompetitive act is the time of acquisition of the intellectual property. On September 21, 2000, the Bureau announced the coming into force of the Intellectual Property Enforcement Guidelines (hereinafter the IP Guidelines). The Bureau announced that its objective in publishing the IP Guidelines was to explain how the Bureau would deal with competition issues involving intellectual property and what behaviour would be susceptible to attracting the Bureau’s attention as actionable in light of the Competition Act. Notwithstanding that the IP Guidelines are not law, they are an instrument that provides the public with an indication of how the Bureau will apply the law in connection with commercial practices involving intellectual property.
11.6 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
The main objective in the publication of the IP Guidelines is to achieve a certain uniformity in the procedures adopted by the Bureau; some believe that this objective, if attained, would contribute to the development and furtherance of competition law in Canada. In its evaluation, the Bureau begins with the principle that the exercise by the owner of his intellectual property rights is not in and of itself anticompetitive, then follows the procedure prescribed in the IP Guidelines to verify that the Competition Act has not been breached. The IP Guidelines are divided into seven parts; part 4 describes the procedure to be used by the Bureau. The Bureau proceeds using a five-step analysis: (1) determining the nature of the transaction; (2) determining the relevant market; (3) determining whether the enterprises involved possess market power; (4) verifying whether the transaction unduly impedes or reduces competition; and (5) verifying the existence of any motives that may be based on efficiency. Following this analysis, the Bureau then decides if there are sufficient grounds to intervene and apply the remedial powers available to it by virtue of the Competition Act’s criminal and civil provisions. One example of the Bureau’s powers would be penal sanctions, or the use of special remedies that permit the cancellation of a contract, revocation of a patent, expungement of a trademark, or even the compulsory grant of licenses, among others. However, the IP Guidelines state that the Bureau will only use those special powers on rare occasions and only when other recourses are not available pursuant to the intellectual property law in question. A problem to be noted with the IP Guidelines is that an analysis of a commercial transaction by the Bureau, using the criteria previously defined, involving intellectual property can be long, expensive, and complex. Because of this, it will often be difficult to determine if it would be prudent to wait for the Bureau to finish its analysis before closing a transaction. Even though the publication of the IP Guidelines can be of assistance in foreseeing the type of behavior that could offend the Bureau and trigger application of the Competition Act, it also gives rise to a number of questions. There will always be an element of subjectivity in the exercise of the discretion of the Bureau to initiate any kind of procedure against a party under the provisions of the Competition Act. One thing is certain: It is important to take anticompetitive implications in all commercial transactions involving intellectual property into account, including for example, licenses and partnership agreements.
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS
Regardless of the transaction—merger, sale, or acquisition—the parties to the transaction are bound by the contracts prepared by their respective legal representatives. Therefore, it is essential that a party to a transaction master the contents of its contracts—the risks involved with the transaction contemplated—so it can readily assess the extent of its rights and obligations. It is equally important that the other party to the transaction carefully reviews these contracts to assess the risks involved with the transaction contemplated. One of the main objectives of carrying out a due diligence audit of intellectual property is to understand exactly what is being transferred.
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.7
Many types of intellectual property owe their existence to the law, and a legal threat could mean complete loss of ownership or availability to use a particular asset that may be fundamental to the business concerned.17 Proper searching and evaluation of the results can ensure that the costs associated with obtaining the rights are as economical as possible and that the rights are obtained as rapidly as possible.18 Patents. Canadian patents are awarded to applicants who file patent applications for an invention as defined in section 2 of the Patent Act.19 An invention is “any new and useful art, process, machine, manufacture or composition of matter, or any new and useful improvement in any art, process, machine, manufacture or composition of matter.” Nonstatutory subject matter for patents include methods of surgical treatment, mathematical algorithms, laws of nature, and software, per se. However, if the invention includes software but is framed in terms of a system that forms traditional subject matter, a patent can be granted. Any inventor or legal representative may apply for a patent with respect to any invention. A patent is awarded to the first person who files the patent application. Furthermore, to maintain the requirement of novelty, the application must be filed prior to any third party disclosing the invention to the public in Canada or elsewhere. Methods of doing business have traditionally been held to be unpatentable, as have rules of playing a game or any other invention that relies on mental abilities. Higher life forms, such as mice, are patentable until the Supreme Court rules otherwise.20 For a valid patent to be granted in Canada, requirements of novelty, utility, and nonobviousness must have been met. The requirement of novelty is absolute novelty, except that Canada provides a grace period to inventors to disclose their inventions and file valid applications up to one year after having publicly disclosed the invention. This grace period also extends to people who directly or indirectly obtained such knowledge from the inventor. The term of a patent is 20 years from the filing date, provided annual maintenance fees are paid to maintain the patent application or patent in force, and cannot be extended. However, for patents issued before October 1, 1989, or stemming from applications filed before October 1, 1989, the term is 17 years from the date of issue. Certain patents that are based on applications filed before October 1, 1989, that have not yet expired, may benefit from up to an additional three years of patent protection because of an amendment to the Patent Act (introduced as Senate Bill S–17) intended to bring the term of patent protection in line with Canada’s obligations under the World Trade Organization TRIPS agreement.21 Under the proposed new Section 45, a patent would expire on whichever is the later between 17 years after the date of issue or 20 years after the date of filing. As a result, licensees should review their license agreements to determine if they will be required to pay royalties for an extended period of time. Companies or individuals who are planning to manufacture, use, or sell products that are subject to third-party patents on the basis that those patents are about to expire will need to be especially vigilant in determining the correct expiry dates of the relevant patents.22 The grant of a patent confers on the holder the exclusive right, privilege, and liberty of making, constructing, and using the invention, and selling it to others to be used.
11.8 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
Although stated positively, this is, in fact, a negative right in that the right granted by the patent is the right to prevent a third party from practising the invention. Patents can be granted on improvements, but the owner of the improvement patent does not thereby obtain the right of making, selling, or using the original invention; nor does the patent for the original invention confer to its owner the right of making, selling, or using the patented improvement. Canadian patent applications can claim priority of foreign applications of countries that are members of the Paris Convention,23 provided such claim to priorities are made within 16 months from the priority date. Canadian applications are published 18 months after the filing date or priority date, if there is one. Canadian patent applications are not automatically examined. A request for examination must be filed within five years of the filing date; otherwise, the application becomes abandoned. Co-ownership of Patents Legislative Jurisdiction. The rights of co-ownership in relation to a patent are not
addressed in the Canadian Patent Act. We are therefore required to revert to alternative applicable legislation. Given that “Property and civil rights” fall under the jurisdiction of the provinces pursuant to section 92(13) of the Canadian Constitution of 1867,24 the rights and obligations of co-ownership are dictated by provincial laws. That is to say that once a patent is awarded, particular questions as to property rights vested in the patented matter are regulated by civil law and are, therefore, under provincial jurisdiction. The issue of co-ownership of patents is more complex in Canada than elsewhere becaues of the duality in legislation that exists between Common Law provinces and the province of Quebec, where the civil law may give rise to results that differ from other provinces. Unfortunately, in Canada, there are very few decisions that address the co-ownership of a patent. Even the Common Law provinces, which traditionally have reached decisions based on jurisprudence from the United Kingdom, are finding themselves being influenced more and more by decisions emanating from the United States. As a result, there are a number of diverging solutions to the issues of co-ownership of patents emanating from different jurisdictions in Canada. The Patent Act. The only section of the Patent Act that refers to joint or collective
patent applications is found at section 31. Generally, subsection 31(1) contemplates situations in which an invention is made by two or more inventors, and one of them refuses to apply for a patent or his whereabouts cannot be ascertained after diligent inquiry. The other inventors or their legal representatives may make application, and a patent may be granted in the name of the inventors who apply, on satisfying the Commissioner that the joint inventor has refused to apply or cannot be found. Although in the United States the courts have tended to invalidate a patent when it was clearly revealed that all of the true inventors had not been identified,25 the jurisprudence for this matter in Canada has not been well established. The courts appear more concerned with the effects that may arise from an erroneous identification of an inventor on the ownership of the patent than with the annulment of the patent when another solution is available.26
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.9 Joint Holding of a Patent. Pursuant to paragraph 31(5) of the Patent Act, a patent is
awarded in the name of all the applicants. Therefore, co-applicants are co-owners of the awarded patent. If a person who is not an inventor is included by error in the application, he will retain co-ownership in the patent, holding the same title as the other inventors, with all the rights of use attached. Similarly, an inventor who is omitted from the application will have no rights in the patent. When the parties proceed with a joint application, and there is no contract that determines the rights of each in an awarded patent, the patent is granted conjointly to all the parties.27 Ownership rights in a patent, therefore, may be the result of silence. Co-ownership of a patent may also be the result of an express clause in a contract which provides that any technology developed remains jointly owned by all parties. However, such contractual clauses foreseeing joint title to the rights in a technology are often the source of problems that must be resolved at some point in the future, through further agreements, arbitration, or the courts. Most contracts foreseeing joint ownership of a patent do not stipulate the legal consequences of such a joint ownership. Contracts that create a joint ownership should specify the rights and obligations regarding the grant of a patent, its maintenance and use, and the rights conferred to co-patentees.28 The Co-inventors Portion. At common law, since a patent is awarded to all co-applicants, and no provision of the Patent Act specifies in what proportion the patent is awarded to each, it appears that the co-patentees can claim equal rights in the patent. In Quebec, in the absence of an agreement between the parties, the Civil Code of Quebec provides that the shares of undivided co-owners are presumed equal.29 Coownership is said to be undivided when the property rights are not accompanied by a literal division of the property. By analogy, co-ownership of a patent is also undivided, given that it is impossible to literally divide a patent. It follows that each undivided coowner has the rights and obligations of an exclusive owner in regard to his or her share. Thus, each may alienate or hypothecate his or her share, and his or her creditors may seize it. The Right to Use the Invention. Is a co-patentee obliged to obtain the consent of the other co-patentees prior to exploiting the patented technology? Yes. A particular copatentee would have the power to hinder the other co-patentees from exploiting the patent and could completely prohibit the use of the patented invention. Until 1978, most Canadian decisions regarding co-ownership of a patent followed British jurisprudence,30 which indicates that a co-patentee may use an invention for his own benefit without the consent of his co-patentees. In 1978, in Marchand v. Péloquin,31 Justice Mayrand of the Quebec Court of Appeal rendered an opinion that proved incompatible with the British decisions and, in doing so, stated:
Canadian law does not refer to the right of each of the co-patentees to grant a license without the consent of the other co-patentees, nor on his right to exploit the patent for his own profit. To determine the rights of a co-patentee, our courts are at liberty to return to their own interpretative norms and foreign decisions relative to the same or similar laws can only serve as an authority for a logical argument.
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This case applies equally to the rights of co-patentees to exploit the patent and the obligation to render an account of this exploitation to their co-patentees. In the opinion of Justice Mayrand, co-patentees hold indivisible rights that are preferably exercised together, for the benefit of all co-patentees, in a manner similar to that of coauthors of a literary work or co-owners of corporeal property. The Court arrives at the conclusion that a patentee cannot exploit the invention for his own gain without the consent of his co-patentees, to whom he owes a duty to render account. Justice Mayrand’s decision was certainly inspired by principles of indivision drawn from Quebec civil law. This could be the reason why common law courts did not follow the reasoning of this single Canadian decision, but rather returned to the reasoning of English jurisprudence. In fact, in 1995, in Forget v. Specialty Tools of Canada, Inc.,32 Justice Wood of the Court of Appeal of British Columbia stated that the obligation to obtain the consent of the co-patentee and to share the profits resulting from use of the patent was incompatible with the right of each co-patentee to exploit the invention as foreseen by section 42 of the Patent Act. Justice Wood thereby concluded that a patent is not infringed when a co-patentee manufactures or sells the invention within Canada without the consent of his co-patentees. The question of profits was not addressed by the Court of Appeal in this decision. Nevertheless, given that it was based on an English decision in which it was found that sharing of profits was not required in the absence of an agreement between the parties,33 one may predict that the Court would have chosen to follow this reasoning. Assignment of Patents. Once the patent has been awarded, it is considered property and is susceptible to being sold, assigned, or otherwise alienated in a manner similar to other types of intangible property. However, section 50 of the Patent Act provides certain requirements, which are pertinent to any related due diligence, concerning the assignment or licensing of an exclusive right to use a patent. First, any such assignment must be made in writing. Additionally, for any such assignment to be opposable to third parties, it must be registered with the Canadian Patent Office.34 This also applies to the grant of an exclusive license to use the patent.35 Therefore, during any due diligence, it is imperative to locate and identify the inventor or inventors to ensure the validity of the chain of title between the inventor and the assignee. It may be necessary to verify the contents of any employment contracts to ensure that the inventors have assigned all the rights in any inventions to their employer. When dealing with universities or other research centers, an investigation of any codevelopment contract is important in order to identify any remaining rights in the technology. When faced with the rights of one or more co-patentees, can a patentee assign a portion of his interest without the consent of the co-patentees? The answer to this question varies according to two hypotheses which were raised in Forget:36 (1) the assignment by a co-patentee of all his interest in the patent and (2) the assignment by a co-patentee of a portion of his interest in the patent. At common law, in the first case, the British Columbia Court of Appeal considered that a co-patentee who transferred all his rights in a patent to an assignee did not dilute the rights of the co-patentees. The assignee is simply substituted for the assignor, and there is no impact on the rights of the co-patentees who continue to share the patent
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.11
with another person. The Court went on to conclude that the consent of the co-patentee was unnecessary in such a case. In the second case, if the assignor decides to assign a portion of his rights to one or more persons, the co-patentee of the assignor finds himself in undivided co-ownership with an increasing number of co-patentees and a corresponding dilution of his rights. The consent of the co-patentee is therefore required in such cases to guarantee that the essential characteristics of the patent (i.e., exclusivity) are maintained. At civil law, however, article 1022 of the Civil Code of Quebec reveals an important restriction on the right of a co-owner to assign his rights by conferring a right of redemption to the other undivided co-owners. By analogy, all co-patentees who learn that a third party has acquired, by onerous title, the share of a co-patentee, may, within 60 days of learning of the acquisition, exclude this third party from the indivision by reimbursing him the transfer price and expenses incurred. However, it should be noted that the right of redemption must be exercised within one year from the date of the assignment.37 It should also be noted that, although the undivided portion in a patent may be hypothecated,38 this right to hypothecate is subject to the same rights of redemption in the case where a secured creditor considers selling the share or to take it in payment.39 Research at the Patent Office. The Canadian Patent Office40 allows for several types of
searches.41 The most common is an index search using the name of the enterprise being acquired. Searching this index allows patents granted to the enterprise (and applications for patents that have been filed and are pending) to be identified. The purchaser may also carry out a search on any assignments or licenses granted by the enterprise. The Patent Act requires that all assignments or grants of exclusive licenses be registered with the Patent Office in order to be made opposable to subsequent assignees. Further searches may be carried out to identify security interests that burden a patent or patent application. Section 11 of the Patent Act also enables one to determine through the Patent Office if an application for a patent is pending in Canada by providing the name of the inventor (if available), the title of the invention, and the number and date of a patent said to have been granted in a named country other than Canada. A validity search attempts to find patents or publications that may affect the validity of claims of a patent because they would tend to make the invention obvious or anticipated. Since the scope of such search is very broad, its results will likely include patents that were not found by the Patent Office examiner in the course of the application process. The infringement search is meant to locate claims (including product claims method and apparatus claims) in patents or patent applications that may be infringed by the commercial activities of the target company. The fact that any such process or method is patented by the target does not mean that it does not infringe on other patents, because a patent does not grant the right to do something specific, but rather the right to prevent others from doing the same. These types of searches are of particular importance when the target company’s success or viability depends on the fact that its products do not infringe on others’ patent rights.
11.12 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE Trademarks Introduction. A trademark is a word, symbol, or shape (or a combination of them) used
to distinguish the goods or services of one person from those of others. Trademarks may not be used in a way that would confuse the public. Confusion may arise if a trademark is used in a manner that may lead to the inference that the goods or services associated with such trademark are in the same general class as the goods or services associated with a confusing trademark. Rights through Use. There is no requirement to register a trademark in Canada. The use
made of a trademark in a specific region will enable its owner to protect its market and prevent other businesses from using a trademark that is identical or likely to be confusingly similar to the original trademark. The owner of a trademark, therefore, acquires certain rights merely through the use of the mark. However, an unregistered mark is likely to be geographically limited in scope. A registered mark, on the other hand, provides the holder with an exclusive right to use the mark throughout Canada along with a number of other advantages described hereafter, as long as the registration is maintained. In Canada, common law and civil law (in Quebec) rights in a trademark exist in addition to the rights provided by the Trade-marks Act.42 The statutory jurisdiction over trademarks is federal, while the jurisdiction of passing off is provincial, on the basis of authority of the provinces over “property and civil rights.”43 Trademark owners often use the common law action of passing off to restrain the activities of others. Such action may be coupled with an action for trademark infringement under the Trade-marks Act or brought separately where a statutory cause of action does not exist. Registration. As previously mentioned, it is not necessary to register a trademark under the Trade-marks Act in order to obtain enforceable trademark rights. However, there are many advantages in registering a mark. It confers an exclusive right to use the trademark throughout Canada. It creates two statutory causes of action: (1) action for passing off and (2) action for trademark infringement and depreciation of the goodwill attaching to the registered trademark pursuant to the Paris Convention.44 Also, the applicant may rely on a priority filing date in Canada as its filing date in a foreign country (if application is filed within six months of the application in Canada). The Trademarks Act also provides that the exclusive rights of a trademark owner are deemed infringed by a person who sells, distributes, or advertises wares or services in association with a confusing trademark or trade name. Until recently, it was only possible to register a licensee as a user of a trademark if the trademark was registered. That requirement has since been eliminated by the amendment to the Trade-marks Act abolishing the registered user system.45 Application for Registration. In general, an application for the registration of a trade-
mark in Canada can be based on any of the following: (1) use of the trademark in Canada by the applicant (or its predecessor in title or its licensee), (2) making known the trademark in Canada by the applicant (or its predecessor in title) so the trademark becomes well-known in Canada, (3) corresponding registration (or application) in a Paris Convention country, and (4) use anywhere in the world or (5) intent to use the trademark in Canada by the applicant (or a licensee).
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.13
A period of approximately 20 to 24 months exists between the filing of an application and the issuance of the registration. Once the application for registration is filed, a first step consists in the review by an examiner of the Trade-marks Office of the application for registration of a trademark. The role of the examiner is to affirm the registrability and compliance with trademark law and practice. A trademark can be registered if it is not merely descriptive, primarily a family name, deceptively misdescriptive (in French or English, of the wares or services), or the name in any language of the wares or services. Also, the trademark has to be distinctive and must not create confusion with a trademark or trade name previously registered, made known, or used in Canada. If the trademark seems to be registrable to the examiner, it is published in the weekly Trade-marks Journal. Any interested party may seek to oppose the application within two months of the date of publication of the applicable Trade-marks Journal. Such opposition is carried out before the Trade-marks Opposition Board, where the opponent files a statement of opposition setting out its objections. Term of Protection. Registration of a trademark in Canada is valid for consecutive 15-
year terms. Because the terms may be renewed any number of times, the protection afforded by registration may be of an infinite length. In certain situations, it may prove of interest to trademark owners to take advantage of the provisions of the Criminal Code with respect to the protection of trademark rights.46 Limits on Trademark Enforcement. Some limits to the validity of a registered trademark
are defects in registration, adverse changes in the distinctiveness of the trademark, loss of distinctiveness, or failure to use the trademark. Review of Marking in Association with Trademarks. The Trade-marks Act does not con-
tain any section requiring that marking be used in association with trademarks. However, it has been recommended that trademarks be properly marked, whether they be registered or simply adopted. Marking is especially important when a trademark is used under license. Five symbols may be used for marking purposes: • ® Should be used when the trademark is duly registered • ™ Should be used when the trademark is adopted (used without registration) or has been filed for registration with the Trade-marks Office • * Used when a trademark is adopted (used without registration) • md Used in the French language only. Means that the trademark is registered (marque déposée) • mc Used in the French language only. Means that the trademark is adopted (used without registration) or has been filed for registration with the Trademarks Office (marque de commerce). These symbols should appear to the right of the trademark and must refer to a legend describing which entity is the owner of the trademark:
11.14 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
• “Registered trademark of [name of owner]” • “Registered by or [name of owner]” • “A trademark of [name of owner]” The trademark associated with the products or services sold or offered in Canada must, by application of the Consumer Packaging and Labelling Act,47 be identified in the two official languages, English and French. In the French language, the legend should therefore read as follows: • “Marque de commerce enregistrée de [name of owner]” • “Enregistrée par [name of owner]” • “Marque de commerce de [name of owner]” The ® symbol can be used only if a trademark is registered. If the products and/or services are exported or offered in the United States, the ® symbol can be used only if the owner of the trademark has a duly registered trademark in the United States. If it is not the case, ™ or * must be used. If the trademark is used under license, the following legend should be associated with the trademark by application of section 50 of the Trade-mark Act: • “Trademark of [name of owner] used under license by [name of licensee]” • “Registered trademark used under license by [name of licensee]” • “A trademark used under license by [name of licensee]” Assignment of Trademarks. Trademarks may also be sold like any other property.
However, if the trademark is registered, the sale must also be registered with the Trademarks Office. A trademark may be licensed or franchised through an agreement by and between the interested parties. However, to ensure that a trademark does not lose its distinctiveness, the owner of the mark must, by contract, maintain control over (1) the characteristics and quality of the merchandise or services offered in connection with the trademark, (2) the use of the trademark, and (3) the advertisement or display of the trademark. The owner must also, in fact, ascertain these rights to maintain the distinctiveness of the trademark. In the case of a sale of a trademark, the parties must prepare an assignment document indicating the change of ownership of the trademark. The Registrar, on being satisfied with the furnished evidence, will then, by virtue of subsection 48(3) of the Trade-marks Act, register such transfer. Research at the Trade-marks Office. Trademarks in Canada may be registered with the Trade-marks Office.48 As previously stated, registration of a mark with the Trade-marks Office provides the holder with an exclusive right to use the mark throughout Canada, along with a number of other advantages, as long as the registration is maintained. Similar to patents, a number of searches49 may be carried out at the Trade-marks Office. First, an index search may be conducted as a first step in a commercial transaction; this type of search is made to determine trademark registrations and pending applications for registrations recorded in the name of a person. Second, a registered
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.15
user search of the records permits may be conducted to point out instances in which third parties had been authorized to use a particular trademark, or if the company had been licensed to use trademarks of third parties before the amendments to the Trademarks Act abolishing the authorized user registration obligation. An opposition search may also be done to determine if opposition applications are pending. It is also possible to verify documentation relating to security interests recorded against a trademark registration or application. This type of search is not always reliable because the information is not recorded against title; therefore, it is important to review the file history. However, it should be noted that, as there is no requirement to register a trademark, it is likely that any search at the Trade-marks Office will be incomplete. Additional searches outside of the Trade-marks Office may be necessary to provide a more complete picture. Copyright. Copyright is the protection of the expression of creativity that can be a literary, artistic, musical, or dramatic work. Upon the creation of an original work that is fixed in tangible form, copyright occurs automatically, and the benefits of a certain protection arise, giving its creator different rights. Neither notice nor registration is needed to automatically extend copyright protection in Canada, as is the case in many other countries. Therefore, very few businesses register copyright unless the work is valuable. The essential concept of copyright is that there is no protection for the ideas or concepts themselves, only for their expression. In Canada, copyright is a statutory right that exists solely under the Copyright Act.50 The federal parliament has exclusive jurisdiction over copyright. However, provincial law will apply as supplemental law with respect to the sale, transfer, lease, or license of copyrights, as such transactions fall under the provincial jurisdiction of “Property and civil rights.”51 Rights. Simply put, copyright means the sole right to produce a work, or any substan-
tial part thereof, in any material form. It also includes the sole right to perform the work, or any substantial part thereof, in public, to produce, reproduce, perform, or publish any translation of the work. In the case of a literary, dramatic, or musical work, it includes the right to make any sound recording, cinematographic film, or other contrivance by means of which the work may be mechanically reproduced or performed; or in the case of computer programs, the sole right to license the computer program. In addition, the copyright holder has the sole right to authorize the commission of these acts. The sole right to authorize these acts is a separate and substantive right, which means that the copyright owner is not the only person entitled to reproduce the entire work or any substantial part thereof, but is the only person who can properly authorize a third party to produce or reproduce the entire work, or any substantial part thereof. Term of Protection. In general, copyright subsists upon creation of the work for the life
of the work, including to the end of the year in which the author dies (because copyright protection always ends on the last year of protection) plus 50 years. In the case of more than one author (joint authors), the term of protection of copyright in the work is the life of the author who dies last, until the end of the year in which he dies, plus 50 years.
11.16 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
In the case of an unknown author, the term of protection of the copyright will be the earlier of either (1) the end of the year of first publication plus 50 years or (2) the end of the year of the making of the work plus 75 years. The date of death of the author determines the protection for an unpublished work. If the author died after January 1, 1999, the term of protection of the copyright will be the end of the year of first publication, public performance, or communication, plus 50 years. If the author died before January 1, 1999, the term of protection of the copyright will be the end of the year in which the author died plus 50 years. If the author of a work died before September 1, 1949, the term of copyright protection, independent of any publication, public performance, or communication, will be five years from December 31, 1999. In other words, every work for which the author died before September 1, 1949 will become public and will no longer benefit from copyright after December 31, 2004. In the case of photographs the term of copyright protection will be the remainder of the year of the making of the initial negative or plate of the initial photograph plus 50 years. Where the copyright belongs to her majesty, the term of protection will be the end of the year of the first publication of the work plus 50 years. In the case of joint authorship where authors are nationals of any country, other than a country that is party of the North American Free Trade Agreement, the term of protection will be the shorter term of protection granted among the different systems. For cinematographic works in which the arrangement or acting form, or the combination of incidents represented give the work a dramatic character, the term will subsist for the same period as for a dramatic work. In the other cases, the copyright protection will subsist: • If published, the end of the year in which the work was first published plus 50 years • If not published, the end of the year of its creation plus 50 years (if still not published) Registration. There is no formal requirement to confirm the existence of a copyright by registration. However, Canada has a registration system which has the advantage of providing the holder of a registration certificate with a number of presumptions in his favor, including presumptions as to (1) the validity of the copyright subsisting in the work, (2) the ownership of the copyright by the registered owner, and (3) the knowledge on behalf of third parties of the subsistence of copyright in a given work. Absence of registration does not preclude the copyright owner from filing an action into court. The owner can obtain registration by submitting an application filed in a specific form with payment of the prescribed fees at the copyright office. There is no examination and no requirement to file a copy of the work. Ownership. Except in specific circumstances, the author of a work is presumed the first owner of the copyright subsisting in a work. The most important exception to this rule is the case of a work “made in the course of employment.” When a work is made
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.17
in the course of employment or apprenticeship, the person by whom the author was employed retains title as first owner unless a written agreement to the contrary exists between the parties. It should be noted that this concept of “made in the course of employment” does not extend to consultants or independent contractors. Apart from this particular case, however, the ownership of copyright remains with the first author of a work until such time as it is assigned in writing. Limits. Copyright prohibits the reproduction of an original work. It does not, however, prohibit the independent creation of a similar work. This complicates enormously any verification carried out in due diligence. It is suggested, therefore, to insist that the assignor remain responsible if it later comes to light that the works in question are in fact infringing copyright of a third party. Due Diligence. The first step in any due diligence related to copyright is to examine the
chain of title of the works in question to ensure that the vendor possesses the right of ownership. The Copyright Act confers the right of ownership in the work to the titulary of the work from the moment of its creation. In fact, any registration of copyright confers only a rebuttable presumption of ownership. Of note is subsection 13(3) of the Copyright Act, which creates, as previously discussed, a presumption, in absence of an agreement to the contrary, that ownership in works created by an employee during his employment are the property of the employer. However, an important deviation from this principle applies in the case of consultants who are hired by an enterprise from time to time. In the absence of an agreement to the contrary, there is a presumption that the rights in any works created during the course of the agreement are vested in the consultant and not the employer. Assignment of Copyright. Assignment of copyright provides another exception to com-
mon law or civil law (in Quebec) by requiring a written document signed by the assignor attesting to the assignment of copyright. As copyright is not subject to any formal requirements of registration, neither is the assignment of copyright. However, it is recommended to register any and all rights in a work, and to register any assignment during the acquisition of an enterprise. An assignee may find his assignment declared null in the face of a third party in good faith who acquired the rights in the work for value and registered the assignment before the assignee’s registration.52 In the event of a silent agreement about the transfer of copyright in a work, the transfer of copyright will generally not be implied. However, a general clause regarding the assignment of all the intellectual property rights necessary to operate a corporation would normally include copyright. Furthermore, the transfer of a physical object does not imply the transfer of its copyright. Insolvency. The Bankruptcy and Insolvency Act53 specifies at section 83 that in the case
of insolvency of the assignee, all assigned copyrights or interests in a copyright automatically return to the author. However, the work must not have caused expenses or been published; if it has, the Copyright Act specifies repurchase terms in favor of the
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author. It is important to note that any agreement to the contrary entered into with a bankrupt is null and void. Moral Rights. The Copyright Act also creates moral rights, which benefit only the
author, in a work. Moral rights concern the right to the integrity of the work and the right to paternity in respect of the work. In essence, moral rights in a work may restrict the modification or exploitation of a work after it has been sold or licensed by enabling the author to prohibit an assignee from defacing the work and to reclaim the work under certain circumstances. An author’s right in the integrity of a work is only infringed upon when the work is, to the detriment of the honor or reputation of the author, distorted, mutilated, or otherwise modified; or used in association with a product, service, cause, or institution.54 This may prove important when modifying a given software, for instance. Note that moral rights also extend to the rights to remain anonymous and use a pseudonym. Moral rights cannot be assigned, but the Copyright Act foresees that an author can renounce his moral rights in a work. This renunciation may have the same or different terms than the assignment. In any case, it is recommended that the owner of the rights in the work also obtain a clear renunciation from the author of his or her moral rights in the work. In the absence of such waiver in the assignment agreement, it is recommended to have the vendor sign an agreement to obtain such a renunciation. Research at the Copyright Office. A number of different types of searches can be carried
out at the Copyright Office. The index search may be used to locate the copyright registered by name and to determine what copyright has been granted or transferred. A title search may be used to reveal any licenses and security interests that affect the copyright in a work. As for the limits of such searches, in practice, searches carried out in the Copyright Office provide little information, since the majority of copyrights are not registered— with the exception of enterprises whose activities rely greatly on the protection afforded by copyright. Applications for registration are not available for searching. Also, records at the Copyright Office might contain errors that will affect reliability of the search. Marking in Association with Copyright. It is recommended that work distributed to the
public be properly marked by indicating the familiar copyright notice:” ©, [year of first publication], [name of the owner].” Trade Secrets Definition of Trade Secrets. No specific legislation in Canada defines what constitutes a
trade secret. A number of authors have held that a trade secret consists of information— including formulas, procedures, methods, techniques, or compounds—which is not in the public doman and has an economic value, used in the business of an enterprise.55 At common law, trade secret means information including, but not limited to, a formula, pattern, compilation, program, method, technique, or process, or information contained or embodied in a product device or mechanism that:
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• • • •
Is, or may be, used in a trade or business Is not generally known in that trade or business Has economic value from not being generally known Is the subject of efforts that are reasonable, under the circumstances, to maintain its secrecy56
At civil law (in Quebec), the case of Positron Inc. v. Desroches et al.57 confirmed that the common law cases were applicable in the province of Quebec. Mr. Justice Biron went on to propose the following definition: Trade secrets are usually formulas, manufacturing processes unique to their owner, that have been revealed confidentially to an employee. This is not experience acquired by an employee but, more exactly, knowledge or know-how belonging to the employer and revealed by him for the sole purpose of permitting the employee to produce what the trade secret enables him to do. Included in this category are chemical formulas, recipes, manufacturing technologies (...). [translated]
The notion of a trade secret may be defined broadly to include know-how and confidential information (i.e., all confidential information belonging to a business that provides the holder with an economic advantage over a competitor). This information may consist of knowledge (or know-how) of a technical nature, as well as client mailing lists, reports on strategic development, and so forth. Given that a trade secret is, in essence, information, it implies that once a trade secret is known or discovered by someone else, there is no concrete means by which this person may be divested of it. It also means that although a trade secret is transferred to a buyer with other intellectual property assets, the seller is not deprived of its ability to use this information in the course of its business unless contractual obligations prevent it from doing so. The persons who benefit from trade secrets bear the risk of losing that benefit and being prevented from using the trade secret if a third party obtains a patent for the same subject matter. When technical information is kept secret, a third party may develop the same innovation on its own and seek patent protection for it. In this scenario, the person benefiting from the trade secret could not invoke prior art or non-obviousness in order to invalidate the patent claim if the use that was made of the trade secret was not disclosed or deemed disclosed to the public. The person who was using the information without patent protection could then be precluded from using the information he or she developed, discovered, or acquired, even if he or she was using it before the patent owner. Obviously, not all information to which an employee will be exposed in the course of his or her work is confidential. Even when it is confidential, in many cases, it will not benefit from any protection subsequent to the rupture of the employment contract without an implied duty of confidentiality (e.g., with respect to senior employees), or of a restrictive clause in the employment contract or dismissal agreement. Only if the information is of a nature so confidential that it can be assimilated to a trade secret will it benefit from protection at law. Although the requirements may vary slightly from one country to the next, the following six protective measures can be considered the main guiding principles to follow in order to maintain a sufficient protection level for the trade secrets of an enterprise.
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1. 2.
3. 4. 5. 6.
Make sure that the information the enterprise wants to protect as trade secret is not generally known outside the enterprise. Assess the extent to which employees and other people involved in the production of the wares or provision of the services have knowledge about the information that the enterprise wants to protect as trade secret. Maintain and review the measures that were taken to keep the information confidential on a regular basis. Measure the value of the information that the enterprise wants to protect as trade secret, both for itself and for its competitors. Keep track of the investments and efforts that were made by the enterprise during the process of developing the trade secret. Evaluate the investments and efforts that would be required by a third party to obtain the information or to duplicate on its own the benefits derived from the information that the enterprise wants to protect as trade secret.
Even if these are the measures that are generally recognized by jurisprudence, they should not be considered an exhaustive list of all the possible means to protect trade secrets. Enforcement of Trade Secret Rights. Trade secrets, know-how, and confidential informa-
tion are also considered part of the intellectual property of an enterprise. However, they differ from other types of intellectual property in that they do not receive any specific legislative protection. Nevertheless, in the event that trade secrets, know-how, or confidential information are illegally divulged or communicated to a third party, civil remedies may potentially be available in the form of damages and injunctions. More specifically, in a breach of confidence case, the focus is on the loss to the plaintiff and, as in tort actions, the particular position of the plaintiff must be examined. The objective is to restore the plaintiff monetarily to the position he or she would have been in if no wrong had been committed; this is generally achieved by an award of damages. Of particular importance in the province of Quebec is the Springboard Theory. This theory was expressed in Terrapin Ltd. v. Builders Supply Co. (Hayes) Ltd.:58 . . . a person who has obtained information in confidence is not allowed to use it as a springboard for activities detrimental to the person who made the confidential communication, and springboard it remains even when all the features have been published as can be ascertained by actual inspection by any member of the public . . . The possessor of the confidential information still has a long start over any member of the public . . . It is, in my view, inherent in the principle upon which the Saltzman case rests that the possessor of such information must be placed under a special disability in the field of competition to ensure that he does not get an unfair start.
When confidential information or trade secrets have leaked to a competitor, the application of the Springboard Theory will protect the trade secrets and head start held by the owner of this information and will set back those who illegally gained access to and used the information. Assignment of Trade Secrets. Strictly put, a trade secret may not be sold since it is not a “property,” but merely a proprietary right acquired by contract, from both a common
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.21
law and civil law perspective. From a practical standpoint, however, it is always possible to transfer confidential information. The transfer can be made with or without restriction upon the transferor, and the transferor may continue to use the trade secret. The transferee wishing to have exclusive rights must ensure, by way of an agreement, that the transferor will (1) maintain the confidentiality of the information and (2) undertake not to use the trade secret transferred. Nature of the Right. The commercial advantages that an enterprise may derive from confidential information (including trade secrets) reside in its capacity to keep such information secret and to prevent others from gaining access to it. Therefore, such information may not be considered property that may be sold or bought.59 However, the holder of confidential information may acquire certain rights arising from nondisclosure agreements or from the fiduciary duties imposed—on the employees of a holder, for instance. Industrial Designs, Integrated Circuit Topographies, and Plant Breeders’ Rights. The
Industrial Design Act60 permits the registration of, and results in the grant of, an exclusive right in the visual and ornamental characteristics of a utilitarian product. Industrial design has a close relationship with copyright because useful works that are considered industrial designs may also be considered artistic works and capable of copyright protection. Features of an object that are solely functional may not be the subject of an industrial registration. Registration is required to protect an industrial design; application must be filed within one year of the first sale of the design. An exclusive license must also be registered. Subsection 64(2) of the Industrial Design Act provides that where copyright subsists in a design applied to a useful article and (1) the article is reproduced in a quantity of 50 or more or (2) the article is a plate, engraving, cast, and so on, used for producing more than 50 articles, it is no longer copyright infringement to reproduce the article. The Industrial Design Act counters this loss of copyright protection by awarding a 10year period, within which the registrant may maintain a monopoly right on the design in question. The Integrated Circuit Topography Act61 provides a regime of protection for the complex three-dimensional sets of electronic interconnections within a semiconductor. Protection is only available by registering the topography; failure to file an application within two years of any commercial sale may result in the loss of rights. Pursuant to section 3, the Integrated Circuit Topography Act provides for exclusive rights, upon registration, to reproduce, manufacture, and import, or commercially exploit the topography or a product based on the topography. The term of protection is 10 years from the date of application for registration of the topography. The Plant Breeders’ Rights Act62 provides a system of protection for new varieties of plants. Under the act, the registered holder of plant breeders’ rights to a particular variety of plant has the exclusive right to sell seeds of such plant variety and an exclusive right to produce seeds of the variety for selling. The act typically protects a clone, hybrid, or genetic variation of a plant, as well. The term of the monopoly right is 18 years with a requirement for the holder to pay yearly maintenance fees if he desires to maintain the protection.
11.22 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
Section 13 of the Industrial Design Act expressly provides for the licensing or assignment of a registered or unregistered design (e.g., at the application stage), as to either the whole interest or any undivided part. The licensing or assignment must be made in writing and recorded in the office of the Commissioner of Patents. Pursuant to section 7 of the Integrated Circuit Topography Act, any interest in the exclusive rights to a topography, if registered, may be transferred or be the subject of a license agreement. Subsection 5(1) of the Plant Breeders’ Rights Act describes the nature of the plant breeders’ rights. Paragraph 5(1)(d) of such Act provides that one of these rights includes the exclusive right to authorize, conditionally or unconditionally, the doing of any act described in the other paragraphs. Section 31 of the Plant Breeders’ Rights Act prescribes the manner in which the rights may be assigned. An assignee’s rights may not be opposable to a subsequent assignee if the assignment was not done in accordance with subsection 31(1) of the Plant Breeders’ Rights Act.63 Other State-Granted Licenses. In some cases, particular laws may come into play, depending on the area of activity of an enterprise. This would be the case, for example, in the area of (1) broadcasting in which the Canadian Radio and Telecommunications Commission (CRTC), by virtue of the Broadcasting Act,64 has the power to review all changes of control of an enterprise engaged in broadcasting, or (2) pharmaceutical preparation, in which the Therapeutic Product Program65 (TPP), a division of Health Canada, has the duty, under the Food and Drug Act66 to approve the sale of pharmaceutical products. In such cases, further procedures may be required to ensure adequate transfers of the right to commercialize the various rights acquired. Assets in Personnel. Assets in the form of personnel are not, strictly speaking, a type of intellectual property forming part of the property of an enterprise, but rather the advantage that an enterprise has through employing a particular individual. In many cases, the impact of the human factor cannot be underestimated, and a successful acquisition of intellectual property may often depend greatly on an appropriate management of human factors. Impact of Employee-Employer Relationships. In the context of a merger or acquisition, a number of employees are often dismissed. When a rupture occurs in the employeeemployer relationship, an upset ex-employee may take client lists, business plans, and other intellectual property with him or her. An assessment must be made of the rights of both the employee and employer. The jurisprudence in Canada makes a distinction among three categories of knowledge that an employee may acquire during the course of his work:
1.
2.
Knowledge of such a nature that a reasonable person would not consider confidential. An employee may make any use he or she wishes of this knowledge. Knowledge that an employee must treat as confidential, either because it is confidential by its nature or the employer has indicated that it is confidential.
INTELLECTUAL PROPERTY IN DUE DILIGENCE AUDITS 11.23
This knowledge, when acquired by an employee, forms part of the intellectual baggage that he will carry with him from job to job. This is referred to as subjective knowledge (i.e., the personal and subjective experience of the employee that will remain with him when he leaves his employ). As long as a contract of employment binds the employee and employer, the employee must retain this knowledge in a confidential manner. This is by virtue of an implicit clause of loyalty that prohibits an employee from revealing to a competitor something that might procure him or her a material gain. Upon the rupture of the employment lien between employee and employer and, in the absence of an agreement to the contrary, the employee is free to place at the service of a new employer, even a main competitor, the general knowledge that the employee has acquired with regard to the organization and the business methods of his ex-employer. Quebec has a particular regime in this regard, which is stated in article 2088 of the Civil Code of Quebec: The employee is bound not only to carry on his work with prudence and diligence, but also to act faithfully and honestly and not to use any confidential information he may obtain in carrying on or in the course of his work. These obligations continue for a reasonable time after cessation of the contract, and permanently where the information concerns the reputation and private life of another person. [Authors’ emphasis.]
3.
It must be remembered that subjective information acquired during the course of the employee’s work is not considered confidential information. Furthermore, what is considered a “reasonable time after cessation” is left to the appreciation of the courts, which have been reluctant to find that such a time period exceeds 24 months. Knowledge related to manufacturing secrets such as formulas or secret manufacturing processes known only by the employer and revealed to the employee. This knowledge is not acquired by the employee during the course of his employment, but rather is knowledge belonging to the employer, which is revealed to the employee solely for the purpose of allowing him or her to manufacture what the secret reveals. This is objective knowledge, which remains the property of the employer even after the employee’s dismissal.
It should also be noted that in Quebec, pursuant to article 2095 of the Civil Code of Quebec, when an employer dismisses an employee without serious reason, any noncompetition clause that may have been entered into is of no effect. An employer is always well advised to have the employee enter into a dismissal agreement whereby he or she agrees to abide by the terms of a non-competition clause. In common law provinces, the decision of the Supreme Court of Canada in LAC Minerals v. International Corona67 held that three elements were required to establish a breach of confidence (apart from contract):
11.24 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
1. 2. 3.
The knowledge must “have the necessary quality of confidence about it.” The knowledge must have been divulged in circumstances importing an obligation of confidence. There must have been an unauthorized use of the knowledge to the detriment of the party communicating it.
The “necessary quality of confidence” was detailed by the U.K. Court of Appeal in the decision of Saltman Engineering v. Campbell Engineering:68 The information, to be confidential, must . . . have the necessary quality of confidence about it, namely, it must not be something which is public property and public knowledge. On the other hand, it is perfectly possible to have a confidential document, be it a formula, a plan, a sketch, or something of that kind, which is the result of work done by the maker upon materials which may be available for the use of anybody; but what makes it confidential is the fact that the maker of the document has used his brain and thus produced a result which can only be produced by somebody who goes through the same process.
LICENSES, ASSIGNMENTS, AND OTHER AGREEMENTS RELATING TO INTELLECTUAL PROPERTY
Exhibit 11.1 provides an overview of the actions required on behalf of the parties when assigning or licensing a right in statutory intellectual property. Licenses. Before a license is acquired during a merger or acquisition, the buyer must satisfy himself that the licensor had a legal right to grant a license on the property in question. To do this, the party carrying out the due diligence must be in a position to appreciate the essential subject matter of the license. It has been suggested that the best way to do this is by going to the source of the technology—the programmers who
Statute
Assignment
License
Patent Act
In writing69 Registration required70
Registration required for exclusive license71
Plant Breeders’ Act
Inform the commissioner72
No statutory requirements
Trade-marks Act
No statutory requirements Registration optional
Public notice useful to prove quality control by the owner73
Copyright Act
In writing74 Registration optional
In writing75 Registration optional
Industrial Design Act
In writing Registration required76
In writing Registration required77
Integrated Circuit Topologies Act
No statutory requirements
No statutory requirements
Exhibit 11.1
Overview of Statutory Requirements for Assignment or License
LICENSES, ASSIGNMENTS, AND OTHER AGREEMENTS 11.25
developed a particular licensed software, the patent agent, or inventor in the case of a licensed patent, for example.78 A visit of the premises may be needed to perform a verification of this nature. In some cases, it may reveal that the viability of the seller’s business largely depends on the existence of licenses with third parties, whether as licensor or licensee. A careful review of all contracts related to the intellectual property of the seller, including all the licenses and royalties that are paid by and to the seller is also unavoidable. This will help to provide the buyer with a clear portrait of the potential contractual obligations and restrictions it would be confronted with once the transaction is completed, or to determine whether the intellectual property “balance sheet” of the seller reveals a market position that is as strong as it was initially thought to be. Particular attention must be paid to questions related to the subject matter of the licenses—their duration, exclusive or nonexclusive character, assignability, conditions for renewal or resiliation, events that trigger their application, and the damages specified if an infringement occurs. License agreements generally include provisions that restrict assignment rights or cause the agreement to terminate when a change of control occurs with the licensee’s (or the licensor’s) identity. Even if the company that is the target of the transaction is entitled to use a technology or trademark as a licensee, it does not necessarily imply that this right will be transferred to the buyer. In principle, licenses are personal to the licensee, which indicate an intuitu personnae relationship. It follows that, unless otherwise provided in the contract, a licensee may be in a position in which he cannot assign a license agreement without the consent of the licensor. Additional restrictions may also be found in secrecy agreements that exist between licensee and licensor. Finally, there may be situations in which the seller needs to retain ownership of one or several elements of its intellectual property portfolio, either permanently or temporarily, for transitional purposes. In such cases, it will be necessary to add a license agreement as part or the transaction to allow the buyer to acquire the rights it needs in order to perform what it intended to do without preventing the seller from carrying on its business. The Right to Grant Licenses. At common law, the concept of a license has been defined as a negative right whereby the licensor agrees, subject to compensation, not to sue the licensee for infringement or the violation of the licensor’s rights. The concept of licensing has not yet found its proper place in Quebec civil law. Many have assimilated a license to a type of rental.79 However, many features distinguish a license from a lease. For instance, it is very difficult to reconcile the definition of a lease in the Civil Code of Quebec as a contract by which a person undertakes to provide another person with the enjoyment of a movable or immovable property for a certain time, in exchange for a rent,80 with the idea that nonexclusive licenses can be granted to several persons at the same time in exchange for royalties.81 Article 1016 of the Civil Code of Quebec permits an undivided co-owner to use the property. This provision appears to hinder the granting of a license without the approval of the co-patentees because such a license on an undivided co-owned property could be seen as infringing on the rights of the other undivided co-owners; there is also a risk of diluting the rights of the other co-patentees. It appears, therefore, that the consent of all
11.26 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
the co-owners is essential for the grant of all licenses on property held in undivided coownership. In fact, in Canada—including Quebec—the courts have established that a patentee cannot grant a license without the consent of his co-patentees.82 What does not appear to be as clear is if the co-patentees have to render an account of the profits realized from the license. The Quebec Court of Appeal seems to impose an obligation to share the profits,83 as it also appears from section 1018 of the Civil Code of Quebec, but for common law jurisdictions, the Appeal Court of British Columbia does not offer as clear a response on this matter.84 When a license is granted, it would normally be granted on the undivided coowned property as a whole and not on a portion of the patent held by the undivided coowner. Article 1025 of the Civil Code of Quebec clearly stipulates that the undivided co-owners administer the property in common in its entirety. Consequently, certain decisions about the undivided property are made by a majority of co-owners, in number and shares, while other decisions must be made unanimously by all undivided coowners.85 The grant of a license would appear to require the approval of a majority of undivided co-owners in number and share since it does not seem to fall under the category of actions requiring unanimous approval. Assignments in an International Context. When a merger or acquisition involves the acquisition of technology across national borders, additional efforts must be made to ensure a level playing field (i.e., all parties to the agreement abide by the same set of rules). In such situations, it is important that control over the technology be determined to ensure that the parties are not entitled, for example, to proceed against each other with respect to any dispute in different jurisdictions.
SECURITY INTERESTS IN INTELLECTUAL PROPERTY Legislative Context. As mentioned in the introduction, for a growing number of busi-
nesses, IP represents a substantial portion of their value. Accordingly, lenders have increasingly turned to intellectual property as security for their loans. In Canada, contracts and the transfer of personal property are generally matters falling under individual provincial jurisdictions. However, with some IP assets, it is also possible to register a security interest under a federal regime. It appears that patents and patent applications, copyrighted works, registered and unregistered trademarks, registered and unregistered industrial designs, registered integrated circuits topographies, registered plant varieties, and, in certain jurisdictions, maybe even trade secrets can be given as collateral. Every Canadian province except Quebec has adopted, with some variations, Personal Property Security legislation (PPS legislation) that is modeled upon Article 9 of the American Uniform Commercial Code. Security interests in Quebec, on the other hand, are governed by the Quebec civil code, which has merged all previously existing security interests into the “hypothec,” a legal concept of security similar to PPS legislation as it concerns moveable property whether tangible or intangible. Security interest is defined under the PPS legislation as meaning “an interest in personal property that secures payment or performance of an obligation . . ..” In Quebec, one can hypoth-
SECURITY INTERESTS IN INTELLECTUAL PROPERTY 11.27
ecate immovable and moveable property; moveable property includes, among others, incorporeal assets. Thus, it is now clearly established that most intellectual property rights in Canada fall within the meaning of personal property, and, consequently, transactions involving intellectual property rights given as collateral will be subject to PPS legislation or the Quebec civil code provisions dealing with security interests. Validity and Perfection of Security Interests. There are different legislative provisions governing the attachment and perfection of such security interests in the various provincial jurisdictions, but a security interest will usually be created when the debtor signs a security agreement that gives a value to the security and sufficiently describes the collateral so that it may be identified. To enjoy priority over other subsequent claims, including on floating charges, a security interest, once created (or once it “attaches” to the property), needs to be perfected through the proper form of registration (usually a financing statement) filed with the relevant provincial register. The main question, then, is where to perfect a security interest in intellectual property. In this regard, the Quebec civil code and other provincial PPS legislation all contain provisions relating to the forum for perfection of security interests. As an example, section 3105 of the Quebec civil code states that the validity of a security charged on an incorporeal movable is governed by the law of the jurisdiction where the grantor was domiciled at the time of creation of the security, and its publication and effect are governed by the law of the jurisdiction in which the grantor is currently domiciled. The Ontario PPSA states that the validity, perfection, and effect of perfection or nonperfection of a security interest in an intangible shall be governed by the law of the jurisdiction where the debtor is located at the time the security interest affects the intangible property in question.86 Also under the Ontario PPSA, a debtor shall be deemed to be located at the debtor’s place of business, if one exists, at the debtor’s chief executive office, if there is more than one place of business, or at the debtor’s principal place of residence.87 Accordingly, registration under at least the personal property security legislation in force in the debtor’s province is located at the time of signing of the security agreement is strongly recommended.88 Although there are many complex and different rules under provincial legislation for the determination of priorities in the event of a default of the debtor, having a perfected security interest generally means that a creditor will have priority over subsequent creditors who perfect their security interest after him; it also means, however, that other creditors who perfected their security interest before will enjoy a priority over him. Therefore, it is necessary to carry out appropriate security interest searches of public registers to determine the rank of the security interests a lender is willing to accept. Security Interest Searches and the Intellectual Property Registers. Although an academic discussion is ongoing about whether the federal or provincial legislation has jurisdiction over security interests affecting IP assets and whether one registration system overrides the other, all of the appropriate provincial and federal registers should be verified in a due diligence exercise. The federal intellectual property statutes, which create IP rights, provide for their registration and transferability or assignment. They do not, however, define what is meant by an “assignment,” nor do they expressly mention
11.28 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
security interests. It appears that the granting of a security interest may, in some cases, be considered an “assignment” in guarantee. The Copyright Office and Patent Office (which is also the entity in charge of administering the Industrial Design Act) will register security interests or liens against the title of a specific IP asset. The Trade-marks Office will place a copy of such security interest or lien on file. Despite the absence of express registration provisions for security interests, it has become a practice to file such security interests in both the appropriate federal and provincial registers when such costs are not exorbitant, depending on the number of assets involved. (A fee must be paid for each application or registration of a security interest sought at the federal level.) The effects of a federal registration without the filing of a corresponding provincial registration are unclear, but the following issues might help one understand the possible effects of not filing a registration at the federal level. • A prior assignment of copyright is void against a subsequent assignee (who has given valuable consideration) or licensee unless notice is given or registration is made in accordance with the act (subsection 57[3] Copyright Act). • A prior assignment of a patent is void against a subsequent assignee who has given valuable consideration unless registered in accordance with the act (section 51 Patent Act).89 • A prior assignment of a plant variety is void against a subsequent assignee who has given valuable consideration, has no knowledge of the prior assignment, and becomes the registered holder unless the prior assignee is registered before the subsequent assignee (subsection 31[3] Plant Breeders’ Rights Act). • The Trade-marks Act, Industrial Design Act, and Integrated Circuits Topography Act do not make reference to priorities, although it is not unusual to see security interests or liens recorded on such registers. Although searches on the IP federal registers are useful, the security interests and liens or hypothecs granted on IP will not always appear on those registers because (1) some of those rights might not be registered, (2) a security granted on after-acquired property, for example, cannot be registered against title of those assets on the federal registers, or (3) a backlog exists in the federal intellectual property offices. It is also very important to note that the federal IP registers will not deny registration of a subsequent assignment to a third party, even though a previous security interest might have been recorded against that asset. Moreover, they will not even give notice to the secured party of a subsequent registration of assignment or grant of security interest. In light of this, when the value of the secured assets is substantial, it is still recommended to file the security interest at both the provincial and federal registers until a clear judicial interpretation of those provisions can be obtained. To avoid these types of problems, a certain practice has developed whereby rather than taking security against IP rights of the debtor, the IP rights in question are assigned to the creditor until full payment of the loan with a license back to the debtor so he can continue to use those assets. Although this may solve the problems of having to register the security interest at both the federal and provincial registers and the need to enforce the security in case of default, the assignments impose registration on the
TAX CONSIDERATIONS 11.29
appropriate federal register by the creditor as new owner of the IP. Moreover, in the event of litigation involving the IP assets, the new owner would have to become a party to the litigation. This practice is not recommended for trademarks because of quality control obligations imposed on the owner of the trademarks by virtue of the Trademarks Act (section 50), and in most cases, the creditor is not in a position to meet such a requirement. Nor is this practice recommended for patents when the patent owner must be made a party to any action (section 55[1] and [3]) or when the licensee, suing for infringement, must make him a defendant on his refusal to join as co-plaintiff.90 Enforcement. Finally, upon the default of the debtor, the secured party will have the rights and remedies available in the applicable PPS legislation or Quebec civil code in addition to the remedies provided for in the security agreement. Generally, those rights will include taking possession of the collateral or selling such collateral with the proceeds applied in satisfaction of the loan after a certain notice period in which any interested party can remedy the default.
TAX CONSIDERATIONS
Tax considerations applicable in the evaluation of an acquisition can be very complex, especially when related to technology-based deals.91 The Canadian Income Tax Act (hereinafter the ITA) provides a number of incentives in the form of tax deductions and credits for corporations engaged actively in scientific research and development. Furthermore, the ITA provides for a number of mechanisms that may reduce the impact of the taxation process during a merger or acquisition. The following provides a brief overview of issues that may arise given the nature of the Canadian income tax system as it relates to mergers and acquisitions and intellectual property. Eligible Capital Expenditures. Of particular importance to intellectual property assets is
the concept of an eligible capital expenditure, which is defined at subsection 14(5) ITA. Such expenditures can generally be said to be intangible in nature and expenditures for which no other provision exists in the ITA, which allows for depreciation or deduction from a taxpayer’s income (which, therefore, excludes patents). Furthermore, the asset in question must have been acquired for the purpose of gaining or producing income from a business. Interpretation Bulletin IT-386R, Eligible Capital Amounts provides the following examples of the types of transactions that could result in an eligible capital amount. • • • •
A person sells a franchise or license for an unlimited period A sale of goodwill that would include trademarks or trade names A sale of a process that an individual has developed A payment made to disclose the process and allow it to be used by the payer.
Under this heading, therefore, a purchaser can deduct, over time, 75 percent of the costs of acquisition with a rate of 7 percent on a regressive base as the costs of customer lists or costs related to the acquisition of trademarks or copyrights. This includes any
11.30 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
costs related to the registration of trademarks or copyrights. Note that trademark and copyrights that have been granted for a limited time period fall into class 14 of schedule II to the income tax rules and are therefore depreciable and not deductible for the purposes of section 14 ITA. (However, any depreciation may be deducted pursuant to paragraph 21(1)(cc) ITA.) A further eligible capital expenditure is the cost of rights or licenses issued under government authority, which could include the acquisition of broadcasting licenses issued by the C.R.T.C. Depreciation of Intellectual Property Costs and Undepreciated Capital Cost (UCC).
Pursuant to paragraph 20(1)(a) ITA, a taxpayer may deduct an amount due to depreciation from certain listed capital assets. The manner in which the costs for intellectual property may be depreciated depends on the type of property in question and is governed by Part XI of the ITA and Schedule II of the Regulations, which lists the contents of each class. The method for calculating the deduction for depreciation reveals four major characteristics: 1. 2. 3. 4.
Property to be depreciated is gathered into classes.92 The deduction is calculated based on the undepreciated capital cost (UCC) of all property in a class. A taxpayer is entitled to deduct, in a given year, the maximum amount, or a lesser amount if he so chooses. There is an adjustment following sale or deduction for terminal loss to reconcile any amounts deducted for depreciation with the actual loss in value of the property.
Note that royalties and maintenance fees paid under licensing agreements for the use of a patented invention or other types of intellectual property may be deducted from current expenses. Intangible properties that do qualify as depreciable properties are listed in Class 14 (“patent, franchise, concession or license for a limited period in respect of property”) and Class 44 (“a patent, or a right to use patented information for a limited or unlimited period”). A class 44 asset can be treated as a Class 14 asset (if it has a limited life) or as an eligible capital expenditure (if it has an unlimited life), if the taxpayer so elects. Because the Class 44 capital cost allowance rate is 25 percent (declining-balance), which allows for a relatively fast writeoff, it is usually advantageous to treat the asset as a Class 44 asset.93 The costs of acquisition of a patent, which can be grouped either under class 14 or class 44, may be depreciated either linearly at a rate of 10 percent over 10 years or at a rate of 25 percent using regressive depreciation, for example. Alternatively, an amount may be deducted each year based on the use made of the patented invention. The costs of acquiring a copyright for a limited time may be depreciated linearly according to class 14. In the event that the term of usage is for an unlimited duration, 75 percent of the costs of acquisition may be depreciated using a regressive depreciation of 7 percent. Similar to copyright, 75 percent of the costs of acquisition of trademarks may be depreciated using a regressive depreciation of 7 percent. In addition, the costs of acquisition of a trademark may be depreciated according to its use.
TAX CONSIDERATIONS 11.31
The case is similar for licenses of all of the previously discussed types of intellectual property, excluding software. In the case of software, the license may be amortized in the first year (i.e., a 100 percent deduction), except for operating system software, pursuant to class 12. The costs of acquisition of system software may be depreciated using a regressive rate of 30 percent, pursuant to class 10. A supplementary accelerated depreciation applies in Quebec. Know-how purchased in the form of services may be deducted as a current cost. The purchase of rights to access information may, in some cases, be depreciated as an eligible capital expense (i.e., 75 percent of the acquisition costs amortized using a regressive depreciation with a rate of 7 percent). Undepreciated Capital Cost. As previously stated, one of the major concepts used in the
ITA in dealing with the acquisition and disposal of capital assets is that of undepreciated capital cost (UCC) and a notional UCC account. When the taxpayer acquires an asset of a particular class, the UCC of that class is increased by an amount equal to the costs of acquisition. Likewise, when a taxpayer disposes of a depreciated asset of a particular class, the lesser of the proceeds of sale or capital cost of the asset must be deducted from the UCC account of that class. In the event that the notional UCC account is negative following the disposal of an asset, the negative amount must be added to the taxpayer’s income for the tax year in question. In this way, tax deductions granted for capital assets that are eventually sold at a premium are grabbed back by Revenue Canada. The taxpayer can avoid having to declare the negative balance as income by purchasing additional assets of the same class, thus raising the UCC of that class. In the event that an amount still remains in the notional UCC account following disposal of all assets of a class, the terminal loss provisions of subsection 20(16) ITA take effect. This notional amount is deducted from income as a terminal loss. Any disposition of an asset in excess of its capital cost will result in a capital gain equal to the excess. Capital gains are taxed in accordance with paragraph 39(1)(a) ITA. In addition, special considerations exist with respect to capital cost for assets purchased other than at arm’s length. Subparagraph 13(7)(e)(i) ITA deems the capital cost of assets acquired in such a transaction to be the same as the capital cost of the assets immediately prior to transfer, plus any capital gain realized by the transferor on the assets (but only to the extent that a capital gains exemption was not applied to the capital gain). Scientific Research and Development. A large number of corporations are involved in
scientific research and development in Canada, in large measure because of generous tax incentives offered by both Federal and Provincial governments. The combination of relatively low rates of corporate taxation and the benefits of tax credits on the purchase of some types of equipment are of particular advantage. Advantages under the Income Tax Act. The Income Tax Act provides broad incentives to encourage scientific research and experimental development in Canada. What Revenue Canada considers scientific research and experimental development is defined in considerable detail by regulation 2900 of the Income Tax Regulations. Subregulation 2900(1) provides an overview definition of scientific research and development as
11.32 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
“systematic investigation or search carried out in a field of science or technology by means of experiment or analysis.” Subregulation 2900(1) goes on to define scientific research and development more precisely as: • Basic research, namely work undertaken for the advancement of scientific knowledge without a specific practical application in view • Applied research, namely work undertaken for the advancement of scientific knowledge with a special practical application in view • Development, namely use of the results of basic or applied research for the purposes of creating new, or improving existing, materials, devices, products, or processes The federal government offers two principle types of benefits for corporations engaged in scientific research and development: deductions for all expenses related to, and tax credits for investments made in, scientific research and development. Deductions—Section 37 ITA. Expenditures of a current and capital nature relating to
scientific research and development carried on in Canada may be deducted in calculating the income from a business carried on by the taxpayer for the year in which the expenditure is made, or may be rolled over and deducted in any subsequent year. This includes all expenses but generally excludes expenses related to the acquisition or lease of immovables (except in the case of “special purpose buildings,” which are essentially clean rooms with strict requirements as to the number of airborne particles allowed). Section 37 ITA does not permit the deduction of capital expenditures for scientific research and development made outside of Canada. However, section 37(2) ITA allows for a deduction for current expenditures incurred outside of Canada in the year the expenditure was made, provided the scientific research and development was undertaken by or on behalf of the tax payer and is related to his business. Investment Tax Credit—Section 127 ITA. The investment tax credit is available for
expenses related to scientific research and development carried out in Canada. The credit is of either 20 or 35 percent and varies as a function of the type of business engaged in, its taxable capital, and taxable revenues, as well as those of any affiliates. Withholding Tax When Purchasing Intellectual Property Assets. It is possible to structure
the purchase of an Intellectual Property asset in one of three ways: 1. 2. 3.
A lump-sum payment Payments by installments Royalties
The tax implications will vary depending on the manner in which the assets are acquired. Furthermore, paragraph 212(1)(d) ITA, in general, levies a withholding tax of 25 percent on rent, royalty, or similar payments made by a resident—although in certain cases a nonresident is deemed a resident for the purposes of the Act, (see subsections 212(13), (13.1) & (13.2) ITA)—to a nonresident for the purposes of:
TAX CONSIDERATIONS 11.33
• Obtaining the right to use a trademark, patent, secret formula, or a number of other types of intellectual property (subparagraph 212(1)(d)(i) ITA) • Services of an industrial, commercial, or scientific nature performed by a nonresident in which the total amount payable as consideration is dependent on the use or benefit to be derived from those services, production, or sales or profits, but not including a payment for services in connection with the sale of property or the negotiation of contract (subparagraph 212(1)(d)(iii) ITA) • Obtaining a negative covenant not to use or permit others to use any of those items previously listed (subparagraph 212(1)(d)(iv) ITA) However, this withholding tax does not apply in the case of royalties or similar payments made with respect to a copyright for the production or reproduction of any literary, dramatic, musical, or artistic work (subparagraph 212(1)(d)(vi) ITA). These withholdings may be reduced generally to 10 percent by the application of tax treaties. The withholding tax also does not apply in the case of an outright purchase of a patent, the assignment of an existing license, or a lump-sum payment made for the purpose of obtaining an exclusive right to distribute certain products.94 It is also of note that the withholding tax does not apply to payments made for the use of intellectual property outside of Canada (see, again, subparagraph 212(1)(d)(i) ITA). In the case of computer software, However, which is protected under the Copyright Act as a literary work, it is Revenue Canada’s opinion that when the taxpayer has obtained an end-user license to use a computer program that includes the right to make copies for his own personal use, such a taxpayer is not making use of a copyright but is rather exercising his rights under the license agreement, so the exception does not apply. Pursuant to Article XII, paragraph 4 of the Canada-U.S. Tax Treaty, services are excluded from the definition of royalties. As the treaty takes precedence, it overrides the subparagraph 212(1)(d)(iii) that expressly includes services. The provisions related to business profits of the Canada-U.S. Tax Treaty therefore apply to services, and no withholding tax will be levied against payments made by a resident to a nonresident in their regard. Non Arm’s Length Transfers. In the event that the transfer of an intellectual property
asset is not at arm’s length, and the consideration received for the asset is less than the fair market value of the assets, then the deeming provision of paragraph 69(1)(b) ITA applies, and the vendor is deemed to have received fair market value for the asset. Tax-Free Transfers of Property to a Corporation. The Minister of Revenue taxes 50 percent of all capital gains at the taxpayer’s rate, which may result in some onerous tax consequences to a vendor during a transaction that includes the acquisition of a capital asset that has appreciated in value since its initial acquisition. If the intellectual property is depreciable or an eligible capital property, the transfer could trigger a recapture of deductions claimed for depreciation; this does not apply only to capital gains. If the intellectual property is capital property to the transferor, the gain will be a capital gain and half95 of the gain will be taxed. If the intellectual property is eligible capital property, it could be taxable as income on half96 of the recaptured amount. If the intellectual
11.34 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE
property is depreciable or an eligible capital property, the transfer could trigger a recapture of deductions claimed for depreciation. Section 85 ITA provides a rollover mechanism by which a corporate asset may be transferred on a tax-deferred basis to a taxable Canadian corporation. To take advantage of the rollover, the taxable Canadian corporation, as defined in section 89(1) ITA, makes an election, provided consideration paid for the asset includes shares in the corporation. The election is not automatic and must be made in the form and within the time limits prescribed by subsection 85(6) ITA. Pursuant to subsection 85(1) ITA, any eligible property may be subject to a section 85 election. Eligible property is defined in subsection 85(1.1.) ITA and, given the inclusion of eligible capital property (among a number of others) in the definition, provides for the rollover of goodwill and other intangibles such as intellectual property acquired via an eligible capital expenditure. In the absence of section 85 ITA, the transfer of property to a corporation is a taxable transaction. In such a case, the proceeds of the disposition are equal to the value of the consideration received for the asset. This may result in a capital gain, capital loss, recapture of capital cost allowance, or even ordinary income if, for example, the assets sold are inventory. Where the transferor and transferee corporations do not operate at arm’s length, paragraph 69(1)(b) ITA operates to deem the proceeds of disposition to be no less than the fair market value of the property transferred. This gives rise, in the case of nondepreciable capital property, to a capital gain or loss to the extent of the difference, if any, between the proceeds of disposition and the cost of the property transferred. Paragraph 85(4)(b) ITA provides that in computing the adjusted cost base of all the shares of the transferred corporation owned by him immediately after the disposition, there shall be added the amount of the loss. In some cases when the fair market value of an asset exceeds the cost, it is not desirable to make an election under subsection 85(1) ITA. This is potentially the case where a transferee has capital losses from other transactions where the transfer can be adjusted to take advantage of those capital losses. The adjusted cost base of the asset as held by the transferor would be increased. Divisive Reorganizations. The ITA does not provide for any direct distribution of assets
to shareholders who do not give rise to tax consequences. However, by structuring the transaction in a manner such that the rollover of subsection 85(1) ITA may be applied, in situations involving a divisive reorganization the taxation event may be deferred. The basic form of the transaction is as follows: the assets (typically a division of the selling corporation) are transferred to the purchasing corporation in exchange for preferred shares with a redemption value equal to the fair market value of the assets in an arm’s length transaction.97 The selling corporation makes an election under subsection 85(1) ITA such that the cost base of the preferred shares issued to the purchaser is the cost of the assets. The preferred shares are redeemed whereby the vendor corporation receives a tax-free dividend equal to the fair market value of the shares. Generally, redemption of the preferred shares in such a transaction would give rise to a deemed dividend pursuant to subsection 55(2) ITA. However, during a divisive reorganization, paragraph 55(3)(b) ITA acts to stop the application of subsection 55(2) ITA. Paragraph 55(3)(b) ITA only applies where the selling corporation is wound-up or
TAX CONSIDERATIONS 11.35
all shares in the selling corporation held by the purchasing corporation are redeemed. Furthermore, subsection 55(2) does not apply in the case of transfer of assets between related corporations, as this is not a disposition of property to an unrelated party, and therefore, the test in subparagraph 55(3)(a)(i) ITA is not met. Doing the Bump during Corporate Reorganizations. Subsection 88(1) ITA provides a mechanism that may be used to selectively increase the cost basis of assets of a target corporation during a friendly takeover. This is referred to as bumping the (adjusted) cost base of the assets in question. In a takeover situation, the target corporation may be wound-up or merged with the bidder, but the cost of the target’s shares may be transferred to any eligible capital property. The essential elements of the transaction are (1) prior to the winding up or merger, the target transfers the assets in question to a subsidiary. (2) During the merger with or winding up of the target, the bidder transfers the cost of the target’s shares onto the shares of the subsidiary, increasing the cost basis of these shares. (3) If the shares in the subsidiary are disposed of to a third party at a later date, any potential capital gains that may have arisen from the disposal will have been decreased by an amount equal to the value of the target shares transferred to the subsidiary’s shares. Liability for Unpaid Tax. As previously stated, nonresidents are subject to tax on certain investment income derived from Canadian sources. Part XIII (sections 212 to 218.1 ITA) imposes a flat rate (generally 25 percent) on gross amounts. In particular, subparagraph 212(1)(d)(i) ITA requires the payment of a withholding tax of 25 percent on payments in regard to certain types of intellectual property made to a nonresident. The question of residency is one of fact and depends upon the specific facts of each case.98 The Part XIII flat rate tax exhibits three main characteristics:
1. 2.
3.
A nonresident must be paid or credited, or deemed to be paid or credited, an amount by a person resident in Canada. The amount must be credited as, on account of, or in lieu of payment or satisfaction of specified types of amounts including, but not limited to, the payment of interest, dividends, rents, or royalties (as set forth in section 212 ITA). Specified percentages of the amounts are payable by the resident person as a withholding tax on behalf of the nonresident.
It should be noted that the Part XIII withholding tax of 25 percent is often reduced by tax treaty, of which there are a large number in force at any given time, with the reduction often dependent on the type of investment involved. The Canadian resident acts as an agent of the Revenue Canada in collecting tax under Part XIII from the nonresident. Subsection 215(6) ITA provides that, when a person fails to deduct or withhold an amount as required by Part XIII, he will be liable to pay the whole amount not withheld. The subsection also allows the tax paid on behalf of the nonresident to be recovered from him or her. Failure to deduct or withhold may also result in a penalty pursuant to subsection 227(8) ITA being levied as well as interest pursuant to subsection 227(8.3) ITA on the amounts not withheld. In general, it can also be said that this is the case, notwithstanding that the failure to withhold was due to a bona fide error.
11.36 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE ENDNOTES 1
Authors: François Painchaud (Partner), Louis-Pierre Gravelle, Panagiota Koutsogiannis, Christian Danis, and Mari-Ève Côté (Associates) of LÈGER ROBIC RICHARD Lawyers and ROBIC Patent and Trademark Agents. The authors wish to acknowledge the assistance of Marcel Naud in the preparation of this chapter. 2 Patent Act, R.S. 1985, c. P-4, http://laws.justice.gc.ca/en/P-4/index.html. 3 Copyright Act, R.S.C. 1985, c. c-42, http://laws.justice.gc.ca/en/C-42/index.html. 4 Trade-marks Act, R.S.C. 1985, c. T-13. http://laws.justice.gc.ca/en/T-13/index.html 5 Industrial Design Act, R.S., 1985, c. I-9. http://laws.justice.gc.ca/en/I-9/index.html. 6 Integrated Circuit Topography Act, 1990, c. 37. http://laws.justice.gc.ca//en/I-14.6/index.html. 7 Plant Breeders’ Rights Act, 1990, c. 20. http://laws.justice.gc.ca/en/P-14.6/index.html. 8 George S. Takach, High Tech M&A: The Preparation Stage, Lexpert, (April 2000) 109. 9 Robert Michelin, “Establishing ownership in intellectual property: Due diligence requirements,” Journal du Barreau, (October 1, 1997) 21. 10 Cynthia Ledgley, Examining Pros and Cons of Intellectual Property Audits, Intellectual property, Federated Press, Vol II, No. 4, 103. 11 Competition Act (R.S. 1985, c. C-34), http://laws.justice.gc.ca/en/C-34/index.html. 12 http://strategis.ic.gc.ca/ssg/ct01250e.html. 13 Competition Bureau, Merger Enforcement Guidelines, January 24, 1997 (hereinafter the Merger Guidelines). 14 Section 111 and 113 of the Competition Act. 15 Section 123 of the Competition Act. 16 Donald Cameron and Iain Scott, Competition Law for the 21st Century (Huntington, NY: Juris Publishing, 1998) 343–344. 17 Adrian Smith, “Intellectual Property and Managing Legal Risk,” Patent World (November 1997) 2528. 18 Joan Van Zant, Due Diligence Searching...Searching...Searching...Prior Art and Prior Rights (Toronto: Scott & Aylern, date). 19 Supra, note 2. 20 See Harvard College v. Canada (Commissionner of Patents), 7 C.P.R. 4th 1. 21 See article 33 of the Agreement on Trade-Related Aspects of Intellectual Property Rights, Annex 1C of the Marrakesh Agreement Establishing the World Trade Organization, signed in Marrakesh, Morocco, on 15 April 1994. www.wto.org/english/tratop_e/trips_e/t_agm0_e.htm. 22 April 2, 2001. www.internationallawoffice.com/Ld.cfm?Newsletters_Ref=3258. 23 Paris Convention for the Protection of Industrial Property (March 20, 1883), as revised at Brussels on December 14, 1900; at Washington on June 2, 1911; at the Hague on November 6, 1925, at London on June 2, 1934; at Lisbon on October 31, 1958; and at Stockholm on July 14, 1967. 24 Constitution Act of 1867, 30 and 31 Vict., U.K., c.3, Section 92(13). 25 Pointer v. Six Wheel Corp. (1949) 177 F. (2d) 153. 26 Piper v. Piper (1904) 3 O.W.R. 451 (O.C.A.); Harold G. Fox, “Canadian Patent Law and Practice,” 4th ed. (Toronto: Carswell, 1969) 229. 27 Paragraph 31(5) the Patent Act. 28 D. Patrick O’Reilly, “Joint Ownership of Patents in the United States,” article adapted from Chapter 1 of Drafting Patent License Agreements, 4th ed. (Washinton D.C.: Bureau of National Affairs, 1998). 29 Article 1015 C.C.Q.
ENDNOTES 11.37 30
See Mathers v. Green (1865), 35 L.J. Ch. 1 (Chan. Div.) and Steers v. Roger [1893] A.C. 232 (H.L.). Marchland v. Péloquin (1978), 45 C.P.R. (2d) 48 (Q.C.A..), 60. 32 Forget v. Specialty Tools of Canada, Inc. (1996), 62 C.P.R. (3d) 537 (B.C.C.A.) [hereinafter Forget]. 33 Mathers v. Green, supra note 31. 34 S.50(3) & 51 Patent Act. (Section 51 of the Patent Act states that any assignment is void against any subsequent assignee unless the assignment of license is registered as prescribed before registration of the instrument on which the subsequent assignee claims.) Canadian Patent Office, http://strategis.ic.gc.ca/sc_mrksv/cipo/contact/t_list-e.html#patent. 35 S.50(2) Patent Act. 36 Forget, supra note 33. 37 Article 1022 C.C.Q. 38 Article 1015(2) C.C.Q. 39 Article 1023 C.C.Q. 40 Supra, note 35. 41 Canadian Patent Database, http://patents1.ic.gc.ca/intro-e.html. 42 Trade-marks Act, R.S.C. 1985, c. T-13. http://laws.justice.gc.ca/en/T-13/index.html 43 See section 92(11) Constitution Act, 1867. http://laws.justice.gc.ca/en/const/index.html. 44 Supra, note 24. 45 S.C. 1993 c. 15, section 69 and section 50. 46 See section 406 and following of the Canadian Criminal Code, L.R.C. 1985, Ch. C-46. 47 Consumer Packaging and Labelling Act, (R.S. 1985, c. C-38). http://lois.justice.gc.ca/en/C38/32545.html. 48 Trade-mark Office; http://strategis.ic.gc.ca/sc_mrksv/cipo/tm/tm_main-e.html. 49 Canadian Trade-mark Database, http://strategis.ic.gc.ca/cgi-bin/sc_consu/trade-marks/search_e.pl. 50 Supra, note 3. 51 Supra, note 44. 52 Subsection 57(3) of the Copyright Act. 53 R.S.C. 1985, c. B-3. http://laws.justice.gc.ca/en/B-3/index.html. 54 Sheldon Burshtein, Intellectual Property Due Diligence in Commercial Transactions (1994), 11 CIPR 91 at p.120. 55 Pierre Coté and Alexis Bergeron, La proprieté intellectuelle au Quebec: financement et réalisation (Ontario, Canada: McMaster-Meighan, 1998). 56 Institute of Law Research and Reform, Trade Secrets, Report No. 46 (Edmonton: Institute of Law Research and Reform, 1986) 256. 57 [1988] R.J.Q. 1636 at 1653. 58 [1967] R.P.C. 375 at 377. 59 See Gideon et Gideochem Inc. v. Tri-Tex Co. Inc. [1999] RJQ 2324 (C.A.); [1999] REJB 1426 9C.A.). In this case, the court cancelled a writ of seizure before judgment by which the plaintiff was claiming, as owner, trade serets that it assimilated to moveable property. The Court of Appeal confirmed that a trade secret is not moveable property as defined at article 734(1) of the Quebec Code of Civil Procedure. 60 Supra, note 5. 61 Supra, note 6. 62 Supra, note 7. 31
11.38 INTERNATIONAL M&A: THE CANADIAN PERSPECTIVE 63 Article 31(1) of the Plant Breeders’ Rights Act provides that the Commissioner shall be, in the prescribed manner and within the prescribed period after the holder of plant breeder’s rights has assigned them, (a) informed of the name and address of the assignee; and (b) furnished with such proof of service of a notice of the assignment on any person granted any of those rights by license under section 32 as is prescribed or as the Commissioner, in the absence or in lieu of anything so prescribed or in addition thereto, requires. 64 Broadcasting Act, (1991, c.11) http://laws.justice.gc.ca/en/B-9.01/index.html 65 See http://www.hc-sc.gc.ca/hpb-dgps/terapeut/ 66 Food and Drug Act, (R.S. 1985, c. F-27), http://laws.justice.gc.ca/en/F-27/54218.html 67 (1989), 26 CPR 97 (SCC). 68 (1948), 65 RPC 203 (CA). 69 See section 49 of the Patent Act. 70 See section 50 of the Patent Act. 71 See section 50 of the Patent Act. 72 See section 31 of the Plant Breeders’ Act. 73 See section 50 of the Trade-marks Act. 74 See section 13(4) of the Copyright Act. 75 See section 13(4) of the Copyright Act. 76 See section 13 of the Industrial Design Act. 77 See section 13 of the Industrial Design Act. 78 Robert Michelin, “Establishing ownership in intellectual property: Due Diligence Requirements,” Journal du Barreau (October 1, 1997) 21. 79 See I.G.U. (Ingraph) Inc. v. L.B.GP. Consultants Inc. (1990), J.E. 90–1224 (Q.C.S.); Stéphane Gilker, “Le locus standi du titulair d’une licence de droit d’auteur: Une question d’intérêt,” (1989), 1 C.P.I. 1. 80 See article 1851 of the Civil Code of Quebec. 81 This topic, not being the objective of the present text, will not be discussed in more detail. 82 Supra, note 32 et 33. 83 Supra, note 32. 84 Supra, note 33. 85 Article 1026 C.C.Q. 86 Ontario Personal Property Security Act, R.S.O. 1990, P-10, section 7(1). 87 Ontario Personal Property Security Act, R.S.O. 1990, P-10, section 7(4). 88 For example, in Quebec, the Register of Personal and Moveable Property (R.P.M.P.) and in Ontario, the Personal Property Security Registration System (P.P.S.R.) 89 See Les poinçons de Waterloo v. 3288731 Canada inc., Quebec Court of Appeal, Court file 500–09–006534–986. 90 See Pitney Bowes, Inc. v. Yale Security (Canada), Inc. (1987), 80 N.R. 267 (FCA); Bloc Vibre Québec, Inc. v. Enterprises Arsenault & Frères, Inc. (1983) 76 C.P.R. (2d) 269 (F.C.T.D.) 91 George S. Takach, High Tech M&A: The Preparation Stage, Lexpert, (April 2000) 109. 92 There appears to be an attempt to classify assets according to their normal expected life. 93 Peter W. Hogg and Joanne E. Magee, Principles of Canadian Income Tax Law (1995) 248. 94 The Queen v. Farm Part Distributing Ltd., 80 DTC 6157 (FCA). 95 For taxation year ending after October 17, 2000. 96 Under proposals of changes made on 12–21–2000, a choice could be made to tax the amount as cap-
ENDNOTES 11.39 ital. The choice could be made for taxation years ended after February 27, 2001. 97 Some restrictions apply. For example, the assets can only be divided between shareholders pro-rata based on shareholdings. Furthermore, 3 types of property are foreseen, and each of these must be divided equally pro-rata with shareholdings. 98 See e.g., Denis M. Lee v. MNR, [1990] 1 CTC 2082, 90 DTC 1014 (TCC) and IT-221R2 “Determination of an Individual’s Residence Status for a list of factors that are taken into account when determining residency.”
CHAPTER
12
INTERNATIONAL MERGERS AND ACQUISITIONS: THE EUROPEAN PERSPECTIVE Benedict Bird, Anna Carboni, and Deborah Lincoln Linklaters & Alliance1
INTRODUCTION
In any merger or acquisition in which intellectual property rights (IPRs) are significant to the business being transferred, the objective is to ensure that the buyer acquires all the IPRs necessary for the merger to continue the business acquired without risk of third-party challenges or challenges by the seller. This chapter deals with the approach (from an English law perspective) that private practitioners, in-house counsel, and other business people involved in international mergers and acquisitions should take time to check the scope and strength of the target’s IPRs and whether third parties have IPRs that might be infringed by the target’s goods or services. The chapter then discusses how issues arising from this due diligence should be dealt with at signing (assuming that the buyer still wishes to acquire the target) and the formalities required to effectively transfer title to the IPRs. The chapter also provides an overview of EC competition law. This is relevant because the target’s contracts (and, depending on its market power, practices) must be reviewed for compliance as part of the due diligence exercise. Not only can competition law limit the exploitation of IPRs (thereby affecting the value of the transaction), but infringements of EC competition law can expose the purchaser, the target, or the entity providing the warranties to the risk of fines, injunctions, damages, and unenforceability. If the merger or acquisition might be subject to EC merger control, the likelihood of clearance must also be considered. Finally, the chapter includes short sections from lawyers in France and Germany, which provide their perspectives on the earlier parts of the chapter. STRUCTURE OF THE TRANSACTION
A merger or acquisition may take one of many forms, but it essentially will involve a sale of assets, a sale of shares, or a combination of the two. 12.1
12.2 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Private Acquisition of Shares. In a private acquisition of shares, the buyer acquires the shares in the target. Because the target’s assets continue to be owned by it, no separate transfer of IPRs is required, except when another company in the seller’s group owns the IPRs that will be needed by the buyer to continue to run the target’s business. Private Acquisition of Assets. In a private acquisition of assets, the buyer acquires the assets of the target business. Title to (or the right to use) each asset, including each IPR, must be transferred by way of assignment or granted by way of license. Private Acquisition of Part of a Business. This is much the same as the acquisition of a
complete business, but the transfer of IPRs may be more complicated if the seller wants to continue to use some of the target’s IPRs in his retained part of the business. Public Offer. In a public offer, the buyer makes a written offer to each of the share-
holders of a listed company to purchase the shares in that company. The shareholders may be offered cash or shares in the buyer or acquisition vehicle as consideration. When the takeover bid is hostile and the advances of the prospective buyer are unwelcome to the target, the buyer will have no access to the company’s internal documents and records. The buyer, therefore, will not have available to him detailed information about what he is buying. Furthermore, when the number of shareholders in a listed company is large, the buyer will probably be unable to negotiate warranties and indemnities with them. Merger. A merger usually involves the coalescing of two or more companies of approx-
imately the same size. This can be achieved in various ways. One way is for the shareholders of the merging companies to exchange their shares in the merging companies for shares in a new holding company. When this approach is practicable, the principles previously discussed in relation to a private acquisition of shares apply. Another way to achieve a merger is for the merging companies to transfer their assets to a new company and then have the new company issue shares to them. The two existing companies are then liquidated so that their assets—the shares in the new company—are distributed to shareholders. When this approach is practicable, the principles discussed in relation to a private acquisition of assets applies. A third way of effecting a merger is by a scheme of arrangement. This method may be used where the other two approaches are not practicable—for example, where a significant number of shareholders exists. Demerger. A demerger is the segregation of business activities into one or more com-
panies or groups of companies. Often, shares in the demerged entities are held by the same persons in the same proportions following the demerger. One reason for a demerger is to facilitate the sale of part of a business to third parties. An English company can effect a demerger by means of a dividend in specie—a reduction of capital, a liquidation, or a scheme of arrangement. The first and second types of demerger can be carried out (1) by shares in a subsidiary holding the business to be demerged being distributed or transferred directly to shareholders of the company carrying out the
DUE DILIGENCE 12.3
demerger; or (2) by the relevant business being transferred to a new company or third party, which then issues shares to that company’s shareholders. Depending on which method is adopted, the comments made previously in relation to a private acquisition of shares or a private acquisition of assets will apply. Joint Venture. A joint venture is a commercial arrangement between two or more eco-
nomically independent undertakings involving the establishment of a limited liability company, a partnership (or limited partnership), or a contractual collaboration pursuant to an agreement. If a limited liability company is chosen, the joint venture will be achieved either by the subscription by one or more parties for shares in another or by one or more parties transferring assets, which may include IPRs, or businesses to an existing or newly formed company in return for shares in that company. Scheme of Arrangement. Under Section 425 of the Companies Act 1985, a company
may make a compromise or scheme of arrangement with its members, a class of its members, its creditors, or a class of its creditors.2 This procedure can be used to carry out many of the nonhostile transactions listed previously—for example, a private acquisition of shares, a merger, or a demerger.3 When a public company is involved, certain additional requirements may apply.4 It is possible to effect a change of ownership in shares by reducing the target’s capital and thereby cancelling all the shares in the target which are not already owned by the buyer. The buyer then pays the consideration to the target’s shareholders for the cancellation of their shares, and the reserve created by the cancellation is capitalized and applied in paying up new shares that are issued by the target direct to the buyer. Another way of accomplishing a change of ownership of the shares under a scheme of arrangement is by transferring shares not already in the ownership of the buyer to the buyer. DUE DILIGENCE Purpose and Method of Due Diligence. Whether or not the buyer is proposing to pur-
chase a company or assets, its objectives during the intellectual property due diligence exercise will be the following: 1. 2. 3. 4.
To identify all relevant and material IPRs used or owned by the business To identify any material problems or defects, such as title or infringement problems or third-party rights To ensure that such rights receive appropriate treatment during the transaction to enable the relevant IPRs to be transferred To identify which warranties or indemnities it should be seeking
The seller may also want to conduct a due diligence exercise to establish which warranties it can give and which disclosures need to be made against them and to ensure that only those IPRs that it intends to transfer are transferred. There are many different ways in which a due diligence exercise can be carried out. Formal due diligence reports are now commonly required in the United Kingdom, although the process is generally not as extensive as the process conducted by U.S. lawyers. Often clients request that reports be on an exceptions-only basis—that is, limited
12.4 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
to identifying gaps in title to IPRs, conflicting third-party rights, and any other issues that could pose problems to the purchaser in running the target post-acquisition, in which case they will focus on the key IPRs owned by or licensed to (or by) the company and significant problems with such IPRs. The buyer’s legal advisers used to send a due diligence questionnaire (specifically tailored to the transaction in question) to the seller’s legal advisers, and then the seller would produce documents in response to the questions. It is now far more common to have a data room, assembled by the seller in advance, containing all of the materials that the seller considers relevant to the company or business being sold. Access to data rooms is almost always governed by the terms of a confidentiality agreement that is entered into in advance. The buyer’s legal advisers review the data room index of documents prepared by the seller’s legal advisers. If at that stage it is clear that there are gaps in the supplied documents, a questionnaire may be issued to the seller’s legal advisers. Information will not be provided or sought for each and every IPR, but for only those that are material in the context of the transaction. There is no standard way of measuring materiality, but materiality of an IPR is sometimes expressed in terms of the cost of replacing it, the amount of turnover that it generates, or the loss that the business would suffer if it were deprived of the right. This also involves considering which products or services are important to the business in which countries. Ideally, the buyer and the seller will reach agreement on this level of materiality. However, through the due diligence exercise, one can never ascertain with absolute certainty the scope or validity of particular IPRs. For example, one cannot be sure that one has identified all of the prior art that may be relevant to the validity or otherwise of a patent. Similarly, searches of a register of IPRs will not reflect the possibility of attack for non-use of a trademark, recent registrations, or changes in ownership. Searching is an open-ended activity because no limit exists to the amount that can be done, time and cost permitting. The important thing is to conduct an appropriate level of due diligence, given the value and nature of the target. In some cases, for example, where knowledge of an impending sale might damage the business or where the seller wishes to achieve a quick sale, the seller may deny the buyer any meaningful cooperation or assistance with due diligence. In such cases, the buyer will be relying almost totally on the warranties, indemnities, and disclosures made by the seller in the sale agreement and the Disclosure Letter—that is, apart from whatever information the buyer can glean from public records and industry sources. Confidentiality and Privilege. Confidentiality issues often arise in due diligence exer-
cises. One such issue is that documents provided by the seller or the target often contain confidential information or have confidentiality provisions governing their use and disclosure to third parties. The implications of this need to be considered by the seller before such documents are disclosed to the other side. Another issue is that legally privileged documents created for the purposes of obtaining legal advice or in contemplation of litigation may lose their privilege when they, or copies of them, are disclosed to other parties. Copies made for the purpose of a disposal will probably not attract privilege and would have to be disclosed if litigation arose. Special arrangements should be made for the inspection of original docu-
DUE DILIGENCE 12.5
ments concerning actual or potential disputes if there is any likelihood that they may become discoverable. If foreign jurisdictions are involved (especially the United States), advice from local legal advisers is sometimes required. Registrable Rights. English law provides for registration of national patents, trade-
marks, and designs. The relevant statutes are the Patents Act 1977, the Trade Marks Act 1994, and the Registered Designs Act 1949 (in each case, as amended by subsequent legislation). As with other parties to the Madrid system for the international registration of marks, English law also provides for the protection of international trademark applications and registrations that designate the United Kingdom. All of the member states of the European Union provide for the registration of national patents, trademarks, and designs, but lawyers increasingly have to consider Community-wide registered rights as well. Community trademarks have been available since April 1, 1996, under Council Regulation 40/94/EEC; there is a proposal to create a Community registered design right (see Amended proposal for a Council Regulation on Community Design—COM [2000] 660 final, 20.10.2000); and there is also a proposal to create a Community-wide patent by the end of 2001—COM (2000) 412—although this deadline is now recognized to be unrealistic. Patents. A patent is a statutory monopoly right granted for an invention to an individ-
ual or company (the patentee), which gives the patentee the exclusive right to work the invention (for example, by making, using, marketing, or licensing the product or process that embodies the invention) for 20 years. Renewal fees are payable annually from the end of the fourth year. A patent will be granted only when the invention is novel (that is, it has not been made available to the public anywhere in the world by written or oral description, by use, or in other ways) and involves an inventive step (that is, a step that is not obvious to a person skilled in the relevant art in the light of the common general knowledge). The invention must also be capable of industrial application (that is, being made or used in any kind of industry, including agriculture) and not in an excluded category. The scope of the exclusive right is defined by claims (a series of numbered paragraphs appearing at the end of the specification in the application), which distinguish the invention from what is already known. Patents can be revoked in separate proceedings under Section 72 of the Patents Act 1977 or as a result of a counterclaim in an infringement action or in other circumstances (see Section 74). A patent may be revoked on these five grounds: (1) the invention is not a patentable invention; (2) the patent was granted to a person not entitled to it; (3) there is insufficiently clear and complete disclosure to the skilled person; (4) the specification goes beyond that disclosed in the application; or (5) the protection conferred by the patent has been extended by an improper amendment.5 Supplementary Protection Certificates. If the target company is a pharmaceutical or biotechnology company, it may have acquired supplementary protection certificates (SPCs). SPCs may be granted under two EU Regulations for pharmaceutical products and plant protection products. These are available to extend the period of patent protection for a maximum of five years, thereby granting a maximum of 15 years protection
12.6 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
from the initial marketing authorization. This is intended to compensate proprietors for the time lapse between the submission of an application for patent protection and the obtaining of marketing authorization. Trademarks. The proprietor of a registered trademark has an exclusive right to use the
mark for the goods and services covered by the registration (and other goods and services in the case of well-known marks). A trademark means any sign capable of being represented graphically that is capable of distinguishing goods or services of one undertaking from those of other undertakings. A trademark may consist of words (including personal names), designs, letters, numerals, the shape of goods, or their packaging. Registration of a trademark may be refused on absolute or relative grounds. The main absolute grounds for refusal are (1) the mark is devoid of any distinctive character (for example, because it is wholly descriptive of the products or services); (2) the mark describes some attribute or quality of the goods or services for which application is made (the kind, quality, quantity, intended purpose, value, geographic origin, or time of production of goods or of rendering of services); and (3) the mark consists exclusively of signs that have become customary in the current language or in the bona fide and established practice of the trade.6 Registration of a U.K. trademark (or an international application designating the United Kingdom) can also be refused on relative grounds based on conflicts with earlier marks, which include U.K. registered and unregistered marks, community trademarks, or international trademarks that have effect in the United Kingdom. Community trademarks, in line with most of the other national European trademark systems, are not examined on relative grounds. This leaves it up to the owner of any prior conflicting rights to challenge them by way of opposition or cancellation action. The scope of a registered trademark is defined by reference to the list of goods and services included in its specification, but the scope can extend more broadly in the case of well-known marks. Both the U.K. and Community trademarks are initially registered for 10 years and are renewable for further periods of 10 years ad infinitum. The grounds on which a trademark can be revoked for invalidity are the same as the absolute and relative grounds for refusal of registration.7 Any person who is aggrieved may apply for revocation.8 There are four other grounds for revocation: (1) There has been no genuine use within five years from the date of actual registration; (2) nonuse for five continuous years; (3) the mark has become generic (for example, the word is used as a noun or a verb and is not differentiated from the proprietary name); and (4) the mark is liable to mislead the public by reason of the use made of it (such as licensing out to various parties with insufficient quality control). Designs. Two European initiatives are changing the position with regard to the protection of designs. These are the following:
• The Designs Directive (98/71/EC), which aims to harmonize the main features of national laws covering the protection of designs by registration • The Community Design Regulation (COM (2000) 660)
DUE DILIGENCE 12.7
Although the Community Design Regulation is still a draft, the Designs Directive must be implemented into U.K. law by October 28, 2001. The proprietor of a registered design right has an exclusive right to reproduce the design for commercial purposes. Such a design is currently defined as having “features of shape, configuration, pattern or ornament applied to an article by any industrial process, being features which in the finished article appeal to and are judged by the eye.”9 Implementation of the Designs Directive will require a broader definition; “eye appeal” will no longer be required, nor will it be required that the design is applied by any industrial process. Implementation of the Directive will add a new requirement that the design have individual character (as defined).10 Designs are not registerable unless they are new, which currently requires that the design has not been registered or published in the United Kingdom before the date of the application. The Directive provides that a design will fall within the field of relevant prior art if it has been published, exhibited, used in trade, or otherwise disclosed unless “these events could not reasonably have become known in the normal course of business to the circles specialised in the sector concerned” in the EEA.11 Furthermore, disclosure to a third person under conditions of confidentiality will not destroy novelty, nor will disclosures by the designer or his successor in title during the 12-month period preceding the date of filing or the date of priority. This grace period is new to U.K. law and is intended to allow designers a window of opportunity to test the market or seek backers before deciding whether it is worth the expense of registering the design. A design cannot currently be registered when (1) it is a “method or principle of construction” (the domain of patents); (2) it consists of “features of shape which are dictated solely by the function which the article has to perform” (a must fit exception, intended to curb the registration of purely functional designs, reinforcing the requirement for eye appeal); or (3) it consists of “features of shape or configuration which are dependent upon the appearance of another article of which the article is intended by the author of the design to form an integral part” (the must match exclusion, which is intended to exclude such things as car body panels).12 The Directive will not introduce significant changes, except to clarify that designs can be registered if their purpose is to allow multiple assembly or connection of mutually interchangeable products within a modular system (for example, interlocking seating systems or shelving units). The Directive allows design rights to subsist in part of a product. Currently that right only applies in the United Kingdom if the part of the article is made and sold separately. Such parts can be protected under the Directive if they remain visible during normal use and then only to the extent that those visible features themselves fulfill the requirements of novelty and individual character.13 A registered design right initially lasts for five years but can be renewed for further periods of five years on payment of additional fees, subject to a maximum duration of 25 years. The terms of protection will remain the same following implementation of the Designs Directive. The Community Design Regulation is intended to provide a unitary right, enforceable across the entire Community, whose protection in terms of validity and scope will, with limited exceptions, be equivalent to that provided under the national registered designs systems as (substantially) harmonized under the Directive.
12.8 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Utility Models. Utility models (or petty patents) do not currently exist in the United
Kingdom but are protected to varying degrees in certain countries, including the rest of the European Union (except Sweden and Luxembourg). The main features of a utility model are that the level of inventiveness is not as great as for patents; the formal conditions for registration are not subject to preliminary examination; and the term is limited. The European Commission published an amended proposal for a Utility Models Directive on June 25, 1999, (COM (1999) 309 Final). It does not seek to introduce a community-wide right with a single set of filing arrangements, nor to provide for the set-up of a single body with responsibility for granting utility models at a national level. It is aimed simply at aligning national provisions on utility models. Plant Breeders’ Rights. A biotechnology- or horticulture-based company may own plant
breeder’s rights. These are governed by the Plant Varieties and Seeds Act 1964. A person who develops a new breed of plant has certain proprietary rights with respect to its seeds and other reproductive materials. Identifying Registered Rights of the Target. How is the seller to identify its registered rights? It ought to have up-to-date records of its registrations and applications for registration. Alternatively, either the buyer or the seller could conduct a search of relevant registries throughout the world. The buyer will usually wish to focus on those rights that are material in the context of the transaction and may restrict itself to investigating those. Searches of the registers in many jurisdictions can now be carried out online. The register contents are publicly available. Local agents will conduct searches in jurisdictions that are likely to be material to the target where no such facility is available. Searches may be made either against the name of the target or its group, if appropriate, to see what it (or they) own(s) (a proprietorship search). With regard to trademarks, a search can be made against the marks themselves to see who owns them and to determine whether there are any similar marks on the register that may affect the scope or value of the marks being acquired (an availability search). Searches for similar and potentially conflicting patents and designs can be carried out, although these can be timeconsuming and expensive. Investigating Registered Rights of the Target. The first thing to check is whether the target actually owns the registered rights, so that the assignor of the IPRs to be acquired can be confirmed. Some corporate groups are organized so that all IPRs are held by the top holding company, or a separate IP holding company, and are licensed to the operating companies. Alternatively, some groups allow each subsidiary to register its own rights and may permit the use of those rights within the group without any formal licensing arrangements. If the rights to be acquired are not registered in the name of the target company, an intragroup assignment will be required prior to the sale. In businesses for which patents or designs are important, it should be ensured that the relevant inventions or designs are owned by the relevant corporate entity and not by its employees or external consultants. If there is uncertainty following investiga-
DUE DILIGENCE 12.9
tion of the facts, it is sensible to obtain confirmatory assignments from the individuals concerned. The next thing to consider is whether the registrations are still in force (in particular, whether renewal fees have been paid). This will not necessarily be revealed by the searches, so the buyer will have to rely on information supplied by the seller, backed up by suitable warranties. It is important to find out whether the portfolio of IPR registrations covers the target’s range of products and services in each of its material markets. The strength of the target’s IPRs should be assessed—for example, to see whether trademarks registered more than five years ago are still in use; if not, they may be open to challenge. This will not be evident from searches, but it will have to be the subject of further investigations and warranty protection. Similarly, a failure to prevent the use of trademarks by third parties can lead to them becoming vulnerable to cancellation. This will not be obvious from the register, either. It is important to inquire about any pending oppositions, cancellation actions, or litigation. Again, registry searches will not necessarily reveal such problems, but they may come to light during due diligence investigations and as a result of warranties and disclosures. As a final point, it is important to ensure that the buyer will be entitled to be registered as the proprietor of the target’s IPRs. If not, this may necessitate transferring certain IPRs to a different company within the buyer’s group. In effect, this is likely to be an issue only in relation to Community trademarks and/or the Madrid system international registrations or applications. A transferee of either of these IPRs may be registered as their new owner only if he would have met the conditions governing the initial entitlement to apply for their registration.14 For both Community trademarks and international registrations, this is essentially a question of identifying the states in which the buyer has a “real and effective industrial or commercial establishment” and verifying whether these states are parties to the relevant international treaties.15 This requirement effectively rules out the transfer of a Community trademark to a buyer that does not have the necessary presence in a state party to the Paris Convention or the Agreement establishing the World Trade Organization. For international marks, however, the position is more complex. The Madrid system involves a comparison of the states in which the buyer has the necessary presence on the one hand and those designated in the international registration on the other. This exercise is made more difficult by the fact that a state may be party to either the Madrid Agreement, Madrid Protocol, or both. The buyer needs to show that he meets the relevant presence requirements in a state that is party to the same treaty or treaties (for example, the Madrid Agreement and/or the Madrid Protocol) as the states that are designated in the international registration.16 This exercise will inevitably cause difficulties when the buyer is a U.S. company, as the United States is not party to either the Madrid Agreement or the Madrid Protocol. In such a case, it will generally be necessary to transfer international registrations to a subsidiary company situated in a state that is party to the Madrid system, preferably one that is a signatory to both the Madrid Agreement and the Madrid Protocol.
12.10 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Unregistered Rights. Unregistered intellectual property rights include unregistered
trademarks (protected by the law of passing-off in England or unfair competition in other European countries), copyrights, database rights, moral rights, unregistered design rights, and semiconductor topography rights. Passing-off is a common law cause of action, but the other rights are governed by the Copyright, Designs and Patents Act 1988.17 Trademarks. An unregistered mark may be protected by a passing-off action. To suc-
ceed in a passing-off action, the claimant must establish that the defendant is making a misrepresentation, which is causing damage to the goodwill that the claimant has built up in relation to his trademark. The remedies for passing-off include injunctions, delivery up, and either damages or an account of the defendant’s profits. Copyright. There is no system or requirement for registration of copyright works in the
United Kingdom or elsewhere in the European Union. As a general proposition, copyright simply arises upon the creation of the relevant work. Copyright gives the owner the right to control the exploitation of the work in which the right subsists. Works capable of having copyright protection in England are (1) literary works, (2) dramatic works, (3) musical works, (4) artistic works (including “works of artistic craftsmanship”), (5) typographical arrangements of published editions of works, (6) sound recordings, (7) films, (8) broadcasts, and (9) cable programs. Copyright will arise for (1) to (5) only when the work is original (not copied). Periods of protection vary according to the type of work, but the maximum duration of protection is the life of the author plus 70 years for literary, dramatic, musical, or artistic works. International conventions provide that a copyright that subsists in one country will usually subsist automatically in many other countries. Moral rights are (1) the right to be identified as author or director of literary, dramatic, artistic, and musical works and films while they are in copyright (the paternity right); (2) the right to object to derogatory treatment (the integrity right); and (3) the right to object to a false attribution.18 The paternity right must be asserted in order to be enforceable. It does not apply to computer programs, computer-generated works, or the designs of typefaces, nor does it apply to anything done by or with the authority of the copyright owner when the copyright is originally vested in the author’s employer. (This enables employers to avoid having to keep detailed records of all contributors to a work—for instance, advertising brochures or instruction manuals—before they are published.) The integrity right does not apply to computer programs, computer-generated works, or any work made for the purpose of reporting current events. When the copyright is vested originally in the author’s employer, the integrity right does not apply to anything done by or with the consent of the copyright owner unless the author was identified at the time of the relevant act or had been previously identified on public copies of the work. Where in these circumstances the right does apply, it is not infringed if there is a sufficient disclaimer.
Moral Rights.
Database Rights. A database right is a sui generis property right, which exists independently from any copyright that may subsist in the database itself. The Copyright and
DUE DILIGENCE 12.11
Rights in Databases Regulations 1997 came into force in the United Kingdom on January 1, 1998. They implemented the EC Database Directive (96/9/EC), which harmonized the laws of member states relating to the protection of copyright in databases and introduced the 15-year database right. The Copyright, Designs and Patents Act 1988 made no specific reference to databases, and they were protected as copyright works if they qualified as compilations through the intellectual effort that went into their selection and arrangement. Now there are two tiers of protection. Databases that are “original” (as defined19) qualify for copyright protection for the full term (life of the author plus 70 years), whereas others will qualify for the 15-year database right provided there has been “substantial investment in obtaining verifying or presenting the contents of the database.”20 The two rights are independent, and it is possible for both rights to subsist in the same database. The changes apply to databases made both before and after January 1, 1998, but the transitional provisions complicate matters, and care should be taken in relation to databases made before March 27, 1996.21 The 15-year term of protection may be extended when substantial changes are made to the content of a database (through additions, deletions, or alterations).22 A new database with a new term of protection will arise if the database can be considered to be a substantial new investment. If the maker of the database constantly updates it and the on-going work amounts to a “substantial investment,” it is possible for a running right to be created. The obvious companies that are likely to own database rights are those whose business includes creating and maintaining directories, catalogues, and listings—for example, legal, medical, or other professional directories; theatre and restaurant guides; on-line services providing financial or other information; or sporting databases with details of fixtures, betting odds, results, and so forth. Apart from these, most organizations use computers for many reasons in the administration of their businesses, and this can lead to the creation of records that can be quickly and easily stored and manipulated electronically (customer lists, for example). These can be commercially valuable commodities, and many businesses offer such information to others who may wish to communicate with their customers. There is not yet any case law on whether or not these incidentally created databases qualify for the database right (are they the result of a substantial investment?), but the safer view is that they do. Designs. In England, protection of industrial designs arises automatically—subject to the fulfillment of certain conditions—by virtue of the unregistered design right provisions of the Copyright, Designs and Patents Act 1988. These provisions give the owner the exclusive right to reproduce the design for commercial purposes. Unregistered design rights can protect “any aspect of the shape or configuration (whether internal or external) of the whole or part of an article.” There is no requirement for eye appeal (unlike in registered designs), so design right can cover purely functional articles. There are certain exclusions. These are (1) a method or principle of construction (the domain of patents); (2) surface decoration (the domain of copyrights or registered designs); (3) “features of shape or configuration of an article which enable the article to be connected to, or placed in, around or against, another article so that either article may perform its function” (the must fit exclusion, intended to exclude spare parts); and
12.12 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
(4) “features of shape or configuration of an article which are dependent on the appearance of another article of which the article is intended by the designer to form an integral part” (the must match exclusion, intended to exclude such things as car body panels). Unregistered design right arises automatically either when an original design (that is one which is not “commonplace in the design field in question”) has been recorded in a document or when an article has been made to the design. Protection lasts 15 years from the end of the calendar year in which the design was created or 10 years from the end of the calendar year in which articles made to that design were made available for sale or hire (whichever period is shorter). The amended proposal for a Council Regulation on Community Design (COM (2000) 660 final, 20.10.2000) contains provisions for a Community unregistered design right, which will last three years and is intended to protect products that meet the criteria for protection, but have a short lifespan (such as toys and textiles). The requirements will be similar to those for registered Community designs, except that unregistered designs will protect only against copying, rather than creating a monopoly right. The term lasts for three years from the date the design was first made available to the public within the Community. A design is deemed to have been made public within the Community if it has been published, exhibited, used in trade, or otherwise disclosed—except when it could not reasonably have become known in the normal course of business to the “circles specialised in the sector concerned, operating within the Community.”23 Semiconductor Topography Rights. An IT or software-related company may own semi-
conductor topography rights. Protection for semiconductor products is governed by the design right provisions of the Copyright, Designs and Patents Act 1988 as amended by the Design Right (Semiconductor Topographies) Regulations 1989. Topography design rights can exist in any aspect of (1) the three-dimensional pattern of the layers in the whole or part of a semiconductor product, and (2) the design of any part of the pattern applied to the whole or any part of an individual layer (for example, the design of the whole or the parts of masks used in making the semiconductor product). The term of protection is 10 years from the end of the calendar year in which the topography or articles made to the topography were first made available for sale or hire anywhere in the world by or with the license of the topography design right owner. Confidential Information. In order to bring an action for breach of confidence, it is necessary to establish the three requirements identified by J. Megarry in Coco v. Clark [1969] RPC 41:
1. 2. 3.
The information itself must have the necessary quality of confidence about it. The information must have been imparted in circumstances importing an obligation of confidence. There must be an unauthorized use of that information, to the detriment of the claimant.
In Faccenda Chicken v. Fowler,24 an ex-employee began using sales information in a competing business. At first instance, J. Goulding considered whether or not the
DUE DILIGENCE 12.13
information had that necessary quality of confidence. He identified three categories of information: 1.
2.
3.
Information so trivial or so easily accessible from public sources that it could not be regarded as confidential, which an employee may disclose at any time to anyone. Information forming part of the general skill and knowledge of an employee, which had to be treated as confidential during employment and which could be protected subsequently by a restrictive covenant of reasonable scope. Specific trade secrets so confidential that they should not be used to an employer’s detriment even once the employment contract had terminated.
In the Court of Appeal, L. J. Neill held that the information fell into the second category and, therefore, was not protected because there was no restrictive covenant in the employment contract. He confirmed that a covenant would have to be directed to protect a legitimate interest and be reasonable in time and extent. He said that whether information fell into J. Goulding’s third category would depend, inter alia, on the following: 1. 2. 3. 4.
The nature of the employment The nature of the information itself Whether the need to maintain its confidentiality had been impressed on those with access to it Whether the information could have been isolated from nonconfidential information
An injunction restraining use of confidential information is clearly the most important remedy in breach of confidence cases. Once information has been made public, its confidentiality cannot be restored. Identifying Unregistered Rights of the Target. By definition, unregistered rights of the tar-
get cannot be identified by searching a register. The most convenient source of information on unregistered rights is the seller. Information that in practical terms can come only from the seller should be supported by appropriate warranties and indemnities. Investigating Unregistered Rights of the Target. As with registrable rights, it is important to
check that the target actually owns the right. Because there is no registered proprietor, this is not easy, and it will probably be necessary to rely upon the seller’s warranties. It is important to ask the seller if any litigation is pending or threatened about the target’s unregistered, material IPRs. Trademarks. Common law searches can be carried out for unregistered trademarks. To
conduct these, search agents will review sources such as telephone and trade directories, company and business registers, and the Internet. These searches will rarely be conclusive but may give some idea of who is using a particular trade name and if it is also being used by other entities.
12.14 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Copyrights. First ownership of copyright varies according to the type of work involved. For literary, dramatic, musical, and artistic works, the first owner is the author (unless the work is made by an employee in the course of employment, in which case the copyright of the work belongs to the employer). In the case of commissioned works, the author is the first owner unless he has agreed to assign the work. When a work has been made by computer, the author is the person who undertakes the arrangements necessary for the creation of the work. When there is a separate copyright in a typographical arrangement of a published edition of the whole or any part of one or more literary, dramatic, or musical works, the author of the typographic arrangement is the publisher. In sound recordings, films, broadcasts, and cable programs, copyright usually vests in the author. In the case of sound recordings or films, the author is the person who undertakes the arrangements necessary to make the film or sound recording. With broadcasts, the person making the broadcast is the author—that is, the person transmitting the program (if it has any responsibility for its contents) and any person providing the program who makes (with the person transmitting it) the arrangements necessary for its transmission. Where cable programs are concerned, the person providing the cable program service is the author. There may be an agreement to the contrary. Designs. Ownership of unregistered designs is determined according to Section 215 of the Copyright, Designs and Patents Act 1988 and mirrors the rules for registered designs. Database Rights. The owner of a database right is the “maker” of the database.25 The
maker is the person who takes the initiative in obtaining, verifying, or presenting the contents of the database and who assumes the risk of investing in that obtaining, verification, or presentation.26 This need not be the person who carries out the obtaining, verifying, or presenting activities. Instead, the maker will be the person who takes the commercial decision to create the database and invests in it. If a database is compiled by an employee in the course of his employment, his employer will be deemed to be the maker of the database in the absence of an agreement to the contrary.27 However, in practice, reliance upon this deeming provision will generally not be necessary; an employee acting in the course of his employment is likely to be doing so under direction, and even a management-level employee, who may arguably be acting on his own “initiative,” is unlikely to be assuming any investment risk. A point to watch is that a database may be protected by both copyright and database right and these two rights may have different owners. Semiconductor Topography Rights. When the topography is created in pursuance of a commission or in the course of employment, the rights owner will be the commissioner or employer. Confidential Information. Because know-how is not property as such, the owner is who-
ever is in possession of the media containing the information and who is not subject to a confidentiality obligation preventing the use of it. It will be difficult to identify breaches of confidentiality, although the adequacy of the procedures in place for maintaining the confidentiality of the information can be assessed.
DUE DILIGENCE 12.15 Identifying Contractual Rights. Contractual rights in this context are licenses of IPRs from third parties (“licenses-in”) and licenses to third parties (“licenses-out”). Licenses may range from standard-form licenses (such as those from collective licensing agencies and those in respect of off-the-shelf software) to complicated, individually negotiated licenses. Again, the existence of contractual rights can generally be discovered only through information held by the seller. Investigating Contractual Rights. The scope of any licenses granting IPRs to the target should be considered. If a license does not adequately cover the activities of the target, it may be infringing the licensor’s rights. Particular attention should be paid to the definitions of the licensed products and the licensed territory. The number of undertakings entitled to exploit the IPR is relevant to the value of the license and to the price being paid for the business on completion. An exclusive license is more valuable than a sole license, which allows the licensor to use the rights but not license anyone else. An exclusive license will often give the licensee the right to sue infringers. A sole license is more valuable than a nonexclusive license, but it will not normally allow the licensee to sue infringers. It may be that the target is licensed only for particular territories or a particular technical field. Duration and termination must also be considered. If the license is about to expire and the possibility of renewal is in doubt, the impact of such expiration on the business must be assessed. Such impact will also have to be assessed when the licenses give the licensor a right of termination if the licensee (the target) undergoes a change of control. Licensing issues often arise in connection with computer software and can be very time-consuming to resolve. Transfer of existing licenses will not always be appropriate. For example, when software is used by the target business under an umbrella agreement granted by the software publisher to the whole of the seller’s group, a new license will usually be required for the target business when it comes out of the group. In many cases, the buyer, if it is in a similar field of activity to the target, will have suitable alternative software in place already or a relationship with the relevant supplier so that it may negotiate a new license on favourable terms, after the target has been acquired. However, the bargaining power of the licensor is potentially much greater when bespoke software (software designed specifically for the licensee’s needs) is involved. If the licensor’s consent to assignment (or novation) is needed, whether this be due to a change of control clause or restrictions on assignment, the licensor may agree to do so only on payment of a substantial fee—up to 100 percent of the license fee in some extreme cases. This can be very expensive, as license fees can run to millions of dollars. The buyer should make inquiries about whether third parties are infringing the target’s IP or the target is infringing third-party rights. The amount of investigation that can be done into many of these matters will be limited, and the buyer will have to rely upon warranties to protect its position. Regarding licenses granting IPRs to third parties, the buyer should consider whether it would be preferable for the target to exploit the IPR itself and consider the scope of rights reserved by the target. All IP licenses and other contracts should be reviewed for compliance with competition law. Infringements of EC competition law can expose the purchaser, the target,
12.16 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
or the entity providing the warranties to the risk of fines, injunctions, damages, and unenforceability. Dealing with Issues Arising from Due Diligence. Some deficiencies may be dealt with before signing—for example, obtaining further registrations of IPRs that are necessary to provide adequate protection of material IPRs. If third parties are infringing the target’s IPRs, action should be taken to bring this to an end. Conversely, if the target is infringing the IPRs of others, suitable licenses-in should be obtained. When deficiencies in the target’s IP portfolio cannot be fully remedied before signing, warranties and indemnities will often be sought to ensure that the buyer retains the risk. An alternative for certain risks may be for the buyer (or target) to take out insurance. IPR problems can sometimes lead to adjustments being made to the purchase price or, in extreme cases, to the abandonment of an acquisition altogether.
WARRANTIES AND INDEMNITIES Purpose of Warranties and Indemnities. Warranties are statements of facts, sometimes
qualified by the knowledge, awareness, or belief of particular individuals (usually the directors) made about the target company or business that are intended to be relied on by the purchaser in the acquisition. They serve a number of purposes, but their primary role is risk allocation. They can determine whether the seller or the buyer has to foot the bill for problems that emerge after completion. The warranties clause and warranties schedule will often account for a large part of the agreement and a substantial amount of the time spent in negotiation. They are the only way that a purchaser can elicit information about the true value of the target and obtain some redress if any of the statements prove to be untrue. At a practical level, warranties also encourage early disclosure of known problems (see the “Disclosure Letters” section later in this chapter). The seller will want to disclose the problem in order to avoid liability under the warranties. It is in the seller’s interest to make as many disclosures as possible, because the more he discloses, the less he exposes himself to claims from the buyer after completion. That is because the buyer will generally not be able to make a claim against the seller about anything that has been fairly disclosed. The warranties will cover all aspects of the target group. A purchaser will seek to obtain general warranties (often rejected by the vendor), giving it comfort that it has been provided with all the information that it ought to have been given to make a proper assessment of the target and specific warranties covering each asset, including IPRs. IPR warranties are likely to require detailed disclosure of registered IPRs and of whether their validity or right to be registered has been opposed or questioned, and about compliance with software licenses and ownership of the relevant IPRs required for the target’s business. An indemnity entitles the entity indemnified to a payment if the event giving rise to the indemnity takes place. A purchaser will usually seek indemnification for specific liabilities so that if such a liability arises after completion, the vendor will pay on a dollarfor-dollar basis. Sometimes, there is an overlap between warranties and indemnities, and it is common for a clause to be inserted ensuring that a purchaser will not be enti-
WARRANTIES AND INDEMNITIES 12.17
tled to double recovery on a claim for the same subject matter. Indemnities should be clearly worded, because they will be construed by the courts against the person to whom they are given. A key difference between warranties and indemnities is the way in which damages are calculated and the effect that these damages are likely to have on the level of compensation: Indemnities are generally more valuable to the buyer than warranties. Damages for breach of warranty under English law are calculated on the usual breach of contract basis—in other words, to compensate the claimant for the damage, loss, or injury suffered through breach of contract and to place the claimant financially in the same position as if the contract had been properly performed. In either case, the level of damages will be subject to the Hadley v. Baxendale28 test of remoteness: Only damages that may “fairly and reasonably be considered as arising naturally from the breach or such as may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract” will be awarded. In contrast, liability under an indemnity is determined entirely by the wording of the indemnity. A broadly worded indemnity may cover losses or liabilities that would not be recoverable under Hadley v. Baxendale, such as unforeseeable claims by third parties and all costs, legal expenses, and consequential losses relating to them. Warranties and indemnities should not be seen as a substitute for proper due diligence. It is far preferable to identify areas of concern before the deal is signed. Then, they may be addressed either through remedial action or, if this is not possible, through an adjustment to the purchase price. It is also vital to remember that, apart from the inconvenience of having to make a claim months or even years after the deal has been done, the value of a warranty or indemnity ultimately depends on the ability of the warrantor to pay at the time it is called upon to do so, which clearly cannot be guaranteed. Warranties and indemnities are also usually capped: They often have both upper limits and lower limits and claims outside the limits are excluded. Furthermore, warranties will not always be available. If purchasing an insolvent business or its rights from receivers or liquidators, the buyer can expect to receive no warranties and only limited disclosures. Similar considerations apply in a public offer. Factors to Take into Account. There is no standard set of IP warranties. A wide range of factors will determine the type of warranties that are appropriate to deal with IPRs. These include the nature of the business and the importance to it of different types of IP; the amount of information available to the buyer; the negotiating strengths of the parties; one party’s desire to appear reasonable rather than aggressive; any agreed general provision on warranties (for example, that there should be no warranty as to sufficiency of assets); the breadth of other, more general warranties (such as warranties relating to assets, where the term assets includes IPRs and warranties relating to litigation); whether the deal is a sale of shares or a sale of assets; whether the buyer already knows a great deal about the business (in some cases it may know more than the seller, such as in a management buy-out); and so on. Nevertheless, the appendix to this chapter contains some examples of IP warranties with explanatory notes about when different forms of wording might be relevant, and some general comments are made below.
12.18 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Which IPRs Are Likely to Be Relevant? It is essential that warranties address the com-
mercial risks that relate to the target business. There is no point in arguing about a warranty covering outstanding claims by an employee for inventors’ compensation if it is known that there are no (or no material) patent rights. If the acquisition is softwareintensive, it will be necessary to focus on copyrights, and possibly semiconductor topography rights while trademark warranties are likely to be less important. Should the Warranties Be Limited to “Knowledge, Information, and Belief”? It is unusual for
a buyer to get absolute warranties about the status of IPRs except in relation to title, the existence of agreements with third parties, and actual or threatened disputes. It is not usually reasonable for a buyer to expect a seller to give an absolute warranty about validity or infringement. Until a validity action has been fought to a conclusion, one cannot be sure that no prior art exists that may invalidate one’s patent, nor can one be sure that no third party is carrying out acts that may infringe a patent or trademark. However, an absolute warranty even about validity and infringement may be appropriate in certain circumstances—for example, when the relative bargaining power justifies the risk allocation. Do the Warranties Cover IPRs That Are Licensed to, as Well as Owned by, the Seller? The buyer should press for warranties covering all IPs owned or used by the target. The seller will resist giving broad warranties in relation to IPRs of which it is merely the licensee (whether from a third party or from an associated company). A seller is therefore likely to want to distinguish between rights that it owns and those for which it merely has licenses. The buyer should try to obtain a warranty, if possible, that the seller has the right to use all of the IPRs used in the business. This warranty either can be specific to this effect or through a warranty about noninfringement of third-party rights. Which Group Company Is Giving the Warranty? Sometimes the target’s IPRs will be
owned not by the seller or the target itself, but by another group company. This happens if the group has a policy of registering all IPRs in the name of the parent or other holding company and having licenses to the relevant subsidiary company. The warranties may have to be amended accordingly. The buyer should take care when dealing with the assignment provisions to ensure that the seller either assigns or licenses the rights or that the relevant group company does so. Updating of Warranties. There will often be a period of several months between the ini-
tial provision of information by the seller to the buyer and signing the sale agreement. The warranties within the agreement will generally refer to the state of the business shortly before signing. If the information regarding the IPRs was originally supplied many months before that date, this may cause problems. The buyer will be unaware of more recent problems and will resist disclosures in relation to them. Therefore, it is essential that the seller provides updated information and disclosures to the buyer. Disclosure Letters. The disclosure letter sets out exceptions to the warranties in detail
and is referred to in the sale agreement as doing so. Even extensive warranties may be
TRANSFERRING THE INTELLECTUAL PROPERTY RIGHTS 12.19
qualified by disclosure and liability for breach of warranty is generally removed from the warrantors about matters that have been fairly disclosed. The warranties and the disclosures must be considered together, and the disclosure letter needs the same attention as the warranties themselves. It is no good extracting strong warranties from the seller if they are then undermined by voluminous disclosures. It is important to consider the whole of the disclosure letter, not just the IP section. There commonly will be a clause at the beginning of the letter saying that a disclosure in any part of the letter operates generally, whichever heading it is under. Sections of the letter dealing with such matters as material contracts, litigation, and competition law may have IP implications. The introduction and general provisions in the letter should also be read carefully. Sellers often attempt to disclose all matters that might be discovered by examination of official registers open to public inspection. This would include all matters discoverable from every Trademark Registry and Patent Office in the world and could significantly undermine any warranties of title. It will usually be possible to argue that this would not be a fair disclosure. Even if there were time to do so, the cost of carrying out such searches can be enormous. The seller and the buyer must reach a compromise in this regard. Frequently, the disclosure is limited to specified registers in specified jurisdictions and to proprietorship searches against, for example, the seller and the target. Another way sellers often attempt to make broad disclosures against warranties is to refer to all matters disclosed in documents in the data room. Generally, the buyer will resist such a broad disclosure. A compromise is for specific problems to be disclosed with specific reference to relevant documents listed in the data room index. If a specific license is identified in a disclosure against a specific warranty—for example, a warranty that no agreements will terminate on change of control—the buyer will at least know what the problem is. The disclosure letter should state only known facts. There should be no speculation about what is expected to happen in the future, such as the predicted outcome of a dispute. Disclosure letters are often produced, or are greatly enlarged, at the last minute. There is often little that the buyer can do about this, but it is important to ensure that lines of communication are open from relevant individuals to the buyer or the seller, as the case may be, so that the implications of and the approach to be taken toward any over-broad disclosures may be discussed.
TRANSFERRING THE INTELLECTUAL PROPERTY RIGHTS
The method of transferring title to the IPRs will vary according to whether the transaction is a sale of shares or a sale of assets, and where in the seller’s group they are located. In a share sale, the underlying assets remain in the target’s ownership, so that no separate transfer of IPRs is required unless they are held elsewhere in the target’s group. In an asset sale, however, the title to each asset must be transferred. Generally a written assignment is required. The parties can either transfer assets through a clause in the sale agreement (which may be followed by confirmatory assignments in different jurisdictions) or the sale
12.20 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
agreement may contain an agreement to transfer the assets. The actual transfers can then be achieved using a series of individual assignments transferring the different types of assets in the various countries (for example, one assignment of patents in the Netherlands, one assignment of trademarks in Germany, and so on). The first approach, using confirmatory assignments for intellectual property, is problematic. If the sale agreement has passed the legal title, the confirmatory assignment cannot do so again. The confirmatory assignment may therefore have no legal effect. In order for the change of title to be registered at national IP registries, the sale agreement itself will need to be produced. This will be inconvenient if it is a bulky document. Worse, it may be necessary to satisfy national stamp duty or other transfer tax requirements before it can be produced at the notional registries. That can cause problems, for example, if one cannot tell from the agreement the stampable value attributable to the IP in question. Furthermore, different jurisdictions have different formal requirements for IP transfer documents. If the sale agreement has not met the requirements for registration of the IPRs under a particular local law, perfecting the assignment may be difficult. It is therefore recommended that the second approach (agreement to transfer plus separate assignment documents) be adopted. When there is time before completion, foreign legal advice should be taken about the registration requirements in each relevant jurisdiction, such as the correct form of the assignments. It is important in any case to include a further assurance clause in the sale agreement that provides that the seller will execute any further documents or carry out any further action necessary to transfer the title to the buyer after completion. The parties then can agree to transfer the intellectual property as soon as possible after completion and can rely on the further assurances provision to perfect the assignments after completion. Intellectual Property Rights Owned by the Target or a Company in Its Group. Assignment or License? There are two ways to transfer IPRs owned by the target (or a
company in its group): by assignment and by license. An assignment transfers ownership of the intellectual property from one party to the other, whereas a license merely grants a right to use without transferring title to the buyer. Licenses are often for a specified duration and usually provide for termination under certain circumstances, such as breach of the license agreement or the insolvency of the licensee. Numerous factors may influence the decision as to whether to assign or license IPRs. From the buyer’s point of view, it is usually preferable to acquire the rights through assignment, rather than being granted a mere right to use. However, it may be that the seller needs to keep the rights for use in his retained business, so that an assignment may not be suitable. When there is a license, the licensor will (particularly in the case of a trademark) wish to exercise control over the use of the IPR and over the quality of the goods or services provided by the licensee, so as to protect the integrity and value of the IPR. In exceptional circumstances, an assignor of intellectual property can include in the assignment similar protection to that found in a license. For example, provision can be made for assignment back to the original owner on termination of the commercial arrangements between the parties or for specified defaults by the assignee.
TRANSFERRING THE INTELLECTUAL PROPERTY RIGHTS 12.21 Formalities for Assigning Registered IPRs. Registered rights—that is, registered trademarks, patents, and designs—and applications for such rights, may be assigned or licensed to the buyer. Assignments of trademarks must be in writing and signed by (or on behalf of) the assignor.29 Assignments of patents must be in writing and signed by both the assignor and the assignee.30 Assignments of registered designs are usually (but need not be) in writing and signed by the assignor. (When unregistered design right subsists in a design that is registered and the proprietor of the registered design is also the design right owner, an assignment of the registered design shall be taken to be an assignment of the unregistered design as well, unless a contrary intention appears.)31 An assignment of registered rights should itself be registered with the appropriate authority (in the United Kingdom, the Patent Office). By so doing, the buyer gains priority against a right, which is registered later. If an assignment of registered intellectual property is not registered, it will be ineffective against a third-party buyer of interests in that intellectual property who has no notice of the previous assignment. Furthermore, a buyer who does not register the assignment within six months of execution of the assignment cannot claim damages for any infringement between the date of assignment and the date of registration. Formalities for Assigning Unregistered IPRs. Unregistered IPRs include unregistered
trademarks, copyrights (and moral rights), database rights, unregistered design rights, and semiconductor topography rights. Confidential information (including trade secrets and know-how) is also dealt with in this category. Unregistered trademarks can pass only with the associated goodwill. They arise as a result of the generation of goodwill in relation to a name, symbol, or type of get-up, and give rise to a right to sue for passing-off. They are commonly transferred under the sale agreement, being listed as an asset of the business in which they are used, together with the goodwill of that business. It is usual to list material unregistered marks in a schedule attached to the sale agreement. A copyright assignment is not effective unless it is in writing and signed by or on behalf of the assignor.32 An assignment may be partial—that is to say, it may be limited to apply either to one or more, but not all, of the things that the copyright owner has to do, or it may be limited by time.33 In this way, a copyright work may be divided between the target business and the business that is retained by the seller, as an alternative to licensing the rights. Database rights are assigned in the same way as copyright and are subject to the same formalities. Unregistered design rights must be assigned in writing and signed by or on behalf of the assignor.34 As with the assignment of the right in a registered design, there is a rebuttable statutory presumption that when an unregistered design right exists in a design that is also the subject of a design registration and the proprietor of both the registered and unregistered rights is the same, an assignment of the unregistered design right will be included in an assignment of the co-existing right in the registered design.35 Moral rights cannot be assigned. They belong with the original author of the copyright and can be asserted or waived only by that person. They can be transferred only
12.22 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
on death, by testamentary disposition, or under intestacy rules. In the context of a disposal, this means that the seller cannot procure the transfer of any moral rights attaching to copyright works that are to be acquired by the buyer. It may, however, be able to procure a waiver from their owner. Know-how is not property and cannot be assigned as such. In order to transfer the benefit of the target’s know-how to the buyer exclusively, the seller must impart the information to the buyer and covenant not to use the information itself or disclose it to anyone else. Imparting the information may be as straightforward as transferring certain documents to the buyer. However, it may be necessary for key employees to transfer, or at least agree to provide consultancy services, if the relevant information is in their heads. Intellectual Property Licenses. The target business may use not only its own IPRs, but
also IPRs licensed to it by third parties. The buyer will wish to ensure that it continues to benefit from these licenses. There are three ways to transfer the benefit of a license: novation, assignment, and sublicense. A novation involves substituting one company for another as party to the license. Such substitution requires the consent of the licensor, so that a novation agreement is necessarily tripartite. When the buyer and seller wish to keep the acquisition confidential, this option may not be available. Even when there are no confidentiality concerns, novation may be impracticable because the licensor will not consent or will consent only subject to onerous conditions. Assignments may need to be considered instead of novations. Usually, the benefit of a contract may generally be transferred by assignment unless there is some agreement to the contrary. However, intellectual property licenses have often been held to be personal contracts, because the identity of the licensee is important to the licensor. In such cases, it will not be presumed that consent to assignment has been granted unless the license states otherwise. Many licenses contain express restrictions on assignment and change of control provisions, again rendering the consent of the licensor necessary. Another complication arising with assignments is that because the burden of a contract is not so assignable, the assignor will remain liable under the contract. This risk can be shifted contractually: The buyer should indemnify the target from any liabilities arising in connection with the license after completion. The third way to transfer the benefit of a license is to grant a sublicense. Again, this may not be possible without the licensor’s consent. The buyer should be aware of the need for novations or assignments as a result of due diligence or, at the latest, from the disclosure letter. The seller may agree to use its reasonable or best endeavours to obtain the novation or assignment. The most important issues to clarify in the sale agreement are who is to take responsibility for obtaining the new licenses—seller or buyer—and who is to pay any costs that arise. These costs can be considerable. Sometimes the buyer will consider retaining part of the purchase price against the consent fees or the costs involved in obtaining new licenses to use IPRs that were previously licensed to the target. In the case of IT licenses, it may be that the buyer is already running a business that is similar to the target business, so it may be able to expand its existing software arrangements with its usual licensors to accommodate the needs of the business that it has bought.
THE FRENCH PERSPECTIVE 12.23
It will also be necessary to consider any existing licenses of the target’s IPRs in favor of third parties. The buyer will wish to consider them whether it wishes these licenses to continue or whether it has the right to terminate them. A buyer may be content to allow a nonexclusive license that is yielding satisfactory royalties to continue, but it may wish to terminate a license if the licensee is underperforming or if a grant of exclusivity will impede the buyer’s newly acquired business. The termination provisions of the licenses and other key terms should have been considered during the due diligence process. If the licenses allow for termination, it may be appropriate to prepare and serve termination notices following or even just before completion. Some licenses may contain change of control provisions that will cause them to terminate on completion automatically. It may also be necessary to consider whether new licenses need to be put in place for IPRs that are used by the target business but owned by the seller or companies that are not included in the sale. When these IPRs are used exclusively by the target, the seller may be willing to grant an exclusive license, or even an assignment. When the retained business will need to continue using the IPRs (even if they are predominantly used by the buyer), a nonexclusive license is more likely. The buyer will often argue for an exclusive license or assignment with a limited license-back to the seller, when the target is the predominant user of the rights. Stamp Duty and Other Taxes. Effective beginning March 28, 2000, transactions in intellectual property were exempted from stamp duty.36 The exemption applies to all instruments executed on or after March 28, 2000, dealing with patents, trademarks, registered designs, copyrights, plant breeders’ rights, and licenses for any of these. Accordingly, transfer documents relating only to intellectual property no longer need to be stamped. When property sold under an instrument consists partly of intellectual property and partly of other chargeable property, an apportionment of the sale price will be necessary to determine the amount chargeable to stamp duty. The term know-how was not included in the definition of intellectual property in the legislation. However, the Inland Revenue has stated that know-how is not liable to stamp duty. However, buyers should still bear in mind the possibility of foreign equivalents to stamp duty. For example, an assignment of New South Wales trademarks may give rise to stamp duty in New South Wales once the assignments are presented in that jurisdiction for registration.
THE FRENCH PERSPECTIVE
Following are the key differences between the previous regime and the French regime for equivalent transactions. Merger. Under French law, a merger ( fusion) occurs when one or more companies transfer all their assets and liabilities to an existing company ( fusion-absorption) or to a new company under a universal legal transfer (transfert universel de patrimoine), which means that all the legal assets and liabilities are transferred to the surviving legal entity. The fusion-absorption method of effecting a merger of two companies is the method that is the most commonly employed. In consideration for this contribution, the
12.24 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
absorbing company issues new shares to the shareholders of the absorbed companies, which are then dissolved. Demerger. Under French law, a demerger (scission) occurs when a company transfers
all its assets and liabilities to two or more other existing or newly created companies under a universal legal transfer similar to that of a merger ( fusion), as described previously. The allocation of the liabilities in the demerged company among the beneficiary companies is set out in a demerger agreement. As in the case of a merger, on a demerger the former company that has been split is dissolved. More commonly in France, a demerger is effected by transferring a part of a company’s business to another company in exchange for the issue of shares in the latter. The transfer of the business concerned also benefits from the universal legal transfer (transfert universel de patrimoine) when the parties choose to have the contribution governed by the rules applicable to scissions. In essence, the difference between the two methods is that this scheme permits the original company to continue in existence, whereas under a true scission, the original company ceases to exist. Confidentiality and Privilege. The issue of the loss of legal privilege is not relevant
under French law because the procedure of discovery does not exist in France. Confidential Information. In order to bring an action for breach of an obligation of confidence before the French courts, it is necessary to establish the following:
• • • •
The existence of a contractual or legal obligation of confidence The breach by the defendant of such obligation That a loss was suffered by the plaintiff That this loss arose from the breach by the defendant of his obligation of confidence
Purpose of Warranties and Indemnities. In addition to the usual circumstances in which
warranties or indemnities may be sought, it is common in French acquisitions for the vendor to indemnify the purchaser against liabilities that have not been properly recorded in the target company’s most recently audited balance sheet, or (in the case where a completion balance sheet is being prepared) the completion balance sheet. The principle of calculation of damages is the same under French law as under English law. The aim is to place the claimant in the same position as if the contract had been properly performed. Transferring the Intellectual Property Rights. The Universal Transmission Principle. When a merger takes place, all the rights and obligations of the absorbed company are immediately and universally transferred to the absorbing company. Thus, patents, trademarks, copyrights, and the other intellectual property rights, being part of the assets of the target company, are transferred in the same way as the other assets—automatically (that is, without the need for any other documentation). The assets are deemed transferred in the state in which they are when the transaction is completed.
THE FRENCH PERSPECTIVE 12.25 Formalities Required. Because the transfer is a global operation, the general rules applicable to isolated transfers of IP rights are not relevant in a merger. However, certain formalities still need to be satisfied. The transfer of rights needs to be in writing—otherwise, it is void. Simply including the IPRs in the sale agreement is sufficient for this purpose. There is no need for any further documentation. In order to be valid against third parties, the transfer must be published in the national registry of the Institut National de la Propriete Industrielle (INPI) in the case of registered trademarks, and in the national patents registry in the case of patents. It is essential to do this to enable the transferee to act as the owner of the intellectual property rights concerned against potential counterfeiters or infringers. In order for the change of title to be registered at the national registries, various documents need to be produced:
• • • • •
A registration form The sale agreement itself A reproduction of the sale agreement (when the original is kept by the parties) Proof of payment of stamp duty Any mandate that has been granted to the assignee or assignor in respect of the assignment
Transferring Intellectual Property Owned or Licensed by the Target or a Company in Its Group.
As in England, intellectual property rights may either be owned by a company or used by it under a license. The difference between the two is important for a merger, because the transfer of a licensee’s IP rights will, as in other jurisdictions, be different from the transfer of IP rights owned by the company. Formalities for Assigning Registered IPRs. The assignment of registered IPRs must obey the rules that govern general sale agreements. Assignments must also conform to additional rules that are specific to intellectual property matters. As we have seen, under French law the necessary formalities are a written document and a notice in the INPI. To satisfy the need for written documentation, simply mentioning the IP right to be transferred in the general sale agreement is sufficient. Formalities for Assigning Unregistered IP Rights. Unregistered French trademarks are similar to unregistered English trademarks. They can give rise to a right to sue under the law of unfair competition (which does not exist in England, where the closest equivalent is passing off), which says that any damage caused by the wrongful act of a third party must be repaired by that party. The provisions for copyright assignments are the same as under English law, except in France moral rights cannot be waived. Intellectual Property Licenses. As has been discussed, a merger under French law is deemed to transfer the assets of the target considered in their universality. Because contracts to which the target was a party are considered to be part of the assets of the com-
12.26 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
pany, the merger achieves the transfer of these contracts according to the same universal transmission principle. However, it is generally accepted that the consent of the other contracting party is required for the transfer of the agreements in which the personality of the parties has been taken into account when the agreement was entered. If this consent is not given, the transfer cannot be enforced against the other party. This is one exception to the universal transmission theory and means that it is essential to audit the contractual arrangements of the target before the merger takes place. Certain contracts are presumed to be based on personal considerations, even in the absence of an explicit provision to this effect in the contract. For example, a license agreement concerning an IP right is considered by the courts as a contract in which the personality of the parties is presumed to be an essential element. The contracting party’s solvency, his ability to exploit the trademark, and the likelihood of his preserving the reputation of the mark are considered to have been crucial to the trademark owner in his choice of licensee. The transfer of such an agreement is prevented in the context of a merger unless and until the licensor consents. However, this is not a hard and fast rule. French law states that the intuitu personae nature of a contract is a question of fact and must be assessed on a case-by-case basis by the court. Stamp Duty and VAT. In France, the transfer of trademarks is subject to a stamp duty of 4.8 percent. The transfer of patents and plant breeders’ rights is subject to a fixed duty of FRF 500. Other IPRs, such as know-how, trade secrets, and designs are liable either to the 4.8 percent stamp duty, when transferred together with a business, or to the fixed FRF 500 duty when transferred separately. When a transfer agreement is executed in France, the 4.8 percent stamp duty applies to the full consideration or value, whichever is higher, of French and foreign IPRs. When a transfer agreement is executed outside France, the 4.8 percent duty applies only to the French IPRs. Alternatively, the transfer of French IPRs may be kept in a separate document to enable the duty to be calculated on only the French element of the consideration. French VAT also applies at the rate of 19.6 percent on the transfer of IPRs (except when the 4.8 percent stamp duty applies) and on the license of IPRs when the transferee is registered for VAT purposes in France or when the transferor is not established in the European Union and the IPRs are used in France.
THE GERMAN PERSPECTIVE Structure of the Transaction. Merger and acquistion (M&A) transactions can be classified under German law similarly to English law. The most important distinction is between a share deal and an asset deal. In both cases, once the due diligence review has begun, the existing intellectual property rights and the associated risks must be identified. The transfer of intellectual property in a share deal poses no problem. However, it is necessary to look out for change of control clauses in licenses or purchase contracts. Also, agreements on co-owned intellectual property might impose restrictions in the case of a change of control. With an asset deal, the special requirements for the purchase of intellectual property must be taken into account, so that the intellectual property rights are successfully transferred.
THE GERMAN PERSPECTIVE 12.27
Just as in English law, the acquisition of part of a business poses a particular legal challenge if the seller wishes to continue to use some of the target’s IP rights in his retained business. German law also allows for corporate restructuring in the form of a merger (Verschmelzung) and demerger (Spaltung), which are both governed by the Conversion Act (Umwandlungsgesetz). A universal succession takes place in both a merger and a demerger. An individual transfer of IP rights is not necessary, and the agreement of parties to contracts—licensors, for example—is also not necessary. It is common in Germany for there to be cooperation between two or more companies in the form of a joint venture, and the problems encountered here are similar to those encountered under English law. Due Diligence. Undertaking a due diligence review when a company is being sold is
not required under German law, and for the purchaser it could be legally disadvantageous. Under German law, the vendor is not liable for those defects in the target that are known to the purchaser on signing the contract. However, due diligence reviews have caught on in Germany based on the American model and have been regarded for a long time as standard in M&A transactions of all types. Also, the management of the acquiring company is not often in a position to forgo a due diligence review. Only in the case of a public offer is a due diligence review normally not possible. The purpose and method of the due diligence review are in line with the American model. Confidentiality issues can likewise be problematic under German law. These are particularly relevant in two cases. First, information that is the subject of a confidentiality agreement cannot be disclosed. Second, the disclosure of data concerning employees is not always possible. The degree to which such data can be disclosed is still unclear. Sensitive employee data, especially the level of reimbursement and the levels of employee-inventor remuneration, usually will be announced in the second or third round of due diligence—particularly in the case of auctions. Some especially cautious companies choose not to circulate such information at all when this information applies to individual employees. Further restrictions can be imposed under German data protection law. In this case, the interests of the data-disclosing party (the target or the seller) and those of the party whose data is to be protected, must be balanced. The result is that on the sale of a company the disclosure of protected data is, at least in stages, permissible. Because there is no case law on this question yet, it is not possible to take a definite legal position. In practice, vendors or the target are encouraged to provide the purchaser with information about the company that is as comprehensive as possible due to the effect on its liability, described previously. Intellectual Property (Commercial Protection Law and Copyright Laws). A German target can own not only German IP rights (such as German patents, trademarks, and design rights) but also foreign IP rights (French patents, American trademarks, and so on). These foreign IP rights in particular can also be acquired through international patent or trademark registration. In addition, German companies can own European IP rights, although there is currently only the Community trademark in this category. Unlike the Community trademark, a European patent application results in a bundle of national registrations, not a pan-European patent.
12.28 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
Only the IP rights existing under German law are described in the following discussion, because for all others there is no difference to targets in other countries. Patents. Patents are issued in Germany for inventions that are new, are based on an
inventive activity, and are commercially useful. However, the following are not regarded as inventions: discoveries such as scientific theories and mathematical methods, aesthetic forms, plans, rules and methods for intellectual activities, games or commercial activities, and programs for data processing. At the moment, the patenting of commercial ideas and software is not permitted according to this principle. This applies more in theory than in practice, however, because in practice, there are actually countless patents for software in Germany. The German Patent and Trademark Office and the courts permit the patenting of software if the software is of a technical nature (that is, it comprises a technical effect or is embedded in a technical product). Much is unclear and changing in this area. The patenting of biotechnological discoveries is highly controversial in Germany at the moment. This is partly due to legal reasons, but mainly due to political and ethical reasons. With a German patent, only the patent owner is entitled to use the patented invention. It is forbidden for others to produce, offer, market, or use a product that is the subject of the patent or to introduce or possess a product for those purposes. Regarding patents for procedures, it is forbidden to use the procedure that is the subject of the patent or, under certain other conditions, to offer it for use in Germany. Furthermore, it is forbidden to offer products that have been directly produced using a patented procedure, to market or use such a product, or to introduce or possess a product for those purposes. Patent protection lasts for 20 years, beginning with the day after the patent registration. In order to obtain protection for 20 years, it is necessary to pay an annual fee to the patent office. A patent is issued by the German Patent and Trademark Office (Deutsches Patentund Markenamt). Before it issues the patent, the Patent Office verifies that the subject of the registration is capable of being patented. Due to this verification, there is a likelihood that third parties will not attack the patent owing to an invention’s lack of capacity to be patented. However, the issuing of a patent does not provide an absolute guarantee. Within three months of publication, oppositions may be raised against the issuing of a patent. An opposition may be based on the following: The subject of the registration cannot be patented; the patent does not clearly and completely describe the invention in a way that an expert could carry out the invention; or the main content of the patent has been taken from another unlawfully. After three months, opposition actions can still be brought at the patent court (Patentgericht) for a declaration of nullity of the patent. As a result, the purchase of a patent—whether or not as part of the purchase of a company—still carries risks. The original owner of the patent is the person to whom it was issued. This does not necessarily have to be the inventor. The inventor can transfer the right to the patent, the right to the granting of the patent, and the patent itself. In relation to inventors who are employees, the law on employee inventions (Gesetz über Arbeitnehmererfindungen) applies. This law differentiates between inventions made in the course of employment and free inventions. Inventions made in the course of employment are inventions made during a working relationship and result from the worker’s incumbent activity or relate
THE GERMAN PERSPECTIVE 12.29
largely to the experience or work of the firm. All other inventions by employees are free inventions. Inventions made in the course of duty must be declared by the employee to his employer. The employer then can decide whether to claim the invention, restricted or unrestricted. This must be done within four months of the declaration. If the employer decides to make an unrestricted claim, all rights to the invention pass to the employer. When a limited claim is made, the employer obtains a nonexclusive right to use the invention. If the employer does not claim the invention, it is “free,”—that is to say, the employee can use it as he wishes. If the employer does claim the invention, he must pay the employee a certain amount of compensation in addition to the employee’s salary. This amount is assessed on the basis of several relatively complicated factors. Experience shows that on average about DM 3,000 are paid per annum during the period of patent use. The amount of compensation is calculated according to a legal guideline. An important factor for the calculation is the level of returns the employer receives from the invention. Before the employee uses the invention elsewhere during the course of the working relationship, he must offer the employer a nonexclusive right to use the free invention under certain conditions, in case the invention falls within the area of the work of the employer. Supplementary Protection Certificates (Ergänzende Schutzzertifikate). Under German law,
supplementary protection certificates for pharmaceuticals and plant protection products can also be obtained. These supplementary protection certificates are based on European Union directives, so roughly the same applies in Germany as in England. Utility Models (Gebrauchsmuster). Unlike English law, German law allows for the protection of utility models (Gebrauchsmuster). Inventions are protected as utility models if they are new, are based on an inventive step, and are commercially applicable. The requirements are very similar to those for patent protection. However, current opinion is that a lower level of invention is required for a utility model than for a patent. The period of protection of a utility model is considerably shorter than that of a patent and lasts for a maximum of 10 years. A further difference is found in registration. A utility model is issued by the German Patent and Trademark Office. However, the Office only verifies formal conditions before issuing the utility model and does not verify the presence of novelty and an invention step. The issuing of a utility model does not offer any probability about the utility model’s validity. Anyone can call for the cancellation of the utility model if the object of the utility model is not protectable. An application for cancellation can be made at the Patent Office at any time. The proprietor of the utility model is the person to whom it was issued, as well as his legal successor. The law on employee inventions also applies to inventions capable of being utility models. Semiconductor Topography Rights (Halbleiterschutzrechte). The German Semiconductor Topography Protection Act (Halbleiterschutzgesetz) protects the three-dimensional structures of micro-electric topographies, if and in so far as these topographies are characteristic. If a topography is protected, the holder of that protection alone is entitled to make use of it. Without the consent of the owner, it is forbidden for a third party
12.30 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
to reproduce the topography, to offer the topography or the semiconductor containing the topography to others, to circulate or distribute these, or to work toward these goals. A topography that is in conformity with the relevant conditions for registration is entered into a special register by the German Patent and Trademark Office. This register and the registration documents are open to the public, as long as they are not defined as containing operational or trade secrets by the person registering the topography. The registration is not a condition of the validity of the protection—rather it is a condition of the effective assertion of rights under it. The protection of a topography occurs the first day of the public commercial application of the topography on the condition that the topography is registered with the Office within two years of this application or, if the topography is not subject to public commercial application on the day that it is registered with the Office. The protection of the topography ends after 10 years. Anyone can demand that the registration be cancelled in situations where the topography is not capable of protection or where the owner of the protection is not the person entitled to it. The right to protect a topography belongs to whomever creates it. However, when the creator of topography is an employee, the right to protect the topography belongs to the employer. Topographies can be protected through a patent or through registration as a utility model, as long as they fulfill the usual requirements. It is also conceivable that copyright protection could apply to a model of the topography. Plant Breeders’ Rights (Sortenschutzrechte). Under German law, plant species and biolog-
ical processes used in the breeding of plants cannot be patented. Their protection is, however, regulated by a special law—the Plant Breeders’ Protection Act (Sortenschutzgesetz). Species protection will be granted to a species of plant that is distinguishable, homogenous, consistent, and new, and that can be categorized through a species characterization capable of registration. The species protection dictates that only the owner of the protection is entitled to produce the materials needed to propagate the species, to prepare these for propagation, to bring them into circulation, to import or export them, or to work towards these goals. Protection is issued through the Federal Species Office (Bundessortenamt) according to a comprehensive protectability test including, among other things, cultivation of the species. Protection lasts for 25 years—although for some plants the period is 30 years—from issue. It is possible to raise objections against the issue of species protection. These objections can be based on the fact that the species is not eligible for protection, that the applicant is not eligible, or that the kind of species is not capable of registration. There are various time limits for raising objections. Once these deadlines have passed, the Federal Species Office must revoke protection in any case where the species is not distinguishable, not new, not homogenous, or not consistent. Revocation can also occur upon an informal request of third parties. The issue of species protection is registered in a special register. This register is available for inspection by the public, as are the registration documents and the culture (for testing purposes) of the species. The right to protection belongs to the original grower or the discoverer of the species. This also applies when the grower or discoverer is an employee. However, the employee is obliged to transfer the right to the employer, as under German employment law the results of work done by employees belong to the employer.
THE GERMAN PERSPECTIVE 12.31 Trademarks (Marken). Trademark law is harmonized throughout the Member States of the European Union, so that there are only minor differences to the regime under English law.
In Germany, aesthetically effective industrial designs and models that are new and individual can be protected as registered designs. The owner of a registered design has the power to prohibit any reproduction of the model or design done with the intention of distributing the aforementioned and any actual distribution of such a reproduction. The right lasts 20 years at the most, beginning on the day registration takes place. Protection begins with registration of the design at the German Patent and Trademark Office. The Office examines neither the entitlement of the registering party nor whether the conditions for registration of the design have been fulfilled. Third parties who wish to have a registration set aside must file a suit against the owner of the right in the civil courts to gain the court’s consent to revocation. Because the Office does not check a registered design before registration, there is no guarantee that the registered design right is enforceable. The author of a design or model is the person who has the right to register a design. If the author is an employee in a German company and produces the design in the course of his or her employment, the employer alone has the right to register the design.
Registered Design Rights (Geschmacksmuster).
Copyright (Urheberrecht). In Germany, literary, scientific, and artistic works are protected by copyright law. As in all other Member States of the European Union, copyright also applies to computer programs. The German copyright law protects both the moral rights (Persönlichkeitsrechte) and the exploitation rights (Verwertungsrechte) of the author. Copyright exists from the creation of a piece of work and expires 70 years after the death of the author. Registration is not necessary to obtain the protection. A peculiarity of German copyright law is that it applies only to individuals and is not transferable. The author can, however, grant single or exclusive licenses to third parties to allow them to use the work. However, this is only possible for manners of use that are already known at the time of the grant. Under this condition, a license can also be granted to works not yet created. However, a license does not affect the moral rights of the author, who can only partially waive such rights. The principle of the nontransferability of the copyright also applies to works that are made through an employment relationship. In this case, the employer himself is not the owner of the copyright in the work, but he has an exclusive right of use. This is the case even when there is no formal contractual agreement between the employer and the employee. Secret and Nonsecret Know-How (Geheimes und Nicht-Geheimes Know-How). Under German law, regardless of whether or not know-how is secret, no proprietary right to it is recognized. Secret technology or commercial know-how is protected by the law against unfair competition and by contractual confidentiality agreements. It is furthermore recognized that secret know-how can be licensed. A definite transfer of know-how, however, is only possible through a total transfer of the employees who represent the know-how or data-medium that contains the know-how. Furthermore, the seller would have to agree that he will not make use of the know-how anymore. Even that will not give absolute protection.
12.32 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Warranties and Indemnities. The concept of warranties (Gewährleistungen) is somewhat
different under German law than under English law, whereas indemnities (Freistellungen) are treated similarly under both legal systems. However, in a German sale and purchase agreement, the purpose of warranties and indemnities is the same as in an English sale and purchase agreement. Consequently, the content of warranties and indemnities in a German sale and purchase agreement is also not significantly different from that in similar English agreements, because German contractual practice relating to the purchase of companies is also influenced by Anglo-American examples. Transfer. The question of the transfer of intellectual property rights is relevant only in the context of an asset deal; as in a share deal, the legal entity owning the intellectual property rights is transferred. German law distinguishes between the obligation to transfer the intellectual property rights (Verpflichtungsgeschäft) and the actual transfer of the right (Übertragungsgeschäft). The parties themselves can choose which law is applicable to the obligation to transfer; however, the transfer of the right is governed, according to German conflictof-law rules, by German law. The transfer occurs through a simple agreement between the seller and the purchaser. This agreement need not be in any particular form and could also be tacitly entered into. However, for evidential reasons, business transactions will always be carried out under a formal written agreement. It must be ensured, when drafting the agreement, that the right to be transferred is either defined or definable; otherwise, the transfer will be ineffective. When the intellectual property rights are registered, an amendment in the registration is not required for the effectiveness of the transfer. However, it is recommended on grounds of legal clarity. There is a particular characteristic in the transfer of the rights to the granting of a patent registration. In the case of these, the German Patent and Trademark Office requires that the purchaser verifies the transfer with a certified deed of assignment. In this connection, it must be noted that the legal status that arises out of an opposition to the registration of a property right cannot be transferred. In an asset sale, the vendor should, if necessary, include provisions in the sale and purchase agreement for the continuation of such proceedings. As already explained, German copyright cannot be transferred. However, the author can grant third parties simple or exclusive rights of use. These rights of use themselves can then be transferred again by the third party. In order to do this, the consent of the author is required. Such consent, however, is not required if the right of use is transferred within the scope of the disposal of a company or the disposal of part of a company. The author can also give his consent in advance, at the time of granting the rights of use. This is important if the rights are to be individually disposed of further after the acquisition. There is a further specific characteristic relating to the transfer of secret or nonsecret know-how. As no IP rights exist for know-how under German law, the transfer of know-how can occur only through a transfer of the employee responsible for the know-how or of the data-medium containing the know-how. In the case of secret knowhow, this should be supplemented by an express agreement, in which the vendor undertakes not to use the transferred know-how himself and not to allow third parties access
COMPETITION LAW 12.33
to it. In case of nonsecret know-how, only a noncompete clause in the sale and purchase agreement will prevent the vendor from using such know-how. Finally, it should be noted that claims for damages due to an infringement of IP rights, which were already in existence at the time of the transfer, are not automatically transferred with the affected IP rights. In order to transfer such claims, it is necessary to have a separate agreement. In most asset deals, however, all of the claims belonging to the business will be transferred, and no additional agreement is required. COMPETITION LAW Relevance to Corporate Transactions. Competition law is relevant at all stages of a transaction. When carrying out due diligence, advisers will have to be aware of possible infringements of competition law by the target, exposing it to invalidity, fines, and claims for damages and injunctions in national courts. Furthermore, competition law may place limits on the exploitation (and the value) of IPRs. Competition law is also of great relevance at the transactional level, and approval for the transaction may be required from a national competition authority or the European Commission. The EC Competition Rules. Only European Community competition law is dealt with here. The competition rules of the European Community are contained in the Treaty of Rome (as amended), secondary legislation (Regulations), decisions and notices of the European Commission, and judgments of the Community Courts (the Court of First Instance and the Court of Justice—the junior and senior courts, respectively).37 The competition rules also apply in the European Economic Area, which includes Iceland, Norway, and Liechtenstein. Article 81 of the Treaty of Rome38 controls restrictive agreements between undertakings.39 In order for Article 81 to apply, an agreement must prevent, restrict, or distort competition in the common market to an appreciable extent. There must also be an appreciable effect on trade between member states.40 Article 82 controls unilateral conduct amounting to an abuse of a dominant position.41 In order for Article 82 to apply, the undertaking in question must have a dominant position42 within the common market or a substantial part of it.43 Again, there must be an appreciable effect on trade between member states. Concentrations among undertakings with a certain level of turnover in the Community are controlled by the EC Merger Regulation (ECMR).44 Concentrations are defined to include mergers in the strict sense, acquisitions of sole control, and the creation of fullfunction joint ventures.45 A concentration is “compatible with the common market” only if it “does not create or strengthen a dominant position as a result of which effective competition would be significantly impeded in the common market or in a substantial part of it.”46 These three regulatory regimes are considered further in the following sections. Assessing Market Power. In order to assess the economic effects of an agreement, mar-
ket practice, or merger, it is necessary to assess the market power and market position of the relevant undertakings.
12.34 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
Economic strength can be assessed only through reference to a particular product and geographic market.47 The relevant product market comprises all of those products or services that are regarded as interchangeable or substitutable by the consumer through the products’ characteristics, their prices, and their intended use.48 The relevant geographic market comprises the area in which the undertakings concerned are involved in the supply of and demand for products or services, in which the conditions of competition are sufficiently homogeneous and that can be distinguished from neighboring areas because the conditions of competition are appreciably different in those areas.49 The Commission’s notice on the definition of the relevant market for the purposes of Community competition law sets out the basic principles used by the Commission for market definition and the types of evidence relied upon to define markets. In practice, political considerations may also influence the definition of the relevant product and geographic markets adopted by the Commission.50 Certain intellectual property rights confer a monopoly right on their owner, but a monopoly right does not necessarily confer a monopoly in the economic sense. The degree of market power enjoyed by an undertaking in a relevant market will depend on the number of substitutes for the undertaking’s products, which are available on the market. IPRs can severely limit the number of substitute products that are available, however. This limitation of the number of substitute products, coupled with the Commission’s tendency to define markets narrowly,51 can have two effects. The first is that an undertaking’s power in a given relevant market can be exaggerated, making a finding of dominance more probable. (If the dominance is so strong that the undertaking has a de facto monopoly, rendering the product an “essential facility,” stricter controls may be placed on that undertaking than in the case of mere dominance.) The second is that a narrow market definition will push products that might have been included in a wider relevant product market into separate, narrower product markets. The Commission is keen to intervene when undertakings use their power in one relevant market to gain an advantage in related52 upstream or downstream markets. For example, a dominant supplier of machinery may bundle that machinery with consumables to eliminate a competitor in the consumables market.53 Article 81. Article 81 provides as follows:
81(1) The following shall be prohibited as incompatible with the common market: all agreements between undertakings, decisions by associations of undertakings and concerted practices54 which may affect trade between member states55 and which have as their object or effect the prevention, restriction or distortion of competition within the common market, and in particular those which: (a) directly or indirectly fix purchase or selling prices or any other trading conditions; (b) limit or control production, markets, technical development, or investment; (c) share markets or sources of supply; (d) apply dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage;
COMPETITION LAW 12.35 (e) make the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts. (2) Any agreements or decisions prohibited pursuant to this Article shall be automatically void. (3) The provisions of paragraph 1 may, however, be declared inapplicable in the case of: —any agreement or category of agreements between undertakings; —any decision or category of decisions by associations of undertakings; —any concerted practice or category of concerted practices; which contributes to improving the production or distribution of goods or to promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit, and which does not; (a) impose on the undertakings concerned restrictions which are not indispensable to the attainment of these objectives; (b) afford such undertakings the possibility of eliminating competition in respect of a substantial part of the products in question;
Hence, any agreements of the target that fall within Article 81(1) are void pursuant to Article 81(2), unless exempted under Article 81(3). An infringement of Article 81 exposes the target to the risk of fines and actions for damages or injunctions in the national courts. An important part of the due diligence exercise is the review of the target’s contracts for compliance with Article 81. It is also necessary to review the transaction documentation for restrictive covenants and other clauses that may raise Article 81 issues. Before examining how Article 81 applies to particular types of agreement, a few general comments should be made. Agreements Having as Their Object or Effect the Prevention, Restriction, or Distortion of Competition. In reviewing the target’s contracts and the transaction documentation for
compliance with Article 81, the first step is to identify any restrictions of competition. If the object of the agreement is not to restrict competition, the effect of the agreement must be considered in its economic and legal context.56 If the effect of the agreement, considered in its economic and legal context, is not to restrict competition, the individual clauses of the agreement must be examined. If the clauses contained in the agreement are reasonable and necessary to make the transaction viable, they may merely be ancillary restraints that do not have as their object or effect a restriction of competition.57 The Community Courts have drawn a distinction between the existence and the exercise of IPRs.58 The competition rules cannot interfere with the existence of IPRs, but may permit or prohibit certain forms of exercise of IPRs. In the context of Article 81, the Court of Justice has stated . . . it is conceivable that certain aspects of the manner in which the right is exercised may prove to be incompatible … with Article [81] where they serve to give effect to an agreement, decision or concerted practice which may have as its object or effect the prevention, restriction or distortion of competition within the common market.59
12.36 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Appreciability. A restriction of competition is not prohibited by Article 81(1) unless it is appreciable.60 The Commission set out its understanding of the concept of appreciability in its Notice on Agreements of Minor Importance in 1997.61 In the Commission’s view, agreements do not generally fall within Article 81(1) if the aggregate market share held by all the participating undertakings does not exceed, in any of the relevant markets, 5 percent in the case of a horizontal62 agreement or 10 percent in the case of a vertical63 agreement.64 In the case of a mixed horizontal and vertical agreement or when it is difficult to classify the agreement as either horizontal or vertical, the 5 percent threshold is applicable. However, the applicability of Article 81(1) is not ruled out below those thresholds when the object of horizontal agreements is to fix prices, to limit production or sales, or to share markets or sources of supply. Similarly, the applicability of Article 81(1) is not ruled out below those thresholds when the object of vertical agreements is to fix resale prices or to confer territorial protection on the participating undertakings or third undertakings. However, the European Commission is increasingly adopting a more economic (and less formalistic) approach to the notion of appreciability. Since the publication of the latest version of the minor agreements Notice previously referred to (see the “Notice”), the Commission has adopted guidelines, separately, on the treatment of horizontal cooperative agreements and vertical agreements. The horizontal guidelines65 suggest that many agreements between competitors that create efficiencies will be regarded as outside Article 81(1) when the parties’ aggregate market share is below 15 percent— that is, a higher threshold than the 5 percent previously mentioned. The vertical restraints guidelines,66 issued three months earlier refer to the same 10 percent threshold used in the Notice. Although the general direction in administrative policy (and judicial decision making)67 is undoubtedly toward a more generous application of the Treaty, the balance in treatment between horizontal and vertical agreements is still in some doubt, and the various Commission Notices do not fit together in all respects.68 Exemption. If an agreement is found to fall within Article 81(1), it is void unless
exempted under Article 81(3).69 Exemption under Article 81(3) will be granted only when, in broad terms, the procompetitive effects of the agreement outweigh the anticompetitive effects. Originally, in order to avoid the consequences of an agreement falling within Article 81(1), the agreement had to be notified to the Commission, because only the Commission had the power to grant an exemption.70 Then, to avoid having the Commission deluged with notifications, block exemptions were introduced to remove the need to notify agreements in many low-risk cases. The structure of a block exemption is generally as follows. Clauses that the Commission considers to be restrictive of competition under Article 81(1), but capable of exemption under Article 81(3) are listed as such. Clauses that are generally not restrictive of competition, but exempted for the avoidance of doubt, are white-listed. Both sets of clauses must, however, be read together with the black list. Inclusion of any black-listed provisions renders the block exemption inapplicable. In such a case, notification to the Commission for individual exemption is necessary (although the Commission will rarely exempt a black-listed provision).
COMPETITION LAW 12.37
Advantages of notifying include the following: • Obtaining either clearance of an agreement falling outside Article 81(1) altogether, or individual exemption of an agreement that is within Article 81(1) but does not fall under a block exemption. • Immunity from fines until such time as the Commission withdraws this immunity.71 • In respect of a horizontal agreement, the Commission will probably backdate any exemption to the date of notification but cannot (in respect of most horizontal agreements) backdate it to a point earlier than notification.72 Disadvantages of notifying include the following: • The time spent and expense incurred in preparing notifications. • Uncertainty until exemption is given and uncertainty about the effect of a comfort letter if that is given instead of an individual exemption. • The possibility that the Commission will start asking questions about the parties’ other arrangements. • The possibility that the Commission will require renegotiation or deletion of offending clauses, perhaps months or years after original notification, after a party’s bargaining power has diminished. Modernization of EC Competition Rules. In April 1999, the Commission published a
White Paper,73 setting out radical proposals for reform of the way in which Article 81 (and Article 82) is applied. The Commission published draft legislation in September 2000, to achieve this.74 The basic proposal is that Article 81 will be applied by Member State courts as a single provision, and the Court will be entitled to make a finding (a) that the agreement does or does not fall within Article 81(1) and (b) if so, whether it falls within Article 81(3). The Commission will no longer accept notification or grant exemptions.75 Accordingly, national courts and authorities will be called on much more frequently to assess whether Article 81(1) is infringed and, if so, for the first time they will have jurisdiction to determine whether the requirements of Article 81(3) are satisfied. This means that companies will no longer be able to rely on the view of the Commission as to whether their agreements infringe Article 81 and whether they require individual exemption, but will have to make their own assessment.76 Licenses of IPRs. Article 81 must be considered when drafting IP licenses as part of a
corporate transaction or reviewing existing licenses during due diligence. The Court of Justice has drawn a distinction between open exclusive licenses (exclusive licenses to manufacture and sell in a particular territory) and closed exclusive licenses (under which the licensee enjoys absolute territorial protection through obligations on other licensees not to sell in the territory).77 The Court has held that open exclusive licenses can fall outside Article 81(1) in certain circumstances,78 but has equally held in some limited circumstances that even absolute territorial protection may be justified.79
12.38 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
While the Commission in the past seems to have taken the contrary view that exclusive licenses, even if open, always infringe Article 81(1) unless they are de minimis,80 the Commission now seems to be adopting a more liberal approach. It is not possible to give an exhaustive list of license clauses that may infringe, nor is it easy to generalize about clauses that would necessarily be exempted or would never be exempted. However, certain provisions need to be considered particularly carefully, including grants of exclusivity and restrictions relating to customers, product markets, and other commercial activities. Patent and Know-How Licenses. Reasonably clear guidance has been provided for
licenses of patents or know-how by the Technology Transfer Regulation No. 240/96. This is designed to exempt licenses to which two undertakings are party and that are drafted in accordance with the Regulation. Articles 1, 2, and 3 of the block exemption follow the usual structure—exemption, white-list, and black-list. Under Article 4, agreements containing provisions not expressly covered by Articles 1 and 2 (but not prohibited by Article 3) may be notified to the Commission under the opposition procedure, by which an agreement will be exempted automatically if the agreement is not opposed within a period of four months. Article 5 excludes certain arrangements, such as patent pools, from the field of application of the block exemption. Article 6 applies the block exemption to sublicenses and assignments. Article 7 provides the Commission with the power to withdraw the exemption if in a particular case it decides to do so. Article 1 of the Technology Transfer Regulation identifies and exempts certain territorial restraints in patent and know-how licenses that would otherwise infringe Article 81(1). For example, it exempts a prohibition of active selling into the territory of the licensor81 or another licensee.82 The permissible duration of such prohibition varies according to the type of IPR involved. For patents, the relevant period is the duration of the licensed patents in each territory;83 for know-how, 10 years from when the licensed product was first marketed in the EU by any licensee (provided that the knowhow remains secret and substantial);84 and for mixed licenses, 10 years from when the licensed product was first marketed by one of the licensees or the duration of the licensed patents in each territory that are necessary to continue to sell the licensed products—whichever is the longer.85 It also exempts a prohibition on unsolicited (passive) sales into the territory of the licensor86 or another licensee.87 Irrespective of the type of IPR involved, this prohibition is permissible only for five years from when the licensed product was first marketed by one of the licensees.88 Other permissible territorial restrictions on the licensor include an obligation not to license others in the territory and an obligation not to exploit the licensed technology itself in the territory. The permissible duration of such restrictions is the same as active sales bans by the licensee, which was previously described. The white-list identifies a range of nonobjectionable clauses concerning confidentiality, sublicensing and assignment, post-term use bans, feedback and grantback of rights in improvements, minimum quality specifications, enforcement of the licensor’s IPRs, royalties and quantities, field of use restrictions, most favored nation clauses, indications of the licensor, construction of facilities for third parties, provision of second sources of supply, exhaustion, termination if the licensee challenges the validity of
COMPETITION LAW 12.39
the IPRs, best endeavors, and the licensor’s rights if the licensee enters into competition with it. According to the black list, the block exemption will not apply if the parties inhibit parallel trade of the licensed products once lawfully put in the common market.89 Other black-listed clauses are those that provide for price fixing,90 noncompetition,91 customer allocation,92 limitation of the quantities to be manufactured or sold,93 an obligation on the licensee to assign to the licensor rights to improvements that the licensee has brought about,94 and excessive duration.95 Licenses of IPRs Other Than Patents and Know-How. The Technology Transfer Regulation applies only to licenses of IPRs other than patents and know-how if such other IPRs are ancillary to or contribute to the objects of the licensed technology. The provisions relating to such other IPRs must “contain no obligations restrictive of competition other than those also attached to the licensed know-how or patents and exempted under this Regulation.”96 Otherwise, licenses of trademarks, design rights, and copyrights (including software copyrights) fall outside the scope of the block exemption. However, the block exemption does provide guidance about the Commission’s thinking with regard to licenses of these other IPRs, enabling the risk of infringement to be assessed and a decision made about whether or not to notify the agreement. Depending on the nature of the transaction, other block exemptions may apply. The vertical restraints block exemption, for example, may apply to certain vertical agreements containing IPR provisions.97 The vertical restraints block exemption replaces three block exemption Regulations previously applicable to exclusive distribution, exclusive purchasing, and franchising. It applies to agreements for the assignment or use of intellectual property, but only when such assignment or use is ancillary to the main purpose of the agreement and provided certain other conditions are met.98 For example, in practice, it should cover many agreements for the resale of software, and agreements for the repackaging of goods so as to apply a trademark to the licensor’s goods and franchise agreements. Research and Development Agreements. On November 29, 2000, the Commission adopted a revised block exemption on research and development agreements.99 At the same time, the Commission adopted guidelines on horizontal cooperation agreements.100 The block exemption contains a more broad-based exemption, which departs from the usual clause-bound approach. The underlying principle is that cooperation in R&D brings benefits (such as reduction of duplicative costs) and should normally be allowed when the parties lack market power. When the parties are competitors, the market share threshold above which the research and development block exemption does not apply is an aggregate market share of 25 percent. Between noncompeting manufacturers, the block exemption provides that there is no maximum permissible market share. In order for the block exemption to apply, all the parties to a research and development agreement must have access to the results of the joint research and development, and each must be free independently to exploit the results. Such right to exploitation may be limited to one or more technical fields of application when the parties are not
12.40 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
competing undertakings101 at the time the research and development agreement is entered. A further condition is that any joint exploitation must relate to results that are protected by IPRs or constitute know-how that “substantially contribute to technical or economic progress” and the results must be “decisive for the manufacture of the contract products or the application of the product processes.” Article 5 of the R&D block exemption sets out the black-listed clauses. Described as “severe anti-competitive restraints,”102 these include the following: • Restrictions on cooperation with third parties outside the field of the relevant R&D or in the same field as the relevant R&D post-termination of the R&D agreement • Prohibitions on challenging the validity of intellectual property rights • Limitations on output or sales and price-fixing103 • Certain territorial sales restrictions • Prohibitions on passive sales • Prohibitions on granting licenses to enable third parties to manufacture if exploitation by the parties does not take place or is not provided for. The R&D block exemption has done away completely with the concept of whitelisted clauses. Hence a clause-by-clause analysis of the R&D agreement is only required to ascertain that it is free of black-listed provisions. However, Article 7 of the R&D block exemption empowers the Commission to withdraw the benefit of the block exemption in certain circumstances.104 When the results are jointly exploited, the exemption lasts for seven years from the time the contract products are first marketed within the common market. The same time limits apply to competing undertakings, as long as their combined market share does not exceed the specified thresholds. Guidelines on Horizontal Cooperation Agreements. The Horizontal Guidelines apply to types of cooperation that potentially generate efficiency gains and exclude agreements, for example, on information exchange and on minority shareholdings.105 They also expressly exclude from their scope areas in which specific sectoral rules exist, such as insurance and transport, and arrangements that fall within the scope of the ECMR.106 One chapter of the Guidelines deals with R&D agreements. This chapter is expressed to apply to “all forms of R&D agreements including related agreements concerning the production or commercialisation of the R&D results provided that the cooperation’s centre of gravity lies in R&D.”107 According to the Guidelines, R&D agreements may restrict competition in product markets, technology markets,108 or R&D efforts (competition in innovation). Competition in innovation (not the existing product markets) will be affected when the result of R&D work is a product that is completely new and may create its own market or market sector. In such cases, assessment of market power must be made through the number and strength of other R&D efforts directed at products similar to, or substitutable with, the product to be produced under the R&D cooperation in question. Such R&D efforts are called R&D poles. The Guidelines single out the pharmaceutical industry as an example of an industry sector in which such an analysis is particularly appropriate.
COMPETITION LAW 12.41
Such an assessment is likely to be a far from straightforward exercise, because information about competing R&D poles is likely to be confidential and very difficult to obtain. Measurements of access to financial and human resources, know-how, patents, or other specialized assets is likely to be very difficult to carry out, even if such information is publicly available. The Sale Agreement. Compatibility of the Sale Agreement with Article 81 will need to be considered when the corporate transaction in question does not amount to a concentration with a Community dimension within the meaning of the ECMR. When the transaction does amount to a concentration with a Community dimension, certain restrictions may be cleared along with the merger if they are ancillary to it.109 Examples of transactions that are not dealt with under the ECMR are joint ventures that do not create a fully autonomous entity, joint ventures which are regarded as resulting in (negative) joint control, and demergers in which there is no change of ultimate control. Article 82. Article 82 of the EC Treaty (previously Article 86) provides that
Any abuse by one or more undertakings of a dominant position within the common market or in a substantial part of it shall be prohibited as incompatible with the common market in so far as it may affect trade between member states.
Such abuse may, in particular, consist in: (a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; (b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage; (d) making the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts.
In order for Article 82 to apply, the undertaking in question must hold a dominant position within the common market or a substantial part of it. The most important indicators of dominance are a large market share on the part of the undertaking (relative to the size of its nearest competitors) and the existence of barriers that prevent other entities from entering the relevant market. The Court and Commission have taken a wide view about what constitutes a barrier to entry and have considered as factors: provisions of national law, an undertaking’s superior technology, availability of capital, the need to achieve economies of scale, an undertaking’s high level of vertical integration, differentiation of an undertaking’s products, an undertaking’s overall size and strength, the strength of an undertaking’s brands, opportunity costs faced by a new entrant, the conduct of an allegedly dominant undertaking and an undertaking’s economic performance. A dominant position under Article 82 (and the ECMR) may be held by a single firm or a number of firms jointly. In broad terms, collective dominance exists when a small number of undertakings in a given market are able to coordinate their actions and maintain prices above the competitive level.
12.42 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
An abuse may be exploitative or exclusionary. The concept of an abuse was described by the Court of Justice in Hoffmann La Roche v. Commission110 as . . . an objective concept relating to the behaviour of an undertaking in a dominant position which is such as to influence the structure of a market where, as a result of the very presence of the undertaking in question, the degree of competition is weakened and which, through recourse to methods different from those which condition normal competition in products or services on the basis of the transactions of commercial operators, has the effect of hindering the maintenance of the degree of competition still existing in the market or the growth of that competition.
In Michelin,111 the Court of Justice held that an undertaking in a dominant position has a special responsibility not to allow its conduct to impair genuine undistorted competition on the common market.
Examples of abuses under Article 82 are refusal to license or supply, tying, and excessive, discriminatory, or predatory pricing. If an objective justification can be shown for the dominant undertaking’s behavior, the practice will not amount to an abuse. As mentioned previously in connection with Article 81, the competition rules cannot interfere with the existence of IPRs, but may permit or prohibit certain forms of exercise of IPRs. In Hoffmann La Roche v. Centrafarm,112 the Court of Justice stated: to the extent to which the exercise of a trade-mark right is lawful in accordance with the provisions of Article 36 [now 30] of the Treaty, such exercise is not contrary to Article 86 [now 82] of the Treaty on the sole ground that it is the act of an undertaking occupying a dominant position on the market if the trade-mark right has not been used as an instrument for the abuse of such a position.113
Case law on refusal to license or supply and tying can limit the exploitation of IPRs. It may be that there are a number of separate but related product markets relating to a particular technology. (For example, the markets for spare parts114 and consumables115 are likely to constitute markets separate from the market for the product with which they are intended to be used.) It is important to ask which of these separate product markets are covered by an IPR, as an attempt by an undertaking dominant in the primary market to reserve a secondary market (not covered by an IPR) to itself can be restrained under Article 82. One of the early cases dealing with this question was Volvo v. Veng.116 In this case, Volvo refused to license its design rights that protected the design of certain body panels. Veng was thereby prevented from importing the body panels it had manufactured. The Court of Justice held that Volvo’s right to grant licenses (or not) constituted the “very subject matter of its exclusive rights” and so would not be condemned under Article 82. In Hilti AG v. Commission,117 Hilti had a patent for cartridge strips for its nail guns but not for the relevant consumables. It tied in (bundled) the consumables with the cartridge strips. The Commission found that this attempt to reserve to itself the secondary
COMPETITION LAW 12.43
market for these consumables constituted an abuse of a dominant position under Article 82, imposed a fine of 6 million ECU on Hilti and ordered it to bring the infringements to an end. The Court of First Instance and the Court of Justice upheld the Commission’s findings. Similarly, in Tetra Pak v. Commission (“Tetra Pak II”),118 Tetra Pak held a patent for machines but no patent for consumables. The Court of Justice upheld the Commission’s decision that Tetra Pak could not attempt to reserve the secondary market to itself by tying in (bundling) the consumables with the machines. Tetra Pak was fined 75 million ECU. In Radio Telefis Eireann v. Commission (“Magill”),119 three broadcasting companies each held the copyright (and, significantly, a de facto monopoly in the economic sense) for their program schedules. The broadcasting companies refused to license this information to Magill, so it could not introduce a TV guide incorporating all three sets of information. The practice in question can be analyzed in two ways—either as an attempt to prevent the introduction of a new product or as the reservation by the dominant undertakings of a secondary market to themselves (by excluding a new entrant). The Court of Justice upheld the Commission’s imposition of a compulsory license but noted that exceptional circumstances must be found before the exercise of (or refusal to license) an IPR can be held to be contrary to the competition rules.120 In the circumstances of the case, a compulsory license was the only way to put an end to the abuse. The application of Magill has been limited by the Court of Justice in Oscar Bronner v. Mediaprint.121 In that case, Oscar Bronner was seeking access to Mediaprint’s home delivery scheme for newspapers. The Court dealt with the matter as a refusal to supply (rather than adopting the U.S. concept of “essential facilities.”)122 The Court held that there would only be an abuse of a dominant position to the extent that the conduct in question was likely to eliminate all competition on the part of the undertaking seeking supplies.123 Furthermore, the Court referred to its statement in Magill that “exceptional circumstances” must be present before the exercise of an intellectual property right can involve an abuse. The service that Mediaprint was refusing to supply would have to be “in itself indispensable to carrying on that person’s business, inasmuch as there is no actual or potential substitute in existence for that home-delivery scheme.”124 The service would be indispensable only when it was not economically viable for any competitor to duplicate the facility.125 A similar approach was followed by the Court of First Instance in Tiercé Ladbroke.126 This case concerned the Commission’s rejection of a complaint by the leading operator in the Belgian horse-betting market against the refusal by undertakings holding the video and audio rights to French horse races to license such rights for use by the complainant’s betting shops in Belgium. The CFI considered that, whereas in the Magill decision the refusal to grant intellectual property rights had hindered the complainant from entering a market, here the complainant was not only present but was also the leading operator on the Belgian betting market and occupied a significant position in respect of bets on French races. Accordingly, there was no abuse. Three main conclusions can be drawn from the jurisprudence of the Courts and decision making of the Commission. First, the Commission and Community courts do respect the integrity of intellectual property rights. Second, although intellectual
12.44 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE
property rights give their owner an exclusive right to use the property, this will not necessarily amount to a dominant position—a market analysis is necessary to determine this. Third, the use of intellectual property rights is not immune from EC competition law control; the manner in which licensing is exercised will be subject to scrutiny under Article 82, and Article 82 may be raised where intellectual property rights are used to deny or foreclose access to a neighbouring or derivative market, whether existing or new. The ECMR. The ECMR provides that concentrations127 with a Community dimen-
sion128 must be notified to the European Commission on the first of several triggering events and in any event before implementation.129 Whether or not a concentration has a Community dimension involves assessing the level of turnover130 of the undertakings concerned131 (separately) worldwide, within the Community and within EC member states. Only the Commission may investigate the concentration, unless Article 9 or Article 21(3) are invoked.132 If a concentration is implemented before it has been notified and cleared, or in breach of conditions imposed, the Commission may impose penalties.133 The Commission must decide within certain time limits whether the concentration is “compatible with the common market.” The first relevant time limit is one month from notification. At this point,134 the Commission may take one of three courses. It may decide that the transaction in question is not a concentration (and so falls outside the ambit of the ECMR); that the Commission does not have “serious doubts as to its compatibility with the common market” (and declare it compatible with the common market); or that the Commission does have such serious doubts, in which case it must decide to initiate proceedings known as a “Phase II” investigation. Within the onemonth period, the parties may submit commitments to the Commission to secure the second type of decision (in which case the initial one-month period is increased to six weeks135). For example, they may offer to divest parts of their business to reduce the combined share of the relevant market to an acceptable level. When a Phase II investigation is undertaken, the Commission has a further four months to reach a decision. At the end of these four months, the Commission must declare the concentration compatible with the common market (with or without attaching conditions) or declare it incompatible. When a corporate deal can be brought within the ECMR regime, there are a number of procedural advantages. First, because of the principle of one-stop merger control, there is no need to notify the transaction to the competition authorities of individual member states.136 Second, the level of market share at which the Commission will intervene is generally higher than under Article 81. Third, strict time limits apply, unlike in an investigation under Article 81. Fourth, the procedure ends with a formal decision, when all that the notifying party is likely in practice to receive following a notification under Article 81 is a comfort letter. Fifth, agreements that are “directly related and necessary to the implementation of the concentration” (including IP agreements that satisfy that test) may be cleared as ancillary to the concentration itself and do not, in that event, need to be notified separately for negative clearance or exemption under Article 81.137
APPENDIX 1 12.45 APPENDIX 1 SAMPLE INTELLECTUAL PROPERTY WARRANTIES DEFINITIONS:
Intellectual Property means trademarks, service marks, trade names, logos, get-up, patents, inventions, registered and unregistered design rights, copyrights, semiconductor topography rights, database rights, and all similar proprietary rights that may exist in any part of the world (including know-how) including where such rights are obtained or enhanced by registration, any registration of such rights and applications, and rights to apply for such registrations. Business IPR means all rights and interest held by the Vendors (whether as owner, licensee, or otherwise) in Intellectual Property that is used at or before completion [or is capable of being used] [exclusively/primarily] [in] [or in connection with] the business of the Group Companies. Know-how means confidential [and proprietary] industrial and commercial information and techniques in any form (including paper, electronically stored data, magnetic media, film, and microfilm) including without limitation drawings, formulae, test results, reports, project reports, and testing procedures, instruction and training manuals, tables of operating conditions, market forecasts, and lists and particulars of customers and suppliers. THE FOLLOWING SET OF WARRANTIES IS A STARTING POINT FOR THE VENDORS: 1
Intellectual Property.
1.1 [So far as the Vendors are aware/To the best of the knowledge, information, and belief of the Vendors] [after making due and careful enquiries [of the persons listed in Part [*] of Schedule X]] all [material] Business IPR (whether registered or not) and all pending applications therefore are (or, where appropriate in the case of pending applications, will upon registration be) legally owned by, licensed to, or used under the authority of the owner by the Vendors. Brief details of all such [material] licenses and authorities are set out in Part 3 of Schedule X (excluding any shrink-wrap licenses for computer software). 1.2 [So far as the Vendors are aware/To the best of the knowledge, information, and belief of the Vendors] [after making due and careful enquiries [of the persons listed in Part [*] of Schedule X]] all [material] Business IPR that is owned by the Vendors (whether registered or not) and all pending applications therefore are (or, where appropriate in the case of pending applications, will upon registration be): (a) not being infringed or attacked or opposed by any person (b) not licensed to a third party [except under those licenses brief details of which are set out in Part 2 of Schedule X]
12.46 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE (c) in force and in the case of such rights as are registered or the subject of applications for registration, listed and briefly described in Part 1.1 of Schedule X (d) [in the case of unregistered trademarks that are [likely to be] material to any Group Company, listed and briefly described in Part 1.2 of Schedule X]
and no claims have been made and no applications are pending (other than as listed in part 1.1 of Schedule X), which if pursued or granted might be material to the truth and accuracy of any of the above statements. 1.3 [So far as the Vendors are aware/To the best of the knowledge, information, and belief of the Vendors] [after making due and careful enquiries [of the persons listed in Part [*] of Schedule X]] the principal processes employed and the principal products and services dealt in by each Group Company do not infringe any rights of third parties in Intellectual Property (other than those belonging to or licensed to the Group Companies and referred to in Schedule X) and no claims of infringement of any such rights have been made by any third party. 1.4 [Where patents are relevant: [So far as the Vendors are aware/To the best of the knowledge, information, and belief of the Vendors] [after making due and careful enquiries [of the persons listed in Part [*] of Schedule X]] there are no outstanding claims against any Group Company under any contract or under Section 40 of the Patents Act 1977 for employee compensation in respect of any rights or interests in Intellectual Property.] THE FOLLOWING SET OF WARRANTIES IS A STARTING POINT FOR THE PURCHASER: 2
Intellectual Property.
2.1 All Intellectual Property (whether registered or not) and all pending applications that have been, are, or are capable of being used in or in relation to [or that is necessary for] the business of each Group Company is (or, where appropriate in the case of pending applications, will be): (a)
legally and beneficially owned by a Group Company or lawfully used with the consent of the owner under a license, brief details of which are set out in Part 3 of Schedule X
(b)
valid and enforceable
(c)
not being infringed or attacked or opposed by any person
(d)
not subject to any Encumbrance, any license, or authority in favor of another [except those brief details of which are set out in Part 2 of Schedule X]
(e)
in the case of rights in such Intellectual Property as are registered or the subject of applications for registration, listed and briefly described in Part 1.1 of Schedule X and all renewal fees that are due and steps that are required for their maintenance and protection have been paid and taken
(f)
[in the case of unregistered trademarks that are likely to be material to any Group Company, listed and briefly described in Part 1.2 of Schedule X]
ENDNOTES 12.47
and no claims have been made and no applications are pending (other than as listed in part 1.1 of Schedule X), which if pursued or granted may be material to the truth and accuracy of any of the previous information. 2.2 The processes employed and the products and services dealt in by each Group Company [both now and at any time within the last [six] years] do [and did] not use, embody, or infringe any rights or interests of third parties in Intellectual Property (other than those belonging to or licensed to the Group Companies and referred to in Schedule X), and no claims of infringement of any such rights or interests have been made by any third party. 2.3 The several licenses and agreements (including all amendments, novations, supplements, or replacements to those licenses and agreements), brief details of which are set out in Parts 2, 3, and 4 of Schedule X and true copies of which are attached to the Disclosure Letter are in full force and effect, no notice having been given on either side to terminate them; the obligations of all parties have been fully complied with; and no disputes have arisen or are foreseeable in respect thereof; and when the licenses are of such a nature that they could be registered with the appropriate authorities and when such registration would have the effect of strengthening the Group Company’s rights, they have been so registered. Parts 2,3, and 4 of Schedule X contain all licenses to the Group Companies of Intellectual Property. 2.4 There has been and is no misuse of know-how by any Group Company and the Vendors have not made any disclosure of know-how to any person other than the Purchaser, except properly, in the ordinary course of business, and on the basis that such disclosure is to be treated as being of a confidential character. [The Vendors agree not to use or disclose the know-how to any person after completion.] 2.5 No moral rights have been asserted or are likely to be asserted that would affect the use of any of the Intellectual Property in the business of any Group Company. 2.6 [Where patents are relevant: All patentable inventions made by employees of the Group Companies and used or intended to be used in the business of any Group Company were made in the normal course of the duties of the employees concerned and there are no outstanding or potential claims against any Group Company under any contract, under Section 40 of the Patents Act 1977, or any equivalent provision of any foreign law providing for employee compensation or ownership with respect to any rights or interests in Intellectual Property.] 2.7 [The Business IPR comprises all the rights and interests in Intellectual Property necessary or convenient for the carrying on of the business of each Group Company in and to the extent that it is presently conducted.] ENDNOTES 1
Benedict Bird and Anna Carboni are partners and Deborah Lincoln is a consultant at the international law firm of Linklaters & Alliance—all based in its Intellectual Property, Technology and
12.48 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE Communications Department in London. They have been assisted in writing this chapter by Steven Altham and Brian Sher, both associates in the EU/Competition Department of Linklaters & Alliance, and by their Continental colleagues, Patrick Rignell based in Paris and Markus Deck and Jiri Philippi based in Cologne. 2 On the meaning of “compromise” and “arrangement,” see Palmer’s Company Law, paragraph 12.011 or Tolley’s Company Law, paragraph R2012. 3 A scheme of arrangement requires the approval of a majority in number representing three-fourths in value of the members (or class of members) voting (excluding the buyer and persons having an identity of interest with him) at a specially convened meeting and, subsequently, the sanction of the court. The court will sanction the scheme only if it considers that the statutory majority of shareholders have not voted in favor of the scheme other than to promote the interests of those of the class whom they purport to represent (although this is not the only requirement). The court can attach conditions to its sanction. The scheme, once effective, binds all shareholders of the class that has approved the scheme. 4 See Section 427A and Schedule 15B of the Companies Act 1985, which were added by the Companies (Mergers & Divisions) Regulations in 1987 to implement the Third and Sixth Directive (Directives 78/885/EEC, [1978] OJ L295/36 and 82/891/EEC [1982] OJ L378/47, respectively) on the harmonization of company law in the EC. 5 Section 72(1) Patents Act 1977. 6 Other limits on registrability are as follows: A mark cannot be registered if it is deceptive or contrary to public policy; consists of specially protected emblems (such as flags, insignia, or representations of crowns or the Royal Family); conflicts with a provision of Community law, such as an appellation d’origine (“Cognac,” “Champagne,” etc.); or is applied for in bad faith. 7 Sections 47(1) and (2) Trade Marks Act 1994. 8 Section 46(4) Trade Marks Act 1994. 9 Section 1 Registered Design Act 1949. 10 Article 5 Directive 98/71/EC. 11 Article 6 Directive 98/71/EC. 12 Ibid. Further exclusions are to be found in Rule 26 of the Registered Designs Rules 1995. 13 Article 3 Directive 98/71/EC. 14 Rule 31(3) of Commission Regulation (EC) No. 2868/95 (Community trademarks); Rule 25 of the Common Regulations under the Madrid Agreement and Protocol (international registrations). 15 The full conditions for entitlement to be registered as proprietor of a Community trademark are set out at Article 5 Council Regulation 40/94/EEC and for international registrations at Articles 1(2) and 2 of the Madrid Agreement and Article 2(1) of the Madrid Protocol. 16 Rule 25 (3) of the Common Regulations under the Madrid Agreement and Protocol. 17 Copyrights arising before August 12, 1989, are governed by earlier Acts. 18 Sections 77–85 Copyright, Designs and Patents Act 1988. 19 Section 3(2) CDPA 1988. 20 Regulation 13(1) Copyright and Rights in Databases Regulations 1997. 21 Regulation 30 Copyright and Rights in Databases Regulations 1997. 22 Regulation 17(3) Copyright and Rights in Databases Regulations 1997. 23 Amended proposal for a Council Regulation on Community Design Article 12. 24 Faccenda Chicken v. Fowler, [1986] 1 All ER 617. 25 Copyright and Rights in Database Regulations reg. 15. 26 Copyright and Rights in Database Regulations reg. 14(1). 27 Copyright and Rights in Database Regulations reg. 14(2). 28 Hadley v. Baxendale, [1854] 9 Exch 341. 29 Section 24(3), Trade Marks Act 1994. 30 Section 30(6), Patents Act 1977. 31 Section 224, Copyright, Designs and Patents Act 1988. 32 Section 90(3), Copyright, Designs and Patents Act 1988. 33 Section 90(2), Copyright, Designs and Patents Act 1988.
ENDNOTES 12.49 34
Section 222(3), Copyright, Designs and Patents Act 1988. Section 19(3B), Registered Designs Act 1949. 36 Section 129(1) and Schedule 34, Finance Act 2000. 37 Increasingly, EC member state courts and competition authorities are also contributing to the development of EC competition law. 38 Article 12 of the Treaty of Amsterdam renumbered the provisions of the Treaty of Rome so that Article 85 became Article 81. 39 An undertaking is any collection of resources to carry out economic activities (including a company, partnership, sole trader, and an association). A group of companies is treated as a single undertaking, provided that the subsidiary companies are completely dependent on the parent and act in accordance with its instructions. See, for example, Case 30/87 Bodson v. Pompes Funebres, [1988] ECR 2479. 40 Ibid. On the meaning of effect on trade between member states, see Case 56/65 Société la Technique Minière v. Maschinenbau Ulm, June 30, 1966, [1966] ECR 235 and, more recently, Cases C-215/96 and C-216/96 Bagnasco v. Banca Popolare di Novara, January 21, 1999, [1999] ECR I 135. 41 Article 12 of the Treaty of Amsterdam renumbered Article 86 as Article 82. 42 See below. 43 “Substantial part of the common market” has been given a wide interpretation. 44 Council Regulation (EEC) No 4064/89 of December 21, 1989. 45 A full-function joint venture is a joint venture performing on a lasting basis all the functions of an autonomous economic entity. See Article 3(2) ECMR and the Commission notice on the concept of full-function joint ventures. 46 See Article 2 ECMR. 47 Commission notice on the definition of the relevant market for the purposes of Community competition law OJ C372, December 9, 1997. 48 Commission notice on the definition of the relevant market for the purposes of Community competition law, OJ C372, December 9, 1997, paragraph 7. 49 Commission notice on the definition of the relevant market for the purposes of Community competition law, OJ C372, December 9, 1997, paragraph 8. 50 The desire of the Commission to regulate certain behaviour can lead to narrow product market definitions. See, for example, Commission Decision 78/68 Hugin/Liptons, [1978] OJ L22/23; in the Court of Justice, Case 22/78 Hugin v. Commission, [1979] ECR 1869. Regarding the relevant geographic market, see, for example, Case 322/81 Michelin v. Commission, [1983] ECR 3461 in which the relevant geographic market was narrowed to the area in which the abuse occurred. 51 See, for example, the “ice cream cases:” Commission Decision 93/405 Schöller Lebensmittel, [1993] OJ L183/1; in the Court of First Instance, Case T9/93 Schöller v. Commission, [1995] ECR II 1611; Commission Decision 93/406 Langnese Iglo, [1993] OJ L183/19; in the Court of First Instance, Case T7/93 Langnese-Iglo v. Commission, [1995] ECR II-1533; in the Court of Justice, Case C-279/95 Langnese-Iglo v. Commission, [1998] ECR I-5609; Commission Decision 98/531 Van den Bergh Foods Limited (“Unilever” [1998], OJ L246/1). 52 Related markets are also described as neighboring markets. Competition authorities have paid particularly close attention to derivative and secondary markets (for example, markets for spare parts for goods sold in the “primary” market) and to markets for services following the sale of a good (known as “aftermarkets”). 53 Case C-333/94, Tetra Pak International SA v. Commission, [1996] ECR I - 5951. 54 On the meaning of concerted practice, see Case 48/69 ICI v. Commission (“Dyestuffs”), [1972] ECR 619; Cases 40/48, 50, 54–56, 111 and 113–114/73, Re: the European Sugar Cartel, [1975] ECR 1663; Cases C-89, 104, 114, 116–117 and C-125–129/85, A. Ahlström v. Commission (“Wood Pulp I”), [1993] ECR I 1307. 55 Société la Technique Minière v. Maschinenbau Ulm; Bagnasco v. Banca Popolare di Novara, supra. 56 See, for example, Case C-234/89 Delimitis v. Henninger Bräu, [1991] ECR I 935. 35
12.50 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE 57
This concept originated in cases involving a sale of a business where it was normal to find clauses that restricted the vendor from competing with the business sold to protect the goodwill of the business sold (for which the purchaser will have paid). See Case 42/84 Remia and Nutricia v. Commission, [1985] ECR 2545. The doctrine has since been applied to provisions of a franchise agreement in Case 161/84 Pronuptia de Paris v. Schillgalis, [1986] ECR 353. 58 Cases 56/64 and 58/64 Consten & Grundig v. Commission, [1966] ECR 299. 59 Case 262/81 Coditel SA v. Ciné-Vog Films SA (“Coditel II”), [1982] ECR 3381, paragraph 14. 60 Case 5/69, Völk v. Vervaecke, July 9, 1969, [1969] ECR 295. 61 [1997] OJ C372/13. The notice is not binding, but it gives guidance as to the Commission’s decisional practice. 62 A horizontal agreement is an agreement between undertakings operating at the same level(s) in the market, for example between manufacturers. 63 A vertical agreement is an agreement between undertakings operating at different levels in the market, for example between a manufacturer and a distributor. 64 Paragraph 9. 65 Commission Notice—Guidelines on the applicability of Article 81 of the EC Treaty to horizontal cooperation agreements, 2001/C3/02. 66 Commission Notice—Guidelines on vertical restraints, 2000/c291/01. 67 See Joined cases T-374/94, T-375-94, T-384-94, and T-388-94, European Night Services Ltd. (ENS), Eurostar (UK) Ltd, Union internationale des Chemins de fer (UIC), NV Nederlandse Spoorwegen (NS) and Société nationale des chemins de fer française (SNCF) v. Commission [1998] ECR II 3141 for a Court of First Instance judgment that signals a new, more economic, approach to the concept of appreciability. 68 On May 16, 2001, the Commission published a draft Notice on Agreements of Minor Importance, seeking observations on it with a view to adopting it later in the year. Under the draft Notice, the 5 percent threshold for horizontal agreements would be raised to 10 percent and the 10 percent threshold for vertical agreements would be raised to 15 percent. However, where competition is restricted by the cumulative effect of parallel networks of agreements, the 10 percent threshold for horizontal agreements would remain at 5 percent. 69 Only the provisions that restrict competition will be void: Société la Technique Minière v. Maschinenbau Ulm, supra; Case 319/82 Société de Vente de Ciments et Bétons de l’Est v Kerpen & Kerpen, [1983] ECR 4173. The rest of the agreement will stand, provided that the provisions rendered void are “severable” as a matter of national law. In England and Wales, this turns on the particular agreement in question and whether deletion of the anticompetitive clause materially affects the nature of the agreement (the blue pencil test). 70 Article 4, Regulation 17/62. 71 The Commission cannot impose a fine for infringement of Articles 81 and 82 for acts taking place after notification and before the decision by which the Commission rules on the application for exemption, provided that those acts fall within the limits of the activity described in the notification. The Commission can withdraw this immunity after preliminary examination of the agreement (Articles 15(5) and 15(6), Regulation 17/62). 72 This benefit is now very substantially reduced in respect of vertical agreements and many patent, design, and trademark licenses, because the Commission now has the power to grant exemption for such agreements retroactive to the date of entry into force of the agreement (Article 4(2)(a) and (b), Regulation 17/62 as amended). 73 White paper on modernization of the rules implementing Articles 85 and 86 (now 81 and 82) of the EC Treaty. 74 Proposal for a Council Regulation on the implementation of the rules on competition laid down in Articles 81 and 82 of the Treaty - COM(2000) 582. 75 The burden of proof that the criteria of Article 81(3) are satisfied continues to lie with the party seeking to benefit from Article 81(3). 76 A number of other recent and ongoing initiatives already point in the same direction, encouraging companies to take responsibility for assessing the legality of their agreements themselves.
ENDNOTES 12.51 Examples are the reformed policy on vertical restraints (such as supply and distribution agreements) that entered into force on January 1, 2000, with application from June 1, 2000, and the reform of the rules on horizontal cooperation agreements, including R&D agreements, which entered into force on January 1, 2001. 77 Case 258/78 Nungesser v. Commission (“Maize Seed”), [1982] ECR 2015. 78 Ibid. 79 Case 262/81 Coditel SA v. Ciné-Vog Films SA (“Coditel II”), [1982] ECR 3381; Maize Seed, supra; Case 27/87 Erauw-Jacquéry v. La Hesbignonne Société Co-opérative, [1988] ECR 1919. 80 Korah, An Introductory Guide to EC Competition Law and Practice, Seventh Edition 2000, pages 283 to 284. 81 Article 1(1)(3). 82 Article 1(1)(5). 83 Article 1(2). 84 Article 1(3). “Secret” and “substantial” are defined in Article 10. 85 Article 1(4). 86 Article 1(1)(3), which refers to “exploitation” of the licensed technology in the territory of the licensor within the common market. “Exploitation” is defined in Article 10(10) to mean “any use of the licensed technology in particular in the production, active or passive sales in a territory even if not coupled with manufacture in that territory, or leasing of the licensed products.” 87 Article 1(1)(6). 88 Article 1(2), 1(3) and 1(4). 89 Article 3(3). The IPR owner’s rights in the IPR are “exhausted” once the product is lawfully marketed anywhere in the common market. See Case 15/74 Centrafarm v. Sterling Drug, [1974] ECR 1147. 90 Article 3(1). 91 Article 3(2). 92 Article 3(4). 93 Article 3(5). 94 Article 3(6). 95 Article 3(7). 96 Recital 6, Article 1(1) and Article 5(1)(4). 97 Commission Regulation (EC) No 2790/1999 of December 22, 1999, on the application of Article 81(3) of the Treaty to categories of vertical agreements and concerted practices; Guidelines on Vertical Restraints, paragraphs 30 to 45. 98 The other main conditions are that the IPRs must be part of a vertical agreement and assigned to, or for use by, the buyer; the IPR provisions must be directly related to the use, sale, or resale of goods or services by the buyer or his customers; and there must not be any black-listed restrictions of competition (Guidelines on Vertical Restraints, paragraph 30). 99 Commission Regulation (EC) No. 2659/2000 of November 29, 2000, on the application of Article 81(3) of the Treaty to categories of research and development agreements. The Regulation replaces the R&D block exemption 418/85. 100 The Guidelines replace the 1968 Co-operation Notice, the 1979 Notice on Sub-contracting and the 1993 Notice on Co-operative Joint Ventures. 101 A competing undertaking is defined in Article 2(12) of the block exemption as “an undertaking that is supplying a product capable of being improved or replaced by the contract product (an actual competitor) or an undertaking that would, on realistic grounds, undertake the necessary additional investments or other necessary switching costs so that it could supply such a product in response to a small and permanent increase in relative prices (a potential competitor).” 102 Recital 17. 103 This does not include the setting of production targets in joint production of the R&D products or the setting of sales targets and the fixing of prices charged to immediate customers in joint distribution of the R&D products (block exemption, Article 5(2)). 104 The new block exemption for vertical restraints of competition also empowers national authorities to withdraw the benefit of the exemption: Article 7, Commission Regulation (EC) No. 2790/1999.
12.52 INTERNATIONAL M&A: THE EUROPEAN PERSPECTIVE 105
Paragraph 10. Paragraph 13. 107 Paragraph 39. 108 According to paragraph 47, “When rights to intellectual property are marketed separately from the products concerned to which they relate, the relevant technology market has to be defined as well. Technology markets consist of the intellectual property that is licensed and its close substitutes, that is other technologies which consumers would substitute at comparable costs.” 109 On ancillary treatment of restrictions, see the section on the ECMR. 110 Case 85/76 Hoffmann La Roche v. Commission, [1997] ECR 461. 111 Michelin v. Commission, supra. 112 Case 102/77, Hoffmann La Roche v. Centrafarm, [1978] ECR 1139. 113 Paragraph 16. 114 Hugin/Liptons, supra. 115 Case C-53/92 Hilti AG v. Commission, [1994] ER I - 666; Case C-333/94, Tetra Pak International SA v. Commission, [1996] ECR I - 5951. 116 Case 238/87. Volvo AB v. Erik Veng, [1998] ECR 6211. 117 supra. 118 Case T-51/89 Tetra Pak International SA v. Commission, [1994] ECR II - 755. 119 Cases C-242/91 and C-241/91, Radio Telefis Eireann v. Commission, [1995] ECR I - 743. 120 Radio Telefis Eireann v. Commission at paragraphs 49 and 50. Derek Ridyard has asked why it is valid for competition law intervention to lead to compulsory licensing of TV listings, when it would not be valid to use the same laws to insist on compulsory licensing for every other valuable IP right that some competitor would like to have. In his view, the answer “must lie in the fact that TV listings are a by-product of another activity (television broadcasting) rather than a creative activity that is subject to effective competition.” See Essential Facilities and the Obligation to Supply Competitors under UK and EC Competition Law, [1996] ECLR 438. 121 Case C-7/97 Oscar Bronner v. Mediaprint, [1998] ECR I - 7791. 122 At paragraph 34 of his Opinion, [1998] ECR I - 7791, the Advocate General (who provides an Opinion for the court in all cases before the European Court of Justice) referred to the essence of this doctrine as follows: “a company which has a dominant position in the provision of facilities which are essential for the supply of goods or services on another market abuses its dominant position where, without objective justification, it refuses access to those facilities. Thus in certain cases a dominant undertaking must not merely refrain from anti-competitive action but must actively promote competition by allowing potential competitors access to the facilities which it has developed.” 123 Paragraph 38, referring to Cases 67/3 and 77/3, ICI v. Commission, [1974] ECR 223. 124 Paragraph 41. 125 It has been questioned whether or not this criterion should be strictly applied, as this would mean that the essential facilities doctrine could be used only in cases of natural monopoly. See Bergman, The Bronner Case—A Turning Point for the Essential Facilities Doctrine?, [2000] ECLR 59. 126 Case T-504/93 Tiercé Ladbroke v. Commission, [1997] ECR II 923. 127 See Article 3 ECMR and Commission notice on the concept of concentration. Corporate deals that will normally constitute a concentration are a private acquisition of shares, a private acquisition of assets, a private acquisition of part of a business, and a public offer. A merger will qualify as a concentration, although a demerger may not, because there is often no change of ultimate control. A joint venture will qualify as a concentration only when it is a “full function.” 128 See Article 1(2) ECMR. 129 See Article 4 ECMR. 130 See Article 5 ECMR and Commission notice on calculation of turnover. 131 Commission notice on the concept of undertakings concerned. 132 Under Article 9 ECMR, the competent authorities of a member state may request the Commission to refer to them a notified concentration when the concentration threatens to create or to strengthen a dominant position as a result of which effective competition will be significantly impeded on a market within that member state, which presents all the characteristics of a distinct 106
ENDNOTES 12.53 market. Article 21(3) allows Member States to take certain measures to protect legitimate interests in fields such as public security and plurality of the media. 133 See Article 14 ECMR. 134 If Article 9 is invoked, the period is increased to six weeks from notification: Article 10(1) ECMR. 135 Article 10(1) ECMR. 136 The possibility remains that the competition authorities of a member state may ask for the whole or part of the concentration to be referred to them under Article 9. 137 Clauses capable of falling within this definition include noncompetition covenants, nonsolicitation clauses, confidentiality provisions, licenses of technical and commercial property rights and of know-how, purchase and supply agreements, agreements relating to the use of trademarks, outsourcing agreements, and distribution agreements. “Necessary to the implementation of the concentration” means that in their absence the concentration could not be implemented or could only be implemented under more uncertain conditions, at substantially higher cost, over an appreciably longer period or with considerably greater difficulty. Agreements that aim at protecting the value transferred, maintaining the continuity of supply after the break-up of a former economic entity, or that enable the startup of a new entity, usually meet these criteria. See the Commission’s Notice on restrictions directly related and necessary to concentrations (still in draft form—available at http://europa.eu.int/comm/dg04/lawmerg/merger.htm).
CHAPTER
13
INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES Susan Barbieri Montgomery and Leonard Schneidman Foley Hoag & Eliot LLP
INTRODUCTION
As intellectual property rights become an increasingly significant business asset, the need for tax planning relating to any intellectual property rights obtained in a merger or acquisition transaction becomes more important. One critical question with both tax and business consequences is whether or not to extract the intellectual property rights from where they were held by the acquisition target and place them in a separate intellectual property rights holding company. On the business and operations side, there are a number of factors to consider in weighing the advantages of centralized, versus localized, ownership of intellectual property assets. Localized ownership may be favored when the intellectual property is used only by distinct local businesses or brands; where the companies wish to avoid intercompany royalties or imputed income, which might be seen as skewing corporate earnings; or in anticipation of a spinoff or divestiture of the local business, including the intellectual property rights used in that business’ territory. Centralized ownership of intellectual property assets, however, offers many business advantages, which include centralized strategic planning; a single team handling legal, marketing, and administrative matters; uniform policies and enforcement; and administrative and maintenance cost efficiencies. The business interests often favor a decision to centralize ownership in an intellectual property holding company. The tax issues to consider in deciding whether to transfer the acquired intellectual property rights to a holding company include those relating to • The formation and transfer of intellectual property rights to the holding company • The location of the holding company (e.g., United States or foreign) • The compensation to be paid to the holding company by the affiliated group companies utilizing the intellectual property rights 13.1
13.2 INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES
This chapter will explore these tax issues in greater detail, with particular emphasis on the use of a Delaware holding company for U.S. state tax planning purposes and the use of an offshore holding company for global intellectual property rights tax planning, including licensing the intellectual property rights to a U.S. affiliate. FORMATION OF THE HOLDING COMPANY Contribution of Intellectual Property Rights. Typically, a holding company is formed by
the contribution of the particular intellectual property rights to a related corporation in exchange for its stock. Domestic Transfer of Intellectual Property Rights. Section 351 of the Internal Revenue Code of 1986 (the Code)1 provides that no gain or loss shall be recognized when property is transferred to a corporation for stock if, immediately after the transfer, the transferor owns at least 80 percent of the stock of the transferee. With the proliferation of valuable technology and information, the definition of property for purposes of Section 351 has come under pressure.2 Section 351 provides no definition of property. It should be noted, however, that Section 351(d) specifically excludes services from the meaning of property for Section 351. Generally, court cases indicate that Section 351 property status attaches to “anything of value that can be legally owned and transferred.”3 A more specific starting point for the Section 351 property concept is the extensive listing of intangibles contained in Section 936(h) (3)(B). The term intangible property means any
• • • • •
Patent, invention, formula, process, design, pattern, or know-how; Copyright or literary, musical, or artistic composition; Trademark, tradename, or brand-name; Franchise, license, or contract; Method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical date; or • Similar item that has substantial value independent of the services of an individual. Even if the transferred intellectual property rights constitute property for the purposes of Section 351, the transaction will fail to qualify for nonrecognition treatment unless it constitutes a transfer for purposes of Section 351. Because of the wide variety of means to convey, or partially convey, such rights, the transfer requirement can be particularly difficult in transactions involving intellectual property rights. The Internal Revenue Service has tended to apply the sale or exchange versus lease or license analysis to the transfer requirement and, in effect, requires a complete conveyance of all rights in the intellectual property for Section 351. In the case of E.I. Dupont de Nemours & Co.,4 the Court of Claims rejected this Internal Revenue Service analysis and, in effect, discredited the IRS’s insistence on a complete conveyance for the Section 351 transfer requirement. To provide a statutory listing of intangibles that qualify as Section 351 property (by referring to the listing in Section 936(h)) as well as to resolve the partial conveyance
FORMATION OF THE HOLDING COMPANY 13.3
dispute represented by the Dupont case against the IRS, an amendment to Section 351 was proposed in the Taxpayer Refund and Relief Act of 1999. Although that act was vetoed by President Clinton, the proposed amendment (or one similar) to Section 351 may yet appear in tax legislation. Offshore Transfers of Intellectual Property Rights. Transfers of intellectual property rights
made with a Section 351 exchange to related corporations are subject to Section 367(d). In a transaction that would have qualified for tax-free treatment under Section 351 had the foreign corporation been a domestic corporation, Section 367(d) treats a U.S. corporation that transfers intellectual property rights to a foreign corporation as having sold the intellectual property rights in exchange for payments that are contingent upon the productivity, use, or disposition of the property. These imputed royalty payments must reasonably reflect the amounts that would have been received (1) annually in the form of such payments over the useful life of the intellectual property rights or (2) in the case of a disposition following the transfer (whether direct or indirect) at the time of the disposition.5 These amounts are required to be commensurate with the income attributable to the intellectual property rights. (See the discussion concerning “The Superroyalty Provisions,” infra.) Originally, Section 367(d) treated any income includable by the transferor under that section as ordinary income from sources within the United States. This reverse-sourcing rule denies a foreign tax credit for withholding taxes paid to the foreign jurisdiction. The reverse-sourcing provision was repealed, and under Section 367(d), effective from August 1997, imputed royalties are treated as derived from foreign sources as an actual royalty would have been foreign-sourced. Business Purpose. A holding company formed with a proper business purpose and
operated as a functionally separate entity is substantially more likely to survive the rigors of an income tax examination than one that lacks such purpose and functionality. If there are valid business purposes other than the reduction of taxes for the transfer of intellectual property rights to the holding company, the existence of tax savings alone should not cause the structure or transaction to be ignored. Among the valid nontax business reasons for forming a holding company for trademarks, the following have been accepted by at least one court:6 • Protecting and enhancing the value of the trademarks • Segregating the trademark from the company’s other assets so that the parent can determine how valuable the marks might be • Protecting the marks from the claims of the parent’s creditors • Giving management greater flexibility to pursue other business strategies (e.g., franchising, creating spinoffs, and raising capital). It must be noted, however, that more recent cases have shown courts being much more wary about the purported business purposes supposedly supporting the often substantial tax savings inherent in utilizing a holding company. In addition to nontax business purposes, the holding company should carry on its own separate business activities, including the following:
13.4 INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES
• • • • •
Maintenance of an office Hiring of staff Maintaining a bank account Holding itself out to third parties as a separate corporation Having its own board of directors that holds regular meetings
USE OF A DOMESTIC HOLDING COMPANY
Once the acquiror has decided to maintain its acquired intellectual property rights in the United States and has considered the management and location issues, it will seek to structure the ownership and use of those intellectual property rights in the most taxefficient manner. One common structure used to shelter taxable income from state and local taxes is to establish a Delaware Investment Holding Company that will own and license the intellectual property rights.7 Delaware Investment Holding Companies. A Delaware Investment Holding Company’s
income is exempt from Delaware income and gross receipts tax.8 Therefore, a typical use of a Delaware Investment Holding Company (DIHC) is to transfer the intellectual property rights to the DIHC, which then licenses the intellectual property rights in exchange for royalty income or licensing fees (see Exhibit 13.1). These royalty payments and licensing fees are exempt from Delaware taxes as long as the activities of the DIHC are confined to the maintenance and management of intangible assets, such as intellectual property rights. In addition, the licensee corporations may be entitled to a deduction in many state and local jurisdictions for royalties or licensing fees paid to the DIHC. The transfer of intellectual property rights to a DIHC, which then licenses the intellectual property rights to related corporations has the effect of converting taxable income in one state into tax-exempt income in Delaware. For example, Company A’s wholly owned subsidiary, Company B, has an operating business in State X that sells products with a certain trademark. In Year 1, net sales income for Company B attributable to products sold with the trademark is $1 million; therefore, it pays tax on $1 million to State X. In Year 2, Company A transfers its trademark tax-free to a DIHC; Company B and the DIHC enter a licensing agreement with
Company A
100% Stock Delaware Investment Holding Company
Intellectual Property Rights
100 %
Loan or distribution ($) License Royalty ($)
Exhibit 13.1 Delaware Investment Holding Companies
Company B
USE OF A DOMESTIC HOLDING COMPANY 13.5
one another that requires Company B to make royalty payments equal to 8 percent of the net sales income of products sold with the licensed trademark. In Year 2, Company B’s net sales income from products sold with the licensed trademark is again $1 million. It remits an $80,000 royalty payment to the DIHC. Delaware will not impose tax on the $80,000 received by the DIHC. On its State X tax return, Company B will report $1 million of income attributable to sales of products with the licensed trademark, less an $80,000 deduction for royalties paid to the DIHC, with the result that the Companies’ taxable income for licensed products sold is $920,000. As this example demonstrates, using the DIHC shelters income from taxation by State X. Attacks on Delaware Investment Holding Companies. Because using a DIHC to hold title
to and license intellectual property rights may result in reduced tax liability in states other than Delaware, several states have resisted the DIHC structure. Courts in a number of states have sanctioned different methods of attacking the DIHC structure and its intended tax results. Some states have devised legislative solutions to thwart the intended tax benefits of DIHCs, as well. Sham Corporation. Some states believe the DIHC is a sham that lacks substance; therefore, the local company to which the trademark is allegedly licensed is taxable on the DIHC’s income. Because of the high legal threshold necessary to disregard a corporation for tax purposes, no states have made a widespread attempt to tax DIHC income on the sham corporation theory. Economic Presence. Courts in some states have avoided the intended tax result of the
DIHC structure by accepting that the DIHC does business in the same state as the licensee, so it is taxable in that state. In Geoffrey, Inc. v. South Carolina Tax Commission,9 the South Carolina Supreme Court held that the mere economic presence of a DIHC created a nexus sufficient to impose an income tax on the DIHC. Geoffrey, Inc. was a DIHC that owned and licensed the “Toys R Us” and related trademarks to “Toys R Us” stores, including six retail stores in South Carolina. Geoffrey was entitled to a royalty of one percent of the net sales of products sold and services rendered under the licensed trademark. The South Carolina Tax Commission initially determined that the Toys R Us licensee was not entitled to deduct the royalties it paid to Geoffrey because Geoffrey was a paper corporation, and the royalty expenses paid to Geoffrey entailed an arbitrary shift of income and expenses. Although the Commission reversed its initial position and allowed the deduction, it attempted to tax Geoffrey’s earned income. Geoffrey challenged the assessment on the basis that the due process and commerce clauses of the U.S. Constitution prohibit South Carolina from taxing Geoffrey’s royalty income. Geoffrey specifically argued that no nexus existed between South Carolina and Geoffrey and that South Carolina had not conferred benefits, to which the tax was rationally related, on Geoffrey. South Carolina’s Supreme Court held that the nexus requirement was satisfied, even though Geoffrey had no physical presence in South Carolina. The Supreme Court noted that Geoffrey had purposefully directed its activities to that state’s economic forum by consenting to and benefiting from the use of Geoffrey’s intangibles in South Carolina.
13.6 INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES
The Court additionally found that South Carolina made it possible for Geoffrey to earn royalty income. As a result, the Court concluded that taxing Geoffrey’s royalty income would not violate either the due process or commerce clauses of the Constitution and sustained the tax commission’s assessment of tax against Geoffrey. The U.S. Supreme Court denied Geoffrey’s petition for certiorari, leaving open the question of whether a state may impose an income tax (as distinguished from a sales or use tax) on a taxpayer that does not maintain any physical presence in the state. Although a few states have adopted positions similar to that of South Carolina’s Supreme Court in Geoffrey, (see e.g., Massachusetts Department of Revenue Directive 96–2), because of the serious constitutional issues raised by the Geoffrey decision, it is unclear if other courts will adopt the “economic presence” rationale of the case. For example, in a long-awaited decision, the Tennessee Court of Appeals has ruled that an out-of-state bank’s credit card activities in Tennessee were insufficient to establish a Commerce Clause nexus.10 Agency Nexus. Perhaps the most thorough and well-written description of the use of a
holding company to hold and license intellectual property rights (in this case, trademarks) is in the case of Kmart Properties, Inc.11 In this case, the national retailer, Kmart Corporation, transferred all its trademarks to a wholly-owned subsidiary, Kmart Properties, Inc. (KPI), then licensed them back to Kmart Corporation, the parent.12 As stated by the court: The net effect of these transactions for Kmart is that its taxable income in the states in which it does business which allow it to report on a separate corporate entity basis is reduced by both the royalties and interest it pays to KPI. Although this income has been effectively transferred to KPI, Michigan does not tax KPI on this income. KPI does not have employees or tangible property in states other than Michigan and so hopes to avoid being subject to the taxing jurisdiction of those states in which it licenses its intellectual property and which allow its parent to report taxes on a separate entity basis. At the time Kmart implemented this strategy, it was estimated to save Kmart approximately $12 million a year in state corporation income taxes.
Because of its 186 enumerated Findings of Fact and excellent discussion of relevant trademark law, the opinion is required reading for any tax professional or corporate executive contemplating using a holding company to hold and license IP rights. Although the Hearing Officer articulated a very clever legal theory, it is difficult to read the Findings of Fact without the impression that the Hearing Officer felt the entire transaction lacked any business purpose other than reducing New Mexico tax. Although this may or may not be true, it clearly influenced the Hearing Officer’s legal conclusions in the case. Turning back the hands of time, and neatly sidestepping the entire Geoffrey “economic presence” debate in the process, the Hearing Officer relied on early cases such as Scripto13 and Tyler Pipe14 and decided the Kmart Properties case essentially on an agency nexus rationale. That is, the Hearing Officer determined that, by the contractual relationship created by the license agreement between KPI and Kmart Corporation, which had stores located in New Mexico, Kmart Corporation’s physical presence created the physical presence required to subject KPI to New Mexico taxing jurisdiction.
USE OF A FOREIGN HOLDING COMPANY 13.7
Whether “economic presence,” “agency nexus,” or some other legal theory can be successfully asserted by state tax authorities against the use of DIHCs is debated heatedly among tax professionals. The resolution of the issue will probably eventually be determined by the United States Supreme Court. Legislative or Administrative Actions. Other states have not relied on judicial remedies
to attack DIHCs, but, instead, have implemented legislative or administrative changes. Specifically, some states have enacted laws that make local companies taxable on the income of DIHC that is connected with the state. Ohio, for example, enacted a law that requires its corporate taxpayers to include in income interest and intangible costs and expenses paid to investment or holding companies that are part of the taxpayer’s affiliated group.15 This adjustment, however, will not apply to payments that the taxpayer can prove came from a transaction not primarily tax motivated and were made, directly or indirectly, to an unrelated party by the related holding company. Florida has promulgated a rule that selling or licensing the use of intangible property in Florida will create a nexus for state income tax purposes.16 The result is to tax the income of a DIHC that relates to the license of an intangible to a Florida business. USE OF A FOREIGN HOLDING COMPANY Offshore Intellectual Property Rights Licensed to a Related United States Licensee.
If valuable IP rights are owned outside the United States but are intended to be exploited in the U.S. market, licensing them to a related U.S. licensee will typically cause a tax deduction in the United States for the royalty payments because the payments are generally deductible as a business expense under Section 162. Deductibility of License Royalties.17
Royalty Rate. Under Section 482, the IRS has the power to reallocate income, deduc-
tions, credits, and allowances among business enterprises controlled by the same interests, as necessary to clearly reflect the income of each such enterprise. The IRS can shift income and deductions to produce the tax results that would have been obtained if the related parties had been dealing as independent parties at arm’s length. The arm’s length standard applies to transfers of intangible rights—including intellectual property rights—between entities that are controlled by the same interests, regardless of whether the transfer is in the form of a license, sale, or contribution to capital. The regulations of Section 482 give several methods a taxpayer may use to determine the arm’s length royalty rate amount that should be charged in a controlled transfer of intangible property.18 • As its name suggests, the comparable uncontrolled transaction method evaluates whether the amount charged reflects an arm’s length amount regarding the amount charged in comparable uncontrolled transactions.19 • The comparable profits method makes that same evaluation relating to objective measures of profitability from uncontrolled taxpayers that engage in similar business activities under similar circumstances.20
13.8 INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES
• The profit split method arrives at the arm’s length charge by the relative value of each controlled taxpayer’s contribution to the combined operating profit or loss attributable to one or more controlled transactions.21 • Finally, the regulations permit the use of an alternative method that takes into account that uncontrolled taxpayers evaluate the terms of a transaction by considering realistic alternatives to the transaction and enter into the transaction only if no alternatives are preferable.22 The “Superroyalty” Provision. Inclusion of the superroyalty provision in the Internal
Revenue Code resulted from lingering concerns about the possibility of avoiding taxes on the exploitation by foreign affiliates of intangibles developed in the United States, despite the basic provisions of Section 482. That provision states, “In the case of any transfer (or license) of intangible property . . . the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” This superroyalty provision allows the Internal Revenue Service to adopt a retrospective view when determining whether income relating to the transfer of IP rights is commensurate with the income attributable to the IP rights. That is, even if the terms of a transfer reflect an arm’s length approach at the time of the transfer, if the exploitation of the intellectual property rights is more profitable than anticipated in subsequent years, the IRS can adjust the royalties deemed paid to or received by a related corporation. Withholding for U.S. Tax. Generally, foreigners are taxed at the graduated rates that
apply to U.S. taxpayers on their U.S. source income that is effectively connected with a U.S. trade or business. If the U.S. source income not effectively connected with a U.S. trade or business and received by foreigners is “fixed or determinable annual or periodical income,” that income is subject to a 30 percent tax on the gross amount of the income.23 For example, royalties paid to nonresident aliens and foreign corporations for IP rights exploited in the United States are subject to this 30 percent tax. The 30 percent tax also applies to the proceeds of any sale of intangibles when the payments made regarding the sale are contingent on the productivity, use, or disposition of the intangibles.24 This is collected by means of a 30 percent withholding tax imposed on the person or entity making the payment to the foreign licensor. Internal Revenue Service Enforcement. In recent years, Section 482 has been the princi-
pal focal point of IRS international tax compliance efforts. The IRS has been greatly aided in these efforts by the draconian accuracy-related penalty imposed under Section 6662 for failure to properly reflect the arm’s length standard of Section 482. In fact, the Section 6662 penalty of 20 to 40 percent produces the largest penalty in the Code, other than for outright fraud, and imposes that penalty even for innocent errors. The penalty provision generally requires proper documentation of related analysis and contemporaneous adherence to the Section 482 rules. Surveys of corporate tax officers consistently show that dealing with Section 482 is their leading tax compliance concern. THE EFFECT OF TAX TREATIES Withholding Rates. Tax treaties often reduce or eliminate the rate of withholding for
United States tax on royalties. A common tax planning technique in cross-border
THE EFFECT OF TAX TREATIES 13.9
licensing of IP rights to use in the United States has historically been to place the IP rights in a business of a country with an income tax treaty (which provided no withholding tax on royalties) with the United States. That business entity then licensed the IP rights to the U.S. licensee for a stream of royalty payments. Because the treaty provided no withholding for U.S. tax on royalties paid to a resident business entity of the treaty country, the parties could avoid U.S. tax on the royalties. Cascading Royalties. SDI Netherlands B.V. v. Commissioner25 presents an example of
how in the past tax planning could avoid the United States tax on royalties paid to foreigners (see Exhibit 13.2). In SDI Netherlands, SDI Bermuda (an affiliate of SDI Netherlands) granted the worldwide rights to certain software to SDI Netherlands. SDI Netherlands licensed the software to SDI USA, its affiliate in the United States, collected licensing fees from SDI USA, and paid royalties to SDI Bermuda. Royalties paid by SDI USA to SDI Netherlands were, at that time, exempt from withholding for U.S. tax under the United States-Netherlands Treaty. Had SDI USA paid the royalties directly to SDI Bermuda, however, it would have been subject to 30 percent withholding for U.S. tax. The IRS claimed that SDI Netherlands was liable for the 30 percent tax imposed on U.S. source royalties paid to foreigners, contending that royalties paid by SDI USA to SDI Netherlands were U.S. source and retained that character when paid to SDI Bermuda by SDI Netherlands. The Tax Court, however, concluded that the royalties paid to SDI Bermuda could not be characterized as U.S. source income. Characterizing such royalty payments as U.S. source income would result in cascading royalties because the royalties were paid from a licensee in the United States to intermediate licensors abroad and ultimately to the owner of the intangible property, resulting in the possibility of multiple withholding taxes being paid on the same royalty. Limitations on Treaty Benefits. In response to tax planning techniques such as those used in SDI Netherlands, the Treasury Department initiated a program to include a “limitation on benefits” article in all treaties, both existing and new, that prevents “treaty shopping” by restricting third-party use of U.S. tax treaties.26 As a result, essentially all U.S. treaties in effect have limitation on benefits provisions that limit the treaty’s availability to taxpayers who are economically present in the treaty country.
SDI Ltd.
100
100% SDI Antilles 100% SDI Netherlands License
SDI Bermuda Ltd.
License Royalties
%
($)
100% Royalties ($) SDI USA
Exhibit 13.2 Cascading Royalties
EUROPEAN AFFILIATES
13.10 INTELLECTUAL PROPERTY TRANSFERS—HOLDING COMPANIES Anti-Conduit Regulations. When the IRS determines that the participation of a foreign
intermediary in a licensing transaction is pursuant to a tax avoidance plan under the anti-conduit regulations, even if a taxpayer is eligible for treaty benefits and complies with the limitation on benefits article, the IRS may disregard the intermediate entity if the intermediary is related to the ultimate licensor or licensee, or would not have participated in the licensing arrangement on substantially the same terms, but for the fact that the other party of the licensing arrangement engaged in the licensing transaction with it.27 For example, had the facts in the SDI Netherlands case arisen after the enactment of the anti-conduit regulations, the IRS might have been able to disregard the existence of SDI Netherlands in the licensing transaction, even though that corporation was otherwise entitled to the benefits of the United States-Netherlands Income Tax Treaty. Foreign Holding Company Licensing to Its Foreign Affiliates. IP rights located outside the United States and intended to be exploited in non-U.S. markets are often acquired from target. In this context, it is often advantageous from a tax planning perspective to put the intellectual property rights in a convenient foreign holding company jurisdiction. In Europe, that jurisdiction is typically the Netherlands, primarily because of its advance tax ruling system and extensive tax treaty network that permits the tax-efficient licensing of the acquired intellectual property rights. The tax objective of using the foreign holding company to license the intellectual property rights into non-U.S. markets to avoid the imposition of U.S. tax on the non-United States source royalty income earned by the foreign holding company involves intricate questions of Subpart F of the Code related to controlled foreign corporations, which are beyond the scope of this chapter. Note that if the intellectual property rights acquired are held by a U.S. taxpayer, any transfer of the acquired intellectual property rights to a foreign holding company must run the gamut of Section 367(d), previously discussed.
ENDNOTES 1
All section references are to the amended Internal Revenue Code of 1986 (Title 26 USCA). See generally, Bristol and Leibler, “Intellectual Property as Transferable Property for Purposes of Section 351 PLI,” Tax Strategies for Corporate Acquisitions, 1999. 3 J. Clifton Fleming, Jr., “Domestic Section 351 Transfers of Intellectual Property: The Law as It Is vs. The Law as the Commissioner Would Prefer It to Be,” 16 J. Corp. Tax n.99 (1989). 4 471 F.2d 1211 (Ct. Cl. 1973). 5 Code § 367(d)(2)(A). 6 See Aaron Rents, Inc. v. Collins, Civil Action File D-96025 (Ga. Superior Ct., Fulton, CY, 1999). 7 See, generally, Gaggini, “State Taxation of Passive Income Subsidiaries, PLI,” Tax Strategies for Corporate Acquisitions, 1999. 8 30 Del.Code § 1902(b)(8). 9 437 S.E.2nd 13 (S.C. 1993). 10 J.C. Penney National Bank v. Johnson, Appeal No. M1998–00497–COA–R3–CV (Ct. App. Tn. 1999). 11 New Mexico Taxation and Revenue Department, No. 00–04, February 1, 2000. 12 Because of the particular operation of Michigan tax law, KPI was established as a Michigan, rather 2
ENDNOTES 13.11 than a Delaware, corporation. 13 Scripto, Inc. v. Carson, 362 U.S. 207, 80 S.Ct. 619 (1960). 14 Tyler Pipe Industries, Inc. v. Washington State Department of Revenue, 483 U.S. 232, 107 S.Ct. 2810 (1987). 15 57 Ohio Rev. Code 5733.042. 16 12 Fla. Admin. Code Ann. § 12C–1.011(1)(p). 17 The following discussion assumes the transaction involved constitutes a license, rather than a sale, for tax purposes. 18 See Treas. Reg. § 1.482–4. 19 Treas. Reg. § 1.482–4(c). 20 Treas. Reg. § 1.482–5. 21 Treas. Reg. § 1.482–6. 22 Treas. Reg. § 1.482–4(d). 23 Code §§ 871(a); 881(a). 24
Code § 871(a)(1)(D). 107 T.C. 161 (1996). 26 See Daniel M. Berman and John L. Hynes, “Limitation on Benefits Clauses in U.S. Income Tax Treaties,” Tax Mgmt International Journal, Vol. No. 29/12 (Dec. 8, 2000). 27 See Treas. Reg. § 1.881–3(c). 25
CHAPTER
14
OFFSHORE CORPORATIONS Tira Greene Consultant, Anguilla
Michael J. Ward Counsel Limited, Anguilla
INTRODUCTION
Going offshore is a big step for most businesses. Furthermore, contrary to the common perception, it is not a simple matter involving the following of basic rules to obtain maximum goals. Rather, it is the result of detailed planning based on a business model, the countries involved, and other requirements of the corporation or group of corporations undergoing the process. In view of these restrictions and the need to retain business privacy for clients engaged in international structuring, it is not possible to offer specific examples of successful (or even unsuccessful) ventures. Instead, an attempt has been made to point out areas of possible interest and potential problems and pitfalls. OFFSHORE JURISDICTIONS
When approaching the issue of offshore tax havens, it should be noted that there is no generic type of offshore jurisdiction and there are significant differences within jurisdictions that offer tax-free status to foreign corporations and persons. These differences can have an impact on tax liability originating from the taxing jurisdictions. There are so-called pure tax havens such as Anguilla and Bermuda, where there are no income taxes levied on local and foreign persons and corporations alike. Then there are havens that distinguish between taxation of locals and that of special categories of offshore persons. These jurisdictions offer tax-free status to qualifying persons and corporations. The differences are important because of the implied intentions of the Organization for Economic Development (OECD) and the current harmful tax regime campaign.1 There is the growing possibility that non-pure havens may be legislated against or at least harassed out of existence in the near future. Pure tax havens provide greater flexibility in exploiting properly placed Intellectual Property. 14.1
14.2 OFFSHORE CORPORATIONS HOLDING COMPANY OR ACTIVE BUSINESS?
In examining the issues revolving around mergers and acquisitions as they relate to Intellectual Property and going offshore, it would be equally useful to examine Intellectual Property in the context of a startup. This serves to illustrate both the issues that arise in mergers and acquisitions and the difficulties and challenges in designing schemes to achieve the desired objectives in going offshore. A startup is usually characterized as having possession of Intellectual Property that is, for the most part, unproven in terms of value or marketability. At this stage the Intellectual Property is only potentially valuable. There are two options for transferring the ownership of the Intellectual Property to an entity established in an offshore jurisdiction. 1.
2.
The corporation holding the Intellectual Property can be used for the mere parking of the Intellectual Property until such time as it is ready to be exploited. The corporation can be used to actively manage the worldwide exploitation of the Intellectual Property.
Today, most Intellectual Property is placed offshore to facilitate its efficient and/or effective exploitation. Tax legislation has effectively negated the benefit of nominee corporations—see, for example, the “mind, management and control” common law tests in Canada2 or the “suitably equipped for business” provisions in the Republic of South Africa.3 Management of Intellectual Property in this context relies heavily on treaty and nontreaty licensing. For example, structures can be employed utilizing Holland or Ireland for principal licenses to take advantage of their treaty networks and friendly corporate tax regimes.4 Due to the aggressive tax regimes in North America and Australia, it is often advisable to license directly into these territories in order to isolate specific transactions from the global structure. There are two factors to this type of treatment that need to be assessed—first, the initial cost for proper legal advice, particularly in the more aggressively taxed countries, can be quite expensive; second, the professional, active, mind, and management in the offshore jurisdiction. Recent decisions in the U.S. indicate that with proper planning and the advice of qualified U.S. tax counsel, these structures can be used to mitigate ultimate U.S. taxation and isolate the United States income from worldwide income. WHEN TO GO—BEFORE THE INTELLECTUAL PROPERTY EXISTS
The problem with IP is that it has value as soon as it leaves someone’s head and enters the outside world. Whether there is a patent or trademark, high-taxing jurisdictions, for obvious reasons, like to retain that value of intellectual property within their sphere. There is a tendency to attribute value to intellectual property leaving the country and tax the value as though it were a disposition,5 whether an actual disposition takes place or not. This concept is employed in the United States and Canada. The deemed value is often the potential commercial value rather than the actual value based on expendi-
WHEN TO GO—EARLY IN THE DEVELOPMENT CYCLE 14.3 OFFSHORE VEHICLE
INVENTOR
OFFSHORE IP
Purchase and Sale of Invention
IP Development
Exhibit 14.1 Simple Removal of IP Prior to Creation
ture. This is partially due to the often highly inflated values used by promoters of a stock or (in Canada) to maximize the tax writeoff associated with the sale of a Class 12 asset.6 Where practicable, the best time to bring Intellectual Property offshore is before it even exists. The idea can be brought offshore and sold to a development corporation situated offshore where the value is created (refer to Exhibit 14.1). In recent years, a small but highly respected group of cryptographers has employed this technique in Anguilla, primarily to avoid developing cryptographic software inside the United States where it is subject to military export procedures, while benefiting from a favorable tax climate. WHEN TO GO—EARLY IN THE DEVELOPMENT CYCLE
Although ideal, it is not often possible or desirable to create Intellectual Property in an advantageous environment, whether the reasons for wishing to do so are tax-driven or driven by a desire to operate in a simpler regulatory environment. Additionally, in a post-merger situation, the Intellectual Property is likely to have existed prior to merger. It is advisable that once Intellectual Property has been moved offshore, steps should be taken to ensure that further development is commissioned by the Intellectual Property holding corporation in order to maximize benefits. The earlier the stage of the R&D process when the property is removed, the lower the costs of moving to an offshore jurisdiction. It has been suggested (and tried) in some quarters to balance early R&D costs and tax benefits against the exit taxation costs, (for example, if U.S. $1.0M in R&D has created software with a value of U.S. $3.0M, the exit tax will be in the region of U.S. $1.0M and balance out the existing tax losses). This is very difficult to achieve in practice, and experience shows that there is a tendency to hang on too long due to a reluctance to allow tax losses to be extinguished (see Exhibit 14.2).
ONSHORE VEHICLE
OFFSHORE VEHICLE Purchase and Sale of IP Price < $3.0M
ONSHORE IP
R&D Cost = $1.0M Value = $3.0M Exit Tax = $1.0M
Exhibit 14.2 Balancing of Losses Against Exit Taxes
OFFSHORE IP
14.4 OFFSHORE CORPORATIONS
SHAREHOLDERS
SHAREHOLDERS
ONSHORE VEHICLE Private/Country 1
OFFSHORE VEHICLE
ONSHORE VEHICLE Public/Country 2
ONSHORE IP
OFFSHORE IP
OFFSHORE VEHICLE
SHAREHOLDERS
OFFSHORE IP
Exhibit 14.3 Flip Leaving IP Offshore
TRANSACTION TYPES
Methods of bringing intellectual property offshore vary. Aside from straightforward sales, there are many devices that may be employed. At the end of the day, a balance must be sought between cost; complexity; shareholder confidence and the requirement for, and availability of, professional offshore management. In the mid 1990s the preferred method for transferring intellectual property offshore was a reverse takeover, whereby existing assets in one jurisdiction are sold to an offshore corporation (usually by means of a share exchange). The assets are subsequently flipped into a listed vehicle in a third jurisdiction (again, usually by share exchange), leaving the intellectual property offshore. The intellectual property is then held in an offshore subsidiary from which it can be exploited (see Exhibit 14.3). This method has been streamlined in recent years, so that it is now possible to redomicile the putative parent corporation prior to the reverse, and hence have the whole structure in an optimum jurisdiction. (see Exhibit 14.4) However, it should be noted that this type of deal often meets major resistance, largely due to lack of knowledge of or confidence in smaller jurisdictions. As a result of such resistance, more recent deals have involved the creation or early purchase of Intellectual Property into an offshore corporation, followed by early rounds of private
TRANSACTION TYPES 14.5
SHAREHOLDERS
ONSHORE VEHICLE Private/Country 1
SHAREHOLDERS
ONSHORE IP
OFFSHORE VEHICLE Public
OFFSHORE VEHICLE Public
OFFSHORE IP
REDOMICILIATION
ONSHORE VEHICLE Public/Country2 SHELL?
Exhibit 14.4 Flip into Offshore Public Vehicle
capital placement for early development, then a flip into a U.S. parent with a view to further private placements, then NASDAQ listings (see Exhibit 14.5). The benefits of these techniques are mainly long-term. There is a Catch-22 element to such strategies. In order to be successful, it is necessary to spend a lot on structuring before knowing whether the product will be successful. These benefits include tax deferral or minimization, lower management costs, lower regulatory costs, ease of use of treaty networks, and maintenance of capital market liquidity. The disadvantages include difficulties with recognition by onshore markets, shareholder resistance, potential problems with management efficiency, and cost of setup and maintenance.
14.6 OFFSHORE CORPORATIONS
INVENTOR US
OFFSHORE ENTITY
Tick-the-Box Tax Nullity
OFFSHORE ENTITY
Development of IP
Sale of Invention
OFFSHORE ENTITY
INVESTORS
ONSHORE PARENT
Patent and Trademark Activities
Financing Activities
License OFFSHORE ENTITY
IP
Sub Licenses
Non Treaty Exploitation
TREATY ENTITY
Development and Management and Sales Activities
Sub Licenses
Treaty Exploitation
Exhibit 14.5 Latest Structure Used
WHICH VEHICLE TO USE
There is a plethora of financial vehicles in use in today’s market. These range from limited companies (whether limited by shares or guarantee and whether public, ordinary, or private) to more specialized entities such as limited partnerships or U.S.-style limited liability companies (LLCs) and equity-based arrangements such as trusts. Which vehicle option is appropriate will depend on the individual circumstances of the business involved and the overall objectives of the group. There is a variety of factors to take into account: ownership (jurisdiction, individual, corporate, public, or private); originating jurisdiction; taxing jurisdiction for the parent
WHICH VEHICLE TO USE 14.7
vehicle; jurisdictions where business is done; type of business; and whether property is held to generate income or capital. For example, the advent of the “tick-the-box” 7 regulations and the increased separation between income and capital gains taxes has resulted in many U.S. shareholders ceasing to avoid U.S. taxation altogether and adopting a strategy of deferring taxation and ensuring that the lower tax rates applicable to capital gains are utilized. During the early 1990s a grantor trust was required to achieve this benefit; however, with tick-thebox, a simple offshore corporation (for an individual) or LLC (for a group) suffices. The shares in the holding corporation or (sometimes) parent corporation may be held as capital and no income is imputed to the owner who has ticked the box as a partnership vehicle. Upon sale of the underlying shares, there is a capital gain attributable through the corporation to the individual shareholder (see Exhibit 14.5). In this way, no income taxes accrue while the shares are held and a lower tax rate applies upon disposal (in the United States currently 31 percent versus 35 percent and higher).8 Another example is the vehicle used for the parent corporation. Many people equate offshore with low-regulation international business companies (IBCs), which are special tax-exempt vehicles with little or no reporting required in the home jurisdiction. However, in a world where substance over form is the governing principle of the revenue collection agencies and is rapidly being supported by the courts, this makes little sense. Many businesses are being structured as either public corporations in the international jurisdiction or subsidiaries of public corporations. In these cases, it is often preferable to employ limited companies that can be seen to be legitimate businesses. (This is particularly so when a listing is to be sought, as many exchanges will not accept IBCs for listing.)9 In the average year there are 200 changes to the U.S. Tax Code. Other taxing nations have similar rates of change. These are more often than not reactive (rather than proactive), but they have far more effect on sensible tax planning than the latest ephemeral and/or capricious protected-cell partnership-limited-by-guarantee vehicle introduced in the Sucker Islands, formerly British Micronesia, which will be largely ignored or looked through by the tax collection agencies.10 On the world stage, the dot-com stock boom gave those offshore jurisdictions with established stock market connections the advantage of no initial hurdle to overcome. However, the collapse of the bubble and the return to the assessment of corporations by their business models and plans, rather than their names and fields of operation, have removed this factor. The collapse of the dot-com bubble has dented many people’s optimism about the future of the Internet as a business-to-business (B2B), or even business-to-consumer (B2C), communications system. However, there is little doubt that the industry will continue to grow—albeit based on more traditional economic models and business plans. For the international financial centers, the Internet has two crucial advantages that should be addressed by any large international group of companies: first, data is a commodity that is relatively easy and cheap to transport in large quantities. There is little to prevent it from being exported to countries with friendly fiscal and regulatory regimes where value can be added in an economically efficient manner, then reimported with the transaction occurring outside the country of final sale; second, the Internet by its nature makes the collection of income taxes nearly impossible—transactions on the
14.8 OFFSHORE CORPORATIONS
Internet take place in an environment not unlike that in which international shipping operates, where flagging out is the order of the day. Any offshore jurisdiction with decent interconnection for telecommunications can take advantage of the first factor. However, the second is the preserve of the pure havens with their pre-installed consumption tax regimes. CONCLUSION
In conclusion, the preference should be for properly planned, individually tailored structures instead of standard, off-the-peg products. This point cannot be overemphasized. Going offshore should not be treated as a cheap and easy panacea to fiscal structuring. Rather, it should be viewed as an integral part of an international business and, as such, financed and operated in the same way as the more mainstream domestic businesses. Having said that, the rise of the Internet and other advanced communications systems means that data-based businesses and, thus, intellectual property-based businesses can be operated through a multinational structure far more efficiently than has previously been the case. A group not considering placement of intellectual property offshore, whether from startup or as part of a merger and acquisition process, is giving up potentially massive competitive advantages to rivals who have properly considered their options in this regard. ENDNOTES 1 The Organization for Economic Development (OECD) together with many other international organizations whether economic (Financial Stability Forum) or political (European Union) in their objectives, have been engaged in a high profile campaign targeted at so-called harmful tax practices since 1998. A simple search of the OECD website (www.oecd.org) for “harmful tax” reveals 122 items. Harmful tax practices would appear to include any practice that conflicts with the interests of the G7 (now G8) economies and bears little relation to the reality of income versus consumption tax basis arguments. This issue is closely tied to the ongoing worldwide campaign to combat money laundering and organized crime, although in practice it appears to have been directed more at ensuring higher tax collections in the high-tax jurisdictions, i.e., a political agenda. The OECD plans are running into opposition in many developing nations, as they are seen as setting a less-than-level playing field in the financial services industry. Taxation is seen in many nations as fundamental to sovereignty, and attempts by large economies to force their methods on smaller ones are viewed with suspicion and even hostility. Having said that, the pressure being brought to bear is enormous and, when combined with anti-money laundering and other initiatives, cannot simply be ignored. The situation is particularly hazardous for the pure tax havens, as they employ fiscal regimes relying on consumption taxes and not income taxes—however, they do have the advantage of not having to maintain artificial offshore entities for clients to use, which is another bugbear of the taxing nations. The issue remains unresolved at present. 2 From a Canadian perspective, a corporation is a resident if it is incorporated or its mind and management is situated in Canada. The place that mind and management is situated is usually considered to be the place where the board of directors exercises statutory authority to direct the corporation’s affairs. The principle will pertain provided that the directors actually manage the corporation and do not abdicate or shirk their responsibilities to the point where they merely carry out decisions made elsewhere (as puppets or nominees). Typically, this test is satisfied by ensuring that the majority of the board are not resident in Canada, corporate offices are situated outside Canada, all directors’ meetings are held outside Canada, all contracts are entered into outside Canada, and all corporate decisions are
ENDNOTES 14.9 made outside Canada. Also, it is typically appropriate to ensure that all activities take place in the jurisdiction of residence: nonresidence in Canada does not preclude residence in some other unsatisfactory jurisdiction. 3 Exceptions that will not be subject to South African Income Tax are the investment income of a resident, “arising from and connected with the business activities of a substantive business enterprise” (not defined) conducted by such resident through a “permanent establishment” (as defined in international tax treaties) in any country other than South Africa where such permanent establishment is “suitably equipped” (not defined) for “conducting the principal business of such enterprise.” 4 Both Holland (61 treaties in 1999) and Ireland (34 treaties in 1999) have negotiated extensive double taxation treaty networks providing for zero or very low withholding tax rates on royalties flowing into and/or out of the jurisdiction. Similar low rates also apply to interest and dividend payments in both countries. Choice between the two will depend on individual circumstances, but it should be noted that Holland continues to charge a zero rate on royalties paid to non-treaty countries, whereas Ireland has recently attracted much business based on its low (and proposed to be even lower) corporate tax rates. A primary license to one or the other can be combined with a center of other activity in that country (Ireland is currently popular for software design and development; Holland continues to be favored for group financing activities) in order to satisfy residence requirements and nullify accusations of treaty shopping. Sublicense networks can then be developed with subsidiaries, franchises, or third parties on either a nation-by-nation or regional grouping basis (e.g., Australasia or North America) depending on business requirements. 5 A deemed disposition occurs when the revenue authorities conclude that property is deemed to have been sold upon exiting the jurisdiction and the proceeds of that presumed sale are taxed as a normal sale would be, irrespective of the actual transaction involved. 6 A schedule of assets attracting 100 percent deductions in respect of income calculations for investments is provided under section 20 of the Income Tax Act (Canada) and regulation 1100 of the Income Tax Regulations (Canada). Included in Class 12 of the schedule are items such as computer software and movies. Throughout the 1990s, a popular tax shelter for wealthy Canadian individuals was to purchase units in limited partnerships holding such Class 12 assets. It was clearly in the interests of the investors to maximize the value of the property in order to maximize the annual tax writeoff. Unfortunately, this became counter-productive as it attracted the attention of Revenue Canada, and very few such shelters have survived without scrutiny and the concomitant expenses thereof. 7 The tick-the-box regulations allow a U.S. taxpayer to choose how an entity is to be treated for tax purposes. Normally, the choice is for a corporation or similar entity to be treated as a “corporate” vehicle or as a “partnership” vehicle. The former are taxable entities and the normal provisions apply. The latter are treated as flow-though vehicles for tax purposes, and any applicable taxation is attributed to the owners. 8 Based on recent U.S. advice. 9 The demise of the international business corporation (IBC) is a stated goal for regulatory organizations worldwide. For example, in a UN report titled, “Financial Havens, Banking Secrecy and Money Laundering,” dated May 29, 1998 (https://www.imolin.org/finhaeng.htm), it is stated that, “IBCs are at the heart of the money-laundering problem. Virtually all money-laundering schemes use these entities as part of the scheme to hide the ownership of assets. A threshold question for consideration by Member States is whether IBCs should be permitted to do business, open bank accounts, and trade outside of the jurisdiction of incorporation under any circumstances.” It should also be noted that another stated goal of international organizations such as the UN and OECD, as well as organizations at the national level, is to increase the standards of regulation in offshore centers regarding banking, corporation management, and trust management. In fact, the levels being imposed on and set by many offshore financial centers far exceed those employed in the high tax and, allegedly, more sophisticated jurisdictions. This is another example of the unlevel playing field. This excessive zeal has been seized upon in some offshore centers as a competitive advantage, in that business conducted under such oppressive regimes must, a priori, be legitimate. 10 See, for example, the U.S. “conduit” regulations.
CHAPTER
15
ACQUISITION AND LICENSING OF FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY IN THE UNITED STATES Theodore C. Max1 Phillips Nizer Benjamin Krim & Ballon LLP
INTRODUCTION
Humans have used symbols to identify the creator and origin of goods for thousands of years. From the dawn of humanity, marks have been used by single artisans to designate the source of authorship. The caves of Lascaux, France, and Altimara, Spain,2 or the artwork of Native Americans3 serve as testament to this fact. In the early days of handmade craftworks, trademarks also served as personal symbols of the artisans. Indeed, some surnames are derived from an individual’s role or craft in the community.4 The mark died when the artisan died. The purpose of such trademarks and what they represented—to identify superior or defective merchandise that could be traced back to the creator—died when its owner died. Trademarks were not generally used to prevent consumer confusion.5 The most obvious mark that an artisan could use was his or her name, or a derivation thereof. Today, the Lanham Act defines a trademark as “any word, name, symbol, or device, or any combination thereof—(1) used by a person, or (2) which a person has a bona fide intention to use in commerce and applies to register on the principal register . . . to identify and distinguish his or her goods, including a unique product, from those manufactured or sold by others and to indicate the source of the goods, even if that source is unknown.”6 A trademark represents the goodwill of the seller and is used to identify the goods and/or services of one person or business from another. Quality control and product approval are integral to the concept of licensing, otherwise a naked license may result and endanger the mark itself. Trademark protection is crucial for the individual, especially a famous person such as a fashion designer, an entertainer, or a sports figure. The Lanham Act places certain limitations on the registration of trademarks that comprise the name, portrait, or signature of a living individual. The Lanham Act § 2(c) provides that: 15.1
15.2 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY No trademark by which the goods of the applicant may be distinguished from the goods of others shall be refused registration on account of its nature unless it: * * * (c) consists of or comprises a name, portrait, or signature identifying a particular living individual except by his written consent, or portrait of a deceased President of the United States during the life of his widow, if any, except by the written consent of the widow.7
Section 2(c) may be invoked by the U.S. Patent and Trademark Office (USPTO) in an office action, in an opposition to prevent the federal registration of a trademark, or in a petition for cancellation by a party with such name. Thus, to acquire federal trademark rights under the Lanham Act in a personal name, one must obtain a form of written consent of the individual. Lack of federal registration under Section 2(c) does not necessarily preclude use of common law trademark rights.8 When a name is considered “primarily merely” a surname, the USPTO trademark examiner may reject the registration of the trademark.9 The USPTO bears the burden of proof to establish that the mark is primarily merely a surname. Oftentimes, to prove this, the USPTO will use evidence based on 1. 2. 3. 4. 5. 6.
The rarity of name (“unusually large number of telephone listings,” LEXIS/NEXIS search, surname dictionaries); Whether the name refers to someone in the organization; Whether initials or a first name have been added; Whether the word has any significance other than as a surname; Whether the “spelling and pronunciation” of surname differs from a common spelling and pronunciation; or Whether the word is part of a composite design.
If a trademark is federally registered and has become incontestable by use in commerce for more than five years, the surname registration will be incontestable, and the defendant would be precluded from arguing that the mark is not registrable because it is merely a surname.10 The Trademark Manual of Examining Procedure (TMEP), which is the internal set of guidelines used by USPTO trademark examiners, distinguishes between instances in which the applied-for mark constitutes the name of a living person and in which the applied-for mark is a fanciful fictitious name or the name of a historical figure.11 The TMEP provides: If it appears that a name, portrait or signature in a mark may identify a particular living individual but in fact the applicant devised such matter is fanciful, or believes it to be fanciful, a statement to the effect should be placed in the record. If appropriate the statement that name portrait or signature does not identify a particular living individual will be printed in the Official Gazette and on the registration certificate.12
If the fanciful name also “just happens” to be the name of a “particular living individual,” consent is required if “the public would recognize and understand the mark” as identifying that person:
INTRODUCTION 15.3 Whether consent to register is required depends upon whether the public would recognize and understand the mark as identifying the person. Thus, if the person is not generally known, nor well known in the field relating to the relevant goods or services, it may be that the mark would not constitute the identification of a particular person under §2(c) and consent would not be recognized.13
This test has been upheld by the Trademark Trial and Appeals Board (TTAB) in Martin v. Carter Hawley Hale Stores, Inc., in which registration of the mark NEIL MARTIN was opposed by a San Diego attorney, Neil Martin, who opposed registration based on the Section 2(c) requirement of written consent from a particular living individual.14 The TTAB dismissed the opposition because the San Diego attorney failed to produce evidence that the NEIL MARTIN mark as used by the applicant uniquely identified him: [T]he question to be determined in this proceeding is whether the public would recognize and understand that the mark used on applicant’s goods identified opposer . . . [T]he statute was intended to protect one who, for valid reasons, could expect to suffer damage from another’s trademark use of his name . . . [C]oincidence, in and of itself, does not give rise to damage to that individual in the absence of other factors from which it may be determined that the particular individual bearing the name in question will be associated with the mark as used on the goods, either because that person is so well known that the public would reasonably assume the connection or because the individual is publicly connected with the business in which the mark is used.15
The TTAB held that the opposer was not a celebrity known to the public or known in the field of men’s clothing.16 In a recent case, the TTAB upheld the opposition of James W. Ross, Jr., to the registration of ROSS for specialized scientific equipment in electrochemical analysis because he had helped develop the product and cofounded the predecessor-in-interest of the applicant.17 The TTAB held that two factors are relevant to determine whether a name used by the applicant would be recognized and understood as identifying a particular person: 1. 2.
The person is so well known that the public would reasonably assume the connection; and The person is publicly connected with the business in which the mark is used.
Despite the fact that the opposer, Ross, had left the business after a debilitating stroke, the applicant failed to establish that Ross would no longer be recognized by persons active in the field. The TTAB noted that the infringement of the right of publicity per se is governed by the same test of identifiability employed under the TMEP: If Section 2(c) is viewed as an embodiment of at least the concept of a right of publicity, it must be construed as a protection of the right of a person to control the commercial use of his or her identity. Infringement of the right of publicity per se is governed by the test of ‘identifiability’, i.e. if more than an insignificant number of people identify the object person from the unpermitted commercial use. McCarthy on Trademarks and Unfair Competition (4th ed.) §§28:1 and 28:2. Thus, it seems appropriate that Section 2(c) would be governed by [the right of publicity’s] test of identification.18
15.4 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY
The opposition was sustained because it was held that Ross had established that a substantial number of product purchasers or users would identify the mark with the opposer. In 1996, Congress enacted the Federal Trademark Dilution Act (FTDA), which, for the first time, created a national law forbidding the dilution of “famous” trademarks, even though no likelihood of consumer confusion of source, sponsorship, or approval exists under traditional trademark law. The FTDA provides that “[T]he owner of a famous mark shall be entitled . . . to an injunction against another person’s commercial use in commerce of a mark or trade name, if such use begins after the mark has became famous and causes dilution of the distinctive quality of the mark.”19 The FTDA may be applied in the case of a famous name trademark.20 In the case of famous or historical names, secondary meaning is generally not required because the use of a famous or historical name has inherent distinctiveness and may also be seen as fanciful when applied to goods. “If a mark consists of the name of an historical figure or other noted person and is likely to be recognized as such by prospective purchasers, secondary meaning ordinarily will not be required.”21 The TTAB has drawn a distinction between such historical names as DaVinci or Franklin and other names such as Picket, which, although historically significant, may also be recognized primarily as a surname.22 If a historical name is recognized as a symbol of origin, it is generally seen as protectable.23 FAIR USE DEFENSE: “A ROSE BY ANY OTHER NAME . . . .”
Early in the history of trademark jurisprudence, the right to use one’s given name was considered a personal right. Today, the “sacred” right to use one’s name is no longer absolute.24 This is because personal name trademarks, especially those that are famous and well-known, represent more than a means of identifying superior designs or craftwork of one artisan or designer. Personal name trademarks, like other trademarks, represent goodwill and source identification. In addition, because famous name trademarks are often used with fashion or consumer products and, since the advent of licensing, may even be combined with the right of publicity and take on an endorsement or sponsorship character, the risk that the junior user may be utilizing his surname to ride the coattails of the famous designer or artisan is heightened. When the personal name trademark is established in the marketplace, the state of mind of the infringer may not be the issue. As the New York Court of Appeals held in David B. Finlay v. Findlay: “[F]raud or deliberate intention to deceive or mislead the public are not necessary ingredients to a cause of action. . . . The objective facts of this unfair competition and injury to plaintiff’s business are determinative, not the defendant’s state of mind.” When a personal name trademark has become strong and famous, persons with identical, homophonic, or similar names have no right to adopt personal name trademarks to confuse the public. Thus, “McDonald’s” cannot be used by Bill McDonald for his hamburger shop, and “Gallo” could not be used by Joseph Gallo to sell his cheese.25 In the Gallo case, the Ninth Circuit Court stressed that even though the goods at issue were not identical, consumers might confuse the source of Gallo cheese and dairy products with wines from the Ernest and Julio Gallo vineyards.26 When little or no evidence of willfulness or bad faith exists and the junior user makes a genuine and legitimate effort to generate his or her own fame instead of attempting to profit from the fame of someone
RIGHT OF PUBLICITY: WHAT’S IN A PERSONA 15.5
who shares the same name, courts generally may be reluctant to impose an absolute prohibition from the use of the mark. Instead, they may use disclaimers or place restrictions on the nature and extent of the use or presentation of the personal name trademark (inclusion of an individual’s first name and initials) to avoid confusion and balance the equities.27 When a person or his family has sold, transferred, or disposed of personal name trademark rights, the person (or family) is not generally precluded from exploiting his personal name trademark unless the contract specifically provides for this, but certain restrictions may be imposed.28 Such a disposition of rights in and to a personal name trademark also may restrict the creator’s right to exploit his right of publicity or privacy and persona if the grant of rights is sufficiently broad to encompass such rights. Where bad faith is evident or the use of a disclaimer or restrictions have proved ineffectual, a court may impose an absolute prohibition against use of a personal name as a business trademark.29 Courts are especially likely to impose such prohibition when the fame of the senior trademark is well known and the nature of the goods at issue is the same or related. RIGHT OF PUBLICITY: WHAT’S IN A PERSONA
In contrast to the personal name trademark, which is created with the generation of goodwill and secondary meaning in the marketplace as a result of the efforts of the trademark proprietor, the right of publicity is the intrinsic right of every person to control and benefit from the commercial exploitation of his or her identity (including a person’s name, signature, likeness, picture, portrait, or voice). No prior exploitation is required. Unlike in trademark law, a person may assign his or her right of publicity without goodwill and may license such rights without any quality control. The right of publicity is governed by state law or common law, depending on the jurisdiction, which affords individuals varying degrees of protection. The Name Must Be Identifiable and Known to Be Protected. The right of publicity, which
is encompassed by an individual’s identification by name, signature, likeness, picture, or voice, generally protects only widely known nicknames or the name by which the person is known.30 Although nicknames can identify a famous person, not all states protect the right of publicity of nicknames. For example, New York’s Civil Rights statute does not recognize a nickname as a protectable name.31 A person can also invoke his or her right of publicity for protection against the unauthorized use of his or her photograph or likeness.32 Jurisdictions differ on the proper test for identifying the nature of rights and whether the photograph or likeness must be recognized by the public in general or someone familiar with the person(s) depicted in the photograph or likeness. For example, the New York Court of Appeals held that a photograph that depicted only the sides and rears of a nude woman and young girl was subject to the New York Civil Rights Act because “[t]he identifying features of the subjects include their hair, bone structure, body contours and stature and their posture.”33 In another case in the Ninth Circuit Court of Appeals, the Court held that an issue of fact existed about whether or not baseball pitcher Don Newcombe’s stance was so distinctive that the use of a drawing of his stance that did not depict his face in a print advertisement for Coors beer infringed his right of
A Person’s Persona Also May Be Identified by a Photograph or Likeness.
15.6 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY
publicity.34 A Massachusetts court held that a photograph that depicted only the back of a small boy and was identifiable by only “a small group of intimates” who knew the plaintiff and the circumstances under which the photograph was taken did not create a sufficient level of “publicity” to trigger invasion of false light privacy.35 Voice and Sound Are Now Protectable under the Right of Publicity. Where an individual’s
persona is inextricably linked to an identifiable and well-known voice or sound, applying the same principles used with names, courts have ruled that an individual’s voice and sound are also protected by the right of publicity.36 In Midler v. Ford Motor Co., the Ninth Circuit held that Bette Midler had a valid claim for infringement of her common law right of publicity claim under California law “when a distinctive voice of a professional singer [was] widely known and is deliberately imitated in order to sell a product. . . .”37 The court stated that the statutory right of publicity in California was not violated because the soundalike was an imitation and not the actual voice of the plaintiff. In a later case involving the singer and songwriter Tom Waits, the term “widely known” was defined as “known to a large number of people throughout a relatively large geographic area.”38 STATE AND COMMON LAWS GOVERN THE RIGHT TO PUBLICITY IN THE UNITED STATES
The right of publicity grants a person an exclusive right to control the commercial value of his name and likeness and to prevent others from exploiting that value without permission.39 Eighteen states have statutes governing the right to publicity: California,40 Florida,41 Illinois,42 Indiana,43 Kentucky,44 Massachusetts,45 Nebraska,46 Nevada,47 New York,48 Ohio,49 Oklahoma,50 Rhode Island,51 Tennessee,52 Texas,53 Utah,54 Virginia,55 Washington,56 and Wisconsin.57 The statutes of these states are not identical varying regarding, among other things, the range, descendibility, and duration of protection offered. In Kentucky, for example, the range of statutory protection is limited to one’s name and likeness,58 while statutory protection extends to one’s name, voice, signature, photograph, likeness, image and distinctive appearance, gestures, and mannerisms in Indiana.59 It is crucial, therefore, not to assume that one state’s statutory provision resembles that of another, but rather to consult each state’s statute to determine the scope of protection. Postmortem Rights of Publicity. Whether an individual maintains his right to publicity after death depends on the law of the particular jurisdiction. Although the popular view has long been that the right of publicity is derived from the right of privacy, which terminates at death, certain jurisdictions have held the right of publicity to be descendible, viewing it as a type of property right.60 Thirteen states recognize descendible and transferable postmortem rights of publicity: California, Florida, Illinois, Indiana, Kentucky, Nebraska, Nevada, Ohio, Oklahoma, Tennessee, Texas, Virginia, and Washington. The duration of protection in these states ranges from 10 to 100 years.61 Four of these states—California, Oklahoma, Nevada, and Texas—require registration of postmortem publicity rights to put the public on notice. Even without applicable statutes, some states have recognized common law postmortem rights. These states include: Connecticut,62 Georgia,63 New Jersey,64 and Tennessee.65
STATE AND COMMON LAWS GOVERN THE RIGHT TO PUBLICITY 15.7 Seventeen States Recognize Common Law Rights of Publicity. Although only 18 states have
statutes governing the right to publicity, 17 states, some of which also have applicable statutes, protect the commercial value of an individual’s persona under state common law: Alabama, California, Connecticut, Florida, Georgia, Hawaii, Illinois, Kentucky, Michigan, Minnesota, Missouri, New Jersey, Ohio, Pennsylvania, Texas, Utah, and Wisconsin. Alabama. “Alabama has not denominated the interest protected by its commercial appropriate invasion of privacy tort is the right of publicity.”66 The 11th Circuit Court of Appeals, however, held in Allison v. Vintage Sports Plaques that: “We read Alabama’s commercial appropriation privacy right, however, to represent the same interests and address the harms as does the right of publicity as customarily defined. . . . As a technical matter, then, we construe appellants’ claim as one sounding in commercial appropriation, rather than in publicity, although we conclude that the distinction is largely semantic.” The court noted that the Alabama Supreme Court has addressed the tort of commercial appropriation only twice.67 California. Under California common law, to prevail on a cause of action for commer-
cial misappropriation of name or likeness, a plaintiff must prove: (1) the defendant’s use of the plaintiff’s identity; (2) appropriation of the plaintiff’s name or likeness to the plaintiff’s advantage, commercial or otherwise; (3) a lack of consent; and (4) resulting injury.68 Numerous cases have addressed the right to publicity in California.69 In a recent decision, Comedy III Productions, Inc. v. Gary Saderup Inc.,70 the Supreme Court of California held that the defendant’s unauthorized sale of lithographs and tee shirts based on the defendant’s charcoal drawing of the Three Stooges was not protected by the fair use doctrine of Section 107 of the Copyright Act or the first amendment. The Court ruled against the defendant, holding that the defendant had made “no significant transformative or creative contribution. This undeniable skill is manifestly subordinated to the overall goal of creating literal, conventional depictions of the Three Stooges so as to exploit their fame.”71 Connecticut. Although no Connecticut court has directly addressed rights of publicity, courts in other jurisdictions have found that, if given the opportunity, Connecticut courts would recognize a common law right to publicity.72 Florida. In Genesis Publications, Inc. v. Goss,73 a Florida court held that the magazine
publisher was liable to the plaintiff for compensatory damages for using a nude photograph of the plaintiff, without plaintiff’s permission, in a commercial advertisement. In Heath v. Playboy Enterprises, Inc., the U.S. District Court for the Southern District of Florida noted that Florida recognizes three theories of common law invasion of privacy claims—publication of private facts, intrusion upon seclusion, and placing fact in a false light—and a fourth theory of recovery, appropriation for commercial benefit.74 Georgia. Georgia courts also recognize a common law right to publicity.75 In Georgia,
the right of publicity exists even if the person has not yet exploited it. The right of publicity is also distinct from the right of privacy.76 Hawaii. In Fegerstrom v. Hawaiian Ocean View Estates, Inc., a Hawaii court upheld
the plaintiff’s right to privacy but referred to such right as a privacy right, rather than a right of publicity.77
15.8 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY Illinois. In Winterland Concessions Co. v. Sileo, the district court held that under Illinois law, protection of an individual’s persona includes musical groups and unauthorized printing of musical groups’ likenesses or trademarks on shirts constituted a violation of right to publicity.78 Illinois law limits the right to publicity regarding the portrayal of public figures in the news, however. In Jackson v. MPI Home Video, the court held that public figures possess right of publicity for commercial use of their names and likenesses but not against use of their names and likenesses in the news media. Accordingly, the court held that the right of publicity did not protect the Reverend Jesse Jackson against the use of his picture on the cover of Time or Newsweek as part of a news report.79 Kentucky. In Cheatham v. Paisano Publications, a designer’s unauthorized photograph,
which was taken at a biker festival, appeared in a magazine and on tee shirts. The designer claimed invasion of privacy based on unauthorized appropriation of the designer’s likeness or “right of publicity.”80 Louisiana. Louisiana case law does not expressly provide for a right of publicity, but the right of privacy in that state has been interpreted to protect a person’s name or likeness from commercial exploitation.81 Likewise, under Michigan law, the common law right to privacy protects against, among other things, appropriation of the defendant’s likeness. This right, which is known as the right of publicity, protects an individual pecuniary interest in the commercial exploitation of his or her identity.82 For example, in Carson v. Here’s Johnny Portable Toilets, Inc., the Sixth Circuit held that use of the phrase “Here’s Johnny”—a phrase readily identified with Carson—was tantamount to commercial exploitation of Carson’s celebrity identity to promote portable toilets.83 Similarly, in Janda v. Riley-Meggs Industries, Inc., the court held that one cannot endorse or promote a product by associating the plaintiff with the product without the plaintiff’s permission.84 However, in Ruffin-Steinback v. de Passe (a case in which the plaintiffs sought compensation for use of their names and life events in a mini-series based upon the story of the musical group, the Temptations, by the National Broadcasting Company and other defendants), the federal district court in Michigan refused to extend the right of publicity to give rise to a claim of infringement of the plaintiffs’ names or likenesses in depiction of one’s life story or in promoting the story about the plaintiffs.85 Minnesota. Federal courts have recognized the right to publicity under Minnesota state
common law in Uhlaender v. Henricksen86 and Cepeda v. Swift and Company.87 In these two cases involving baseball players, Minnesota courts recognized an individual’s valuable property right in his or her name, photograph, and image, and the right to sell such rights.88 New Jersey. In Estate of Presley v. Russen,89 a U.S. District Court in New Jersey held
that the defendant’s stage act, in which he imitated Elvis Presley’s voice, violated the deceased performer’s right of publicity under New Jersey law. More recently, in Prima v. Darden Restaurants, Inc.,90 a district court in New Jersey held that imitating a celebrity’s voice can give rise to a cause of action for violation of right of publicity. The Court held that where there was no doubt that the defendants imitated Louis Prima’s
STATE AND COMMON LAWS GOVERN THE RIGHT TO PUBLICITY 15.9
voice on a commercial, and that the defendants used the soundalike voice for commercial purposes without the plaintiff’s consent, the plaintiff made a prima facie case for infringement of the plaintiff’s right of publicity. The Ohio right of publicity was recognized in Zacchini v. Scripps-Howard Broadcasting Co.91 This case, which ultimately resulted in the 1977 decision of the U.S. Supreme Court, involved the rebroadcasting on the television news of a human cannonball’s performance at a local county fair. The right to control the rebroadcast of the human cannonball stunt, which was termed the right of publicity by the Supreme Court, has been described by some more appropriately understood under common law copyright or misappropriation.92 In Reeves v. United Artists Corp.,93 the Sixth Circuit Court of Appeals held that Zacchini v. Scripps-Howard Broadcasting Co. indicated that Ohio recognizes the right of publicity as part of its common law.94 The Sixth Circuit affirmed the decision of the district court, granting summary judgment to the defendants because the right of publicity was not descendible in Ohio, and, therefore, no claim could be brought because of the depiction of a deceased professional boxer in the film Raging Bull. Ohio.
Oklahoma. In 1978, the Oklahoma Supreme Court recognized the common law tort of
invasion of privacy by intrusion.95 In 1980, the Court adopted the four types of invasion of privacy listed in the Restatement of Torts, Second.96 Pennsylvania. Pennsylvania courts first recognized the right of publicity in an action by
golf legend Ben Hogan.97 In a subsequent decision involving the famed “Empress of the Blues,” Bessie Smith, the U.S. District Court for the Eastern District of Pennsylvania recognized the right of publicity but concluded that such a right would be incidental to her music “if Columbia possessed all the incidents of ownership of Smith’s songs and recordings . . . , then Columbia plainly possessed the right to use Smith’s name, likeness, and photograph.”98 In a more recent case, the same court held that no right of publicity extends to trademarks or corporate names.99 Tennessee. The Tennessee Supreme Court has never expressly found liability based on
a common law right of publicity, but has decided cases on the assumption that a common law right of publicity exists in Tennessee.100 In two cases involving famed native son, Elvis Presley, the Sixth Circuit Court of Appeals and Tennessee Court of Appeals both recognized the common law right of publicity.101 Texas courts have recognized a common law right of publicity,102 but the common law right does not extend to prevent the misappropriation of events in one’s life in a biography.103 Texas.
In 1990, the U.S. District Court for Utah held that the 1981 Utah statute did not preclude an independent claim based on the common law right of publicity in Utah.104 The Court noted that the common law right also was descendible and enjoined the defendant’s use of the late Dr. John Christopher’s name with the sale of herbal formulas. Utah.
15.10 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY Wisconsin. In 1979, the Wisconsin Supreme Court distinguished between the common law right of privacy—which it had previously rejected in Zinda v. Louisiana Pac. Corp.105—and the common law right of publicity, which it defined as “the right of a person to control the commercial exploitation of the property right in the use of that person’s name.”106 The claim of the famed football player “Crazylegs” Hirsch defeated summary judgment and an issue of fact for trial existed about whether his nickname served as a service mark for his services as a football player and manager and whether a likelihood of confusion existed that such a right had been infringed.107
FEDERAL PROTECTION OF THE RIGHT OF PUBLICITY UNDER THE LANHAM ACT § 43(a): IMPLIED ENDORSEMENT
False endorsements are covered by the amendment to Section 43(a) of the Lanham Act, effective November 1984, which makes actionable a “false or misleading representation of fact” that: “(1) is likely to cause confusion, or to cause mistake, or to deceive as to the affiliation, connection, or association of such person [the defendant] with another person [the plaintiff] or as to the origin, sponsorship, or approval or his or her [defendant’s] goods, services, or commercial activities by another person [plaintiff], or (2) in commercial advertising or promotion, misrepresents the . . . characteristics, [or] qualities . . . of his or her [defendant’s] goods, services, or commercial activities.”108 The Ninth Circuit has used this provision as a basis or partial basis for many decisions.109 In Hoffman v. Capital Cities/ABC, Inc., the district court found that Los Angeles Magazine violated Section 43(a) by using Hoffman’s name or likeness in a manner that was likely to cause customer confusion about whether Hoffman had sponsored or endorsed the magazine’s depiction of his image or the designer clothes and shoes he appeared to be wearing. The court further found that § 43(a) had been violated because Hoffman suffered injury by being unable to reap the commercial value or control of the use to which his name or likeness was put.110 The Ninth Circuit Court of Appeals reversed this decision, holding that the use of the photograph was not commercial speech and no clear and convincing showing of actual malice had been made.110A DEFENSES TO RIGHT OF PUBLICITY CLAIMS First Amendment. Most state statutes have exemptions that try to balance First Amendment concerns regarding newsgathering and communicative interests.111 The focus is whether the predominant nature is commercial or communicative. Parody. Parody also is recognized as a form of free speech, but this can be a close call in the context of the right of publicity.112 Statutes of Limitation. Various states apply different statutes of limitation with respect
to the right of publicity. Often the period is provided for and is the same as the time provided for bringing a claim for invasion of privacy. Certain states will set a different time limitation. Generally speaking, the statute of limitations for the right of publicity is one to two years. The Lanham Act sets forth no statute of limitations and vests courts with the power to grant injunctions “according to the principles of equity.”113 Courts will generally look to the relevant forum state statute that best approximates and effectuates the rights
TRANSACTIONS INVOLVING FAMOUS NAME TRADEMARKS 15.11
implicated.114 Oftentimes, however, courts will look at laches, rather than the state statute of limitations, to determine whether injunctive or monetary relief is available.115 TRANSACTIONS INVOLVING FAMOUS NAME TRADEMARKS AND THE RIGHT OF PUBLICITY: ASSIGNMENT AND LICENSES
When considering business transactions involving famous individuals, one must consider not only the implications surrounding the licensing or transfer of the trademark rights, but also if and how this transaction impacts and relates to the right of publicity. The acquisition of trademark rights in and of themselves will ordinarily not convey the right to exploit the name, likeness, or persona of the individual with whom the trademark has been associated. Such rights must be separately conveyed by the individual, especially when that person is living. Such a transaction also does not limit the individual, except to the extent that he or she may not infringe the trademark rights that the transaction conveyed. For example, a transfer of the personal name trademark alone may not protect the acquiring party from competition or adverse publicity generated by the individual or references to his or her name in association with the commercial exploitation of his or her talents. Care must be taken to understand and account for the differences between the types of rights to ensure that all necessary and appropriate protections have been secured. The fundamental differences between famous name trademarks and the right of publicity are accentuated when one considers the differences between licensing and assignment of trademarks and rights of publicity and privacy. Trademark rights, including famous name trademarks, may be assigned only if the transfer of the mark is accompanied by the goodwill symbolized by the mark.116 A naked transfer or assignment of a trademark without the goodwill it symbolizes is known as an assignment in gross and is forbidden. The rationale for this is simple: The anti-assignment-in-gross rule is founded upon the assumption that if a mark is assigned without associated good will, the assignee may use the mark on goods or services not having any continuity with or similarity to those sold by the assignor under the mark. The situation sought to be prevented by the rule is customer deception resulting from abrupt and radical changes in the nature and quality of the goods on a temporal scale. Customers expect the general nature and quality of goods and services sold under the mark to remain relatively stable, no matter who has bought and sold the mark. That customers might soon perceive a port assignment change in the nature and quality of the goods “fails” to give the protection it initially deserves.117
The right of publicity, as noted here, is a property right, not a personal right.118 The traditional rule has been that, although rights of privacy may generally be waived, consented to, or licensed, they may not be assigned.119 The further commercialization, expansion, and recognition of the right of publicity and commercial realities have created exceptions to the traditional limitations on the licensing and transfer of individual rights of publicity and privacy. One exception provides that an individual’s agent may be authorized to grant consents or licenses for the use of the individual’s name, likeness, or persona on behalf of that individual. Under such circumstances, the actions of the agent, if acting within the scope of agency, could bind the individual. The scope of agency will be governed by
15.12 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY
the agency agreement between the agent and individual, subject to state agency law principles unless otherwise provided. An individual also may grant an assignment of the right of publicity, conveying all rights to the assignee. Unlike trademark law, the anti-assignment-in-gross rule does not apply to the right of publicity.120 “The right of publicity . . . is not dependent upon public association of the identify with a particular source of goods or services, and publicity rights may thus be assigned in gross without the transfer of any accompanying business or good will.”121 California, Florida, and Tennessee right of publicity statutes provide that the state-recognized rights of publicity may be assigned in gross.122 Notable examples of outright rights of publicity grants of famous individuals include Elvis Presley, who assigned his right of publicity to a business controlled by Colonel Tom Parker, and the Beatles, who assigned their rights of publicity to their names and likenesses to Apple Corps., Ltd.123 One should consult the local law to determine how granting an assignment might impact the rights of publicity and privacy at issue. Statutory requirements involving the recordation of such an agreement may also exist. The differences between license and assignment are marked. The license grants permission to the right of publicity use within a limited and defined time and in a specified manner, market, or territory and associated with a particular product or service. An assignment conveys legal and equitable title, but in cases of license, title remains with the individual licensor. Additionally, a trademark license generally does not convey with it the right to secure a trademark.124 An assignment of a personal name trademark must include the transfer of assets sufficient “to go on in real continuity with the past.”125 Moreover, if the continuity of the nature and quality of the goods associated with the trademark is maintained, the assignment of the trademark may be deemed valid even if no tangible assets are transferred.126 Where an individual’s name is registered as a trademark with that person’s use of the mark representing his or her services, the assignment may be complicated because the goodwill associated with the registered trademark may be deemed personal to that individual. When the goodwill reflects the business reputation of the individual through the display of his talents and expertise with an individual or group, a mark signifying personal services and the goodwill symbolized by the trademark may be incapable of being validly assignable to another.127 The transfer of one’s name as a trademark, without more, does not preclude an individual from utilizing his or her name to indicate personal creation or representation. As the Second Circuit noted in Madrigal Audio Laboratories, Inc. v. Cello, Ltd.: Whether a person who sells the trade name rights to his personal name is barred from using his personal name depends on the terms of the sale. Id. at §19.60. See also Duryea v. National Starch Manuf’g Co., 79 F. 651, 653 (1897), aff’d, 101 F. 117 (2d Cir. 1900). When an individual sells no more than the right to use his name as a trade name or trademark he is precluded only from using his personal bane as part of that of another company or on other products, Levitt, supra, 593 F.2d at 468; Taylor Wine Co. v. Bully Hill Vineyards, Inc., 569 F.2d 731, 735 (2d Cir. 1978), and not from taking advantage of his individual reputation (as opposed to the reputation of the company which bore his personal name as a trade name) by establishing a company which competes against the purchaser of the trade name, 3 Callmann, supra, §19.60 at 236; see also Guth Chocolate Co., supra, 215 F. at 767, 772; The LePage Co., supra, 51 F. at 944-46, or from advertising, in a not overly intrusive manner, that he is affiliated with a new company. 3 Callmann, supra,
TRANSACTIONS INVOLVING FAMOUS NAME TRADEMARKS 15.13 §19.60 at 236. See also Guth Chocolate Co., supra, 215 F. at 767; Auto Hearse Mfg. Co. v. Bateman, 109 A. 735, 736 (N.J. Ch. 1920).
In Madrigal, the Second Circuit held that, though “Madrigal at most acquired such good will as was associated with the use of trade name ‘Levinson,’” it had not acquired “the right to use Levinson’s personal name as a symbol of his individual reputation.”128 Consequently, and most importantly, documentation of such a transfer should be carefully worded to limit or preclude the individual selling the right to use his personal name as a trade name and then advertise his association with a competing company “to arrogate to himself the trade reputation for which he received valuable consideration.”129 Where the documentation provides that the individual has sold all rights to the commercial use of his or her name—or when the individual has permitted the corporation to use his or her name as a trademark—the sale of the individual’s interest in the corporation or trademark precludes his or her right to use the personal name as a trademark.130 In drafting an assignment or a license, the following items should be carefully scrutinized: 1.
Scope of Rights Granted: The assignment or license should be carefully set forth in the scope of rights granted. If trademark rights are assigned or licensed, the trademarks at issue and scope of assignment or license should be made clear. If the grant of rights is a license, the document should specify whether the grant is exclusive or nonexclusive. a. Exclusive or Nonexclusive Grant: The grant to a licensee of an exclusive right to the right of publicity generally carries with it standing to sue.131 Some courts even have implicitly inferred such a right to sue.132 b. Limitations of Grant: The scope of the grant of rights may also include limitations on certain aspects of the grant. For example, a grant, assignment, or license to right of publicity may include limitations on how the right of publicity is to be exploited. As a result, an appropriate license may provide that Charlie Chaplin may always be portrayed as The Little Tramp or Bela Lugosi as Dracula. Additionally, certain photographs may be specified as authorized images, but care must be taken to ensure that the rights in and to a fixed image of a fictional character such as The Little Tramp or Dracula are not owned by another entity. As a result, one who wishes to retain the late Clayton Moore as The Lone Ranger would also need a license from the film studio which held the rights to the Lone Ranger films.133 c. Format and Context of Grant: Care should be taken by the person granting the trademark rights and rights of publicity to ensure that the format and context of use is plainly stated, that sufficient limits are placed on the type of products identified, and that the channels of trade are specified so the fame is not diminished by the licensee’s use of the name. In one noted case, because a grant of a license of a right of publicity with respect to baseballs did not prohibit the sale of
15.14 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY
2.
3.
4.
5.
autographed baseballs to promote sales of meat products, the resulting lawsuit failed.134 Licenses and assignments should also specify that the license or assignment is limited to the context and format envisioned by the grant or license. Such a restriction may have prohibited the use of a Fred Astaire dance advertisement for selling and advertising vacuum cleaners.135 d. Nature and Type of Goods or Services: Whether any types or classes of goods or services for which no right of publicity is either assigned or licensed should also be considered. For example, publicity rights might not be granted for goods that do not comport with the image or persona of an individual. As a result, it is unlikely that a fashion designer would ever grant the right to use his or her name, likeness, image, or voice with insect and pest control products, while a comedian might, depending on the script, context, channels of trade, and nature of the product. Territory: The territory of any license or assignment needs to be spelled out specifically because the rights may vary depending upon the jurisdiction and degree of use in various locales. The licensor may restrict the territory in which the licensee may manufacture, distribute, offer for sale, or sell the licensed goods. Term: The term of and conditions for renewal of the license should be clearly stated. If a license does not specify a termination or expiration date, the license is terminable at will. The renewal term of the license may be based upon achievement of certain licensee sales or profit targets. License agreements are also subject to termination based on expiration, conditioned on a default by licensor or licensee, or subject to other addressed grounds. The conditions for renewal should be set forth precisely. If renewal is dependent on reaching certain sales targets, the exact method of calculating such sales figures (and if any discounts or adjustments apply) should be agreed upon and set forth in the license. Quality Control: Quality control is an important part of any license. It is especially important when the licensee is making a trademark or service mark use of the licensed persona. A trademark owner has “an affirmative duty . . . to take reasonable steps to detect and prevent misleading uses of [its] trademark.”136 Quality control can be subjective or objective in nature, depending on the degree of control exercised by the licensor. Some licenses will require that extensive reasons be given for disapproval of samples, and in other cases, the licensor may not unreasonably withhold approval. Quality control is an essential part of the license, so licensors should be careful to protect their interests by adequately providing for control and oversight of the quality of licensed goods manufactured, sold, and distributed. Royalties and Guaranteed Minimums: The royalty clause specifies the terms under which the licensor is paid for use of the rights at issue. It is important that the royalty scheme, including any guaranteed minimum, be clearly articulated because the amount of royalties paid can often become the subject of controversy. A guaranteed minimum royalty is an upfront payment made to
TRANSACTIONS INVOLVING FAMOUS NAME TRADEMARKS 15.15
6.
7.
8.
9.
ensure that the licensor is paid something for the use of its intellectual property and its opportunity cost in entering into the license agreement, even if annual sales are low or non-existent. The royalty may be paid in a variety of ways—as a lump sum payment, percentage of sales, or fixed amount per each licensed item sold. The guaranteed minimum royalty ensures that a licensor is paid for its opportunity cost in entering into the licensed agreement. Generally, a licensee also provides terms on which the licensee shall report and pay royalties and by which a licensor may audit the royalties reported and paid by the licensee. The audit or accounting provisions should be drafted to balance the interests of both parties and lessen the possibility that the audit provision and process will become a sore point between them. One way to avoid conflict would be to provide that the costs of the accounting or audit will be borne by the licensor unless the discrepancy figure exceeds a certain amount. Another way to avoid conflict would be to limit the number of audits available per year and the scope of the audit or accounting. Use of Notice: If a famous name mark is licensed as a trademark or service mark, the licensor should require that the licensee provide a proper trademark notice. If the mark is not registered, the notice should be TM for trademarks and SM for service marks. If the trademark is federally registered, the ® symbol should be used. The license should provide that notice be given about samples and goods manufactured, offered for sale, and sold pursuant to the license. Termination Rights: The license should provide for a mechanism whereby the termination of the license is subject to a variety of events, including a breach of agreement or a default in the terms of the license agreement, such as failure to pay royalties, meet quality standards, or meet a delivery schedule. In most cases, licenses provide for a notice of default and an appropriate cure period. The termination clause also should carefully spell out what rights, if any, the licensee has to dispose of the licensed goods and what rights, if any, the licensor has to purchase the inventory on hand in case of a default. The license also should specify that, upon termination for any cause, including expiration, all rights granted to the licensee revert to the licensor. Right to Assign or Sublease: Licenses generally contain prohibitions on assignment by the licensee. If a famous name mark is licensed, the right to assignment or sublicensing should be restricted because this is a means of ensuring that quality control standards will be maintained and that expectations created by negotiation and license agreement will be met. Assignment and sublicensing may create problems with the manufacture of goods if different factories and manufacturing in different locales are permitted.137 The licensee, however, may want the licensor to agree that the grant of rights is binding for the licensor’s heirs and beneficiaries in the event of the licensor’s death. Indemnification or Insurance: In the use of a famous name mark or where a celebrity’s rights of personality are licensed, the involved parties should ensure that indemnification and insurance are provided against tort liability for deception or products liability claims. In turn, a licensor will often
15.16 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY
10.
indemnify the licensee from any intellectual property claims that may arise from the use of the licensed rights. The license also should indicate how claims to the licensed rights can be asserted and which party is responsible for enforcement. Dispute Resolution, Choice of Law, and Venue: The license should provide for some alternative form of dispute resolution, such as mediation or arbitration.138 Care should be taken, however, to limit the scope of the review afforded the arbitrators or mediators. For example, the licensor may not want to risk the adjudication of intellectual property rights to an arbitration, especially when there is no right of appeal. As a result, the arbitration or mediation clause should be limited to questions concerning the formation, validity, construction, performance, and termination of the license agreement. The arbitration clause should also specify where the arbitration shall take place, what law will be applied, and what size the arbitration panel will be. Because of the differing laws concerning the rights of publicity and privacy, licensee and licensor should be careful in selecting the proper law venue.
ENDNOTES 1
A member of the law firm of Phillips Nizer Benjamin Krim & Ballon LLP. See, e.g., J. Bronowski, The Ascent of Man, 56 (1973) (“All over these caves the print of the hand says: ‘This is my mark. This is man.’”). 3 C.F. Greene and T.D. Drescher, “The Tipi With Battle Pictures: Kiowa Tradition of Intangible Property Rights,” The Trademark Reporter 481, 484 (1994). 4 Surnames such as Miller, Smith, Baker, Fisher, and Cooper are examples. See, e.g., D. Boorstein, The Creators, 428 (1992). (“For centuries in Europe other crafts had been handed down in families, and often—like the Carpenters, Shoemakers, Smiths and Wagners—they [composers] took their family name from their craft.”) 5 1 J. Thomas McCarthy, McCarthy on Trademarks and Unfair Competition, Vol. 1 § 5:1, 5–1–5–2 (4th ed., 2000). 6 Lanham Act § 45, 15 U.S.C.A. § 1127. 7 Lanham Act § 2(c), 15 U.S.C. § 1052(c). 8 See In re Masucci, 179 U.S.P.Q. 829 (T.T.A.B. 1973). (Notwithstanding any common law trademark rights which applicant asserted, registration of the name of U.S. President Dwight D. Eisenhower is barred by Section 2(c)). 9 Lanham Act § 2(e), 15 U.S.C. § 1052(e). 2
10
Lanham Act § 15, 15 U.S.C. § 1065. Trademark Manual of Examining Procedure § 1206.02 (rev. 1997). 12 Ibid. 13 Ibid. 14 Martin v. Hawley Hale Stores, Inc., 206 U.S.P.Q. 931 (T.T.A.B. 1979). 15 Id. at 933, accord Fanta v. Coca-Cola Co., 140 U.S.P.Q. 671 (T.T.A.B. 1964); Bland v. Fairchester Packing Co., 84 U.S.P.Q. 97 (Comm’r Pat. 1950). 16 Martin v. Carter Hawley Stores, Inc., 206 U.S.P.Q. at 933. 17 Ross v. Analytical Technology, Inc., 51 U.S.P.Q.2d 1269, n.13 (T.T.A.B. 1999). 18 Ross v. Analytical Technology, Inc., 51 U.S.P.Q.2d 1275, n.13 (T.T.A.B. 1999). 19 Lanham Act § 43–c(4), 15 U.S.C. § 1125–c(4). 11
ENDNOTES 15.17 20 See, e.g., Panavision Int’l, L.P. v. Toeppen, 141 F.3d 1316 (9th Cir. 1998); Elvis Presley Enters., Inc. v. Capece, 141 F.3d 1988 (5th Cir. 1988); Ford Motor Co. v. Ford Financial Solutions, Inc., 55 U.S.P.Q. 2d 1217 (N.D. Ind. 2000). 21 Restatement (Third) of Unfair Competition §14, comment 3 (Tentative Draft No. 2, 1990). 22 Compare Lucien Piccard Watch Corp. v. Crescent Corp., 314 F. Supp. 329, 165 U.S.P.Q. 459 (S.D.N.Y. 1970) (DA VINCI); Franklin Mint Inc. v. Franklin Mint, Ltd., 331 F. Supp. 827, 169 U.S.P.Q. 403 (E.D. Pa. 1971), mot. granted, 360 F. Supp. 478, 178 U.S.P.Q. 176 (E.D. Pa. 1973)(FRANKLIN MINT) with In re Pickett Hotel Co., 229 U.S.P.Q. 760 (T.T.A.B. 1986) (PICKETT HOTEL). 23 See Wyatt Earp Enterprises, Inc. v. Sackman, Inc., 157 F. Supp. 621, 116 U.S.P.Q. 122 (S.D.N.Y. 1958)(WYATT EARP); Ex parte Crockett Seafood, Inc., 114 U.S.P.Q. 508 (Comm’r Pat. 1957) (DAVY CROCKETT). 24 See L.E. Waterman Co. v. Modern Pen Co., 235 U.S. 88 (1914) (Defendant’s use of his own surname in conjunction with the sale of pens held to infringe upon prior user’s rights in the same name for the same goods.); David B. Findlay, Inc. v. Findlay, 18 N.Y.2d 12 (1966) (affirming injunction preventing one brother from using trade name “Wally Findlay Galleries” for art gallery on same street as brother’s “Findlay Galleries” business). 25 See E&J Winery v. Gallo Cattle Co., 967 F.2d 1280, 1291-92 (9th Cir. 1992); Nina Ricci, S.A.R.L. v. E.T.F. Enterprises, Inc., 889 F.2d 1070, 1073 (Fed. Cir. 1989) (VITTORIO RICCI infringes NINA RICCI); John B. Stetson v. Stephen L. Stetson, Co., 85 F.2d 586 (2d Cir.), cert. denied, 249 U.S. 605 (1936)(STEPHEN STETSON infringes STETSON mark). 26 E&J Gallo Winery v. Gallo Cattle Co., 967 F.2d at 1291. 27 See Joseph Scott Co. v. Scott Swimming Pools, Inc., 764 F.2d 62 (2d Cir. 1985); Taylor Wine Co., Inc. v. Bully Hill Vineyards, Inc., 590 F.2d 701 (2d Cir. 1979); R.J. Toomey Co. v. Toomey, 685 F. Supp. 873 (D. Mass. 1988). But see J. Jacoby and R. Raskopf, “Disclaimers in Trademark Infringement Litigation: More Trouble Than They Are Worth?” 76 The Trademark Reporter 35, (1986). (Consumer studies show that disclaimers do not eliminate consumer confusion.) 28 See, e.g., Taylor Wine Co., Inc. v. Bully Hill Vineyards, Inc., 590 F.2d 701 (2d Cir. 1979). 29 See Bertolli USA, Inc. v. Filippo Bertolli Fine Foods, Ltd., 662 F. Supp. 203 (S.D.N.Y. 1987); Basile, S.p.A. v. Basile, 899 F.2d 35 (D.C. Cir. 1990); David B. Findlay, Inc. v. Findlay, 18 NY.2d 12, 19, 271 N.Y.S.2d 652, 655 (1966); Cerruti 1881 S.A. v. Cerruti Inc., 45 U.S.P.Q.2d 1957, 195960 (S.D.N.Y. 1998). 30 See Ali v. Playgirl, Inc., 447 F. Supp. 723 (S.D.N.Y. 1978) (Heavyweight boxer Muhammad Ali was found to be identifiable partly because of use of the nickname “The Greatest”); Hirsch v. S.C. Johnson & Sons, Inc., 90 Wisc. 2d 379, 280 N.W.2d 129, 137 (1979); Abdul-Jabbar v. GMC, 75 F.3d 1391, amended rehearing and reconsideration denied, 85 F.3d 407 (9th Cir. 1996). (Use of name Lew Alcindor without compensation was not violation of right of publicity because athlete abandoned his birth name by changing his name). But see Meeropol v. Nizer, 560 F.2d 1061, 1067 (2d Cir. 1977), cert. denied, 434 U.S. 1013 (1978). (References to Michael and Robert Rosenberg were not actionable as infringement of right of publicity because the book did not identify sons known by adopted partner’s name); De Clemente v. Columbia Pictures Industries, Inc., 860 F. Supp. 30 (E.D.N.Y. 1994) (Motion pictures based on fictional character The Karate Kid do not infringe statutory rights under New York Civil Rights Act of sometime karate dojo operator and exhibition organizer who had used the same name for years, because his nickname was not widely known); People v. Charles Scribner’s Sons, 205 Misc. 818, 130 N.Y.S.2d 514, 519 (Brooklyn Cty. Ct. 1954). (“The statute protects the true name of a person from use for purposes of advertising or trade. It does not protect a nickname known to a few intimates any more than it protects . . . an assumed name.”) 31 Geisel v. Poynter Prods., Inc., 295 F. Supp. 331, 355 (S.D.N.Y. 1968) (The name Dr. Seuss is not protected under statute); Moreno v. Time, Inc., 11 Media L. Reptr. 2196, 2200 (N.Y. Sup. 1985). (The stage name Senior Wences is not protected under N.Y. Civil Rights Statute).
15.18 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY 32 See, e.g., Cohen v. Herbal Concepts, Inc., 63 N.Y.2d 379, 459 (1984); Newcombe v. Adolph Coors, 157 F.3d 686 (9th Cir. 1998); White v. Samsung Elec. Am., Inc., 971 F.2d 1395 (9th Cir. 1992), rehearing en banc denied, 989 F.2d 112 (9th Cir. 1993), cert. denied, 508 U.S. 951, 113 S.Ct. 2443 (1993). 33 Cohen v. Herbal Concepts, Inc., 63 N.Y.2d at 459. 34 Newcombe v. Adolph Coors Co., 157 F.3d 686 (9th Cir. 1998) (“[T]here is a genuine issue of material fact as to whether Newcombe’s stance was so distinctive that the defendants used his likeness by using a picture of Newcombe’s stance”). 35 See Brauer v. Globe Newspapers Co., 351 Mass. 53, 217 N.E.2d 736, 740 (1966). 36 See Midler v. Ford Motor Co., 849 F.2d 460 (9th Cir. 1988); Waits v. Frito-Lay, Inc., 970 F.2d 1092 (9th Cir. 1992). But see Miller v. Universal Pictures Co., 11 A.D.2d 47 (1st Dep’t 1960), aff’d, 10 N.Y.2d 972 (1961) (Widow had no right to “Glenn Miller Sound”); Jarvis v. A&M Records, 827 F. Supp. 282, 299 (D. N.J. 1993) (The mere sampling of selected vocal phrases was held not to constitute infringement of a vocalist’s right of publicity because no evidence of appropriation of reputation and unique sound was found as opposed to copyright infringement); Oliveira v. Frito-Lay, Inc., 50 U.S.P.Q.2d 1152 (S.D.N.Y. 1999). (Advertiser was permitted to use recording of singer in advertisement without payment when she had disposed of the recordings of her voice); Wendt v. Host Int’l., Inc., 50 F.3d 18, rehearing denied, 125 F.3d 806 (9th Cir. 1997) (identifiability of robot “Bob” and “Hank” to “Norm” and “Cliff” question for jury). 37 Midler v. Ford Motor Co., 849 F.2d at 463. 38 Waits v. Frito-Lay, Inc., 978 F.2d 1093, 23 U.S.P.Q.2d 1721, 1727 (9th Cir. 1992). 39 Bi-Rite Enterprises, Inc. v. Button Master Co., 555 F. Supp. 1188, 1198 (S.D.N.Y. 1983), citing Martin Luther King, Jr. Ctr. for Social Change v. American Heritage Products, Inc., 694 F.2d 674, 680 (11th Cir. 1983); see generally Winner, “Right of Identity: Right of Publicity and Protection for a Trademark’s ‘Persona,’” 71 The Trademark Reporter 193 (1981). 40 Cal. Civ. Code § 2233. 41 Fla. Stat. Ann. § 540.08 (West 1977)(“Unauthorized Publication of Name or Likeness”). 42 Ill. Rev. Stat. Ch. 765 § 1075/1–60 (1999)(Right of Publicity Act). 43 Ind. Code Ann. § 32–13 (West 1994)(Rights of Publicity). 44 Ky. Rev. Stat. Ann. § 391.170 (Michie/Bobbs-Merrill 1984). 45 Mass. Gen. L. ch. 214 §§ 1B, 3A (1979). 46 Neb. Rev. Stat. § 20–201 (1989). 47 Nev. Rev. Stat. § 597.770. 48 New York Civil Rights Law § 51 (McKinney Supp. 2000). 49 Ohio Rev. Code Ann. §§ 2741.01–2741.09 (Baldwin 1999). 50 Okla. Stat. tit 21 §§ 839, 840 (1965). 51 R.I. Gen. Laws § 9–1–28 (1972). 52 Tenn. Code. Ann. § 47–25–1104–5. 53 Tex. Prop. Code Ann. § 26.001 et seq. (West 1987). 54 Utah Code Ann. § 45–3–1 (1981). 55 Va. Code Ann. § 8.01–40 (Michie 1950). 56 Wash. Rev. Code Ann. § 63.60.010 (West 1998). 57 Wis. Stat. Ann § 895.50 (West 1977). 58 Ky. Rev. Stat. Ann. § 391.170. 59 Ind. Code §32–13–7. 60 See Reeves, 572 F. Supp. 1231, 1234.
ENDNOTES 15.19 61 For example, Tennessee’s right of publicity statute provides that personal property rights protected by the statute are descendible and remain exclusive for ten years after the death of the individual. Following ten years, exclusivity may be terminated with proof of non-use of decedent’s name or likeness for a 2-year period. Tenn. Code. Ann. § 47–25–1104; 46 J. Copyright Soc’y of the U.S.A. 75, 86. 62 See Jim Henson Prods. v. John T. Brady & Assocs., 867 F. Supp. 175 (S.D.N.Y. 1994). (Conn. common law recognizes postmortem rights.) 63 Martin Luther King Ctr. for Social Change v. American Heritage Prods., 694 F.2d 674, 680 (11th Cir. 1983). (Georgia right of publicity recognized for deceased civil rights leader.) 64 Estate of Elvis Presley v. Russen, 513 F. Supp. 1339, 1355 (D. N.J. 1981) (New Jersey common law would recognize descendible right of publicity); Prima v. Darden Restaurants, Inc., 78 F. Supp.2d 337, 345 (D. N.J. 2000) (In New Jersey, right of publicity is transferable and descends to the holder’s estate at his death); McFarland v. Miller, 14 F.3d 912, 914 (“Infringement of a person’s right to exploit commercially his own name or the name of a character so associated with him that it identifies him in his own right is a cause of action that under New Jersey law survives the death of the person with whom the name has become identified”). 65 Elvis Presley Int’l Memorial Found v. Crowell, 733 S.W.2d 89, 99 (Tenn. Ct. App. 1987) (held that the right of publicity was descendible under common law regarding those rights of publicity in existence before effective date of the statute, without any limitations period); 46 J. Copyright Soc’y of the U.S.A. 75, 86. 66 Alison v. Vintage Sports Plaques, 136 F.3d 1443, 1447 (11th Cir. 1998). 67 Id. at 1447; see Birmingham Broadcasting Co. v. Bell, 259 Ala. 656, 68 So.2d 314 (1953); Smith v. Doss, 251 Ala. 250, 37 So.2d 118 (1948). 68 See Lugosi v. Universal Pictures, 25 Cal.2d 813, 820, 603 P.2d 429, 160 Cal. Rptr. 327; Eastwood v. Superior Court of Los Angeles County, 149 Cal. App. 3d 409, 416, 198 Cal. Rptr. 342 (1983). 69 See, e.g., Newcombe v. Adolf Coors Co., 157 F.3d 686 (9th Cir. 1998) (Court held that a triable issue of fact existed about if baseball pitcher is readily identifiable as pitcher in the Coors advertisement); Midler v. Ford Motor Co., 849 F.2d 460 (9th Cir. 1988) (Court held that the common law right of publicity includes a claim for a soundalike); Hoffman v. Capital Cities, ABC, Inc., 33 F. Supp.2d 867 (1999) (Publisher’s conduct in using a still photograph of Hoffman from the motion picture Tootsie without authorization to create composite computer-generated image of Hoffman, falsely depicting him in designer women’s clothing, violated Hoffman’s common law and statutory rights of publicity). 70 Comedy III Productions, Inc. v. Gary Saderup Inc., 25 Cal. 4th 397, 21 p.3d 797, 106 Cal.RpH. 126 (2001). 71 Ibid. 72 See Jim Hensen Productions, Inc. v. John T. Brady & Assocs., Inc., 867 F. Supp. 175, 189-90 (S.D.N.Y. 1994) (United States District Court for the Southern District of New York held that the Connecticut court would recognize a common law right to publicity that would be descendible); BiRite Enters. v. Button Master Co., 757 F.2d 440 (1st Cir. 1985) (First Circuit Court of Appeals held that Connecticut would recognize right of publicity). 73 Genesis Publications, Inc. v. Goss, 437 So. 2d 169 (Fla.1 Dist. Ct. App. 1983). 74 Heath v. Playboy Enterprises, Inc., 732 F. Supp. 1145, 1147–1148 (S.D. Fla. 1990). 75 Martin Luther King, Jr. Ctr. for Social Change v. American Heritage Prods., 694 F.2d 674 (11th Cir. 1983), aff’d in part and rev’d in part, 735 F.2d 257 (11th Cir. 1984); see also Bi-Rite Enterprises, Inc. v. Button Master, 555 F. Supp. 1188, 1199 (S.D.N.Y. 1983). 76 Ibid. 77 Ibid., 441 P.2d 141 (Hawaii 1968). 78 Winterland Concessions Co. v. Sileo, 528 F. Supp. 1201 (N.D. Ill. 1981), aff’d. 830 F.2d 195 (7th Cir. 1987).
15.20 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY 79 Jackson v. MPI Home Video, 694 F. Supp. 483 (N.D. Ill. 1988); see Kelly v. Franco, 71 Ill. App.3d 642, 391 N.E.2d 54, 57 (Ill. App. 1979). 80 891 F. Supp. 381 (E.D. Ky. 1995). 81 See Prima v. Darden Restaurants, Inc., 78 F. Supp.2d 337, 346 (D. N.J. 2000), (citing Prudhome v. Procter & Gamble Co., 800 F. Supp. 390, 396 (E.D. La. 1992)). 82 See Ruffin-Steinback v. dePasse, 82 F. Supp.2d 723 (E.D. Mich. 2000). 83 698 F.2d 831 (6th Cir. 1983). 84 764 F. Supp. 1223 (E.D. Mich. 1991). 85 82 F. Supp.2d 723, 730-731 (E.D. Mich. 2000). 86 316 F. Supp. 1277, 1282 (D. Minn. 1970) (Use of major league baseball player’s name in association with the sale of baseball games violated celebrity’s legitimate right in his public personality). 87 415 F.2d 1205 (8th Cir. 1969) (Orlando Cepeda, professional baseball player, had valuable right in his name, photograph, and image, which could be sold to Wilson and licensed to Swift in association with the sale of leaseholds). 88 See Uhlaender v. Hendricksen, 316 F. Supp. at 1282 (quoting Cepeda v. Swift & Co., 415 F.2d at 1206). 89 513 F. Supp. 1339 (D. N.J. 1981); see also McFarland v. Miller, 14 F.3d 912 (3d Cir. 1994) 90 78 F. Supp.2d 337, 345 (D. N.J. 2000). 91 351 N.E.2d 454 (Ohio 1976), rev’d on other grounds, 433 U.S. 562 (1977). 92 See, e.g., 2 J. Thomas McCarthy, The Rights of Publicity and Privacy § 8:103 (2d ed. 2000). 93 765 F.2d 79 (6th Cir. 1985). 94 Id. at 80. 95 Munley v. ISC Financial House, Inc., 548 P.2d 1336 (Okla. 1978). 96 McCormack v. Oklahoma Publicity Co., 613 P.2d 737 (Okla. 1980). 97 Hogan v. A.S. Barnes & Co., 114 U.S.P.Q. 314 (Pa. Tr. Ct. 1957). 98 Gee v. CBS, Inc., 471 F. Supp. 600, 662 (E.D.Pa. 1979). 99 Eagle’s Eye, Inc. v. Ambler Fashion Shop, Inc., 627 F. Supp. 856 (E.D. Pa. 1985). (“The right of publicity inures to an individual who seeks to protect and control the commercial value of his name or likeness”). 100 Landgord v. Vanderbilt University, 287 S.W.2d 32 (Tenn. 1956); Martin v. Senators, Inc., 418 S.W.2d 660 (Tenn. 1967); Lamdin Funeral Service Inc. v. Griffith, 559 S.W.2d 791 (Tenn. 1978). 101 Elvis Presley Enters., Inc. v. Elvisly Yours, Inc., 936 F.2d 889 (6th Cir. 1991); State ex rel. Elvis Presley Int’l Mem’l Found. v. Crowell, 733 S.W.2d 89, 2 U.S.P.Q.2d 1663 (Tenn. Ct. App. 1987). 102 Kimbrough v. Coca-Cola/USA, 521 S.W.2d 719 (Texas App. 1975) (right of “privacy” recognized); National Bank of Commerce v. Shaklee Corp., 503 F. Supp. 533 (S.D. Texas 1980). 103 Matthews v. Wozencraft, 15 F.3d 432, 439 (5th Cir. 1994) (“Even Texas courts recognized the cause of action for misappropriation of events in one’s life, it likely would recognize an exception for biographies”). 104 Nature’s Way Prods., Inc. v. Nature-Pharma, Inc., 736 F. Supp. 245 (D. Utah 1990). 105 149 Wis. 2d 913 (1989). 106 Hirsch v. S.C. Johnson & Sons, 90 Wis. 2d 379, 280 N.W.2d 129, 137 (1979). 107 Hirsch v. S.C. Johnson & Sons, 90 Wis. 2d 379, 280 N.W.2d 129 (1979); see 1 J. Thomas McCarthy, The Rights of Publicity and Privacy § 5:14 (2d ed. 2000). 108 See Tin Pan Apple v. Miller Brewing Co., 737 F. Supp. 826, 835 (S.D.N.Y. 1990) (Fat Boys lookalikes enjoined because of bad faith based on request and refusal). 109 Newcombe v. Adolf Coors Co., 157 F.3d 686, 691 (9th Cir. 1998); Abdul-Jabbar v. Gen. Motors Corp., 85 F.3d 407, 409 (9th Cir. 1996); White v. Samsung Elecs. Am., Inc., 971 F.2d 1395, 1396 (9th Cir. 1992); see Waits v. Frito-Lay, Inc., 970 F.2d 1092 (9th Cir. 1992).
ENDNOTES 15.21 110
33 F.Supp. 2d867 (C.D.Cal. 1999). 255 F.3d 1180, 1185–86 (9th Cir. 2001) (defendant magazine entitled to First Amendment protection accorded non-commercial speech). 111 See Zacchini v. Scripps-Howard Broadcasting Co., 433 U.S. 562 (1977) (News broadcast of human cannonball is not protected by the First Amendment); New Kids on the Block v. News America Publicity, Inc., 745 F. Supp. 1540 (C.D. Cal. 1990), aff’d on other grounds, 971 F.2d 302 (9th Cir. 1992); Hoffman, 33 F. Supp.2d at 874 (First Amendment defense was unavailable to protect the exploitative commercial use of Mr. Hoffman’s name or likeness when the magazine article provided no newsworthy commentary on fashion trends or current styles), reversed, 255 F.3d at 1196 (First Amendment defense accorded to photograph which was held to be non-commercial speech). 112 See White v. Samsung Elecs. American, Inc., 971 F.2d 1395 (9th Cir. 1992) (parody defeated); Cardtoons, L.C. v. Major League Baseball Players Ass’n, 95 F.3d 959 (10th Cir. 1996)(parody defense upheld); Elvis Presley Enters., Inc. v. Capece, 950 F. Supp. 783, 802–803 (S.D. Tex. 1996). (Sixties theme nightclub called “The Velvet Elvis” was not liable under parody defense). 113 15 U.S.C. § 1116. 114 Coca-Cola Co. v. Howard Johnson Co., 386 F. Supp. 330 (N.D. Ga. 1974); Beauty Time, Inc. v. VU Skin Systems, Inc., 118 F.3d 140 (3d Cir. 1997). 115 Clamp Mfg. Co. v. Enco Mfg. Co., 870 F.2d 512 (9th Cir. 1989), cert. denied, 493 U.S. 8672 (1989); Ediciones Quiroga S.L. v. Fall River Music, 35 U.S.P.Q.2d 1814 (S.D.N.Y. 1995). 116 See 2 J. Thomas McCarthy, The Rights of Publicity and Privacy § 10:11 at 10–17 (2d ed. 2001). 117 Id. (quoting Pepsico, Inc. v. The Grapette Co., 416 F.2d 285, 163 U.S.P.Q. 193 (8th Cir. 1969)); In re D.B. Kaplan Delicatessen, 225 U.S.P.Q. 342, 344 (T.T.A.B. 1985). 118 Restatement (Third) of Unfair Competition, § 46, Comment g (1995). (“The interest in the commercial value of a person’s identity is in the nature of a property right and is freely assignable to others”).; Restatement (Second) of Torts § 652C, Comment a; § 652A, Comment b; § 652I, Comment a. 119 Lugosi v. Universal Pictures, 25 Cal. 3d 813, 820, 160 Cal. Rptr. 323, 327, 603 P.2d 425, 205 U.S.P.Q. 1090 (1979). (“The right [of privacy] is not assignable. . . . ”) James v. Screen Gems, Inc., 174 Cal. App. 2d 650, 653, 344 P.2d 799 (1959). 120 See Estate of Elvis Presley v. Russen, 513 F. Supp. 1339, 1350, 211 U.S.P.Q. 415 (D. N.J. 1981). In re D.B. Kaplan Delicatessen, 225 U.S.P.Q. 342, 344 (T.T.A.B. 1995); Haelan Laboratories, Inc. v. Topps Chewing Gum, Inc., 202 F.2d 866, 868 (2d Cir. 1953). (“We think that, in addition to and independent of that right of privacy (which in New York derives from statute), a man has a right in the publicity value of his photograph . . . and that such a grant may validly be made “in gross” i.e., without an accompanying transfer of a business or of anything else”). 121 Restatement (Third) of Unfair Competition § 46, Comment g, (1995). 122 Cal. Civ. Code § 990(b) (postmortem rights); Fla. Stat. § 540.08(1)(b); Tenn. Stat. § 47–25–1103(b). 123 See Factors, Etc., Inc. v. Pro Arts, Inc., 579 F.2d 215, 221, 205 U.S.P.Q. 751 (2d Cir. 1981) (Elvis Presley); Apple Corps. Ltd. v. Button Master, 47 U.S.P.Q. 1236 (E.D. Pa. 1998)(Beatles). 124 See In re D.B. Kaplan Delicatessen, 225 U.S.P.Q. 342, 344 (T.T.A.B. 1985). 125 Merry Hull & Co. v. Hi-Line Co., 243 F. Supp. 45, 146 U.S.P.Q. 274 (S.D.N.Y. 1965). 126 Haymaker Sports, Inc. v. Turian, 581 F.2d 257, n.7, 198 U.S.P.Q 610 (C.C.P.A. 1978). 127 See Messer v. Fadettes, 168 Mass. 140, 46 N.E. 407 (1997) (name of orchestra); Callas v. Broun, 211 Ala. 443, 100 So. 769 (1924) (restaurant); Blakely v. Sousa, 197 Pa. 305, 47 A. 286 (1900) (name of orchestra). 128 Id. at 825. 129 Levitt Corp. v. Levitt, 593 F.2d 463, 468 (2d Cir. 1979) (William J. Levitt was precluded from proclaiming his “track record” by recounting his stewardship of Levitt and Sons when the contract 110A
15.22 FAMOUS NAME TRADEMARKS AND RIGHTS OF PUBLICITY explicitly forbade company uses of his name and Levitt Corporation’s trade representation as symbolized by marks LEVITTOWN, LEVITT AND SONS, and STRATHMORE). 130 Levitt Corp. v. Levitt, 593 F.2d 463, 201 U.S.P.Q. 513 (2d Cir. 1979); Bellanca Aircraft Corp. v. Bellanca Aircraft Engineering, Inc., 190 U.S.P.Q. 158, 163 (T.T.A.B. 1976). (When Bellanca chose, as president of the aircraft company, “to have his company adopt and use ‘BELLANCA’ as a trademark, he severed ‘BELLANCA’ from the personality of himself and his family and made the mark subject to the common law principles and statutory provisions pertaining to all types of marks”); Hazel Bishop, Inc. v. Perfemme, Inc., 314 F.2d 399, 404 (2d Cir. 1963) (Miss Hazel Bishop was enjoined from making competitive use of her name when she had assigned all rights to name and picture in the cosmetics field to Hazel Bishop Inc.). 131 Haelan, 202 F.2d at 867–68; Bi-Rite Enterprises, Inc. v. Button Master, 555 F. Supp 1188 (S.D.N.Y. 1983); MJ & Partners Ltd. v. Zadikoff, 19 F. Supp. 2d 922, 930 (N.D.Ill. 1999). See also Restatement (Third) of Unfair Competition § 46, Comment g, (1995). (“ . . . . When the license is exclusive, courts have held that the licensee has standing to object to commercial uses that infringe on the scope of the licensee’s exclusive right”). 132 Bi-Rite Enterprises, Inc. v. Bruce Miner Co., Inc., 757 F.2d 440 (1st Cir. 1985); Factors, Etc., Inc. v. Pro Arts, Inc., 444 F. Supp. 288 (S.D.N.Y. 1977), aff’d, 579 F.2d 215 (2d Cir. 1981); Hillerich & Bradsby Co. v. Christian Bros. Inc., 943 F. Supp. 1136 (D. Minn. 1996). 133 In a case against Clayton Moore, an actor who became famous for his portrayal of the Lone Ranger, the Supreme Court of California granted a preliminary injunction sought by Lone Ranger Television, Inc., a subsidiary of the Wrather Corp., which secured all rights to the Lone Ranger character for $3 million in 1964. It was ruled that Wrather Corp., not Moore, held the property rights in the character. See The Associated Press, Los Angeles (August 31, 1979). 134 Cepeda v. Swift & Co., 415 F.2d 1205 (8th Cir. 1969) (Had the license been more narrowly crafted to exclude promotional items or to limit the license to the retail sale of sporting goods, the give-away baseballs promoting meat products would not have been within the scope of the license). 135 Astaire v. Best Film & VideoCorp., 116 F.3d 1297 (9th Cir. 1997), amended, 136 F.3d 1209 (9th Cir. 1998), cert. denied, 525 U.S. 868 (1998). 136 See, e.g., Dawn Donut Co. v. Hart’s Food Stores, Inc., 267 F.2d 358, 366 (2d Cir. 1959). 137 For example, if no restriction on manufacturing locations exists, a United States company could assign the license to a company that manufactures in locations where workers rights may be at risk, thereby creating a sensitive issue for a celebrity and his or her persona. 138 See T. Max, “Available Remedies for Dispute Resolution in International and Domestic Trademark Licenses,” The New Role of Intellectual Property in Commercial Transactions, (2000 Supp.).
CHAPTER
16
TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION Lanning G. Bryer and Scott J. Lebson Ladas & Parry
INTRODUCTION
It would be difficult to conceive that any chief executive officer, senior manager, investment banker, corporate counsel, accountant, financial adviser, or consultant could or would ignore the unprecedented frequency and staggering proportion of merger and acquisition activity since the late 1990s and well into the twenty-first century, or the ramifications of such unions on their company or clients. In this age of electronic commerce, the marriage of corporate, media, and industrial giants is hastening the realization of a so-called global economy. Only 10 days after the beginning of the new millennium, America Online announced that it had agreed to buy Time Warner for $165 billion dollars, clearly making it the largest merger in terms of monetary value that the world had ever seen. The shock that so many experienced when this relatively new Internet Service Provider agreed to purchase the worldwide leader in traditional media services served only to reinforce the concept that the global economy is entering a new technology-driven age. The merger was consummated by the end of the year 2000, and revenues from the combined business operations are expected to reach or exceed $40 billion in the first year.1 Increasingly, the value and importance of intangible assets are the driving forces behind such mergers and are playing a greater role in terms of assets received through mergers, acquisitions, and takeovers.2 Although the America Online and Time Warner merger was classified during the height of the tech-stock boom as the Internet Triumph,3 both Time Warner and America Online viewed the merger as a marriage of necessity. (Time Warner needed access to America Online’s estimated 22 million online subscribers and “content”4 availability, and America Online could not ignore its dearth in terms of providing services to consumers through traditional media outlets.)5 The new combination can provide an Internet audience for Time Warner’s television, movie, and magazine operations while America Online has access to speedy Internet cable lines.6 The combination has created the first true entity with the presence to touch upon all aspects of the converging entertainment and technological industries.7 16.1
16.2 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
Despite cyclical variances and the fallout from the tech-stock frenzy of the late 1990s, the trend of giant entertainment mergers is not likely to dissipate soon. In fact, when President Clinton signed the Gramm-Leach-Bliley Act (also known as the Financial Services Modernization Act) into law in November 1999, which became effective March 11, 2000, one of its main goals was to eliminate the barriers imposed by regulatory schemes adopted in the 1930s—especially Sections 20 and 32 of the Glass-Steagall Act—and to hasten affiliation among securities, insurance, and banking institutions. Additionally, the Gramm-Leach-Bliley Act allows for the creation of a financial holding company (FHC) that will be capable of creating a wide range of financial services, including securities underwriting, insurance, and loans, services that had been required to be provided separately.8 Although this profound new legislation is expected to be a driving force behind corporate combinations for many years, its immediate impact is uncertain. Due to the breadth of this legislation, which sweeps away traditional restrictions and the inherent uncertainty about what functions companies will be allowed to perform, its immediate impact is unclear. In light of this uncertainty, executing alliances among banks, securities firms, and insurance companies will, in all likelihood, be a complex and expensive task.9 The traditional relationship between earnings per share and stock price is no longer the primary factor driving market capitalization. In this technology-driven economy, the new paradigm for determining market capitalization is the value of a company’s intellectual property.10 These intangible assets comprise a substantial portion of the underlying value of most emerging new companies.11 However, established Internet and so-called “new economy” companies are not the only ones that enjoy premium valuation based upon the underlying value of their intangible assets. For instance, Microsoft’s intangible assets represent 95 percent of its total capitalization, and Merck’s intangible assets represent 82 percent of its total capitalization.12 It is no secret that both Microsoft and Merck have sought to maximize market capitalization by exploiting their intangible assets to the fullest extent. In view of the forgoing, understanding why intangible assets are the driving force behind the continuing wave of merger and acquisition activity becomes more critical. First, acquiring a company whose intangible assets are capable of providing expanded global marketing and use of intellectual property is an efficient method of achieving a competitive advantage from assets that are difficult, if not impossible, to reproduce. Brand, image, know-how, and technology are not only difficult to reproduce because they are very often specialized resources but are also tremendously rewarding to reap in terms of market capitalization.13 In this respect, merging with or acquiring another company can provide instant access to these intangible assets. Second, intellectual property rights survive as the collateral against which many transactions are financed. For example, when Kohlberg, Kravis & Roberts paid $25 billion for RJR Nabisco ($21.7 billion above its book value), intellectual property—particularly trademarks—were pledged as underlying collateral serving to help justify the purchase price.14 Furthermore, well-recognized intellectual property has enormous potential for new markets. For example, AOL-Time Warner executives identified the content—essentially, the intellectual property rights of Time Warner—as a primary reason for the acquisition.15
MEANS OF ACQUIRING INTANGIBLE ASSETS 16.3
Among the valuable intellectual property being acquired are the traditional intellectual property assets such as patents, trademarks, copyrights, and trade secrets. More recently included in this category, and of ever-increasing importance, are mask works and Internet domain names.16 In the event of a merger or other type of corporate restructuring, it is critical that the acquiring party obtains equitable and record ownership of these intangible assets or, at the very least, acquires the appropriate license. Intellectual property assets need to be properly transferred in the name of the new owner for numerous reasons. For example, with respect to patents, a written instrument conveying ownership should be unambiguous and demonstrate a clear intent to transfer the ownership and right to sue for past infringements.17 For trademarks, a transfer instrument should expressly include common law rights acquired by the seller’s use of the mark and indicate whether this transfer is being made with the goodwill of the business. Additionally, proof of ownership must be provided if the new owner intends to proceed with a cancellation, opposition, or infringement action against a third party. Prompt recording of the instrument will ensure that a central location exists to search the chain of title and avoid the potential loss of rights because of a subsequent transfer by the seller. Furthermore, ensuring proper record title will allow the new owner to file renewal applications and affidavits of use in its name and take all necessary steps to protect the trademark.18 MEANS OF ACQUIRING INTANGIBLE ASSETS
It is often critical for one to understand that the transfer of intellectual property rights is not a transaction standing alone, but rather an essential aspect of a larger transaction.19 Intellectual property is often the predominant factor driving mergers and acquisitions; however, the transaction should be construed as the sale of an entire business in which those intangible assets are used. Businesses are generally sold through either the purchase of the stock in a corporation or of assets used by the business being sold. In either scenario, an acquisition agreement and a set of transfer documents will be prepared and negotiated.20 Mergers. Mergers are often classified as horizontal, vertical, or conglomerate. A horizontal merger is the combination of two competitors into one entity. A vertical merger involves two companies who previously had a buyer-seller relationship. A conglomerate merger occurs when two companies who were neither competitors, nor engaged in a buyer-seller relationship, combine. The structure of a merger and the methods of merger financing are widely varied and can be all cash, all security, or a combination of both. Variations on merger types include short-form mergers, leveraged buyouts (including a management buyout—as attempted by the management of RJR Nabisco during its thwarted takeover attempt), and freeze-out mergers.21 Purchase Agreement. A purchase agreement is prepared for detailing the terms and conditions under which stock will be purchased or assets will be sold.22 The purpose of the purchase agreement identifies the specific transaction’s essential issues, such as the type of stock or assets, purchase price, method of payment, date of closing, and any
16.4 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
conditions precedent that one of the parties is expected to meet before the closing date.23 When intellectual property is involved, the seller will usually be asked, additionally, to make certain representations and warranties about the intangible assets being sold.24 The need to list the assets and liabilities is greater with an asset purchase than a share purchase because the asset purchaser will typically acquire the assets covered in the transfer agreement, but the share purchaser will transfer all rights in the intellectual property by operation of law. Regardless of the nature of the transaction, asset schedules for intellectual property are key in determining the representations and warranties to be included in the agreement.25 Supplemental Closing Documentation. Several other documents, especially involving
intellectual property, are generally executed separately from the purchase agreement previously discussed to effect the sale. If the acquisition is structured as a stock purchase, documents transferring the assets are generally not necessary; however, documents that transfer stock will allow the buyer to indirectly become the owner of the assets, or in which the target will become a wholly owned subsidiary. Often, intellectual property assets will be separately transferred to a holding company and then either licensed back to the operating company or become the subject of a subsequent sale to the ultimate purchaser.26 If the transaction is structured as an asset purchase, the intellectual property assets will be specifically mentioned in the purchase agreement, become the subject of a separate bill of sale, or both. However, intellectual property assets are often the subject of a separate agreement because they require recordal of the new owner in the respective jurisdictions in which they are validly owned and used. Furthermore, the forms and requirements for valid transfers differ from country to country and become a matter of public record.27 The parties of the transaction should anticipate these contingencies and contemplate one, or perhaps several, separate agreements about intellectual property assets. Sale of Assets. If a party gains certain intellectual property rights by acquiring a busi-
ness vis-à-vis a sale of assets, it is not unusual (although not recommended) for the transfer agreement to not specifically mention trademark or other intellectual property rights.28 If a business is sold as a going concern, the intent to transfer trademarks and the goodwill associated with this intent may be presumed, even though not expressly provided for. However, it is recommended that such issues be addressed in the supplemental closing documentation. An exception to this concept lies in the context of transactions between parent corporations and their wholly owned subsidiaries. Asset-based purchases in this context will not automatically include intellectual property rights; rather, ownership of the intangible assets will remain with the parent corporation unless the underlying agreement expressly provides for transfer to the subsidiary.29 Stock Purchase. In stock purchase acquisitions, ownership of trademarks and other intellectual property remains with the acquired company. Share purchases will not affect distinct property rights in intangible assets or other intellectual property to be properly transferred, although a separate agreement is usually recommended to underscore the parties’ intentions.30
ANTITRUST 16.5 TAX CONSIDERATIONS
Depending on the scope of the business activities of the purchaser, it may choose not to obtain record title to intellectual property assets received in a merger or acquisition; rather, it may choose to sell its newly acquired intangible assets to a third party (for which the purchaser may own a substantial portion of the shares) and receive a license back to use same. Very often, this can be achieved in the most tax-efficient manner by placing ownership of the intangible assets in a holding company that then licenses back the assets for the operating company’s use. For example, the establishment of a Delaware Investment Holding Company (DIHC) provides an excellent framework for this model. Delaware, similar to many other states, imposes a net income tax derived from business activities and a franchise tax based on the number of authorized shares of stock. Any type of income from intangible investments located outside Delaware and received by a DIHC, which is exempt from Delaware’s corporate net income tax.31 Title to the intangible assets typically will be transferred to the DIHC, which subsequently licenses the use of the intangible assets to whichever operating entity the purchaser (normally the party who has dominant ownership and is created the DIHC) desires the assets to be used in exchange for a royalty.32 Not only is the DIHC exempt from Delaware’s income and gross receipts tax, but the royalties received by the DIHC are exempt from Delaware taxes as long as the activities of the DIHC are confined to maintenance and management of intangible assets.33 The licensee may receive further tax benefits through a deduction for payment of the royalties, depending upon the state or local jurisdiction.34 Transactions in which one company has a presence outside the United States can generate more complex tax implications. Pretransaction considerations should include whether any tax treaties exist among the respective nations, U.S. Federal and State tax requirements, and taxation in the foreign jurisdiction.35 ANTITRUST
Parties to a merger or acquisition would be ill-advised to ignore antitrust concerns in the context of obtaining intellectual property assets. In fact, the Justice Department has been taking an ever-increasing interest in the acquisition of intellectual property rights from an antitrust perspective. The intellectual property rights component of a commercial merger or acquisition is increasingly the prominent focus of the Justice Department or Federal Trade Commission’s premerger examination of the proposed combination.36 The Hart-Scott-Rodino Act imposes a premerger notification requirement upon parties to a commercial merger or acquisition, if the two parties are of sufficient size (i.e., $100 million and $10 million in sales or assets), and the transaction in question involves at least 15 percent of the sellers’ assets, or has a value greater than $15 million.37 The necessary documentation must be submitted to the Federal Trade Commission and the Assistant Attorney General of the Antitrust Division of the Justice Department, and the waiting period is 30 days from receipt thereof, not including extensions and requests for further information and documentation.38 Failure to comply with these notification requirements can result in a civil penalty of no more than $10,000 for each day in which
16.6 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
there is noncompliance.39 As such, great care should be taken with respect to valuation of the intellectual property rights to determine whether compliance with the notification provisions of the Hart-Scott-Rodino Act is required.40 The 1992 Merger Guidelines of the Department of Justice and Federal Trade Commission would apply the HHI index “to assess the potentially combined market shares represented by the intellectual property being transferred, and depending on the degree of concentration, an initial assessment could be made of the likelihood of challenge by the Department of Justice or Federal Trade Commission.”41 The 1995 Federal Antitrust Guidelines for the Licensing of Intellectual Property make specific reference to the 1992 Horizontal Merger Guidelines in its treatment of acquisition of intellectual property rights from an antitrust perspective.42 Section 7 of the Clayton Act is particularly relevant to intellectual property transfers concerning antitrust.43 Section 7 prohibits those acquisitions of stock or assets where “the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly.”44 As is frequently the case, Section 7 antitrust concerns can be cured by granting licenses to competitors to ensure vibrant competition in a particular industry.45 However, it is not unusual for companies to be reluctant to license their intellectual property rights. For example, in Image Technical Services Inc. v. Eastman Kodak Co., the court concluded that Kodak’s refusal to license was a matter of jury interpretation to determine whether such refusal was merely a pretext invoking possible antitrust violations.46 The jury found Kodak liable and assessed damages in the amount of $23.8 million, which was trebled under Federal law.47 However, in CSU L.L.C. v. Xerox Corp., this rational was rejected by the court, who concluded that the owner retained the right to refuse to deal.48 This line of cases demonstrates the ever-increasing scrutiny imposed by the relevant governmental authorities in connection with the convergence of intellectual property and antitrust laws and the divergent state of the case law pertaining thereto. In fact, U.S. antitrust authorities are already beginning to rethink the treatment of mergers and acquisitions from a policy perspective. In view of the volume and scope of merger activity in the late 1990s, the Federal Trade Commission is expected to outline its evolving approach to these mega-mergers. Stemming from uneasiness on the part of government officials due to the aforementioned mega-mergers are proposed policy changes expected to yield a tougher approach.49 This expected get-tough policy is slated to be a response to changes in the marketplace from settlement proposals from merging parties intending to use any means necessary to make certain a merger passes governmental antitrust scrutiny.50 The grant of licenses to ease governmental oversight regarding intellectual property may not work as effectively as in the past. Before the transition to the Bush administration, the Clinton administration earmarked sharp increases in funding for both the U.S. Department of Justice’s Antitrust Division and the Federal Trade Commission in its proposed budget for fiscal year 2001.51 The proposed budget asks for a 22 percent hike to $134 million for the Justice Department and a 30 percent hike to $165 million for the Federal Trade Commission.52 The budget supports increasing merger filing fees under the Hart-Scott-Rodino Act to pay for the increased funding.53 The combination of Time-Warner and America Online, Inc., faced tough scrutiny from federal regulatory authorities. Sen. Orrin Hatch, Chairman of the Senate Judiciary Committee, issued an immediate warning about the proposed combination, asserting
ANTITRUST 16.7
that the deal raises “profound public policy implications” and that “we need to proceed with a degree of caution to ensure that potential antitrust concerns, if any, are properly addressed.”54 Sen. Paul Wellstone addressed even deeper concerns, stating, “I am very concerned about the effects these massive mergers will have on the flow of information in our democracy.”55 Although these initial statements indicated that the merger would face tough scrutiny, the deal was ultimately consummated, despite the concessions that had to be made. Statements to this effect by influential legislators indicate an increasing uneasiness with such grand-scale mergers. Patents. It is clear that a patent holder has the right to sell an exclusive interest in a patent
without violating any provisions in the respective antitrust laws.56 However, potential antitrust implications may arise under those limited circumstances, other than through governmental grant, in which patent acquisition occurs. For example, in SCM Corp. v. Xerox Corp.,57 the court concluded that when a dominant competitor in a particular industry or market acquires a particular patent or group of patents, which gives this dominant competitor monopoly power in that industry when added to those patents already owned, it is a violation of Section 2 of the Sherman Antitrust Act.58 Section 2 provides that Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine not exceeding $10,000,000.00 if a corporation, or, if any other person, $350,000.00, or by imprisonment not exceeding three years, or by both said punishments, in the discretion of the court.59
As such, the market power of the purchasing party is one of the overriding factors through which the acquisition of a patent or patents will result in an antitrust violation.60 In addition, if the intent of the purchase is to eliminate competition within the field, the dominant purchaser will be left susceptible to antitrust violations.61 Copyrights. Although copyrights may be purchased in a manner similar to other tan-
gible or intangible assets, no case law thus far has held that the mere acquisition and accumulation of copyrights violates any aspect of antitrust legislation. Conversely, case law directly on point confirms that no antitrust violation will be found simply by accumulating copyrights, or otherwise, in a particular industry.62 Trademarks. Thus far, the mere accumulation of trademarks has not given rise to lia-
bility under either the Sherman or Clayton Acts.63 However, aggressive accumulation of trademarks can potentially create some form of antitrust liability,64 because trademarks have been held to constitute assets within the meaning of Section 7 of the Clayton Act.65 Grant-backs. The 1995 Federal Antitrust Guidelines for the Licensing of Intellectual
Property define a grant-back as “an arrangement under which a licensee agrees to extend to the licensor of intellectual property the right to use the licensee’s improvements to the licensed technology.”66 The imposition of grant-back requirements in a licensing arrangement by a patent holder who already wields considerable market power may result in a violation of antitrust laws.67 Furthermore, to commandeer a dominant position
16.8 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
within a relevant market, under rule of reason analyses, courts have construed that the use of grant-back clauses are evidence of intent to commandeer a dominant position within a relevant market.68 Generally, grant-back antitrust implications lend themselves to interpretation only concerning patents, because the nature of trademarks and copyrights does not give rise to grant-back analyses.69 Competition Law in the European Community. The rules governing competition laws in
the European Community are set forth in Articles 81 and 82 of the European Economic Community Treaty. Relevant provisions of Article 81 provide • The following shall be prohibited as incompatible with the common market: all agreements between undertakings, decision by associations of undertakings and concerted practices which may affect trade between Member States and which have as their object or effect the prevention, restriction or distortion of competition within the common market, and in particular those which • Directly or indirectly fix purchase or selling prices or any other trading conditions • Limit or control production, markets, technical development, or investment • Share markets or sources of supply • Apply dissimilar conditions to equivalent transaction with other trading parties, thereby placing them at a competitive disadvantage • Make the conclusion of contract subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts • Any agreements or decisions prohibited pursuant to this Article shall be automatically void.70 Article 81(3) exempts certain transactions that would otherwise violate the previous rules, if they contribute to “improving the production or distribution of goods or to promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit.”71 Conduct that falls within the prohibitions set out under Article 81 can can also violate Article 82, which covers the abuse of dominant positions. Relevant portions of Article 82 provide Any abuse by one or more undertakings of a dominant position within the common market or in a substantial part of it shall be prohibited as incompatible with the common market in so far as it may affect trade between Member States. Such abuse may, in particular, consist in: (a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; (b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage;
WORLDWIDE RECORDAL OF INTELLECTUAL PROPERTY RIGHTS 16.9 (d) making the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts.
Examples of abusing a dominant position include exploitation, conduct that oppresses buyers and sellers dealing with a dominant firm, excessive pricing, underpayment, restricting production or markets, and discrimination against firms with the practical effect of reducing their ability to compete.72 Both articles 81 and 82 are enforced by the Commission under Regulation 17 and the national courts of the Member Nations.73 However, for purposes of merger and acquisition activity, Article 81 is the controlling provision for interpretation of EC competition law. In Continental Can, the Community Court held that Article 86 (now Article 82) prohibits the acquisition of a substantial majority of the shares in a potential competitor by a dominant firm in the product dominated if this would substantially reduce competition.74 However, the Commission doubted whether Article 82 granted the power to restrain such a merger and did not, until December 21, 1989, adopt Regulation 4064/89, which requires prenotification procedures through which the Commission would be able to prohibit a proposed combination.75 Concentrations that have a community dimension in which “(a) the aggregate worldwide turnover of all the undertakings concerned is more than ECU 500 million, and (b) the aggregate Community-wide turnover of each of at least two of the undertakings concerned is more than ECU 250 million.”76 As such, a concentration that exceeds this threshold will be subject to review in order to determine whether the proposed combination is compatible with the common market. Articles 2(2) and 2(3) of Regulation 4064/89 set forth the standard for which a combination will be deemed incompatible with the goals of the common market. This key article provides that, “a concentration . . . creates or strengthens a dominant position as a result of which effective competition would be significantly impeded in the common market or in a substantial part of it.”77 In making its determination of whether a dominant position is created or strengthened, the Commission will take into account such factors as the need to preserve effective competition, the market position of the newly created entity, opportunities available to supplier and users, legal barriers to entry into a relevant market, and the interests of consumers.78 WORLDWIDE RECORDAL OF INTELLECTUAL PROPERTY RIGHTS
With the exception of all-stock deals or relatively similar stock transactions, the assets, including the intellectual property rights of the acquired company, need to be transferred into the name of the new owner in each jurisdiction where such rights exist. Timely recordal of a change of ownership is critical to protect the ongoing validity and enforcement of intellectual property rights for several reasons, including: • If a change of ownership is not promptly recorded, a misconception can arise in the marketplace as to the identity of the actual owner, leading to a possible loss of rights where a trademark no longer functions as a true indication of origin. This is particularly true in the case of well-known trademarks, or in the case of other marks which are extensively used in their particular jurisdiction.
16.10 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
• The new owner may not be able to prosecute infringements, file oppositions, or attend to renewals or annuity payments. For example, enforcement of a patent can only be carried out under the authority of the owner of record or its exclusive licensee. If prompt injunctive relief is required, an undesired delay will result from a necessity to record the transfer of rights. Furthermore, the right of the patent owner to obtain damages for acts of infringement which occurred before the transfer documents were recorded may be lost in certain jurisdictions. • Fines and/or penalties may be assessed for late recordal of a transfer. In certain jurisdictions, there are time limits after which it may be too late to effect proper recordal of an assignment. • The failure or delay in recording a transfer of ownership may result in a possible loss of royalties. For example, if a license is to be given under a patent, the licensor must be the owner of record. Therefore, a delay in recording the transfer can delay the date when the license agreement becomes effective; this, in turn, can delay manufacturing and/or sales. The resulting loss of royalties may not be recoverable. In a number of countries, a license agreement must be approved by government authorities and, in the license agreement submitted for such approval, the record owner should appear as the licensor. Delay in recording thus delays approval, with consequential loss of royalties. • License recordals and registered user entries will no longer be current and may affect the validity of the use by a licensee and/or governmental approval for foreign exchange authorizations for remission of royalties. • In the event an “equitable transfer” occurs without the requisite official change of “record ownership” at the relevant patent and trademark offices throughout the world, the new owner will encounter enormous difficulties when confronted with the maintenance, sale, enforcement, hypothecation, licensing and/or use of the intellectual property rights. For example, proof of use (where required for maintenance of existing trademark registrations) may not be accepted when used by the current owner unless that party is now reflected as the “record owner.” In order to reflect the new owner of the patent, trademark, or copyright as the “owner of record,” it will be necessary in most jurisdictions for counsel to prepare separate assignment documents for each jurisdiction in which such rights exist. In some jurisdictions, a certified copy of a “general” worldwide assignment may be acceptable. Intellectual property statutes exist in most countries of the world and provide a mechanism for the recordal of a change of ownership at a central registry. The form and substance of these documents vary from jurisdiction to jurisdiction, which underscores the advisability for the preparation of separate document for each jurisdiction. Such documents must be filed and recorded at the respective local registry. Furthermore, several multicountry registration systems, such as the Patent Cooperation Treaty or the Madrid Agreement, have special requirements with which counsel must be familiar in order to properly record a transfer of title. In this respect, it is recommended that the acquiring company engage counsel experienced in the worldwide transfer of intellectual property rights and familiar with preparation of documents necessary for each jurisdiction. Separate Documents for Each Jurisdiction Are Required.
TRANSFER OF TRADEMARKS 16.11
Furthermore, several issues can arise with respect to the filing and recordal of the assignment documents at the respective local registry. In particular, stamp, value added or ad valorem taxes may be assessed on the transfer, official actions issued encompassing a potentially broad range of issues (e.g., the existence of associated trademarks) and advertising and publication requirements. Furthermore, these local requirements underscore the need for separate transfer documents to be prepared, executed and recorded in each jurisdiction in the native language. Similarly, confidential information which the buyer does not wish to disclose can be omitted as each transfer document can be prepared simply to satisfy the local requirements for transfer of the national intellectual property rights exclusively. Experienced intellectual property counsel familiar with the worldwide recordal of ownership transfers should bring these issues to the acquiring company’s attention prior to the preparation of the required assignment documents for each jursdiction. Costs. Where a significant number of intellectual property rights that exist in multiple jurisdictions are the subject of a merger or acquisition, the costs of simply preparing and recording the necessary documents can be substantial. Official fees are assessed by the number of trademarks or patents included in the transfer. The burden of absorbing the costs of effecting recordal of the assignment or merger frequently is borne by the acquirer. However, this is not always the case. In some cases, the costs are factored into the purchase price and in other cases these costs are shared by the parties. Accordingly, it is advisable that the issue of costs are discussed by the parties and treated in the Purchase or Acquisition Agreement entered into during the course of an M&A transaction.
TRANSFER OF TRADEMARKS
Trademark rights in the United States are governed by the laws of the 50 states and Puerto Rico and, most importantly, by federal law under the Lanham Act.79 Federal trademark protection for those marks “used in commerce” provides the most comprehensive protection and is widely regarded as the best way to protect trademarks whose use expands beyond a local territory or jurisdiction.80 In the change of ownership of trademarks in a merger or acquisition, basic requirements for establishing proper ownership are specifically covered by federal statute.81 Assignment. In the United States, a trademark cannot be assigned apart from the good-
will it symbolizes.82 In addition to the plethora of case law expounding and reinforcing this traditional requirement, the Lanham Act specifically requires that the goodwill associated with a trademark accompany any transfer of the trademark itself.83 Section 10 of the Lanham Act provides, “[a] registered mark or a mark for which an application to register has been filed shall be assignable with the good will of the business in which the mark is used, or with that part of the good will of the business connected with the use of and symbolized by the mark.”84 A trademark is merely a symbol of goodwill and has no independent significance apart from the goodwill associated with it.85 Attempts to transfer trademarks without the associated goodwill of the business have been characterized as “assignments in gross” and are invalid.86 The public policy behind the requirement for transferring the goodwill of the business with the trademark itself is to prevent use of a trademark with a different goodwill
16.12 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
and different product, which may result in consumer deception.87 The requirement that goodwill accompany the trademark ensures that a transferee’s use will not be deceptive or break the continuity of the goodwill associated with the trademark.88 Outside the United States, many jurisdictions do not impose a similar goodwill requirement in conjunction with the assignment of trademarks.89 In fact, the majority rule worldwide is that trademarks may be assigned without the goodwill.90 There are basically three categories worldwide in which trademarks may or may not be transferred with goodwill. The first category of countries comprise those which allow for the unfettered assignments of trademarks. An example of a country in this category is France. The second category of countries are those that allow assignments with or without the goodwill but impose an advertising requirement. Generally, British law countries that have adopted the Trade Marks Act 1938 and the U.K. Trade Marks Act 1994 are included in this category. The third and final group of countries are those such as the United States which impose a goodwill requirement. Intent-to-Use Trademarks. The Lanham Act allows for the application of trademarks based on a bona fide intent-to-use the trademark later.91 The Lanham Act specifically allows for intent-to-use applications to be assigned, but imposes specific requirements limiting the circumstances in which they may be validly transferred.92 Section 10 of the Lanham Act states, “[n]o application to register a mark under section 1051(b) (intent to use applications) of this title shall be assignable prior to . . . the filing of the Verified Statement of Use . . . except for an assignment to a successor to the business of the applicant, or portion thereof, to which the mark pertains, if that business is ongoing and existing.”93 Essentially, this statute requires that either use of the mark be made (along with the proper filing of the Verified Statement of Use with the U.S. Patent & Trademark Office) or the entire business associated with the intent-to-use trademark applications has been transferred before the assignment can be considered valid. The Paris Convention. The Paris Convention for the Protection of Industrial Property
specifically discusses trademark transfers in the context of its associated goodwill.94 Under Article 6quater, whether the transfer of the business of the assignor is required to effect a valid transfer of trademark rights is determined by the national law of the particular jurisdiction in which the transfer is taking place.95 Furthermore, Article 6quater does not impose upon the member nations of the Paris Convention an obligation to recognize an assignment that does not transfer the associated goodwill of the trademark.96 Goodwill under the Community Trademark System. The Community Trademark (CTM) system does not require that the goodwill of the business associated with the trademark accompany a transfer.97 In the event a transfer agreement is silent about goodwill, an assignment under the CTM system will be assumed to include the entire business associated therewith.98 Furthermore, it is not possible to assign the mark of a Community Trademark Registration (i.e., assign the mark for only a particular member nation of the European Community).99 Goodwill under the Madrid Agreement and Protocol. The Madrid Agreement and Protocol do not require that a transfer of the ownership of a trademark be accompanied by its associated goodwill.100 In fact, Article 9ter(1) requires the International Bureau to record a
TRANSFER OF TRADEMARKS 16.13
partial transfer containing only a portion of the goods and services covered under a specific International Registration.101 However, this mandatory recordal requirement by the International Bureau is qualified in that individual member nations may refuse to recognize the validity of such an assignment without the entire goodwill.102 Recordal of Trademark Assignments in the United States. Under the Lanham Act, it is critical that companies who recently acquire ownership of trademark rights, regardless of the nature in which they were received (merger, acquisition, takeover, or sale), record with the Commissioner of Patents and Trademarks their newly acquired ownership. The time frame in which to record and the result of failure to record are specifically provided for by statute.103 The relevant provision reads
An assignment shall be void as against any subsequent purchaser for a valuable consideration without notice, unless it is recorded in the Patent and Trademark Office within three months after the date thereof or prior to such subsequent purchase. A separate record of assignment submitted for recording hereunder shall be maintained in the Patent and Trademark Office.104
In the event that the acquiring party fails to properly record its new ownership of the trademark and the party from which the rights were bought transfers the same trademarks to a third party at a later date, the acquiring party will lose its rights in the marks. This statute is designed to protect third parties who, without knowledge of the initial transfer because of lack of recordal and who provided sufficient consideration for the trademarks, are not penalized by the initial purchaser’s failure to provide notice by recording its ownership in the trademarks. In this respect, recordal prevents the third party from losing its rights and priority because of the unscrupulous behavior of the seller or its own misunderstanding of the transaction’s nature. Proper recordal of the new ownership in trademarks achieves more than having the name of the new owner reflected on the Federal Register. The Trademark Office will not allow an entity to file a Section 8 Affidavit of Use or even renew a trademark if that company is not reflected as the proper owner of record at the Trademark Office.105 After assignment of a registered trademark, the assignee obtains all right, title, and interest previously owned by the assignor.106 Furthermore, it is essential that any assignment deed provide for the transfer of all common law rights in the mark.107 The rationale behind this practice is that common law rights usually predate the actual federal registration, further extending the priority period in a trademark.108 Additionally, in the event that a federal registration is later declared invalid, the common law rights still allow for priority of rights in the mark.109 Despite nonrecordal of a transfer of ownership in trademarks, the assignee retains the right to file an infringement action, cancellation, or opposition proceeding.110 In order to proceed in an opposition or cancellation, however, the assignee must demonstrate through formal documentation that it has acquired ownership in the trademark upon which the action is based.111 Benelux. The term “Benelux” is an acronym for Belgium, the Netherlands, and
Luxembourg. These three European jurisdictions formed the Uniform Benelux Trademark Law, which became effective on January 1, 1971.112 As a result, the national trademark law of each of the three jurisdictions was abolished, paving the way for a uniform system of
16.14 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
recording the transfer of trademarks.113 This makes it necessary to record a trademark transfer in a single location—the Hague, Netherlands. The Community Trademark. In an effort to harmonize the respective trademark laws of its
member nations and eliminate trade barriers, the European Community created a unified trademark law to cover the entire community.114 Implementing Regulation (EC) No. 2868/95 took effect on January 1, 1996; at a central office in Alicante, Spain, it is now possible to file an application to transfer and record ownership, which has effect within all the member nations vis-à-vis a unified system.115 The Community Trademark does not replace the member nations’ respective trademark laws, however;116 it is critical that purchasers of trademarks record their new ownership in the Alicante office so that it may have effect against subsequent third-party purchasers.117 Madrid Agreement and Madrid Protocol. The Madrid Agreement Concerning the International Registration of Marks (Madrid Agreement), signed on April 14, 1891, enables a trademark owner who is a national, has a domicile, or has an “effective industrial or commercial establishment” in one of the member states of the agreement to obtain a single trademark registration covering multiple jurisdictions.118 One of the principal disadvantages of the Madrid Agreement is that, if the home registration upon which the International Registration is based ceases to exist within the first five years, the International Registration and all its territorial extensions will also cease to exist. As a result, the Madrid Protocol Relating to the Madrid Agreement Concerning the International Registration of Marks (Madrid Protocol) was proposed in an effort to attract more nations and went into effect on April 1, 1996.119 The distinct element that makes the Protocol more attractive is that an application for an International Registration may be based on either a trademark application or a registration in the applicant’s country of origin. Trademark ownership transfers are governed under Articles 9, 9bis, 9ter, and Rules 25, 26, and 27 of the Common Regulations under the Madrid Agreement concerning the international registration of marks and the Protocol relating to that Agreement, which became effective on January 1, 1998. Recording a transfer is necessary for it to be valid and enforceable against subsequent third-party purchasers acting in good faith. It is recommended that any transfer instrument include a provision for recovery of past infringements, since the national laws of member nations may preclude such recovery by a transferee if not expressly provided for. Because an International Registration is not effective in the home country, it is critical that a transferee obtain all right, title, and interest to the home registration upon which the International Registration is based.120 When a corporation is acquired by purchase of all its shares without specifically mentioning its trademark rights, ownership of the trademarks will remain with the corporation being acquired. However, if a business is acquired by purchase of all its assets and the underlying agreement does not specifically mention the acquired company’s trademark rights, the purchase may not be recognized in some jurisdictions where the International Registration has been extended. Essentially, mergers and acquisitions are governed by the national laws of the member nations; however, if the owner of the International Registration changes because of a merger or acquisition, this change should be recorded with WIPO, the governing body responsible for the administration of both the Madrid Agreement and
TRANSFER OF PATENTS IN THE UNITED STATES 16.15
Protocol. Furthermore, transfers of ownership of an International Registration will only be effective in jurisdictions subject to the Madrid Agreement or Protocol. The United States is noticeably absent from the contracting nations. Other Multilateral Treaties. In addition to the arrangements and treaties previously dis-
cussed, other multilateral arrangements and treaties include the African Intellectual Property Organization (OAPI) arrangement, Andean Pact, Pan American Convention of 1929, Central American Convention, North American Free Trade Agreement (NAFTA), and Trade-Related Intellectual Property Rights (TRIPS), all of which grant reciprocal rights or harmonize national trademark laws to some degree.121 WORLDWIDE PATENT ASSIGNMENT RECORDAL
Similar to trademarks, “record title” of newly acquired patent assets need to be transferred to the new owner in each jurisdiction where such rights are valid and subsisting. The parties should engage counsel familiar with the preparation of documents for submission to the local patent offices and the varying local requirements that must be complied with in order to properly and expeditiously record the new owner of record. TRANSFER OF PATENTS IN THE UNITED STATES
The Patent Act provides that applications for patents, granted patents, and any related interests are fully assignable and transferable.122 The act specifically requires that the transfer must be effected by a written instrument.123 Such instrument should contain language evidencing a clear and unmistakable intent to transfer ownership and must be executed by the patentee or its assignees.124 Generally, a patent assignment conveys the exclusive right to make, sell, or use a particular invention, although in many instances assignments are effected to convey an undivided ownership interest in the patent.125 A valid assignment will put the assignee in control of a patent standing to enforce any and all rights thereunder.126 Additionally, a deed of assignment should expressly provide the assignee with the right to sue for past infringement.127 The Patent Act specifically addresses the issue of timely recordal of assignment documentation.128 The Patent Act states, An assignment, grant or conveyance shall be void as against any subsequent purchaser or mortgagee for a valuable consideration, without notice, unless it is recorded in the Patent and Trademark Office within three months from its date or prior to the date of such subsequent purchase or mortgage.
In the event of conflicting transfers of title in the same patent or patent application, the Patent Act gives the first purchaser a 90-day window in which to record. Even if a subsequent purchaser records before the original purchaser, the first purchaser will prevail if it records within the statutorily-granted 90-day period. However, the public policy behind the statute is intended to protect the interests of bona fide subsequent purchasers of patents who have acted without notice of a prior, unrecorded assignment.129 A subsequent purchaser who has actual or constructive notice will not be able to employ the protective measures of the patent recordal statute.130
16.16 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION TRANSFER OF TRADE SECRETS IN THE UNITED STATES
Trade secrets are a fully assignable and transferable type of intangible asset.131 Despite the adoption of statutes, such as the Uniform Trade Secret Act and Economic Espionage Act of 1996, by some states,132 the Restatement of Torts § 757(b) still provides the most comprehensive and widely relied-on definition of a trade secret.133 Due to the intangible nature of trade secrets and the fact that most trade secret disputes are still interpreted under the common law of individual states, the extent of the property right in a trade secret is determined by the extent to which the owner protects its trade secret interest from disclosure to third parties.134 Disclosure of a trade secret to a third party who is not obligated to protect the confidentiality of the information will end the property owner’s right in the trade secret.135 One of the basic tenets that must be followed in any trade secret transfer is that, in order for a valid transaction to take place and for the transfer to be perfected, the purchaser of a trade secret must take possession of the property.136 The problem therein lies in the fact that trade secrets, as intangible property, are not easily possessed.137 A trade secret that is sold and still retained by the transferor poses the risk that the transferor will assign the same trade secret to a subsequent, bona fide purchaser for value.138 Accordingly, courts have been called upon to resolve disputes in which the transferor retains the trade secret after an initial sale and assigns the same property to a subsequent good faith assignee.139 Interpretation based on this scenario has ultimately resulted in a line of cases in which courts have decided that the subsequent assignee’s rights in the property are valid and the original purchaser’s remedy is against the transferor.140 After an assignment of a trade secret, the transferor will generally be enjoined from continuing use of that trade secret, making it available to third parties and, of course, selling an interest in the same property to a subsequent bona fide purchaser.141 Qualifying this general rule is the partial assignment of a trade secret that will, in most instances, constitute a valid transaction.142 Furthermore, if an inventor opts to assign an unpatented invention, he or she will be enjoined from seeking a letters patent in derogation of the rights of his assignee.143 WORLDWIDE COPYRIGHT ASSIGNMENT RECORDAL
Similar to trademarks and patents, “record title” of newly acquired copyright assets needs to be transferred to the new owner in each jurisdiction where such rights are valid and subsisting. The parties should engage counsel familiar with the preparation of documents for submission to the local copyright offices and the varying local requirements that must be complied with in order to properly and expeditiously record the new owner of record. TRANSFER OF COPYRIGHTS IN THE UNITED STATES
The Copyright Act of 1976 defines the transfer of copyright ownership as “an assignment, mortgage, exclusive license, or any other conveyance, alienation, or hypothecation of a copyright or of any of the exclusive rights comprised in a copyright, whether or not it is limited in time or place of effect, but not including a nonexclusive license.”144 The Copyright Act expressly permits such transfers to be effectuated, including only specific
TRANSFER OF COPYRIGHTS IN THE UNITED STATES 16.17
aspects of the bundle of rights in a copyrighted work by means of a conveyance or by operation of law.145 Section 201(d) of the Act provides that: (1) [t]he ownership of a copyright may be transferred in whole or in part by any means of conveyance or by operation of law, and may be bequeathed by will or pass as personal property by the applicable laws of interstate succession. (2) [a]ny of the exclusive rights comprised in a copyright, including any subdivision of any of the rights specified by section 106, may be transferred as provided by clause (1) and owned separately. The owner of any particular exclusive right is entitled, to the extent of that right, to all of the protection and remedies accorded to the copyright owner by this title.146
The Copyright Act of 1976 expressly provides that mere transfer of a material object that is the subject of copyright protection does not, in and of itself, transfer ownership of a copyright in part or in whole.147 Conversely, transfer of a copyright will not suffice to obtain title to any specific material object that may be the subject of copyright protection.148 For a transfer of copyright to be valid other than by operation of law,149 the transfer must be in the form of an instrument of conveyance (i.e., a writing.)150 The Act expressly requires that the instrument bear the signature of the transferor—not only the transferee— to be valid.151 As with all contracts, the term “assignment” or “transfer” is not expressly required to be incorporated into the body of the document; rather, the overriding factor is the mutual intent of the parties to transfer an ownership interest in the copyright.152 Furthermore, an instrument that embodies the transfer of copyright ownership may in fact be valid in and of itself; however, the Copyright Act of 1976 states that notarial acknowledgment of the transfer document will serve as prima facie evidence of a valid transfer.153 The Copyright Act of 1976 provides a mechanism by which parties to a copyright assignment or other transfer may record the transferee as the owner of the copyright.154 Although the act does not specifically require a transfer to be recorded, a generally accepted and highly recommended practice is for a transferee to submit transfer documents to the Copyright Office for recordation. In many instances, a transferee does not want specific terms contained in the transfer document to become a matter of public record, so hesitates or fails to record the transfer at all. However, this problem can be easily remedied by using a short form document, which incorporates the basic provisions evidencing transfer to the new owner but may omit certain terms and conditions that are unnecessary for recordal purposes but vital to the transaction.155 For instance, transferees often do not wish to disclose the consideration recited in the transfer document, so may choose to replace the specific dollar amount with a phrase such as “for good and valuable consideration.”156 Timely recordal of a transfer document is critical in protecting the new owner’s rights over and above any representations and warranties incorporated in the transfer document itself. Recordation of a document is constructive notice to third parties about the transferee’s recently acquired ownership interest.157 Constructive notice operates as a vital precaution to both the transferee and a possible subsequent purchaser in the same copyright. In the event that the original transferor attempts to once again sell an interest in the same copyright, timely recordation by the original transferee will alert the new potential buyer that the transferor does not have clear and
16.18 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION
unfettered title to the copyright. In fact, this specific scenario is contemplated by the Copyright Act of 1976, which establishes priority in ownership of a copyright based upon timely recordal:158 As between two conflicting transfers, the one executed first prevails if it is recorded, in the manner required to give constructive notice under subsection (c), within one month after its execution in the United States or within two months after its execution outside the United States, or at any time before recordation in such manner of the later transfer. Otherwise the later transfer prevails if recorded first in such manner, and if taken in good faith, for valuable consideration or on the basis of a binding promise to pay royalties, and without notice of the earlier transfer.
Thus, a transferee who fails to record may lose its ownership interest in a copyright, despite the existence of a valid transfer document, by failing to record before a subsequent purchaser who was unaware of the existence of the prior transfer and paid valuable consideration for the same copyright. The presumed public policy behind this penalty for lack of recordation is an increase in the certainty of commercial transactions and a penalty for those who fail to announce their rights.159 However, a transferee who records the transfer of ownership before a subsequent assignee will always prevail against the subsequent transferee.160 In rare circumstances when a subsequent transferee purchases for value and records a transfer of a copyright before the original transferee within one month of the original transfer, the original transferee is protected by the statutory one month grace period in which to record. As such, the original transferee will be protected from any attempt by a subsequent purchaser for value without notice if recordation occurred within the one-month grace period.161 TRANSFER OF DOMAIN NAMES
Parties, especially the buyer, to a merger or acquisition for which domain names represent a portion of the assets to be acquired should be aware of the pitfalls that accompany domain name transfers so as to address such issues in the relevant agreement. Although not specifically governed by statute under U.S. law, the transfer of domain names attendant to a merger or acquisition, as with any form of intellectual property, should be a careful undertaking with particular attention paid to the language concerning transfer therein. The transfer of ownership of a domain name should consist of at least three documents: Purchase Agreement, Registrant Name Change Agreement (if the domain name is registered with Network Solutions, Inc., or, if not, pertinent documentation issued by the relevant registry), and assignment agreement. The latter two documents may be set forth as exhibits to the Purchase Agreement. The Purchase Agreement should make certain to address the intersection of domain names and trademark law. In addition to stating the intentions of the parties and transferring the domain name itself, all common law trademark, copyright, and other intellectual property rights related to the domain name should be subject to the transfer as well. Representations and warranties to the effect that the seller is the sole owner and that the subject domain name is not subject to any claims or actions should be made with indemnity provisions in favor of the buyer. The agreement should further prohibit the seller from registering or using a similar or related domain name.162
ENDNOTES 16.19
Specific reference to the Registrant Name Change Agreement (RNCA) should be made with an affirmative obligation for both buyer and seller to execute same. In most instances, the buyer is responsible for filing the RNCA with Network Solutions, Inc., as should be explicitly set forth in the Purchase Agreement. For the buyer to be reflected as the owner of record on NSI’s database subsequent to closing, the buyer will need to complete an email template provided by NSI that sets forth certain information such as administrative contacts, billing contacts, and server information. Upon completion of this template, NSI will furnish a “NIC” tracking number that should be incorporated into the RNCA before filing same. In addition to the standard notice issued by NSI confirming that the new owner of the domain name has been entered into its system, a check of NSI’s “WhoIs” database may be worthwhile, as well. If the domain name is not registered with NSI, the applicable registry will provide details about domain name transfers. Finally, a standard Deed of Assignment should be exhibited to the Purchase Agreement, further evidencing the transfer of title to the domain name. Although this document will not be filed and recorded with any specific governmental or regulatory authority, it should incorporate those issues not addressed by the Purchase Agreement and serve as a stand-alone document that evidences the transfer in case disclosure to a third party (e.g., tax authorities) is required, and the terms of the Purchase Agreement should be kept confidential. CONCLUSION
As the global economy races to become information based, the value of intellectual property will continue to play an increasing role as the driving force behind future merger and acquisition activity. Indeed, intellectual property is anticipated to be the dominant force in future commercial transactions comprising tomorrow’s mergers and acquisitions. ENDNOTES 1
See Chipman, Picchi and Stein, America Online to Buy Time Warner for $178 Billion in World’s Biggest Merger, Bloomberg.com (Jan. 10, 2000), 1. 2 See William A. Tannenbaum, “Patent, Copyright and Domain Name Intellectual Property Due Diligence for Mergers and Acquisitions,” Law Journal Extra (May 25, 1999). 3 See Saul Hansell, “America Online Agrees to Buy Time Warner for $165 Billion; Media Deal is Richest Merger,” The New York Times (Jan. 11, 2000), A1. 4 The term “content” as it pertains to Internet services generally refers to any type of data, text, software audio or visual information that is readily accessible or available for downloading or distribution over the Internet. “Content” may also include information intended to be stored and retained by the user, as well as “live” images displayed on a particular Web site. See Marcelo Halpern, Licensing Content on the Internet, World Licensing Law Report, Bureau of National Affairs (Nov. 1999), 1. 5 See Laura M. Holson, “The Online Generation Courts the Old Guard.” The New York Times (Jan. 11, 2000), C1. 6 See Chipman, Picchi, and Stein, “America Online to Buy Time Warner for $178 Billion in World’s Biggest Merger,” The New York Times (Jan. 11, 2000), 1. 7 Ibid. 8 See Lisa I. Fried, Financial Industry Cautious on Reform Act, N.Y.L.J. (Feb. 17, 2000), 1.
16.20 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION 9
See Fried, Financial Industry Cautious on Reform Act, 1. See Weston Anson, “How Intangible Assets Drive Capitalization,” Les Nouvelles (Sept. 1999), 133. 11 Ibid. 12 Ibid., 134. 13 Ibid. 14 See Thomas W. Hoens, The Rating Agency View of Intangible Assets, Intellectual Property in the Global Marketplace, §10.13, V.I. (1999). 15 See Saul Hansell, “America Online Agrees to Buy Time Warner for $165 Billion; Media Deal is Richest Merger,” The New York Times (Jan. 11, 2000), C11. 16 See Semiconductor Chip Protection Act, 17 U.S.C. §901(a)(2)–(a)(3), defining a mask work as a series of related images, however fixed or encoded, (A) having or representing the predetermined three-dimensional pattern of metallic, insulating, or semiconductor material present or removed from the layers of a semiconductor chip product; (B) in which series the relation of the images to one another is that each image has the pattern surface of one form of the semiconductor chip product; and (C) a mask work is “fixed” in a semiconductor chip product when its embodiment in the product is sufficiently permanent or stable to permit the mask work to be perceived or reproduced from the product for a period of more than transitory duration. 17 See Carol Anne Been and Samuel Fifer, The Acquisition and Disposition of Intellectual Property in Commercial Transactions: The U.S. Perspective, as published in Intellectual Property in the Global Marketplace (New York: John Wiley & Sons, Inc., 1999), 24.1. 18 See Susan Barbieri Montgomery and Richard J. Taylor, Worldwide Trademark Transfers, §IIIB.1.a, (Clark Boardman Callaghan, 1999). 19 Glenn A. Gunderson and Paul Kavanaugh, Intellectual Property in Mergers & Acquisitions, Trademarks in Business Transactions Forum, International Trademark Association, (Sept. 16–17, 1999), 87. 20 Ibid. 21 See Patrick A. Gaughan, Mergers, Acquisitions and Corporate Restructurings (New York: John Wiley & Sons, Inc., 1996), 7–8. 22 Ibid. Depending on the complexity of a specific transaction, the Purchase Agreement is prepared, negotiated, and executed in advance of the actual sale or closing date. In smaller, less complex transactions, the Purchase Agreement may be signed on the closing date. 23 Ibid., 88. 24 Ibid. 25 See L. M. Brownlee, Intellectual Property Due Diligence in Corporate Transactions, §13.35 (West Group, 1998). 26 Ibid. 27 Ibid. 28 Ibid., 5. With the increasing recognition of the value of intellectual property rights, however, this practice is becoming less commonplace. Indeed, intellectual property rights are becoming the prime targets in asset-based purchases in further recognition of their inherent value and potentially tremendous effect in terms of a company’s market capitalization value. 29 Ibid. 30 Ibid. 31 See George T. Bell, Melvin Simensky, and Gordon V. Smith, “A State Tax Strategy for Trademarks,” The Trademark Reporter, v.81, (1992), 448. See also Del.Cod. Ann. tit 30, §1902(b)(8), which exempts “[c]orporations whose activities within this State are confined to the maintenance and management of their intangible investments or of intangible investments of corporations or business trusts registered under the Investment Company Act of 1940, as amended and the collection and distribution of the income from such investments or from tangible property physically located outside this 10
ENDNOTES 16.21 State. For purposes of this paragraph, ‘intangible investments’ shall include without limitation investments in stocks, bonds, notes and other debt obligations . . . patents, patent applications, trademarks, trade names and similar types of intangible assets.” 32 See Sari Ann Strasburg, Holding Company Issues—Who Should Own the Intellectual Property, Trademarks in Business Transactions Forum, International Trademark Association, (Sept. 16–17, 1999), 98. 33 Ibid., 99. 34 Ibid. 35 Ibid., 101. 36 Robert A. McTamaney, N.Y.L.J., (Feb. 2, 1998), 5. 37 15 U.S.C. §18a. 38 See 15 U.S.C. §18a(b)(1)(A). 39 See U.S.C. §18a(g)(1). 40 See McTamaney, Antitrust and Intellectual Property Rights: The Devil is in the Details, 5. 41
Ibid. The Herfindahl-Hirschman Index (HHI) is a mathematical formula utilized by the Department of Justice to determine a company’s market share in a particular industry. 42 See The 1995 Federal Antitrust Guidelines for the Licensing of Intellectual Property, §5.7, which provides that:
Certain transfers of intellectual property rights are most appropriately analyzed by applying the principles and standards used to analyze mergers, particularly those in the 1992 Horizontal Merger Guidelines. The Agencies will appply a merger analysis to an outright sale by an intellectual property owner of all of its rights to that intellectual property and to a transaction in which a person obtains through grant, sale, or other transfer an exclusive license for intellectual property (i.e., a license that precludes all other persons, including the licensor, from using the licensed intellectual property). Such transactions may be assessed under Section 7 of the Clayton Act, Sections 1 and 2 of the Sherman Act, and Section 5 of the Federal Trade Commission Act. 43
See 15 U.S.C. §18. Ibid. 45 See Mc Tamaney, 6. 46 See 125 F.2d 1195 (9th Cir. 1997). See also John E. Daniel, Antitrust Law, N.Y.L.J., (Aug. 3, 1998), 1. 47 Ibid., 2. 48 See 986 F.Supp. 1131 (D.Kan.1997). Although the CSU and Kodak cases were not refusals to deal after a merger or acquisition, questionable antitrust violations for refusal to deal have the potential for impacting such transactions. 49 See John R. Wilke, “FTC Weighs Stricter Policy on Mergers,” The Wall Street Journal, (Jan. 12, 2000), A3. 50 Ibid. 51 See Karen Donovan, Fee Hikes Sought to Fund Antitrust Regulators, N.Y.L.J., (Feb. 17, 2000), 1. 52 Ibid. 53 Ibid., 1. The filing fees for mergers valued at $100 million or less would remain at $45,000.00; $100,000.00 for mergers valued between $100 million and $200 million, and $200,000.00 for mergers valued above $200 million. 54 See Jaret Seiberg, Regulators Eye AOL-Time Warner Deal, N.Y.L.J., (Jan. 11, 2000), 1. 55 See Seiberg, Regulators Eye AOL-Time Warner Deal, 1. 56 See United States v. Gypsum Co., 333 U.S. 264 (1948). 44
16.22 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION 57 645 F.2d 1195 (2d Cir. 1981), cert. denied, 445 U.S. 1016 (1982). Additional cases with similar holdings include Kobe, Inc. v. Dempsey Pump Co., 198 F.2d 416 (10th Cir.), cert. denied, 344 U.S. 837 (1952); U.S. v. Besser Mfg. Co., 96 F.Supp. 304 (E.D. Mich. 1951, aff’d, 343 U.S. 444 (1952). See also Von Kalinkowski on Antitrust, §73.01(2). 58 15 U.S.C. §2. 59 Ibid., §2. 60 See Von Kalinkowsky on Antitrust, §73.01[2]. 61 See United States v. Parker Rust-Proof Co., 61 F.Supp. 805 (E.D. Mich. 1945). 62 See Lawlor v. National Screen Service Corp., 270 F.2d 146 (3d Cir. 1959), cert. denied, 362 U.S.922 (1960). 63 See, e.g., FleerCorp. v. Topps Chewing Gum, Inc., 658 F.2d 139 (3d Cir. 1981), cert. denied, 455 U.S. 1019 (1982); Oak Distributing Co. v. Miller Brewing Co., 270 F.Supp. 889 (E.D. Mich. 1973). 64 See L.G. Balfour Co. v. Federal Trade Commission, 442 F.2d 1 (7th Cir. 1971). 65 See United States v. Lever Bros. Co., 216 F.Supp. 887 (S.D.N.Y. 1963). See also Von Kalinkowski, §73.01[2]. 66 See 1995 Intellectual Property Guidelines, §5.6. 67 See U.S. v. Aluminum Co. of America, 91 F.Supp. 333 (S.D.N.Y. 1950); U.S. v. General Elec. Co., 82 F.Supp. 752 (D.N.J. 1940). 68 See General Elec. Co., 80 F.Supp. 989 (S.D.N.Y. 1948). 69 See Von Kalinkowski, §73.01[3][b]. 70 See Art. 81(1)–(2). 71 See Article 81(3), which further provides that these exemptions only exist if the resulting benefits do not “(a) impose on the undertakings concerned restrictions which are not indispensable to the attainment of these objectives; (b) afford such undertakings the possibility of eliminating competition in respect of a substantial part of the products in quest.” 72 See Valentine Korah, An Introductory Guide to EC Competition Law and Practice (Oxford: Hart Publishing, 1997), 4. 73 Council Regulation 17 enables the Commission to enforce Articles 81 and 82. 74 See (6/72) [1973] E.C.R. 215. 75 See Regulation 4064/89, O.J. 1990, L257/14 [1990] 4 C.M.L.R. 286. 76 Ibid. 77 See Article 2, Regulation 4064/89 O.J. 1990, L257/14 [1990] 4. C.M.L.R. 286. 78 See Regulation 4064/89 at Article 2(1). 79 The Lanham Act is codified at 15 U.S.C. §1051–§1127. 80 See 15 U.S.C. §1051(a). 81 See 15 U.S.C. §1060. See also 37 C.F.R. §§3.1–3.85 and the Trademark Manual of Examining Procedure (T.M.E.P.) §§501–503.09 for in-depth analyses of the formal requirements, documentation, and fees regarding proper recordal of trademark right transfers. 82 See McCarthy, Trademarks and Unfair Competition, §18.2. See generally, Defiance Button Machine Co. v. C & C Metal Products Corp., 759 F.2d 1053 (2d Cir. 1985), cert. denied, 474 U.S. 844 (1985); Money Store v. Harriscorp Finance, Inc. 689 F.2d 666 (7th Cir. 1982); Visa U.S.A., Inc. v. Birmingham Trust Nat’l Bank, 696 F.2d 1371 (Fed. Cir. 1982); Warner-Lambert Pharmaceutical Co. v. General Foods Corp., 164 U.S.P.Q. 532 (T.T.A.B. 1970); Pepsico, Inc. v. Grapette Co., 416 F.2d 285 (8th Cir. 1969). 83 See 15 U.S.C. §1060. 84 Ibid. 85 See Marshak v. Green, 746 F.2d 927 (2d Cir. 1984).
ENDNOTES 16.23 86
See Berni v. International Gourmet Restaurants, Inc., 838 F.2d 642 (2d Cir. 1988). See McCarthy, §18:3. 88 Ibid. 89 Ibid., §18.10. 90 Ibid. 91 See 15 U.S.C. §1051(b)(1), which provides, “A person who has a bona fide intention, under circumstances showing the good faith of such person, to use a trademark in commerce may request registration of its trademark on the principal register hereby established by paying the prescribed fee and filing in the Patent & Trademark Office an application and a verified statement, in such form as may be prescribed by the Commissioner.” 92 See 15 U.S.C. §1060. 93 Ibid. 94 As of April 15, 2001, the following countries were parties to the Paris Convention: Albania, Algeria, Argentina, Armenia, Australia, Austria, Azerbaijan, Bahamas, Bahrain, Bangladesh, Barbados, Belarus, Belgium, Benin, Bolivia, Bosnia and Herzegovina, Botswana, Brazil, Bulgaria, Burkina Faso, Burundi, Cambodia, Cameroon, Canada, Central African Republic, Chad, Chile, Colombia, Congo, Costa Rica, Croatia, Cuba, Cyprus, Czech Republic, Denmark, Dominican Republic, Ecuador, Egypt, El Salvador, Equatorial Guinea, Estonia, Finland, France, Gabon, Gambia, Georgia, Germany, Ghana, Greece, Grenada, Guatemala, Guinea, Buinea-Bissau, Buyana, Haiti, Holy See, Honduras, Hungary, Iceland, India, Indonesia, Iran, Iraq, Ireland, Israel, Italy, Ivory Coast, Japan, Jordan, Kazakhstan, Korea, Laos, Latvia, Lebanon, Lesotho, Liberia, Libya, Liechtenstein, Lithuania, Luxembourg, Macedonia, Madagascar, Malawi, Malaysia, Mali, Malta, Mauritania, Mauritius, Mexico, Moldova, Monaco, Mongolia, Morocco, Mozambique, Netherlands, New Zealand, Nicaragua, Niger, Nigeria, Norway, Oman, Panama, Papua New Guinea, Paraguay, Peru, Philippines, Poland, Portugal, Romania, Russia, Rwanda, Saint Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, San Marino, Sao Tome and Principe, Senegal, Sierra Leone, Singapore, Slovakia, Slovenia, South Africa, Spain, Sri Lanka, Sudan, Suriname, Swaziland, Sweden, Switzerland, Syria, Tajikistan, Tanzania, Togo, Trinidad and Tobago, Tunisia, Turkey, Turkmenistan, Uganda, Ukraine, United Arab Emirates, United Kingdom, Uruguay, Uzbekistan, Venezuela, Vietnam, Yugoslavia, Zambia, Zimbabwe. 95 Article 6quater of the Paris Convention provides: (1) When, in accordance with the laws of a country of the Union, the assignment of mark is valid only if it takes place at the same time as the transfer of the business or goodwill to which the mark belongs, it shall suffice for the recognition of such validity that the portion of the business or goodwill located in that country be transferred to the assignee, together with the exclusive right to manufacture in the said country, or to sell therein, the goods bearing the mark assigned. (2) The foregoing provision does not impose upon the countries of the Union any obligation to regard as valid the assignment of any mark the use of which by the assignee would, in fact, be of such a nature as to mislead the public, particularly as regards the origin, nature, or essential qualities, of the goods to which the mark is applied. 96 Ibid. 97 See Article 17(1). See also Counsel Regulation (EC) No. 40/94. 98 See Article 17(2). 99 Article 17(1) provides, “A CTM registration can only be assigned for the entire European Union. The registration cannot be apportioned, and rights in the mark assigned only for a particular European Union country.” See also Ethan Horwitz, World Trademark Law and Practice, §8.03. 100 See Madrid Agreement Concerning the International Registration of Marks, Article 9ter(1). 101 Article 9ter(1) provides, “If the assignment of an international mark for part only of the registered goods or services is notified to the International Bureau, the Bureau shall record it in its Register. Each of the contracting parties shall have the right to refuse to recognize the validity of such assignment if the goods or services included in the part so assigned are similar to those in respect of which the mark remains registered for the benefit of the assignor.” 87
16.24 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION 102
Ibid. See 15 U.S.C. §1060. 104 Ibid. 105 See Worldwide Trademark Transfers, 4. 106 Ibid. 107 Ibid. 108 Ibid. 109 Ibid. 110 Ibid. 111 Ibid. 112 See Worldwide Trademark Transfers, IA. 113 Ibid. 114 See Counsel Regulation (EC) No. 40/94, which took effect on March 15, 1994. The fifteen (15) member nations of the European Community are Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, and the United Kingdom. 115 See Implementing Regulation, (EC) No. 2868/95. 116 Ibid. 117 Ibid. 118 The following jurisdictions are Member Nations of the Madrid Agreement as of April 15, 2001: Albania, Algeria, Armenia, Austria, Azerbaijan, Belarus, Belgium, Bhutan, Bosnia and Herzegovina, Bulgaria, China, Croatia, Cuba, Czech Republic, People’s Democratic Republic of Korea, Denmark, Egypt, Estonia, Finland, France, Georgia, Germany, Hungary, Iceland, Italy, Japan, Kazakhstan, Kenya, Kyrgyzstan, Latvia, Lesotho, Liberia, Liechtenstein, Lithuania, Luxembourg, Macedonia, Moldova, Monaco, Mongolia, Morocco, Mozambique, Netherlands, Norway, Poland, Portugal, Romania, Russia, San Marino, Sierra Leone, Slovakia, Slovenia, Spain, Sudan, Swaziland, Sweden, Switzerland, Tajikistan, Turkey, Turkmenistan, Ukraine, United Kingdom, Uzbekistan, Vietnam, and Yugoslavia. 119 Member Nations to the Madrid Protocol as of Dec. 14, 1999, include Austria, Belgium, China, Cuba, Czech Republic, Democratic People’s Republic of Korea, Denmark, Estonia, Finland, France, Georgia, Germany, Hungary, Iceland, Japan, Kenya, Latvia, Lesotho, Liechtenstein, Lithuania, Luxembourg, Moldova, Monaco, Morocco, Mozambique, Netherlands, Norway, Poland, Portugal, Romania, Russia, Sierra Leone, Slovakia, Slovenia, Spain, Swaziland, Sweden, Switzerland, Turkey, Turkmenistan, United Kingdom, and Yugoslavia. 120 See Lanning G. Bryer, Melvin Simensky, and Neil J. Wilkof, Intellectual Property in the Global Marketplace, (New York: John Wiley & Sons, Inc., 1999). 121 See Bharati Bakshani and Dr. Ian Jay Kaufman, Imperative Strategies for Protecting Trademark Assets: The International Market, Intellectual Property in the Global Marketplace, V.I., §12.4(c)(1999). The OAPI arrangement covers the following jurisdictions: Cameroon, Central African Republic, Chad, Congo, Benin, Gabon, Guinea, Mali, Ivory Coast, Mauritania, Senegal, Togo, Burkina Faso, and Niger. 122 See 35 U.S.C. §261. See also Zenith Radio Corp. v. Hazeltine Research, Inc., 395 U.S.100 (1969); Valmet Paper Machinery, Inc. v. Beloit Corp., 868 F.Supp. 1085 (W.D.Wis. 1994). 123 Ibid. 124 See University Patents, Inc. v. Kligman, 762 F.Supp. 1212 (E.D.Pa. 1991). 125 See Fifer and Been, “The Acquisition and Disposition of Intellectual Property in Commercial Transaction: The U.S. Perspectives,” as published in Intellectual Property in the Global Marketplace. (New York: John Wiley & Sons, 1999). 103
ENDNOTES 16.25 126
Valmet Paper Machinery, Inc. v. Beloit Corp., 868 F.Supp. 1085 (W.D. Wis. 1994). Ibid. 128 See 35 U.S.C. §261. 129 See Thomas v. Tomco Acquisitions, Inc., 776 F.Supp. 431 (E.D.Wis. 1991). 130 Ibid. 131 See Painton & Co. v. Bourns, Inc., 442 F.2d 216 (2d Cir. 1971); Dr. Miles Co. v. John D. Park & Sons Co. 200 U.S.373 (1911). 132 18 U.S.C. 1831–39. Section 1832 of The Economic Espionage Act of 1996 makes it a federal crime for any person to convert a trade secret to his own benefit or the benefit of others intending or knowing that the offense will injure any owner of a trade secret. See also R. Mark Halligan, The Economic Espionage Act of 1996: the Theft of Trade Secrets is Now a Federal Crime, [email protected], (1997), 1. 133 The Restatement of Torts §757(b) defines a trade secret as “any formula, pattern, device or compilation of information which is used in one’s business, and which gives him an opportunity to obtain an advantage over competitors who do not know or use it. It may be a formula for a chemical compound, a process of manufacturing, treating or preserving materials, a pattern for a machine or other device, or a list of customers. It differs from other secret information in a business . . . in that it is not simply information as to single or ephemeral events in the conduct of the business, as, for example, the amount or other terms of a secret bid for a contract or the salary of certain employees, or the security investments made or contemplated, or the date fixed for the announcement of a new policy or for bringing out a new model or the like. A trade secret is a process or device for continuous use in the operation of the business. Generally, it relates to the productions of goods, as, for example, a machine or formula for the production of an article. It may, however, relate to the sale of goods or to other operations in the business, such as a code for determining discounts, rebates or other concessions in a price list or catalogue, or a list of specialized customers, or a method of bookkeeping or other office management.” 134 See Ruckelshaus v. Monsanto Co., 467 U.S. 986 (1984). See also Kaiser Aetna v. U.S., 444 U.S. 176 (1979) (holding that the right to exclude others is “one of the most essential sticks in the bundle of rights that are commonly characterized as property.”). 135 See Ruckelshaus, 467 U.S. at 1002. See also Harrington v. National Outdoor Advertising Co., 196 S.W.2d 786 (1946); Kewanee Oil Co. v. Bicron Corp. 416 U.S. 470 (1974). 136 See Milgrim On Trade Secrets §2.02[1]. 137 Ibid., §2.02[1]. 138 Ibid. 139 See Stewart v. Hook, 45 S.E.369 (S.Ct Ga. 1903) (holding that when a transferor assigned its secret formula to a subsequent good faith assignee after selling the same property to the original assignee, the first assignee’s recourse was not against the subsequent purchaser; rather, its proper remedy and cause of action was against the transferor. The subsequent good faith assignee was entitled to retain the trade secret that it had purchased for value.). 140 See e.g., Sprague v. Rust Master Chem. Corp., 70 N.E.2d 831 (1947). 141 See generally Hooker Chem. & Plastic Corp. v. United States 591 F.2d 652 (Ct.Cl. 1978); Platinum Prods. Corp. v. Berthold 21 N.E.2d 520 (NY 1939); See also Milgrim on Trade Secrets §2.02[2]. 142 See Milgrim on Trade Secrets, §2.02[2]; See also American Dirigold Corp. v. Dirigold Metals Corp., 125 F.2d 446, 452 (6th Cir. 1942). 143 See Milgrim on Trade Secrets, §2.02[2]; See also NewEra Electric Range Co. v. Serrell, 252 N.Y. 107 (1929). 144 See 17 U.S.C. §101. 145 See Nimmer on Copyright, §10.03[A][1]. The concept of indivisibility under the Copyright Act of 1909 has essentially been abolished. The doctrine of indivisibility provided that transfer of ownership 127
16.26 TRANSFER OF INTELLECTUAL PROPERTY UPON MERGER OR ACQUISITION in a copyrighted work must include the entire “bundle” of rights, and assignment of specific aspects of a copyright was prohibited. The restraint on the marketing abilities in the entertainment industry and American jurisprudence slowly whittled away the concept of “indivisibility” until its virtual abolition by the enactment of the Copyright Act of 1976. See Nimmer at §10.01. 146 See 17 U.S.C. § 201(d). 147 See 17 U.S.C. § 202, which provides “Ownership of a copyright, or of any of the exclusive rights under a copyright, is distinct from ownership of any material object in which the work is embodied. Transfer of ownership of any material object, including the copy or phonorecord in which the work is first fixed, does not of itself convey any rights in the copyrighted work embodied in the object; nor, in the absence of any agreement, does transfer of ownership of a copyright or of any exclusive right under a copyright convey property rights in any material object.” 148
Ibid. Although the Copyright Act mentions transfers “by operation of law,” the act itself does not specifically define the circumstances behind which this concept may apply. However, it has been generally recognized that this concept encompasses transfers through legal fiction such as probate and bankruptcy proceedings. See Nimmer on Copyright, §10.03[A][7]. 150 See 17 U.S.C. 204(a). “A transfer of copyright ownership, other than by operation of law, is not valid unless an instrument of conveyance, or a note or memorandum of the transfer, is in writing and signed by the owner of the rights conveyed or such owner’s duly authorized agent.” See Nimmer on Copyright, §10.03[A][1]. See also Saenger Org., Inc. v. Nationwide Ins. Lice. Assocs., Inc., 864 F.Supp. 246 (D.Mass. 1994); Techniques, Inc. v. Rohn, 592 F.Supp. 1195 (SDNY 1984). 151 See PMC, Inc. v. Saban Entertainment, Inc. 45 Cal. App. 4th 579. 152 See Nimmer on Copyright, §10.03[A](2). See also Armento v. Laser Image, Inc., 950 F.Supp. 719 (W.D.N.C. 1996); Schiller & Schmidt, Inc. v. Nordisco Corp., 969 F.2d 410 (7th Cir. 1992); Playboy Enterprises, Inc. v. Dumas, 53 F.3d 549 (2d Cir. 1995), cert. denied, 116 S.Ct. 567 (1995). 153 See 17 U.S.C. 204(b), which provides “A certificate of acknowledgment is not required for the validity of a transfer, but is prima facie evidence of the execution of the transfer if—(1) in the case of a transfer executed in the United States, the certificate is issued by a person authorized to administer oaths within the United States; or (2) in the case of a transfer executed in a foreign country, the certificate is issued by a diplomatic or consular officer of the United States, or by a person authorized to administer oaths whose authority is proved by a certificate of such an officer.” 154 See 17 U.S.C. §205(a), which provides, “Any transfer of copyright ownership or other document pertaining to a copyright may be recorded in the Copyright Office if the document filed for recordation bears the actual signature of the person who executed it, or if it is accompanied by a sworn or official certification that it is a true copy of the original, signed document.” 155 See Nimmer on Copyright, §10.07[A]. 156 Ibid. 157 See 17 U.S.C. 205(c): Recordation of a document in the Copyright Office gives all persons constructive notice of the facts stated in the recorded document, but only if— (1) the document, or material attached to it, specifically indentifies the work to which it pertains so that, after the document is indexed by the Register of Copyrights, it would be revealed by a reasonable search under the title or registration number of the work; and (2) registration has been made for the work. 149
158
See 17 U.S.C. §205(d). See Nimmer on Copyright, §10.07[A]. 160 Ibid., §10.07[A][1](a). 161 Ibid. 162 See Peter J. Ansel, Domain Name Deals Demand Diligence in Drafting, N.Y.L.J., (Aug. 27, 1999), B11. 159
INDEX Accounting accounting systems, objective of, 5.2 amortization, 5.5 asset recognition, 5.1–5.2 business combinations choice of method, 5.3 generally, 5.2 pooling method, 5.2 purchase method, 5.3 Financial Accounting Standards Board, 5.6–5.7 generally, 5.1 intangible assets acquisition of, 5.3–5.6 generally, 3.3 impairment of, 5.6 pooling method, proposed elimination of, 5.6–5.7 research and development charges generally, 5.8 historical treatment of, 5.8–5.10 in-process charges defined, 5.8 potential changes, 5.8 SEC scrutiny of, 5.9–5.10 tax consequences. See Tax considerations Acquisition agreements ancillary agreements, 6.4–6.5 asset purchase agreements. See Asset purchase agreements business, definition of, 8.61 description of assets, drafting, 6.5–6.7 generally, 6.1 indemnification, 6.2, 6.16–6.17 intellectual property representations and warranties. See Warranties and representations licenses. See Licenses provisions of, 6.2–6.3
stock purchase agreements, 6.1 transfer documents, 6.3–6.4 Advertising agreements, review of, 8.45 due diligence and, 8.39–8.40 African Intellectual Property Organization generally, 16.13 American Institute of Certified Public Accountants (AICPA) accounting rule changes, 2.39–2.41 Amortization impairment of intangibles, 5.6 intangible assets, 5.5 proposed accounting changes, 5.7 tax treatment, 5.5–5.6 Andean Pact generally, 16.13 Antitrust considerations Antitrust Guidelines for Collaborations Among Competitors, 7.3 Antitrust Guidelines for the Licensing of Intellectual Property, 7.3, 7.7, 16.6 Canadian law. See Canada copyrights, 16.7 European countries. See Europe generally, 1.4, 7.1–7.2, 16.5–16.7 grant-backs, 16.7 horizontal and vertical restraints, 7.6–7.7 Horizontal Merger Guidelines, 7.2, 16.5–16.6 horizontal mergers and joint ventures, 7.3–7.5 Intellectual Property Guidelines, 7.3 joint ventures, 7.3–7.5 licensing, 7.7, 16.6 Non-Horizontal Merger Guidelines, 7.2–7.3 patents, 16.7 trademarks, 16.7
transfers of technology, restrictions on, 8.58–8.59 vertical mergers, 7.5 Asia corporate restructuring and, 1.2–1.3 Asset purchase agreements See also Acquisition agreements description of assets, 6.5–6.7 due diligence and, 8.4 generally, 6.1, 9.3, 16.3, 16.4 Assets asset portfolio, 3.1 intangible, generally, 3.3 intellectual property, 5.1–5.2 monetary, 3.1–3.2 shared assets, 8.9 tangible, 3.2–3.3 types of, 2.30, 5.2 Assignment See also Transfers of intellectual property agreements, review of, 8.43 Canadian law. See Canada documents, 6.3 intellectual property rights, 6.3–6.4, 8.10 licenses, 6.4 trademarks generally, 8.30, 16.9–16.10 and security interests, 9.19 transfers of intellectual property, 9.12–9.13 Attorney-client privilege patent opinions and, 10.8 waiver, 10.13–10.15 Attorneys disqualification and patent opinions, 10.12–10.15 legal opinions. See Legal opinions Audits of intellectual property Canada, 11.6–11.7 components of, 9.5–9.8 scope of, 9.5
I.1
I.2 INDEX Bankruptcy Canadian law, insolvency of copyright assignee, 11.18 intellectual property, valuation of, 4.7 purchase of intellectual property assets from receiver or trustee, 8.4–8.5 Berne Convention generally, 8.36 Bill of sale acquisition agreement and transfer documents, 6.3 and domain names, 6.4 copyright transfers, 6.5 Biotechnology industry due diligence issues, 8.55 Borrowers due diligence by, 8.7 Brand-name equity valuations generally, 2.43 Bricks and clicks companies generally, 2.1 Broadcasters’ rights Canada, 11.22 generally, 8.17, 8.33 Business plans due diligence and, 8.14
Canada assignments international transactions, 11.26 statutory requirements, chart, 11.24 broadcasting rights, 11.22 Competition Act, 11.3–11.6 Competition Bureau of Canada, 11.3–11.6 copyright assignment of, 11.17 chain of title, 11.17 generally, 11.15 insolvency of assignee, 11.18 limits, 11.17 marking, 11.18 moral rights, 8.33, 11.18 ownership, 11.17 registration, 11.16–11.17 rights, 11.15 searches, 11.18 term of protection, 11.15–11.16 due diligence copyright, 11.15–11.18 cost of, 11.2–11.3
intellectual property audits, 11.6–11.7 patents, 11.7–11.11 personnel, 11.22–11.24 purpose of, 11.2 scope of, 11.2 trademarks, 11.12–11.15 trade secrets, 11.18–11.21 English common law, 11.1–11.2 French Civil Law, 11.1–11.2 industrial designs, 11.21–11.22 integrated circuit topographies, 11.21–11.22 Intellectual Property Enforcement Guidelines, 11.4–11.6 intellectual property rights, 11.1 intellectual property, statutory law generally, 11.1 legal system, 11.1–11.2 licenses generally, 11.25 right to grant, 11.25–11.26 state-granted, 11.22 statutory requirements, chart, 11.24 Merger Enforcement Guidelines, 11.3–11.4 mergers, legal aspects of, 11.3 moral rights, 8.33, 11.18 patents assignment of, 11.10–11.11 co-ownership of, 11.8–11.10 generally, 11.7–11.8 searches, 11.11 pharmaceutical industry, 11.22 plant breeders’ rights, 11.21–11.22 security interests in intellectual property enforcement, 11.29 intellectual property registers, 11.27–11.29 legislation, 11.26–11.27 searches, 11.27–11.29 validity and perfection, 11.27 tax considerations corporate reorganizations, 11.35 cost basis, bumping, 11.35 depreciation and undepreciated capital cost, 11.30–11.31 divisive reorganizations, 11.34–11.35
eligible capital expenditures, 11.29–11.30 generally, 11.29 installment payments, 11.32–11.33 intellectual property purchase, structure of, 11.32–11.33 lump-sum payments, 11.32–11.33 offshore corporations, 14.2–14.3 research and development, 11.31–11.32 royalties, 11.32–11.33 tax-free transfers to corporation, 11.33–11.34 unpaid tax liability, 11.35–11.36 trade secrets assignment of, 11.21 defined, 11.18–11.20 enforcement, 11.20–11.21 rights, 11.21 trademarks application for registration, 11.12–11.13 assignment of, 11.14 enforcement, 11.13 generally, 11.12 marking, 11.13–11.14 registration, 11.12 rights through use, 11.12 searches, 11.14–11.15 term of protection, 11.13 Central American Convention generally, 16.13 Charitable contributions patents and other intellectual property, 4.5 Checklists buyer’s checklist, intellectual property assets, 6.7–6.8 copyright due diligence, 9.8 Co-packing agreements review of, 8.44 Co-promotion agreements review of, 8.45 Comparable company analysis generally, 2.6–2.7 procedure, 2.9–2.10 Comparable transaction analysis generally, 2.7–2.8 procedure, 2.10
INDEX Competition law antitrust law. See Antitrust considerations European countries. See Europe Computers databases. See Databases hardware. See Hardware information technology industry, due diligence issues, 8.47–8.52, 8.51–8.52 Internet. See Internet software. See Software Confidentiality failed merger negotiations and, 2.27 generally, 3.9 secrecy agreements due diligence and, 8.15 generally, 8.9 review of, 8.42 Conglomerate mergers generally, 1.5 Consolidating mergers and global market power, 2.19–2.22 mergers, reasons for, 1.6 Contractors agreements, review of, 8.45–8.46 Contracts acquisition agreements. See Acquisition agreements advertising agreements, review of, 8.45 assignments. See Assignments co-packing and toll manufacturing agreements, 8.44 co-promotion agreements, 8.45 contractor agreements, review of, 8.45–8.46 distribution and supply agreements, review of, 8.43–8.44 employee contracts, review of, 8.45–8.46 franchise agreements, review of, 8.43 generally, 9.6–9.7 government contracts, review of, 8.45 information technology as core business asset, review of agreements, 8.51–8.52 database contracts, review of, 8.49
e-commerce contracts, review of, 8.50–8.51 hardware contracts, review of, 8.47–8.48 Internet contracts, review of, 8.49–8.50 software contracts, review of, 8.48–8.49 joint venture agreements, 8.44 license agreements. See Licenses research and development agreements. See Research and development review of and due diligence, 8.40–8.47 secrecy agreements, 8.42 security agreements, 8.42 settlement agreements, 8.47 sponsorship agreements, 8.45 strategic alliance agreements, review of, 8.44 Control price premium excessive fees as cause of failure, 2.26 Copyrights assignment of, 6.4 broadcasters’ rights. See Broadcasters’ rights Canadian law. See Canada computer software, 3.13 database rights. See Databases due diligence. See Due diligence entertainment industry due diligence issues, 8.56 foreign rights, 8.36–8.37 generally, 3.10–3.11, 8.16, 8.31, 9.2 mask works, 3.15, 8.33–8.34 moral rights Canada, 11.18 Europe, 12.10 generally, 8.32–8.33 neighboring rights, 8.33 performer’s rights, 8.17, 8.33 publishing industry due diligence issues, 8.55–8.56 representations and warranties, 6.10–6.11 searches author search, 8.32 index search, 8.32 infringement, 8.52–8.53 limitations to, 8.32 title search, 8.32
I.3
types of, 8.32 work search, 8.32 security interests and generally, 8.37–8.38 proposals for reform, 9.20–9.21 and Uniform Commercial Code, 9.14–9.17 software, 8.48–8.49 transfer of ownership, 6.5–6.6, 16.7, 16.14–16.16 work made for hire doctrine, 8.31, 9.2 Corporate restructuring Asia, 1.2, 1.3 generally, 1.4–1.7 Corporations sham corporation and use of holding company, 13.5 Cost approach to valuation. See Valuation Costs due diligence, 8.8–8.9 intellectual property maintenance costs and due diligence, 8.40 Damages litigation and valuation of intellectual property, 4.7 Damodaran, Aswath, 2.12, 2.17–2.18, 2.28, 2.31, 2.42 Databases computer and information technology industry, due diligence issues, 8.51–8.52 copyrights, 3.11 database rights, 8.17, 8.33 due diligence and, 8.49 Delaware Investment Holding Companies. See Holding companies Deregulation mergers and acquisitions, effect on, 2.2 Design patents design registration, 8.23 generally, 8.16, 8.23 searches author search, 8.23 index search, 8.23–8.25 infringement search, 8.24–8.25 inventor search, 8.23 license search, 8.23 limitations to, 8.24–8.25
I.4 INDEX novelty search, 8.24 patentability search, 8.25 registrability search, 8.25 state-of-the-art search, 8.23–8.25 types of, 8.23 validity search, 8.24–8.25 Discounted cash flow analysis benefits of, 4.11 comparables-based royalty rates adoption rate and life cycle, 4.13 generally, 4.12–4.13 market introduction, timing of, 4.13 useful life, 4.13 discount rate, 4.15 established intellectual property, 2.43–2.44 future cash flows, 2.8–2.9 generally, 2.8–2.9, 4.10–4.11 in-process research and development, valuation of, 5.9 income stream computing expected income stream, 4.14–4.15 steps in determining, 4.11–4.12 present value, discounting to generally, 4.15 hurdle rates, 4.16 venture capital required rates of return, 4.16 weighted average cost of capital, 4.15 procedure, 2.10–2.11 profit, apportioning excess earnings method, 4.12 generally, 4.11 residual income method, 4.12 rules of thumb, 4.12 sales base and profitability, 4.11 Distribution and supply agreements review of, 8.43–8.44 Diversification mergers, reasons for, 1.6 problems with, 1.7 Divestiture and acquisitions, 2.38–2.39 generally, 1.5 merger failures and, 2.26–2.27 Due diligence access to information legislation, 8.58 ancillary agreements, 8.9–8.10 antitrust issues, 8.58–8.59
asset purchase agreements, 8.4 assistance, 8.15 biotechnology industry, 8.55 borrower’s due diligence, 8.7 buyer’s due diligence, 6.8 Canada. See Canada checklists, 9.8–9.10 contract review. See Contracts copyrights checklist, 9.8 database rights, 8.33 follow-up, 8.33 generally, 8.31–8.32, 9.8–9.9 limitations of searches, 8.32 moral rights, 8.32–8.33 neighboring rights, 8.33 types of searches, 8.32 cost of, 8.8–8.9 defined, 8.3 design patents and design registrations follow-up, 8.25 generally, 8.23 infringement searches, 8.24 inventor or author searches, 8.23 license search, 8.23 limitations of searches, 8.24–8.25 novelty searches, 8.24 patentability search, 8.25 registrability search, 8.25 state-of-the-art searches, 8.23–8.24 types of searches, 8.23–8.24 validity searches, 8.24–8.25 discovery of information and failed merger negotiations, 2.27 domain names, 9.11 entertainment industry, 8.56, 9.4 European countries. See Europe financing transactions, 8.5–8.6 foreign rights, 8.36–8.37 franchise industry, 8.54, 8.59 generally, 3.17, 8.1 information technology computer and information technology industry, 8.51–8.52 data, 8.49 electronic commerce, 8.50–8.51 generally, 8.47 hardware, 8.47–8.48 Internet issues. See Internet software, 8.48–8.49 intellectual property
audit, 9.5–9.8 rights, 8.16–8.40 valuation, 4.2–4.3 international businesses, 8.13–8.14 interpretation of results, 8.60 issuer’s due diligence, 8.7–8.8 legal opinions, 8.15–8.16, 8.62–8.64 liabilities generally, 9.7–9.8 infringement risks, 8.52–8.53 litigation, 8.53–8.54 licenses, review of, 9.6 maintenance costs of intellectual property, 8.40 marketplace, 8.14 mask works, 8.33–8.34 merchandising industry, 8.55 multinational transactions, domestic issues, 8.13 multiple location businesses, 8.13 nature of business, 8.10–8.11 need for, 8.1–8.3 on-site investigations, 8.39 ownership rights, 9.6 parties to transaction, 9.4 partnerships, 8.12–8.13 patents checklist, 9.9 follow-up, 8.22–8.23 generally, 8.16, 8.18–8.19, 9.9 infringement searches, 8.20 inventor searches, 8.19–8.20 limitations of searches, 8.21–8.22 novelty searches, 8.20 security interest searches, 8.21 state-of-the-art searches, 8.20 target company, 8.22–8.23 types of searches, 8.19–8.21 validity searches, 8.20–8.21 validity and enforceability, 9.6 personality rights, 8.35 pharmaceutical industry, 8.55, 8.59 plans for the business, 8.14 plant breeders’ rights, 8.34 primary and related transactions, identifying nature of, 8.3–8.6 privacy and personal information issues, 8.58
INDEX products, advertising, and packaging, 8.39–8.40 proprietary information, 8.35–8.36 publishing industry, 8.55–8.56 purpose of, 9.4 receiver or trustee, purchase from, 8.4–8.5 regulatory issues, 8.57–8.59 related companies, 8.11–8.12 representations and warranties. See Warranties and representations schedules of intellectual property, verifying, 6.6 scope of, 8.8–8.11 secrecy agreements, 8.15 secured intellectual properties, 8.37–8.39 seller’s due diligence, 8.6–8.7 semiconductor chip rights, 8.33–8.34 small businesses, 8.12 sports industry, 8.56–8.57 stock purchase agreements, 8.4 structure of business, 8.11 technology transfer restrictions, 8.57–8.58 time frame, 8.2, 8.8 trade secrets, 9.11 trademarks cancellation proceeding searches, 8.27 checklist, 9.9–9.10 domain names, 8.28–8.29 follow-up, 8.29–8.30 generally, 8.25–8.26, 9.10–9.11 index searches, 8.26 limitations of searches, 8.27–8.28 name searches, 8.26 opposition searches, 8.27 registrability searches, 8.26 trade dress, 8.28 types of searches, 8.26–8.27 validity and enforceability, 9.6 tradenames, 8.30–8.31 transaction, form of, 9.3–9.4 transitional issues, 8.16 Websites, 9.11–9.12 Earn out method of payment generally, 2.14 Economy economic expansion and merger waves, 1.4
Employees Canadian law, 11.22–11.24 contracts, review of, 8.45–8.46 Entertainment industry due diligence issues, 8.56, 9.4 Equity carve-outs generally, 1.5 Equity contributions valuation of intellectual property and, 4.4 Equity-valuation grids generally, 2.41 Europe Belgium, 16.11–16.12 Community Trade Mark (CTM) system, 3.13 competition law appreciable restriction of competition, 12.36 ECMR, 12.44 European Community rules, generally, 12.33 European Community rules, modernization of, 12.37 exemption, 12.36–12.37 generally, 16.8–16.9 horizontal cooperation agreements, guidelines, 12.40–12.41 know-how licenses, 12.38–12.39 licensing of rights, 12.37–12.39 market power, assessing, 12.34–12.44 patents, 12.38–12.39 prevention, restriction, or distortion of competition, 12.35 research and development agreements, 12.39–12.40 sale agreement, 12.41–12.44 demergers, 12.2–12.3 due diligence confidential information, 12.12–12.14 confidentiality issues, 12.4–12.5 contractual rights, 12.15–12.16 copyrights, 12.10, 12.14 database rights, 12.10–12.11, 12.14 designs, 12.6–12.7 designs, unregistered, 12.11–12.12, 12.14
I.5
methods of, 12.3–12.4 moral rights, 12.10 patents, 12.5 petty patents, 12.7 plant breeders’ rights, 12.7 privileged documents, 12.4–12.5 purpose of, 12.3 registered rights, 12.5–12.9 semiconductor topography rights, 12.12, 12.14 supplementary protection certificates, 12.5–12.6 trademarks, 12.6 trademarks, unregistered, 12.10, 12.13–12.14 unregistered rights, 12.10–12.15 utility models, 12.7 fifth merger wave and, 1.1, 1.2 France. See France Germany. See Germany hostile takeovers, 1.1 joint ventures, 12.3 Luxembourg, 16.11–16.12 Madrid Protocol, 3.13 merger waves, 1.1, 1.2, 1.11, 2.2–2.3 mergers, 12.2 Netherlands, 13.10, 16.11–16.12 private acquisitions, 12.2 public offers, 12.2 scheme of arrangement, 12.3 trademarks Community Trademark system, 16.10, 16.12 European Community unified trademark law, 16.12 goodwill, transfer of, 16.10–16.11 Madrid Agreement and Protocol, 3.13, 12.9, 16.10–16.13 Paris Convention, 16.10–16.11 Uniform Benelux Trademark Law, 16.11–16.12 transfer of intellectual property rights assignment and licensing compared, 12.20–12.21 generally, 12.19–12.20 licenses, 12.22–12.23 rights owned by target, 12.20–12.22
I.6 INDEX stamp duty, 12.23 taxes, 12.23 unregistered rights, assigning, 12.21–12.22 Uniform Benelux Trademark Law, 16.11–16.12 warranties and indemnities considerations, 12.17–12.18 disclosure letters, 12.18–12.19 knowledge, information, and belief limitation, 12.18 licensed intellectual property rights, 12.18 owner of intellectual property, 12.18 purpose of, 12.16–12.17 sample provisions, 12.45–12.47 updating warranties, 12.18 Excess earnings method generally, 4.12 Experts consulting, 8.15 Failure rate of mergers causes of failures, 1.7–1.11, 2.26 generally, 2.25–2.27 high-tech firms and bankruptcy, 2.29 Internet IPO market, impact of, 2.27–2.28 negotiation failures, impact of, 2.27 Fair market value generally, 4.8 Financial Accounting Standards Board proposed changes, 5.6–5.7 Financing due diligence and, 8.5–8.6 intellectual property to obtain or secure debt, 4.6 Foreign rights copyright and trademark issues, 8.36–8.37 generally, 8.36–8.37 France See also Europe assignment of registered rights, 12.25 assignment of unregistered rights, 12.25 confidentiality, 12.24 demergers, 12.24 intellectual property licenses, 12.26 mergers, 12.23–12.24
privilege, 12.24 stamp duty, 12.26 transfer of rights, 12.24–12.26 universal transmission principle, 12.24–12.25 VAT, 12.26 warranties and indemnities, 12.24 Franchises agreements, review of, 8.43 due diligence issues, 8.54 sports industry due diligence issues, 8.56–8.57 transfers of technology, disclosures and filings, 8.59 Free offers. See Giveaway strategy Geographical clustering intellectual property firms and, 2.37–2.38 Germany See also Europe copyright (urheberrecht), 12.31 due diligence, 12.27 foreign rights, ownership of, 12.27–12.28 patents, 12.28–12.29 plant breeders’ rights, 12.30–12.31 registered design rights (geschmacksmuster), 12.31 secret and nonsecret know-how (geheimes und nichtgeheimes know-how), 12.31–32 semiconductor topography rights, 12.29–12.30 structure of transaction, 12.26–12.27 supplementary protection certificates, 12.29 trademarks (marken), 12.31 transfer of rights, 12.32–12.33 utility models, 12.29 warranties and indemnities, 12.32 Giveaway strategy bundling of add-ons, 2.23 generally, 2.22–2.23 Goodwill accounting issues, 2.39–2.41, 3.7 acquisition of, accounting for, 5.3–5.5 amortization, 5.5 excess earnings, 3.6 generally, 3.6 impairment of, 5.6
patronage, 3.6 proposed accounting changes, 5.7 residual value, 3.6 Government contracts review of, 8.45 Grant-backs licensing and antitrust considerations, 16.7
Hardware due diligence computer and information technology industry, 8.51–8.52 generally, 8.47–8.48 Hatch Waxman Act drug patents and, 2.3–2.4 Holding companies benefits of, 13.1 Delaware Investment Holding Companies, 13.4–13.5, 16.5 domestic holding companies agency nexus, 13.6 Delaware Investment Holding Companies, 13.4–13.5, 16.5 economic presence, 13.5–13.6 generally, 13.4 legislative and administrative actions, 13.7 sham corporation, 13.5 foreign holding companies Internal Revenue Service enforcement, 13.8 license royalties, deductibility of, 13.7 royalty rate, 13.7–13.8 superroyalty provision, 13.8 withholding, U.S. income tax, 13.8 formation of business purpose, 13.3–13.4 domestic transfers of intellectual property rights, 13.2–13.3 offshore transfers of intellectual property rights, 13.3 generally, 13.1–13.2 offshore, 14.1–14.2 ownership of intellectual property and due diligence, 8.11–8.12
INDEX tax issues, generally, 13.1–13.2 tax treaties anti-conduit regulations, 13.10 benefits, limitations on, 13.10 cascading royalties, 13.9 foreign holding company licensing to foreign affiliates, 13.10 withholding rates, 13.9 Horizontal mergers See also Antitrust considerations generally, 1.4 horizontal and vertical restraints, 7.6–7.7 Horizontal Merger Guidelines, 7.2, 16.5–16.6 joint ventures and, 7.3–7.5 Non-Horizontal Merger Guidelines, 7.2–7.3 Hostile takeovers Europe, 1.1 Hurdle rates generally, 4.16 Income approach to valuation. See Discounted cash flow analysis Indemnification acquisition agreements, 6.2, 6.16–6.17 infringement risks and due diligence, 8.52–8.53 Industrial design rights Canadian law. See Canada registration, 8.16 representations and warranties, 6.11 Infringement due diligence and, 8.52–8.53 warranties, 8.62 Inspections. See Investigations Intangible assets acquisition of, accounting for. See Accounting going concern value, 3.7 goodwill. See Goodwill growing importance of, 3.16 intellectual property. See Intellectual property relationships customers, 3.5–3.6 distributors, 3.6 generally, 3.5 workforce, 3.5 rights, 3.4–3.5
types of, 3.4 uses of, 4.2 Intellectual capital generally, 2.41, 3.15–3.16 Intellectual property acquisition of asset purchase, 16.4 generally, 16.3 mergers, 16.3 purchase agreements, 16.3–16.4 research and development as alternative to, 2.4–2.5 stock purchase, 16.4 audits Canada, 11.6–11.7 components of, 9.5–9.7 scope of, 9.5 computer software. See Computer software copyrights. See Copyrights as force behind mergers and acquisitions, 16.1–16.3 generally, 3.7–3.15, 9.1 importance of in valuing mergers, 2.3–2.4 intellectual capital, 3.15 Internet domain names. See Internet patents. See Patents proprietary technology. See Proprietary technology right of publicity. See Publicity, right of trade secrets. See Trade secrets trademarks. See Trademarks transfers of. See Transfer of intellectual property types of, 3.7 International business companies (IBCs) offshore business entities, 14.7 International businesses due diligence and, 8.13–8.14 International mergers and acquisitions Canada. See Canada Europe. See Europe merger waves. See Merger waves Internet access to and merger wave, 2.2–2.3 computer and information technology industry, due diligence issues, 8.51–8.52
I.7
domain names disputes, 6.12 due diligence, 9.11 generally, 9.3 importance of, 3.13 registries, 8.29 searches, 8.28–8.29 transfer of, 6.4–6.7, 16.16–16.17 due diligence electronic commerce, 8.14, 8.50–8.51 domain names, 9.11 generally, 8.49–8.50 impact on business, 2.1–2.3 merger prices, impact of new Internet IPO market, 2.27–2.28 offshore corporations and advantages of Internet, 14.7–14.8 Websites design and development agreements, review of, 8.49–8.50 due diligence issues, 8.39–8.40, 8.49–8.50, 9.11–9.12 representations and warranties, 6.11–6.12 Investigation due diligence. See Due diligence on-site technology investigations, 8.39 Ireland tax treaties, 14.2 Joint ventures agreements, review of, 8.44 antitrust issues, 7.3–7.5 Knowledge assets generally, 2.41 Lawyer-witness rule patent opinions and, 10.12–10.13 scope of disqualification, 10.13–10.15 Legal opinions due diligence and, 8.15–8.16, 8.62–8.64 litigation, outcome of, 9.7 patent opinions. See Patent opinions
I.8 INDEX Leveraged buyouts (LBOs) mergers, reasons for, 1.6–1.7 Liabilities assessment of, 9.7–9.8 due diligence and potential liabilities, 8.52–8.54 monetary assets and, 3.1–3.2 Licenses See also Royalties acquisition agreements, 6.4–6.5 agreements, review of, 8.42–8.43, 9.6–9.7 antitrust considerations, 7.7, 16.6 Antitrust Guidelines for Licensing of Intellectual Property, 7.3 assignments of licenses, 6.4 Canadian law. See Canada databases and due diligence, 8.49 entertainment industry due diligence issues, 8.56 exclusive licensing and antitrust considerations, 7.7 famous name trademarks and, drafting considerations, 15.13–15.16 income from and valuation of intellectual property, 4.3 intellectual property, 4.2 merchandising industry, due diligence issues, 8.55 pharmaceutical industry, due diligence issues, 8.55 post-sale use of intellectual property, 6.7 shared assets, 8.9 transitional licenses, 8.9–8.10 valuation issues industry royalty rates, 4.17–4.18 negotiation range, floor and ceiling, 4.16–4.17 pricing factors generally, 4.18 Limited liability companies offshore business entities, 14.6–14.7 Litigation attorney disqualification and lawyer-witness rule, 10.12–10.15 due diligence and, 8.53–8.54, 9.7 patent opinions, use of, 10.1 valuation of intellectual property and, 4.7
Location of business multiple locations, due diligence and, 8.13
Madrid Agreement and Protocol generally, 3.13, 12.9, 16.10–16.13 Market approach to valuation. See Valuation Market introduction timing of, 4.13 Market power consolidation of, 2.19–2.22 Mask works Canadian law, Integrated Circuit Topography Act, 11.21–11.22 Europe, 12.12, 12.14, 12.29–12.30 generally, 3.15, 8.17, 8.33–8.34 Merchandising industries due diligence issues, 8.55 sports industry due diligence issues, 8.56–8.57 Merger waves Asia, 1.2, 1.3 causes of, 2.2 Europe, 1.1, 1.2, 1.11, 2.2–2.3 failure rate of mergers, 2.25–2.27 fifth merger wave consolidating and roll-up mergers and, 1.6 deal prices and, 1.8 generally, 1.1, 1.3–1.4 leveraged buyouts and, 1.6–1.7 prior merger waves compared, 1.3–1.4 technology sector and, 1.7 fourth merger wave generally, 1.4 leveraged buyouts and, 1.6–1.7 generally, 1.1, 1.11 Mergers and acquisitions business combinations, accounting for, 5.2–5.3 conglomerate mergers. See Conglomerate mergers consolidating mergers, 1.6, 2.19–2.22 failure of. See Failure rate of mergers generally, 16.3, 16.1–16.3 historical background, 1.1–1.4
horizontal mergers. See Horizontal mergers merger waves. See Merger waves problems with, 1.7–1.11 reasons for, 1.5–1.7 recent trends, 16.1–16.3 role of intellectual property in, 1.7 types of, 1.4–1.7 vertical mergers. See Vertical mergers Moral rights Canadian law. 11.18 Europe, 12.10 generally, 8.32–8.33 Multinational transactions domestic issues and due diligence, 8.13 Negotiations representations and warranties, 6.12–6.16 Netherlands tax treaties, 14.2 trademark law, 16.11–16.12 North American Free Trade Agreement (NAFTA) generally, 16.13 Offshore corporations business entity, 14.6–14.8 generally, 14.1 holding companies. See Holding companies international business companies, 14.7 Internet and, 14.7–14.8 jurisdictions, 14.1 limited companies, 14.6–14.7 parent corporation, 14.7 partnerships, 14.6–14.7 pure tax havens, 14.1 timing of transfer of intellectual property, 14.2–14.3 transactions, types of, 14.4–14.6 trusts, use of, 14.6–14.7 Oligopolies consolidation of market power, 2.19–2.22 recent trends, 2.2 second merger wave and, 1.4 Open source code free code, impact of, 2.22–2.23 Option valuation generally, 2.11–2.12, 4.9
INDEX procedure, Damodaran’s option valuation for patent dividend yield, 2.13–2.14 exercise price of option, 2.13 expiration of option, 2.13 generally, 2.12–2.13 underlying asset value, 2.13 variance in asset value, 2.13 Organization for Economic Development (OECD) generally, 14.1 Overpaying mergers, problems with, 1.7 winner’s curse, 1.7, 2.5–2.6 Packaging due diligence issues, 8.39–8.40 Pan American Convention of 1929 generally, 16.13 Paris Convention trademarks, 16.10–16.11 Partnerships due diligence, 8.12–8.13 offshore business, 14.6–14.7 Patent opinions applications, opinions on, 10.11 attorney-client privilege and, 10.8 clearance opinions, 10.1–10.2, 10.7, 10.9–10.11 competence assessment of, 10.8–10.9 generally, 10.6 exculpatory opinions, 10.12 generally, 10.1–10.2, 10.5 identification of device or process, 10.7 infringement, effect of opinion on damages, 10.5 legal principles, 10.6–10.7 limitations and assumptions, 10.7 litigation and disqualification of opinion’s author generally, 10.12 lawyer-witness rule, 10.12–10.13 necessary witness defined, 10.13 scope of waiver and disqualification, 10.13–10.15 opinions used against recipient, 10.10 patent as right to exclude, 10.5–10.6
patentability, 10.11 pending patent applications, possibility of, 10.7 prior art searches, 10.6, 10.10–10.11 recipient, identifying, 10.7–10.8 right to use opinions, 10.9–10.11 scope of, 10.7 technical merit, 10.12 thoroughness, 10.6 willful infringement and, 10.10 Patents applications, 8.19 assignments, 6.3 Canadian law. See Canada charitable donation of, 4.5 design patents. See Design patents drug patents, 2.3–2.4 due diligence. See Due diligence duty of candor, 8.22 European countries. See Europe generally, 3.9–3.10, 8.16, 8.18–8.19, 9.1, 16.13 infringement claim construction, 10.2–10.3 contributory, 10.4 damages, 10.5 doctrine of equivalents, 10.3–10.4 generally, 10.2 induced, 10.4 literal infringement, 10.3 role of opinions, 10.5 international patent applications, 8.19 litigation and valuation of intellectual property, 4.7 maintenance fees, 10.6 mergers and, 2.3–2.4 patent opinions. See Patent opinions plants. See Plant breeders’ rights prior art, 8.22, 10.6 representations and warranties, 6.8–6.9 right to exclude, 10.5 searches index search, 8.19–8.22 infringement search, 8.20, 8.22 inventor search, 8.19–8.20
I.9
license search, 8.20 limitations to, 8.21–8.22 novelty search, 8.20, 8.22 state-of-the-art search, 8.20, 8.22 types of, 8.19 validity search, 8.20–8.22 security interests and UCC, 9.17–9.18 software, 3.13 transfer of, 6.6, 16.7. 16.13 validity and enforceability, 9.6, 10.4–10.5 warranty of enforceability, 8.62 Performer’s rights generally, 8.17, 8.33 Personality rights. See Publicity, right to Pharmaceutical industry Canada, 11.22 drug patents and mergers, 2.3–2.4 due diligence issues, 8.55 regulation of and transfers of technology, 8.59 Plant breeders’ rights Canadian law, 11.21–11.22 Europe, 12.7 generally, 8.34 Pooling method business combinations, accounting for, 5.2, 5.3 proposed elimination of, 5.6–5.7 Post-merger integration mergers, problems with, 1.7 Premiums acquisition premiums, 3.3–3.4 Producers’ rights generally, 8.17 Products adoption rate, 4.13 due diligence and, 8.39–8.40 life cycle, 2.17–2.19, 4.13 market introduction, 4.13 useful life, 4.13 Proprietary information See also Trade secrets generally, 3.8, 8.35–8.36 types of, 3.9 Publicity, right of common law, 15.6 defenses assignment and licenses, 15.11–15.16 First Amendment, 15.10 parody, 15.10
I.10 INDEX statutes of limitation, 15.10 transfer of trademark rights and, 15.11–15.16 federal law, 15.10 generally, 3.15, 8.17, 15.5 identifiable name, 15.5 personality rights, 8.35 photographs or likeness, 15.5 postmortem rights, 15.6 representations and warranties, 6.11 state law, 15.6–15.10 voice and sound, 15.6 Publishing industry due diligence issues, 8.55–8.56 Purchase agreements asset purchase agreements. See Asset purchase agreements generally, 16.3–16.4 stock purchase. See Stock purchase agreements Purchase method business combinations, accounting for, 5.3 Rate of return generally, 4.16 method, 4.12 Real option valuation. See Option valuation Receivers purchase of intellectual property assets from, 8.4–8.5 Research and development accounting treatment and hightech firms, 2.28 agreements, review of, 8.44 Canadian tax law. See Canada costs of and exit taxation costs, balancing, 14.3 in-process charges, accounting for generally, 5.8 in-process charges defined, 5.8 potential changes, 5.8 write-offs, 5.8–5.9 joint projects, Antitrust Guidelines for Collaborations Among Competitors, 7.3 Residual income method generally, 4.12 Roll-up mergers mergers, reasons for, 1.6
Royalties See also Licensing holding companies and. See Holding companies industry rates, 4.17 relief from royalty construct, 4.14 and discounted cash flow analysis, 4.10 right to receive payments and security interests under UCC, 9.7 royalty method for valuation of in-process research and development, 5.9 royalty rates and computing income stream, 4.12–4.14 tax consequences state taxation of royalty income, 4.5 Super Royalty provision, 4.4–4.5 Rules of thumb generally, 4.12 Secrecy agreements. See Confidentiality Securities issuer, due diligence by, 8.7–8.8 Securities and Exchange Commission (SEC) in-process research and development write-offs, 5.9–5.10 Security interests in intellectual property Canadian law. See Canada intellectual properties and due diligence, 8.37–8.39 proposals for reform, 9.20–9.21 Uniform Commercial Code (UCC) copyright accounts receivable, 9.16–9.17 copyrights, 9.14–9.16 federal preemption, 9.14 general intangibles, 9.14 intent-to-use trademark applications, 9.19–9.20 patents, 9.17–9.18 perfection, 9.13 provisions of, 9.13 trademarks, 9.19 UCC-1 financing statement, 9.13 unregistered copyrights, 9.17
Sell-offs effects of, 1.10–1.11 Sellers due diligence by, 8.6–8.7 Semiconductor chip registration and rights. See Mask works Service marks generally, 3.12 Settlements agreements, review of, 8.47 Shareholders mergers and acquisitions, wealth effects, 1.8–1.10 Small businesses due diligence, 8.12 Software applications software, 3.14 copyright issues, 3.11 due diligence computer and information technology industry, 8.51–8.52 generally, 8.48–8.49 mask works, 3.15 operating systems, 3.14 operational software, 3.14 patents, 3.13 product software, 3.14 protection for, 3.13–3.15 system software, 3.14 Spin-offs generally, 1.5 valuation of intellectual property and, 4.4 Sponsorship agreements review of, 8.45 Sports industry due diligence issues, 8.56–8.57 Stock tracking stock, 1.5 Stock purchase agreements See also Acquisition agreements due diligence and, 8.4 generally, 6.1, 9.3, 16.3, 16.4 intellectual property, identifying, 6.5 Strategic alliance agreements review of, 8.44 Synergy mergers, reasons for, 1.5–1.6 Tax considerations amortization of intangible assets, 5.5–5.6 best method requirement for valuation, 4.4–4.5
INDEX Canadian law. See Canada charitable donations of patents, 4.5 generally, 16.4–16.5 intercompany transfer pricing of intangible assets, 4.4 holding companies. See Holding companies offshore corporations. See Offshore corporations state taxation of royalty income, 4.5 Super Royalty provision, 4.4–4.5 Tax havens generally, 14.1 Tax treaties anti-conduit regulations, 13.10 cascading royalties, 13.9 generally, 13.9 limitations on benefits, 13.10 Netherlands and, 13.10 Title chain of title Canada, 11.17 and ownership rights, 9.6 warranties, 8.62 Toll manufacturing agreements review of, 8.44 Trade dress generally, 3.12, 8.17, 8.28 searches, 8.28 Trade secrets Canadian law. See Canada computer software, 3.13 due diligence, 9.11 European countries. See Europe generally, 3.8, 8.17, 9.2 proprietary information and, 8.35–8.36 protection of, 3.9 representations and warranties, 6.11 transfer of, 16.13–16.14 Trade-Related Intellectual Property Rights (TRIPS) generally, 16.13 Trademarks assignment of, 8.30 Canadian law. See Canada defined, 15.1 dilution of, 15.3–15.4 due diligence. See Due diligence European countries. See Europe famous names, 15.1–15.5 foreign rights, 8.36–8.37 generally, 3.11–3.13, 8.17, 8.25–8.26, 9.2
holding companies for, 13.3 intent-to-use trademark applications and security interests, 9.19–9.20 multilateral treaties Europe. See Europe other treaties, 16.13 names generally, 15.1–15.4 public confusion, 15.4 registration, assignment of, 6.3–6.4 representations and warranties, 6.9–6.10 searches cancellation proceedings, 8.27 index search, 8.26–8.28 infringement, 8.52–8.53 limitations to, 8.27 name, 8.26–8.27 opposition, 8.27 registrability, 8.26–8.27 reliability of, 8.28 results of, follow-up, 8.29–8.30 types of, 8.26–8.27 security interests and UCC, 9.19 software, 3.13 transfer of assignment, 16.9–16.10 generally, 6.5–6.6, 16.7, 16.9 intent-to-use trademarks, 16.10 recording of assignments, 16.11 and right of publicity, 15.11–15.16 validity and enforceability, 9.6 warranty of enforceability, 8.62 Tradenames generally, 3.12, 8.17, 8.30–8.31 Transfer documents See also Transfer of intellectual property assignments, 6.3 bill of sale, 6.3–6.4 domain names, 6.4 generally, 6.3 stock powers and stock certificates, 6.3 Transfer of intellectual property See also Assignment access to information legislation and government filings, 8.58 acquisition of technology assets and mergers, 2.3
I.11
antitrust issues. See Antitrust issues closing documents, 16.4 copyrights, 16.14–16.16 cost efficiency of acquisition by merger, 2.4 domain names, 16.16–16.17 franchise legislation, 8.59 high-tech firms geographical clustering, 2.37–2.38 valuation of, 2.28–2.31 holding companies. See Holding companies merger and acquisition valuation and, 2.1–2.2 obsolescence, 2.24 offshore transfers, types of transactions, 14.4–14.6 patents, 16.13 personal information issues, 8.58 pharmaceutical industry regulations, 8.59 privacy issues, 8.58 product life cycle and valuation, 2.17–2.19 proprietary technology. See Proprietary information; Trade secrets rapid advances, impact of on valuation, 2.23–2.25 restrictions on transfers, 8.57–8.58 tax considerations. See Tax considerations technology companies and due diligence issues, 9.4 timing of transfer, 14.2–14.3 trade secrets, 16.13–16.14 trademarks assignment, 16.9–16.10 generally, 6.5–6.6, 16.7, 16.9 goodwill, 16.10–16.11 intent-to-use trademarks, 16.10 Paris Convention, 16.10 recording of, 16.11 right of publicity and, 15.11–15.16 Trustees purchase of intellectual property assets from, 8.4–8.5 Trusts offshore business entities, 14.6–14.7
I.12 INDEX Uniform Commercial Code (UCC) copyrights applicability to, 9.14–9.16 unregistered copyrights, 9.17 federal preemption of intellectual property, 9.14 filing financing statement (UCC-1), 9.13 generally, 9.13 intellectual property and, 8.38–8.39 patents, applicability to, 9.17–9.18 perfection, 9.13 security interests generally, 9.7 trademarks, applicability to, 9.19 United Kingdom (UK). See Europe Useful life intellectual property, 4.13 Valuation accounting rules, 2.39–2.41 acquisition planning, 4.2–4.3 acquisition premiums and, 3.3–3.4 approaches cost approach, 4.9–4.10 generally, 4.9 income approach. See Discounted cash flow analysis market approach, 4.9 asset portfolio and, 3.3 best method requirement, tax regulations, 4.4–4.5 brand-name equity valuations, 2.42–2.44 business enterprise value, 3.3 calculated intangible value (CIV), 2.16 comparable company analysis, 2.6–2.7, 2.9–2.10 comparable transactions analysis, 2.7–2.8, 2.10 competitor’s intellectual properties, 2.44 complexities of, 2.1
defensive value, 4.8 discounted cash flow. See Discounted cash flow analysis established intellectual properties, 2.42–2.44 exclusivity value, 4.8 fair market value, 4.8 generally, 2.31–2.33, 4.18 high-technology firms, 2.28–2.31 income and future value of intellectual property, 2.43 investment bankers problems with valuation, 2.44–2.45 and strategy consultants, 2.31–2.33 licensing, pricing considerations. See Licensing merger failures and valuation problems, 1.8 merger valuation example, 2.33–2.36 methods of generally, 2.6–2.19, 4.7–4.8, 4.9 new methods, need for, 2.25 selection of method, 2.16 option valuation. See Option valuation patents charitable donation of, 4.5 as primary asset of company, 2.14–2.15 payback period, 2.17 product life cycle and, 2.17–2.19 proxy valuation, 2.16 ranges of valuation, 2.41–2.42 rapid technological advances, impact of, 2.23–2.25 reasons for financial reasons, 4.6–4.7 generally, 4.2 strategic reasons, 4.2
tax reasons, 4.4–4.6 transactional reasons, 4.2–4.4 return on investment (ROI), 2.16–2.17 tax consequences, 2.39–2.41 transfer value, 4.8–4.9 valuation principles, 4.8–4.9 Value intellectual property, creation of value defensive value, 4.8 exclusivity value, 4.8 option value, 4.9 transfer value, 4.8–4.9 Venture capital required rates of return, 4.16 Vertical mergers antitrust issues, 7.5 generally, 1.5 horizontal and vertical restraints, 7.6–7.7
Warranties and representations acquisition agreement provisions, 6.2 copyrights, 6.10–6.11 due diligence and, 8.15–8.16, 8.60–8.62 generally, 6.7–6.8, 9.12 indemnification, 6.16 industrial design rights, 6.11 Internet-related assets, 6.11–6.12 negotiating, 6.12–6.16 patents, 6.8–6.9 qualifications, 6.13 rights of publicity, 6.11 trademarks, 6.9–6.10 trade secrets, 6.11 Weighted average cost of capital (WACC) generally, 4.15 Winner’s curse examples, 2.5–2.6 generally, 1.7
