IP Due Diligence Considerations for Corporations
By Ross E. Alexander // April 18, 2016
Many IP issues arising after a merger or an acquisition might have been avoided by performing a proper IP due diligence.
In some circles, a typical IP due diligence is limited to confirmation of record ownership of identified IP assets and a search for typographical errors. Additional efforts may extend to whether the identified IP assets have had most current maintenance fees paid in the U.S. However, a proper IP due diligence effort regarding a merger or acquisition (hereinafter for simplicity, “acquisition”) should go further. In order to prevent potential issues from arising down the road, you should consider checking all of the boxes when it comes to your IP due diligence.
√ Independently Find the IP
It is critically important to make sure that IP which should come with the acquisition, does come. While lists of identified IP assets are presumably prepared in good faith, there are times when IP is not the focus of the deal, and mistakes are made. Relevant IP can be identified by an assignee search (both the target and its known subsidiaries), an inventor search, and a Uniform Commercial Code (U.C.C.) search. Even if no unidentified IP assets are located, this effort is also beneficial to determine that identified IP assets are assigned to the proper entity.
As an aside, the largest consideration regarding IP in an acquisition (and in IP portfolio management) tends to be whether the IP is owned, of record, by the correct entity. Though companies can transfer IP after the deal closes to remedy clear errors/omissions, it is far easier to be ahead of the situation. Thus, it is important to perform independent searches to seek out unidentified IP assets that may be owned by individual inventors, or related companies that may be holding relevant IP assets. In some cases, individuals may be under an obligation to assign these assets to the company, and such an assignment should be executed prior to the completion of the deal. You should be aware that if individuals, such as employees or executives, have failed to assign IP assets to the company, then it must be proved that there was an obligation to assign. Otherwise, the individuals may own the IP assets independently. By identifying such assets, you will be in a better position during negotiations and at the completion of the deal.
√ Look For Impairment of the IP
Terminal disclaimers are another important item to look for while performing IP due diligence. During prosecution of a patent application, a prosecuting attorney may file a terminal disclaimer in order to overcome an obviousness-type double patenting rejection. These terminal disclaimers require the two issued patents to be owned by the same entity to be enforceable. Though the later issued patent will be identified as being subject to a terminal disclaimer on its face, the previously issued patent will not be so identified, because the patent has already issued and published. Thus, when a company’s patents are being acquired, it is important to identify whether the patents are subject to a terminal disclaimer requiring ownership of one or more other patents in order to be enforceable.
Security interests, licenses, employment agreements, and other agreements should also be reviewed to identify restrictions on IP assets. These types of agreements generally have IP clauses that address changes in ownership of IP. It is important to review these agreements during the IP due diligence to ensure proper ownership of the IP assets by the company after the acquisition.
√ True Value of the IP
During an acquisition, IP is generally appraised and valued by companies without the involvement of an attorney. Thus, these appraisals usually fail to consider the validity or scope of the claims in the issued patents that are being valued. True value assessment in IP assets should be based on 1) validity of the IP, and 2) the number of potential infringers. For patents of special value, the validity of patents may be assessed by performing an invalidity analysis. The patents that are determined to be more likely to be invalid, should have their valuation revisited.
To identify the potential infringers of a patent, a claim construction may be performed to determine the scope of the claims and a search may be performed based on the construed claims to identify potential infringers of the claims. The number of potential infringers may help to identify valuable patents over less valuable patents. This type of analysis is rarely performed in larger acquisitions, thus, companies are usually left paying for IP assets first, and then finding out the validity and/or value of those IP assets in the market well after the completion of the acquisition. These surprises may be prevented by performing the proper analysis during the IP due diligence.
√ Vulnerability to Infringement
Often times an acquisition acts as a signal to litigious patent owners to take another look at asserting their portfolios, perhaps encouraged by the “deep pockets” of the acquirer. It is worth noting that this IP pitfall has nothing to do with identified IP assets, and everything to do with the acquiree’s business operations. It can be helpful to identify some of these patent owners and their patents prior to the completion of the acquisition, in order to prepare for potential defenses and understand the costs that may be associated with the acquisition. The vulnerability of infringement resulting from an acquisition may be assessed with a “freedom to operate” analysis. This type of an analysis may include a patent search, a construction of the claims in the patents, and a determination as to whether the claims of the patent are likely infringed by the activity of the acquiree. Leadership of the acquiree already have a base knowledge of the other operating companies in their industry. However, as today’s patent market is evolving, it may be beneficial to do a “freedom to operate” analysis that also identifies non-practicing entities that own patents in an identified market.
√ Obligations under Federal Statutes
In an acquisition, the validity of some of the patents in a portfolio may questionable, as noted above. Besides having a negative impact on the value of the deal, the loss in value to the patent portfolio may also lead to additional obligations by the company under federal statutes, such as the Sarbanes-Oxley Act.
The Sarbanes-Oxley Act of 2002 was enacted to require financial disclosures and reporting in publicly-traded companies. Section 302 of the Act requires signing officers, such as CEOs and CFOs, to certify that they have reviewed annual and quarterly reports and that the reports do not include any material untrue statements or material omissions affecting the value of the company. In order to abide by Section 302, an analysis should be performed on the company’s “crown jewel” IP to ensure that the annual and quarterly reports accurately reflect the value of the IP. If certain assets are determined to be invalid in light of recent case law, this information should be considered when reporting on the IP of the company.
Section 409 of the Act also requires reporting of “material changes” in a company’s financial conditions to the public. In some instances, these material changes may include invalidity of patents or involvement in patent litigation that may invalidate the patents. In order to properly identify if there has been a material change with regard to the validity of a company’s patents, the patents may need to be analyzed for validity, such as at the time of an acquisition.
In summary, given the risks and potential issues after the fact, an IP due diligence effort should extend beyond a pro forma checking of identified IP assets.