Intellectual Asset M&A Due Diligence and Risk Management

In a typical corporate merger or acquisition, the associated intellectual assets exhibit several concurrent financial behaviors. On the balance sheet, intellectual assets behave like financial derivatives. On the asset side of the balance sheet, an intellectual asset creates the opportunity but not the obligation for an owner to capture above-average 'rents' from the sale of patented and/or branded goods and services ' a call option. An intellectual asset also creates the opportunity but not the obligation for an owner to assert patent rights against someone else, even if the owner is not using the rights otherwise ' a put option. On the liability side of the balance sheet, an intellectual asset holder may find himself targeted as a defendant where a host of incurred but not reported ('IBNR') historic events comprise a Pandora's box of expensive 'issues.' Hence, intellectual assets by their nature tend to generate volatile returns if the owner does not fully appreciate and manage associated risks.

Principles of Intellectual Asset Risk Management

Risk managers are tasked to reduce volatility. We can identify at least three causes of volatility in intellectual asset value:

1) First-Party Risk ' the owner loses a legal right to asset returns (examples: compromised trade secret or trademark estoppel);

2) Third-Party Risk ' the owner is forced to indemnify third parties in connection with a dispute over asset rights, or the owner infringes the rights of third parties possessing stronger claims to an intellectual asset (example: the owner incorporates third-party code in proprietary software); and

3) Transfer Risk ' the owner incurs liability in connection with the transfer of intellectual property (example: the owner's internal transfer pricing understates asset value incurring tax penalties).

Risk may of course be mitigated contractually through the purchase of insurance, the negotiation (and alert exploitation) of indemnity agreements, and the utilization of derivatives. Virtue (ie, prudence, diligence, rigor in research) also mitigates risk. Risk managers are inclined to rely on contracts because of the law of supply and demand. For example, the risk manager can tap into trillions of dollars in notional derivative, insurance, and indemnity contracts. Virtue is often in shorter supply.

A word about contract rights, including insurance policies and limits, may be in order, though it is not strictly within the purview of this article. Sometimes the target will have higher limits, broader coverage, or lower retentions than the acquirer. The acquirer is also buying such contractual rights. They should be identified, inventoried, and, where appropriate, utilized. Contract rights comprise the most reliable volatility-reducing tool for intellectual assets and commensurate attention should be paid to those rights, in some cases even months or years after the acquisition in question (ie, in connection with policies containing 'occurrence' triggers).

We now apply the above to specific intellectual asset classes.

Patents

When requesting information about patents and patent applications, a buyer should request copies of ownership records, fee payment records, files corresponding to pending applications, and an explanation of how each patent relates to the company's products or services. The buyer should also independently check ownership records, fee payment records, and status information with the USPTO. The buyer's review should ensure that each inventor has assigned his or her entire interest in the patent to the seller, because the patent will be jointly owned unless the seller has acquired all such interests. The buyer should also identify and acquire all of the seller's patents that expired within the past 6 years, as the buyer can acquire the right to sue for past infringement of such patents.

A common risk mitigation alternative for patent risk is a detailed indemnity agreement with a commercial counterparty. The risk-transferee should be wary of relying solely on insurance limits or the status of 'additional named insured' since coverage could be evanescent (and in the latter case, express exclusions may defeat the purpose). Standardized contracts of indemnity or surety should be used, with an internal tracking system to flag available indemnity sources and contractual notice provisions. Note that the UCC may imply or impute indemnity coverage in certain circumstances even when it is not expressly negotiated.

Insurers flee from this risk with two exceptions: 1) high-level excess cover (usually attaching at a point >$100M) and, 2) transaction facilitation insurance policies in which specific legal issues may be insured in connection with complex acquisitions. Where insurance is available, it tends to be pricey. It should be added that Director's & Officer's liability policies sometimes include coverage for patent infringement liabilities and usually respond in cases where the unfortunate Director is accused of inattentiveness to the company's own portfolio.

Derivatives can be utilized in interesting ways to plug certain patent risk gaps. In asserting patent rights, credit default swaps can sometimes be used to hedge a defendant's insolvency. Where it is important to obtain market pricing (as in complying with international tax standards on transfer pricing or attempting to enhance accounting transparency), structured swaps may be utilized to establish value without impairing title. We think the flexibility of derivatives will lead to their more widespread use, possibly building out insurance capacity.

Trademarks

When requesting information about trademarks and trademark registrations, the buyer should inquire about and independently check the status of all trademark applications and registrations. In addition, it is important to correlate the registration with the goods or services that are the subject of the registration, to ensure that the seller is using the mark in connection with the relevant goods or services. This is because a trademark owner must continuously use the mark with the goods or services in order to keep its trademark rights.

The value of trademarks may be protected, and associated risks may be mitigated, by using techniques that parallel patent risk management. However, certain conventional insurance policies contain a measure of coverage. Cyber-risk policies, Errors & Omissions policies, and sometimes even Commercial General Liability ('CGL') policies may provide defense and indemnity for trademark claims. Some CGL forms now exclude trademark infringement, but policyholders should be alert to the potential applicability of earlier policies. Specialty IP policies covering trademark liabilities are somewhat more available (and less expensive) in the marketplace than patent infringement policies.

Trademark rights have a high degree of association with brand value. A few insurers have developed formulae for covering damage to the brand, ranging from PR costs to significant first-party limits. The correlation of brand value to debt and equity performance is suggestive of further insurance and hedging flexibility.

Finally, global companies should be especially alert to brand value and trademark value in allocating profit and cost centers in transfer pricing regimes. For example, a well-known case involved a dispute over the relative contributions of brand and patent value to the profitability of the Zantac medication. Smaller cases have highlighted interestingly esoteric issues ' Japanese tax authorities, for example, imputed Honda's sales in Brazil to brand development in Japan (an asset value not recognized by Brazilian tax authorities). In general, the global client should recognize that brand building efforts will be cited by aggressive tax authorities and should be rigorously tracked and, where possible, tested with market transactions.

Domain Names

The buyer should obtain a list of domain names that are owned and registered by the seller. Then, the buyer should independently check ownership records for those domain names with a known registrar. The buyer may also wish to check domain name registrations that correspond to important trademarks of the business. This independent check can be performed using a database from a commercial domain name registrar.

Liabilities or first-party losses arising out of domain name issues are often directly addressed in Cyber-risk policies and may be within the CGL scope of coverage for 'advertising injury' as well, depending on timing and precise policy wording.

Copyrights

The seller should provide a list of registered copyrights, along with a list of unregistered copyrights that are material to the business. Many times a company will not obtain a copyright registration on software that it owns. It is important to obtain this software by listing it on a schedule of material unregistered copyrights. It is also important to determine who created material copyrightable works (ie, employee or non-employee), to ensure that the seller owns the work. If a non-employee created the work, then the target should produce an assignment document showing that the target acquired the work from the creator.

Copyright infringement may be covered under the CGL, Cyber-risk, E&O, and specialty IP policies.

Liens and Licenses

The target should provide copies of all licenses, security interests, payment obligations, and other documents affecting the company's intellectual property. Licenses are often a primary source of indemnity agreements (thus commercial counterparty 'insurance') and they should be reviewed with appropriate rigor.

Third-Party IP

The target should identify all third-party intellectual property that it uses, and it should also provide copies of all license agreements regarding third-party intellectual property, including off-the-shelf software. If any of the licenses involve patents, the buyer must note that patent licenses are not assignable unless assignment is specifically permitted by the terms of the license agreement. If uncertainties remain, they may be identified with the requisite clarity and precision to support a transaction facilitation insurance policy (where the issues are otherwise deal killing). Insurance may offer leverage in cases where the alternative is a liquidity-killing escrow arrangement.

Opinions

A buyer should ask the target whether it has obtained any legal opinions relating to intellectual property. However, the target may be reluctant to provide copies of the opinions before closing, as disclosure of the opinions may result in loss of attorney-client privilege.

Transaction facilitation insurance will usually cover an acceptable attorney opinion, so the availability of off-the-shelf opinions can save time and costs in binding such policies.

Litigation

The buyer should request detailed information about current litigation, past litigation that resulted in a settlement or court order that affects current operations, and any other information suggesting that a potential for litigation involving IP exists. Litigation matters include not only infringement matters, but also claims that could adversely affect the validity or target's ownership of IP. If a potential for litigation exists, the buyer should determine the
potential loss of income that may occur if the lawsuit were to prevail against the target in order to assess the potential risk that the litigation may pose.

The buyer should also receive assurances that all sources of insurance or indemnity in connection with outstanding litigation have been investigated and, where appropriate, utilized. Transaction facilitation insurers may issue coverage in connection with pending litigation, 'capping' or 'collaring' the acquirer's exposures.

Transfer Pricing and Tax Liabilities

We have previously identified this issue (PSM 2005 6(1), May and 2006 6(9), Feb.), but it merits some amplification. Global enterprises are obliged to mark assets to market in transactions between transnational affiliates. The effect of such transactions will naturally decrease taxable income in one jurisdiction and increase taxable income in another. Intangible assets such as intellectual property are particularly open to challenge, especially where tax authorities suspect that tax-optimizing strategies have been deployed.

We have referenced swap techniques to confer price discovery on otherwise nontransparent values, reducing the risk of noncompliance. The structure of such transactions is too complex for a detailed treatment here, but markets exist that can enhance transparency. As a diligence matter, attention should be paid to the target's global tax architecture, especially as this applies to IP. Whether domestically or internationally, does the target utilize IP holding company structures? Is IP ownership concentrated in tax havens? Are valuations rigorous and current? Does the target value all IP ' not simply patents? Know-how, IT values, brand, and trademark assets should all factor into global cost and revenue allocations.

Tax counsel and patent counsel need to engage in a coordinated dialogue to identify tax risk. Where it exists, it can be tested utilizing the techniques referenced, but the alert buyer will demand that the inherent asset volatility be reflected in purchase price adjustments.

Nir Kossovsky, M.D. ([email protected]) is CEO of Technology Option Capital, LLC (www.tocllc.com), which develops innovative financial and risk reduction strategies to discover, realize, and protect intangible asset value. The company is the national technology correspondent office of UCC Capital Corp, an intellectual property merchant bank. (http://www.ucccapital.com/). Robert J. Block ([email protected]) is managing direc-tor of Johnson & Higgins, a provider of finance and investment advisory; risk management and insurance; and consulting services (http://www.johnsonhiggins.com/). Johnson & Higgins is not affiliated in any way with Marsh USA Inc., Marsh & McLennan Companies, Inc., (MMC) or any other Marsh entity (NYSE: MMC). James M. Singer ([email protected]) is a patent attorney and partner in the Intellectual Property Practice Group of Pepper Hamilton LLP (http://www.pepperlaw.com/), and his practices focuses on helping clients identify, protect, and maximize the value of their intellectual property.

In a typical corporate merger or acquisition, the associated intellectual assets exhibit several concurrent financial behaviors. On the balance sheet, intellectual assets behave like financial derivatives. On the asset side of the balance sheet, an intellectual asset creates the opportunity but not the obligation for an owner to capture above-average 'rents' from the sale of patented and/or branded goods and services ' a call option. An intellectual asset also creates the opportunity but not the obligation for an owner to assert patent rights against someone else, even if the owner is not using the rights otherwise ' a put option. On the liability side of the balance sheet, an intellectual asset holder may find himself targeted as a defendant where a host of incurred but not reported ('IBNR') historic events comprise a Pandora's box of expensive 'issues.' Hence, intellectual assets by their nature tend to generate volatile returns if the owner does not fully appreciate and manage associated risks.

Principles of Intellectual Asset Risk Management

Risk managers are tasked to reduce volatility. We can identify at least three causes of volatility in intellectual asset value:

1) First-Party Risk ' the owner loses a legal right to asset returns (examples: compromised trade secret or trademark estoppel);

2) Third-Party Risk ' the owner is forced to indemnify third parties in connection with a dispute over asset rights, or the owner infringes the rights of third parties possessing stronger claims to an intellectual asset (example: the owner incorporates third-party code in proprietary software); and

3) Transfer Risk ' the owner incurs liability in connection with the transfer of intellectual property (example: the owner's internal transfer pricing understates asset value incurring tax penalties).

Risk may of course be mitigated contractually through the purchase of insurance, the negotiation (and alert exploitation) of indemnity agreements, and the utilization of derivatives. Virtue (ie, prudence, diligence, rigor in research) also mitigates risk. Risk managers are inclined to rely on contracts because of the law of supply and demand. For example, the risk manager can tap into trillions of dollars in notional derivative, insurance, and indemnity contracts. Virtue is often in shorter supply.

A word about contract rights, including insurance policies and limits, may be in order, though it is not strictly within the purview of this article. Sometimes the target will have higher limits, broader coverage, or lower retentions than the acquirer. The acquirer is also buying such contractual rights. They should be identified, inventoried, and, where appropriate, utilized. Contract rights comprise the most reliable volatility-reducing tool for intellectual assets and commensurate attention should be paid to those rights, in some cases even months or years after the acquisition in question (ie, in connection with policies containing 'occurrence' triggers).

We now apply the above to specific intellectual asset classes.

Patents

When requesting information about patents and patent applications, a buyer should request copies of ownership records, fee payment records, files corresponding to pending applications, and an explanation of how each patent relates to the company's products or services. The buyer should also independently check ownership records, fee payment records, and status information with the USPTO. The buyer's review should ensure that each inventor has assigned his or her entire interest in the patent to the seller, because the patent will be jointly owned unless the seller has acquired all such interests. The buyer should also identify and acquire all of the seller's patents that expired within the past 6 years, as the buyer can acquire the right to sue for past infringement of such patents.

A common risk mitigation alternative for patent risk is a detailed indemnity agreement with a commercial counterparty. The risk-transferee should be wary of relying solely on insurance limits or the status of 'additional named insured' since coverage could be evanescent (and in the latter case, express exclusions may defeat the purpose). Standardized contracts of indemnity or surety should be used, with an internal tracking system to flag available indemnity sources and contractual notice provisions. Note that the UCC may imply or impute indemnity coverage in certain circumstances even when it is not expressly negotiated.

Insurers flee from this risk with two exceptions: 1) high-level excess cover (usually attaching at a point >$100M) and, 2) transaction facilitation insurance policies in which specific legal issues may be insured in connection with complex acquisitions. Where insurance is available, it tends to be pricey. It should be added that Director's & Officer's liability policies sometimes include coverage for patent infringement liabilities and usually respond in cases where the unfortunate Director is accused of inattentiveness to the company's own portfolio.

Derivatives can be utilized in interesting ways to plug certain patent risk gaps. In asserting patent rights, credit default swaps can sometimes be used to hedge a defendant's insolvency. Where it is important to obtain market pricing (as in complying with international tax standards on transfer pricing or attempting to enhance accounting transparency), structured swaps may be utilized to establish value without impairing title. We think the flexibility of derivatives will lead to their more widespread use, possibly building out insurance capacity.

Trademarks

When requesting information about trademarks and trademark registrations, the buyer should inquire about and independently check the status of all trademark applications and registrations. In addition, it is important to correlate the registration with the goods or services that are the subject of the registration, to ensure that the seller is using the mark in connection with the relevant goods or services. This is because a trademark owner must continuously use the mark with the goods or services in order to keep its trademark rights.

The value of trademarks may be protected, and associated risks may be mitigated, by using techniques that parallel patent risk management. However, certain conventional insurance policies contain a measure of coverage. Cyber-risk policies, Errors & Omissions policies, and sometimes even Commercial General Liability ('CGL') policies may provide defense and indemnity for trademark claims. Some CGL forms now exclude trademark infringement, but policyholders should be alert to the potential applicability of earlier policies. Specialty IP policies covering trademark liabilities are somewhat more available (and less expensive) in the marketplace than patent infringement policies.

Trademark rights have a high degree of association with brand value. A few insurers have developed formulae for covering damage to the brand, ranging from PR costs to significant first-party limits. The correlation of brand value to debt and equity performance is suggestive of further insurance and hedging flexibility.

Finally, global companies should be especially alert to brand value and trademark value in allocating profit and cost centers in transfer pricing regimes. For example, a well-known case involved a dispute over the relative contributions of brand and patent value to the profitability of the Zantac medication. Smaller cases have highlighted interestingly esoteric issues ' Japanese tax authorities, for example, imputed Honda's sales in Brazil to brand development in Japan (an asset value not recognized by Brazilian tax authorities). In general, the global client should recognize that brand building efforts will be cited by aggressive tax authorities and should be rigorously tracked and, where possible, tested with market transactions.

Domain Names

The buyer should obtain a list of domain names that are owned and registered by the seller. Then, the buyer should independently check ownership records for those domain names with a known registrar. The buyer may also wish to check domain name registrations that correspond to important trademarks of the business. This independent check can be performed using a database from a commercial domain name registrar.

Liabilities or first-party losses arising out of domain name issues are often directly addressed in Cyber-risk policies and may be within the CGL scope of coverage for 'advertising injury' as well, depending on timing and precise policy wording.

Copyrights

The seller should provide a list of registered copyrights, along with a list of unregistered copyrights that are material to the business. Many times a company will not obtain a copyright registration on software that it owns. It is important to obtain this software by listing it on a schedule of material unregistered copyrights. It is also important to determine who created material copyrightable works (ie, employee or non-employee), to ensure that the seller owns the work. If a non-employee created the work, then the target should produce an assignment document showing that the target acquired the work from the creator.

Copyright infringement may be covered under the CGL, Cyber-risk, E&O, and specialty IP policies.

Liens and Licenses

The target should provide copies of all licenses, security interests, payment obligations, and other documents affecting the company's intellectual property. Licenses are often a primary source of indemnity agreements (thus commercial counterparty 'insurance') and they should be reviewed with appropriate rigor.

Third-Party IP

The target should identify all third-party intellectual property that it uses, and it should also provide copies of all license agreements regarding third-party intellectual property, including off-the-shelf software. If any of the licenses involve patents, the buyer must note that patent licenses are not assignable unless assignment is specifically permitted by the terms of the license agreement. If uncertainties remain, they may be identified with the requisite clarity and precision to support a transaction facilitation insurance policy (where the issues are otherwise deal killing). Insurance may offer leverage in cases where the alternative is a liquidity-killing escrow arrangement.

Opinions

A buyer should ask the target whether it has obtained any legal opinions relating to intellectual property. However, the target may be reluctant to provide copies of the opinions before closing, as disclosure of the opinions may result in loss of attorney-client privilege.

Transaction facilitation insurance will usually cover an acceptable attorney opinion, so the availability of off-the-shelf opinions can save time and costs in binding such policies.

Litigation

The buyer should request detailed information about current litigation, past litigation that resulted in a settlement or court order that affects current operations, and any other information suggesting that a potential for litigation involving IP exists. Litigation matters include not only infringement matters, but also claims that could adversely affect the validity or target's ownership of IP. If a potential for litigation exists, the buyer should determine the
potential loss of income that may occur if the lawsuit were to prevail against the target in order to assess the potential risk that the litigation may pose.

The buyer should also receive assurances that all sources of insurance or indemnity in connection with outstanding litigation have been investigated and, where appropriate, utilized. Transaction facilitation insurers may issue coverage in connection with pending litigation, 'capping' or 'collaring' the acquirer's exposures.

Transfer Pricing and Tax Liabilities

We have previously identified this issue (PSM 2005 6(1), May and 2006 6(9), Feb.), but it merits some amplification. Global enterprises are obliged to mark assets to market in transactions between transnational affiliates. The effect of such transactions will naturally decrease taxable income in one jurisdiction and increase taxable income in another. Intangible assets such as intellectual property are particularly open to challenge, especially where tax authorities suspect that tax-optimizing strategies have been deployed.

We have referenced swap techniques to confer price discovery on otherwise nontransparent values, reducing the risk of noncompliance. The structure of such transactions is too complex for a detailed treatment here, but markets exist that can enhance transparency. As a diligence matter, attention should be paid to the target's global tax architecture, especially as this applies to IP. Whether domestically or internationally, does the target utilize IP holding company structures? Is IP ownership concentrated in tax havens? Are valuations rigorous and current? Does the target value all IP ' not simply patents? Know-how, IT values, brand, and trademark assets should all factor into global cost and revenue allocations.

Tax counsel and patent counsel need to engage in a coordinated dialogue to identify tax risk. Where it exists, it can be tested utilizing the techniques referenced, but the alert buyer will demand that the inherent asset volatility be reflected in purchase price adjustments.

Nir Kossovsky, M.D. ([email protected]) is CEO of Technology Option Capital, LLC (www.tocllc.com), which develops innovative financial and risk reduction strategies to discover, realize, and protect intangible asset value. The company is the national technology correspondent office of UCC Capital Corp, an intellectual property merchant bank. (http://www.ucccapital.com/). Robert J. Block ([email protected]) is managing direc-tor of Johnson & Higgins, a provider of finance and investment advisory; risk management and insurance; and consulting services (http://www.johnsonhiggins.com/). Johnson & Higgins is not affiliated in any way with Marsh USA Inc., Marsh & McLennan Companies, Inc., (MMC) or any other Marsh entity (NYSE: MMC). James M. Singer ([email protected]) is a patent attorney and partner in the Intellectual Property Practice Group of Pepper Hamilton LLP (http://www.pepperlaw.com/), and his practices focuses on helping clients identify, protect, and maximize the value of their intellectual property.