The Securities Act of 1933: Assessing and Managing IP Liability

For nearly 75 years, the initial public offering ('IPO') of securities has been regulated by the Securities and Exchange Commission under the authority of the Securities Act of 1933. Among other considerations, the 1933 Act requires the disclosure of anything that might affect the value of the securities being issued and imposes civil liability on those that sign registration statements containing material omissions of fact. Over that same 75-year period, the role of intellectual capital as a leading driver of corporate value has increased significantly. As a result, an issuer's officers, directors, lawyers, underwriters, and auditors should consider whether they fully understand (and disclose) the extent to which intellectual capital drives their company value and risk.

The 1933 Act

In simple terms, the 1933 Act was enacted to ensure that investors had access to sufficient information to make informed investment decisions. To that end, the 1933 Act requires:

most issuers to file registration statements with the SEC that contain financial and other significant information concerning the securities being issued to prospective investors. Registration statements generally must contain information about the issuer's properties and business, the security being offered for sale, the management of the issuer, and the issuer's audited financial statements.

Section 11 of the 1933 Act imposes civil liability on anyone who signs a registration statement containing a material misrepresentation or omission of fact. Importantly, a finding of liability under '11 does not require proof of negligence or intent to deceive on the part of the defendant, nor does it require a showing of reliance on the misrepresented/omitted fact on the part of the plaintiff. Rather, if a registration statement contains a material misrepresentation or omission of fact, liability may be demonstrated with two simple elements: 1) the plaintiff acquired the stock; 2) the plaintiff suffered a loss (i.e., damages). Liability under '11 of the 1933 Act extends to every person who signed the registration statement, as well as other related parties including officers and directors of the issuer, accountants, engineers, appraisers, lawyers, underwriters, and those who prepared or certified any part of the registration statement. In practical terms, the 1933 Act requires the disclosure of any material facts that might affect the value of the securities being issued and imposes stringent liability on those with inadequate registration disclosures.

Intellectual Capital Drives Corporate Value

Within the last quarter century, intellectual capital has been recognized as a leading driver of corporate value. The term 'intellectual capital' generally refers to both traditional intellectual property assets, such as patents, trademarks, and copyrights, as well as assets without tangible, physical substance, such as research and development, production/process information know-how, sales and marketing information, licenses, assembled workforce/management, and leasehold rights, for example.

The growth in value and importance of intellectual capital can be seen when evaluating the market capitalization of the S&P 500. As shown in Figure 1, in 1975 more than 80% of the market's value was composed of tangible assets such as factories, machines, and inventory. However, over the next 30 years, the relationship of tangible and intangible assets to value almost completely inverted, and by 2005 only 20% of the market's value was composed of tangible assets. Not only do intangible assets account for the majority of corporate value, but also empirical evidence confirms that investments in companies ' both large and small ' with strong intellectual property outperform comparable benchmarks. As illustrated in Figure 2, a 10-year performance tracking of the Ocean Tomo 300^TM ' a diversified portfolio of 300 companies that own valuable patents ' would have outperformed the S&P' 500 by 310 basis points annualized for the 10 years ended September 2006.

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Intellectual Capital and the 1933 Act

Notwithstanding the ascending significance of intellectual capital to corporate value, many registration statements filed under the 1933 Act may contain an inadequate assessment and disclosure of intellectual property facts and risks. Indeed, an informal survey of the 141 registration statements filed in connection with IPOs that issued around the final six months of 2007 revealed that 32 (23%) of such statements made absolutely no reference to intellectual property.

Additionally, although 50 of the statements filed during that same time period provided a seemingly detailed discussion of the specific value and/or risks associated with specific patents and/or other intellectual property, the remaining 59 statements provided a relatively limited discussion (i.e., relating generally to the ownership of certain intellectual properties and the importance of protecting them). As can be seen in Figure 3, of the 141 registration statements reviewed, wholly 65% included either limited or no disclosures related to the impact of intellectual property on driving business value and/or the associated risks.

[IMGCAP(3)]

Despite the above findings, the authors contend that it would be difficult for those familiar with recent trends in intellectual property and law to identify many industries and/or businesses that are not in some way impacted by intellectual property and therefore immune to the associated risks. Because some such intellectual property risks could potentially be deemed substantial, registration statements that fail to sufficiently assess and disclose those risks may facilitate liability under '11 of the 1933 Act.

While a complete overview and assessment of all intellectual capital risks is beyond the scope of this article, an overview of some patent-related risks is described herein. A valid patent confers on its owner the right to exclude others from making, using, or selling the claimed invention for the term of the patent. By excluding competition, patents can significantly alter the competitiveness (and profitability) of firms within an industry or of products within a marketplace. Companies accused of infringing third-party patents may face some combination of monetary damages, risk of a permanent injunction, or both. Conversely, companies holding patents face a risk that their patents will be infringed by others, invalidated by the courts, or licensed by the courts on a compulsory basis. Moreover, inventors bear a risk that patent rights secured by counsel will be overly narrow or broad in scope, that patent rights will not be maintained as required by the USPTO, or that foreign patent rights will not be filed on a timely basis. Even if patent rights are properly secured by counsel, companies bear a residual risk that they will be unable to license those rights to or from third parties on a value accretive basis.

Although companies that compete in technology-driven industries are likely to consider the potential business impact of IP-related risks, such risks now extend well beyond such industries. To that point, as seen in Figure 4, although Fortune 100 companies in the High-Tech and Telecom industries have experienced the most patent litigation, other 'non-technology' industries have also been actively involved in patent litigation as well. Such industries include Retail, Automotive, Grocery, Drug-store, and Freight. These data suggest the need to consider IP-related risks extends well beyond those industries traditionally considered to be high-tech.

[IMGCAP(4)]

Materiality Defined

Liability under '11 of the 1933 Act for material misrepresentation or omission of facts about intellectual capital risks appears to hinge on the concept of materiality. When evaluating materiality, the central inquiry is 'whether the defendants' representations, taken together and in context, would have misled a reasonable investor about the nature of the investment.' I. Meyer Pincus, 936 F.2d 759, 761 (2d Cir. 1991) (citation omitted). Given the patent-related risks discussed above, one need not exercise fantastic imagination to envision a scenario where the value of an issuer would depend heavily on its exposure to third-party intellectual property claims and the effective management of its own intellectual property. Although much of the information necessary to evaluate such intellectual property risk is available in the public domain (e.g., monitoring competitor filing activity), most investors lack the specific expertise necessary to conduct a complete and thorough analysis of all such risks. As such, responsibility for identifying and analyzing those risks rests with the issuer. To the extent the issuer lacks the expertise necessary to do so, the retention of additional outside expertise may be necessary to identify all material IP-related risks.

Due Diligence Defense

Although the recent Supreme Court decision in Stoneridge Investment Partners v. Scientific-Atlanta appears to have limited the liability of third parties, such as law firms, accountants, and investment banks, it is important to note that the Stoneridge decision relates to liability under the Securities Act of 1934 (which regulates the secondary trading of securities), and not the Securities Act of 1933, which regulates original issues. However, even under the 1933 Act, liability by such third parties can sometimes be contested with a due diligence defense. A 'due diligence defense' precludes liability to third parties that did not reasonably believe, after 'reasonable investigation,' that an issuer's registration statements contained no untrue statements or omitted no material facts.

A third party's ability to establish a due diligence defense is determined by the standard of reasonableness outlined in '11 of the 1933 Act. To that point, the 1933 Act states that 'in establishing what constitutes reasonable investigation and reasonable ground for belief, the standard of reasonableness shall be that required of a prudent man in the management of his own property.' Therefore, as support for a due diligence defense focused specifically on intellectual property, third parties wishing to conduct a 'reasonable investigation' and establish 'reasonable grounds for belief' may consider obtaining an independent assessment of any such risks from outside experts with relevant experience. Moreover, anyone who signs a registration statement may also wish to obtain IP risk management products (e.g., insurance), which would not only protect against such risks, but also thoroughly identify any such risks as part of the underwriting process.

Conclusion

Given the potential liability exposure established under the Securities Act of 1933, it is becoming increasingly important that a company's internal management and outside advisers thoroughly understand the IP-related risks associated with the realization of corporate value. While certain defenses and risk management products may provide protection against such liability, a comprehensive investigation, identification, and disclosure of any such risks is the best approach for avoiding liability under the 1933 Act.

Kevin Arst and Michael Milani are Managing Directors of Ocean Tomo, LLC. They are based out of the firm's San Francisco and Chicago offices, respectively. The authors wish to thank Mark Rollins, Chris Schulte, and Philip Kline, who contributed valuable research to this article.

For nearly 75 years, the initial public offering ('IPO') of securities has been regulated by the Securities and Exchange Commission under the authority of the Securities Act of 1933. Among other considerations, the 1933 Act requires the disclosure of anything that might affect the value of the securities being issued and imposes civil liability on those that sign registration statements containing material omissions of fact. Over that same 75-year period, the role of intellectual capital as a leading driver of corporate value has increased significantly. As a result, an issuer's officers, directors, lawyers, underwriters, and auditors should consider whether they fully understand (and disclose) the extent to which intellectual capital drives their company value and risk.

The 1933 Act

In simple terms, the 1933 Act was enacted to ensure that investors had access to sufficient information to make informed investment decisions. To that end, the 1933 Act requires:

most issuers to file registration statements with the SEC that contain financial and other significant information concerning the securities being issued to prospective investors. Registration statements generally must contain information about the issuer's properties and business, the security being offered for sale, the management of the issuer, and the issuer's audited financial statements.

Section 11 of the 1933 Act imposes civil liability on anyone who signs a registration statement containing a material misrepresentation or omission of fact. Importantly, a finding of liability under '11 does not require proof of negligence or intent to deceive on the part of the defendant, nor does it require a showing of reliance on the misrepresented/omitted fact on the part of the plaintiff. Rather, if a registration statement contains a material misrepresentation or omission of fact, liability may be demonstrated with two simple elements: 1) the plaintiff acquired the stock; 2) the plaintiff suffered a loss (i.e., damages). Liability under '11 of the 1933 Act extends to every person who signed the registration statement, as well as other related parties including officers and directors of the issuer, accountants, engineers, appraisers, lawyers, underwriters, and those who prepared or certified any part of the registration statement. In practical terms, the 1933 Act requires the disclosure of any material facts that might affect the value of the securities being issued and imposes stringent liability on those with inadequate registration disclosures.

Intellectual Capital Drives Corporate Value

Within the last quarter century, intellectual capital has been recognized as a leading driver of corporate value. The term 'intellectual capital' generally refers to both traditional intellectual property assets, such as patents, trademarks, and copyrights, as well as assets without tangible, physical substance, such as research and development, production/process information know-how, sales and marketing information, licenses, assembled workforce/management, and leasehold rights, for example.

The growth in value and importance of intellectual capital can be seen when evaluating the market capitalization of the S&P 500. As shown in Figure 1, in 1975 more than 80% of the market's value was composed of tangible assets such as factories, machines, and inventory. However, over the next 30 years, the relationship of tangible and intangible assets to value almost completely inverted, and by 2005 only 20% of the market's value was composed of tangible assets. Not only do intangible assets account for the majority of corporate value, but also empirical evidence confirms that investments in companies ' both large and small ' with strong intellectual property outperform comparable benchmarks. As illustrated in Figure 2, a 10-year performance tracking of the Ocean Tomo 300^TM ' a diversified portfolio of 300 companies that own valuable patents ' would have outperformed the S&P' 500 by 310 basis points annualized for the 10 years ended September 2006.

[IMGCAP(1)]

[IMGCAP(2)]

Intellectual Capital and the 1933 Act

Notwithstanding the ascending significance of intellectual capital to corporate value, many registration statements filed under the 1933 Act may contain an inadequate assessment and disclosure of intellectual property facts and risks. Indeed, an informal survey of the 141 registration statements filed in connection with IPOs that issued around the final six months of 2007 revealed that 32 (23%) of such statements made absolutely no reference to intellectual property.

Additionally, although 50 of the statements filed during that same time period provided a seemingly detailed discussion of the specific value and/or risks associated with specific patents and/or other intellectual property, the remaining 59 statements provided a relatively limited discussion (i.e., relating generally to the ownership of certain intellectual properties and the importance of protecting them). As can be seen in Figure 3, of the 141 registration statements reviewed, wholly 65% included either limited or no disclosures related to the impact of intellectual property on driving business value and/or the associated risks.

[IMGCAP(3)]

Despite the above findings, the authors contend that it would be difficult for those familiar with recent trends in intellectual property and law to identify many industries and/or businesses that are not in some way impacted by intellectual property and therefore immune to the associated risks. Because some such intellectual property risks could potentially be deemed substantial, registration statements that fail to sufficiently assess and disclose those risks may facilitate liability under '11 of the 1933 Act.

While a complete overview and assessment of all intellectual capital risks is beyond the scope of this article, an overview of some patent-related risks is described herein. A valid patent confers on its owner the right to exclude others from making, using, or selling the claimed invention for the term of the patent. By excluding competition, patents can significantly alter the competitiveness (and profitability) of firms within an industry or of products within a marketplace. Companies accused of infringing third-party patents may face some combination of monetary damages, risk of a permanent injunction, or both. Conversely, companies holding patents face a risk that their patents will be infringed by others, invalidated by the courts, or licensed by the courts on a compulsory basis. Moreover, inventors bear a risk that patent rights secured by counsel will be overly narrow or broad in scope, that patent rights will not be maintained as required by the USPTO, or that foreign patent rights will not be filed on a timely basis. Even if patent rights are properly secured by counsel, companies bear a residual risk that they will be unable to license those rights to or from third parties on a value accretive basis.

Although companies that compete in technology-driven industries are likely to consider the potential business impact of IP-related risks, such risks now extend well beyond such industries. To that point, as seen in Figure 4, although Fortune 100 companies in the High-Tech and Telecom industries have experienced the most patent litigation, other 'non-technology' industries have also been actively involved in patent litigation as well. Such industries include Retail, Automotive, Grocery, Drug-store, and Freight. These data suggest the need to consider IP-related risks extends well beyond those industries traditionally considered to be high-tech.

[IMGCAP(4)]

Materiality Defined

Liability under '11 of the 1933 Act for material misrepresentation or omission of facts about intellectual capital risks appears to hinge on the concept of materiality. When evaluating materiality, the central inquiry is 'whether the defendants' representations, taken together and in context, would have misled a reasonable investor about the nature of the investment.' I. Meyer Pincus, 936 F.2d 759, 761 (2d Cir. 1991) (citation omitted). Given the patent-related risks discussed above, one need not exercise fantastic imagination to envision a scenario where the value of an issuer would depend heavily on its exposure to third-party intellectual property claims and the effective management of its own intellectual property. Although much of the information necessary to evaluate such intellectual property risk is available in the public domain (e.g., monitoring competitor filing activity), most investors lack the specific expertise necessary to conduct a complete and thorough analysis of all such risks. As such, responsibility for identifying and analyzing those risks rests with the issuer. To the extent the issuer lacks the expertise necessary to do so, the retention of additional outside expertise may be necessary to identify all material IP-related risks.

Due Diligence Defense

Although the recent Supreme Court decision in Stoneridge Investment Partners v. Scientific-Atlanta appears to have limited the liability of third parties, such as law firms, accountants, and investment banks, it is important to note that the Stoneridge decision relates to liability under the Securities Act of 1934 (which regulates the secondary trading of securities), and not the Securities Act of 1933, which regulates original issues. However, even under the 1933 Act, liability by such third parties can sometimes be contested with a due diligence defense. A 'due diligence defense' precludes liability to third parties that did not reasonably believe, after 'reasonable investigation,' that an issuer's registration statements contained no untrue statements or omitted no material facts.

A third party's ability to establish a due diligence defense is determined by the standard of reasonableness outlined in '11 of the 1933 Act. To that point, the 1933 Act states that 'in establishing what constitutes reasonable investigation and reasonable ground for belief, the standard of reasonableness shall be that required of a prudent man in the management of his own property.' Therefore, as support for a due diligence defense focused specifically on intellectual property, third parties wishing to conduct a 'reasonable investigation' and establish 'reasonable grounds for belief' may consider obtaining an independent assessment of any such risks from outside experts with relevant experience. Moreover, anyone who signs a registration statement may also wish to obtain IP risk management products (e.g., insurance), which would not only protect against such risks, but also thoroughly identify any such risks as part of the underwriting process.

Conclusion

Given the potential liability exposure established under the Securities Act of 1933, it is becoming increasingly important that a company's internal management and outside advisers thoroughly understand the IP-related risks associated with the realization of corporate value. While certain defenses and risk management products may provide protection against such liability, a comprehensive investigation, identification, and disclosure of any such risks is the best approach for avoiding liability under the 1933 Act.

Kevin Arst and Michael Milani are Managing Directors of Ocean Tomo, LLC. They are based out of the firm's San Francisco and Chicago offices, respectively. The authors wish to thank Mark Rollins, Chris Schulte, and Philip Kline, who contributed valuable research to this article.