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ABA Section of Business Law

Business Law Today

Ongoing IP due diligence
The duty to protect valuable corporate assets
By Stephen Ball and Kathy Chapman
The transition from the industrial age to the information age has yielded an increased reliance on intangibles such as designs, ideas, and data. Intangible assets now account for the bulk of a company's value, not only for hi-tech companies with innovative inventions but also for more conventional companies with confidential customer lists and elaborate marketing strategies. Intellectual property (IP) includes a broad range of corporate assets such as copyrighted content, trade secret data, patentable technologies, and trade identities. Owners of these intangible assets have the responsibility to manage them appropriately and should actively perform regular internal audits—in other words, ongoing due diligence—to assure they are recognizing, exploiting, and protecting IP in the most productive way.

IP Due Diligence in M&A
Despite the fact that IP comprises a large portion of a company's value, IP due diligence is often only considered in anticipation of a transfer of corporate assets. Even then, however, comprehensive analysis is unlikely. A 2008 study by independent mergers and acquisitions (M&A) business development service "mergermarket" found that only 12 percent of private equity respondents performed IP due diligence in M&A transactions. In that same study, 80 percent of all respondents acknowledged that failure to identify IP risks is the most common consequence of insufficient due diligence. Nearly all respondents cited lack of time and budget constraints as justification. Even if due diligence is undertaken, it is usually only after the deal is on the table and a closing schedule has been set. As a result, when IP specialists are brought in, they may have insufficient time or mandate to properly assess risk.

The consequences of failing to properly assess IP risks have been well documented. In 1990 the Clorox Corporation (Clorox) purchased the Pine-Sol Corporation's business and trade identity in the hopes of expanding the brand into other product areas. Clorox soon learned, however, that the Pine-Sol(r) trademark was subject to a preexisting agreement that restricted its use to disinfectants. Though Clorox was able to manufacture products branded with the Pine-Sol(r) trademark, it was unable to accomplish its strategic goals. Another example of IP due diligence failure in M&A involves the 1998 purchase by the Volkswagen AG Corporation (Volkswagen) of the automobile assets of Rolls-Royce Motor Cars Limited (Rolls-Royce). Volkswagen purchased the plant, the machinery, and the automobile designs from Rolls-Royce. Only after the deal closed did Volkswagen learn that the purchased assets did not include the famous Rolls-Royce(r) trademark. So while Volkswagen was able to build the car, it could not brand it with the Rolls-Royce(r) trademark. These examples make it evident that even the most sophisticated companies may fail to perform adequate IP due diligence.

Since the requirements associated with M&A bring due diligence to the forefront, a company can appreciate the benefits of ongoing IP due diligence by viewing itself as a potential acquisition. When a company becomes an M&A target, it is evaluated on the quality of its IP assets and related agreements, IP risks, strategic options for IP risk management, and any potential problems associated with integrating its IP with the acquiring company. Thus, if a target company routinely audits and maintains detailed information about its IP portfolio, it could be viewed as a more attractive purchase or merger partner than, for example, a company whose due diligence is only begun in conjunction with a particular M&A transaction. Attending to any upcoming IP maintenance deadlines as soon as possible also guarantees they will not be missed in a post-transaction shake-up.

IP Due Diligence and Compliance
Outside of M&A activity, comprehensive assessment of an IP portfolio is typically only performed in reaction to litigation, bankruptcy, or conditions set by deal partners. But ongoing IP due diligence may be obligatory to assure that important assets are maintained as well as to properly assess corporate value. Under Securities Act § 11, a person who signs a registration statement to sell securities in the United States is liable to anyone with an interest in the company if the statement "contained an untrue statement of a material fact or omitted to state
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a material fact required . . . or necessary to make the statements therein not misleading." In addition, Sarbanes Oxley (SOX) § 302 holds senior executives responsible for corporate financial reports and internal controls, and any deficiencies or fraud related thereto. Since every piece of financial information likely relates to the value of IP assets, corporate officers may be responsible for any failure to properly assess an IP portfolio. These obligations are in addition to the fiduciary duties that officers have to shareholders to maximize IP value and keep competitors in check.

Ongoing IP due diligence can mitigate the risk of breaching these obligations by quantifying the value of a company's goodwill and documenting due care, providing the reasonable grounds needed for a good-faith defense under securities law. To ensure ongoing compliance, corporate governance and SOX information should be reviewed periodically with respect to IP assets, and a regular evaluation of the company's disclosure and internal controls also should be performed. Moreover, at various times a company may engage in IP activity that implicates additional regulations such as export controls, privacy, and health and safety laws, and those regulations should be frequently reviewed since they could change during the life of the company.

Because IP assets are financial assets, ongoing financial due diligence should include a detailed review of a company's projections and business model with respect to IP. Statement of Financial Accounting Standards 157, titled "Fair Value Measurements," provides guidance on the measurement of fair value in financial disclosures without requiring that the fair value be applied to specific items. Ongoing IP due diligence, therefore, should analyze IP valuation, which changes over time. As an example, the value of a patent may decrease as its expiration date approaches, whereas the value of a trademark may increase with consumer recognition and appreciation. Such value fluctuations may have a dramatic impact on a company's balance sheet. Further, any credit facilities, liabilities, contingencies, and financing documents that involve IP assets should be inventoried and reviewed to assure proper valuation.

SOX § 404 requires management to establish internal controls and publish information in annual reports concerning the scope, adequacy, and effectiveness of the procedures for financial reporting. Ongoing IP due diligence can be integrated into existing company procedure and best practices to assure performance and compliance with valuation requirements. In conjunction with § 404 requirements, Statement on Auditing Standards 70, developed by the American Institute of Certified Public Accountants, provides guidance on auditing internal controls, as well as reporting by service organizations, including those involved with information technology and outsourcing. It is worth noting that if a company promotes its ongoing due diligence program as a competitive advantage, its officers can be sanctioned for breaching their fiduciary duties by not following the advertised process.

Beyond compliance requirements, ongoing IP due diligence makes good business sense. Just as with any other asset portfolio, comprehensive review helps to assess business risks and maximize asset value. Each change in business climate may require a corresponding change in IP strategy. While IP as a whole makes a significant contribution to a company's valuation, it is often consolidated on a balance sheet and assigned a value without explanation. Such generality can only be justified through inventorying and the linking of revenue streams to particular IP assets. With each IP asset the analysis can then focus on how it is best exploited to satisfy strategic plans. For instance, there may be greater value in licensing a technology to different industries in order to open new revenue streams. In the alternative, it may make sense to sell unneeded or underutilized assets to raise capital. Many options exist to realize various strategic goals including trading, joint venturing, or even donating IP assets.

Basics of Conducting IP Due Diligence
IP due diligence should begin with inventorying all IP assets, life spans, current status, termination dates, and maintenance statuses. The identification of these corporate assets should include an analysis of their scope of protection. Any contracts or licenses that limit rights in IP assets, commit IP assets to others, or limit or prohibit the transfer of IP assets to others are also relevant to a due diligence analysis. This process also helps to identify where additional protection may be needed, since recognizing unidentified IP may add immediate value. In certain circumstances the failure to obtain or properly maintain IP rights may result in their irretrievable loss, devaluing the company and permitting additional competition. Further associated with the list of IP assets should be any potential threats from others against the company's IP assets, for example, infringement notices, as well as the identification of any competitors and their IP assets.

IP ownership should be ascertained and tracked, including the proper identification of inventors or authors and assignments of IP assets. Under U.S. law, absent an agreement or particular employment status, a copyright is held by its author and a patent is owned by the inventor. To protect the company's interest, each copyright, trademark, patent, and patent application should have an assignment prepared, and possibly a formal filing with the appropriate government office in each country in which IP protection has been sought. Assignment should be required by employment contracts, which also must be reviewed periodically in light of changing employment laws. In special situations, such as the ownership of IP assets created by independent contractors, ownership should be agreed upon and memorialized before the asset is created, and copies of agreements should be maintained and periodically reviewed. Liens and their releases against IP assets also should be inventoried and tracked, whether or not they are recorded with applicable government offices. Finally, trade secret maintenance measures should be documented to substantiate trade secret status, which may otherwise lose legal protection.

IP rights also can be compromised by open source licenses. Ongoing IP due diligence should include information about software components that may have restrictions associated with them and the use of open source modules should be subject to ongoing scrutiny in order to assure compliance with the terms and conditions of any open source license. In particular, if a company has combined its proprietary software with open source software, the details of this combination and the current disposition of the software need to be recorded and tracked and inconsistencies have to be resolved. It is possible that an acquiring company could require a complete rewrite of the code without the open source code.

Ongoing IP due diligence can help a company assess IP risks and provide data to support strategic risk management options. It makes ongoing regulatory compliance easier and yields better quality information than a reactive process resulting from pending litigation or M&A. Ongoing IP due diligence assures that IP assets are maintained and protected and maximizes and qualifies corporate value. Having everything prepared and transparent for potential investors in a central and organized place also can showcase the attractiveness of an acquisition target or investment/lending opportunity.

Ball and Chapman are attorneys in the Intellectual Property/SciTech group of Burns & Levinson LLP. They can be reached at sball@burnslev.com and kchapman@burnslev.com.

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