A driving force in many stock and asset transactions is the seller's intellectual property (IP) portfolio. Typically purchaser's counsel is tasked with conducting due diligence to ascertain what property rights purchaser will acquire and what rights seller is capable of delivering.
Purchaser's IP due diligence usually includes, among other things, obtaining a detailed list from seller describing each intellectual property right within the scope of the transaction, reviewing relevant files of seller, and conducting computerized searches of public records to confirm: (i) the existence and status of seller's IP assets, (ii) IP claims asserted against seller and, in some cases, (iii) the existence of potentially relevant third party rights. As more data resources become available, conducting independent searches now serve as an essential tool in identifying and assessing any gaps or irregularities in seller's IP rights and practices, which could dramatically affect purchaser's valuation of the deal. This article is intended to highlight the top ten considerations for performing IP due diligence.
1. Understand the Structure of the Deal
It is important for an IP attorney to understand the context and implications of the transaction, i.e., asset purchase or stock purchase. In an asset purchase, the assets to be acquired must be identified and included within the scope of the acquisition documents and it is therefore important for counsel to conduct a thorough investigation. As a safety net, purchaser may incorporate representations and warranties that all IP assets owned by seller are included in the purchased assets. However, the reasonableness of purchaser's reliance on such representations and warranties may depend on state law and the extent to which relevant data was or should have been found and known by purchaser through due diligence prior to closing.
In a stock deal, purchaser generally acquires whatever rights and assets seller may own, which may or not be clearly defined with regard to IP assets. Because stock purchases involve the sale of securities, they are governed by Section 10b of the SEC Act of 1934. 15 U.S.C. Â§78j(b). Rule 10b-5 imposes an affirmative duty on purchaser to conduct reasonable due diligence.
2. Determine the Scope of Diligence to be Performed
To focus efforts and avoid unnecessary work and cost, purchaser should define the assets purchaser desires to acquire. The best source for this information is often purchaser's business strategists who understand the deal objectives and what IP or technology may be critically important to purchaser. A cost-effective due diligence plan will focus principally on those assets that are actually of interest to purchaser. However, it is important to check periodically whether purchaser's priorities change as the deal proceeds, e.g., as a result of ongoing negotiations. It is also important to have a strategy for how to phrase various requests for information to ensure that the requests adequately capture the desired information. For instance, it may be useful to ask for the same information in various ways so as to adequately inform the seller of the information to be provided.
3. Give Special Attention to Patent Issues
Patent issues deserve great attention because of the broad scope of protection they afford and the formidable sanctions available when infringement occurs. It is important to verify that seller owns all patent rights it purports to transfer. Any assignments, licenses, security interests, and other encumbrances must be considered, as well as whether required fees were paid to maintain each patent or whether its term has expired. Determine whether any patent applications are pending before any patent office, including status and likelihood of success. For a large portfolio, assess the cumulative amount of any government fees to be paid immediately following deal closing; purchaser might insist that such fees are paid by seller prior to closing.
For a deeper dive on patent issues, it may be desirable to conduct an independent validity search or an infringement analysis with respect to known competitors and to investigate whether the seller has complied with relevant patent marking requirements. See 35 U.S.C. Â§ 287. This is especially true for any patents deemed to be critical to seller's business. Issues with one or more of seller's critical patents could have a significant impact on the valuation of the deal.
4. Trademarks, Domain Names, Social Media Handles Are Also Critical
When the transaction involves acquisition of trademarks or service marks, a number of important issues must be investigated. Again, confirm seller owns the mark rights it purports to convey. Identify any licenses, assignments, security interests or other burdens on seller's absolute rights, e.g., field of use restrictions or co-existence agreements. Bear in mind that some foreign jurisdictions require that a consideration amount be stated in each assignment agreement.
Ascertain whether the marks have been registered federally and/or at a state level. A federal registration conveys prima-facie evidence of validity, ownership, and exclusive right to use. Inspect federal registrations for irregularities, e.g., incorrect owner or goods or services description, which could have dire consequences in disputes regarding priority of rights. If seller's portfolio includes foreign registrations and applications, conduct searches in relevant countries to confirm their existence and status.
It is important to verify that seller's marks are in use in a proper trademark sense and in compliance with applicable regulations. In the U.S., a "token" use may not support a priority of rights claim. Non-use for a certain period of time might constitute "abandonment," and consequently the loss of rights. Improper use may result in a mark being found generic or unprotectable. Review examples of seller's current packaging and promotional materials to identify any undisclosed unregistered marks, slogans, and trade dress rights and to identify any apparent false advertising or infringement issues. When relevant, consult with foreign associates to confirm proper trademark usage and compliance with laws in their jurisdictions.
Domain names, when used as an electronic "address" of a website, are not, without more affirmative actions, protectable as a mark. Consider whether domain names are used in an appropriate and sufficiently distinctive manner to qualify as a trademark and whether registrations should be sought. Confirm that domain names and social media handles are registered in seller's name, not in the name of an individual employee. Also ensure that seller has the right to control and transfer to purchaser all domain names, webpages, social media handles and accounts, including all relevant usernames and passwords.
5. Do Not Overlook Copyrights
An assessment of seller's copyrights is often a low priority in an IP due diligence investigation, particularly where a quick online search confirms seller does not have any copyright registrations. However, even unregistered copyrights could be important to seller's business and should be identified and evaluated. This is particularly true when seller is a software company. If important copyrights are identified, determine the author of the original version of the work in question. This involves identifying all who contributed to creation of the work, including third parties, customers, employees, etc. and the circumstances surrounding their contributions. An employer is generally deemed the author and owner of any works created by an employee within the scope of employment. Otherwise, rights may reside with the third party contributor. Per U.S. statutory law, copyrights are assignable only by written agreement.
It is also a good idea to determine the modification history of the work, including a listing of publicly released versions with dates of creation and first publication for each. To the extent any new version contains new protectable material added to the pre-existing material of earlier versions, it will constitute a derivative work. A new written copyright assignment agreement may be needed for each derivative work to ensure seller has all necessary rights to be transferred to purchaser. If proper formalities have not been observed, e.g., affixation of a proper copyright notice, consider whether such failure can be cured and, if not, what material may have fallen into the public domain.
6. Involve an Open Source Software Expert
Open source software ("OSS") presents unique, and often overlooked, risks for companies that distribute or provide access to software. Most open source licenses impose obligations on a licensee only when licensee redistributes the OSS. Some, however, impose obligations even when licensee provides network access to its software, e.g., a SaaS or web-based model. Some OSS licenses require licensees to make or offer to make source code available for any work derived from the OSS, if the derivate work is provided to third parties. According to certain licenses, a proprietary program that incorporates, links with, or is otherwise combined with the OSS is considered a derivative work. Lesser intrusive obligations include requirements to maintain copyright and attribution notices and legal disclaimers, provide a copy of the OSS source code and a copy of the license, among other requirements.
While some OSS licenses are straight-forward, others include nuances that may be overlooked by those without a trained eye. Involving an attorney with OSS experience and expertise can be critical to a proper assessment of OSS compliance and risks. Failing to track OSS usage and ensure compliance with applicable licensing terms could unintentionally subject seller's proprietary source code to disclosure requirements or open the door for a costly third party audit or action.
Seller's OSS policy, if any, and tracking of known OSS usage should be reviewed. If seller is a software company and does not have an OSS policy or provide a fairly extensive list of OSS used by its developers, this could signal seller is not aware of the extent to which its products use or incorporate OSS. A code scan may be appropriate in these cases to identify OSS used by seller and assess associated risks. Consideration should of course be given to whether seller's use of OSS comports with purchaser's OSS policy and practices and whether any noncompliance by seller can be remediated without unreasonable expense and delay.
7. Determine Reasonableness of Trade Secret Protections
Trade secrets are sometimes overlooked as IP assets because their continued creation and existence depend on secrecy. Trade secrets, which may include confidential technical and other business-critical information, may in fact be more significant to seller's IP portfolio than its registered and publicly disclosed IP combined. Due diligence should involve determining scope and importance of trade secrets to seller's business and whether seller has made reasonable efforts in maintaining their secrecy. The latter should include inquiry into seller's policies and practices regarding: advising employees of the existence of trade secrets, allowing access only on a "need to know basis," requiring employees and third parties to sign confidentiality agreements, controlling access to sensitive documents and computer files, allowing only invited and badged visitors to enter restricted areas within seller's facilities, and the like. Ensure that confidentiality obligations between purchaser and seller encompass their respective counsel, so as not to risk destroying trade secret protection for any information disclosed during diligence.
8. Watch Out for Assignability Clauses and IP Indemnities, Warranties, and Restrictions
All of seller's licenses, assignments, and other commercial agreements should be reviewed to assess IP risks and restrictions. For outbound licenses, unacceptable risks could include unqualified indemnity obligations for infringement claims or unqualified warranties of non-infringement. Other IP representations, warranties and indemnities granted by or to seller could be equally problematic for purchaser, depending on context. Consider whether seller has granted rights under any of its IP to any third party. If so, consider scope and term of and consideration for any such grant. Pay particular attention to any field of use or geographic restrictions imposed on seller's right to use IP. Trademark agreements should also be scrutinized to determine whether seller has engaged in uncontrolled or "naked" licensing, which could result in loss of trademark rights, e.g., where the mark is licensed for use with substantially unrelated products or in a substantially unrelated manner to the originally acquired mark. Copyrights licenses are often limited to specific uses and mediums. Use of the copyrighted work beyond the scope of the license may result in a claim of infringement by the copyright owner. Consider whether seller's software is subject to escrow arrangements, which could potentially result in a third party having access to seller's source code. All other material contracts should also be reviewed for IP implications. In addition, be on the lookout for restrictions on the assignability of IP agreements, including confidentiality agreements, and other material contracts. Such restrictions could drive or alter the manner in which the proposed deal is structured or, in some cases, lead to the deal not be consummated.
9. Dig Deep on IP Litigation Risks
Seller should have no issue disclosing any litigation actions in which it is currently or was recently involved. Sometimes seller is not yet aware of new claims brought against it or claims that were made against its predecessors. Therefore, an independent litigation search should always be conducted. A search may also reveal other past claims alleging infringement or challenging validity and/or ownership of seller's IP rights. Be sure to check patent and trademark office records for any administrative proceedings involving seller or any predecessor. Review filings made and positions taken in any judicial or administrative action to determine impact on scope of seller's IP rights. Seller's rights also may be restricted by administrative orders, judicial decisions or settlement agreements.
Any cease and desist letters sent or received by the seller should be reviewed. Ideally, any opinions of counsel obtained by seller regarding IP infringement, validity, etc. should also be reviewed and assessed for reasonableness. Consider whether a common interest agreement or other confidentiality agreement is sufficient to preserve attorney-client privilege. If not, err on the side of not receiving privileged opinions, otherwise the privilege may not be available to purchaser following closing.
10. Assess and Advise Client About Risks
IP due diligence for complex business transactions almost always uncovers certain problems with seller's IP portfolio or previously unknown IP risks. How these issues are handled is often the subject of vigorous negotiations. A first priority is to assess materiality of the identified issues to the transaction. Further investigation of materiality may result in a finding that the issue is immaterial and may be disregarded or addressed after closing. On the other hand, risk may be sufficiently material that purchaser decides to revalue the deal or perhaps not go forward with the transaction.
In many cases, IP issues uncovered during diligence are handled in the deal documents with representations, warranties, and/or indemnifications provisions. These provisions may encompass a multitude of issues including IP ownership, registration, and possible infringement. Representations and warranties may, particularly for the seller, present significant ongoing obligations and possible liability. In some cases, the parties negotiate certain liability caps and/or set-asides or hold-backs from the deal proceeds with respect to potential IP risks. These negotiations can have significant impact on the deal and therefore require involvement and clear communication from IP attorneys so that business leaders fully appreciate the nature and potential consequences of IP risks to purchaser's business. Often such contractual protections are given a limited survival period, which makes it critical to identify, assess, and advise purchaser about any IP risks before the deal is signed.
As illustrated above, many aspects of seller's IP portfolio, rights and positions must be investigated to identify and assess IP issues and risks prior to closing of any transaction. IP counsel must be aware of the many important doctrinal issues at play in each of the major areas of IP. IP counsel must not rely solely on IP disclosures provided by seller, but must conduct independent searches to identify and evaluate other available information and identify discrepancies in seller's records. For more complex transactions, the IP diligence team should include experts in each of area of IP, including patent, trademark, copyright, and open source software experts.