The trappings of M&As

US

Carey C Jordan

McDermott Will & Emery's Carey C Jordan highlights the top five IP traps to look out for in M&A transactions  

In M&A deals, most corporate lawyers assume that IP rights will automatically transfer with the purchased assets and that any and all IP issues can be cured by general representation/warranties. While strong reps/warranties are useful, falling back on these as the only remedy can doom the deal to failure and relegate future business plans to the rubbish bin. If the IP rights to be acquired provide any sort of value to the ultimate deal, then those rights must be investigated and understood, as they can often lead to a re-evaluation or change in the structure or pricing of the transaction.

A deal that exemplifies the potential power of an IP issue gone awry is the Volkswagen-Rolls Royce acquisition deal. In 1998, Volkswagen outbid BMW to buy the Rolls-Royce and Bentley trademarks and their British factory from Vickers PLC for $917m.  But an odd twist in the deal allowed the Rolls-Royce aerospace company that really owned the trademark to sell rights to the Rolls-Royce trademark to BMW out from under Volkswagen for $78m. Thus, after the deal closed, even though Volkswagen had all of the hard assets to make a Rolls-Royce, Volkswagen did not have the rights to use the Rolls-Royce mark and could not call any car it made a Rolls-Royce. Only after a separate deal was made with BMW (costing Volkswagen more millions and millions of dollars,) did Volkswagen gain the ability to manufacture a Rolls-Royce car and call it a Rolls-Royce, albeit for only a limited period of time. This all may have been due to a failure to appreciate that the Rolls-Royce aerospace company ultimately controlled the trademark rights and that because of that ownership distinction, the trademark would not "come along with" the hard assets from the car division.   

The lesson to be learned from this story is clear. Do not assume that the IP rights will necessary flow with the hard assets. To that end, IP due diligence in an M&A transaction should never be overlooked.  The following are a few of the top IP issues that can impact the value of an M&A transaction. Each of these should be explored before a deal closes so that risk can be assessed and properly accounted for in the transaction. 

Target does not actually have the critical

patent rights

Often, a target will not own the IP rights it claims to have. This may be due to a failure to update the title through corporate name changes or security lien releases ¹, or failure to ensure that employees have assigned to the target their rights to IP assets developed with company resources. This latter situation can be particularly problematic. For example, US law provides that each joint inventor owns a patent as a joint tenancy arrangement in the absence of an agreement to the contrary, which means that each owner has the right to use and to license the technology covered by the patent to a third party without accounting to the other owner. Thus, a non-assigning employee can license to a key competitor of the buyer (and even keep the royalties) without notifying the target. The problem can be more acute in the case of an independent contractor, who usually does not have an obligation to assign rights to the target, as few contractor agreements provide for IP ownership rights. 

In complex corporate arrangements, agreements between related entities may be problematic. As shown in the Volkswagen/Rolls-Royce example above, the IP rights may be owned by a related entity that will not transfer the IP right to the newly formed entity once the deal is completed, at least without additional compensation.

Thus, it is critical to make sure that the target owns what it says it owns, and that the rights are transferrable to the newly formed entity.  More often than not, the target owns significantly less than the buyer anticipates. One should be mindful that there are usually no good surprises with respect to this issue, ie, it is not the case that the target will own more than its representations proffer. 

Prior agreements limit IP rights

Sometimes, the target's IP rights may be subject to prior agreements that restrict their use in other products, geographical areas, or specific fields of use.

For example, when the Clorox Company, one of the largest producers of cleaning products in the world, purchased the Pine Sol business and trademark from American Cyanamid in 1990, Clorox planned to leverage the strength of the Pine Sol mark into other products. Pine Sol is a well-known and best-selling pine-oil cleaner. The Pine Sol mark has been used since 1945, and possibly as early as 1929. Possibly unbeknownst to Clorox, Clorox purchased the Pine Sol assets and mark subject to a prior 1987 agreement that Cyanamid had entered into with the owner of the Lysol trademark, to settle a long-standing trademark dispute between the two companies regarding the use of the Pine Sol mark. That prior agreement restricted Cyanamid (and subsequently Clorox) from expanding the use of the mark beyond the well-known Pine Sol pine cleaner. Clorox tried to void the terms of the settlement agreement through litigation in the US, but was unsuccessful. Thus, Clorox took the mark subject to the restrictions in the agreement, which effectively prevented Clorox from expanding the Pine Sol mark into new products, as perhaps envisioned when closing the acquisition deal.

Another problem occurs when the target has already licensed some or all of the IP rights to another party.  For instance, if the target granted a third party an exclusive licence in a key field of use, to a territory, or to a patent, at least under US law, the buyer will take those rights subject to this exclusive licence. The exclusivity of the pre-existing licence will either prevent the buyer from practicing the licensed technology or, at best, let the buyer take the IP rights subject to a potentially significant exclusive competitor. 

Additionally, if the US government has provided any funding for the development of the patents, the US government may retain certain rights to use the relevant patents and technology. Any subsequent grants will remain subject to those retained rights.  Any purchaser must understand if the US government retains any residual rights.

Significant barriers exist to exploitation of the technology

Third parties may have patents that will prevent the buyer from exploiting the technology or expanding the business. The buyer's freedom to operate must be analysed before completing the transaction to make sure that the buyer will be able to use the assets purchased as intended. If blocking IP is identified, and a meaningful design-around is not possible, then it may be necessary to license or acquire ancillary rights to the blocking IP or, alternatively, to invalidate the blocking IP at a relevant patent office or in a court.

Of course, this still leaves the unknown barriers to exploitation of technology.  Included in this category are issues such as unpublished patent rights that could block a buyer, misappropriation of technology, reverse engineering ² by competitors who have then patented improvements to a target's trade secrets, or even competitors who independently discover trade secrets and patent them, and the like. 

Target is subject to pending/threatened infringement claims

What a buyer does not want to do is buy an expensive lawsuit through an acquisition, and unfortunately, this happens frequently.  At least one reason for this, is that the newly formed entity or the buyer appears to be a deeper pocket for litigation purposes as a larger judgment could be enforced. The buyer might also present more significant competitive threat to competitors in the marketplace, thus attracting potential lawsuits designed to reduce the competitive threat.  Because of this "risk of lawsuit attractiveness", any potential litigation risks must be assessed and independently analysed, and any potential indemnifications that may be applicable must be evaluated to determine their enforceability.  These risks can be identified through the target's legal opinions, cease-and-desist letters, freedom to operate studies, licence agreements, joint development agreements, and the like.

By way of example, in a recent acquisition deal, a target had three opinions of counsel stating there was no infringement risk with respect to three key patents owned by a primary competitor. The buyer evaluated these opinions of counsel and the risks independently, and disagreed with the opinions of counsel, finding significant infringement and risks of suit existed. Viewing the deal as too risky, the buyer allowed the deal to die. Six months later, the target was indeed sued for patent infringement by the competitor, consequently validating the buyer's decision to walk away. 

Target's IP rights are encumbered by liens

IP assets may be encumbered by liens. To determine if liens have been filed on relevant US IP rights, keep in mind that to record and perfect a lien against both patents and trademarks in the US, Uniform Commercial Code (UCC) filings ³ need to be made. Although not legally required, most lenders also record the security agreement in the US Patent and Trademark Office to further evidence the lien. Under US copyright law, however, only a lien recorded in the Copyright Office will perfect a security interest in copyrights; a UCC filing will not

be sufficient.

In sum, IP due diligence in M&A transactions is important because the under appreciation or complete ignorance of an IP issue can undermine the entire deal as it did in the above examples. Fully appreciating these issues can lead to a re-evaluation or change in the structure of the transaction. Thus, in-house counsel should make sure that the due diligence process includes inquiries appropriate to solicit information to enable the buyer to adequately evaluate and make decisions with respect to these issues. In-house counsel should also consult with an IP lawyer on every deal (ideally before the last minute before closing as so often happens,) to make sure that any potential IP issues have been explored to the extent necessary to determine whether a problem exists. 

IP due diligence should always be a component of an M&A due diligence project. Mindfulness of due diligence dollars should not prevent this investigation as the proportionate share of the due diligence budget can be allocated in view of the value of the technology to the deal and the potential exposure to the acquiring company. A small investment in due diligence can save a great deal of effort and money down the road to undo a potential problem that could have been handled in the structure of the transaction.

Footnotes

1. 

A lien is a form of security interest granted over an item of property to secure payment of debt.

2. 

The art of taking something apart to determine how it works or how it was made or manufactured.

3. 

The code is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonise the law of sales and other commercial transactions in all 50 states within the US.

Bio:

Carey C Jordan is a partner at McDermott Will & Emery. Carey focuses her practice on patent prosecution, transactions and strategic portfolio management in the chemical, energy and alternative energy sectors. She regularly advises clients in the acquisition and sale of IP assets to manage risks and maximise value.