I. Introduction. Understanding the Business Objectives

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1 Intellectual Property Due Diligence in Acquisitions Chen Wang, Deputy Chief IP Counsel, E.I. du Pont de Nemours and Company Neil Henderson, Partner, Borden Ladner Gervais LLP Marc Lampert, Student-at-Law, Borden Ladner Gervais LLP I. Introduction One of the primary goals of due diligence in an acquisition is to properly evaluate and allocate the risks involved in the transaction. Effective due diligence can provide a more detailed overview of the assets that are being acquired. The two parties to the acquisition can then negotiate responsibility for the risks. These general objectives do not change when the assets involve intellectual property. Performing due diligence on intellectual property involves evaluating the intellectual property being acquired in order to obtain a complete picture of the target company s intellectual property assets. Intellectual property can be defined in various ways but generally includes a wide array of assets, from the traditional patents, trademarks, copyrights and trade-secrets through to the more recent domain names and social media. One example definition of Intellectual Property includes: algorithms, application programming interfaces, databases, data collections, diagrams, formulae, inventions, know-how, logos, marks, methods, network configurations and architectures, processes, proprietary information, protocols, schematics, specifications, software, software code, subroutines, techniques, user interfaces, uniform resource locators, web sites, works of authorship and other forms of technology. Intellectual property rights associated with these materials and information include works of authorship which contain copyrights and integrated circuit topographies; rights to trade-marks, business names, domain names and trade names; rights to trade secrets; rights to patents and industrial designs; and other proprietary rights in intellectual property. Generally, a company exclusively owns all right, title and interest to its own intellectual property free and clear from other interests. The employees and independent contractors who were involved in the creation of the intellectual property are usually expected to sign an agreement which gives an irrevocable assignment of any of their intellectual property rights over to their employer, including a waiver of any associated moral rights. II. Understanding the Business Objectives Performing intellectual property due diligence for an acquisition requires developing a grasp of the nature and circumstances of the deal. To do so, one must understand the overall business objectives of the acquisition. Only with an understanding of the business objectives can the true scope of the due diligence be ascertained because the scope depends heavily on the purpose and size of the deal. In order to ascertain the business objective, one has to examine the main purpose for acquiring the business. That purpose may be based on the target company having certain assets of particular value, specifically, intellectual property assets such as patents, trademarks, copyrights 1

2 and industrial designs. The acquisition may be motivated by acquiring the target company s market share, entering a new market through the target company s market access, or augmenting the buyer s own technology portfolio with that of the target company. It may even be based on procuring the distinctive talents of the workforce employed by the target company. In many cases, the acquisition is driven by some combination of the above, but it is useful to allocate some weighting to each of the objectives. The scope of the due diligence will depend upon the circumstances of the acquisition, future plans for the acquired business, the importance of the intellectual property rights to the acquisition, and the time and cost that it will take to undertake the intellectual property due diligence. As such, before performing intellectual property due diligence, the nature and extent of the due diligence should be determined early on in the transaction. Unfortunately, intellectual property due diligence in acquisitions can become expensive and time consuming. There are often difficulties establishing true ownership and validity of intellectual property rights. Additionally, intellectual property rights can be protected in any number of jurisdictions and therefore far-reaching searches might be required. Accordingly, one must weigh the cost of performing extensive intellectual property due diligence against the importance of the intellectual property assets to the overall acquisition of the target company. III. Gathering Publicly Available Information Due diligence requires gathering and investigating publicly available information. In some cases, the scope of the search and information gathering should be world-wide but practical realities may require some restrictions. Gathering information should be used to identify potential issues for further investigations and to verify the warranties and representations agreed to by or expected of the target company. Information to be gathered about the target company should include consideration of all areas of intellectual property. Patents and pending applications are the exclusive rights granted by government to an inventor to manufacture, use, or sell an invention. Copyright includes the exclusive right to make copies of a literary, musical, or artistic work. Trade-marks are any name, symbol, or mark used by a company in order to distinguish their goods and associate the goods with their business. Other types of intellectual property must also be covered as needed. Information regarding domain names and social media has become very important recently. This type of intellectual property includes the names and words that form an internet address or social media identifier used to generally identify or be associated with the company in the electronic world. Social media identifiers such as user names, Facebook pages, and Twitter handles have an economic value in the modern marketplace. For example, the case of Phonedog, LLC v. Kravitz 1 involves an employee of a commercial web-site taking his Twitter handle, and its 17,000 followers, over to another company. The former employer sued claiming that the rights to the twitter account belonged to it and that the former employee should have relinquished the account and its followers. 1 PhoneDog, LLC v. Kravitz, (U.S. N.D. Cal.), online: First Amended Complaint < 2

3 Additionally, information should be gathered about the target company s involvement in any intellectual property litigation. Investigating current and past intellectual property litigation can raise questions about the veracity of the target company s intellectual property rights, reveal strengths for holes in the IP portfolio, or even just show that the target company is actively protecting its rights by pursuing infringers. Moreover, in order to get a grasp of how the intellectual property fits into the target company s overall business or into the acquiring company s intended business, information should be gathered about the company s major products and services. Information should also be obtained about the key scientists and inventors employed by the target company. These individuals can illuminate key details of the target company s intellectual property, including what intellectual property the company might develop in the future. It is not uncommon for scientists/inventors to reveal issues with the inventorship on patent applications due to incorrect inclusions or, for example, graduate students/interns that had been involved but left. In addition, to gain an understanding of the marketplace for the intellectual property, it can be important to gather information about the target company s major competitors and major customers. Prior acquisitions or mergers can be reviewed in order to gain an understanding of the company s role in earlier changes in the marketplace. As well, information regarding joint developments and participation in patent pools can illustrate the target company s current role in the marketplace as well as where its intellectual property rights might be subject to limitations. It is common for standards bodies to require inclusion of patents in a licensing body. Information should also be gathered about general intellectual property licensing activities of the target company. Licensing can show to what extent the company has diluted its intellectual property by allowing use by other entities. It may also be necessary to examine information pertaining to outside intellectual property rights belonging to third-parties. Specifically, to examine that the target company has never infringed (directly, contributorily, or by inducement), misappropriated or otherwise violated any intellectual property right of another person or company. This includes making sure that the target company has never received any notice or other communication alleging infringement, misappropriation or violation. Additionally, it may be appropriate to investigate to ensure that third-parties are not currently infringing, misappropriating, or otherwise violating the target company s intellectual property rights. If the target company has knowledge of such infringement, misappropriation or violation, and has not taken action, it could possibly hinder the strength and value of that intellectual property. The information that needs to be gathered may also depend on future plans for the acquired assets. For example, there may be a desire to export products into new geographic areas and jurisdictions. In that case, it would have to be determined if patent protection is available in these new areas or if selling into these new areas would infringe rights of third parties. In another example, there may be an aspiration to expand existing product lines. Information would have to be gathered about whether existing trade-marks on these products are covered by the existing registrations belonging to the target company. 3

4 On the copyright side, look for any contributions the target company may have made to open source software communities. It is now fairly common knowledge that incorrect handling of open source software can result in issues with rights in the software. In particular, the software itself may be forced into an open source regime. Domain names must also be examined to ensure the target company s websites are in good standing and will remain so through closing. IV. On-Site IP Due Diligence A. Documents Review Due diligence also often requires examining various matters that should be investigated on-site at the target company. An on-site examination should begin by conducting a review of the target company s documents, specifically relating to their intellectual property, with the goal of identifying any material issues. For example, the documents relating to the target company s patents, technology or joint developments can be examined. In doing so, looking out for such things as exclusive licenses, non-standard license grants, change of control clauses, and noncompete clauses. The target company s assertions related to its patents in the present and past six years should also be inspected. As well, examine any litigations or negotiations that are centered on the target company s patents. In addition, the documents review should examine whether the target company has filed its patent application under small entity status. Small entity status allows certain small businesses to file a patent application and maintain an issued patent for a 50% reduction in fees. A review of whether the small entity status was properly obtained should be conducted because a business that improperly claims small entity status may lose patent rights for conducting a fraud on the Patent Office. Additionally, if the patent has been licensed or assigned to a third-party, a review of that third-party should be conducted because it too must qualify for small entity status in order for the status to be allowed. 2 A search should be conducted of the target company s documents for signs that some of its intellectual property is burdened by encumbrances. In the documents, look for standards agreements, intellectual property pledges, liens, etc. Also look for key employee intellectual property ownership agreements. Finally, also look for agreements that have non-standard terms or carve outs that entitle an employee to the rights of a piece of intellectual property. Specific to the intellectual property of trade secrets, the documents review should determine whether the information subject to the trade secret has been kept confidential. Particularly, to determine whether the trade secret has been made available only to those individuals employed by the target company who have a need to know, or whether the trade secret has been treated in such a way that it may no longer be confidential, and therefore, no longer protectable. 3 An evaluation of the process in place to protect trade secrets should be part of due diligence USC 41(h); see also The United States Patent and Trademark Office, Manual of Patent Examining Procedure, s For example, see R.I. Crain Ltd. v. Ashton and Ashton Press Manufacturing Co., [1949] O.R. 303 at para. 19 (Ont. H.C.J.), where the court defined trade secrets with the fact that as soon as the secret is discovered, either by an examination of the product or any other honest way, the discoverer has the full right of using it. 4

5 The documents review should also examine the situation where the target company has acquired intellectual property rights from third-parties. All of the documentation that verifies that the licences or assignments were properly granted and received should be reviewed, including the complete chain of title back to the original owner. Additionally, the licence or assignment should be reviewed to ascertain its terms and conditions. Firstly, it should be reviewed in order to determine whether the target company has the right to assign in the event that the acquisition is finalized. It should also be reviewed to ensure that the license does not impose unanticipated obligations post-closing. It may even be advisable to approach the original owner of the intellectual property, at the appropriate time in the transaction, and put in place arrangements to ensure continuation of the licensed rights. B. Process Review On-site due diligence should also include completing process reviews. The objective of these reviews is to identify material gaps in the existing processes and practices. For example, reviews to identify gaps in the invention process, including the invention identification process, invention evaluation process, the list of disclosed inventions, and invention reports for the last twelve months. Other processes that can be examined for gaps are the patent portfolio management process, product development process, intellectual property clearance process, trade secret protection system, employee intellectual property education and certification, and intellectual property access control. C. Products Review Additionally, on-site due diligence should incorporate a review of the target company s products. A product review should be used to identify material intellectual property issues present in the products of the target company. In order to accomplish a product review, one should identify all products in production and under development, identify all critical products in production and development, and identify third party components used in the critical products. An evaluation of the coverage of patent claims relative to the products should be performed to determine the scope of protection surrounding the products themselves. Moreover, it would be prudent to examine all third party software in order to identify such software, review the related licenses, and identify licenses with problematic provisions. Additionally, the product review should consistent of examining whether any research and development work in progress by the target company has been disclosed publicly. If that research and development work could lead to a patentable product, the publicly disclosed pieces of information could ultimately limit or prohibit the ability to obtain a patent. 4 D. Employee Interviews 4 For example, see Martinray Industries Ltd. v. Fabricants National Dagendor Manufacturing Ltd. (1991), 41 C.P.R. (3d) 1 at para 58 (Fed. T.D.), where the court stated that prior public knowledge or sale of the invention constitutes prior publication, and therefore, unpatentability. 5

6 On-site due diligence can also include employee interviews. The objective of these interviews is to uncover potential intellectual property issues relating to intellectual property ownership, contamination, and development processes. The interviews may also be used to confirm whether processes in place are running well or have practical issues. Look to interview key research scientists, key developers for critical products that are in the market or under development, long-term employees, and newer employees. Where the intellectual property due diligence includes know-how or trade secrets, problems related to divulging confidential information may be encountered. The employees at the target company may be reluctant to provide comprehensive information if there is a chance that the acquisition may not be finalized. This can be addressed by using confidentiality and nondisclosure agreements. Another option is to explore whether the target company would allow such interview to be conducted by buyer s outside counsel, with the promise that such outside counsel would not share details of the interview with buyer, but just the assessment. On top of that, the target company may request an agreement that the buyer not engage in similar business activity for a certain period of time if the acquisition does not finalize. However, these types of agreements should be signed cautiously because the buyer may be precluded from using disclosed confidential information even though the buyer might have otherwise developed it independently. V. Intellectual Property Risks List Fourthly, due diligence should result in an intellectual property risks list that will identify and rank all major intellectual property risks in order of priority. The priorities should be categorized such that the extent of work which will need to be undertaken in order remedy any identified problems can be easily understood. In this way, the overarching decision of whether or not to go through with the acquisition, or more specifically, whether the benefits of the acquisition outweigh the potential risks, is presented in a functional and utilizable manner. As an example, a first category of risk may include intellectual property risks that are deemed unacceptable. These are risks that would frustrate the main purpose of the acquisition with no reasonable near-term solutions. These risks are colloquially referred to as deal killers. The second category is intellectual property risks that are significant. These are risks that would require significant resources to be addressed before or after the acquisition in order to remedy to the identified problem. The final category is manageable risks. Manageable risks can be addressed after the acquisition without having to commit significant resources. The second and third category of risks may also be addressed by reducing the purchase price of the acquisition or increasing the escrow amount until such time such risks are addressed to the satisfaction of the buyer post-closing. Examples of items that can be placed on a risk list include problems over intellectual property ownership, contamination, excessive agreements with no limitation of liability, non-compete clauses, change of control provisions in license agreements, intellectual property asset escrow provisions, and critical dependency. VI. Intellectual Property Remedial Plan Fifth and finally, due diligence should encompass an intellectual property remedial plan. The objective of this type of plan is to manage each unacceptable or significant intellectual property risk that has been identified on the intellectual property risks list. Overall, a remedial 6

7 plan can play a large role in assisting the important decision on whether to proceed with an acquisition or to terminate it. As an example of a remedial plan, take the situation where no standard intellectual property ownership agreements exist between the target company and its key employees. A remedial plan will call for intellectual property ownership agreements to be signed by all key employees prior to signing of the acquisition documents. In another example of a remedial plan, take the situation where third party software is integrated in the products of the target company without the necessary third part licences. A remedial plan will suggest obtaining the necessary licences prior to acquisition, or having the target company commit to accept the risk and replace the software after the acquisition. VII. Conclusion Intellectual property due diligence allows the undertaking of an independent investigation of the representations and warranties that are made by the target company. Where intellectual property rights form a significant portion of the assets being acquired in the acquisition, taking heed of the aspects of due diligence that are distinctive to intellectual property becomes even more important. Therefore, understanding the aspects of a proper intellectual property due diligence can be a vital factor in ensuring that the acquisition is appropriate and, if so, that the acquisition runs as effectively and efficiently as possible. 7