United States: Assessing A Company's Most Valuable Assets: Conducting An Intellectual Property Audit

When An Intellectual Property Audit Is Needed

The term intellectual property includes patents (including design registrations in certain foreign jurisdictions), trademarks, copyrights and trade secrets. These intangible assets come to the forefront, and the need for an audit of intellectual property arises under many circumstances.

Acquisitions

The most common circumstance is the purchase or sale of a business or company. In the case of a share or stock purchase, the buyer is purchasing some or all of the shares of a company (the "target company") which directly, or though wholly owned subsidiaries, is the owner of the intellectual property.

Due diligence or an audit¹ is also required in an asset purchase, when among the assets being purchase is intellectual property. Here, the audit not only confirms the status of the material intellectual property, but must also identify all the intellectual property involved in the transaction, so the all assets intended to be included will be transferred.

Public Offerings

In the case of a public offering, an audit may be necessary in order to be able to advise the client as to what representations and warranties the company can make in the offering statement concerning its intellectual property, particularly when such assets play a significant role in the desirability and/or value of the stock.

Financing

More and more frequently, intellectual property is serving as part of the collateral for financing. This can arise when the company which owns the intellectual property is seeking a loan or a factoring relationship. It can also arise when a lender is putting up a significant portion of the money for the stock or asset purchase of the target company.

Miscellaneous

Other times when an audit may be beneficial is when a "snap-shot" of a closely-held company's intellectual property is needed for review by a potential investor.

In-house counsel may wish to confirm that the company's intellectual property is in order, such as after austerity measures may have forced cut-backs in the company's intellectual property maintenance program, or if in-house counsel has just joined the company.

Intellectual Property Are Valuable Assets Which May Affect The Terms Of A Transaction

The various types of intellectual property are important assets, but they are frequently misunderstood by the corporate, tax and finance lawyers, making a properly done intellectual property audit or due diligence crucial in many situations. Intellectual property (or licenses to use intellectual property) may, in fact, be one of a company's most valuable assets. This is frequently the case with companies involved in technology or the new media, whose economic heart is often its copyrights, patents and trade secrets. Intellectual property is also central to any consumer products company, whose trademarks are the residuary of the company's goodwill. But virtually every company has important intellectual property, often taken for granted until a sale, public offering or financing.

The validity and enforceability of intellectual property may effect the purchase price for the target company or its assets; and may even effect a potential purchaser's decision of whether or not to buy the target company. These factors may also effect the price of the stock being offered. They can effect the terms of a loan (or if it will be made), and whether a lender will rely on the intellectual property as the principal collateral for the loan or seek other collateral.

Therefore, if charged with doing such an audit, the lawyer will need to ascertain:

1. the validity and enforceability of the intellectual property (both in the United States and in markets important to the client)
2. the validity and assignability of licenses to use the intellectual property (whether the target company is licensor or licensee)
3. the strength or scope of the rights in the intellectual property -- both for the goods or services for which they are currently being used and for areas of potential expansion.

Focusing The Audit

Before the audit is begun, it is essential that it be focused, so that the client has the information necessary to make informed business decisions. On the other hand, a "perfect" investigation could well involve costs to the client far in excess of the value of the answers.

Limitations On A Audit

Remember, an audit is always limited by time and money.

Time -- how much time the intellectual property lawyer has for due diligence or to conduct an audit depends on when the client, and/or the corporate and tax lawyers realize that the intellectual property is an essential asset in the deal.

The time needed for due diligence is typically underestimated, particularly for global transactions. Additionally, the earlier in the transaction the intellectual property lawyer is involved, the more complete the results and the more useful the information is to the client. For example, it would be better for the client to know about a problem with an important mark before the final price is negotiated.

Money -- a major part of the cost of an audit is comprised of disbursements for searches, U.S. and other countries. The more countries and the greater the number of marks, patents and/or copyrights involved, the greater the expense.

As with all due diligence, intellectual property due diligence is also very paralegal and/or young associate intensive. However, it is ultimately only an experienced intellectual property lawyer who can understand the ramifications of the diverse information which will be amassed, and have the experience to determine what must be done, and what can be left undone in order to save money.

What The Client Needs To Tell The Intellectual Property Lawyer

Without critical input from the client, an audit can flounder. It is essential that the lawyer in charge of the audit understand both the underlying deal, and the client's short and longer term goals. This will enable the searches, examinations and investigation to be tailored to what really interests the client.

For example, in order to uncover all necessary information, yet avoid unnecessary expense, the intellectual property lawyer should know which countries are most important to the target company's current business and which markets are important to the client for future expansion plans.

The lawyer doing the audit needs to know:

Trademarks

What is the client's intended use of the target company's trademarks?

If more than one mark is involved, which of the marks are important, and which are secondary?

Does the client plan on expanding the use of the mark(s) to goods not covered by current registrations and pending applications?

Does the client have plans to use the mark(s) in new countries, where they had not previously been registered or used?

Is the client planning to use the mark(s) in conjunction with another trademark, such as its own brand or house name?

Patents And Trade Secrets

Is there particular technology which is material to the business of the target company as it is currently conducted?

Is there any particular technology which is material to the client's future plans for the target company?

Which technology is subject to patents or patent applications, and are those filing in the markets material to the client?

Which of the material technology is claimed to be a trade secrets?

Copyrights

What copyrightable works are material to the business of the target company as currently conducted or the client's future plans?

Remember -- copyrightable subject matter includes such diverse kinds of works as computer databases and software, films, music, advertising materials, packaging, instruction manuals and even business letters.

Even when auditing a non-technology, or non-media company, there may be particular software or database copyrights which are crucial to the running of the company, such as an inventory control system.

What Due Diligence Should Include

Following is a discussion of what would be included in a full-blown -- you have all the time in the world and cost is no object -- due diligence of a target company's intellectual property. This type of audit is almost never done, because there are always limits on both time and money.

Initial Investigation From The Target Company's Files

While the schedules of the intellectual property involved in a transaction are not usually finalized until just prior to closing, it is essential that the seller be obligated to prepare draft schedules as early as possible. These draft schedules are one of the best starting points for the audit. And the inability to easily provide such schedules is an early warning signal that the target company's intellectual property may not have been well maintained.

Initially determine from the target company (or from the draft schedules) what trademarks, patents and copyrights it has registered (or for which it has pending applications) throughout the world.

Examine the current status and prosecution history of each such registration and pending application. When reviewing the files at the target company or its outside intellectual property counsel, include those for abandoned applications and contested proceedings -- which often provides clues to problems.

Trademarks

Determine what trademarks the target company is actually using -- which may or may not be the same as what is registered. This may require speaking with knowledgeable business people. Another good source for this type of information are company brochures and sales materials.

Trade Secrets

If trade secrets are material, the intellectual property lawyer must ascertain what procedures the target company has in place to protect those trade secrets, and determine whether those procedures are adequate and being followed. This often requires review of employee agreements, internal security arrangements and contracts with third party vendors, independent contractors and joint venturers.

Patents

In addition to reviewing a copy of each patent, reissue patent and reexamination certificate, the intellectual property lawyer should review the prosecution history of each patent and patent application. Confirm that maintenance fees have been paid and that the original patent certificates are in the target company's possession.

For a target company which does its own research and development, it is not enough to review its patent docket, however. The intellectual property lawyer must ascertain what procedures the target company has in place (and if they are they followed) to become aware of and protect -- for the benefit of the company -- patentable inventions produced by its employees and independent contractors. This would include a review of employment or inventor agreements, as well as office procedure manuals.

Copyrights

Copyright presents unique issues for due diligence. An initial question which must be asked is how has the company gained its rights in the copyrights which are material. Rights under copyright can be obtained when the work was created by a regular employee, acting in the usual course of his or her employment. They can be obtained by assignment, exclusive or non-exclusive license, or under independent contractor work-for-hire agreements.

Often a company may believe it owns, for example, a specially created software package, because it paid a consultant a substantial sum for its creation. However, unless the contract with the consultant so provides (by assignment or exclusive license), it may merely have a non-exclusive license to use the software, with no right to internally update the software (or hire another programmer to do so).

In auditing copyright rights, therefore, a careful review of the target companies contracts are often required.

Licensed Intellectual Property Rights

Among a target company's most valuable intellectual property may be licenses to use third party intellectual property (or the right to royalty income from licensing its own intellectual property to others). The initial investigation should be to determine which intellectual property is subject to licenses. This can be done by reviewing the target company's contracts, which are usually required to be identified in a schedule.

Next, the intellectual property lawyer must determine if the rights under the license will be affected by the proposed transaction. Often intellectual property licenses are not assignable without consent of the licensor. Most transactions require the seller to obtain all necessary consents.

One of the benefits of structuring an acquisition as a stock purchase is to avoid the necessity of requesting consent -- particularly if there are numerous consents which would be required (such as a publishing company with hundreds of author/publisher agreements). Often a licensor will use the request for consent as an opportunity to extract more from the licensee, or to terminate the license.

Be aware, however, that a stock purchase may not avoid the need for licensor consent -- if the license provides for consent in the case of a "change of control." This type of provision is not that uncommon in trademark licenses for fashion designer marks, for example.

Because of the nature of trademarks, it is particularly important to thoroughly examine agreements with third parties which relate to the marks.

All license agreements should be reviewed (whether the target company is licensee or licensor, including those between parents and subsidiaries and between sister companies). All too frequently, there are no intra-company license agreements in place, although the intellectual property is owned by a holding company and the intellectual property is used by one or more related operating companies. Without a license, an argument can be made that the mark was used by the licensee without quality control, which could have the effect of invalidating the mark. I believe this result is unlikely in the United States (where quality control is presumed with common ownership). However, having a written license agreement on file may be required in other jurisdictions; for example, so that the use by the operating company will satisfy the use requirements to maintain the registration.

It is also important to confirm that all necessary registered user agreements and licensing agreements have been recorded as is required under local law. Registered user agreements must be filed in some jurisdictions such as Australia. With recent changes in their laws, it is no longer required in Canada and the U.K. In Korea and a number of other countries, particularly in South America, license agreement should be recorded.

Infringement Claims

It is essential to know whether the target company has made any claims of infringement against any third party or if any third party has made any claims against the company regarding the use of any of the target company's intellectual property.

Examine litigation and contested proceedings files. Did any of these proceedings result in settlement agreements? What limitations do these agreements impose on the rights to use the intellectual property or the client's future plans.

Also review any consent to register or use agreements involving the marks. What limitations do they impose on current uses, or the client's future plans.

Searching Of Publicly Available Records

To confirm the information received from counsel for the target company and the accuracy of its files, the intellectual property lawyer will have to order and review trademark searches, patent searches, and for material patents, conduct validity and/or non-infringement studies.

The public research materials for trademarks and patents is quite extensive today. The records of the U.S. Patent and Trademark Office ("USPTO) can be searched on-line (through Dialog) and are also available on cd-roms. Trademark and patent records of other countries are also available on-line, including Canada, U.K., France, Germany and Benelux.

Particularly in a transaction for only part of the assets of a business (and therefore, only some of the trademarks), an owner search may locate marks which are closely related (the client would think infringing), which needs to be included in the assets transferred, or copyright registrations forgotten by the target company.

A search may also have to be conducted by registration / application number if the owner search hadn't located all the trademarks and patents that the target company believes it owns. Such search may give you more company names to search.

Often a target company's material trademarks are unregistered. For such unregistered / common law marks, in the United States, conduct an availability search to determine if the mark can be used and registered.

For material trademarks, even if the subject of a U.S. registration, a full search (which includes, federal and state registration records and common law and trade name uses), by mark will offer the first indication of the strength of the mark and if there are any third party problems -- or breaks in the chain of title. The search will indicate whether other similar trademarks are registered, enabling the intellectual property lawyer to advise on the strength and scope of protection of the trademark.

A full search will also enable the intellectual property lawyer to advise the client whether the use of the mark can be expanded to new goods or services which are not the subject of existing registrations. Such full searches can be order from CCH Trademark Research Corporation, Thomson & Thomson, or from Coresearch.

In some circumstances, a search of the trademarks owned by major competitor(s), to determine the strength and scope of protection of the target company's marks, may be advisable.

Search the USPTO records for pending oppositions or cancellation actions filed by the target company or by third parties against the target company. Have local associates do the same in other jurisdictions.

Order and review the file wrappers or prosecution history in the USPTO records for important marks or patents, or if the target company's records are poor.

To get a global overview of a target company's major trademarks, order a Thomson & Thomson WISS search.

Know The Limitations Of Searches

Searches will not reveal pending U.S. patent applications, which are confidential. They may not reveal recently filed trademark applications, expired or cancelled registrations, registrations on record under a different corporate name, especially if assignments have not been recorded.

Compare registrations with how the target company actually uses the marks. Just because a mark is registered does not necessarily mean it is valid. A U.S. registration is vulnerable to cancellation for non-use after 3 years, and cannot be renewed without proof of use. Non-U.S registrations may also be vulnerable to cancellation for non-use and may not be able to be renewed without use.

It may also be advisable to conduct and review NEXIS searches. The NEXIS searches may reveal what competitors are doing, how the trademarks are used in the trade (including potential genericism problems), and the possible existence of agreements with third parties.

Outside The United States

For important markets outside the United States, the intellectual property lawyer should contact his or her own local associates and have them check records in the local Patent and Trademark Office.

Items of particular concern include whether the marks are registered by licensees or local distributors, rather than the target company, or whether the marks are registered or used by unrelated third parties (making a mark unavailable in a country of interest) and whether periodic maintenance fees have been paid.

Confirm with the associate that the way the deal is being structured will not effect the validity of the marks. E.g., there are still a few countries which do not allow holding companies to own trademarks. The local lawyer or agent can then give his or her opinion on problems found in the files or records.

For unimportant or secondary marks and patents and/or in secondary markets, the intellectual property lawyer may limit his or her investigation to the target company's (or its outside intellectual property counsel's) files, understanding that problems may have to be cleaned up post-closing. The most common problem is a break in the chain of title, when an earlier assignment or change of name had not been recorded.

Security Interests In Intellectual Property

Intellectual property frequently serves as collateral for a loan, particularly in the United States, but in other countries as well. Because of this, a purchaser or lender wants to be sure than there are no existing liens (or none that won't be satisfied at closing). All liens should be cleared prior to or at closing.

Trademarks And Trade Secrets

The Uniform Commercial Code provides that to perfect a security interest in general intangibles (such as trademarks), the security interest must be filed in the Secretary of State's Office where the debtor is located. UCC Article 9.

Consequently, you must see a copy of the UCC-1 searches done by corporate counsel (or do your own if they are not otherwise being done). These must include:

A search of the Secretary of State's Offices for those states in which the target company (or its subsidiaries which own marks) is located. In certain states, such as New York, county clerks' offices may also have to be searched.

You also need to search the state of incorporation of the target company (and subsidiaries which own marks).

Beware of liens against "general intangibles," even if they do not specifically mention that trademarks are included, as trademarks, trade secrets and know-how, are general intangibles under the UCC. (Patents and copyrights are also general intangibles, but see below.)

Also be aware of liens against "after acquired" intellectual property. It is quite common for security agreements (and the financing statements) to list not only currently existing trademarks as collateral, but include future or after acquired collateral of a like kind.

No case holds that a security interests in trademark registrations and applications must be recorded in the USPTO to perfect the lien. However, the USPTO will now accept security interests in registrations and applications for recording. (A wise secured transactions lawyer, however, will always add this "belt" to his or her UCC-1 "suspenders" with regard to trademarks, and reference patents and patent applications and copyrights in the UCC-1 financing statement in addition to filing in the USPTO and the Copyright Office.) Additionally, recording such a lien (which is a conditional assignment) is also constructive notice to subsequent purchasers for value, if recorded as per the respective statutes. (Trademarks, 15 U.S.C. § 1060, patents 32 U.S.C. § 261, copyrights 17 U.S.C. § 205.)

Therefore, even for trademarks, the USPTO records must be searched. Initial searches can be done on-line. However, a search at the USPTO in Washington itself should be done right before the closing, as the database of the departments which record patent and trademark assignments are not up-to-date.

Security interests in intellectual property such as trademarks can now be filed in a number of countries (such as Japan, U.K., France). Other jurisdictions such as Hong Kong and China due not recognize security interests in trademarks. A good local associate should be able to locate existing liens, as well as assist in preparing lien documents in proper form for filing locally.

Copyrights And Patents

Copyrights are also general intangibles. However, a decision in California, In re Peregrine Entertainment Ltd., 116 B.R. 194 (C.D. Cal. 1990), held that a security interest in copyrights or rights under copyright must be recorded in the Copyright Office to perfect the lien. No case has taken a contrary position. Under the reasoning of In re Peregrine, the perfection of security interests in mask works must be filed in the Copyright Office, as well. In re Peregrine also holds in dicta that a security interests in patents and patent applications must be records in the USPTO, although earlier cases had not so held.

Under the belt and suspenders theory, however, a lien on copyrights, mask works and patents should be included in the UCC financing statement.