The bargained-for exchange of intellectual property rights forms the foundation of value in many corporate transactions. However, it is often the case that purchasers and sellers do not fully appreciate the scope of rights that are to be transferred between the parties. These misunderstandings can lead to increases or decreases in bargaining power.

While every transactional attorney has a multipage, single-spaced diligence checklist, the lion’s share of IP issues fall into three categories: chain of title, scope of present and potential future protection, and freedom to practice the business interests that are involved in the transaction. This article briefly explores the three aspects of IP diligence primarily involved in a transaction weighted with intellectual property, with particular focus on chain of title and the shift of bargaining power that IP issues create.

Chain of Title

Chain of title is the most often overlooked, or even ignored, facet of IP diligence, which is remarkable given the funding and exit problems that chain-of-title issues create for a seller, investor or purchaser. Because much information about chain of title is publicly available, and inventors and creators of IP often publicly post their own employment history online, chain-of-title issues are often used as leverage by an investor or purchaser because merely having an executed assignment may not be enough to actually secure chain of title.

For example, once the layers of a chain of title are removed, it is apparent that fact patterns like the one in Stanford v. Roche, 131 S.Ct. 2188 (2011), are quite common. In the Stanford case, the rights acquired by a third party based on a late present assignment were found superior to an earlier agreement to assign the IP rights. While a breach of contract may have occurred, the remedies for that breach typically do not include nullification of the assignment to the third party.

For a present assignment rather than for a promise to assign, it is only recently that university employment agreements have begun to change from “agrees to assign” language to the present effective “hereby does assign” language. Even then, such language may only apply to new hires. Because of costs associated with updating employment agreements, evaluating whether additional consideration will be required and, frankly, fear of upsetting faculty, most legacy employees are still subject to the “agrees to assign” language. It will be years before these legacy employees are phased out and replaced by employees subject to a present assignment. Until then, take extra care in reviewing assignment documents by also looking into the history of the parties involved in the execution of the assignment documents. With entrepreneurial university employees, it is also important to investigate other companies the creator or inventor was involved with to determine if potentially relevant assignment documents exist.

With respect to inventions developed many years ago, where the memories of who was working where, when and on what have blurred and faded, and where now such intellectual property may be part of an established company’s technology, these chain-of-title problems persist. Just because an early-round investor or an early diligence did not call out a chain-of-title problem does not mean the IP is free of defects in chain of title (for example, recordation of unexecuted assignments). Indeed, early-round investors typically do not look into chain of title because of the expense, and later-round investors sometimes do not want to look into it based on the improper belief that earlier investors would have caught the breaks in chain of title.

Most chain-of-title issues can be corrected by an exchange of money between a creator, inventor or assignor and an assignee. However, the costs of correction also typically rise with the passage of time. To avoid the classic holdout problem, it is best for a seller to investigate and address IP ownership concerns as early as possible while the value of the IP is uncertain. Thus, it is very important to ask where each creator or inventor was working at the time the IP was developed and what the assignment obligations at that time were to find, and aggressively seek to fill, any gaps in the chain of title.

From a seller’s perspective, it is also preferable to complete a detailed chain-of-title review before an investor or purchaser’s diligence occurs, because if an investor or purchaser finds a material defect in the chain of title, it may be more cost-effective for the investor or purchaser to acquire the outstanding rights or use the defect in title to diminish the value of the desired IP assets. Of course, the investor or purchaser could walk away from the transaction entirely.

Ultimately, if there are issues with chain of title, even easily correctible ones, the diligence process can become significantly delayed, and thus substantially more expensive for both the seller and the investor or purchaser, because the interested parties will invariably focus much more heavily on the scope of IP rights and freedom to practice than they might have otherwise.

Scope of Rights

From a scope-of-rights perspective, trademark rights tend to take a backseat to patent rights in technology and life science IP-weighted transactions, because the market exclusivity patents provide typically outweighs the value of a trademark. However, the value of a transaction can be substantially diminished if the IP does not encompass or apply to one or more key products or is of insufficient breadth to at least make competitors think twice about entering a market.

If there are no granted patents, having a cogent position to communicate about potential patentability and scope of rights before transactional diligence occurs is vital. If a seller has a well-reasoned analysis prepared in advance, the value of the IP in the transaction is not typically diminished, and it can even increase in value by addressing skepticism. When a patentability analysis is prepared in advance, even if a purchaser or investor presents additional art of interest during diligence, that new art typically can be woven into the fabric of the already existing position, thereby reducing its impact on the value of the transaction. Of course, if a seller does not have a well-reasoned position about the scope of exclusivity, the purchaser or investor can freely fill the void by substituting its own analysis of the art, putting the seller on the defensive and diminishing the seller’s relative bargaining position.

Where granted patents exist, many transactions have diminished in value (or worse) because during diligence a purchaser or investor discovered for the first time that a marketed product is excluded from the seller’s patent claim scope. This typically happens when the seller’s patent attorneys or agents are unfamiliar with the client’s business in general, the actual products of the company or the business goals of the company in particular, and the agents or attorneys are merely tasked by the seller to just “get patents.”

Even where defects in chain of title and scope of rights exist, these defects can typically be addressed during negotiations by adjusting compensation between the parties — namely, by either increasing or decreasing payments, holding funds in escrow until defects are corrected and the like, where each defect is a potential detriment to the seller. However, the third aspect of IP diligence is not so easily addressed.

Freedom to Practice

While chain-of-title and scope-of-protection issues can be problematic or even fatal to a transaction, a freedom-to-practice issue can trump chain-of-title and scope issues.

Here, more so than with respect to scope of protection, it is imperative to maximize value that the seller have a cogent freedom-to-practice position prepared in advance. Ideally, that position centers on non-infringement and has less of a focus on invalidity of third-party rights. Anything less and the negotiations will tilt heavily in favor of the investor or purchaser, because no one wants to invest in or buy an IP infringement lawsuit. Again, as with chain of title and scope, such costs would necessarily be figured into price negotiations and representations and warranties, to the seller’s detriment.

Even if there is a clear story of non-infringement of any valid third-party rights, it is not uncommon for an investor or purchaser to have dominant rights already or approach third-party patentholders, potentially in breach of confidentiality with the seller, to obtain an assignment of rights or options to the third-party rights. In such instances, the seller may become limited in its choice of investors or purchasers, resulting in a shift in the balance of negotiation in favor of the investor or purchaser.

Therefore, because there is almost always uncertainty as to scope of rights and validity of third-party rights until there is a final determination on the merits in a court of law (that is, a court may agree or disagree with the seller’s analysis), that uncertainty can be used by an investor or purchaser to diminish the value of a seller’s assets. To that end, a seller should have a well-reasoned position to present to an investor or purchaser concerning chain of title, scope of potential future and present rights, and freedom to practice to maximize value. A sophisticated investor or purchaser should examine each aspect to minimize the same. 

Chris Halliday is a partner in Morgan, Lewis & Bockius’ intellectual property practice, resident in the firm’s Philadelphia office.