Key issues in IP due diligence – practical considerations for Japanese companies

In our IP/TMT newsletter of July 2011, we highlighted the increasing trend of outbound M&A and outlined some of the key intellectual property ("IP") issues for Japanese companies in M&A transactions. Figures have recently been released showing that Japan's foreign direct investment exceeded 10 trillion yen for the first time in three years in fiscal 2011.¹

One of the issues we raised in our July newsletter was IP due diligence, which is the process of identifying and verifying the IP assets and liabilities to be sold and acquired in the transaction. In this newsletter we expand on this topic and discuss practical considerations that should be taken into account by Japanese companies in this critical phase of an acquisition.  

Why is IP due diligence important?

It is undoubtedly difficult to identify and quantify intangible rights; however, it is equally certain that such rights are an important, and sometimes critical, part of an acquisition. It will virtually never be the case that a target company does not own or use any intellectual property; at most, IP assets merely may not be immediately apparent. A failure to consider and include IP assets in a deal can be catastrophic: the inability of a business to continue using a trade name post-sale is an obvious example, as is the possibility of an infringement claim by a third party that could imperil continued production and give rise to a damages claim. However, recent cases have also highlighted other issues in relation to goodwill built up through social media, such as the value and the extent of a company's rights concerning an employee's company-issued Twitter account and its followers.2  

IP due diligence allows an acquirer to identify material IP rights (see further below) attaching to the target, and to give them proper treatment in the transaction. It can also bring to light any risks that could affect the value of the target. Risks can then be assessed and categorised into minor, significant and critical risks – the latter two carrying the possibility of jeopardising the deal – and an appropriate remedial plan prepared. The process also supports public statements that may have to be made, such as in offering circulars.  

A purchaser who does not receive satisfactory information from the seller as part of an IP due diligence exercise will often demand, and is usually entitled to, suitable warranties from the seller to cover the gaps in information. The due diligence process also allows a seller to know what warranties it can and cannot sensibly and reasonably give.  

The key aspects of IP due diligence

IP due diligence is a specialised subset of the general due diligence process. In a typical acquisition transaction, this occurs after the execution of a non-disclosure agreement, the structuring of the deal and the signing of a memorandum of understanding. It precedes and informs the drafting of the sale and purchase agreement. The process normally commences with the drafting of a due diligence questionnaire by the legal advisors. This is a very important stage and is discussed in further detail below.

After this step, the results are collated and indexed, with careful regard paid to confidentiality issues. A data room may be set up, either physically or virtually, following which both sides duly review the material produced. The legal advisors will prepare a due diligence report that advises the client (seller or purchaser) about the issues that have arisen, the potential risks and the suggested remedies, such as the necessity for warranties and indemnities. The information produced may give rise to further questions for the parties to address.  

Practical considerations when conducting IP due diligence

1. Role and use of due diligence questionnaire

The due diligence questionnaire is not a one-size-fits all document. Each transaction differs in nature and scope. An experienced legal advisor can advise on the level of detail needed in the questionnaire in the light of the nature and complexity of the transaction, or the value and importance of the IP. It is also not unusual for an advisor to identify IP rights of which the target may not be aware, such as unregistered rights, or unconsidered risks such as the inability simply to transfer software package licences.  

2. Major rights

In addition to unregistered rights, such as unregistered trade marks and designs, and computer software licences, the following are the other major IP rights that should be considered when assessing a target:

• registered trade marks;
• registered designs;
• patents;
• copyright;
• database rights;
• business know-how and confidential information;
• utility rights (also known as "short term patents" in certain jurisdictions, utility rights are a statutory monopoly to protect inventions, and are granted in Japan for a period of 10-15 years); and
• specialist rights, such as plant breeders' rights or semiconductor topography rights.  

3. Materiality

The concept of "materiality" is used to limit what can otherwise appear to be never-ending process. If both sides of a transaction can agree on a definition of the IP rights that are material to the target's business (and those which are not), the due diligence process can be limited to such material rights, leading to time and cost savings. There is no standard definition of materiality. We have seen assessments of materiality by reference to:

• the percentage of turnover or profits associated with the IP right;
• the association of the right to key products/services; and
• the extent to which the IP right can be replaced through purchase on the market.  

4. Foreign jurisdictions

IP rights are national rights. Even in the European Union, there can be marked differences between the civil code and common law approaches. Japanese companies conducting IP due diligence in multiple jurisdictions often sensibly favour a coordinated approach, whereby a single set of international lawyers procure and coordinate the provision of expert advice by local lawyers in each jurisdiction, avoiding duplication of effort and saving costs.

5. Confidentiality

The seller may be asked to provide documents to the purchaser containing confidentiality provisions, such as its contracts with third parties. In such circumstances, it will usually be advisable to obtain the third party's consent before the document is provided to the purchaser. Alternatively, depending on the situation, there may be practical solutions such as restricting disclosure to the parties' legal advisors only.  

If any litigation is on-going or threatened against the target, care should be taken to avoid losing privilege in respect of relevant documents. In the UK, documents created in contemplation of litigation and for the purposes of obtaining legal advice may be privileged, which allows a party to litigation to refrain from providing them to the party it is suing or being sued by. However, such privilege can be lost if copies are provided to the other side in an acquisition. As such, this process needs to be carefully managed.

On what key issues should IP due diligence focus?

Some examples of important issues to be considered in IP due diligence are as follows.

1. Have you identified all material IP rights associated with the target?

When considering the IP rights of the target, it is important to consider IP associated with products under development, as well as those in production. Another very important step is to investigate whether the IP rights are valid, and are owned by or correctly licensed to the target. Is the target in fact infringing any third party IP rights? Any liens or mortgages affecting IP assets should also be considered.

2. Will licences be adversely affected by the change of control of the target?

It is extremely important to review the target's licence agreements to ascertain whether they contain any "change of control" provisions. Such provisions can give the contractual counterparty the right to receive payment or even terminate the agreement where there is a change of ownership or management of the target. The trigger differs depending on the agreement, but can include events such as a sale of more than 50% of the target's shares, a sale of a percentage of assets, or a change in the majority of the board. Where an unfavourable change of control clause exists, the purchaser will likely require that in the transaction documents the seller (a) covenants to renew such licences or obtain the relevant consents, (b) gives a representation that no material damage will be caused by the provision, and/or (c) indemnifies the purchaser in respect of any infringement damages.  

3. Is the target involved in or threatened with IP litigation?

In these circumstances, the status of the dispute and the sales volumes potentially affected by the dispute should be clearly determined. This allows the purchaser and its legal advisors to conduct a risk analysis of each dispute and make relevant provisions. The transaction documents might set out which party will control the dispute, at whose expense and until what date. Alternatively, the settlement of a dispute may be made a condition precedent to the closing of the deal. Indemnities are also used to allocate financial responsibility for the dispute.  

4. To what extent do employees/consultants have any rights in respect of the target's IP rights, whether existing or in the future?

This point relates also to point 1 above, in that it affects the ownership of IP rights by the target. It should be ascertained whether the target has agreed to any co-ownership with, or other vesting of IP rights in, employees or consultants in respect of their inventions. It is generally advisable to interview key employees, such as research scientists, key developers and long-term employees. Such interviews can also uncover potential IP issues in respect of contamination (of the target's products with third parties' IP) and the development process.

Conclusion

IP due diligence is a distinctive part of the general due diligence process. It involves investigating the fundamental question of whether the purchaser will have the rights it thinks it is acquiring and that it needs to conduct the business as it wishes post-acquisition. Equally, IP due diligence and the warranties negotiated as a result of it must satisfy the purchaser that it will not be subject to claims for damages from third parties for IP infringement for which adequate provision has not been made in the transaction documents.  

Overseas or multi-jurisdictional acquisitions bring with them the added challenge of establishing the scope and treatment of these national rights pursuant to local laws, which can often differ substantively from the laws of Japan.