The value of IPRs – including trade secrets – normally exceeds the value of a company’s tangible assets and is a value driver for transactions

It is generally accepted nowadays that the value of most companies’ intellectual property rights (IPRs) far exceeds the value of their tangible assets. A frequently-cited study carried out in the USA in 1999, showed that up to 80 percent of the corporate value of thousands of non-financial companies was associated with intangible assets. Subsequent studies have all confirmed this finding.

In company acquisitions, IPRs are often one of the key factors determining the return on investment by raising company revenues following expansion into new markets. In the retail sector for example, companies looking to expand their business need to ensure that the retail chain’s existing brand identity is not only sufficiently protected for current markets but can also be maintained when they venture into new countries. Failure to do so may mean that synergies may be lost and additional costs incurred by investing in parallel brands. Trademark protection for the brand is therefore of utmost importance. Similarly, if the company’s business is dependent on technology exclusivity provided by patents, the quality of the patents and corresponding patent protection in any new markets are equally important. Considering these facts, we find it very strange that the due diligence of a company still many times seems to center only on reviewing lists of registered IPRs such  as trademarks and patents. Such inadequate appraisals prior to an acquisition will not provide an accurate picture of the IPR position of a company and will almost certainly result in overlooking one of the most significant aspects of a company’s intangible assets – trade secrets.

Conducting an advanced IPR due diligence is essential

Rather than limiting an evaluation exclusively to the information provided, in our experience it is also vital to draw conclusions from what has not been presented and to pose the right questions regarding the target company’s strategy and processes for protecting IPRs and avoiding infringements. To be able to do so, understanding the market in which the company operates and the importance of IPRs in that market is of utmost importance. When it comes to trade secrets, assessing their value and degree of exposure is essential in arriving at a valid assessment, more so since trade secrets are almost never registered or explicitly described.

Trade secrets are much more than technical know-how and should not be ignored

Every IPR can be traced back to, and would never exist without, human knowledge.

The technical know-how of a company’s employees is a prerequisite for innovation and the ability to create and maintain a satisfactory IP position. So although patents and other IPRs are important, employee expertise is often at least as valuable for at least two reasons: (i) it will never be possible to maintain and improve the current IPR portfolio without it and (ii) employees’ technical know-how creates the basis for the next generation of technology,which may be very vulnerable before registered protection has been obtained.

Employee expertise is not only relevant in relation to technical innovation. The European Commission also recently recognized that trade secrets are just as important in protecting non-technological innovation as technical innovation. For example the service sector, which represents some 70 percent of EU Gross Domestic Product (GDP), is very dynamic and that dynamism depends on innovative knowledge creation. Since the service sector does not rely as heavily as the manufacturing industry on technological process and product innovation (which may be protected by patents), confidentiality is often used to build and exploit so-called “soft” innovation for competitiveness. This covers the use and application of a diverse range of strategic commercial information, including but not limited to customer and supplier data, business processes, business plans and market research.

In spite of its importance, many companies still do not actively consider how best to protect this valuable confidential information. If the due diligence focuses entirely on registered IPR and ignores the proper management of confidential information, it will fail to adequately assess the target company’s ability to maintain its competitive position by continued confidentiality of its business information.

Clear increase in information theft in the EU forces the Commission to react but companies need to be proactive

The EU is now rightfully acknowledging that the protection of all kinds of trade secrets is critical for economic growth. The capacity of companies to innovate and compete can be seriously harmed when confidential business information is stolen or misused. According to a recent survey conducted by the Commission, in the last ten years one out of five companies has suffered at least one attack targeting its trade secrets. Another recent study, also conducted by the Commission, found that 25 percent of investigated companies reported theft of information in 2013, up from 18 percent in 2012.

It is not entirely surprising that information theft is increasing. The combination of the digital storage of most confidential business information and the high turnover of employees significantly increases the risk of disgruntled workers copying substantial amounts of information when they leave the company. Such information typically ends up being used in and for a competing business, causing significant damage to the company subject to the theft. At the same time, enforcing the protection of trade secrets by way of court orders and damages is often very difficult due to factors such as inadequate or poor harmonization of national laws.

Against this background, in November 2013 the Commission issued a draft directive proposing new rules to protect trade secrets from unlawful acquisition, use and disclosure. While this initiative is very welcome, investors and companies cannot afford to wait until the directive is codified into national laws.

Even when it enters into force, without the implementation of the right processes for managing confidential information, it will be very difficult to prevent and act on the wrongful disclosure and use of confidential information.

Awareness and analysis of these issues is of vital importance in a transactional context as the consequences could be disastrous if valuable information disappears from the target company once the transaction is completed. A focused trade secret due diligence is also important in a non-transactional context however. So many companies would benefit from analyzing and improving their trade secrets management to avoid the illicit exploitation of confidential information by employees and other parties.

To protect confidential business information, all companies therefore need to adopt a proactive approach to trade secrets management. A first step in this respect is to assess the current situation within the business by conducting a trade secrets audit. Only by understanding the situation “as is” will it be possible to identify and correct possible process deficiencies.

A trade secrets audit can ensure protection of confidential business information and prevent post-acquisition competition

We have developed a model – a “trade secrets audit” – for conducting and reporting on the processes governing the creation, protection and enforcement of a company’s trade secrets. The audit is based on our experience from disputes involving a company’s trade secrets (in Sweden and abroad) and from analysis of numerous companies’ transactions. The audit provides an assessment of the company’s current risk level in relation to trade secrets, with detailed accounts of selected findings reported as issue-implication-action and with a concluding summary of potential follow-up actions.

Conducting a trade secrets audit may be particularly important after a company has been acquired. After change of ownership, there is normally a higher risk that key employees may decide to leave the company. To ensure that the pre-acquisition valuation remains valid, it is important to ensure that employee departures do not result in the use of the company’s confidential business information in competing businesses (especially if employees are not bound by non-compete undertakings).

Ideally, information theft should be entirely avoided by use of preventive measures adopted following the trade secrets audit. However, in the event of any theft, the trade secrets audit should assist in establishing the evidence required in legal proceedings to show misappropriation of trade secrets and any resulting damage.

Four fundamental questions to be answered in a trade secrets audit

In conducting a trade secrets audit,companies are guided to respond to the following fundamental questions about their confidential business information:

  1. What is important for our business and what do we want to keep secret?
  2. How do we control disclosure?
  3. How do we ensure that everyone knows that the information is secret?
  4. How do we ensure that our employees understand the consequences of the information being disclosed?

Once these four questions have been answered, the company can proceed to establish effective trade secrets protection by way of a strategic and structured interplay between units such as the IT, HR, Research and Legal departments. Such measures will not only result in a more robust structure for the business, but will also inspire more confidence in potential investors.

Legal development in Sweden – 2-year time bar makes a trade secrets audit more relevant than ever 

Later in 2014, Sweden is expected to enact amendments to the Act on the Protection of Trade Secrets.

One of the major benefits of the new rules is that the circle of individuals covered in terms of a company’s protection against misappropriation of trade secrets will be extended  beyond employees to include “people participating in a company’s business”. In addition to employees, this will include other hired staff, consultants, auditors and board members. In a transactional context this is particularly important with regard to board members of the target company, who may not have entered into any written agreements.

While the circle of people potentially liable for misappropriation of trade secrets will be expanded, the amendment also proposes that any liability shall be time barred for a period of two years from cessation of participation in the company’s business. It is important to note that in the case of employees the two-year period is calculated from any garden leave and not from the formal end of the employment relationship. This means that it will be more important than ever for companies to closely monitor the risk of misappropriation of trade secrets and to be ready to act within this time limit. A trade secrets audit and related management policy should give companies the necessary tools for achieving the desired level of protection.