Tag: Mergers & Acquisitions

The Top Five Intellectual Property Traps in M&A Transactions

Recently posted in the National Law Review an article by Carey C. Jordan of McDermott Will & Emery  regarding intellectual rights in M&A transactions:  

 

In M&A transactions, many lawyers assume that intellectual property (IP) rights will automatically transfer with the purchase and that IP issues can be cured by general representations and warranties. While getting strong representations and warranties covering intellectual property is useful, relying on a breach of representations and warranties as the only remedy to protect the covered IP can doom the deal to failure or lead to unexpected surprises after closing, including requiring significant changes to future business plans and opportunities. If the target’s IP rights are important to the ultimate deal, then those IP rights must be investigated thoroughly in the due diligence and fully understood.

A due diligence investigation into a company’s intellectual property assets is essentially a methodical audit which will cover at least the following main areas:

  • Patents
  • Know-how
  • Copyright
  • Trademarks
  • Infringements
  • Licenses and collaboration agreements

Failure to examine these during due diligence in a manner appropriate to the deal at hand can lead to reevaluation, repricing or structural changes of the transaction.

For example, Volkswagen outbid BMW in 1998 to buy Rolls Royce and Bentley and their British factory from Vickers PLC for $917 million. But an odd twist in the deal allowed the Rolls-Royce aerospace company to sell rights to the ROLLS-ROYCE trademark to BMW out from under Volkswagen for $78 million. Thus, after the deal closed, Volkswagen did not have the rights to use the ROLLS-ROYCE mark. Only after a separate deal was made with BMW to avoid litigation, did Volkswagen gain the ability to manufacture a trademarked ROLLS-ROYCE car.

Thus, IP due diligence in an M&A transaction should not be overlooked and should be undertaken early in the process. The following are five common IP issues that may impact M&A transactions.

1. Target Does Not Actually Have the Critical Patent Rights

A target company may not actually own the IP rights that it represents that it owns. This may be due to a failure to update the title through corporate name changes or lien releases, or a failure to ensure that employees have properly assigned their rights to IP assets developed with company resources to the target. This latter situation is particularly problematic. For example, under U.S. patent law, each joint inventor has the right to use and to license patented technology to a competitor without accounting to the other owner in the absence of an agreement to the contrary. As a result, a non-assigning employee can license a key competitor of the buyer (and even keep the royalties) without notifying the target. The problem can be more acute in the case of an independent contractor, who may not have an obligation to assign rights to the target. It is therefore important to review contractor agreements related to any IP relevant to the transaction to confirm that the agreements address ownership of any IP created by the contractor.

Trademarks must be evaluated in terms of their goods, services and countries of registration to confirm that they cover the buyer’s intended uses in intended markets. Certain countries recognize common law trademark rights, based on use of a mark, while other jurisdictions give priority to the first party to file a trademark application, regardless of use. Internet domain names are subject to fewer formalities, but must be investigated as well. Domain name registrations may expire and, if expired, the domain names can be bought by anyone. It is also important to confirm that important domain names are owned by an entity relevant to the transaction, as opposed to an information technology (IT) professional within the company, a licensee or another entity.

2. Prior Agreements Limit IP Rights

Sometimes, the target’s IP rights may be subject to prior agreements that restrict their use in other markets or fields of use. The target may have existing licenses or agreements with respect to some or all of its IP rights. For instance, the target may have granted a third party exclusive use in a key field of use, territory or patent, which may limited the buyer’s full and expected use of the IP rights.

For example, when the Clorox Company purchased the PINE-SOL business and trademark from American Cyanamid in 1990, Clorox planned to leverage the strength of the PINE-SOL mark into other products. Clorox purchased the PINE-SOL assets and mark subject to a prior 1987 agreement that Cyanamid had entered into with the owner of the LYSOL trademark to settle a trademark dispute years earlier. That prior agreement restricted Cyanamid (and subsequently Clorox) from expanding the use of the mark beyond the PINE-SOL pine cleaner. Clorox tried to void the terms of the settlement agreement through litigation, but was unsuccessful.

Licensors of intellectual property may argue that a merger in which a licensee does not “survive” as a separate corporate entity may void the license – even if the license agreement contained no prohibition against merger, acquisition or transfer. This argument is based on an arcane line of federal cases holding that patent licenses are not assignable unless expressly made so. More recently, some federal courts have extended this rule in ways that affect corporate mergers, and have found, in effect, that certain mergers can constitute transfers that void patent licenses. This is especially problematic in an acquisition of a licensee.

Additionally, in certain instances in which the U.S. government has provided funding to an entity (usually a nonprofit, university or small business), the U.S. government may retain certain rights to any relevant patents developed from that research, and any subsequent grants relating to those rights (e.g., a license or acquisition) will remain subject to the government’s retained rights. These government “march-in” include the right to license the invention to a third party, without the consent of the patent holder or original licensee, where it determines the invention is not being made available to the public on a reasonable basis.

3. Target is Subject to Pending/Threatened Infringement Claims

No buyer wants to buy an expensive IP-related lawsuit through an acquisition. Any potential litigation or enforcement risks must be assessed and independently analyzed, including evaluating potential indemnifications. Although others exist, two primary areas for inquiry in this context include potential patent infringement and copyright liabilities.

For potential patent liability issues, a purchaser does not want to spend a great deal of time and money to acquire rights that it will not be able to exploit because of third party’s potential infringement lawsuit. Potential litigation and enforcement risks may be identified through the target’s legal opinions, cease and desist letters, freedom to operate studies and similar materials, which should be requested and analyzed in the due diligence process.

As to open-source software, the GNU General Public License governs a large number of open-source products. Open-source code can only be tightly integrated into other open-source products, and a condition of using the code is that the user also publishes its modified version of the code to the public. The Free Software Foundation enforces the GNU General Public License. This can be problematic in an acquisition, especially when the software is a valuable piece of the assets being acquired. There have been instances where an acquiree has been sued by the Free Software Foundation after acquiring a company that had allegedly incorporate open-source code into its software. In at least one instance, the acquirer had to release the acquired software to the public as a result. Open-source liability can kill a deal and affect the value of a transaction. In the absence of insurance, some companies will accept a reduction in deal price.

4. Significant Barriers Exist to Exploitation of the Technology

With regard to patents and the ability to exploit the acquired patented technology, significant barriers may exist. Third parties may have blocking IP rights that prevent the buyer from exploiting the target’s IP or expanding the business as planned. Sometimes, this risk is not specifically known even to a target. Thus, the buyer’s freedom to operate often should be analyzed before completing the transaction, to make sure that the buyer will be able to use the assets purchased as intended in the conduct of the business operations, or as proposed to be used according to the buyer’s future plans. A freedom-to-operate analysis should be performed, which is an assessment of whether making, using sale, offering to sell or importation of a product in the U.S. will infringe any third-party patents.

If third party IP rights are identified that may block or limit the buyer’s use of particular IP rights, and a meaningful design-around is not possible, then it may be necessary to license or acquire ancillary rights to such third party blocking IP rights. Alternatively, the target could seek to invalidate the blocking IP at the United States Patent and Trademark Office (e.g., through a reexamination) or in a court. The inquiry is more complex when pending claims are published yet not issued, so the inquiry not only requires construction of the claims and infringement analysis, but also estimation of whether the published claim(s) will issue. Evolving application of infringement under the doctrine of equivalents and other changing legal standards through judicial decisions only adds to the complexity and cost of the analysis.

Of course, this still leaves unknown barriers to the exploitation of technology. Included in this category are issues such as unpublished patent rights that could block a buyer, misappropriation of technology, reverse engineering by competitors who have then patented improvements to a target’s trade secrets or even competitors who independently discover trade secrets and patent them, and the like. To the extent these can be explored, it is wise to do so. However, there are risks in any deal, and wise IP counsel can consider the impact of potential unknowns based on the industry and technology involved in the contemplated transaction.

5. Target’s IP Rights Are Encumbered by Liens

IP rights may also be encumbered by liens. To record and perfect a lien against both patents and trademarks in the United States, Uniform Commercial Code (UCC) filings need to be made. Although not legally required, most lenders also record the security agreement in the U.S. Patent and Trademark Office (USPTO). Under U.S. copyright law, however, only a lien recorded in the U.S. Copyright Office will perfect a security interest in copyrights. Due diligence should include reviewing reports from all of the applicable filing offices.

In sum, early and comprehensive IP due diligence in M&A transactions is important because it can lead to a reevaluation, repricing or restructuring of the proposed transaction.

© 2011 McDermott Will & Emery

The Top Five Tax Traps in M&A Transactions

Recently posted  in the National Law Review an article by Jeffrey C. Wagner  and Daniel N. Zucker of McDermott Will & Emery regarding tax consequences of acquisition and disposition transactions:

The tax consequences of acquisition and disposition transactions can dramatically impact deal value. Often the potential tax issues can be resolved in a manner that is consistent with the intention of the parties without changing the economics of the deal. If some of these tax issues are not addressed, however, the parties may not obtain the benefit they had bargained for even though it may have otherwise been possible. This puts a premium on the involvement of tax advisors from the outset of a transaction. Although one rarely wants to see tax be the “tail that wags the dog” in a deal, tax issues can present significant economic opportunities or costs that may often warrant tweaking or changing the deal structure to accommodate these issues.

1. Failure to Solicit Tax Advice at the Letter of Intent Stage

Although not binding, the terms of the letter of intent entered into by the parties in the early stages of the acquisition process can put one of the parties in a superior bargaining position as it relates to which party bears the burden or reaps the benefits of the tax costs and benefits associated with a transaction. Too often, a client does not engage its outside advisors (or significantly limits the involvement of its outside advisors) until after a letter of intent is signed. The failure to include the tax advisor at this early stage can mean lost dollars to the seller or additional cost to the buyers.

For example, if the target is an S corporation, in most cases the buyer should be able to secure the benefit of a tax basis step-up for federal income tax purposes without a material increase in the taxes payable by the seller with respect to the sale. However, if the buyer is not well-advised, the letter of intent may simply indicate that the buyer will acquire the stock of the target for the agreed-upon consideration. If, after the letter of intent is executed, the buyer recognizes that a tax basis step-up can be achieved with little or no tax cost to the seller, the buyer may request that the transaction be converted to an asset purchase or that a Section 338(h)(10) election be made by the parties. At this point, the seller has the leverage and can demand additional consideration from the buyer in exchange for the tax benefits that such a structure would provide.

2. Section 197 Anti-Churning Rules

When the acquisition of a business is structured for income tax purposes as an asset purchase (i.e., an asset purchase in form or a stock purchase coupled with a Section 338(h)(10) election), the buyer usually has bargained for the tax benefits that accompany such a transaction—namely, the ability to tax effect the purchase price by depreciating or amortizing the premium paid for the assets, which premium is usually attributable to the goodwill and going concern value of the acquired business. If the business being acquired was in existence on or before August 10, 1993 and, before or after the transaction, the seller or a related party owns, directly or indirectly, greater than twenty percent of the equity of the buyer – which may be the case, for example, if the deal calls for the seller to receive “rollover equity”—the goodwill and going concern value of the target (as well as other Section 197 intangibles) may not be amortizable by the buyer. As a result, the buyer will not obtain the tax benefits that it anticipated and paid for as part of the acquisition. The economic benefit that is lost can amount to as much as 20-25 percent of the purchase price depending on the discount rate used to calculate tax benefits and other factors.

Moreover, if the acquirer is a limited liability company or the corporate acquirer is owned by a limited liability company, and the seller will have an interest in the limited liability company following the acquisition, the anti-churning rules can be an issue even where the seller owns less than twenty percent of the limited liability company. It is therefore critical that any transaction that calls for the seller or a party related to the seller to obtain (or retain) an equity interest in the buyer in connection with the acquisition, the buyer should closely study whether the anti-churning rules could be applicable. A failure to do so can result in a significant – and perhaps needless—reduction in the buyer’s after-tax cash flow and adversely affect the purchase price payable by a subsequent buyer of the business.

3. Qualified Stock Purchase Failure

As an alternative to structuring an acquisition as an asset purchase in form, a buyer can realize the tax benefits of an asset purchase by structuring the acquisition as a stock purchase and making a Section 338 or Section 338(h)(10) election in connection with the transaction (the latter requiring the consent of the seller and being limited to target corporations that are S corporations or subsidiaries of a consolidated group). In order to be eligible to make a Section 338 or 338(h)(10) election, the acquisition must constitute a “qualified stock purchase”, one of the requirements of which is that 80 percent or more of the target corporation’s stock be acquired in a twelve-month period by “purchase”. For this purpose, “purchase” excludes transactions on which gain or loss is not recognized, including exchanges that qualify for tax-free treatment under Section 351. Frequently, when a new corporation is being organized to acquire the stock of the target corporation, one or more of the sellers may “roll over” a portion his or her target corporation stock for stock of the new corporation. When less than 20 percent of the stock of the new corporation is received by the seller(s) in the exchange such that greater than 80 percent of the stock is acquired for cash, it would appear that the requirement that 80 percent or more of the stock of target be acquired by purchase would be satisfied. However, if any seller receives any stock of the new corporation (even one percent) in a transaction that qualifies as a Section 351 exchange, the acquisition will not constitute a qualified stock purchase and will be ineligible for a Section 338 or 338(h)(10) election.

The solution here is to structure the transaction so as to intentionally not qualify as an exchange under Section 351. Although this will undoubtedly have ramifications to the sellers (who may otherwise have been expecting to not have to recognize gain currently with respect to their rollover equity), the failure to obtain a step-up in basis in the assets of target corporation and consequently, the inability to tax-effect the purchase price (through depreciation and amortization deductions) may have an even larger negative impact on the buyer.

4. Acquisition of Shares of “Loss Stock” from Consolidated Group

A recent overhaul of the so-called “loss disallowance rules” changed the rules that apply when a buyer acquires the stock of a target company out of a U.S. federal consolidated group in a transaction in which the seller recognizes a loss. Prior to the change in the law, any limitation on the recognition of that loss for tax purposes would impact only the seller; the buyer was unaffected. However, under the new rules, if the buyer acquires shares of stock from a consolidated group that constitute “loss stock” (i.e., the consideration paid for the stock is lower than the selling consolidated group’s tax basis of the stock), absent a special election made by the seller, the tax basis in the assets of the target corporation (as well as other target corporation tax attributes) may be subject to reduction in an amount equal to some or all of the seller’s loss.

As a result, in all stock purchase agreements where the seller is a member of a U.S. federal consolidated group, the buyer should insist on a representation that none of the acquired shares are “loss shares” and, to the extent any of the shares are “loss shares”, the buyer should insist on a covenant that would require the seller to make the election that would, in lieu of reducing the target corporation’s tax basis in its assets and other tax attributes, cause the loss recognized by the seller to be reduced. In situations where the tax benefit to the seller from the loss is greater than the tax cost associated with the reduction in tax attributes, the seller should compensate the buyer for this tax cost.

5. Phantom Income/AHYDO Rules

Whenever an acquisition is financed, in part, through borrowing, and interest on the loan is not required to be paid at least annually (or there are warrants or other equity instruments issued to the lender in connection with the loan), the parties should consider the potential application of the original issue discount (OID) rules. Generally, subject to certain de minimis rules, if interest on a debt instrument is not required to be paid at least annually—i.e., the interest simply accrues automatically or accrues at the option of the borrower—the interest income and interest expense will be recognized for tax purposes notwithstanding that the interest is not actually paid on a current basis. This means that the holder of the debt instrument will recognize taxable income without receiving any cash—i.e., the holder recognizes so-called “dry income” or “phantom income.” Although the phantom income resulting from the characterization of a debt instrument as an instrument issued with OID is generally manageable (either because the holders are tax-exempt or that portion of the interest needed to cover taxes can be paid on a current basis), in certain circumstances, there are special rules that may result in the borrower’s tax deduction for the interest/OID being deferred or disallowed.

Specifically, the tax rules defer and, in some circumstances, permanently disallow deductions for OID on certain applicable high yield discount obligations (AHYDOs). An AHYDO is defined as a corporate debt instrument that meets three requirements. First, the debt instrument must have “significant OID.” Second, it must have a term exceeding five years. Third, it must have a yield to maturity that is at least five percentage points above the applicable federal rate (AFR) in effect for the calendar month during which the debt instrument is issued. A debt instrument is treated as having significant OID if, at the end of the first accrual period following the fifth anniversary of the issuance of the debt instrument (and at the end of each subsequent accrual period), an amount greater than one year’s worth of OID (the yield to maturity multiplied by the issue price of the debt instrument) can remain unpaid.

Where warrants or other equity-type instruments are issued along with the debt instrument (i.e., as part of an investment unit), there is a greater potential for OID and classification of the debt instrument as an AHYDO because the issue price of the debt instrument will be reduced by any value attributable to this equity thereby reducing the issue price and creating a greater spread between the instrument’s stated redemption price at maturity and its issue price—thus creating more OID.

Advance planning can often neutralize the effect of these rules without significantly changing the business deal. By simply adding a provision to the debt instrument that requires (i) all accrued but unpaid OID (in excess of one year’s worth) to be paid on the first interest payment date following the five year anniversary of the issuance of the debt instrument and (ii) all interest thereafter to be paid on a current basis, the debt instrument can escape classification as an AHYDO. Of course, this change has the potential for real, economic consequences which should not be minimized. However, where, as is frequently the case, the deal contemplates this debt being refinanced before the five-year anniversary (or the borrower is comfortable that a refinancing can be negotiated at that time), the borrower can avoid having its interest/OID deductions deferred or disallowed. In this regard, it should be noted that a debt instrument is tested for AHYDO classification at the time it is issued and is based on when payments on the debt instrument are unconditionally obligated to be paid. If a debt instrument is characterized as an AHYDO, the borrower’s interest/OID deductions are subject to the rules regarding deferral or disallowance even where the borrower actually pays the interest on a current basis.

Conclusion

The foregoing are just a few of the many tax issues that can arise in any deal. If they are spotted early enough, most tax issues can be addressed with relatively inconsequential structural changes to the deal and/or creative planning without changing the underlying business deal. However, if the opportunity to address the tax issues is missed, there are often material economic consequences to one or more of the parties. To the extent that there are tax costs inherent in the deal that cannot be ameliorated through creative planning, the parties need to address how such costs will be shared among the parties; otherwise, the burden of these tax costs may be borne by the wrong party. 

© 2011 McDermott Will & Emery