What Independent Directors Need To Know About Intellectual Property - Part I

Thursday, April 1, 2004 - 01:00

Part II of this article appears in the May 2004 issue of The Metropolitan Corporate Counsel.

"In recent decades . . . the fraction of the total output of our economy that is essentially conceptual rather than physical has been rising. This trend has, of necessity, shifted the emphasis in asset valuation from physical property to intellectual property and to the legal rights that inhere in the latter. . . . The shift of emphasis from physical materials to ideas as the core of value creation appears to have accelerated in recent decades."

Alan Greenspan, April 4, 2003 remarks to the 2003 Financial Markets Conference of the Federal Reserve Bank of Atlanta.

In the past year and a half, expectations about the board's role in monitoring risks and ensuring an appropriate control environment have expanded significantly. New governance reforms emphasize that directors must understand the risks facing the company and ensure that processes are in place to keep them adequately informed about those risks. At the same time, boards are becoming more distinct from corporate management due to new independence requirements. By definition, independent directors lack significant relationships with the corporation and its management. Yet, paradoxically, they are highly dependent on corporate managers for information about the corporation. The combined effects of heightened expectations and board composition changes pose a challenge to directors and the corporate counsel who support them in ensuring that the board is focused on and adequately informed about the right issues.

An often overlooked component of strategy, performance and risk at the board level relates to the company's intellectual property assets. (This is as true for smaller, privately held companies as for large, publicly traded corporations.) As physical assets of U.S. corporations become increasingly commoditized, less tangible intellectual property assets often are key to a corporation's competitive success. Just as directors need to understand the other drivers of corporate performance, directors should understand how intellectual property relates to corporate strategy and have processes in place to make certain that critical issues related to intellectual property are brought to the board's attention in a timely manner. This is a matter of both knowing enough to ask meaningful questions ("digging down") and having in place processes that bring information to the board's attention ("bubbling up").

Digging Down: Seeking Information

The board needs to ensure that it has both the knowledge and the resources necessary to provide management with meaningful guidance on intellectual property. Topics for inquiry include:

• What are the key impacts of intellectual property on corporate strategy, risks associated with that strategy and the bottom line?

• How dependent on intellectual property protection are the corporation's revenue assumptions?

• What proportion of corporate assets are represented by intellectual property? What is the nature of the company's intellectual property assets? Is the company achieving optimal value from these assets?

• What protections are in place for these assets?

• Is the company investing adequately in development of new intellectual property assets?

• What will the competitive landscape be like in two years, in five years, in ten years? What significant intellectual property issues is the company likely to face in those timeframes, and are they being planned for adequately?

Board inquiries into these topics can help focus the development or refinement of the company's intellectual property policy as it relates to both corporate strategy and risk mitigation.

Bubbling Up: Appropriate Processes

In addition to being knowledgeable about the company's intellectual property assets, the board needs to make sure that processes are in place that will provide it with the information it needs to understand and address intellectual property issues - and especially risks relating to intellectual property - in a timely manner. The following are some of the steps that can assist:

• Schedule board agenda time (at least annually) to discuss the kinds of intellectual property issues outlined above.

• Ensure that the board is fully informed on intellectual property issues through activities such as:

> An audit of the company's intellectual property assets, protections and environment.

> An analysis of the company's intellectual property position vis-á-vis its competitors (identify key competitors, now and foreseeable; review their intellectual property portfolios and practices).

> An analysis of emerging trends (technological developments, competitive developments, legal and regulatory developments) that could impact the company's intellectual property assets and related strategy in both the short and long term.

• Provide the board with regular reports - including benchmarks with competitors' practices and "best practices."

• Conduct a focused effort at a board retreat as an opportunity for a full "refresher."

• Verify that processes are in place to assist in identifying issues and information for board attention. The board and management should discuss board expectations about how, when, and in what circumstances information related to intellectual property issues will be provided, including the kinds of "red flag" events that should immediately trigger a report to the board or a board committee. A written policy on this topic may be worthwhile.

The board should have access to appropriate expertise and resources to help determine what information it requires and to help it process the information. Consider whether intellectual property is an issue of such import to the company that regular attention would be enhanced by a board committee. This may not be appropriate for all companies, but it should be considered at least by high technology companies, no matter what their size and product range.

Intellectual Property Issues

In each area of intellectual property law, issues with attendant opportunities and risks can arise out of a myriad of circumstances. This is as true for smaller companies as larger ones. An understanding of intellectual property law can help boards identify and avoid risks that may be associated with a proposed strategy. Some examples make the point better than essays.

Patent Law

A patent is a negative right: the right to prevent an unauthorized third party from making, using or selling the patented subject matter. Patents cover technical devices from airplane engines to computer components to mouse traps, chemical compositions, methods of refining oil, manufacturing semiconductors, performing surgery, and, for about a decade, methods for doing business. Infringement does not depend on any negative intent by the accused party. If that party is making, using or selling a product or process that is covered by a patent, then the party is an infringer.

Exemplary opportunities and risks associated with patents, taken from real life, appear in the sidebar of this article. These examples involve larger companies and show how, even for them, patent issues can have a measurable effect on company fortunes. For smaller companies, particularly those having only a small number of products, the effects can be even larger. On the positive side, attention to the value of patents already obtained has brought revenue streams measured in the billions of dollars per year to companies such as IBM and Texas Instruments. This revenue can be a "bonus" since it derives from the purposeful activity of mining the value in corporate assets already on hand through comprehensive licensing initiatives. Further, Cantor Fitzgerald's subsidiary eSpeed has recently demonstrated in the financial services area the rewards that can flow from patent enforcement efforts Ñ obtaining over $30 million in settlement payments from patent infringement litigation.

In line with these examples, board members should be aware of patent issues arising from the company's own portfolio, such as potential licensing opportunities or strategic use of patent infringement litigation, based on the company's patent assets that can prevent competitors from offering patented - and commercially desirable - products or processes.

On the other hand, a failure to correctly assess a patent threat cost Kodak dearly in its instant-camera battle with Polaroid. Damages of well over $1 billion in current value and the public relations disaster associated with thousands of customers left with unusable cameras taught Kodak, and its board, a painful and expensive lesson about the opportunities and risks associated with patents.

Board Inquiries About Patents

Directors, charged with the duty to be aware of significant issues, need to be asking these and other questions:

• What is our patent policy? Is it to protect our own key future technologies? To cover, and therefore enable us to block, our competitors' technology plans?

• What are our most important patents? What rights to exclude do they provide us? How are we exploiting them? Against whom are they directed? How much revenue is derived from them? How vulnerable are the patents to challenge? What happens when they run out?

• Do we take the appropriate legal steps to protect ourselves against willful infringement?

• What are our competitors patenting? Are they closing off technological paths we are counting on for our future?

• Do we have contingency plans to deal with patent "fences" our competitors may be erecting around their key technology?

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Adobe System's Free Distribution Of Its Portable Document Format
Adobe Systems Inc. developed the Portable Document Format or "PDF" which allows electronic documents containing text and images to be shared in high quality across different computer systems. Adobe gives away its Acrobat Reader free to users; indeed, Adobe proudly announces that more than 500 million copies have been distributed.

Why is Adobe proud of the fact that it has given away 500 million copies of its product? Because it creates a large market for other Adobe products, not given away, that can be used to create, edit, organize and distribute such documents. Adobe clearly considered, as a key element of corporate strategy, the options available to it under intellectual property laws and adopted an unusual, but successful, formula for selectively utilizing those options to optimize the value of its intellectual property assets.

eSpeed, Inc.; Financial Services Patents Can Be Valuable
Cantor Fitzgerald's eSpeed subsidiary has focused significant energy on amassing and enforcing a patent portfolio dealing with financial services activities. In early 2001, eSpeed purchased a patent relating to the trading of futures products and, within 18 months, had sued the Chicago Mercantile Exchange, the Chicago Board of Trade and the Intercontinental Exchange for infringement of that patent. Over the next five years, eSpeed signed lucrative settlement agreements with those defendants, totaling more than $30 million.

eSpeed has since acquired more patent rights in this area and, in July 2003, brought suit against BrokerTec USA for allegedly infringing another eSpeed patent, this one directed to allegedly proprietary systems and methods for electronic trading.

eSpeed's activities are not unique. A small company, Mopex, Inc., caused consternation in the financial services industry recently by asserting a patent it claimed covered the trading of a certain type of popular financial instrument. Until a judge in New York held the patent invalid, Mopex was embroiled in litigation with the American and Chicago Stock Exchanges and nearly two dozen financial institutions.

Kodak's Costly Crossing Of Polaroid Patents
A decade ago, Kodak found out how costly patent infringement can be in financial and customer relations dimensions. After a long and bitter lawsuit, Kodak was found to have infringed several Polaroid patents covering instant photography. The award to Polaroid was just over $900 million dollars in 1990, equivalent to $1.3 billion today. On top of that, injunctive relief prohibiting future infringement put Kodak out of the instant camera business, and concerns about angry customers led Kodak to spend another $200 million ($280 million in current dollars) reimbursing more than 3 million people who had bought the now-useless Kodak cameras.

How and when did Kodak's board become involved in these issues? What did they know and understand about patent law? Were board members fully informed of the risks in timely fashion? Could board members have foreseen the potential damage and guided management toward a better resolution?

Stephen D. Kahn and Holly J. Gregory are Partners in the international law firm of Weil, Gotshal & Manges LLP. Mr. Kahn specializes in patent litigation and other areas of intellectual property law with a focus on the legal protection of computer software. Ms. Gregory specializes in advising boards and managers on corporate governance responsibilities, compliance with governance related laws, regulations and listing rules, and "best practices."

Please email the authors at stephen.kahn@weil.com or holly.gregory@weil.com with questions about this article.