Managing IP Risk In Accordance with Sarbanes-Oxley

Wednesday, February 1, 2006 - 01:00

Gary Bender
Ernst & Young LLP

Properly managing intellectual assets has never been more important to corporate well-being. Granted, the dangers of patent infringement, license violations and counterfeiting have always been a threat to an IP-owner's profit margin. With regulators' increased emphasis on transparency and reporting of all material risks to shareholder value, the ability to appraise and keep track of IP can mean the difference between weathering a conflict and having regulatory investigations and a shareholder class action suit piled onto it.

Intellectual assets - which range from patented products and trade secrets, to unrealized but marketable ideas and processes - can account for as much as 80 percent of a company's total market value. Threats to intellectual assets therefore create a very real concern for shareholders.

As a result of Sarbanes-Oxley, it is the executives' responsibility to catalog the company's intellectual asset portfolio, assess the value of each asset and monitor its use by the company as well as its licensees and even its competitors. Executives are also obligated to foster a culture of compliance and are subject to criminal and civil penalties under the Economic Espionage Act of 1996 for allowing for the misappropriation of third-party trade secrets. Failure to abide by these regulations also could result in inaccurate financial statements which can in turn cause very serious problems for the company.

Responsibility for a company's intellectual assets generally falls under the umbrella of the legal department. Unfortunately, many companies have assigned this task to one person or a very small department, not adequately recognizing the potential consequences. By understaffing or improperly controlling a company's intellectual asset portfolio, organizations can both cut into their profit margin and put the company in jeopardy of a shareholder dispute or regulatory inquiry.

One threat to the value of intellectual assets is that of conflict related to intellectual property. Business disputes can arise over trademarks, patent rights, royalties, and license terms, among many others. Those that would be material to the financial health of the company must be disclosed immediately or reflected in the financial statements, according to the regulations adopted by the SEC in accordance with Sarbanes-Oxley. It should be mentioned that these requirements are not new, although SOX did add specific obligations for certifying executives and imposes strict penalties for failing to disclose material events.

One prevalent type of IP-related conflict is pursuing a company that is using your company's intellectual property without permission. This type of action is usually taken to protect the company's bottom line. In order to prosecute such a claim, however, a company must have a good handle on what intellectual assets it has, and it must closely monitor their use in the marketplace. By doing this, any misuse of the asset by a competitor - or by a licensee - may be detected and the lawful owner's rights protected. Failure to control intellectual assets and keep an eye on them could seriously compromise the bottom line through weakened market share and eroded margins. Enforcing the company's rights can protect profits and is an important deterrent for potential violators.

Conflict related to intellectual property also can emerge in the wake of a merger or acquisition. In conducting traditional acquisition due diligence, corporations struggle to correctly assess the value of intellectual property owned by the target company. Under the recently adopted Financial Accounting Standards 141 and 142, companies must value their intellectual property in the event of a business combination and then test that valuation annually for impairment. The initial IP valuation is presented on the company's balance sheet. Any threat to the IP is a threat to the potential value, which can affect the company's balance sheet down the road, resulting in material adjustments. Shareholders do not usually sit quietly when a company takes large write-offs for asset impairment. In addition, if the initial valuations are later found to be significantly inaccurate, the acquiring entity may find that it overpaid, either because potential profits are lower than anticipated or because of brewing conflicts with others over the target company's IP. This also exposes the company to shareholder disputes and future asset impairment charges.

Disputes related to intellectual asset valuation or other post-acquisition findings can be protracted and expensive, once again jeopardizing shareholder value. In order to avoid such disputes - or at least minimize their likelihood - proper valuations must be conducted before the deal is complete. A good example playing out in the courts today resulted from one company's acquisition of a competitor's assets in 2000. The seller filed for bankruptcy protection shortly after the acquisition, leaving a swath of angry creditors in its wake. The creditors have since filed suit, claiming the assets (mostly intellectual property, as well as some other assets) were sold for well below their true market value. They have sued former executives of the seller, the buyer, and other key participants in the deal for negligence, fraud, corporate waste and failure to live up to their fiduciary duties.

Performing independent IP valuations before the acquisition would not necessarily prevent such a lawsuit. However, companies and individuals able to demonstrate that they acted in accordance with the best information available to them at the time will be better prepared to defend their actions and, hopefully, to resolve disputes more favorably and expeditiously.

Such valuation work can be complex, and there is no one accepted method. However, some consensus methods are evolving, and those who work in the intellectual property field are likely to be the best resources on the most current techniques in estimating a portfolio's worth.

With mergers and acquisitions on the rise, correctly identifying and valuing the real and implied value of an acquired company's intellectual assets is important to the acquirer's continued financial well-being and growth. Additionally, by paying the right price in an acquisition, corporate officers will improve their chances of realizing the objectives for making the acquisition. This, in turn, will help to build trust with the company's boards and shareholders in their handling of the company's fiscal health.

A third IP-related conflict can also be the most complicated: Mishandling another company's intellectual property, or even violating their IP rights. For instance, in one case, the plaintiff claims a competitor is infringing on its intellectual property because the defendant company's products are based on ideas one of its executives developed while employed at the plaintiff company. The claim is therefore that the defendant is inappropriately using patents and trade secrets. The infringement claim itself has potential for causing material harm to the defendant company's business operations. In addition, when it came out in deposition testimony that the defendant's chief scientist stated that he and at least one other executive believed that the company was benefiting from another company's intellectual property, shareholders filed a class action lawsuit for violating federal securities laws. On the day that the defendant's executives' sworn statement regarding their intentional and willful infringement became public, the stock price fell 40%. This case is still pending.

The shareholders' case is based on the assertion that the executives knowingly violated another company's intellectual property rights, thereby putting the company in jeopardy of a lawsuit and a potential adverse decision. The expenses related to fighting litigation and paying a judgment or settlement, if material to the financial statements, must be disclosed to shareholders. In this case, the shareholders are claiming that committing an act that exposed the company to significant financial and operational risk also should be reported. The case could set a precedent for similar disputes in the future and should serve as a warning of further consequences of knowingly violating third-party intellectual property rights.

Once a company gets to the point of having a shareholder class action filed against it, trust in the executives, directors and officers has quite clearly been lost. The legislation passed with the Sarbanes-Oxley Act is intended to govern corporate officers' actions so that they can maintain that trust.

The transparency required under the new SEC rules can truly help corporate officers demonstrate their proper IP management to their shareholders and the public. The processes, however, can be stressful for those responsible. CEOs and CFOs must certify each quarter that the company's financial statements materially represent the operations of the company.

In order to so certify, those executives must rely on others to accurately report to them on material IP threats to the company. When it comes to intellectual property matters, the general counsel, and others, must have a mechanism to report up the ladder on the related risks and other matters involving IP.

If the legal department is not able to assess and closely monitor the IP portfolio, monitor and respond to external IP threats or claims of infringement and then disclose material risks, the company's financial statements and quarterly certifications may be called into question from regulators and/or shareholders down the road.

By properly establishing processes for managing and measuring the value of their intellectual property, companies can take the first step to managing their portfolios and realizing their financial potential. Monitoring the use of intellectual assets by competitors and licensees is then the next step to protect the company's rights and its bottom line. Last, companies also need to build awareness within their organizations about how to appropriately handle the IP rights of their competitors and other third parties. Companies are increasingly at risk of mishandling confidential third-party information as industries converge and partnerships and joint ventures evolve.

These are not simple risks to mitigate. Public companies are realizing managing IP risk is crucial in today's business and regulatory environment. A lot of care and attention is needed in updating IP management processes, capabilities and reporting standards to help prevent regulatory inquiry and/or shareholder disputes. Executives with robust, updated IP management processes and reporting procedures can sleep a little easier with that risk being managed.

Gary Bender is the national co-leader of the Intellectual Assets team within Ernst & Young's Fraud Investigation & Dispute Services practice. He may be reached at 415-894-8354 or at gary.bender@ey.com.