With reports of a continued increase in the volume of mergers and acquisitions—a growth of nearly 160% in just the first half of 2021 alone—and no signs of a slowdown, it remains important for companies and investors to consider the scope of IP diligence appropriate for their targets, and how representation and warranty insurance (RWI) may affect the diligence effort.
In mergers and acquisitions and other transactions, it is typical for the party in the position of buyer or investor to perform intellectual property and other diligence on the target entity. In most cases, this is to help determine if a price adjustment may be necessary, if the deal needs to be restructured, who needs to stay with the company post-close, or if it may be necessary to walk away from the opportunity, if only temporarily.
More and more often, however, the intellectual property diligence is also (if not primarily) for the benefit of the insurance underwriter if a party requires RWI in order to close the deal.
Either a buyer or seller can obtain the RWI. When there is RWI, the incentives and pressure points can change. Without RWI, the party in the position of seller is on the hook for its representations and warranties and, therefore, is motivated to qualify or refuse to give various representations and warranties, or to over-disclose possible problems. With RWI, the insurer, not the seller, is expected to stand behind the representations and warranties, subject to the terms and limitations of the policy. Accordingly, the party in the position of seller may be less likely to focus on the representations and warranties and related disclosures.
As the parties march toward closing, the seller may appear reasonably accommodating from the buyer’s perspective. That can reduce tensions while finalizing the transaction documents, until the insurance underwriting call gets scheduled, which often occurs very close to the date all parties are eager to close.
Without RWI insurance, the party in the position of buyer typically wants to know about the actual or potential problems and risks, and has its counsel document them in some detail in a diligence memo or report for internal consumption. When there is RWI, the insurer will get the diligence report and can ask questions about issues identified. The buyer may be less inclined to have all of the problems spelled out, because insurers often exclude known problems from the scope of the insurance policy’s coverage. Depending on how thorough the diligence report appears to be may affect how thorough the insurer’s diligence will be or how quickly it will underwrite a policy. In most cases, the insurer provides its intellectual property-related questions as an “agenda” for the call after it has reviewed the diligence report.
More often than not, the insurer’s pre-call agenda does not identify specific issues from the diligence report. Those may come up on the call, and they should not be difficult to anticipate. What sometimes can seem surprising (in light of the diligence memo) is the scope of and interest in fundamental questions about the target and intellectual property. The insurer may not get to the “issues” in the diligence memo until the last five minutes. This may be because the insurer is more comfortable with its list, or it may be because the insurer has already decided to exclude from the scope of the policy the more significant problems/risks identified in the diligence memo.
It is important to bear in mind how the involvement of an insurer affects the dynamics as early in the deal as possible. In some ways, the insurer diligence call is more of a review of your work than a review of the target. If you are doing intellectual property diligence on a transaction, whether or not there is insurance, in most cases you will want to be comfortable answering at least the questions below.
- What is the company’s material IP?
- Does the company have all intellectual property necessary to conduct its business?
- Will the company continue to have the same IP rights after closing as before?
- Do you have any reason to believe that any of the IP representations or warranties are untrue or the related disclosures incomplete?
- Did you confirm the accuracy of the IP disclosure schedules with your own searches?
- Did you check chain of title for the IP, including examination of assignment records?
- Did you find security interests or other encumbrances on the IP?
- Is all of the registered or patented IP maintained?
- Have you identified and confirmed ownership of all domain names of the company? Are they on auto-renew?
- Have all developers of IP, including both employees and contractors, assigned their rights in IP to the company?
- Does any employee or contractor/consultant have any rights to any IP of the company?
- Has anyone who has had access to confidential information of the company signed confidentiality agreements? Has any confidential information of the company been disclosed without authorization?
Litigation and Enforceability
- Has any of the IP been alleged or found to be invalid or otherwise unenforceable?
- Are any of the company’s trademarks being opposed or any patents subject to IPR or similar proceedings?
- Has the company been accused of infringement or are you aware of any potential infringement by the company?
- Has the company engaged in any patent or copyright misuse?
- Was any IP of the company developed under contract with a governmental or educational institution?
- Is there any order that restricts use of the company’s IP?
- Has the company abandoned any of its trademarks?
- Did the company perform any freedom to operate, noninfringement, or validity studies or opinions?
- How does the company protect its trade secrets?
- Is any third party infringing the IP of the company?
- Is the company involved in any IP litigation? Was a litigation search performed?
- Is the company’s IP subject to any exclusive licenses?
- Has the company indemnified anyone for possible IP infringement claims?
- How does the company use open source software?
- Has any open source use or software licensing compliance audit been performed? When?
- How does the company protect its proprietary code? Is any of the company’s source code in escrow?
While the questions above are not all inclusive, you likely have gone a long way toward appropriate intellectual property diligence for your company, client, or the insurer if you can answer them all. Something else to keep in mind as you prepare to ride this year’s M&A wave: IT infrastructure and privacy/information security issues should also be closely considered.