Acquisitions and IP Licenses: Looking Out for Poison Pill Affiliate
During due diligence, counsel for a prospective acquiror identifies an IP license agreement in which the target company has granted a counterparty a license under "all patents in the Licensed Field owned by target or any of its Affiliates." The license agreement includes a common definition of "Affiliate"i.e., any entity controlling, controlled by or under common control with targetthat expressly includes all entities who qualify as an "Affiliate" on or after the effective date of the license agreement. Buyer's counsel realizes that after the contemplated transaction closes, buyer and its affiliated companies will be target's "Affiliates," such that buyer's and its affiliates' patents in the Licensed Field may be subject to the target's license grant. Because of this "poison pill," buyer immediately puts the potential transaction on hold to evaluate the risk of proceeding.
This article discusses how to identify during the diligence process provisions such as the one described above that can "infect" a company and its affiliated entities, how courts have viewed those provisions, the potential ramifications on buyer and its affiliated entities, and specific protections to include in purchase agreements to guard against the adverse impact of those provisions.
Pre-acquisition legal due diligence on target's commercial contracts (such as property leases, customer agreements and vendor contracts) typically focuses on several common topics, e.g., fees and pricing; change of control and assignment; term and termination; noncompetition and exclusivity restrictions; indemnification; and warranties.
IP licenses warrant additional inquiries, including identifying the licensed IP, the scope of the license grant, and who is granting and receiving the license. Thorough diligence on IP licenses requires an understanding not only of the business deal reflected on the face of these provisions, but also the impact of any embedded references to defined terms such as "Affiliates" and "Subsidiaries." In the context of an IP license, those seemingly innocuous definitions may broaden the scope of licensors and licensees far beyond the agreement's signatories and expand the license grant to encompass additional intellectual property as third parties subsequently enter into transactions with those signatories.
Failure to appreciate the sometimes-nuanced impact of these definitions can lead to overlooking material aspects of the IP agreement. For example, a common grant of patent license reads as follows:
Company hereby grants Licensee a license under the Licensed Patents to make, have made, use, import, offer to sell, and sell products.
Understanding the scope of the licensed IP then requires a review of the definition of "Licensed Patents," which might include "all patents owned, and patent applications filed, by Company and its Affiliates" that cover inventions in a certain specified field of technology.
If "Affiliates" are referenced in such a manner so as to include their patents and patent applications within the subject matter of the license, it is crucial to study the definition of "Affiliate" to determine whether the patents and patent applications of after-acquired affiliates are included. Particular attention should be paid to definitions of "Affiliate" and "Subsidiary" that expressly encompass entities that fall within the scope of the applicable definition only after the effective date of the license agreement.
The Judicial View
In several reported decisions, courts have held obligations to be enforceable against a signatory's affiliates and subsidiaries, including subsequent buyers.
For example, in Imation v. Koninklijke Philips Electronics,1 the U.S. Court of Appeals for the Federal Circuit (applying New York law) held that Philips' grant of a license to Imation and its subsidiaries extended to two subsidiaries that Imation acquired only after termination of the license agreement. In that agreement, "Subsidiaries" was defined to include subsidiaries "now or hereafter owned" by a party.2 The Imation court noted that under New York law, a court must read the plain language of a contract to give full meaning to its material provisions, interpreted as a whole, and to give effect to its general purpose, mindful not to render language superfluous. In this case, giving effect to the plain language led the Federal Circuit to hold that Imation's after-acquired subsidiaries were licensed to use Philips' patents and immune from suit by Philips for patent infringement.
The Imation court observed that parties may draft license agreements in an intentionally expansive manner to "enable the parties to operate in a given area of technology, free of the risk that the other party would threaten infringement." To make this possible in the context of the transaction described in Imation, "the parties constructed licenses with a fluid scope that grew with the acquisition of additional patent rights and a fluid membership that changed as the partiessophisticated corporations operating throughout the worldchanged their corporate structures."3
Similar reasoning underlies the rationale for courts' enforcement of noncompetition provisions against a buyer pursuant to an agreement "inherited" from a target during an acquisition, such that buyer and its affiliated entities are prohibited from engaging in certain competitive activities in which target "and its Affiliates" previously agreed not to engage.
In Credit Index v. Riskwise Int'l.,4 the New York Supreme Court found Credit Index satisfactorily alleged a cause of action for breach of contract against Riskwise's acquiror Reed Elsevier. In that case, Reed Elsevier had purchased the shares of Riskwise, which, along with its affiliates, was restricted from selling certain products to direct marketing customers pursuant to an agreement between Riskwise and Credit Index.
The court noted that "a number of cases support [Credit Index]'s contention that a nonsignatory entity may, by virtue of its subsequent creation or acquisition of a signatory to an agreement, be considered an 'affiliate' within the meaning of the agreement, and be bound by the noncompetitive provisions therein."5
When a target's contracts purport to bind its affiliates or subsidiaries, the ramifications of an acquisition of or substantial investment in the target may be significant. Put simply, license provisions that apply to affiliates and subsidiaries may "infect" a buyer's businesses. Buyer may find that itsand its affiliated entities'intellectual property is unexpectedly subject to an outgoing license grant on terms it did not negotiate with a party to whom it may not want to be a licensor. Among other things, such a license can weaken a buyer's defensive position in industries where large patent portfolios keep litigation in check through the application of "mutually assured destruction" principles.
When identified during the due diligence process, such forced license provisions also may dampen buyer's interest in, and the economics of, the potential acquisition or investment. A buyer must consider not only the present effect on its businesses, but also whether these provisions may impact its interest in other potential target companies (who would become "Affiliates" of the target) and hamper its ability to eventually divest the signatory to the license agreement (or even buyer's other affiliated entities) at an attractive price.
Protection in Agreement
It is a truism that there is no such thing as perfect due diligence. Whether as a result of imperfect information, target's failure to disclose, or the mistaken belief that a particular agreement was not material, it is always possible that buyer does not identify broad licenses before the consummation of the contemplated transaction. Accordingly, a prudent buyer should consider including in the purchase or merger agreement a representation by the targetbacked, in the case of a private company acquisition, by an indemnification obligationthat offers some measure of protection against the adverse impacts of the target's contracts on the buyer.
Increasingly, buyers include a variation of the following representation in acquisition agreements:
Effect on Purchaser. Neither the consummation of the Transactions nor the negotiation, execution, delivery or performance of the Transaction Documents will result in any of the following pursuant to the terms of any Contract to which Company or a Subsidiary is a party or by which their properties or assets are bound: (i) the grant, license or assignment to any Person of any interest in or to, the modification or loss of any rights with respect to, or the creation of any Lien on, any Company Intellectual Property or any Intellectual Property owned by or licensed to Purchaser or its Affiliates prior to Closing, (ii) Purchaser or its Affiliates, or the Company or the Subsidiaries, being (A) bound by or subject to any noncompete or licensing obligation, covenant not to sue, or other restriction on or modification of the current or contemplated operation or scope of its business, which that Person was not bound by or subject to prior to Closing, or (B) obligated to (1) pay any royalties, honoraria, fees or other payments to any Person in excess of those payable prior to Closing, or (2) provide or offer any discounts or other reduced payment obligations to any Person in excess of those provided to that Person prior to Closing.
While indemnification may be useful in the context of a private acquisition, it may not provide all the protection a buyer may need. Additionally, indemnification is generally not available in public acquisitions. Therefore, in addition to including, for indemnification purposes, a representation like the one noted above, a buyer should focus on closing conditions applicable to the accuracy of this type of representation. In most acquisition transactions, closing conditions regarding the accuracy of representations tend to exclude inaccuracies that are not material to the target as a whole. However, for a representation of this type to be a meaningful closing condition, it would need to be accurate as written and not subject to any broad materiality qualifiers.
Daniel Glazer is a partner and co-head of the technology transactions group and David Shine is a partner and co-head of the M&A group at Fried, Frank, Harris, Shriver & Jacobson. Jason Greenberg, a corporate associate at the firm, assisted in the preparation of the article.
1. 586 F.3d 980 (Fed. Cir. 2009).
2. Some courts have found that after-acquired affiliates are covered by such a license grant even absent a temporal reference in the definition of "Affiliate"; see, e.g., IP Co. v. Cellnet Technology, 600 F.Supp.2d 1351 (N.D. Ga. 2009).
3. Id. at 991.
4. 192 Misc.2d 755 (2002)
5. Id. at 760.