Bennett Best Burn LLP: Barristers and Solicitors (Lawyers)

by: A. Paul Mahaffy
Bennett Best Burn LLP, Toronto

Buying and selling intellectual property has become a growing part of a business lawyer's practice. For many business clients, IP is often a core asset, and may be the only asset of real value. Yet business lawyers may inadvertently treat the sale of IP like they treat the sale of any other kind of property. If they give special attention to the IP component of an asset or share purchase, they may treat all IP the same, without providing for the subtle differences between the various IP types which may be included in the purchase.

As with other kinds of property, IP represents a bundle of rights, including not only rights to own but also rights to sell, rent, license, franchise, manufacture, make, use and so on. But because it's not tangible, and can't be physically possessed, it is easily replicated and transmitted.

The key to the value of IP is its exclusivity. Once it loses its exclusivity, competitors of its owner can enter into the marketplace and get a free ride on the expertise and goodwill the IP owner may have already developed. But if its exclusivity (or monopoly, as some might say) is maintained, the exclusivity rights can be sold to another or licensed to others, for all or a portion of the term of exclusivity, within specific geographical areas, for a fixed sum of money or for payment of on-going royalties, all as the IP owner may decide.

All of these IP rights can add substantially to the net worth of the IP owner. A company can reach and maintain market leadership by properly protecting its patents, trade marks and other IP. Its IP can facilitate the financing it needs to grow by serving as collateral for debt or by providing a revenue stream to entice equity investors. And if the company can't use its own IP to make money, it can probably sell or license the IP to another company that can.

This paper will attempt to provide an overview of how companies can make money from buying and selling IP. It will discuss the due diligence process which purchasers of IP may wish to undertake before they enter into licensing and assignment agreements, or asset and share purchase agreements and will examine some of the terms which ordinarily appear in such agreements. It will also highlight certain competition and tax issues, and certain qualifications in giving opinions, in respect of IP transactions.

This paper will set the stage for today's discussions and the other papers being presented. While the other papers when read together may emphasize the differences among the various types of IP and the commercial implications of such differences, this paper will state a number of generalizations based of their similarities.

Because today's programme has taken on a transactional focus, the legal issues concerned with protecting and enforcing IP rights may receive only cursory mention.

Although there are many types of intellectual property, those which have usually been associated with the most commercial activity and value have been patents, copyrights, trade-marks, industrial designs, and more recently, trade secrets and know how.

A patent affords its owner the exclusive right to make, use or sell an invention claimed to be novel and useful. An invention can be any art, process, machine, manufacture or composition of matter. Its novelty is ordinarily determined as of the date the patent is first applied for. The inventor is the owner of the patent unless the rights have been assigned to another person. The patent gives the owner the exclusive right to practice the invention for the term of the patent. Patents are currently granted for a term of 20 years from the date of application.

Copyright exists in the manner in which ideas are expressed but not in the ideas themselves. It arises automatically upon the creation of a work provided that the provisions of the Copyright Act are satisfied. The copyright holder has the exclusive right to control the copying and other commercial exploitation of the work. Copyright relates to original literary, dramatic, musical and artistic works and can be used to protect works as varied as performers' performances, sound recordings, communication signals, computer programs or architectural designs. Except for certain exemptions provided in the Copyright Act, it exists for the life of the author and a period of fifty years after the author's death.

A trade-mark is a word, symbol or shape which distinguishes the owner's wares or services from those of any other person. The right to protection of a trade-mark flows from the use of the mark or the making known of the mark. A trade-mark need not be registered, as it can be enforced by a common law passing- off action. Registration however gives to the owner the exclusive right to the use throughout Canada of the trade-mark in respect of the wares or services for which registration has been made. A trade-mark can include a certification mark, which is used to designate wares or services of a defined standard, as well as a distinguishing guise, which is the shaping of wares or their containers or the wrapping or packaging of them to distinguish them from the wares of others. Registration is currently effective for a 15 year term.

An industrial design is an original feature of shape, configuration, pattern or ornament in a finished article which appeals to the eye. Protection under the Industrial Designs Act is not given to features applied to a useful article that are purely functional. The exclusive right to an industrial design may be acquired by registration of the design by its proprietor, so long as registration is applied for within one year of the design's first publication. The current term of registration is ten years.

Unlike the foregoing intellectual properties, there is no statutory basis for trade secrets and know how. They are common law rights, based on an action for breach of confidence, breach of contract, or breach of trust. They are often compilations of information, like computer databases, customer lists, and useful statistics, or technological secrets like source codes to computer programs, chemical formulae, series of chemical reactions or manufacturing steps. Many trade secrets, however, can also be protected by the other IP rights mentioned above. For example, patents can protect chemical formulae, and copyright can protect source code. Such alternative protection usually requires a trade off, forgoing secrecy in return for monopoly protection for a limited time, as in the case of patent protection.

Making money from IP is usually accomplished by either assigning the IP to another party, or by licensing another party to use it. Whichever route is taken by the IP owner, the party acquiring the IP ought to conduct some amount of due diligence before paying for it, although due diligence is often regarded as more important for IP assignments. Simply relying on the representations and warranties which the owner may give in an assignment or license agreement may prove to be insufficient protection for an assignee or licensee later on.

Without making some effort to verify those representations and warranties from sources independent of the owner before the money is paid, the acquiring party may discover after paying that the representations and warranties weren't accurate. By then, the only recourse may be to the courts in a claim for damages based upon the owner's breach of the assignment or license agreement.

Conducting due diligence in assignment or licensing transactions generally involves three activities: verifying the owners's rights to the IP being assigned or licensed; ascertaining the adequacy of protection the IP has under applicable law; and identifying any infringement of the IP. Since one of the potential benefits of conducting due diligence is ensuring that the price being paid is within an acceptable range, due diligence investigations help to determine how strong and therefore valuable the owner's IP really is. This means confirming that the IP has been registered, and that it's being used properly by its owners and any others licensed to use it.

Determining IP ownership is the main goal of IP due diligence. Ownership issues constantly arise in connection with buying and selling IP because a lot of IP is created in collaborative settings. Consequently, there is the need to investigate whether the inventor, author, designer or other individual who purportedly created the IP has a partner, fellow student, professor, consultant, client or co-worker who may have participated in the IP's possible "joint" creation and who might claim an ownership interest in it. Such collaborative efforts are not always documented, and often the co-participants are no longer around to sign assignments and releases when the time comes to sell the IP.

As with the due diligence process to be followed when buying or financing a business, IP due diligence involves reviewing numerous agreements and records, searching certain public registries, and interviewing those people who may have an IP interest. It can consume considerable time and money, often much more than any assignee or licensee would be prepared to spend.

Consequently, the priority and number of documents to be reviewed, searches made and interviews conducted usually depend upon the amount of money at risk and the importance of the IP to the business of the buying party. The expense of due diligence can be justified in much the same way as the expense of insurance coverage. If the amount of money being paid is relatively small or is paid over time rather than as a lump sum, or if the warranties and representations are secured by reserve funds or guaranteed by creditworthy third parties, the expense required for comprehensive IP due diligence may not be justified.

If a complete documentary examination is justified, then a review should be undertaken of the IP owner's existing licenses, non-disclosure agreements, assignments, title documents, employment and consulting contracts, secrecy agreements, franchise agreements, distribution agreements, supply agreements, research and development agreements, promotion agreements, advertising agreements and computer agreements.

In addition to a comprehensive document review, certain public registries should be searched. While searching may not reveal moral rights, performers rights, personality rights, proprietary information and many common law rights, searches for ownership interests and security interests in the IP being assigned or sold should be undertaken.

Searching involves federal and provincial registries. The federal registries are those generally maintained by the Canadian Intellectual Property Office in Hull, and the provincial registries are those maintained by the various provincial personal property security offices. The extent to which IP statutes contemplate the granting of security interests is not entirely clear, since their references to assignments don't differentiate between absolute assignments and assignments by way of security. However, if an owner's IP has represented a significant part of the security given for a financing of the owner, the lender concerned has probably effected a dual registration against the owner's IP in both the federal and provincial registries. Technically, registrations in the federal registries are often deposits or notations made in the relevant register.

While there may not be a statutory requirement that all IP assignments or licenses have to be registered, failing to do so by an assignee or licensee can render the assignment or license void against any subsequent assignee or licensee who gives valuable consideration for the IP without actual notice, if the later assignment or license is registered before the first.

Licensing agreements ordinarily involve the grant of IP rights by a licensor to a licensee for the purpose of commercially exploiting those rights. The licensor may not be in a position to commercially exploit those rights to the same extent as the licensee, but may still want to retain ownership of the IP for some other purpose. The licensee, on the other hand, may want to use the IP but not necessarily own it.

Licensing agreements usually come in three varieties: the sole licence, whereby the licensor agrees to grant no other license or interest in the IP during the term of the licence; the exclusive licence, whereby the licensor agrees not to use and exercise the IP; and the non-exclusive licence, whereby the licensor reserves the right to license the IP to others. These licences are often subject to limitations on territory, time and extent of the IP's use. Licences with finite terms are often renewable only upon certain monetary thresholds for royalties or sales being met.

Most licensing agreements narrowly circumscribe the purposes for which the licensed IP may be applied and contain numerous specific prohibitions on its use. Many agreements even attempt to restrict the manner in which the licensee carries on business, not only during but even after the term of the agreement. Sometimes the licensee is prevented from using certain marketing channels, if the licensee's use of such channels might interfere with the rights granted to other licensees. Often the licensee is prevented from selling services or products which might compete against those of the licensor. In addition to being restricted from conducting any sales or use of the IP outside of the licensed territory, the licensee may be under a duty to put such a restriction into any contract it may have with third parties. Yet the licensee may be given rights to acquire additional IP from the licensor for use in the licensed territory during the term, or at least a right of first refusal to do so.

Licensing agreements may also address what happens if new IP or derivative work is created during the term. They often specify who owns it, and may specify to whom it may be assigned and who will prepare the assignment documents and undertake the necessary registrations. Sometimes the parties agree that any improvements to the licensed IP made by either party during the term will become part of the subject matter of the license.

Specific quality control standards are imposed on the licensee in many licensing agreements. Licensing agreements ordinarily prohibit any modification of the licensed IP without the prior written consent of the licensor. They might provide the licensor with a right to approve all advertising and promotional materials of the licensee relating to the IP, or the licensor's deemed approval if no objection is made within a certain time period.

Licensees often request that they be able to assign the license agreement in the future, given that corporate reorganizations, wind-ups for tax purposes, setting up joint ventures and partnerships, and future asset sales and secured financing by the licensee will all require assignment. By the time such events occur, the licensed IP may well be an integral part of the licensee's business, and assignment of the agreement would be essential.

Licensees also often request that the standard clause dealing with termination of the license upon bankruptcy or insolvency of the licensee be eliminated, since it jeopardizes their ability to obtain secured financing. The sale of the licensee's business after such an event is facilitated by having the license then assignable.

Whatever termination provisions are eventually agreed upon, they ordinarily contain comprehensive instructions as to what duties must be performed immediately upon termination. These usually include obligations on the part of the licensee to cease using any part of the licensed IP, to return all material previously provided by the licensor, and to either deliver all of the licensee's products containing the IP to the licensor or destroy such products. Furthermore, all confidential information which may have been disclosed to the licensee normally remains subject to a duty of confidentiality.

Licensors granting exclusive licenses usually insist that a substantial down payment, or minimum royalty payment, be made by the licensee. If an exclusive licensee fails to maximize the commercial potential of the IP, the licensor often wants to be able to cancel the licensing agreement because the IP, which is essentially a wasting asset, could be valueless by the time the originally intended term expires. The need for a right of early cancellation does not arise to the same extent if the down payment is adequate. Alternatively, in the absence of a large down payment or minimum royalty, the licensing agreement might provide that an exclusive licence is converted to a non-exclusive licence should certain financial thresholds or milestones not be met by the licensee.

Since many licensors have difficulty in giving unqualified warranties that they are the absolute owners of the IP being licensed, they often insist that licensees accept instead the less onerous warranties that they have the right to grant the subject licenses and that there are no encumbrances against the licensed IP.

Depending upon how experimental or "early stage" the IP may be, the licensor, particularly a licensor in an educational or research environment, may refuse to give any warranties at all. It is not unusual for a licensing agreement covering experimental IP to be only on an "as is" basis, and specifically disclaim any warranty as to ownership, registrability / patentability, freedom from defect or absence of possible infringement actions.

It's generally advisable for the parties to a licensing agreement to define the circumstances under which infringement proceedings will be instituted. Ordinarily the licensee will want to be protected by the licensor's initiation of an infringement action against anyone wrongfully using the licensed IP in competition against the licensee. The licensee may also wish to be covered by a provision for early cancellation of the license in such event, or a provision for placing any royalties payable by the licensee in escrow pending disposition of the infringement proceedings.

Other matters which may be covered in licensing agreements include the maintenance of product liability and general business liability insurance by the licensee with the licensor as a named insured, the payment of any fees required to maintain the registration of the licensed IP, and the right to grant sublicenses. The right to grant sublicenses is often subject to the prior written approval of the licensor. If royalties are calculated upon reference to revenues generated by the licensee, the agreement might give the licensor a right of access to the licensee's premises for the purpose of auditing the licensee's books.

IP assignment agreements are often much shorter in length than licensing agreements, and some may simply contain words sufficient to "sell, assign and transfer" the IP without saying much more. While longer assignment agreements may contain more comprehensive representations and warranties, and may have more elaborate payment provisions, they lack the detailed restrictions on use, performance standards and termination provisions that are usually found in licensing agreements. Assignments tend to evidence isolated transactions, whereas licensing agreements tend to reflect ongoing relationships.

Generally IP is assignable, in whole or in part, whether registered or unregistered. IP can be assigned while it is still "incomplete" or "unfinished", and will often be assigned at some time during the registration process. For example, since a patent may be granted to any person to whom an inventor has assigned the right to obtain it, inventors often assign patent rights after their patent applications have been filed. Trade-mark applications or registrations may be assigned either in connection with or separately from the goodwill of a business when the business is sold, and either in respect of all or just some of the wares or services of the business in association with which the trade-mark has been used.

Assignments of copyright create an exception. Any assignment of the "reversionary" interest in copyright, which is the 25 year period immediately following the first 25 year period after the death of the author, is void. Section 14(1) of the Copyright Act provides that the reversionary interest devolves on the legal representatives of the estate of the author, notwithstanding any agreement to the contrary. This prohibition, however, does not apply to assignment of copyright in a collective work. Assignments of copyright often include waivers of the author's moral rights.

Most standard form asset and share purchase agreements have fairly general provisions which apply to all intellectual property of the selling or target company. They seldom offer the kind of specific attention which may be found in some assignments and many licensing agreements made in respect of a specific type of IP. They tend to put all IP in one "container", although they should identify individual IP in detail, preferably by way of a comprehensive schedule to the purchase and sale agreement.

During the negotiation of many asset and shares purchase agreements, defining the IP covered can be problematic. Because such agreements serve to allocate the post-closing risks between buyer and seller, often by way of the various representations and warranties contained in them, many buyers want a broad definition of IP and many sellers want a narrow definition, perhaps covering only registered IP.

The reason for this difference in position is attributable in part to the limitations of the due diligence process. Since the buyer can never completely verify the seller's or target's title to the IP which is being investigated as part of the transaction, the buyer will want a broad warranty as to title. Ordinarily the buyer wants warranties that the purchased IP is valid and enforceable against third parties and that the use of such IP will not infringe the rights of others. But such warranties are usually too difficult to give in light of the time and expense that would be required to put the seller in a position to give them. This is particularly true when there are many types of IP used in many different jurisdictions.

The seller is normally prepared to say that all the formalities have been observed with respect to the registered IP, and that the seller has no knowledge of a validity attack being made or of any facts which would constitute grounds for invalidation of such IP. Some sellers may be prepared to warrant that there are no outstanding assignments and security interests.

Warranties as to IP enforceability are particularly difficult to give, since they essentially amount to warranties for both validity and non-infringement. Since it is unusual for an alleged infringer's IP to be identical to a seller's or target's IP, a subjective determination of infringement is required in order to give such a warranty.

As mentioned above, some licensing agreements contain restrictions on not only the use by the licensee of the licensed IP, but also on the licensee's business. Some of these restrictions appear to have the potential to create competition law issues for the parties to the agreement. Provisions in certain IP assignment agreements, and the IP parts of certain asset and share purchase agreements, may also give rise to circumstances causing the parties to contravene the Competition Act, or at least providing the Competition Tribunal with sufficient cause to review, and possibly grant relief for, such IP transactions.

Section 92 of the Act dealing with mergers might apply in the event of a merger of companies whose assets primarily consist of IP. The section 77 provisions dealing with tied selling might apply if a license of IP is tied to the mandatory purchase of other products. The section 77 provisions aimed at exclusive dealing might apply where a licensee of IP is prohibited from dealing with competitors of the licensor.

Because the owner of IP has an exclusive property right, or a monopoly right, the buying and selling of such a right may be different than the buying and selling of goods and services whose owners don't have a monopoly. Ordinarily a seller of goods is supposed to deal with everybody on the same terms, and certainly not refuse to deal with anybody who is prepared to provide the same terms as everybody else. But fortunately for owners of IP, they don't have to. They can be a little more selective when deciding to whom they'll assign or license their IP. They can essentially engage in certain anti-competitive practices in their IP assigning and licensing activities.

Two recent cases initiated by the Director of Investigation and Research, one involving Tele-Direct (Publications) Inc. and the other involving Warner Music (Canada) Ltd., provide some comfort for IP owners who prefer to be discriminating when licensing their IP.

In the Tele-Direct case, the Director alleged that Tele-Direct had engaged in a practice of anti-competitive acts contrary to the abuse of dominant position provisions of section 79 of the Competition Act by refusing to license its Yellow Pages and "walking fingers" trade-marks to competing suppliers of telephone advertising services such as telephone directory publishers. As Tele-Direct would license some suppliers but not others, the Director asked the Competition Tribunal to prohibit this selective licensing practice. The Tribunal held that selective licensing of the trade marks was a legitimate exercise of Tele-Direct's statutory rights under the Trade-marks Act and was not an anti-competitive act.

Mention was made in the case of the special exemption for IP found in section 79 (5) of the Competition Act, which states as follows:

In the Warner case, the Director alleged that Warner acted contrary to the refusal to deal provisions of section 75 of the Competition Act by refusing to grant licenses to a competitor of one of its Canadian affiliates to make sound recordings from Warner master recordings of Canadian artists. Warner had Canadian copyright to the recordings and gave such licenses to its affiliate. While section 75 doesn't provide an exemption for IP like section 79, the Tribunal held section 75 did not apply to the facts. A copyright license was held not to be a "product" for the purposes of section 75 since that section requires there to be an "ample supply" of a product before there can be a refusal to deal in it. According to the Tribunal, copyright and other IP are by their nature exclusive and cannot be made subject to usual trade terms.

While buying and selling IP give rise to a number of tax considerations, a few deserve specific mention. Although this paper has attempted to focus on the similarities among various types of IP, any discussion of IP tax issues tends to reinforce the differences. For example, the sale of a patent receives different tax treatment from the sale of copyright, and the sale of IP by way of assignment receives different tax treatment than its sale by way of non-exclusive license.

Generally speaking, the sale of rights is treated as a capital receipt, and the sale of use, such as gives rise to royalties, is treated as an income receipt. Any amount which a seller receives that is dependent on the production from or use of any property, including IP, whether or not the amount is an installment of the sale price, is to be reported by the seller on income account. The buyer, depending on the circumstances, may either be entitled to a deduction for the payments, or be required to treat the payments as part of the cost of the property.

The sale of a patent by way of assignment normally gives rise to a capital gain for the seller and, if the seller has claimed capital cost allowance prior to the sale, possible cca recapture. The cca recapture may equal the difference between the lesser of the sale price and the capital cost of the patent, and the patent's undepreciated capital cost. The same treatment may apply to the seller who grants an exclusive license. However, the seller who grants a non-exclusive license may find the sale proceeds treated as an income receipt and not a capital gain.

The sale of a trade-mark by way of assignment or exclusive license may result in the receipt of an eligible capital amount, but the sale of a trade-mark by non-exclusive license may be treated as income. The sale of copyright is ordinarily considered a disposition of an eligible capital amount. While the sale of know-how by way non-exclusive license is ordinarily on income account, if the seller receives a lump sum and then ceases to use the know-how, the sale is treated as an eligible capital amount.

For IP which is classified as capital property, it may be eligible for capital cost allowance at either Class 14 rates, deductible on a straight line basis over the term, or Class 44 rates, deductible at 25% of undepreciated capital cost on a declining balance basis. If it is classified as eligible capital property, it may be depreciated on three-quarters of its value on a declining balance basis at 7% per annum.

In order to qualify as Scientific Research & Experimental Development expenses which may be deducted in calculating business income, a taxpayer's current and capital expenses must not be for market research, sales promotion, quality control or routine testing, style changes, routine data collection and certain other activities, nor for the acquisition of a building unless used for prescribed purposes. They must instead be related to the taxpayer's business and lead to some rights to use the results derived. For example, the deduction can be taken in respect of a taxpayer's grant to a university which is used by the university to fund IP development, so long as the IP is licensed back to the taxpayer.

While counsel acting on IP transactions are sometimes asked to give opinions as to IP ownership, validity or priority over other interests, or the absence of any infringement of or by the IP, they ordinarily confine their opinions to registered IP. For most IP, registration merely creates a presumption of ownership, not certification.

IP opinions tend to merely recite the registrations counsel may have made or may have found when searching, describing such prior registrations as covering some aspect of the IP which is the subject of the opinion. Such opinions may also tend to state that all the formalities have been observed in registering the IP and, where applicable, in maintaining IP registration through the payment of necessary fees.

But concluding anything more from such registrations is risky. Entries on a register may be incomplete with respect to any particular IP. The "owner" may be claiming only part ownership in the IP. Since the date of registration, ownership may have reverted to a previous "owner" by contract or operation of law, or may have been assigned to a third party by an unregistered instrument. And some registries can be weeks behind in reflecting current registrations.

Some counsel are prepared to confirm in their IP opinions that they have no actual knowledge of, but have made no effort to inquire into, any infringement claim being made against the IP or any facts that might constitute grounds for invalidation of such IP.

Giving an opinion as to IP ownership is usually prevented by the lawyer's difficulty in determining ownership, since an "owner" often has a right to use the IP but not necessarily the right to exclude others from its use.

In helping clients commercialize their IP, lawyers can play an important role not only in determining how best to protect the IP, but also in facilitating the purchase and sale of the IP. Whether acting for the assignor or assignee, or licensor or licensee, the lawyer is in a position through appropriate due diligence inquiries and document preparation to ensure that the client's expectations regarding the value of the IP are reasonable and are likely to be met.

While no amount of due diligence will guarantee the absence of an infringement action against an assignee or licensee, and no assignment, license agreement or purchase and sale agreement will contain enough warranties and indemnities to assure complete and absolute recourse against an IP seller, the risks in buying and selling IP can at least be made known and hopefully reduced, if not entirely eliminated. Given the importance of IP in today's commercial transactions, it may be about time that practitioners of corporate- commercial law give IP issues special standing.

A. Paul Mahaffy practises business law with Bennett Best Burn LLP of Toronto, with particular emphasis on purchase and sale agreements, technology transfers, joint ventures, strategic alliances and financing, and can be reached by e-mail at pmahaffy@bbburn.com