All-Star Briefing Thought Provoking Insights That Will Keep You At The Top Of Your Game

One

Ethan Horwitz (King & Spalding LLP) examines the continuing conflicts raised by the intersection between contract and patent law

Two

Patrick J. Rondeau (Wilmer Cutler Pickering Hale & Dorr LLP), highlights the most important pre-IPO tasks for a venture-backed company

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Ethan Horwitz: Creative licensing is the key to the restrictiveness inherent in patents

PLI: One area of law that garnered a lot of attention last year continues to do so this year, and that is the intersection between contract law and patent law. What's the latest?

ETHAN HORWITZ: At a fundamental level, the creativity and flexibility afforded by the freedom to contract may seem to be at odds with the built-in limitations in patent law, such as finite patent term and the doctrine of patent exhaustion. Accordingly, it is perhaps not surprising that parties continue to seek creative ways of overcoming the built-in limitations in patent law through the use of creative licensing agreements. As a result, courts continue to be faced with the daunting task of determining whether the policies underlying the built-in limitations of patent law should trump the parties' intent or vice versa.

A good example of this dynamic tension is found in Zila v. Tinnell 502 F.3d 1014, (9th Cir. 2007). It is well established in patent law that a provision in a license agreement is unenforceable if it extends the obligation to pay royalties beyond the expiration of a patent [see, e.g., Brulotte v. Thys, 379 U.S. 29 (1964)]. Until Zila, however, it was not clear whether the presence of such a provision would render the entire license agreement unenforceable.

In Zila, an inventor assigned to a company all of his U.S and foreign rights to an invention, in return for a perpetual 5% royalty that was to be based on the sale of a product incorporating the invention. Importantly, the obligation to pay the perpetual 5% royalty predated the grant of any patent rights, and it was not even known at the time of the assignment whether any patents would issue. Over time, the company obtained two U.S. patents and one Canadian patent covering the invention. After the first U.S. patent expired, the company stopped paying all royalties, including those based on the Canadian patent, and declared that the entire license agreement was unenforceable under the Brulotte rule.

The Ninth Circuit Court of Appeals disagreed, holding that the only portion of the licensing agreement that was unenforceable under Brulotte was that which demanded royalties for a patent beyond the expiration of the patent. The company still had obligations under other provisions in the contract, including the obligation to pay royalties based on the second U.S. patent and the Canadian patent, which had not yet expired.

[]Zila is an example of a case where a court resolves the tension between patent law and contract law in a manner that preserves the parties' original intent, to the extent permitted by patent law. Even after the application of the limiting rule in Brulotte, the license agreement in Zila survived largely intact. However, there may be cases where the application of patent law effectively eviscerates the original intent of the parties involved.

For example, in Quanta Computer v. LG Electronics, Intel obtained a license to patents owned by LG Electronics ("LG") that were related to chipsets and microprocessors. By its terms, the license was limited to Intel only and did not extend to its customers. After Intel sold the licensed products to its customers, LG sued the customers for patent infringement when they began using the licensed products in an infringing manner. In defense, the customers invoked the well-known doctrine of patent exhaustion, arguing that LG's patent rights were exhausted by Intel's sale of the licensed products. Therefore, LG could not sue the customers, even if they were using the licensed products in an infringing manner.

While the district court agreed with this analysis, the CAFC reversed on the basis that the price paid by Intel to obtain the license reflected the limited nature of the license. Thus, the CAFC in Quanta focused on the original intent of the contracting parties, just as the Zila court did.

On appeal, the U.S. Supreme Court was faced with the task of determining whether the original intent of the parties should be trumped by the doctrine of patent exhaustion and its broader underlying public policy concerns. The Court answered this question in the affirmative. After holding that the doctrine of patent exhaustion applied to method claims, the Court held that the license agreement authorized Intel to sell LG components that substantially embodied the patents in suit. Thus, the Court held, LG was prevented by the doctrine of exhaustion from further asserting patent rights as to the products sold by Intel under the agreement. The Court came to this conclusion despite the intended result of the agreement.

For instance, LG argued that there was no authorized sale because the agreement did not permit Intel to sell LG's products in combination with non-Intel products to practice the LG patents. However, the Court pointed out that nothing in the license agreement restricted Intel's right to sell the licensed products to purchasers who would then combine them with non-Intel parts.

LG also argued that the license agreement disclaimed any license to third parties to practice the patents by combining licensed products with other components. In response, the Court stated that "the question whether third parties received implied licenses is irrelevant because Quanta asserts its rights to practice the patents based not on implied license but on exhaustion. And exhaustion turns only on Intel's own license to sell products practicing the LG Patents." Thus, the Court rejected the argument that the third party license disclaimer, which the parties originally agreed upon, could protect LG's patents from exhaustion. Rather, the doctrine of patent exhaustion overcame even this agreement provision. Although LG intended to restrict authorized sales to Intel, and did not intend to give up its patent rights under the license, the agreement as drafted could not overcome the consequences of such authorization under exhaustion principles.

This decision has far-reaching consequences for those who draft licensing agreements.

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Patrick J. Rondeau: Regulatory changes make pre-IPO planning all the more important

PLI: You have said that companies contemplating an IPO in 2008 should be aware that the changes in the regulatory landscape over the last several years have made the IPO process longer and more arduous, and placed more of a premium on careful advance preparation. What should companies be paying most attention to?

PATRICK J. RONDEAU: The following are among the most important matters to be addressed by IPO candidates in the six-to-twelve months before an IPO.

Pricing Option Grants: For a venture-backed company that grants employee stock options (as almost all do), the SEC will review during the IPO registration process the company's determination of fair market value for purposes of recording compensation expense under FAS 123(R) for options granted during the 12-24 month period prior to the IPO. If the SEC challenges the valuation used by the company, the IPO process could be slowed, and the company could even miss its window to go public. Moreover, the company may have to restate its historical financial statements to reflect a higher valuation than originally applied, which results—in addition to delaying the IPO—can be expensive and embarrassing.

For these and other tax-related reasons, it is advisable for a company planning for an IPO to hire an independent valuation firm to determine the fair market value of its stock at the time the company grants options. A rigorous, contemporaneous independent valuation is strong evidence to counter any challenge by the SEC related to the compensation charges included in a company's financial statements. It is important that the company understands and accepts the methodologies used by the valuation firm, and that the company obtains a commitment from the valuation firm to assist the company in any challenges to the valuation raised by the SEC in the IPO process.

Whether it is necessary to obtain a new valuation every time the company grants options is a facts-and-circumstances issues, and will depend largely on how frequently the company makes option grants and whether there has been a significant corporate event—such as a new round of financing, or completion of a fiscal period in which operating results changed significantly from the prior period—since the previous valuation. If the company expects an IPO in the next 12–18 months, quarterly valuation updates are generally appropriate.

Building Relationships with Investment Bankers and Analysts: The much-publicized "global research analysts settlement" has significantly changed the interactions between companies and underwriting firms. Among the changes most relevant to pre-IPO companies are:

  • research analysts may not participate in marketing pitches by investment bankers;

  • investment bankers may not promise research coverage by their bank's analysts; and

  • a company's interactions during the IPO process with the investment banking and the research divisions of the underwriters must be largely separate.

It is therefore critical for a company to separately cultivate relationships with both the investment bankers – who will be responsible for shepherding the IPO process—and the research analysts—who will play an important role in the post-IPO trading of the company's stock—at potential underwriting firms.

Auditor Independence: The Sarbanes-Oxley Act and SEC rules have significantly tightened the requirements for auditor independence. While the SEC auditor independence rules generally do not apply to private companies, a pre-IPO company's accounting firm must be independent with respect to each fiscal period (generally three full fiscal years) covered by the financial statements in the IPO registration statement. Accordingly, a company contemplating an IPO in the future should ensure that its accounting firm satisfies the SEC auditor independence rules even prior to the IPO. One issue that would generally prevent an auditor from being considered independent is the provision by the auditor of specified types of non-audit services to the company, including bookkeeping services, financial information systems design and implementation services, appraisal services, management functions and human resources services. Auditor independence would also be tainted if the company hires, in a senior financial role, any person who worked on the company's audit as an employee of the auditor during the prior year.

Controls and Procedures: The SEC has adopted in the last several years a variety of rules relating to both "disclosure controls and procedures" and "internal control over financial reporting." These rules require public companies to establish and maintain such controls, to evaluate them on a periodic basis and to report on such evaluations in their periodic SEC filings. In addition, a public company's annual report must include a management report on the company's internal control over financial reporting, as well as an audit report from the company's independent auditors.

These requirements make it critical for a company to establish and document robust controls and procedures prior to its IPO. Those controls and procedures are a necessary underpinning of the disclosures the company must make in its IPO registration statement and its periodic post-IPO filings, including the personal certifications of the CEO and the CFO that must be contained in post-IPO SEC filings. In addition, a company's controls and procedures will undoubtedly be the focus of due diligence by the IPO underwriters. Establishing and documenting these controls and procedures is a time-consuming and often expensive process, and is not something that can be embarked upon shortly before kicking off the IPO process.

Corporate Governance Issues: In the wake of the highly-publicized corporate scandals in the early part of this decade, the corporate governance standards applicable to public companies were largely rewritten by the Sarbanes-Oxley Act, the SEC, NASDAQ and the NYSE. The most significant changes affecting pre-IPO companies are:

  • Each public company must have a board of directors comprised of a majority of "independent" directors, as defined by NASDAQ or NYSE rules. Although an IPO company has a grace period of one year from its initial listing to fully comply with this rule (as well as the audit committee rule described below), underwriters and investors often insist on compliance with those requirements at the time of the IPO. As a result of the increased liability and scrutiny to which directors of public companies are subject, it is often difficult to find well-qualified directors. In addition, because all directors of an IPO company have personal liability for material misstatements and omissions in the company's IPO registration statement, some individuals are reluctant to join the board of a company shortly prior to its IPO (and thus face liability for a registration statement describing a company with which they are relatively unfamiliar). Accordingly, it is never too early for a company contemplating an IPO at some point in the future to recruit independent directors.

  • Each public company must have an audit committee comprised of at least three persons, each of whom (i) is independent within the definition of NASDAQ or the NYSE, (ii) satisfies the "super-independence" requirements of the SEC, and (iii) is financially literate. In addition, at least one member of the audit committee must have accounting or financial management experience, and the company must disclose in its SEC filings whether the committee has at least one "audit committee financial expert," as defined by SEC rules. Again, it is advisable for a pre-IPO company to assess whether it needs additional directors for the audit committee, and to begin to recruit them, well in advance of the IPO.

  • NASDAQ and NYSE rules require, as a practical matter, that public companies have a compensation committee and a nominating committee (often structured as a nominating and corporate governance committee), each comprised solely of independent directors. Moreover, these committees, as well as the audit committee, must have committee charters delineating the committee's duties and procedural rules. Pre-IPO companies should establish these committees and prepare their charters before embarking on the IPO process.

  • Each public company must have, and make publicly available, a code of conduct for its directors, officers and employees, addressing matters such as conflicts of interest, accurate and timely public disclosure, compliance with laws and enforcement of the code's provisions. In addition, any waiver of the code for an executive officer or director must be approved by the board of directors and then publicly disclosed. Because of the public disclosure requirements, a pre-IPO company must carefully develop a code of conduct that, in addition to complying with the applicable legal requirements, takes appropriate account of the company's business and culture.

  • Changes to NASDAQ and NYSE rules have tightened the stockholder approval requirements such that virtually all new stock plans, as well as material amendments to existing stock plans, must be approved by stockholders of the company. In addition, the elimination of discretionary voting by brokers on stock plan proposals has made it harder for public companies to obtain stockholder approval for stock plan proposals. Accordingly, if a pre-IPO company foresees, within the next year or two, the adoption of a new stock plan (such as an employee stock purchase plan or a director stock option plan) or an amendment of its employee option plan to increase the number of shares covered by the plan, it should generally obtain stockholder approval of the new plan or plan amendment while it is still a private company and that vote is presumably easier to obtain.

IPO Prospectus: Largely as a result of SEC regulatory developments over the last few years—such as enhanced MD&A disclosure requirements, the new CD&A requirement and related changes in executive compensation disclosure rules, and new corporate governance disclosure requirements—an IPO prospectus is now significantly longer, and takes significantly longer to prepare, than it did several years ago. Accordingly, companies planning on an IPO should begin work on the IPO prospectus—with assistance from their outside counsel, accounting firm and (if selected) lead underwriter—several months before the planned kick-off meeting for the IPO process. The portions of the prospectus for which an early start is most critical are Business, MD&A, CD&A and Risk Factors.

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