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When Acquiring Patent Rights, How Much Diligence Is Due?

Patent Strategy & Management
October 2000

Panitch, Gerson S.

Article

Authored by Gerson S. Panitch

After a recent multimilliondollar acquisition, the purchaser received some shocking news: The patents at the heart of the deal were virtually worthless. Everything had seemed fine. The patents contained text describing a product the acquiring company wanted to make. The purchaser soon learned, however, that the patent claims were too narrow to keep competitors at bay. Even worse, later investigation revealed that a competitor held a blocking patent, preventing the company from making the product at all.

The acquiring company thought it had engaged in the necessary due diligence. But how much diligence is due?

Patents Not Created Equal

Of the various forms of IP, patents most often drive mergers, acquisitions and initial public offerings. But some are narrow and easy to "design around," while others manage to single-handedly bar entry by a competitor. Determining the strength of a patent requires more than traditional due diligence, which generally entails a simple examination of the patent document and its prosecution history and in which patent counsel typically asks questions like: Does the patent owner really own the patent? Is there some technical defect in the patent? Is the patent valid?

These are necessary but insufficient questions. A properly owned, nondefective and valid patent may nevertheless deliver little value. To uncover real value, patent counsel must examine the patent in the context of what the acquiring company hopes to achieve from the transaction. In other words, after defining the objectives of a transaction, the acquiring company must retain patent counsel to test the patents to ascertain how well they further those objectives.

HOW Much Diligence?

A due diligence analysis goes far beyond the patent document and its prosecution history. The analysis should be tailored to answer the following questions: 

    • Validity and Enforceability: Is the patent invalid or is there some technical reason why it might not be enforceable? In any patent infringement suit, the alleged infringer will attack the validity and enforceability of the patent. The due diligence inquiry should test the patent to gauge how well it will withstand those attacks.
    • Strength and Breadth: How easy would it be for a competitor to interfere with business objectives by designing around the patent? The ease with which a competitor can "design around" a patent directly correlates to that patent's value. Counsel should brainstorm with technical staff on ways a creative competitor might avoid the patent.
    • Freedom to Operate: Do any competitors' patents block the acquiring company's ability to achieve its objectives? As a business grows through merger, acquisition or IPO funding, it must identify any competitive patents in the way of further growth. Patent counsel must therefore understand how the acquiring company intends to operate. More particularly, patent counsel needs to know about products or services currently in the pipeline and on the drawing board. But in the current business climate, speed is often everything. As a result, the executives of an acquiring company might not have the time to educate patent counsel about the background and objectives of the deal. Or they might not recognize the importance of taking the time. Or they assume that patent due diligence comes in a box marked "one size fits all."

Furthermore, even sophisticated business people fall prey to the misconception that a patent gives their company the right to make, use or sell what is described in their patent. Not true. It is black-letter patent law that a patent confefs the right only to exclude others from making, using or selling what is described in the patent claims. Someone else might have patented an improvement to the patented technology, making it impossible to practice the invention efficiently without infringing the improvement patent.

An anecdote (names and facts altered) shows how crucial it is to take a strategic approach to patent due diligence. Radar Inc., a manufacturer of radar systems, wanted to acquire NightScope Inc., a company selling aircraft infrared night-vision technology. NightScope was perceived as having a strong patent portfolio, with 12 patents covering every aspect of its proprietary infrared technology. With military spending on the decline, Radar wanted to acquire NightScope to apply its infrared technology to automobiles, whereby an infrared image would be projected on the windshield.

Radar retained outside patent counsel but only asked for "due diligence on the patents." Radar did not think to provide counsel with "minorn details about its future products. After all, it simply intended to apply a proven aircraft vision system to automobiles.

Patent counsel did a competent job of conducting traditional due diligence, but he did not ask about future products or improvements. After a detailed analysis, he concluded that all 12 patents were valid and that the NightScope system did not infringe any third-party patents. The transaction was therefore consummated.

Later, Radar learned that a patent outside its industry blocked use of the windshield-infrared system. One of the major auto manufacturers held a patent on a heads-up automobile display device. That patent broadly covered any display where an "image" is projected onto an automobile windshield. Although the patent did not specify an infrared image, it was written broadly enough to cover any image projected on an automobile windshield, blocking Radar from applying its infrared system to automobiles.

Had due-diligence counsel been aware of Radar's intended foray into an entirely new industry, the due-diligence analysis would likely have uncovered the troublesome patent, and the acquisition could have been canceled or its terms modified.

    • Strategic Planning: Are there any strategies available to better position the acquiring company in the future or to enhance or broaden exclusivity? Strategic due diligence involves examining not only the patents to be acquired, but also the competitive landscape, including competitors' patents and product lines. For example, when analyzing the exclusivity of a transferor's patents, patent counsel might uncover gaps in protection. If so, pending applications may be modified or new applications filed to fill these gaps. In some cases, the company can fill the gaps by "reissuing" a patent to broaden its protection.

Strategic due diligence can also expose competitors' vulnerabilities. For example, the analysis might uncover the opportunity to change an existing patent application to cover a competitor's product. The acquiring company might have no immediate interest in bringing a patent infringement suit, but, even without any offensive interests, holding a patent covering a competitor's product often provides the best insurance against being sued by that competitor.

Copyright © Finnegan, Henderson, Farabow, Garrett & Dunner, LLP. This article is for informational purposes and is not intended to constitute legal advice. This memorandum may be considered advertising under applicable state laws.