Regulation

Courts and Torts: Touching on Intangibles

Intellectual property is important, say executives. So why don't they act as if they mean it?
Marie LeoneFebruary 22, 2005

Like the late Rodney Dangerfield, intellectual property (IP) doesn’t get much respect. Yet the reason is still a bit of a mystery.

To be sure, executives at both big and small companies acknowledge that it’s important to handle IP—the intangible assets most often defined as patents, trademarks, copyrights, and trade secrets—correctly.

Half of 120 global senior executives responding to an Accenture, Ltd. survey released last year confirmed that managing IP and other intangible assets (such as brands, research and development, and goodwill) is one of the top three management issues facing their companies. Fifty-two percent of the executives surveyed worked for small and mid-sized companies with annual revenues of under $500,000, while 37 percent worked for companies generating over $1 billion.

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A whopping 96 percent said that managing IP and intangibles is important to the success of high-performing companies, while 49 percent deemed those assets to be the main source of long-term shareholder wealth creation. (The survey was conducted by the Economist Intelligence Unit, a sister company of CFO.com.)

But there’s a gap between such views and the effort executives expend to track and protect the assets. Only 5 percent claimed that their companies have a robust system to catalog and measure the performance of IP and other intangibles. Another 66 percent said their inventory-measurement process is informal or qualitative, while a full one-third admitted they don’t measure performance at all.

The cost of such inaction, however, can be high. The Federal Bureau of Investigation estimates that U.S. businesses lose between $200 billion and $250 billion a year because of IP violations, and the U.S. Chamber of Commerce claims that those totals translate into the loss of 750,000 American jobs.

Still, most companies don’t even have a complete inventory of their IP portfolios, much less procedures to protect or commercialize their patents, trademarks, and copyrights, asserts valuation specialist Robert Reilly of Willamette Management Associates.

To be clear, not all companies are IP laggards. Some, like the Coca-Cola Company, are masters of that universe. Indeed, Coke needs to be: the value of its flagship brand, or example, is about $39 billion–twice the company’s annual revenues, according to brand management firm Lipcott Mercer. In the 2003 Management Discussion and Analysis section of its 10-K, Coke talks candidly about the care and feeding of its trademark and brand, noting that “maintenance of brand image” is one of the corporation’s three key challenges.

Likewise, IBM., which perennially tops the list of organizations that receive the most annual patents (3,415 in 2003), is a whiz at commercializing its IP portfolio. For the last five years, Big Blue generated over $1 billion in revenues every year from its IP-licensing agreements.

Nevertheless, many companies reportedly mismanage IP in one way or another. One reason is that outside of the context of a merger or acquisition, there’s no accounting standard to move them to repent and disclose their IP assets. Under Generally Accepted Accounting Principles, companies aren’t usually permitted to record the value of self-generated IP (intangibles not acquired as part of a merger), says Dimitri Drone, a director of PricewaterhouseCoopers’ auditing and assurance group.

While some companies might mention IP assets in their MD&As, Drone says, “GAPP generally does not permit IP assets to be capitalized on the balance sheet, other than if they are purchased, such as in merger situations.”

The current M&A boomlet, however, could spawn wider reporting and better management of the assets. GAAP requires that companies involved in business combinations catalog and recognize the fair value of certain acquired intangibles, notes Matt Pinson, a PwC director. Further, acquiring companies continue to test the value of newly-acquired IP for periodic impairment.

Besides the increase in mergers, another key motivation for better intangibles management is the current rise in IP-related lawsuits, which tend to force management to value intangible assets associated with the legal challenges. Preliminary calculations from the U.S. Patent and Trademark Office (PTO) show that 5,533 patent- and trademark-related lawsuits were filed in federal courts during 2004, a 7 percentage point hike from 2003. Further, for the past 10 years, IP-related lawsuits have risen steadily.

There are two reasons for the litigation surge, according to Reilly. One is that companies that are more tenacious about protecting their intangible assets have been suing to protect them. The second is that, with the economy struggling to emerge from a downturn, businesses are willing to pursue even small claims (between $3 million and $5 million) to recover lost IP revenues. A typical patent-infringement case costs plaintiffs between $2 million and $5 million and can last two to five years, according to Gary Morris, an IP attorney at Kenyon & Kenyon, who noted that 95 percent of the cases are settled out of court.

Still, the price of admission can be worthwhile. For example, Texas Instruments Inc won a total of $2 billion in two patent-damage settlements 1996 and 1999. More recently, Johnson & Johnson was awarded $700 million in two patent infringement court decisions in 2003.

Further, patent-infringement, trademark counterfeiting, copyright-piracy, and other, more traditional cases will be joined by newer varieties, Morris thinks. He and other legal experts predict that two different types of lawsuits will emerge this year: suits by private-company investors charging mismanagement of IP assets and shareholder-derivative suits charging public companies with a lack of compliance with the Sarbanes-Oxley Act.

In the case of private companies, original investors who no longer have an interest in a company, for example, may seek to recover their share of the gains realized by the more lucrative management of IP assets by a later owner, according to Morris.

The underlying idea of the Sarbox non-compliance issue is the same. Companies lacking solid process for managing IP assets are most open to regulatory charges of failing to present a fair and accurate picture of their financial health, opines Stacey Rabbino, legal-services network manager at AARP and the former chief IP counsel for VeriSign Inc.

That deficiency may get them into hot water with the Securities and Exchange Commission. The SEC could argue that since senior executives failed to develop procedures to identify and value a company’s IP, they won’t be able to gauge which assets are material and require disclosure, according to Rabbino, who acknowledges that her theory hasn’t been tested yet in the courts.

The allegations, she said, could involve possible violations of sections 302 (certification of financials by CFOs and their bosses) and 404 (assessment and certification of internal controls over financial reporting).

By Rabbino’s lights, executives can’t comply with either of those provisions unless they know what their IP portfolio contains, and then value those assets to find out if there’s material risk associated with the possible mismanagement of them.

Regarding 404, she says, companies must set up ways to ensure that IP information flows up to the Sarbox disclosure committee, where the question of materiality should be debated. One procedure, for instance, is to assign a senior executive to the role of keeper of corporate IP knowledge.

For their part, disclosure committees will likely have to make some tough choices in balancing business and legal interests. Members will have to decide how to disclose enough information to give shareholders an accurate picture of the company without tipping off competitors to trade secrets.

What’s the best defense against Sarbox-related charges of IP mismanagement? While companies that make a good faith effort to inventory and value IP will retain some leeway with the SEC, they won’t get a free ride Rabbino thinks. A good-faith effort involves auditing and valuing IP, and developing an enforcement program to protect and monetize the intangibles, she adds. Companies also should document IP transactions (licensing deals, for example) and assign one point of contact for all IP related issues.

A tall order? Maybe, but companies are already being forced to take tangible steps to avoid a lawsuit concerning their intangible assets.

Marie Leone’s “Courts and Torts” column appears monthly. Contact her at [email protected].

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