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Basic Due Diligence Review in Patent Licensing Transactions

Emily Miao, Ph.D.Margot M. WilsonVol. 17 Issue 2 (snippets)

For startups, intellectual property is a major source of value as well as a major tool for attracting investments. A patent license is an intellectual property asset that can be used to launch a startup. For instance, a startup could seek to license technology from a university or other institution that was developed by a founder of the startup.

Alternatively, the startup may become aware of certain technology developed by others and believe that it can commercialize the technology. Given the cost and effort involved in developing and commercializing new products and processes, a potential licensee should conduct a patent due diligence review to allow informed business-decision making.

For licensing transactions, due diligence can assist potential licensees in identifying any issues that may affect the value of a product or process, or that may hinder development or commercialization of a product or process. This article discusses several basic principles of patent due diligence in a licensing transaction from both the licensor’s and licensee’s perspective, including the identification and handling of licensing issues.

Due Diligence Review from the Perspective of the Licensor/Licensee

 Generally, a party should conduct patent due diligence either before or early in the licensing negotiations, and certainly before a deal is concluded. To encourage fair and open due diligence evaluations, the negotiating parties should consider signing confidentiality agreements that allow for the controlled exchange of confidential proprietary information.

While due diligence is essentially a two-way process between the licensor and licensee, the potential licensor has the burden of gathering and providing information and documents to the potential licensee for evaluation. The principle of “let the buyer beware” still applies, even in licensing transactions, and thus the burden of evaluating the licensor’s information and assessing the value of the patent license generally resides on the potential licensee. As a general rule, licenses to patents with broad claims that can be used to block competitors are considered more valuable than patents having claims directed to minor improvements used by the patentee or licensee.

a. The Amount of Due Diligence Needed Depends on the Licensee’s Goals

Before conducting any due diligence, the potential licensee should define the product and/or process they wish to commercialize as well as identify the timing of the product/process launch and determine the territories for manufacturing and sales. Clarifying the licensee’s goals underlying the licensing deal is important for determining how much due diligence is really necessary for the transaction.

For instance, if the goal of the licensee is to incorporate the licensor’s technology into the licensee’s existing manufacturing process, then the due diligence analysis should be narrowly focused on critical patents that cover the newly acquired process. Conversely, validity/enforceability of non-critical patents remaining in the patent portfolio should not be a critical concern.

Alternatively, if the licensee’s goal is to license the full patent portfolio and to create a primary business based on the portfolio, then validity/enforceability analysis of most, if not all, patents in the portfolio should be of greater importance. In either instance, invalidity or unenforceability of any critical patent can be a deal stopper without even reaching other due diligence issues such as third party rights. Furthermore, a license may not be necessary if the claims do not cover the commercial product/process or any necessary component or step thereof.

b. Licensing Objectives Also Play a Role in Due Diligence

A potential licensee has three main objectives in due diligence review: (i) reducing risk in licensing an asset that may be a liability in the future; (ii) identifying any weaknesses in the patent portfolio; and (iii) obtaining value by licensing the patents at the lowest possible cost. Depending on the circumstances, the potential licensee may seek warranties and indemnifications from the potential licensor relating to non-infringement, validity, ownership, and possibly non-competition.

Conversely, a potential licensor should (a) avoid making any representations or warranties that may result in future liability; (b) avoid any liability due to licensee’s actions; and (c) obtain the highest possible price for the licensing transaction. Before commencing with due diligence review, the licensor should maintain updated patent files[1] as well as lists of (1) all relevant patents and patent applications, including status and annuity payment history; and (2) assignments, confidentiality agreements, joint development agreements, government contracts, material transfer agreements, etc. Generally, any agreement that relates to the patents and patent applications, including security interests and other liens that encumber a patent owner’s rights should be included in these lists.

Steps in a Patent Due Diligence Review

The extent of patent due diligence required depends on the size, value, and nature of the transaction, e.g., patent licensing versus patent acquisition. For licensing transactions, patent due diligence review should be detailed enough to not only verify the ability to exploit the licensed patents, such as by ascertaining ownership and third party rights, but to also ascertain the value of the patents by determining whether the claims cover the product/process, whether the remaining patent term and territory is sufficient for the licensee’s needs, and whether the claims are valid and enforceable. If either party obtains insufficient information during the due diligence review, the parties may consider adjusting the value of the transaction to reflect the uncertainties and shift the potential risk through appropriate representations and warranties. A due diligence review should rely on the use of a due diligence check list as an aid for uncovering any patent-related issues for further investigation.

a. Ownership Rights

As a first step, the due diligence reviewer should confirm that the licensor/patentee owns all of the patents or patent applications subject to the licensing transaction or has the ability to transfer rights to these documents. The reviewer will need to determine how the licensor obtained ownership or license rights to the patents. For instance, did the licensor’s employees develop the patented technology, did independent contractors develop it, or did the licensor obtain it by outright acquisition? Failure to confirm true ownership can have serious consequences in any future litigation involving the patents.[2]

The licensor should have proof of ownership, preferably in the form of an assignment by all of the inventors with subsequent recordation in the patent office of the territory. In the United States, recordation of the assignment within three months from the date of execution or before a subsequent purchase protects the patent owner against subsequent good faith purchasers of the patent.[3] The reviewer should perform an independent assignment search at the Patent Office and carefully review the assignments, particularly in cases with joint inventorship, to ensure that all of the inventors actually assigned their rights to the alleged patent owner. In the absence of any agreement to the contrary, a joint inventor can make, use or sell the claimed invention without the consent of and without accounting to other joint inventors.[4] A licensee should request that the licensor/patentee record all assignments prior to the conclusion of the deal.

If the licensor is the true owner, the reviewer should next determine whether the licensor/owner has the ability to grant licensed rights. This determination generally involves reviewing documents such as material transfer agreements, other licenses, assignments, security interests or other liens, to determine what rights the licensor transferred to third parties. 

If the licensor is not the owner but a licensee of a third party patent, the reviewer will need to determine whether the licensor has the ability to grant sublicenses. Generally, the reviewer should examine all underlying documents related to the patent rights that the licensor received from the third party, e.g., licenses, agreements, contracts, and options. In reviewing such documents, the reviewer should watch for restrictions to fields of use and geographic territories in the underlying agreement as well as the licensor’s obligations to the third party patent owner.

Technology developed with government funds may be subject to government “march-in” rights under 35 U.S.C. § 203, allowing the funding agency, e.g., the National Institutes of Health, to require the patentee or licensee to grant a license under reasonable terms to reasonable applicants.[5] Thus, the reviewer should check for the existence of any march-in rights and adjust the value of the licensing transaction accordingly.

b. Scope and Sufficiency of Protection

As a second step in a proper due diligence strategy, the reviewer should determine the value of the patented technology. This requires determining the scope and sufficiency of the patent claims. The scope-determination process involves reviewing the language of the claims, the patent specification, and the prosecution history.[6] If the patent claims do not cover the product and/or process the licensee seeks to commercialize under the licenses, either literally or under the doctrine of equivalents, the patent owner cannot exclude others from making, using, or selling the product and/or process.

Determining whether a patent claim covers the subject technology or an accused product or method entails a two-step analysis. First, the claim must be properly construed to determine its scope and meaning. Secondly, the properly construed claims must be compared to the product/process subject to the transaction.[7] Literal infringement occurs if the product or process includes the same elements of the patent claims. If a different but similar component has replaced one or more components of the subject technology, a court may find infringement under the doctrine of equivalents if the substitution performs substantially the same way to obtain substantially the same result.[8]  The Supreme Court, however, has ruled that when a patentee narrows the scope of a claim during prosecution for reasons related to patentability, the patentee can be estopped from arguing infringement under the doctrine of equivalents as to the amended portion of the claim.[9]

If a patent does not cover the subject technology literally or under the doctrine of equivalents, its value in the licensing transaction may be dubious. However, if there are related pending patent applications, the applicants may be able to add additional new claims directed to the subject technology if the disclosure in the patent application supports such a claim. But, it may be difficult to predict the outcome of the patent examination proceedings and there is no guarantee that the new claims may retain their original scope.

Another important consideration is that patents have limited lifetimes and territorial scope. For sufficiency of the patent claims, the reviewer will need to consider the term remaining for each patent subject to the licensing transaction as well as consider the existence of patents in the relevant territories. For U.S. utility patents, the patent term is twenty years from the earliest effective filing date of the application. Most foreign patents expire twenty years from the first filed patent application. To preserve the full patent term, a patent office may require payment of periodic maintenance fees. The reviewer should thus examine the maintenance-fee payment history for all patents, including abandoned patents in the event it is possible for a licensee to revive them. The reviewer should also check the face of the patent as well as prosecution files for the existence of any terminal disclaimers or patent term extensions that will shorten or lengthen the patent term, respectively.[10]

Finally, the reviewer should also check for any functionality issues by confirming that the licensed technology works as intended. Patents and patent applications should be reviewed to determine if the specification is full of actual examples or prophetic examples.[11] In other words, did the inventors actually synthesize the claimed composition using the claimed method? What about best mode limitations under 35 U.S.C. § 112(a)?[12] Assuming that best mode was disclosed when an application was filed, what was previously disclosed several years ago in a patent application at the time of filing may not be the best way to practice the technology today. If, in fact, the technology today is better or different than the one that was originally disclosed and claimed, the reviewer should investigate whether the improvements were kept as trade secrets or covered under existing patent applications. It may still be possible to file patent applications to cover these improvements if no applications exist.

c. Freedom-to-Operate Determination

Once a potential licensee determines the scope of a patent’s claims, it is necessary to inquire into potential dominating third-party patents. Patents provide the right to exclude others from making, using, or selling the patented technology, but do not include a right to use the technology. Thus, a third-party patent that covers the same technology that is subject to the transaction could prevent the licensor/licensee from exploiting the technology. Generally, a reviewer should conduct a careful patent-clearance search to identify such patents. If any dominating third-party patents are uncovered, the reviewer should also conduct a careful review to verify that the licensor has or will have the necessary third-party patent licenses to exploit the patents and patent applications of the underlying transaction, and determine whether such third- party-patent licensed rights are transferable to others.

In addition, the potential licensee should make a separate inquiry as to who owns patent rights to any necessary supporting technologies that are required to support the main technology. As not all supporting technology may necessarily be protected by patents, it would be important to investigate the origins of supporting technology to make sure that licensor’s employees did not inadvertently misappropriate trade secrets of former employers or others.[13]

Finally, if the patented technology was subject to past and/or present legal proceedings, the potential licensee should seek information from the licensor and/or a court docket system and ascertain any defenses raised by third parties, particularly concerning the scope of patent protection, enforceability of the patent, and validity of the patent claims. The reviewer should also examine any settlement agreements relating to such proceedings, as well as all communications alleging infringement of any third-party patent rights.

d. Validity Assessment

The validity of a patent is related to the scope of protection but there are additional considerations for the licensee. Generally, a potential licensee may determine the validity of a patent by conducting a prior art search and reviewing the results relative to the claims of the patent at issue. Prior art searches and reviews, however, can be costly and the potential licensee will need to decide whether the licensing transaction is important enough to incur such costs. In the situation where patent enforcement is likely to occur against third party defendants, it is worthwhile for the licensee to have the search performed, especially considering that defendants in an infringement action will certainly conduct such a search on their own as part of a patent invalidation strategy.

The potential licensee should also review both U.S. and foreign patent prosecution histories to verify the absence of a potential inequitable conduct claim resulting from failure to disclose prior art references to the respective patent office. The U.S. patent rules place a duty of candor on all persons involved in the prosecution of an application, requiring disclosure to the Examiner of any prior art references that may be material to the patentability of the claims.[14] Knowingly failing to disclose such prior art would render a patent unenforceable, and this situation cannot be later cured. If prior art references are discovered after the patent issues, a patentee/licensor should consider requesting reexamination of the patent. Depending on the outcome of the reexamination, some patentable subject matter may still exist and the resulting claims, though potentially narrower in scope, can be stronger than the original claims because the resulting claims survived a second examination.

The validity and enforceability of a patent also requires that the proper inventorship be recorded.[15] For example, the exclusion of a true inventor or the inclusion of a non-inventor could invalidate a patent. The reviewer should identify any inventorship issues by requesting that the patentee provide sufficient documentation, e.g., an invention disclosure which demonstrates that the inventors conceived and reduced the subject technology to practice, and such documentation preferably also includes the names and signatures of all of the inventors. If the wrong inventorship entity was identified, the licensee should request that the patentee take the necessary steps to correct the inventorship in the Patent Office as soon as possible.

Finally, the reviewing attorney should consider legal opinions relating to patentability, infringement, validity and enforceability of patents and pending applications subject to the licensing transactions. In particular, the reviewing attorney should review any prior art documents discussed in the opinions, as well as any waivers of infringing activity.

Conclusion

Patent due diligence is important for informed business decision making, particularly for startups that are developing commercial products/processes based on licensed technology. The existence of representations and warranties in the license agreement should not substitute for competent due diligence review by patent counsel, especially when the warranties are insufficient or third-party rights may exist. As part of this process, it is important for startups to keep patent counsel informed of business objectives so that s/he can identify issues that are material to these objectives and work to resolve these issues in order to meet these objectives.

[1] The USPTO includes public databases for patents, published patent applications and patent prosecution files. For further information, please see Public Patent Application Information Retrieval, USPTO, https://portal.uspto.gov/pair/PublicPair (last visited May 22, 2019).

[2] See, e.g., Alps S., LLC v. Ohio Willow Wood Co., 787 F.3d 1379, 1386 (Fed. Cir. 2015) (reversing the district court’s denial of the motion to dismiss for lack of standing where the plaintiff could not establish ownership of the patent); see also Emily Miao and Bryan G. Helwig, Avoiding Common IP Pitfalls: What Every Startup Needs to Know, snippets (Summer 2018), https://www.mbhb.com/intelligence/snippets/avoiding-common-ip-pitfalls-what-every-startup-needs-to-know.

[3] See 35 U.S.C. § 261.

[4] See 35 U.S.C. § 262.

[5] The U.S. Government’s march-in right is one of the most contentious provisions of the Bayh-Dole Act codified at 35 U.S.C. § 102.  Under Bayh-Dole, Federal agencies that funded patented research are empowered to march-in and grant patent license rights to others under reasonable terms.  See, e.g., Setareh Samii, The Importance of the Bayh-Dole Act, The Catalyst (July 12, 2016), https://catalyst.phrma.org/the-importance-of-bayh-dole-act; Philip Simon, The Bayh-Dole Act Has Been Successful in Stimulating a Market for Federally Funded Inventions, Now It’s Time to Bring Those Inventions to the Public, JIPEL (Apr. 18, 2018), https://blog.jipel.law.nyu.edu/2018/04/the-bayh-dole-act-has-been-successful-in-stimulating-a-market-for-federally-funded-inventions-now-its-time-to-bring-those-inventions-to-the-public/.

[6] See Markman v. Westview Instruments, Inc., 52 F.3d 967 (Fed. Cir. 1995), aff’d, 517 U.S. 370 (1996).

[7] See, e.g., Duncan Parking Techs., Inc. v. IPS Grp., Inc., 914 F.3d 1347, 1360-63 (Fed. Cir. 2019) (finding no infringement where the accused product did not cover every element of the asserted claim).

[8] See id. at 1362.

[9] See Power Integrations, Inc. v. Fairchild Semiconductor Int’l, Inc., 904 F.3d 965, 975 (Fed. Cir. 2018), cert. denied, 139 S. Ct. 1265 (2019) (noting prosecution-history estoppel “limits the application of the doctrine of equivalents”).

[10] Terminal disclaimers are limiting statements made by the patent applicant during prosecution which “disclaim or dedicate to the public the entire term, or any terminal part of the term, of a patent to be granted.” 37 C.F.R. § 1.321(b). For a detailed discussion, please see Dennis Crouch, Harvard’s US OncoMouse Patents are All Expired (For the Time Being), Patentlyo (Sept. 18, 2012), https://patentlyo.com/patent/disclaimer. Patent term extensions refer to time added on to the original expiration date of the patent, typically based on delays in regulatory review. 35 U.S.C. § 156. For a detailed discussion, please see Dennis Crouch, Check your Patent Term Adjustment for Applicant Delays due to Late IDS Filings, Patentlyo (Jan. 23, 2019), https://patentlyo.com/patent/2019/01/adjustment-applicant-filings.html.

[11] A prophetic example, as defined by the Patent Office, is “an embodiment of the invention based on predicted results rather than work actually conducted or results actually achieved.”  See e.g., Janet Freilich, Prophetic Patents (June 25, 2018), available at http://www.law.nyu.edu/sites/default/files/upload_documents/Janet%20Freilich_1.pdf.  Although prophetic examples can be helpful, they may be the basis for invalidating a patent for lack of enablement and, in some cases, even grounds for inequitable conduct.  See, e.g., Novo Nordisk Pharm., Inc. v. Bio-Tech. Gen. Corp., 424 F.3d 1347, 1362 (Fed. Cir. 2005).

[12] Best mode refers to the requirement to disclose the best version or method contemplated by the inventor to carry out the invention. Although best mode is required under 35 U.S.C. § 112(a), it is no longer available as a defense for invalidating a patent.  For detailed discussion, please see Jason Rantanen, Best Mode: Only Mostly Dead, Patentlyo (May 27, 2013), https://patentlyo.com/patent/2013/05/best-mode-only-mostly-dead.html.

[13] See, e.g., Molon Motor & Coil Corp. v. Nidec Motor Corp., No. 16 C 03545, 2017 WL 1954531, at *7 (N.D. Ill. May 11, 2017) (denying a defendant’s motion to dismiss a trade secret misappropriation claim); Joshua R. Rich, Trade Secrets in 2018: The Law is Still Trying to Catch Up, snippets (Spring 2018); Joshua R. Rich, Protecting Trade Secrets with Restrictive Covenants: The Question of Consideration in Illinois, snippets (Winter 2019).

[14] See 37 C.F.R. § 1.56.

[15] See In re VerHoef, 888 F.3d 1362, 1365 (Fed. Cir. 2018), as amended (May 7, 2018) (holding a patent invalid for failing to name an individual as a joint inventor).