Wednesday, 20 August 2014

Financial Reporting for IP Intangibles: protecting investors from infringement risks

It's not often that the IP Finance weblog gets the chance to post a response to a response to a response to an original post, but Efrat Kasznik's initial piece on Financial Reporting for Intangibles drew this response from Janice Denoncourt. An anonymous reader then came back this an observation that

"IP is an asset, and one can see that its value should be estimated and reported. However if you are going to 'shine a light' and in particular try to protect investors, then I wonder whether there should be responsibility to report whether a company knows it is likely to be infringing third party rights. This would be very onerous and I would be against making this mandatory. However the 'effect of IP' on value clearly works both ways, and shouldn't investors be protected from this risk too?" 
Janice now responds as follows:
"You are referring to litigation risk. The simple answer is that, as a minimum, current litigation involving the company must be disclosed if it will have a material effect on the company’s financial results. For example, litigation against a company that represents a tiny percentage of the company’s assets would probably not need to be disclosed. It is certainly more difficult to deal with the disclosure of potential litigation risks, eg the risk of being sued for IP infringement in the future. If the board determines that the risk of litigation is high, then appropriate measures should also be taken to limit or eliminate the risk eg obtain a licence. Strong disclosure of litigation risk (bad news) will tend to lower a company’s share price. If there is high risk of litigation, one would also expect the company to publish a more detailed disclosure to explain the impact. 
A company will look at using meaningful cautionary language to minimise the impact of the disclosure, yet still comply with the spirit of the law. The “generally accepted accounting principles” (GAAP) standards used by companies provide that it must set up a ‘reserve fund’ for potential estimated losses due to pending litigation or explain why it has departed from GAAP. Failure to disclose material litigation can result in civil fines, suspended share trading and possibly criminal charges. The regulator can also seek an injunction requiring the company to disclose the litigation. 
As for your second point -- the effect of IP value on the business -- I suggest that, as a starting point, one needs to ensure that the narrative disclosure aligns with the numeric intangible figure in the financial statements. If the intangible figure has increased or decreased significantly from the previous year, the company need to explain why. Basically, directors always need to explain the money".

Monday, 18 August 2014

"Patents and Value: a dialogue": a new IP Finance event

"Patents and Value: a dialogue" is the title of a chaired discussion between IP Finance and IPKat blogger, scholar and legal practitioner Neil J. Wilkof with Intellectual Asset Management (IAM) editor and respected IP commentator Joff Wild. This event, which is co-sponsored by the IPKat weblog, is kindly hosted in the Holborn, London office of patent and trade mark attorneys and litigators EIP. It takes place on Tuesday, 16 September 2014, from 5.30 pm to 6.45 pm (with registration at 5 pm), followed by the usual refreshments. 

Neil and Joff will be discussing contemporary issues involving the value of individual patents and patent portfolios, such as "how do market forces shape corporate strategy for buying, licensing or litigating patents -- and what part does patent litigation play in fixing the price of patents?"  Jeremy Phillips will be in the chair.

Join us for for some fascinating insights from two well-informed and critical contributors to the current intellectual property scene. To find the venue, just click here.  As usual, there is no charge for registration, but anyone who signs up but doesn't attend will be entered on the IPKat's Naughty Book. To register, email theipkat@gmail.com with the subject line "Neil and Joff".

Background reading:

Sunday, 17 August 2014

Financial reporting for intangibles: why IP intangibles remain invisible

Last week's guest post, by Efrat Kasznik, "Financial reporting for intangibles: The Case of the Invisible Assets", has attracted considerable interest, with some perceptive comments being posted by readers. It has also attracted the following comment from Janice Denoncourt (Senior Lecturer, Nottingham Trent University), who writes:

Your post has raised an important question. Companies don't rush into voluntarily disclosing the value of their IP. The question then is, why?” 
There are two forms of mandatory corporate disclosure regimes in play and each is designed with a different purpose in mind.
First, Anglo-American national corporate reporting regimes and corporate governance principles are aimed at ensuring that directors have complied with the requirements of the relevant company legislation in that jurisdiction. Corporate disclosure is made via the annual report or quarterly reports, which include the financial statements and a narrative directors’ report, confirmed by the auditors as providing a true and fair view of the company’s business. The purpose is to monitor the directors’ stewardship of company assets and prevent moral hazards such as a director's conflict between his or her private interests and those of the company. If the company’s intangibles assets are a significant element of the business strategy, then they should feature in the Directors’ Report.

In the UK, reporting on corporate assets should also be reflective of the value they provide to the business in the medium to long term. The sustainability of the organisation and the long term view is enshrined in section 172 of the UK’s Companies Act 2006 (CA 2006) via the concept of ‘enlightened shareholder value’ which provides that directors have a duty to promote the success of the company. Core intangible assets clearly have the potential to contribute to profitability, long term growth and ultimately the success of the business. To comply with the mandatory s.172 CA 2006 legal requirement, both private (unless exempt) and public UK companies would supplement their traditional quantitative financial statements (which provide very little relevant qualitative information about significant intangible assets resulting in information asymmetry) with narrative disclosures.

Secondly, in addition to the above, companies listed on the London Stock Exchange (LSX) for example also subscribe to mandatory disclosure via the Disclosure and Transparency Rules (DTR). The DTR are designed to promote prompt and fair disclosure of relevant information to the public investor market. According to the LSX, “This helps to encourage investor confidence and maintain Europe’s deepest pool of capital”. In this respect I agree with Ken Jarboe’s comments that 
“Investors should have information on intangibles which allow them to come to their own valuation judgements”. 
Relevant information is ‘price-sensitive’ information that would be likely to have a significant effect on the share price in the short term. This relates to Efrat's point on ‘value fluctuations’ inherent in intangible assets. While compliance with DTR is mandatory for listed companies, it is a matter for a company’s board of directors to exercise its collective judgement to determine when to disclose significant inside information, typically applying the ‘reasonable investor test’. Disclosure to the market could even be daily if necessary to comply. The DTR are aimed at preventing market abuse and, as Efrat says, 
“The fact that managers have better information than the market on the value of their IP assets gives them an advantage as they can control the extent and timing of that information disclosure.” 
It seems that while the traditional accounting system may not be coping with volatile intangible asset valuations, the DTR mandate that listed companies must cope with disclosing ‘price sensitive information’ in narrative form or risk their shares being suspended from trading. They must ‘comply or explain’.

To revert to Efrat's problem, one important reason that companies don't rush into voluntarily disclosing additional qualitative information about their intangible assets is that they will then be held accountable for that information. There are severe legal consequences for any failure to report ‘fairly’ so as not to mislead under the CA 2006 and under the DTR for failure to disclose timely price sensitive information. The ‘silence is golden’ argument is problematic. In the UK, a director is liable to compensate the company for any loss it suffers as a result of the omission of anything legislatively required to be disclosed. Directors certainly have tough decisions to make regarding intangible asset disclosures. They will also be concerned about the cost to gather and verify the information, as well as advisor fees.

In fairness to company directors, in my opinion they need more guidance to identify the type of disclosure and how, what, when, where and how much to disclose with respect to the valuable intangible assets they manage on behalf of the company. There is minimal if any bespoke guidance on corporate intangibles reporting published by the regulators. So, although mandatory legal disclosure requirements relevant to corporate intangible assets already exist, the lack of guidance and enforcement by the regulators perpetuate the gap in publicly available information. A broad understanding of an appropriate level of intangible asset reporting has not yet emerged. The ability to evaluate the quality of intangible asset disclosures and then assess whether a company has fallen below the standard, in breach of its disclosure obligations, is highly specialised and a murky area even for the regulators.

One thing is certain however, demand for relevant, accurate and timely information regarding modern companies’ intangible assets will grow. Imperfections in both financial and corporate reporting will cause imperfections in the effectiveness of corporate governance and the protection of a company’s shareholders and other stakeholders. Corporate governance practices, especially in relation to accountability for intangible assets, need additional scrutiny in the public interest. As Efrat suggests, currently companies (that are risk tolerant) may actually benefit from information asymmetry and the lack of regulatory scrutiny. Nevertheless, I am firmly of the opinion that it is always good to shine a light in a dark corner.

Friday, 15 August 2014

Microsoft v Samsung: would a pre-nup have helped?

IP Finance is pleased to welcome the following guest post from patent attorney Ilya Kazi (Mathys & Squire, London) on a royalty fee tussle between two major IP players: what can this dispute teach us? Ilya explains:

Microsoft v Samsung: why it sometimes pays to be cynical 
At the start of this month it emerged that Microsoft and Samsung are embroiled in a dispute over royalty fees relating to Android patent and here are some reflections on this [on which see, eg, The Telegraph and Ars Technica].

"Don't shoot!"
The background is that in September 2011 Microsoft and Samsung entered into a cross-licence agreement; Samsung agreed to pay Microsoft royalties on Android-based devices in return for having access to patents relating to the Android OS. Samsung paid the first royalty in 2012, but blocked a second payment for the 2013 royalty after learning of Microsoft’s deal to take over the Nokia handsets business in September 2013. Samsung did eventually pay the royalty in November 2013 but Microsoft claims that Samsung still owes it money for the interest accrued during the period of non-payment. Samsung is also refusing to pay future royalties.

Samsung claims that the Nokia acquisition breaches the terms of the agreement with Microsoft and that the contract is thus void. If this is the case, Samsung is not required to pay Microsoft the royalties agreed to in the contract and, since Microsoft will not then be entitled to use the technology underpinned by the Samsung patents, Samsung is threatening Microsoft with proceedings for patent infringement.

... but disconnecting Microsoft and Samsung?
Naturally [but disappointingly for those of us who love reading these details ...], only a redacted version of the agreement is publicly available. However, on review of the facts available, it seems Samsung’s action may have portrayed an unconvincing position as to the strength of its case: first refusing to pay the royalty, then changing its mind and paying late, then refusing to pay further royalties. Samsung has also asked the Korean competition authorities to change the private contract between the parties so that the royalty payments to Microsoft are reduced or eliminated. If the terms of an agreement have been breached, attempting to convert a US commercial contract dispute into a Korean regulatory issue seems like a surprising approach.

Looking beyond this particular element of dispute, it is not clear what the endgame will be. If Samsung wins, the agreement will be terminated; if Microsoft wins, the outcome may well be the same, as it would be surprising if Microsoft had not inserted a termination clause to cover non-payment of a royalty. In either situation, Samsung may well be faced with renegotiating terms for a new licence which are unlikely to be more favourable than the ones in the original. Alternatively, a patent battle may erupt. Either way, it seems there is plenty of ammunition to fight this out to the bitter end and, with the publicity, neither party is going to want to lose face.

This case reinforces how important it is, when negotiating a licensing deal, to bear in mind that a seemingly friendly relationship may rapidly turn sour when circumstances change: Microsoft and Samsung had a long history of collaboration. Thinking cynically and creatively about the possible ways in which the commercial situation may shift from what both parties may well have sincerely intended at the time of the agreement is helpful. Parallels with pre-nuptial agreements can be drawn. Watch this space for the next round.

Nothing New Under the Sun: “Patent Trolls” Have Been Around Forever (well, at least a couple hundred years)

In a fascinating paper titled, “Trolls and Other Patent Inventions: Economic History and the Patent Controversy in the Twenty-First Century”, Professor Zorina Khan of Bowdoin makes many interesting points.  Professor Khan, an economics professor who studies law and economics history, essentially states that non-practicing entities (NPEs) have been with us for decades—back to the nineteenth century, that there has not been an "explosion" in patent suits when the last two hundred years are considered, and explains why prizes are not preferable to patents to incentivize invention and commercialization from a historical perspective.  To get a gist of her approach in considering critiques of the patent and copyright systems, Professor Khan states: “In general, these debates and policy proposals are primarily based on rhetoric and self-interest rather than on objective assessments of empirical evidence.”  And, she was referring to debates (very similar to today’s debates) in the nineteenth century. 

In reference to the U.S. Supreme Court eBay v. MercExchange decision concerning injunctions, Professor Kahn notes that:

According to a recent Supreme Court decision, "trial courts should bear in mind that in many instances the nature of the patent being enforced and the economic function of the patent holder present considerations quite unlike earlier cases. An industry has developed in which firms use patents not as a basis for producing and selling goods but, instead, primarily for obtaining licensing fees.”  The historical evidence refutes such claims, since “non-practising entities” or patent rights-holders who do not manufacture their inventions or final goods are hardly anomalous. Rather, as Adam Smith suggested, specialization and the division of labour are endemic to efficient markets. NPEs were the norm during the nineteenth century, and technology markets provide ample evidence that patentees who licensed or assigned their rights were typically the most productive and specialized inventors. As markets in invention became more competitive, many patentees cross-licensed their patents to other inventors to avoid the potential for conflicting rights. In some cases, patent rights were allotted to companies that intended to produce the invention or associated final goods. But in many others, “speculators” invested in patents with the intention of profiting from the margins of price differentials, without participating in either inventive activity or manufacturing, much as a financial investor might trade in a share in a company in secondary and tertiary markets. These different patterns all characterized a process of securitization that proved to be as fundamental to the development of technology and product markets as it was to the mobilization of financial capital.

Professor Kahn also attacks the notion that there has been a “patent explosion” in recent years (the increase in patenting is likely the result of the introduction of a disruptive technology):

Americans from the beginning of the colonial period have always considered themselves to be exceptionally litigious, and equally hyperbolic about decrying its consequences. Litigation is a function of many factors, including changes in legal rules, uncertainty, conflicting interpretations of rights and obligations, defensive and aggressive measures, and the scale of the underlying market. One of the most straightforward explanations of the volume of patent lawsuits is related to the numbers of patents filed. Figures 1(a) and (b) support the hypothesis that the “patent litigation explosion” merely mirrors a parallel “explosion” in patenting. Patent applications and grants alike have risen sharply, from approximately 270,000 applications and 153,000 grants in 1999, to 543,000 and 253,000 respectively in 2012, with especially rapid growth between 2009 and 2010. Opinions may differ but, although it has increased over the past few years, the rate of litigation (cases as a percentage of patents), is still unexceptional. This is especially true since changes in legal rules (ironically intended to reduce litigation) have led to a nominal or administrative increase in the numbers of cases filed in the most recent years.  

However, two decades may be insufficient to assess whether patent disputes have reached a pathological level. We therefore estimate the long run patterns for patenting and litigation, between 1790 and 2012. Figure 2 shows patent grants per capita over the two centuries of the existence of the federal patent system, for total patents and patents filed by domestic residents. It suggests that the “long nineteenth century” was an extraordinarily creative period in terms of patented innovations, when the numbers of patents relative to population attained levels that have not been exceeded until the final three years. Figure 3 presents the patterns over time of reported patent cases relative to patents between 1790 to 2000.  This historical trend in litigation rates relative to patents granted clearly does not support claims that litigation in the past decade has “exploded” above the long term norm. In fact, the per patent rate of litigation was highest in the era before the Civil War and during the subsequent market expansion that started in the 1870s. Patent litigation rates were increasing toward the end of the twentieth century, but the increase comprised a return toward the long-term norm.

Technological innovations in the 21st century have undoubtedly transformed production and consumption. However, from the perspective of a world where mail was delivered by stagecoach, the advent of the telegraph was far more transformative to communications in the antebellum era than the change from a landline to a cellphone. This was not just true of “great inventions” but also of supposedly incremental discoveries such as safety pins, aspirin and manufactured soap. Every new innovation that mattered in the marketplace brought uncertainties, conflicts and consequences that were initially processed in state and federal courts, until these issues were resolved through various institutional mechanisms. Figure 4 shows new innovations like the telegraph, telephone and automobile were inevitably accompanied by an upswing in total civil litigation. . . .

Enormous profits awaited those who were able to successfully commercialize new inventions and satisfy or anticipate market demand, creating wealth for some entrepreneurs on a scale that was unprecedented then, or since. Numerous inventors were attempting to resolve similar problems, leading to multiple patent interferences, overlapping claims, and efforts to invent around existing patents. Complex combinations of hundreds of patents often covered any particular device, so it is not surprising that intense competition for these excess returns centered around these rights.  Licensing and litigation comprised a common strategy by “practicing” and “non-practicing entities” alike. Austin and Zebulon Parker of Ohio prosecuted claims for licenses against millers across the nation and engaged in countless lawsuits regarding an 1829 patent for an improved waterwheel. George Campbell Carson’s smelting patents were held to be worth an estimated $260 million in damages and royalties and he floated shares in the Carson Investment Company, which was formed to pursue potential defendants.  In the railroad industry “… a ring of patent speculators, who, with plenty of capital, brains, legal talent and impudence, have already succeeded in levying heavy sums upon every considerable railway company in the land…. This case is not an isolated one, but there were hundreds of them, and the railway company that made up its mind to insist upon its rights had to keep a large legal force, a corps of mechanical experts, and other expensive accessories, in order to secure that end.”

Her article is full of interesting examples of NPEs of the nineteenth century, and she also notes that Daniel Webster was paid $332,000 as lead attorney in a single patent case in 1852.  She also makes the argument that historically prizes failed to provide the same technological spillover benefits as patents.  Notably, she states that the only thing really different in patent practice and law today than from the nineteenth century is that legislators are actually passing many more laws to address the complaints about the enforcement and use of patents.  Apparently, there was a little more restraint on behalf of legislators in the U.S. back in the day.