United States: Intellectual Property: Stock Purchases And Mergers
Last Updated: July 11 2012
Article by Daniel Glazer

This article was published by The M&A Journal and Practical Law Company on its PL C Intellectual Property & Technology web services

This Note highlights key intellectual property (IP) considerations in stock purchase and merger transactions.

It discusses legal due diligence of the target company's IP and drafting and negotiating IP aspects of stock purchase and merger agreements (including representations and warranties) and ancillary agreements. It also addresses certain information technology (IT) considerations.

In most stock purchase and merger transactions, legal issues involving intellectual property (IP) are handled by IP counsel separately, but concurrently, with the negotiation of other transaction issues.

This Note discusses:

  • Due diligence of the target company's IP assets, including issues commonly identified during the buyer's due diligence review.
  • Key aspects of drafting and negotiating the IP aspects of stock purchase and merger agreements, including representations and warranties, covenants and ancillary agreements.

It also addresses certain information technology (IT) aspects, including the target company's proprietary and licensed software, and its software and IT agreements with other parties.

In any stock purchase or merger transaction, the buyer primarily wants to ensure that it acquires or has access to all IP assets required to conduct the business after the closing date of the transaction. IP issues should not be overlooked in any transaction, but their analysis in a specific transaction depends on many factors, including whether the target company:

  • Is in the business of exploiting IP or otherwise heavily relies on IP in its business.
  • Is a mature business or a start-up.
  • Has a diversified IP portfolio or holds a single key IP asset.
  • Is a stand-alone company or a subsidiary of a larger entity (see Carve-out Transactions).

IP counsel involved in a stock purchase or merger generally have five primary areas of responsibility:

  • Understanding the transaction structure and its implications for the target company's IP assets and liabilities (see Types of Transactions).
  • Conducting IP due diligence, including identifying relevant IP assets and liabilities, and preparing an analysis of the results (see IP Due Diligence).
  • Drafting and negotiating the IP aspects of the purchase or merger agreement, including representations and warranties, and covenants (see Purchase or Merger Agreement).
  • Drafting and negotiating any ancillary IP or IT agreements, including licenses and transition services agreements (see Ancillary IP and IT Agreements).
  • Coordinating any required post-closing IP matters, such as IP prosecution and maintenance (see Post-closing Issues).

For the purposes of this Note, references to the target company include any target company subsidiaries.

This Note focuses primarily on IP and IT issues under US law. If the target company's foreign IP assets are material to the transaction, the buyer should consider retaining local IP counsel in the relevant foreign jurisdiction.

TYPES OF TRANSACTIONS

Understanding the transaction structure is necessary for evaluating the transaction's potential impact on the target company's IP assets, particularly the target company's IP licenses and other IP-related agreements. IP due diligence and the negotiation of IP issues must take into account whether:

  • The transaction is a stock purchase or merger and, if it is a merger, the type of merger structure (see Stock Purchases and Mergers).
  • The target company, or the seller, is a publicly- traded or privately-held entity (see Public versus Private Transactions).
  • The transaction involves the sale of a subsidiary, division or other smaller part of a larger business (see Carve-out Transactions).

Stock Purchases and Mergers

In a stock acquisition, the buyer typically acquires a controlling ownership interest in the target company. By operation of law, control over the target company's assets, rights and liabilities (including unknown or undisclosed liabilities) transfers to the buyer as of the closing. For further information, see Practice Note: Stock Acquisitions: Overview (http://us.practicallaw.com/4-380-7696).

A merger is a legal combination of two companies where the surviving entity succeeds to both companies' assets, rights and liabilities (including unknown or undisclosed liabilities). In a forward merger and forward triangular merger, the target company ceases to exist by merging into the buyer and the buyer's subsidiary, respectively. In a reverse triangular merger, the target company survives the merger as the buyer's subsidiary. For more information, see Practice Note, Public Mergers: Overview: Merger Structures (http://us.practicallaw.com/4-382-2164).

In both stock purchases and mergers, the buyer directly or indirectly assumes control over all IP rights owned by the target company and the benefit of all licenses under which the target company uses third-party IP. However, to ensure that the target company will continue to have all IP rights necessary to operate its business, the buyer must consider:

  • Any potential loss or impairment of the target company's IP rights caused by the transaction itself (see IP and IT Agreements).
  • In a carve-out transaction, the target company's right to continue using IP retained by the seller or its other affiliates (see Carve-out Transactions).

The negotiation of a stock acquisition or merger, therefore, differs from an asset acquisition, in which the buyer only acquires the assets and liabilities it identifies and agrees to acquire and assume, subject to any liabilities imposed on the buyer as a matter of law.

Public Versus Private Transactions

Public Transactions

In public company transactions, the buyer often relies on Securities and Exchange Commission reports and other public filings for material information about the target company. Because the seller in a public company transaction usually does not indemnify the buyer, the buyer cannot rely on the representations and warranties in the purchase or merger agreement to protect it from post-closing IP-related claims and liabilities. Therefore, in a public company transaction:

  • The IP representations and warranties tend to be more streamlined and are often not heavily negotiated.
  • The buyer must rely on IP due diligence to identify potential post-closing risks not disclosed in public filings.

For further information about public mergers, see Practice Note, Public Mergers: Overview (http://us.practicallaw.com/4-382-2164).

Private Transactions

Because public filings are not available for private company transactions, the buyer must rely more heavily on the due diligence analysis and thorough representations and warranties to:

  • Gather information about the target company's IP assets and liabilities.
  • Reduce the risk of unexpected post-closing claims and liabilities.

In private company transactions the IP representations and warranties typically survive closing, leaving the seller (or a fund set aside by the target company) with ongoing indemnification obligations if any of those representations or warranties turn out to be false.

For more information about private mergers and stock acquisitions, see Practice Note, Private Mergers: Overview (http:// us.practicallaw.com/0- 380-9145) and Practice Note, Stock Acquisitions: Overview (http://us.practicallaw.com/4-380-7696).

Carve-Out Transactions

A carve-out transaction is the sale of a subsidiary, division or other smaller part of a larger business. The carved-out business often shares certain IP assets and services, including IT services, with its parent and other affiliates. In this case, due diligence becomes critical to identify the assets transferring to the target company and those remaining with the seller. The parties must also determine whether the seller must license IP assets or provide IP or IT services to the target company for a transitional period or on a long-term basis after closing (see License Agreements and Transition Services Agreement).

For more information on carve-out transactions, see Practice Note, Carve-out Transactions (http://us.practicallaw.com/7-504-1544).

IP DUE DILIGENCE

The buyer 's IP legal due diligence serves many purposes, including:

  • Validating the business reasons for the proposed transaction, in particular, if certain IP assets are critical to the target company's business.
  • Identifying IP-related liabilities that could affect the buyer's valuation of the target company.
  • Identifying IP-related obstacles to completing the transaction and allowing the parties to identify and resolve or mitigate these issues before closing.

In general, IP legal due diligence includes a review and analysis of these areas:

  • Owned IP. This is to confirm that the target company owns the IP it claims to own and that the IP will be retained by the target company and not be impaired by the transaction (see Registered Owned IP and Unregistered Owned IP). It also includes a review of any licenses of the target company's owned IP to other parties (see IP and IT Agreements).
  • Third-party IP. This includes a review of IP used by the target company under licenses from another party (see IP and IT Agreements).
  • IP disputes. This includes a review of actual or potential IP-related disputes involving or impacting the target company (see IP Disputes).
  • IT assets. This includes a review of the target company's proprietary and licensed software and other IT assets (see Information Technology).

For a checklist of common IP due diligence issues, see IP Due Diligence Issues in M&A Transactions Checklist (http://us.practicallaw.com/3-501-1681).

Before beginning its due diligence, the buyer often submits a due diligence request to the target company or seller consisting of a list of questions and requests for documents organized by topic. The buyer's IP counsel should review this request list to ensure it appropriately covers IP and IT.

Registered Owned IP

The buyer should ask the target company to provide schedules of all federal, state and foreign IP registrations and applications owned or held for use by the target company. The target company's registered IP portfolio may include:

  • Patents, patent applications and statutory invention registrations.
  • Trademark and service mark applications and registrations.
  • Copyright applications and registrations.
  • Foreign design registrations.
  • Mask work registrations.
  • Internet domain name registrations, which are not technically IP rights but which are often addressed alongside IP registrations and applications.

The buyer should confirm the accuracy and completeness of these schedules by conducting searches of publicly available US and foreign IP databases (for example, in the US, on the websites of the US Patent and Trademark Office (USPTO) and US Copyright Office. The buyer can also use proprietary databases that consolidate these publicly available IP databases to conduct more comprehensive ownership searches using the target company's present (and previous) names.

The schedules provided often form the starting point for preparing disclosure schedules for the purchase or merger agreement (see IP Schedules).

Common Registered IP Issues

The buyer may identify the these common issues relating to specific IP applications or registrations:

  • Abandoned or expired items. The target company may have abandoned applications or registrations or let them expire by failing to make required filings or pay required maintenance or renewal fees. The buyer should confirm whether the items were abandoned intentionally or inadvertently. If the buyer believes an abandoned or expired item is material, the buyer should consider that:

    • in some cases, it may be possible for the target company to revive the application or registration; and
    • without revival, damages may still be recoverable for pre- expiration or pre-abandonment infringement.

  • Pending applications and registrations set to expire or for which renewal, maintenance or other fees are due. The parties should discuss any material upcoming prosecution decisions on pending applications for registration and existing registrations. They should also agree on the party responsible for prosecution and maintenance after closing. In a carve-out transaction, if the seller's IP counsel handles the maintenance of the target company's registered IP portfolio, the buyer may have to assume responsibility for handling the target company's IP portfolio promptly after closing.
  • Gaps or other inconsistencies in the public record chain of title. The target company or one of its subsidiaries should be identified as the current, record owner in public IP databases of each item of registered IP. The buyer should require that the target company fix any chain-of-title discrepancies before closing. If the record owner of an item is an unrelated third party, the target company's predecessor or a former name of the target company, this may reflect:

    • a third party's superior ownership interest; or
    • a failure to record name changes or assignments with appropriate IP registries.

  • Unreleased security interests. Security interests may be recorded against specific items of IP, including US registered IP in the USPTO and US Copyright Office. Unreleased security interests could reflect either:

    • existing liens on the IP; or
    • the target company's failure to record a security interest release with the appropriate IP registries, including the USPTO or Copyright Office as appropriate.

  • IP held by seller or its affiliates. In a carve-out transaction, the seller or an affiliate of the target company (for example, an IP holding company) may own IP that the target company primarily or exclusively uses. The buyer should require that the affiliate assign this IP, including any registrations or applications, to the target company before closing. Although a separate assignment agreement is not required in a stock purchase or merger for the transfer of IP owned by the target company (see Types of Transactions), the transfer of any IP held by the seller or the seller's other affiliates requires a separate assignment. For IP used by the target company that will be retained by the seller, the target company may seek a license agreement (see License Agreements).

The buyer should also pay attention to:

  • Material changes in the target company's IP filing strategies.
  • The target company's failure to register or apply for registrations:

    • in key foreign jurisdictions where it does business; or
    • that would cover current or future products or services.

These changes or failures may simply reflect a change in business strategy that does not materially affect the target company's business. However, they could also indicate potential conflicts with third-party IP and require further investigation, such as a review of trademark clearance or patent freedom-to-operate searches that may have influenced the target company's filing decisions.

Patents and Patent Applications

Common issues concerning the target company's issued patents and patent applications include:

  • Unpublished patent applications. Because US patent applications are not published for at least 18 months after filing, they cannot be searched for in online public databases during that period. Therefore, the buyer should review the target company's internal patent filing records and consult with the target company's patent counsel to determine the scope and filing status of unpublished US patent applications.
  • Employee patent invention assignments. If a current or former target company employee or contractor is the record owner of a patent or an outstanding patent application purportedly owned by the target company, the buyer should confirm that the:

    • employee or contractor has assigned his ownership interest in the patent or patent application to the target company; and
    • the assignment is properly recorded in the appropriate IP registry.

Trademark Registrations and Applications

Common issues concerning the target company's trademark applications and registrations include:

  • Intent-to-use trademark applications. US intent-to-use (ITU) trademark applications cannot be assigned before submitting evidence to the USPTO that the applicant is using the subject mark in US commerce, unless the assignment occurs as part of a transfer of the entire business to which the mark pertains. The buyer should confirm that the target company does not own applications or issued registrations that were assigned in violation of this restriction.
  • Non-use. The target company's trademark registrations may be vulnerable to a third-party cancellation action for abandonment if the target company has stopped actively using the marks. Under the Lanham Act, a mark, whether registered or unregistered, is deemed abandoned when its owner has discontinued use with an intent not to resume use. There is a statutory presumption of abandonment after three consecutive years of non-use.
  • Appropriate use. The buyer should review the target company's marketing and promotional materials, websites and social media web pages to identify and ensure the appropriate use of the target company's registered trademarks.

Copyright Registrations and Applications

Common issues relating to the target company's copyright registrations and applications include:

  • Failure to register. For copyrighted works created in the US, registration is required to sue for infringement under the Copyright Act. The buyer should identify the target company's material unregistered copyrights and consider requiring that the target company apply for registrations if a legitimate risk of third-party infringement exists.
  • Reversion rights. Under US copyright law, an author of a copyrighted work has the irrevocable right to terminate any assignment or license of the copyright in the work generally within a five-year window beginning 35 years after the grant (or, for pre-1978 grants, beginning 56 years from the date of copyright). The buyer should identify any material works that have been assigned or licensed to the target company and may be subject to a termination notice from the original author. This risk is particularly significant if the target company's business involves the commercialization of music, film or similar entertainment properties. Notably, this termination right does not apply to works made for hire.
  • Chain of title. The buyer should confirm that all works that relate to the copyright registrations owned by the target company qualify as works made for hire (see Unregistered Copyrights) or are the subject of a proper assignment.

Domain Name Registrations

Common domain name registration issues include:

  • Employees or contractors listed as the owner in the applicable domain name registry's records. A present or former employee or contractor of the target company is often identified as the record owner of a domain name registration purportedly owned by the target company. The buyer should ensure that the domain name registrations are transferred to the target company. Uncooperative employees or contractors can demand large sums to transfer the domain names if they believe they have leverage to hold up the acquisition.
  • Jurisdiction-specific top-level domains. Registrations with certain jurisdiction-specific top-level domains can only be owned by persons or entities based in the applicable jurisdiction, including, the European Union (.eu), Canada (.ca), Germany (.de) and the US (.us). In these cases, a local agent used by the target company to register the domain name often appears as the record owner.

Unregistered Owned IP

The buyer should ask the target company to provide schedules or a summary of its unregistered (common law) IP. The target company's unregistered IP portfolio may include some or all of the following:

  • Trade secrets, including unpatented inventions.
  • Unregistered copyrights, including software source code (see also Proprietary Software).
  • Unregistered trademarks and service marks.

To the extent possible, the buyer should confirm the ownership status of key unregistered IP the target company claims to own.

As with registered IP (see Common Registered IP Issues), in a carve-out transaction the buyer should ensure that any unregistered IP that is primarily used by the target company but owned by the seller or another seller affiliate is assigned or licensed to the target company (see License Agreements and IP Assignments).

Trade Secrets

Common issues concerning the target company's trade secrets include:

  • Confidentiality policies and non-disclosure agreements. The buyer should request copies of the target company's written confidentiality policies and non-disclosure agreements. The target company's failure to take appropriate confidentiality measures can threaten the proprietary status of its trade secrets or result in liability to third parties for not protecting their confidential information. In addition, the buyer should ensure that:

    • any confidentiality obligations in the target company's non- disclosure agreements covering trade secrets are perpetual; and
    • the duration of confidentiality obligations for non-trade secret information are appropriate. Some states do not enforce perpetual confidentiality obligations in non- disclosure agreements for non-trade secret information.

  • IP and invention assignment agreements. The buyer should ensure that the target company's IP and invention assignment agreements adequately cover trade secrets (see IP and Invention Assignment Agreements).

Unregistered Copyrights

The buyer should confirm that the target company's IP or invention assignment agreements include work made for hire language. Work made for hire only applies to copyrights and not other kinds of IP. To qualify as a work made for hire, a copyrightable work must be either:

  • Created by an employee within the scope of his employment.
  • Created by a non-employee and fall under one of nine specific types of commissioned works set out in the Copyright Act, with the parties agreeing in writing that the subject work is a work made for hire (17 U.S.C. § 101). Notably, software cannot be a work made for hire when created by a non-employee and ownership rights must be expressly assigned to the commissioning party.

Unregistered Trademarks

Similar to registered trademarks (see Trademark Registrations and Applications), the buyer should ensure that the target's company's unregistered trademarks, particularly those that are material to its business:

  • Are not vulnerable to an assertion of abandonment for non-use.
  • Are being used appropriately in all marketing and promotional materials, websites and social media.

Other IP Ownership Issues

The buyer should consider the following possible restrictions on the target company's use of its IP:

  • Jointly-owned IP. The rules relating to joint IP ownership vary by type of IP and by jurisdiction, but may impair the target company's ability to fully exploit its IP. For example, under US law:

    • each joint copyright owner may license its undivided interest in the entire copyright without the consent of other joint owner(s), but must account for licensing royalties received and must not destroy the value of the copyrighted work; and
    • each joint patent owner may license its interest without the consent of other joint owner(s), but has no duty to account for licensing royalties to its co-owner(s).

  • IP developed using government, university or military resources, or as part of a standards- setting organization or patent pool. These arrangements often restrict transfer of the IP, or require licensing, joint ownership or other mandated sharing of the IP with third parties.

IP and IT Agreements

As part of its due diligence requests, the buyer should ask the target company to provide complete and executed copies of all IP licenses and other IP and IT agreements to which the target company is a party.

Depending on the transaction, other IP and IT agreements may include:

  • Research and development agreements.
  • IP and invention assignment agreements.
  • Trademark co-existence agreements.
  • Disaster recovery agreements.
  • Outsourcing arrangements.
  • Sponsorship and marketing agreements.

These agreements can raise a range of IP-related issues that could affect the valuation or closing of the contemplated transaction.

Restrictions on Change of Control or Assignment

The buyer should review the target company's licenses and other IP and IT agreements to determine whether they prohibit or restrict:

  • Changes of control of the target company.
  • The target company's assignment of the agreement.

If the transaction violates an assignment or change of control clause or triggers a termination right by the other party, the licensee or vendor's consent may need to be obtained before closing to avoid a breach of the agreement.

In the event of a change of control restriction, the buyer must determine whether the transaction falls within the scope of transactions described in the relevant change of control provision. For example, a merger typically triggers a change of control provision. Stock purchases may or may not trigger a change of control provision, depending on the percentage of stock the buyer intends to acquire.

Whether a stock acquisition or merger violates a non-assignment clause depends on both the transaction structure and the nature of the license grant. In particular, courts have found that for certain types of IP and licenses a licensee's rights in licensed IP are not freely transferable because of the licensor's interest in controlling the identity of its licensee.

The following are some general guidelines for evaluating the transferability of licenses when the target company is the licensee, although the outcome may be depend on, among other things, the applicable law and the type of IP at issue:

  • Forward mergers, including forward triangular mergers. Because the target company ceases to exist as a separate entity following a forward merger, a forward merger is likely to be treated as an assignment, possibly violating a non-assignment provision (see, for example, Cincom Systems, Inc. v. Novelis Corp., 581 F.3d 431 (6th Cir. 2009)).
  • Stock purchase. Because the target company survives as a separate entity following a stock purchase, a stock purchase is not treated as an assignment and is not likely to violate a non- assignment provision.
  • Reverse triangular merger. Because the target company survives as a separate entity following a reverse triangular merger, reverse triangular mergers typically are assumed to not violate non-assignment provisions. However, in conducting due diligence, the buyer should be aware that under some circumstances a reverse triangular merger may be found to violate an anti-assignment provision.

    For example, the decision in SQL Solutions v. Oracle held that a reverse triangular merger violated a non-assignment clause in a non-exclusive copyright license 1991 WL 626458 (N.D. Cal. 1991), and in Meso Scale Diagnostics, LL C v. Roche Diagnostics GMBH, C.A., a reverse triangular merger transaction was found to violate a non-assignment clause that prohibited assignment by operation of law in a non-exclusive patent license (No. 5589-VCP (Del. Ch. April 8, 2011)).

The buyer may discover that the target company is a party to certain licenses that are silent on the issue of assignment. The majority of courts have found that when a license is silent:

  • Non-exclusive IP licenses may not be assigned by the licensee without the licensor's consent.
  • Exclusive IP licenses are assignable by the licensee without the licensor's consent.
  • A licensor may assign an IP license without the licensee's consent.

Trademark Agreement Issues

The buyer should consider the following issues relating to the target company's trademark agreements:

  • Trademark assignment agreements. A trademark assignment must include the goodwill associated with the assigned marks or may be deemed an invalid assignment in gross.
  • Trademark license agreements. Trademark license agreements should include quality control provisions because the target company's failure to exercise quality control over its licensees' use of the target company's marks can result in the abandonment of those marks.

IP and Invention Assignment Agreements

The buyer should request copies of the target company's IP and invention assignment agreements. Each should include:

  • A present assignment of rights, rather than a promise to assign at a future time (see Board of Trustees of the Leland Stanford Junior University v. Roche Molecular Systems, Inc., et al., 563 U.S. _____ (2011)).
  • A broad assignment to the target company of all relevant forms of IP.

Other Common IP and IT Agreement Issues

Other common issues in the target company's IP and IT agreements may include:

  • Enterprise or group license agreements. In a carve-out transaction, the target company's rights to use third-party IP, including software, may flow from an enterprise or group license agreement that will be retained by the seller after closing. The buyer should confirm whether the license agreement includes a divestiture provision, permitting the target company to remain licensed to use the IP or software for a period of time after closing, even though it will no longer be the seller's affiliate. Alternatively, the buyer may need to enter into its own agreement with the licensee or obtain access to and use of the IP or software from the buyer for an interim period after closing (see Transition Services Agreement).
  • Adverse impact on buyer's IP. The target company may be party to a license that contains obligations that may apply to the buyer or its affiliates. For example, an agreement may define the IP that the target company licenses to a third party as "all IP owned by the target company or any of its affiliates." After closing, the buyer and its affiliates may be considered affiliates of the target company. In this case, the buyer's own IP may be licensed under the target company's agreement.
  • Termination rights. The target company may be party to licenses in which the licensor can terminate the target company's rights to use the licensed IP at any time without cause.
  • Exclusive licenses. The target company may have granted an exclusive license of its IP or agreed to other restrictions on the use of its IP that would prohibit the buyer's planned expansion of the target company's business.
  • Terminated agreements or agreements soon due to terminate. If the buyer identifies any agreements that have terminated or may soon terminate, the target company should confirm whether the parties have executed or are negotiating a new agreement.

IP DISPUTES

The buyer should ask the target company to identify and provide relevant documents for all pending, asserted and threatened infringement, dilution, misappropriation and other IP-related claims involving:

  • The target company and its affiliates.
  • Any key licensee or licensor, if an actual or threatened dispute involving these parties may relate to the target company's business.

These claims can include:

  • Pending litigations and arbitrations, including:

    • arbitrations conducted under the Uniform Domain-Name Dispute-Resolution Policy (UDRP); and
    • industry-wide patent infringement litigations initiated by non-practicing entities (NPEs), which have been of particular concern in recent years. These lawsuits are typically initiated by patent owners that do not manufacture or use the patented inventions to encourage defendants to enter into royalty-bearing licenses.

  • USPTO proceedings, including:

    • trademark office actions and patent re-examinations pending before the USPTO; and
    • Trademark Trial and Appeal Board (TTAB) oppositions and cancellations.

  • Cease-and-desist and invitation-to-license letters from third- party IP owners.
  • Pending government investigations and proceedings.

The buyer can perform online searches for some of these disputes to confirm the accuracy of the information the target company provides.

When evaluating IP disputes, the buyer should consider, among other things:

  • The materiality of the dispute to the target company's business.
  • The worst-case scenario and its likelihood of occurring.
  • The availability of alternatives, including a technological workaround, in case of an injunction against the target company.
  • The likelihood of settlement on terms acceptable to the target company.
  • Whether the buyer has a relationship to the adverse party and whether that relationship can aid or hinder resolution of the dispute.
  • The possibility of parallel actions in foreign countries.
  • The cost of the dispute to date and the likely future costs, including:

    • whether the target company has indemnification obligations or can look to another party for indemnification coverage; and
    • the availability of insurance coverage.

INFORMATION TECHNOLOGY

The buyer's IP counsel typically assists with due diligence review of the following IT issues. This Note does not address technical aspects of software systems and hardware integration, which are typically handled in a parallel diligence process by the target company's and buyer's IT personnel.

Proprietary Software

The buyer should investigate the target company's rights in any proprietary software, particularly if:

  • The target company licenses or distributes proprietary software products to customers.
  • Relies on software licensed from third parties that is not readily replaceable or is costly to replace.

For software created by or for the target company, the buyer should confirm that all relevant rights have been assigned to the target company. In particular, if the software is created by a nonemployee, it cannot qualify as a work made for hire and all rights must be expressly assigned to the target company.

For software licensed to the target company by third parties, the buyer should ensure that the rights licensed in to the target company are consistent with the rights the target company has licensed to its customers or other third parties. In particular, the buyer should confirm that if the target company's licensed rights are terminated:

  • The target company's licenses permit the target company's customers to continue using the licensed software.
  • The target company will continue to have the right to provide its customers with maintenance and support.

Open-source Software

The buyer should investigate the target company's use of open- source software. Improper use of open-source software could jeopardize the proprietary nature of the target company's or its customers' software. The buyer should review the terms of each applicable open-source license agreement, because each agreement may impose different restrictions on the permissible uses of the licensed open source software.

For more information on open-source software, see Practice Note, Open-source Software: Use and Compliance (http://us.practicallaw.com/9-504-7111).

Source Code Escrow

For material third-party software licensed to the target company, the buyer should determine whether the target company either:

  • Is in possession of a copy of the source code.
  • Is party to a source code escrow agreement.

A source code escrow agreement gives the target company access to and the right to modify the licensor's source code on the occurrence of certain conditions (for example, if the licensor enters bankruptcy or ceases operation and is unable to continue providing maintenance and support).

The buyer should confirm that any source code escrow agreement naming the target company as a beneficiary includes:

  • An obligation for the source code and other deposited materials, such as documentation, to be automatically released if a release condition occurs.
  • A present license to the source code. Some source code escrow agreements purport to grant a license to source code that is effective only if the release condition occurs. However, a bankruptcy court may characterize a license grant that is contingent on the licensor's bankruptcy as an impermissible transfer from the bankruptcy estate.

If the target company has granted other parties access to or rights in its source code, the buyer should understand:

  • The scope of the other parties' permitted access.
  • The terms and conditions of permitted access.
  • The potential impact of any escrow or other agreement governing the release of the target company's source code.

Privacy and Data Security

The buyer should confirm that the target company maintains appropriate policies and internal practices concerning its collection, use and protection of personal information. Because the complexity of overlapping data protection laws and regulations makes it difficult to confirm the target's compliance through due diligence, the buyer often relies heavily on representations and warranties. However, even if the buyer is conducting an expedited due diligence review, it should consider:

  • Reviewing the target company's agreements with service providers and other vendors to ensure those agreements reflect the third parties' obligations to hold in strict confidence the personal information of the target company's customers or website users.
  • Consulting local counsel if the target company's business involves or the transaction will result in the cross-border transfer of personal information.
  • If the target company collects users' personal information on its website, reviewing the target company's website privacy policies to ensure that they do not include:

    • an obligation to notify users of a change of control; or
    • any other restrictions that may be triggered by the transaction.

Back-office IT Systems

Due diligence is also necessary to ensure that the transaction will not disrupt the functioning of and the target company's access to its back-office IT systems. In a carve-out transaction, if the target company relies on the seller's IT systems, the seller should provide continued access and support for a transitional period after closing (see Transition Services Agreement).

User-generated Content

If the target company's website permits users to post content, the buyer should ensure that:

  • The target company's website has appropriate terms of use and a copyright policy.
  • The target company has complied with the take-down procedures and safe harbor provisions of the Digital Millennium Copyright Act (DMCA) in a manner sufficient to qualify for immunity from copyright infringement claims.

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