Intellectual property diligences from an insolvency lens

• Introduction

  Combing through countless documents in the course of conducting a due diligence exercise rarely leaves lawyers feeling like they are encountering something new. This is also true when it comes to diligences conducted on intellectual property (IP), with IP diligences often being limited to basic and high-level checks on the title, changes of control relating to licences, and IP litigation.

  However, evolving insolvency laws in India have underscored the need for buyers to be aware of and protect themselves from risks that impact IP sales or licensing arrangements due to the insolvency of companies holding the IP. Therefore, rather than adopting a formulaic approach to IP diligences, a different lens needs to be applied in identifying and mitigating risks posed by a potential insolvency, especially considering the significance of IP in reviving distressed companies that rely on technology for their offerings.

  Enter the concept of vuja de. It was succinctly described by Adam Grant in his book, Originals, as follows:

  "The starting point [of creativity] is curiosity: pondering why the default exists in the first place. We're driven to question defaults when we experience vuja de, the opposite of déjà vu. Déjà vu occurs when we encounter something new, but it feels as if we've seen it before. Vuja de is the reverse—we face something familiar, but we see it with a fresh perspective that enables us to gain new insights into old problems."

  In this backdrop, this article highlights the risks that need to be assessed in transactions where the primary or significant focus is sale of IP and the holder of the IP is financially distressed (for instance, such person is selling assets to stay afloat or is likely to face insolvency on account of its inability to repay debt). These transactions may include sale of brands or trademark (as in, a retail business where goodwill and market recognition are connected to the brand) or copyright in software code or media properties (like the acquisition of a product technology company, or a movie or music catalogue), or even a sale of a business which is dependent on third party proprietary IP licences (IP Assets).

• Insolvency-related risks impacting IP transfers and licensing

  • Restrictions on IP transactions where they are found detrimental to the interests of creditors

    The Insolvency and Bankruptcy Code, 2016 allows authorities to review past transactions on various grounds, including to determine if they are favourable or detrimental to the interests of the creditors.

    Therefore, during an insolvency process, a previously completed transfer of IP Assets may be rendered void if it is proved to:

    • be preferential, i.e., for the benefit of a creditor or guarantor,
    • be undervalued,
    • be executed with an intent to defraud the creditor, or
    • require the borrower to make exorbitant payments to creditors.

    The ambit of such restricted transactions could include some of the following :

    • a deal that executes the sale of IP Assets to a related party at a price lower than its fair value,
    • the sale of IP Assets to an operational creditor immediately prior to the commencement of the insolvency proceeding, and
    • the intentional re-negotiation of deal terms to receive a lower consideration for the IP Assets and receive the rest through alternate structures like earn-outs.

    The lookback period for such transactions with related parties is two years (and with unrelated parties, one year) from the date of commencement of the insolvency process (Twilight Period).

  Certain risks need to be assessed in transactions where the primary or significant focus is sale of IP and the holder of the IP is financially distressed (for instance, such person is selling assets to stay afloat or is likely to face insolvency on account of its inability to repay debt).

  • Restrictions on transactions which involve the sale or alienation of IP during the moratorium period

    Insolvency laws restrict sale or alienation of assets, or rights or interest of a corporate debtor once the authorities have accepted the insolvency initiation application and imposed a moratorium on a company. These restrictions are relaxed in limited circumstances, such as when the resolution professional is of the opinion that such a sale or alienation is necessary for ‘better realisation of value’ (a very subjective parameter) of the assets or rights or interest, or upon the approval of the committee of creditors.

    For instance, technology licensing arrangements frequently include a source code escrow, which may be invoked by a licensee if the licensor files for bankruptcy, to ensure maintenance of the software. However, such invocation could run the risk of being challenged as an alienation of the licensor’s assets during the pendency of a moratorium, which could interfere with a licensee’s ability to continue operations.

  • Amendments to existing contractual arrangements relating to IP

    In addition to the above restrictions on transactions that have been executed recently, resolution professionals may also modify, terminate, or disclaim any contracts on the grounds that they are 'onerous contractual arrangements'. For instance, they may claim that: (i) a perpetual and exclusive licence for a one-time royalty; or (ii) structures involving deferred or contingent consideration, are onerous for the licensor, and ought to be disclaimed.

    Resolution professionals also have the power to question the validity of ipso facto termination clauses, i.e., clauses that terminate contractual arrangements like IP licences on account of an insolvency or a potential insolvency, leading to further uncertainty on the status or validity of a specific IP right, granted via a contract.

    Moreover, the jurisprudence on the powers of the National Company Law Tribunal (NCLT) to terminate or modify existing contractual arrangements and interfere with legally valid contracts is still evolving, which further complicates matters for parties to IP transactions, especially IP licensing arrangements.

    In certain cases, the NCLT has refused to adjudicate on a contract or its termination because contracts are privately negotiated between reciprocating parties and the NCLT generally lacks the jurisdiction to interfere with a legally valid and binding contract, unless it is arising out of or in relation to the insolvency proceedings. In other cases, the NCLT has approved resolution plans that contemplate a termination or modification of a contract. Until a binding decision on this point is given by the Supreme Court, deals involving IP licences or deferred consideration may be at risk.

• Mitigating insolvency risks using a vuja de approach

  A vuja de approach will require parties to look at standard IP diligence checklists with the added perspective of mitigating insolvency-related risks such as those discussed above. Some checks that buyers should consider to ensure their IP rights remain protected in case of insolvency are set out below.

  • Assessment of financial health

    In case of distressed deals, checks on financial health should assess the seller's ability to repay existing debt after the closure of the transaction. Such checks assume greater importance in structures involving a perpetual licence or a staggered sale of IP Assets.

    For instance, a buyer of a music catalogue should be cautious in accepting deal structures which contemplate a perpetual licence of copyright or the staggered sale of different copyrighted assets, if the seller is likely to be unable to repay its debt as the seller’s insolvency may render the transaction void.

  • Pre-emptory assessment of the impact of potential insolvency on IP Assets

    • While tracing the title of IP Assets, buyers should assess if insolvency proceedings against the seller, a joint owner, or any erstwhile owner (that held the IP Assets in the Twilight Period) are likely to affect the deal. Buyers should consider favouring structures that contemplate an outright assignment of the IP Assets, over a perpetual licence of such IP, if the risk of an insolvency is imminent. Otherwise, buyers may expose themselves to the risk of the licensing arrangement being modified or terminated by a resolution professional on the grounds that it is an onerous contractual arrangement.

      In technology deals, where the technology cannot be assigned directly and must be licensed, buyers may consider executing source code escrows or upfront negotiating a right of first refusal. This may at least enable the buyer to participate in the price discovery process.

    • Second, the buyer should ensure that the seller has adequate documentation to prove that past transactions carried out in the Twilight Period, if any, occurred strictly at arm's length or in the ordinary course of business, and with the consent of relevant stakeholders including lenders, shareholders, etc. This assessment should mandatorily cover intra-group arrangements as the Twilight Period is longer for such related party transactions and the risk of them not being carried out at arm's length is higher.
    • Next, buyers should also assess whether the IP Assets were acquired by the seller from an entity while a moratorium (due to initiation of insolvency) was imposed on that entity. If the seller acquired the IP Assets from such an entity, buyers should review the consent from the creditors and orders from the NCLT to be satisfied that the title to these IP Assets is not exposed to a challenge and vests with the current seller. These checks should also cover foreign companies involved in the title flow of the IP Assets.
    • Finally, the buyer should conduct a check on whether the IP Assets or any part thereof have been licensed to any person facing insolvency. If so, buyers should assess if contractual provisions resulting from insolvency (like termination or suspension) can be validly invoked. This is pertinent as the purchase of the IP Assets will usually be subject to existing licensing arrangements. In some jurisdictions, licences may also be implied. A detailed review of the terms of the licence will help the buyer strategise, should the licensee face insolvency and the licence be transferred to a third person (like a competitor).

  A vuja de approach will require parties to look at standard IP diligence checklists with the added perspective of mitigating insolvency-related risks.

  • Assessment of existing charges on IP Assets

    While reviewing financing arrangements, buyers should assess both the nature of charge on the intangible property and whether such charge covers future developments, as well as current arrangements with creditors such as those under one-time resolution plans.

    For instance, if the buyer is proposing to purchase derivative works of pre-existing intellectual property, it will need to ensure that the security interest created on such works is released by the creditors prior to such purchase. Further, the licence to the pre-existing intellectual property would need to be secured in case the seller becomes insolvent at a later date.

  • Issues relating to valuation of IP Assets

    At the time of purchase of IP Assets, buyers should be prepared to justify the value of the IP Assets to mitigate the risk of a sale transaction being questioned on grounds of being undervalued. For this, they may either maintain internal records or procure a valuation report from an independent valuer.

• Conclusion

  Adopting a fresh perspective when conducting IP diligences on cash strapped companies will help buyers identify specific risks to their IP rights or assets. Based on the outcome of the diligence, buyers will be better equipped to finalise the structure of the transaction, for example, to purchase or license IP Assets, or to choose between undertaking a business transfer or an itemised sale, or a staggered versus immediate sale, etc. This approach will also help buyers crystalise the representations and warranties and indemnity package with a keener insight.

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