1. Introduction
The discussions around intellectual property risks have become increasingly important in the M&A context, in particular surrounding software issues. Whilst the challenges of the last two years have had a negative impact on M&A activities, companies with business models heavily focused on software, were amongst the winners of the crisis.1
The insurability of IP risks most commonly becomes practically relevant in the context of corporate transactions, especially in relation to the insurability of the warranties within a company purchase agreement. This raises the question of under which conditions and through which insurance products IP risks can be insured.
2. Differentiation of various IP Risks and insurance solutions
2.1 W&I Insurance
Warranty and Indemnity Insurances (W&I) only cover unidentified risks arising from a breach of warranties within company purchase agreements. In the first instance, warranties typically incorporated in company purchase agreements include warranties that certain intellectual property rights are owned by the target company and that there are no existing restrictions in this respect.
Schedule 1 contains a list of all registered and unregistered inventions, patents, utility models, trademarks, service marks, design rights, domain names, copyrights including rights in software developed or acquired by the company and its source code, rights in databases, know-how, in each case and as applicable including registrations and applications for registration, and similar forms of protection anywhere in the world, owned by the company or to which the company has exclusive, perpetual worldwide, unrestricted rights of use for any purpose (the “Owned IP Rights”). The company owns all rights, title and interest in and to its Owned IP Rights free and clear of any third-party rights and of any and all encumbrances. Other than non-exclusive licences granted to customers in the ordinary course of business, no licences or other rights of use have been granted with respect to the Owned IP Rights and there are no obligations to encumber or grant licence or other right of use in and to the Owned IP Rights. The group companies are free to operate their business as currently conducted using the Owned IP Rights and to dispose of the Owned IP Rights at their own discretion without owing payment of any royalties or similar fees to any third party.
In the context of registered IP rights, it is often guaranteed that the required registration fees have been paid and that further measures to maintain rights have been taken. This warranty is flanked by the promise of confidential treatment of IP rights as a whole, which is of decisive importance for non-registered IP rights.
The typical warranties that IP rights of the company are not infringed by third parties and that the company will not infringe upon IP rights of third parties are of decisive importance for W&I insurance from a liability point of view. From the seller’s perspective, it is usually not possible to make a final judgment on whether these declarations are true and therefore, almost without exception, these warranties can only be made to the best knowledge of the seller. Depending on the agreed standard of best knowledge, the buyer must therefore demonstrate and prove that the seller had a positive knowledge of or was grossly negligent regarding the incorrectness of this warranty in the case of a dispute.
Additionally, there are often further warranties with regard to licenced IP rights and the permission to use them. For companies heavily focused on software, particular importance is attached to the warranty for the use of open-source software (“OSS”). The seller guarantees that the relevant licence agreements have been complied with and that there is no disclosure obligation or obligation to provide rights of use free of charge.
The use of any software or other material that is distributed as “freeware”, “free software”, “open-source software” or under a similar licensing or distribution model in the development of or incorporated into or combined with the Owned IP Rights complies with the applicable licensing terms. The company’s products or services do not use or incorporate any open-source software or materials that are subject to licence terms which provide for any obligation for the company (i) to disclose or distribute any of its intellectual property in source code form to third parties, (ii) to licence any of its intellectual property for the purpose of making derivative works or (iii) to distribute any of its intellectual property without a charge.
2.2 M&A Insurance for identified risks
Whilst identified risks are excluded from insurance cover in W&I insurance policies, under certain circumstances individual M&A insurance policies also offer coverage for identified risks.
An extremely low probability that the legal risk will occur is a prerequisite for the insurability of identified risks. This may for example be the case with pending IP litigation in which both the lawyers of the target company and the insurer’s external advisors consider the prospects of legal success to far outweigh the prospects of failure. Purely factual issues such as the likelihood of a certain IP related claim stemming from an identified area of risk, cannot be covered by this type of insurance product. Of course, the interplay between legal and actual risk is complex and can ultimately only be evaluated by means of a concrete examination in each individual case.
2.3 Standalone IP Insurance solutions
The insurance industry is developing an increasing number of products for the insurance of IP risks independent of the field of corporate transactions. These are insurance policies that cover the costs of defence in the case of an alleged infringement of IP rights by third parties and also pay compensation in the case of justified claims, therefore ultimately offering a type of specialised legal protection policy. On the other hand, they also cover the area of IP ownership, for example in connection with cancellation or invalidity proceedings. This may be particularly relevant in connection with contractual obligations of the company towards third parties.
3. Verifiability of IP Risks in Due Diligence
The W&I insurance is the most practically relevant insurance solution for IP risks. The key prerequisite for the insurability of IP warranties in the company purchase agreement is the performance of a due diligence regarding IP by the buyer and thus potential policy holder.
3.1 Relevant IP Risks in the context of M&A
Several different IP risks are examined during M&A transactions. Arguably, the most important question is whether the company has all the necessary IP rights to carry out its business without infringing the IP rights of third parties. Should the company’s products or services infringe upon IP rights of third parties, the third parties may be entitled to a number of claims, in particular for injunction and removal, information and damages. Especially companies in the technology and software industry can be severely affected by these claims, even rendering their business model completely impossible in the worst-case scenario.
Additionally, companies do not always have the necessary understanding of possible IP violations e.g., such as when using OSS.
To explain: according to the licensing conditions of some OSS components, the use, modification or distribution of the OSS component is only permitted under the condition that the software continues to be placed under the corresponding OSS licence (so-called copyleft). This can mean that in-house software developments which are connected to or modify OSS components must be placed under the relevant OSS licence. In this context, it is spoken of a “viral effect” of OSS which can include an obligation to publish the source code of the software for some licences. However, for the determination of the point at which a viral effect occurs, a differentiated technical and legal examination in each individual case is required.
According to a study in 2021 conducted by Bitkom, 71% of all companies surveyed in Germany with over 100 employees stated that they use OSS in their company. For companies with 2,000 employees or more, this figure is even higher at 87%. Conversely, however, only 22% of all respondents stated that they had a policy regarding OSS in their company.2 This shows that companies often still underestimate the risks that can arise from the use of OSS components.
3.2 Conducting the IP Risk analysis
In corporate transactions, the scope of a legal due diligence is regularly defined in advance between the client and the advisor. Due to financial reasons, so-called red flag reports are drawn up in most cases in today’s practice, the aim of which is to show the potential buyer of a company the most important risks of the target company. A qualitative examination and in particular reporting only takes place within this limited scope.
(1) Registered IP Rights
In IP due diligence, this approach means that the examination of intellectual property rights of the company is limited to the information that can be derived from publicly accessible registers (such as the register of the German Patent and Trade Mark Office) or the documents provided by the seller. For these registered rights, it is possible that conflicting IP rights of third parties could be clarified within the scope of a “freedom-
to-operate” search. In particular in the field of patent law, these are however usually associated with a considerable effort.
A comprehensive international patent research is only possible with the involvement of patent lawyers with scientific expertise from the respective technical disciplines. In addition to the examination for possible collisions with the patents of third parties, an extensive search by patent lawyers can also be used to verify whether the patent portfolio is qualitatively suitable for the adequate protection of the company’s own inventions. A graduated approach is typically recommended with larger patent portfolios and numerous potential competitors in which the patent lawyer and the technical department of the company mapout and define the key innovative and commercially relevant features as well as the main competitors and then carry out a focussed and targeted research as part of the market comparison. However, such an extensive review requires considerable time and financial effort and can therefore only rarely take place within the often time-critical due diligence.
(2) Non-Registered IP
The most important intangible assets of a company are often those that are not recorded in a register and about which the company itself often does not have a complete overview. These include in particular works protected by copyright (especially software), technical know-how that has not yet been registered as a patent or industrial design, as well as trade secrets which derive their value precisely from their non-disclosure. Quite often there is a lack of knowledge on the part of the company about the existence and relevance of the submission of particular information. Naturally, this makes a due diligence more difficult, in particular with regard to possible conflicting rights of third parties.
In some cases, software tools can help to shed light on a situation for example when checking a software code for the presence of OSS components. Even without an OSS policy and continuously maintained OSS licence management some conclusions can thereby be drawn about the use of OSS in the software of a company. An example of such a tool is the “Black Duck” software, which reviews the code of a software to see which OSS licences have been used. Hereby, the vast majority of copyleft licences can be detected. However, neither a technical nor a legal evaluation of the concrete use of the OSS component in the individual case is covered by the report. It therefore often remains unclear whether the somewhat risky OSS has actually been modified in any way or whether the company’s proprietary software has been linked thereto in such a way that it leads to the infection of the software development by the OSS-licence. Both the detailed technical knowledge of the software developers and the legal interpretation of a specialised lawyer is necessary for such an assessment in each individual case. Such an examination can be either more or less extensive depending on the size and complexity of the software. Moreover, the partly still very new, but in any case, vague rules of copyright law in this respect are not clearly defined by case law. Therefore, ultimately, even after such a detailed examination, residual risks that the company software infringes upon OSS licences may still exist.
If neither a black duck report nor a list of the OSS licences used in the software exists for the company, the due diligence is essentially limited to uncovering the most important risks within the Q&A process. It is advisable to talk directly to the technically responsible employees of the target company (e.g. the CTO or the senior software developers) in the technical Q&A call.
4. Risk assessment from a W&I Insurance perspective
From a W&I insurance perspective, it is particularly relevant to recognise the potential financial impact of the breach of an IP warranty in the worst-case scenario. For example, it is key to understand whether a particular patent is essential to the respective business model or in which products the OSS components are found and/or whether the software is only needed by the company to provide the externally offered service. The limited nature of “red flag” reporting means that the commercial relevance of IP (which is often assessed on the basis of due diligence reports submitted in the underwriting process) often does not become sufficiently clear. Such clarification only takes place via written queries to the buyer or during discussions in the underwriting call. The better the insurer can comprehend the concrete economic impact of a breach of warranty, the more differentiated and usually advantageous the coverage turns out to be for the policy holder.
5. Conclusion and prospects
In conclusion, the W&I insurance, which is now more or less established as a standardised insurance product in the M&A insurance market, offers solutions to various problems but does not provide conclusive coverage with regard to the relevant challenges from the buyer’s perspective. However, under certain circumstances identified risks can be covered by special solutions. The insurance market already offers some solutions regarding IP risks that buyers may face in the future irrespective of concrete risk areas and independent of corporate transactions, which provide a value-added contribution to the management of IP risks.
1 Kengelbach et. al., Decoding the Competitive Software M&A Market, Exhibit 1, verfügbar: web-a sets.bcg.com/7e/6e/f07e502f46699dee6e9f4da78c55/bcg-decoding-the-competitive-software-m-a-market-feb-2021.pdf. 2 Cf. Bitkom: Open Source Monitor 2021, abrufbar unter www.bitkom.org/sites/main/files/2021-12/211207-bitkom-studie-openmonitor-2021.pdf (Stand: 25.05.2022)
