Will Your Intellectual Property Rights Survive Your Merger?

You've just acquired a multi-million-dollar company with a license to technology that's critical to the strategic future of your business. The transaction took nearly a year to complete and thousands of hours to finalize. The structure – a "forward triangular" merger in which the target corporation merges out of existence into a newly created shell subsidiary – is complicated, but it defers taxation for the target corporation's shareholders. It's a good deal for all concerned.

But don't break out the champagne yet. Imagine that your next phone call is from an arch-competitor, who makes a startling claim. He tells you that it turns out that your competitor licensed this critical technology years earlier to the company you just acquired. And, because of the way you've structured your merger deal, the license was improperly transferred and is now void.

Oh, and he also mentions that the price to re-license the technology just went up. A lot.

Could this be? The license agreement says nothing about mergers, nothing about acquisitions, and in fact, it doesn't even restrict transfer. Even so, the next day your competitor files a complaint in federal court, alleging breach of the license agreement and infringement of the underlying patent. A year later, after a painful and expensive discovery period, the court grants the competitor's motion for summary judgment and renders your license void.

A legal horror story? Absolutely. Could it happen to you? Unfortunately, yes.

Licensors of intellectual property may argue that a merger in which a licensee does not "survive" as a separate corporate entity may void the license – even if the license agreement contained no prohibition against merger, acquisition, or transfer.

This argument is based on an arcane line of federal cases holding that "patent licenses are not assignable unless expressly made so." More recently, some federal courts have extended this rule in ways that affect corporate mergers, and have found, in effect, that certain mergers can constitute transfers that void patent licenses. Acquirers of licensees can find themselves the losers in a very expensive game of corporate "Gotcha!"

How Mergers Work

Does a merger involve a transfer of assets? Most statutes say no.

The corporation laws of most states, including Delaware, Minnesota, Iowa, and those states that have adopted the Revised Model Business Corporation Act, provide that, in the event of a merger, the merging corporation ceases to exist as a separate legal entity, and all of its assets are vested in the surviving corporation.

The phrase "vested in" is the product of a deliberate evolution in state law. Originally, most state statutes said either "transferred to" or "transferred to and vested in." But this language has been eliminated from most (but not all) merger statutes, specifically to avoid any "transfer" of assets resulting from the transaction.¹

This often-overlooked language of state corporate law is actually critical to the functioning of corporate mergers. If mergers did create an express transfer of assets from a merging to a surviving corporation, then none of the non-transferable assets of the merging corporation would survive the transaction.

With this in mind, let's look at the three principal ways that mergers are generally structured:

• a "direct" merger merges the target into the acquirer, with the target ceasing to exist;
• a "forward triangular" merger merges the target into a shell subsidiary of the acquirer, with the target ceasing to exist; and
• a "reverse subsidiary" merger merges the shell subsidiary into the target, with the target surviving.

There may be internal factors that affect the choice of structure. For example, triangular mergers often allow the acquiring corporation to avoid giving its shareholders voting or dissenters' rights, which they would have in a direct merger. Moreover, the tax code encourages certain transactional forms in order for the deal to qualify as a reorganization that allows shareholders of the target corporation to defer capital gains taxes on their shares.

One of the most advantageous transactional forms for this beneficial tax deferment is the forward triangular merger, in which the target does not survive.² Other than to the IRS, however, there is no significance in this choice to any outside party, such as a patent licensor, and no basis for any rule on assignability of assets that runs contrary to state corporation statutes. To any third party, the effect of the transaction is exactly the same.

So why are your IP rights potentially at risk? The answer comes from a rare and nearly extinct branch of the law known as "federal general common law."

An "Erie" Problem

To trace the roots of this issue, we have to go all the way back to 1852. In the case of Troy Iron & Nail Factory v. Corning, the United States Supreme Court alluded to a supposed rule that patent licenses were not assignable unless the contract explicitly said so. In other words, if a patent license said nothing about its assignability, then the license was not assignable, and a licensee could not transfer the license without the licensor's consent. Although this rule was contrary to the standard doctrine that contracts are assignable absent a provision to the contrary, the Court subsequently recognized it as a federal general common law rule – a judicially created federal rule – in several of its other decisions that century.

The Supreme Court has never recognized this rule in modern times, and in 1938, the Court discarded altogether the notion of federal general common law in the landmark case of Erie R.R. v. Tompkins, when it held, "There is no federal general common law." But the Court never struck down the purported rule on assignability, and even since Erie, several federal circuit courts of appeal – including the Sixth, Seventh, and Ninth Circuits – have continued to recognize the rule.

In the context of a corporate merger, the most important of these cases is PPG Indus., Inc. v. Guardian Indus. Corp., a 1979 case out of the Sixth Circuit. PPG presented a problem similar to the one described above: a licensee merged into a competitor of the licensor; the license was expressly not transferable; and the licensor cried foul. In voiding the license, the Sixth Circuit recognized the purported federal rule and found that the applicable state merger laws did create a transfer of assets (even though one of them, Delaware, used only the "vested in" language). The court held that it was up to the licensee to negotiate a provision allowing it to merge, which the licensee had failed to do.

The main difference between PPG and the situation described above is that in PPG the licensee merged directly into its competitor. In our hypothetical example, the licensee merged into a shell corporation, with no assets or liabilities of its own, created for the single purpose of effecting the acquisition. At least some federal district courts have distinguished similar situations as an exception to the federal rule, because the only result of the transaction is a transformation in the licensee's corporate form.

In other words, in the eyes of the licensor, the licensee looks exactly the same as it did prior to the transaction – as opposed to a direct merger, where the ultimate result may be a much larger entity. As recently as last year, however, a federal district court in the Eastern District of Missouri reviewed a forward triangular merger and found "that federal law governs the issue of transferability of [a patent license] and that the [forward triangular] merger constituted a transfer." After 150 years, federal courts are still applying the rule.

Nevertheless, there are substantial flaws in this doctrine. First, the structure of the merger, which is usually chosen primarily for tax purposes, cannot matter to the licensor. The acquiring company could accomplish the same result by reverse triangular merger, or even by a simple direct stock purchase or tender offer, without triggering the federal general common law rule. There is no reason such a rule should apply to some mergers and acquisitions but not to others when the ultimate result is the same.

Second, this federal common law doctrine would not seem able to survive the Erie decision. In order for federal courts to create federal general common law, there must be some significant conflict between state law and some federal policy or interest. But the federal patent laws are silent on patent licenses, and in fact, the Supreme Court has repeatedly recognized that patent licenses, like all other contracts, are governed by state law. Federal general common law cannot be used for the mere purpose of shifting a contracting burden. Yet that is all this purported rule does. It shifts the burden from the licensor to the licensee to obtain express provisions regarding transferability and merger.

Avoiding the Problem

The easiest way to avoid this problem is to negotiate around it in advance. The doctrine applies only if there is no merger-related provision in the licensing agreement, so parties can avoid any dispute by negotiating terms in a license related to a possible merger of the licensee. Although such terms may make the license more expensive, the increase in price will pale in comparison to the expense of foregoing significant tax benefits or having to renegotiate a favorable license. Importantly, choosing the law of a particular state to govern the contract may not be enough to avoid application of the federal doctrine. Some courts have done so anyway.

If the license already exists, however, and a merger transaction is on the horizon, then it is important to understand the possible impact of this doctrine during the initial stages of the deal. During due diligence, the buyer should conduct a thorough review of all intellectual property licenses. If a potential problem is uncovered, the parties may want to consider alternative structures to get the deal done. If it is possible to obtain tax deferment through a reverse subsidiary merger, for example, then this may be a preferable form. For those acquisitions that cannot qualify for tax deferment under this form, there is one other option, called a "double dummy" or "double wing" merger, which is more complicated, but which may offer the same tax benefits with the licensee still surviving as a legal entity.

If the transaction is already too far along, then you may decide – in fact, may need – to damn the torpedoes and accept the litigation risk. Recent Supreme Court decisions indicate that the Court continues to be skeptical of federal general common law. Moreover, some lower federal courts have recognized that the rule does not apply to mere changes in corporate form, suggesting that some courts would accept forward triangular mergers as an exception to the rule.

But the fact is that acquirers can still get caught in the unfortunate position of having to renegotiate valuable license agreements, or to surrender them altogether. Knowing and understanding this rule in advance may prevent you from having your merger celebration cut short.

¹While the Colorado statute retains the language "transferred to and vested in," it provides further that a merging corporation need not obtain any consent absent an express contractual provision prohibiting merger.

²Although it is possible to obtain the same tax benefits using a reverse triangular merger – which allows the target to survive as a legal entity – the tax code places higher hurdles in the way of this transactional form.