Volume 5, Number 5 - September 2004
Managing IP Value at Risk (Part One of a Two-Part Series)
Patent Strategy & Management
By Andrew W. Carter and Robert J. Block

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According to a recent academic overview, American patent-holders pay their lawyers $5 billion per year for patent prosecution services and approximately another $2.4 billion for patent litigation (not counting payments of settlements or damages). Besides being good news for the patent bar, this level of investment in patent creation and protection suggests that patents are valuable.

Senior management is now tasked to explain patent value to the capital markets. Shareholders perceive that patents are valuable which can have a downside: the day Eli Lilly unexpectedly lost rights to the patent for Prozac, the company lost approximately 20% of its market capitalization. Shareholder interest brings with it regulatory interest and thanks to the Sarbanes-Oxley Act of 2002, the margin for error has been narrowed and the stakes have been raised.

This article is the first of two that will review the role of risk management in the management of an IP portfolio, focusing primarily (but not exclusively) on patents. Our purpose is to alert risk managers and treasurers to the most critical issues. Although those concerns are hardly identical for technology start ups, online retailers, and global pharmaceutical companies, some of the following will be relevant for most American commercial entities.

Patent Infringement
The most obvious threat for the risk management professional is the payment of costs and/or damages in the course of defending patent infringement litigation.

Unfortunately, insurance markets have not yet developed a way to underwrite this product profitably. The result is that most underwriters have exited the market. Clients with the very best risk profile may be able to laboriously put together the kind of program one expects for global 1000 casualty exposures: nine figures in limits for a 3 to 8% rate on line (ie., hundreds of millions of dollars in coverage at a cost of 3% to 8% of the coverage amount). The market leader in this space, global broker AON Risk Services, has perhaps half a dozen such jewels in its crown. For most policyholders it is unrealistic to expect to be able to obtain such a policy. For certain categories of policyholder - pharma companies for example - it is out of the question.

To meaningfully address this risk, we will need to fashion our own tools. These include:

• Captive Strategies - a captive is an insurer owned by a policyholder or group of policyholders. It offers tax, transparency, and reserving benefits. Sometimes captives enable policyholders to access capacity, in the form of reinsurance, more efficiently. Captives may serve secondary accounting and fiscal objectives as well.
• Strategic Transactions - if the policyholder possesses assets such as capital loss carry-forwards, it is possible to step-up the basis for non-strategic patents or other leveraged leasing candidate assets. By selling, then licensing or leasing back the property without incurring capital gain tax, the policyholder may create positive NPV to fund a captive or loss sensitive patent infringement policy.
• Legal Opinion Insurance - even if the policyholder is unable to access blanket coverage at agreeable rates, some insurers will take narrow, well defined risks off the table. These policies can facilitate broadly defined transactions including R&D funding decisions.
• Loss Mitigation - just because the house is on fire, we shouldn't necessarily give up on insuring it. Insurers will "collar" existing litigation, capping the worst case for a premium calculated to exceed the realistic case. While this is an expensive option, it can signal to capital markets or important counter-parties that a potential catastrophe has been averted and a loss contained.
• Indemnity Agreements - a sophisticated global entity may have dozens or hundreds of sources of contractual indemnity for IP exposures. Such indemnity agreements can represent significant hidden shareholder value, but that value is at risk if the indemnitee fails to comply with conditions such as notice. Risk management needs to track such agreements and conditions and develop a program for accessing and monetizing indemnity proceeds in a liability crisis.
• Portfolio Mapping & Monitoring - Patent Analytics can identify threats before they happen and help develop an aggressive IAM defense to lawsuits before they are filed.

In consideration of the risk management tools above, and in the absence of available standardized policies, the function of risk management is more critical to developing the company's strategic defenses against patent infringement risk.

1^st Party Losses
How does the risk manager defend the value of the company's own IP portfolio? In this arena, insurance markets are only beginning to understand and internalize the concept. One suggested leader may be Kiln, a well respected London syndicate, which offers moderate insurance capacity primarily for a loss of licensing revenue resulting from a patent invalidity finding (though Kiln has considered and underwritten policies based on alternative, rigorous value models).

Other imaginative underwriters will offer risk finance vehicles, covering shocks to portfolio value with relatively narrow corridors of risk transfer. Such a program has its uses, but from a balance sheet standpoint, it primarily offers the benefits of a well designed captive.

It may be that Kiln-like programs represent a future trend, but until underwriting capacity for such products builds, the risk manager should think of the issue as a Directors and Officers ("D&O") challenge. At present, the company can best protect shareholders against volatility resulting from IP portfolio impairment by accurately communicating patent value and risk. Such an approach might include:

• Utilization of objective valuation systems
• Regular value audits
• Vetting relevant disclosure language (i.e. 10K & 10Q reports) with D&O or Management Liability underwriters

Until the risk may be efficiently transferred, it must be identified and disclosed using the most advanced and comprehensive techniques in the market place. Other tools may supplement disclosure and the prudent nurturing of the Kiln initiative. One example may be applied to trade secrets.

If a patent is infringed, the right survives and may be enforced. This is not so with trade secrets; once trade secrets are disclosed, the holder's only recourse is to seek damages. The typical global 1000 company possesses valuable trade secrets that are entrusted or disclosed to professionals, intermediaries and consultants on a relatively routine basis.

One example of a nightmare scenario in managing trade secret disclosure occurred with a manufacturer of digital assistants that confided new product specs to an engineering partner. An employee of the partner leaked critical features on the web. While the features were not detailed at such a level as to be copied, the manufacturer was forced to write down $60M in existing products as buyers found existing models inadequate by comparison. In this case, the innovation ended up cannibalizing inventory. The lesson for risk managers is to understand how breaches of confidence can impact the bottom line.

What is at least a partial solution to this nightmare scenario? Under the law, the trade secret holder is obliged to take reasonable steps to maintain secrecy. Bonding professionals in receipt of disclosures may be one such step. Bonds work better than liability policies because sureties pay obligees and liability insurers defend obligors. Such bonds may then be underwritten by applying basic actuarial principles underlying fidelity risk and can be utilized to protect, validate, and even quantify intangible asset value.

In short, one important question the risk manager should be asking of the company's IP portfolio is this: where can risk be transferred to third parties? Put another way, the risk manager might ask why the company should underwrite premium for risks created by third parties. Simply knowing the right questions to ask is often the best way to determine the most appropriate tool to hedge against risk.

Conclusion
Assumptions and choices about patent value will materially affect shareholder value in any company with a major IP portfolio. The planning consequences go far beyond infringement damages. As IP risks and opportunities continue to emerge in the most surprising ways, infringement issues, D&O issues, and tax planning (to be reviewed in the next article) all show that risk managers have much to offer to IAM and legal in supporting critical policy choices. The risk manager offers insights and techniques that must be adapted to IP portfolio management. The assets are intangible, but the attendant risks and rewards have never been quite so visible.

Andrew W. Carter (acarter@oceantomo.com ) is a Managing Director and co-founder of Ocean Tomo, an intellectual capital merchant banc.

REPRINTED WITH PERMISSION FROM THE VOLUME 5, NUMBER 5 - SEPTEMBER 2004 EDITION OF THE PATENT STRATEGY & MANAGEMENT © 2004 ALM PROPERTIES, INC.
ALL RIGHTS RESERVED. FURTHER DUPLICATION WITHOUT PERMISSION IS PROHIBITED.