© 2005, Gallagher & Dawsey Co., LPA
June 2005

In reaction to various corporate scandals such as Enron, Worldcom, and the like, Congress put into law rules to govern corporate accounting and ethics standards. These standards were enacted with the passage of the Sarbanes-Oxley Act of 2002 (‘Act’), and the potential for criminal penalties has surely caused corporate executives and attorneys to take a closer look at internal controls and procedures for verifying periodic reports. However, what many executives do not realize or take into consideration is the role their businesses’ intellectual property (IP) portfolio plays in the periodic disclosure requirements under the Act.

The Requirements:
The Act imposes several requirements upon the principal executive officer and principal financial officer, or persons performing similar functions. Section 302 of the Act requires these parties to certify that annual or quarterly reports do not contain any untrue statements of material facts or omit a material fact necessary to make the statements in the report not misleading. In addition, S302 requires the executives to certify that the reports “fairly present in all material respects the financial condition and results of operations” of the company for the periods presented in the report. In addition to the corporate responsibility for financial reports imposed by S302, the Act also requires management assessment of internal controls in S404 and establishes criminal penalties in S906 for failure of corporate officers to adequately certify the content of periodic reports.

IP Portfolio Implications:
These sections of the Act require public companies to report several aspects of their IP portfolios. However, the inherent difficulties attached to IP considerations in the corporate environment make disclosing and valuing intangible assets complicated, creating the risk that executives could unknowingly violate the Act.

The Act requires disclosure of important company assets in the business section; generally some type of IP should be considered in this category. Clearly, for a technology company, the value of an intangible asset, such as a patent or a bundle of licensing rights, is central to appraising the company’s worth. This requirement is not only of concern to companies that rely nearly exclusively on technology; other examples of valuable intangible assets frequently overlooked include customer databases and unique customer interfaces employed by financial service companies, as well as trademarks and domain names.

In addition to disclosure of intangible assets, the Act also requires identification, measurement, and disclosure of risks that could result in unreliable financial disclosures. Once again, the inherent nature of IP assets often makes this an arduous and perplexing task. It is often difficult to determine if the risks relating to the use and protection of the company’s IP could result in unreliable financial disclosures, especially for companies that are not primarily focused on technology. Some obvious examples of an IP-related risk which must be disclosed are material litigation with respect to the IP portfolio or an interference or reexamination proceeding concerning a patent central to the business operations. Other risks which are not so obvious but may nevertheless need to be disclosed include upcoming expiration of IP rights the company owns or licenses from others or loss of exclusivity privileges of IP rights owned by the company.

Making this disclosure even more difficult are the inherently inconsistent obligations created by the Act. Often, the value of IP lies at least in part in its secrecy. However, the corporate officers must follow the disclosure requirements of the Act with respect to material risks of financial unpredictability in all periodic reports. These disclosures are required if they assist investors in evaluating the company or have a potential financial impact. Corporate officials face a significant challenge in balancing the disclosure obligations against the fiduciary duty to preserve asset value, magnified when that asset value may be diminished or destroyed by disclosure. This requirement of corporate officers to fulfill inconsistent responsibilities demonstrates how difficult it is to successfully walk the line in the Act’s IP arena.

What’s a CEO/CFO To Do?
The appropriate action under the Act with respect to intangible assets will often depend on a myriad of factors. The factors often relate to the type of business releasing the periodic financial statement, particularly that company’s reliance on IP. However, there are some steps every corporate executive can execute to assist in IP management.

A key step is to conduct a thorough audit of the company’s IP portfolio, updating the audit on a regular basis. In order to carry out this examination, the company must perform an inventory of their intangible assets, including patents, trademarks, copyrights, licenses, and exclusivity agreements with third parties, just to name a few intangible assets. The next step in assessing the IP portfolio is the speculative valuation of asset worth, a process wrought with complex issues. For example, patent valuation raises concerns of whether there are blocking patent rights owned by third parties, especially if such third parties are competitors, and whether alternate technologies not covered by the patent would reduce its value. Likewise, the value of a license may be difficult to determine if revenue from the license is set in terms of future sales of the licensee’s product. Finally, in establishing the value of the IP portfolio, the corporate officials must determine the volatility of the various types of IP, and the degree to which the company relies on that property. Obviously, the more central intangible assets are to the operations of a company, the more significance must be placed on the IP portfolio in the periodic disclosures.

Rules for CEO’s and CFO’s to Live By:
By making themselves familiar with their company’s IP portfolio, and the processes used to monitor and assess the portfolio, corporate officials can manage the expectations of the Act. Specifically, corporate officials must:

• Familiarize themselves with the composition of the IP portfolio, the processes by which new assets are identified and developed, the procedures used to audit and update the contents and value of the portfolio, and the events which create turbulence in the portfolio (claims, alleged infringement, license or patent expiration);
• Keep directors informed as to the content, value, and significant risks to the IP portfolio;
• Document all IP transactions, including any information that would affect the assets involved in the transaction; and
• Develop an enforcement program to manage and protect IP assets.

Clearly, in order to accomplish these tasks, the corporate executives will need to utilize a multi-discipline team, consisting of marketing professionals, engineers, corporate attorneys, and others. However, by efficiently utilizing these resources, the Act’s requirements can be accomplished.