October 1, 2007 (Vol. 27, No. 17)

Proper Attention to Intellectual Property Can Facilitate the Turnaround of a Struggling Firm

Intellectual property (IP) is everywhere. This is especially true in the life science and biotech industries, where technological innovation, R&D, and IP rights are integral to meeting the needs of consumers and sustaining growth. The risks and costs of developing the next blockbuster drug, however, have never been higher.

A recent (www.pfizer.com) annual report asked the question, “Why does a little pill cost me so much?” The obvious answer was significant: R&D costs and increased risks. Nearly 50% of all new drug candidates fail to reach regulatory approval after the bulk of R&D has been expended.

While many life science and biotech companies tried to mitigate or share these risks through vehicles such as joint ventures or alliances inevitably a portion of these organizations find themselves in a distressed position. Companies such as Nobex and Aphton spent millions to bring their drugs to market, yet ultimately failed to obtain regulatory approval and chose instead to institute bankruptcy proceedings.

Writings on the legal and economic aspects of IP in the life science and biotech industries abound. This article avoids these well-trodden paths and rather focuses on the legal and economic role of IP applied to distressed companies.

Turnaround and Bankruptcy

The terms turnaround and bankruptcy are the antithesis of the innovation-driven and IP-dependent vision that is prevalent in the life science and biotech industries. Accordingly, it may be hard for management to admit that the organization is in a distressed position.

Turnaround and bankruptcy, however, need not be dirty words. The turnaround process, which may incorporate bankruptcy proceedings, provides important legal and financial tools that can set an organization back on the road to profitability and assist management to carry out its fiduciary duties to shareholders and creditors.

The turnaround process is based on the existence of a viable core business, availability of funds to support a turnaround, and time necessary to affect the turnaround. By definition, a company in this process has something valuable worth saving.

Furthermore, bankruptcy proceedings are often an integral part of the turnaround process. In fact, a case filed under Chapter 11 of the U.S. Bankruptcy Code is typically referred to as a reorganization bankruptcy, whereby a debtor can propose a plan to restructure around a viable core business.

A Diamond in the Rough

To initiate the turnaround process, an organization should perform an inventory of its IP on a regular basis. The inventory should be more than a counting exercise and should include a consideration of the legal rights associated with the identified IP.

Many organizations have unused IP that could be the proverbial diamond in the rough, or at a minimum, an additional source of revenue from licensing or sale of the assets. For example, during 2006 Neo-Magic recorded a $3.5 million gain on the sale of its unused patents, which represented over 37% of the company’s total revenue during the year.

The sale of IP assets in a Chapter 11 bankruptcy provides the debtor significant benefits. Section 363 of the Bankruptcy Code permits a distressed entity to sell some or all of its assets under an orderly mechanism that typically constitutes a marketing period and an open auction.

Perhaps nothing is more crucial than the buyer’s avoidance of successor liability. This protection, which typically precludes anyone with a presale claim from pursuing the buyer, insulates a buyer from the prior debts/claims of the distressed company. It allows the buyer to take IP free and clear of liens, claims, and encumbrances. This free-and-clear advantage increases value and usually influences a buyer to bid more than it ordinarily would.

Executory Contracts

Generally, the Bankruptcy Code permits a distressed company to assume its existing executory contracts, where both parties maintain material obligations, and assign them to the buyer. The assumption and assignment is accomplished over the objection of the nondebtor contract party, even if the terms of the contract itself forbid such assignment. This is beneficial to distressed companies and their potential suitors, where the distressed company contracts or licenses for a particular component of their product up for regulatory approval.

Importantly, no life science entity can truly afford to locate another supplier mid-stream. This is especially acute for a late-stage product when it is likely that the regulatory agency would require further efficacy testing of the new supplier’s components and their impact on the main product. Such delays would drive down the value of the firm’s IP. Using the bankruptcy mechanisms to overcome potential resistance from the supplier, thereby maintaining the progress of regulatory testing, provides a distinct value advantage to a distressed entity.

Generally, the same advantages can be said for imposing and requiring nondebtor license parties to perform under their agreements with the acquiring party. These unique bankruptcy advantages often permit the distressed entity to pave a smooth transition for the regulatory testing, production, distribution, and marketing of the product thereby generating additional value for the IP assets.

License Compliance and Revenue Recovery

Life science and/or biotech companies may out-license IP as a way to generate additional revenue. However, statistics cited by major accounting and consulting firms indicate that reported royalties from licensees were incorrect in approximately 80% of investigations. Many license agreements include an audit provision, whereby the licensor has a periodic right to audit the records of the licensee. This provision typically entitles the licensor, in the event an underpayment is identified, to the costs of the audit (i.e., professional fees) and late fees.

For an organization that actively out-licenses its IP, a royalty audit can be an effective tool in recapturing revenue. A royalty audit can be performed in a variety of contexts. It can be done as part of a regular licensee-compliance program and/or prior to the sale of IP. Under the sale scenario, the increased cash flows associated with the IP may positively impact its selling price. Further, as an ancillary benefit, the increased cash flows recovered by royalty audits may assist the company in obtaining outside financing.

IP can play an important and central role in the turnaround of a distressed company. A necessary first step is to recognize that turnaround and bankruptcy are not bad words. The legal, financial, and economic issues surrounding IP can be complex. It requires a significant investment of time to understand the issues, the relevant legal guidance, and the economic theory underpinning the valuation and the licensing process.

Optimizing the use of IP requires an effective integration of law, economics, corporate finance, and turnaround/bankruptcy specialists. While the suggestions provided in this article only scratch the surface they, nonetheless, provide a good starting point for understanding the role of IP in distressed businesses.

Ronald S. Gellert

Gregory J. Urbanchuk

Ronald S. Gellert (rgellert@eckertseamans. com) is a member of Eckert Seamans Cherin & Mellott and practices in the bankruptcy and restructuring department. Gregory J. Urbanchuk (gurbanchuk@ esba.com) is a managing director in the forensic and dispute services practice of Executive Sounding Board Associates.

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