Gray Matters: Protecting and Increasing the Value of Intellectual Property

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By Peter J. Gerken

Marsh Vice President, Peter J. Gerkin is leader of the firm's Intellectual Property Practice.

In an economy powered by knowledge and creativity, intellectual property (IP) is a significant corporate asset for companies in virtually every industry. Patents for inventions, trademarks for names and commercial symbols, and copyrights for publications and other works of authorship provide their owners with exclusive commercial rights for some period of time. Enabling businesses to create value in a variety of ways, IP helps companies gain a sustainable competitive advantage.

Approximately 60 to 80 percent of companies’ assets today are intangible. They include brands, technology, and know-how, as well as the legally protected assets, defined as intellectual property. Essential for attracting investment, particularly for small- and medium-size businesses, IP allows companies to charge premium prices and increase their market share. It gives companies of all sizes freedom to operate in patented areas.

Software, an asset that can be protected by both patent and copyright, is ubiquitous in business and homes, and increasing numbers of companies — for example, in the financial services industry — are creating their own applications. Within the biotech and life science industries, proprietary drugs, processes, and new compositions of matter are constantly being invented — and protected. The licensing and technology transfer business is a $100 billion-per-year industry with a 10 percent annual growth rate. Patents can be used as collateral in secured lending, and royalty streams can be packaged and securitized for capital market investors.

Many companies today are managing their IP risks more proactively and maximizing the value of their intellectual property. The identification, evaluation, and valuation of IP for downside risks and upside potential can help companies and university technology transfer operations:

• enforce their intellectual property rights as well as prevent and defend against claims of infringement;
• develop risk-mitigation and risk-transfer solutions for potential liability loss and the loss of profits;
• strengthen due diligence in mergers and acquisitions;
• facilitate deals in joint ventures and licensing agreements in which there are representations, warranties, and indemnification issues;
• comply with new accounting regulations for recognition of intangible assets;
• make more informed strategic investments in R&D; and
• increase revenues from licensing and related activities.

“Protecting Ideas”

Seeking to encourage socially beneficial innovation, intellectual property rights are a public policy tradition that dates back to the 15th century, when the Venetians enacted the first patent law. The framers of the U.S. Constitution empowered Congress “to promote the progress of science and useful arts by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries.” And Abraham Lincoln, who first journeyed outside of Illinois to litigate a patent case, observed that legal protection “added the fuel of interest to the fire of genius, in the discovery of new and useful things.”

Throughout history, there has been tension between legal rights that promote innovation and anti-trust policies that encourage competition. Some contemporary critics of intellectual property charge that legal protection for ideas inhibits free expression and is poorly suited to the information age. Yet in the words of my NERA colleague David S. Evans, “Protecting ideas always demands a delicate balance between competing objectives and values: stimulating creativity but thwarting monopoly; creating knowledge yet disseminating it broadly; enforcing rules while responding to change. Economic, technical, and social changes have complicated the balance between these competing goals and renewed debate over who should own what ideas and for how long. Nevertheless, it is a time-tested proposition that society benefits enormously when the expression or product of some ideas is owned and exploited for profit.”¹

In the United States, applications for intellectual property protection have been increasing dramatically. The number of submissions for patents rose from 211,000 in 1995 to 346,000 in 2001, an increase of 70 percent. In 2001 the U.S. Copyright Office registered more than 600,000 claims to copyright and “mask works,” which include three-dimensional images and patterns on semiconductor chips.

Patent activity in the United States received a boost in 1998 from the U.S. Court of Appeals for the Federal Circuit. In State Street Bank and Trust Co. v. Signature Financial Group, the court ruled that “business practices” – in this case, a softwareenabled system for allocating assets, income, and losses in a financial partnership – can be patented.

The Cost of IP Litigation: Median Expense
	$1-25M at risk	$25M+
Patent	$1,499,000	$2,992,000
Trademark	$502,000	$1,001,000
Copyright	$400,000	$750,000
Trade secret	$699,000	$1,009,000
source: American Intellectual Property Law Association (2001)

Traditional accounting tools and financial reporting have been slow to recognize the value of IP and other intangible assets in company balance sheets. In June 2001 the Financial Accounting Standards Board (FASB) issued two statements to clarify accounting for intangible assets. The first, FASB 141, helps companies distinguish between IP and goodwill (the difference between the purchase price of a company and its book value) when acquiring a company. The second statement, FASB 142, provides guidance on accounting for intangibles going forward and measuring their impairment.

One consequence of FASB 142 is that goodwill cannot be amortized over long periods of time. Instead, goodwill must be marked to market at least annually. Although these regulations refer only to acquired intellectual property, companies should not ignore IP that is created internally. Whether for legal, risk management, due diligence, or financing purposes, companies should identify, evaluate, and value all of their intellectual property.

Risk Solutions

Intellectual property issues are complex and multi-dimensional, involving legal, financial, R&D, and other corporate functions. The IP issue with which executives and insurance companies are most familiar is infringement liability litigation. It continues to grow steadily in both frequency and severity. Total IP litigation grew from 6,800 suits in 1993 to almost 9,000 in 2000. In the first quarter of 2003, more than 600 new patent litigation cases have been filed, often with multiple defendants. As indicated in the chart on page 4, the median costs for patent litigation range up to about $3 million per case.

Since patent infringement liability is not covered under general liability insurance, and advertisers’ liability only covers some copyright and trademark risks, the vast majority of IP litigation is uninsured. For defendants, the perils of this litigation are the legal costs of defending against claims of infringement and any resulting damages, which can cripple a company. For plaintiffs, the perils are the legal expense of enforcing rights and for the losing side the potential loss of a protected position due to patent invalidity.

Parties to IP contracts also face title risk. It is not always clear who owns the IP rights, which may have been pledged, for example, in early rounds of financing. There could also be multiple inventors.

To date, most of the specialty insurance written has been thirdparty infringement liability, which protects the corporation from financial losses arising from IP infringement or misappropriation of trade secrets. Enforcement insurance reimburses companies for legal costs associated with protecting their IP rights. The protection of profits due to patent invalidity, injunctions, or defective title can also be insured. Other risk solutions include using surety for appeals, capping uninsured litigation, and insuring known events. Deals can be facilitated though the insuring of representations, warranties, and indemnification issues.

The market for IP insurance is an emerging one. On the supply side, a handful of lead underwriters provide coverage. Total liability capacity with excess support is between $100 million and $150 million. In the pharmaceutical industry, where drug patents are critical assets, there is strong demand for IP insurance. Total annual premiums on the demand side of the market are estimated at about $50 million. But the future size of a mature market, counting both products and services, could be equivalent to that of directors and officers liability insurance, or some $2-3 billion.

Monetization

Intellectual property protects the competitive space in which a company operates. These rights also provide business with “trading cards” for cross–licensing agreements with competitors who may claim infringement on their IP.

Inventions, software, and business practices often have applications beyond a company’s core business or industry. For example, patents on bar-coding or “one click” on-line ordering are protected innovations with applications in many businesses. Marketing IP to potential licensees can be as “simple” as posting the innovation on electronic exchanges. A more elaborate approach to monetization can include the use of IP holding companies domiciled in low-tax environments. (For additional information on leveraging intellectual property assets, see “Monetizing Innovation.”)

Companies that license IP have to be prepared to litigate – both to protect intellectual assets and to establish a position in the marketplace. Companies should conduct an objective analysis of costs and risk factors as well as develop a model for recovering damages. Preparing and managing a budget for litigation expense will enhance economic and strategic planning.

Conclusion

Intangible assets, including brands and intellectual property, constitute a majority of corporate assets – perhaps as much as 80 percent of the value of some companies. Proactive management of these assets can create competitive advantage for companies. Marsh has developed a broad range of IP products and services that seek to mitigate downside risk and increase upside opportunity.

¹ David S. Evans, “Who Owns Ideas? The War Over Global Intellectual Property,” Foreign Affairs, November/December 2002.

Peter Gerkin helps Marsh clients develop insurance solutions for IP risks. He works closely with colleagues at Marsh Risk Consulting, NERA, and Lippincott Mercer who specialize in analyzing, valuing, and monetizing intellectual property and other intangible assets. Mr. Gerken can be reached at peter.gerken@marsh.com or at 212 345 6390.