by Feng Ai and Chen Xunan  King & Wood’s Finance Group

In the process of an Initial Public Offering ("IPO"), the issuer’s intellectual property ("IP"), such as trademarks, patents, copyrights and know-how, is often directly related to the issuer’s competitive advantage and long term profitability. The Examination and Verification Committee of the China Securities Regulatory Commission ("Examination and Verification Committee") often takes this fact into consideration.

I. IP Issues Arising from A share IPOs within Legal Framework

This article focuses on IP rights from the perspective of A share public offerings, and particularly on trademark, patent, know-how and copyright issues that have caught the attention of the Examination and Verification Committee.

Within the legal framework, core IP issues are addressed in the Measures of the Administration of Initial Public Offering and Listing of Stocks, the Interim Measures for the Administration of Initial Public Offerings and Listings on the Second Board, and the Opinions on Auditing the Stock Issuance by the Examination and Verification Committee of the China Securities Regulatory Commission.

II. IP Issues Arising from A Share IPOs

In practice, the Examination and Verification Committee audits IP issues in the following aspects:

A. Independence

There are three situations relating to IP independence:

a. Incomplete assets due to lack of key IP rights

For example, in relation to a manufacturer of laser organic photo conductor drums , four design patents used in most of the company’s products and one utility model patent used in over 50% of the company’s products were found to be terminated (the "OPC Drums Case").

b. Dependency issues for key IP rights

Sometimes enterprises do not directly own but rather only possess the rights to use certain key IP, and this will create a dependence on related parties. Take one pharmaceutical company as an example, where ownership of the trademark for the company’s second leading product belonged to another enterprise sharing a common shareholder with the pharmaceutical company. Therefore, the right to use trademarks on the issuer’s important products was dependent on the continued cooperation by that common shareholder.

c. Uncertainties in key IP rights

Although the above situation is primarily a dependency concern, such dependence also creates crucial uncertainties in the future viability of such IP rights. For example, one manufacturer of magnetic switches and other related products signed a joint licensing agreement with another enterprise in which the manufacturer was authorized to use an important trademark. However, the licensing agreement did not clearly stipulate renewal rights upon expiry of the term of the agreement or exclusivity rights between the parties.

In addition, when universities or research institutions establish a business or become core technical staff in a company about to go public, the Examination and Verification Committee will be concerned about whether the issuer’s related IP rights are service inventions. One example involves a professional enterprise in the business of researching, developing, producing and selling security video surveillance & transmission technology that applied for six patents. The Examination and Verification Committee saw cause for concern because the actual controller of the applied patents was a regular teacher in a university in Zhejiang Province.

B. Sustainable Profitability

In practice, the Examination and Verification Committee often pays particular attention to whether there have been material adverse changes in the issuer’s acquisition and use of important IP rights. Such changes may lead to uncertainties in auditing A share initial public offerings and listings, just as in the OPC Drums Case. Furthermore, the upcoming expiry of important IP rights would also have a major impact on an issuer’s ability to maintain profitability.

C. Significant Pending Litigation

Unlike general litigation, litigation involving an issuer’s key IP rights, regardless of the litigation amount, will attract the scrutiny of Examination and Verification Committee. In A Stock IPOs, pending litigation may seriously affect an issuer’s potential listing. One such example is a glass deep-processing equipment enterprise that put off its IPO twice due to pending litigation and has gone public only recently. Similar difficulties have faced an intaglio press enterprise, a silicon wafer processing enterprise and a laser cutting industry application solution provider.

D. Information Disclosure

In addition, the above-mentioned issues with an issuer’s key IP rights will often cause information disclosure problems such as incompleteness, inaccuracies, and inconsistencies between information disclosed and information presented on an issuer’s website. On April 20th, 2010, the Examination and Verification Committee of the China Securities Regulatory Commission released the Circular Implementing Sponsorship Requirements, Regulating and Improving the Quality of Sponsors’ Due Diligence (Fa Xing Jian Guan Han [2010] No.121) ("Circular"). The Circular requires a full review of applications handled before May 1st, 2010. The verifications will cover patents, trademarks, litigation and arbitration, related parties, prospectuses and other important information.

III. Analysis of Relevant Projects and Recommendations

A. Special Inspections of Issuer’s IP During Due Diligence

Potential issuers and their professional advisors should consider performing special inspections in the following aspects: (1) issuer’s acquired IP rights and legal status of such rights; (2) whether the issuer has sole ownership; (3) the legal status of assigned IP rights, exclusive nature, duration, and relevant renewal terms (if any); (4) maintenance and updates since IP application; and (5) IP ownership disputes and potential disputes.

B. Active Defensive and Strategic Protection

Issuers should protect their key IP rights using a defensive and proactive strategy. For instance, issuers should consider:

a. applying for registered trademarks in advance of prospective products and services,

b. retaining professionals to conduct regular maintenance of its intellectual property portfolio (application, renewal or extension, alteration, etc),

c. instructing internal staff to track information on a regular basis,

d. maintaining consistency between information disclosure and the legal status of the IP rights.

However, defensive and strategic protection may sometimes spark IP ownership disputes or potential disputes that the issuer should try to avoid.

C. Management Principles and Schemes for Existing IP Issues

After specialized due diligence is conducted on an issuer’s IP rights, the issues that are revealed must be dealt with using tailored solutions. Management principles should focus on eliminating the Examination and Verification Committee’s concerns about independence of the issuer’s IP rights, profit sustainability, significant pending litigation and information disclosure issues that may potentially have a negative influence the value of the company or its ability to be publicly listed.

In IPO practice, management schemes for IP issues are as follows:

a. In order to optimize protection of an issuer’s IP and minimize legal risks such as dependency, inaccuracies or incomplete IP ownership, the company should seek to acquire original registrations. For example, one prospective public issuer applied for a private trademark, accompanied with a brand operation strategy, to eliminate dependency issues. For IP rights that are about to expire, original acquisition is a useful way to apply for alternative or updated IP registrations (such as patents, copyright, etc).

b. If the issuer can afford the cost, another option is to obtain relevant IP rights through acquisition transactions. This approach requires the original IP owners to confirm the issuer’s right to use the IP rights as a trading condition, represent that they do not object with the issuer’s past use of the IP, and finally, the IP owner should release its rights to file suit in the future. However, the full scope of IP covered by the transaction should be confirmed; the original IP owner may conduct reverse infringement by continuing to use the transferred IP rights after the transaction.

c. Another option is to engage in strategic cooperation with the IP owner, who may become a shareholder in the issuer’s enterprise in exchange for fully transferring the IP to the issuer. The IP ownership holder could either make equity contributions with related IP rights or transfer related IP rights at fair price (or free) and become a shareholder.

d. For those situations where directly obtain IP ownership is not possible, the issuer should review the IP licensing agreement and ensure that it has the right to use the IP in the foreseeable future. The issuer should then verify the legal status and the right of disposition of the related IP rights, adopt exclusive licensing and long-term agreements in which license fees and renewals are clearly stipulated. In addition, the IP licensing agreement should be filed with the relevant authorities according to laws and regulations.

e. Where obtaining long term solutions for protecting key IP rights is not possible, the issuer should seek to mitigate potential losses by reducing the influence of related products on the enterprise’s operation and performance. If the products related to the IP rights are not core products for the issuer, the issue may consider upgrading the IP related products, changing product structure, or decreasing sales/profits proportion to reduce the potentially negative influence of such products. When necessary, the issuer may even call off the related products entirely and abandon the related business.

f. When issuers apply for a trademark review or file a petition for invalidity, these administrative means or litigation could impact related IP ownership. If the issuer cannot obtain ownership or the right to use the IP and the related IP products are core products for the issuer, the issuer should try to testify that the original IP ownership was obtained against the law, otherwise these would be real legal obstacles for an initial public offering.

In addition, for significant IP litigation that has already begun, other than the above-mentioned schemes such as acquisition, strategic cooperation, mitigation, and active defense, the issuer should set aside capital in preparation for liability as well and demand complete information disclosure.

(This article was originally written in Chinese, and the English version is a translation.)