IP-Related Disclosure Requirements Under the Sarbanes-Oxley Act

Congress enacted the Sarbanes-Oxley Act [SOx] in the wake of several major corporate and accounting scandals involving Enron, WorldCom and other well-known corporations.  SOx established new reporting standards for all U.S. public company boards, management, and public accounting firms.  George W. Bush signed SOx into law in 2002, proclaiming that it encompassed “the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt.”  SOx applies to all public companies in the U.S. and international companies that have registered equity or debt securities with the U.S. Securities and Exchange Commission (SEC), as well as the accounting firms that provide auditing services to those entities.  The potential for criminal penalties for violating the provisions of SOx has caught the attention of corporate managers and board members alike, prompting those responsible to feverishly investigate the accounting practices of their corporation.

In the intellectual property (IP) domain, two Sections of SOx are particularly relevant to acquired IP assets, namely, Sections 404 and 409.  Under SOx Section 404 (codified under 15 USCS § 7262) publicly traded corporations must document and certify their internal financial reporting procedures and controls in their annual report.  In assessing procedures for verifying financial reports, acquired IP assets cannot be overlooked.  

The reporting requirements for acquired intangible assets are set forth in the Financial Accounting Standards Board (FASB) Statements of Financial Accounting Standards (FAS) 141 and 142.  FAS 141 and 142 apply to intangible assets that are acquired from outside the corporation, as opposed to intangible assets that are generated internal to the corporation, which are not typically reported on a balance sheet.  Acquired intangible assets, such as patents, copyrights, license agreements, trademarks, trade secrets and customer lists, for example, are an increasingly important economic resource for many entities and are an increasing proportion of the assets acquired in many business combinations. 

FAS 141 was designed to better reflect the investment made in an acquired entity, improve the comparability of reported financial information and provide more complete financial information to stakeholders.  Embracing the purchase method of accounting, FAS 141 mandates that acquired, identifiable intangible assets, including IP assets, be evaluated apart from goodwill.  FAS 141 defines numerous categories and sub-categories for organizing identifiable intangible assets.  Those intangible assets are typically segregated according to the following categories:  (1) Marketing-related intangibles, such as trademarks and domain names;  (2) Technology-related intangibles, such as patents and software;  (3) Artistic-related intangibles, such as musical compositions;  (4) Contract-related intangibles, such as licensing agreements; and, (5) Customer-related intangibles, such as customer lists.  Once the identifiable intangible assets are identified, the value and useful life of those assets must be determined.  Determination of both the value and useful life of patented technology, for example, may account for the patent expiry date, licensing agreements, comparable licensing transactions, expected future sales covered by patented technology, royalty rates, product obsolescence, and more.

FAS 142 introduced new provisions for the remaining useful life estimation, amortization, and impairment of acquired intangible assets.  FAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually.  FAS 142 further requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed annually for impairment in accordance with FAS 144.  Assets such as patents, licenses, leases and other contract-related assets that have a specific expiration date are included in the definite category. The value and/or expected useful life of the intangible asset may be impacted by the effects of obsolescence, demand, competition, and litigation.  

In sum, the internal financial reporting procedures of a publicly-traded corporation must comply with at least the foregoing provisions of FAS 141 and 142 to adequately account for acquired IP assets.  Documenting those procedures will satisfy the burden of complying with SOx Section 404, as it relates to the accounting of acquired IP assets.  

Turning now to SOx Section 409 (codified under 15 USCS § 78m(l)), that section requires companies to make real time disclosures of “material changes” in their financial conditions and operations on “a rapid and current basis.”  To facilitate the reporting of material changes, the SEC amended the requirements for Form 8-K reports in 2004 by further expanding the financial transactions and events requiring the filing of a Form 8-K.  Moreover, the SEC mandated that a Form 8-K must be filed within four (4) business days following any “material change” in financial conditions and operations.  Little guidance is provided as to what financial events rise to the level of being “material.”

To help define what events rise to the level of being “material”, it is useful to consider the U.S. Supreme Court decision in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976), where the Court articulated the requirement of materiality in securities fraud cases holding that “under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder.  Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”  Furthermore, Financial Accounting Concepts No. 2 defines materiality as “[t]he magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”  

In view of the foregoing, one might conclude that the materiality of a fact or omission of a fact may be considered in light of the expectations of the reasonable shareholder.  A reasonable shareholder is concerned with the share price of the public corporation.  A change in the value of an IP asset, which has a cognizable effect on the share price, would have actual significance in the deliberations of the reasonable shareholder, requiring its disclosure.  Of course, material changes are not limited to negative events (i.e., causing a loss of revenue or share price); positive events that are material in the deliberations of the reasonable shareholder should also be considered.  Additionally, a clear link should exist between a share price fluctuation and a change in the value of an IP asset.  In the context of shareholder class-action suits, the U.S. Supreme Court has held that for a shareholder to recover, it must show proximate causation, i.e., a link between a misrepresentation and a decline in share price.  See Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 346 (2005).  

Any “material” change in the value of an IP asset of a corporation should be reported to the SEC and the shareholders by filing a Form 8-K within four (4) business days following the “material change.”  See 17 C.F.R. §228, 229, 230, 239, 240 and 249.  There are several situations for which it is clear that a Form 8-K should be filed in the interest of fulfilling obligations under SOx Section 409.  As one example, the expiration of a patent granting a limited monopoly right to a blockbuster drug will likely be materially significant to reasonable shareholders, thereby worthy of a Form 8-K disclosure.  As another example, a court’s ruling that the patent to a blockbuster drug is invalid would also be materially significant to reasonable shareholders.  Expiration or invalidity of a patent leads to increased competition, which impacts revenue.  As yet another example, the obsolescence of a business-critical patented product would also be materially significant to reasonable shareholders.  Obsolescence of a product, patented or otherwise, impacts revenue.  In each of the hypotheticals, the adverse patent position impacts revenue, which is materially significant to reasonable shareholders. 

Because an SEC Form 8-K may be filed within four (4) business days following a “material change” that is known to the public and material changes can be linked to the share price of a stock, a corporation may be interested to observe changes in its share price over those four days prior to filing a Form 8-K.  It follows that if the share price remained steady, one might argue that the change in value of an IP asset was not “material” to reasonable shareholders.  Conversely, if the share price plummeted, one might argue that the change in value of an IP asset was “material” to reasonable shareholders.  Of course such arguments are fraught with assumptions.  One assumption is that “material” changes are reflected in the share price of a stock.  Another assumption is that the shareholders could or would be aware of a material change when the material change occurred, which is not always the case.  Yet another assumption is that no other intervening events occurred within the four-day period following the “material” event that could have altered the share price.

In conclusion, SOx Section 404 mandates publicly traded corporations to document and certify their internal financial reporting procedures and controls in their annual report.  Under SOx Section 409 publicly traded corporations are required to make real time disclosures of “material changes” in their financial conditions and operations on “a rapid and current basis.”  In an effort to comply with both sections of SOx, IP assets cannot be overlooked.  Corporations need a process for evaluating changes in the value of their acquired IP assets in real time.