Business & Technology Report - Winter 1997 | |
Obtaining Confidential Treatment for Information Furnished to the SEC Stock-Based Compensation in the Biotech Industry Insurance Coverage Considerations for Technology Companies Bankruptcy Code Section 365(n) Protects Licensees Right to Continued Use of IntellectualProperty | OBTAINING CONFIDENTIAL TREATMENT FOR INFORMATION FURNISHED TO THE SEC by Wayne Shortridge and Edward Ted Johnson, Jr. return to top All companies, especially those engaged in the biotech and electronic high tech businesses, have sensitive information they wish to keep confidential. In the ordinary course of business, companies seek to protect their confidential information from unauthorized disclosure by means of contractual restrictions on employees, consultants, vendors and other third party contractors. A company that will go or has gone public, however, must make detailed disclosures about its business because one of the regulatory procedures that the SEC has established. To be eligible for confidential treatment, the information sought to be protected must meet one of several FOIA exemptions from disclosure. The only one of these that is ever likely to be available is the one for trade secrets and commercial or financial information [that is] privileged or confidential. To fulfill its purpose of ensuring that material information is disclosed to investors, the SEC takes a narrow interpretation of what information is eligible for confidential treatment under the exception for trade secrets and commercial or financial information. It is not possible to claim confidentiality for any information otherwise required to be disclosed under the securities laws or any information the company has in fact already disclosed to the SEC without having made a confidential treatment request. Even if a contract does not contain information specifically required to be disclosed or already disclosed, the SEC will almost never accept a confidentiality request applicable to the entire contract, or even to sections or paragraphs of the contract. Instead, confidentiality requests must usually be made on a word-by-word or phrase-by-phrase basis. For instance, in a 40-page patent and trade-secret licensing contract, the company might request confidential treatment only for the name of the other contracting party (if not already publicly known or previously disclosed), the term of the agreement, the exact technology covered and the pricing information (e.g., the royalty rate and any other fees). For each item requested to be kept confidential, the company must show that it has sought to keep the information confidential, that disclosure of the information would cause substantial harm to the company's competitive position and that this harm outweighs the need of investors to know the information. To make a confidentiality request, the company, generally using its counsel, sends a letter tothe SEC that itself contains no confidential information, because it has been held that a letter requesting confidentiality cannot itself be maintained confidential. With an attached but separate transmittal letter, which the SEC will keep confidential if requested, the company provides a detailed explanation and justification of its confidentiality requests and attaches the documents for which confidential treatment is being requested, providing for each document one clean copy and one with the portions requested to be held confidential so marked.(There is also a separate procedure for making confidentiality requests for the non-disclosure of documents that the SEC requests as supplemental information for its review, but which arenot required to be publicly disclosed.) In response to a confidentiality request, the SEC staff routinely asks questions and provides comments. It may request that further information be provided explaining the justification for a given request or it may advise that the request should be withdrawn with respect to certain information. To the extent the request is finally granted, anyone making an FOIA request forthe document will only be able to receive a copy that has the confidential information redacted, or blacked-out. In our experience, a well thought-out, well-explained and limited request for confidentiality is generally granted. Even if the request for confidentiality is granted, a company should keep in mind that the SEC is still required to provide all such confidential information to other U.S. government agencies that request it and, in particular situations, to foreign governmental authorities. Wayne Shortridge is a partner and Ted Johnson is an associate in PHJ&W s Atlanta office. return to top Designing effective compensation programs is never easy. Supporting shareholder value creation, motivating employees, determining realistic performance goals, complying with government regulations and addressing investor expectations are complex and often competing objectives. The biotechnology industry faces these difficulties, and more. Companies in this industrymust attract employees with cutting-edge knowledge and skills, manage five- to ten-year product development cycles and obtain government approval as a make-or-break point in the business all the while conserving capital and riding the volatility of the market for biotechnology shares. Stock-based programs are often the solution. Yet linking employee interests to those of shareholders while rewarding employees for results they can influence may be the biggest challenge of all in the temperamental biotech equity market. The Issues While often lumped into the broad category of technology companies, significant differences from software and networking companies render their equity compensation strategies moot for biotech firms. The technology industry's focus on stock options works well when a series of new product introductions can somewhat predictably produce the economic performance to support a continually rising share price. This, in turn, creates a great opportunity for the innovative use of stock-based compensation. The biotech industry's great variation in company size and strategy complicates the discussion of biotech compensation. Many companies in this industry are private, hoping for the right combination of market success and stock market timing to allow a public offering perhaps long before any prospect of profitability. Others enter joint ventures with major companies, providing a more stable situation. Still others have become established and grown to mature companies faced with patent expiration and threats of new developments by competitors. While there is great commonality among compensation structures in other industries, a single model does not apply to this industry. Potential Solutions Despite the continuing focus on regulatory issues, many constraints limiting compensationdesign -- accounting charges, tax regulations and investor expectations -- have little impact on some biotech companies. These firms can take a fresh view of many available compensation tools. Stock Options. Biotech companies with no foreseeable prospects of profitability may choose to use Incentive Stock Options (ISOs), enabling employees to defer taxation at the time of exercise and receive capital gains treatment on the entire gain when the stock is sold. The company tax deduction that would be realized with a Nonqualified Stock Option (NSO) maybe of no concern for these firms. Discounted stock options can combine insulation from short-term stock price volatility with adeferred compensation opportunity. A source of institutional investor criticism, earnings charges and lost deductibility for grants to top executives, discounted options may meet the needs of an emerging biotech company with affiliated investors, a focus on revenue overshort-term profit and no taxable income. Stock Grants. Restricted stock or outright stock grants with no restrictions can be an effective approach to replacing cash with equity while eliminating some of the risk of options. Like discounted options, stock grants present the issues of earnings charges, investor objection and lost deductions for senior executives but when designed and explained well, they may be an effective solution. Simulated Equity. Many situations, such as close ownership of equity by founders or joint ventures, may preclude the use of actual equity in compensation plans. In these instances, simulated equity programs, such as phantom stock, may provide equivalent benefits and beacceptable to all parties. These programs can be structured to later convert into actual equity programs with no negative accounting or tax effects. Performance Measures The compensation strategy that worked at the time of the start-up or the public offering maybe less effective as the company matures. While stock price is an effective measure of overall success for smaller enterprises, as companies grow and diversify their product offerings they must tailor rewards to subsegments of the organization. Potential approaches include: Product Milestones. The long development cycle and market volatility in the industry may require delivery of rewards, particularly to key technical staff, before realizing financial outcomes. Granting and/or vesting stock awards at completion of key product development events can bridge the gap between internal efforts and market results. Financial Milestones. Early investors may resist rewarding employees before they see their investments bear fruit. Certain financial milestones venture capital, private placement or initial public offering may represent key performance accomplishments by executivesinvolved in the transaction as well as the technical staff's accomplishments that create value for investors. Shareholder Return. Of course, the enterprise's ultimate performance measure is return to shareholders, and investors may want the employees equity-based compensation value to parallel investor returns. Creative approaches to vesting and restrictions on sale, combined with a reasonable and progressive liquidity plan, can allow employees to reap incremental rewards while reassuring investors that all parties are locked in until expected returns materialize. Reaching the Right Solution An industry full of opportunities for creating economic value while solving worldwide health issues also has unique opportunities for rewarding employee achievements. Ultimately, companies in the biotech industry must consider equity as a solution to employee compensation challenges. But emulating the technology sector's use of ordinary stock options with standard terms and provisions may not work. Meeting compensation objectives through stock-based programs requires thinking through the purpose of the equity. Any stock-based approach must be analyzed thoroughly to ensure strategic, financial and behavioral considerations are balanced and support the needs of the business. Fred Whittlesey is a founding principal of Compensation and Performance Management, Inc.(CPM), a management consulting firm based in Newport Beach, Calif. CPM works with clients to improve organization performance through evaluation, design and implementation of employee compensation programs and performance management processes. The firm specializes in working with entrepreneurial growth companies. return to top For technology sector companies, new media outlets and emerging technologies have resulted in exposure to previously unknown liabilities. While insurance coverage is available and enforceable to protect companies against many of these exposures either under traditional policies or newer coverages designed specifically for these risks it is important to understand the scope and the limitations of the coverages and to know when steps need to be taken to avoid an uninsured, and potentially serious, liability. Trademark and Trade Dress Infringement Claims Biomedical and technology companies must increasingly confront intellectual property lawsuits seeking damages for trademark and trade dress infringement, where the claimant typically alleges that the company's use of a mark, a look or an image has infringed the claimant's exclusive rights. Quite appropriately, the company faced with such a suit turns to its liability insurance carrier for defense and payment of any judgment or settlement that may result. Frequently, insurance companies have disputed coverage for such claims under their general liability policies, but recent trends in coverage law have confirmed that coverage does in fact exist for these torts under the advertising injury provisions in the standard form commercial general liability(CGL) policy. To enforce advertising injury coverage, the insured has two hurdles to overcome: (1) showing that the claimant is asserting one of the listed advertising injury offenses, and (2) demonstrating that the offense happened in the course of advertising the insured's products or services. In the recent cases, the courts have found that a third party's claim contending that the insured has unlawfully used or taken the plaintiff's mark or style of doing business is a covered offense, satisfying the first prerequisite for coverage. Just as significantly, the courts have generally found that trade dress and trademark infringement necessarily occurs in advertising, and meets the second requirement for coverage. The Internet While the Internet has created tremendous opportunities for entrepreneurs from online services to content providers to creators of 3-D graphics it has also given rise to a number of potential liabilities. Because existing insurance policies were not created with these liabilities in mind, Internet users and entrepreneurs need to be aware of the scope of their coverage and the gaps that may exist. The standard general liability policy, for example, expressly covers defamation. But are online computer services (or their users) covered when allegedly defamatory statements are posted on an electronic bulletin board or published in an electronic newsletter? The controversy in the underlying defamation case turns on control -- and knowledge. Wherean online service acts essentially as an electronic library, with little or no editorial control over content, the service has been held not liable for defamation. However, where the service holds itself out to the public as controlling the content of its electronic bulletin board, it acts as a publisher and not simply a distributor of information, and can be liable for defamation. >From an insurance point of view, these issues take on another light. The typical CGL policy does not cover defamation by companies that are in the business of advertising or publishing. The online service that acts merely as an electronic library may well obtain a defense and coverage for a suit claiming it distributed defamatory statements. In contrast, a service that acts as a publisher in control of content may find itself excluded from coverage. Some Internet providers may find that coverage for their activities does not fit easily within the traditional general liability policy. For example, companies whose business involves the advertising of products, goods and services on the Internet could run afoul of the business of advertising exclusion in the general liability policy. By obtaining (before the fact) aspecialized media perils or multimedia professional liability policy, these companies can avoid disputes with their insurance companies after a suit is brought. The value of knowing your insurance in advance, and enforcing its protection once a claim is brought, cannot be overstated. Summary To sum up, the best strategy to deal with the insurance issues posed by new technologies involves a combination of three elements: (1) loss prevention measures, to prevent the loss before a claim occurs; (2) insurance placement, to take advantage of new policies that may cover the loss; and (3) vigorous enforcement of existing coverages, to maximize the company's overall insurance benefits. Cindy Roth is a vice president at Johnson & Higgins, the largest privately held insurance brokerage consulting firm in the world. Grace Carter is a partner in the Los Angeles office of PHJ&W. return to top In the rapidly changing world of technology, it is not uncommon for large companies to become dependent on start-up, financially vulnerable firms through the licensing of key technology. Withthe now you're hot, now you're not pace of the high-tech world, many licensors have been forced into bankruptcy, jeopardizing the right of the licensee to use the technology. Prior to 1988, a licensee could not rely on a licensing agreement for the continued use of the licensed technology in the event of a licensor bankruptcy. After intense lobbying by vendors and trade groups (including launching a celebrated case, Lubrizol Enterprises v. Richmond Metal Finishers, Inc., which illustrated the plight of a licensee whose licensor goes into Chapter 11),Congress enacted the Intellectual Property Bankruptcy Act of 1988 codified in Section 365(n) ofthe Bankruptcy Code to limit the power of the licensor to prevent the continued use of the license. Limited Scope of Section 365(n) Section 365(n) of the Bankruptcy Code only applies to licenses of intellectual property in the context of a licensor bankruptcy. Moreover, Section 365(n) applies only to the following types of intellectual property:
Protections of Section 365(n) If a debtor/licensor rejects an executory license, Section 365(n) of the Bankruptcy Code provides the licensee with the option of treating the license as terminated by virtue of the rejection and asserting damages for breach, or retaining its rights under the license for its duration and any applicable extensions. Section 365(n) expressly provides that the licensee may only retain its rights as such rights existed immediately before the case commenced. Section 365(n) provides no rights to the licensee in intellectual property that the licensor may create after the bankruptcy filing. Affirmative Covenants Unenforceable As to the scope of the retained rights, the licensee may retain its rights as such rights existed prior to the filing including a right to enforce any exclusivity provision, but excluding any other right under applicable non-bankruptcy law to specific performance of such contract. Under these provisions, the exclusive rights granted to the licensee will still be enforceable, but other rights of the licensee cannot be specifically enforced. The licensor will thus be relieved of any burdens to take additional affirmative acts under the contract such as infringement protection,training and development and maintenance obligations. Royalty Obligations Additionally, in exchange for being permitted to retain its rights, the licensee is required to makeall royalty payments due under the license in accordance with the contract and for the remaining term and is deemed to have waived any setoff rights with respect to those payments and any claim for administrative expenses. While setoffs are not permitted, Courts have allowed recoupment of certain advances made by the licensee. In construing the term royalty, Congress has directed the courts to look to the substance, and not the label given to the transaction. In a Ninth Circuit Court of Appeals case, In re Prize Frize,32 F.3d 426 (9th Cir. 1994), the Court held that all payments due for the use of intellectual property should be treated as royalties regardless of how the payments are labelled by the parties, and thus held that a fixed license fee was in fact a royalty under Section 365(n). It is noteworthy that the Court suggested it might have held otherwise if the license fee had been payable in consideration for affirmative covenants such as warranties or indemnifications that were not enforceable by the licensee. Thus, when drafting royalty provisions, the licensee should be careful to separate out payments covering affirmative obligations like maintenance, training or development. If the payments are not segregated out and are lumped together as royalty payments, the licensee may end up paying for affirmative obligations that the licensor is not required to perform. Conclusion Although Section 365(n) removed some of the uncertainty and risk associated with a licensor bankruptcy, drafters of an intellectual property license arrangement are well-advised to consider the effect of a potential bankruptcy upon the arrangement. As with any transaction, testing the rights, duties, obligations and expectations of each party against a theoretical bankruptcy may provide additional protection and certainty to reduce the often disruptive effects of a bankruptcy filing. Carl Anderson is a partner working out of PHJ&W s Stamford and Los Angeles offices. Leslie Plaskon is an associate in the Stamford office. For more information: For more information, please contact: Mike Lindsey or Bob Miller (Los Angeles); Steve Cooke, Bill Simpson or Peter Tennyson (Orange County); Andy Scott or Wayne Shortridge (Atlanta); Barry Brooks, Vicki Cundiff, Leigh Ryan or Neil Torpey (New York); Steve Ferrer (Stamford); or Ham Loeb (Washington, D.C.) Atlanta, GA (404) 815-2400 Los Angeles, CA (213) 683-6000 New York, NY (212) 318-6000 Orange County, CA (714) 668-6200 Stamford, CT (203) 961-7400 Tokyo, Japan (81-3) 3586-4711 Washington, D.C. (202) 508-9500 West Los Angeles, CA (310) 319-3300 Business & Technology Report is published solely for the interest of friends and clients of Paul, Hastings, Janofsky & WalkerLLP and should in no way be relied upon or construed as legal advice. For specific information on recent developments orparticular factual situations, the opinion of legal counsel should be sought. Paul, Hastings, Janofsky & Walker LLP is alimited liability law partnership including professional corporations. |
Business & Technology Report Winter 1997
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