Thanks to the rise in business bankruptcies, there's a large amount of distressed intellectual property coming onto the market. Pending IP liquidation sales include the trademarks, copyrights, inventory and other assets of Death Row Records Inc., Sharper Image Corp., Electro-Chemical Technologies Ltd. and Isabella Fiore LLC. While these transactions are discouraging news for the failed businesses, they also create an opportunity for strategic buyers to buy distressed assets at sometimes bargain prices.

But buyer beware. Vetting the IP owned by a business that no longer exists presents considerable challenges. Employees familiar with the technology, products or associated IP may have moved on to a more secure (and solvent) situation, and files may have been lost -- making it difficult to assess the strength, uniqueness or value of the assets.

Indeed, the fact of bankruptcy may itself be an indicator of frail internal structures -- poor record keeping, lack of institutional awareness or worse. Important information such as a threat of litigation by a competitor might surface after the deal has closed. The acquirer may find out years later it has made a bad deal.

The bankruptcy setting does not change the goals of due diligence. The acquirer must still ask the relevant questions, and the business issues remain the same. The nuances of the bankruptcy setting do, however, complicate the investigation.

In any acquisition, the extent and focus of a buyer's due diligence depends directly on the objectives the acquirer hopes to achieve. Typically, the buyer believes it can better manage the IP than the previous owner. For instance, the buyer may plan to introduce the IP in new countries, market it more aggressively than the previous owner or use it in a new product. In any case, the due diligence has to take into account how the buyer wants to use the IP and test whether the IP supports those assumptions.

If the acquirer's ability to market the product is better, the acquirer cannot rely on the fact that the prior owner had no claim made against it for patent infringement. It may be that the prior owner was not sufficiently important in the marketplace to warrant the attention of a patent infringement suit, whereas the new owner is well worth suing. Conversely, competitors may have not copied the IP mainly because the prior owner failed to generate consumer demand. If the buyer's marketing efforts generate that demand, competitors may take notice and test the patents protecting the IP.

The key to good due diligence is information. In a typical acquisition, the acquirer can dive deeply into the record, probing the IP for offensive potential and the product for defensive risk. It can then investigate what other IP exists that may pose a challenge. The acquirer can expect the target to make relevant materials available for inspection. Moreover, the acquirer can review the files and test the knowledge of employees -- the company's experts -- who (ideally) can put the technology and IP into perspective.

Bankruptcy proceedings skew the acquirer's vantage point and restrict available information. In the typical bankruptcy, due diligence materials are posted electronically, and this electronic record constitutes nearly all the information available. The acquirer, hoping to peek behind the bankruptcy veil, may find little useful information.

Fortunately, there are tools available to buyers of distressed assets that can help. As with any acquisition, it is essential to understand the market and the target's place within it. With a certain amount of investigation, the acquirer can determine whether the market has turned into a litigious free-fire zone or is relatively tame. If the former is true, the buyer must be prepared to defend its newly acquired IP. Public filings by the target or other public information about it may provide useful information as well, including descriptions of potential threats. Also, searches can be made to see what other IP may be lurking in the marketplace. Such searches should be made in all countries where there is significant risk.

In the bankruptcy setting, representations and warranties are standard and quite limited. The representations of an insolvent target will likely provide little protection, and any representation or warranty will not survive the sale. Finally, because of their limited nature, the target's representations and warranties often add little to the information available electronically.

Most important, the acquirer may take advantage of the unique protection offered by the bankruptcy setting. Discharge from bankruptcy will settle liabilities within the United States -- indeed, orderly payment of creditors is a primary goal of the process. The acquirer may purchase assets without fear that past liabilities will hang, like Coleridge's albatross, around the company's neck.

A bankruptcy discharge in America will not, however, clear up lingering liability overseas. Such liability depends on foreign law and cannot be revoked by American courts. Although there are some ways to try to extend U.S. bankruptcy protection, the distinction presents a potential pitfall for buyers. Often, only assets are purchased to avoid past liabilities of the company.

Still, foreign IP rights may diminish the continuing offensive value of the assets and increase the continuing defensive risk. If the product has better value overseas -- perhaps the primary reason for the acquisition -- buyers must beware of legal restraints that could prevent full exploitation of an acquisition.

For the acquirer facing defensive exposure overseas, there is a silver lining: In most countries, damages (particularly for patent infringement) do not approach the massive awards that sometimes occur in the United States. This lessened exposure to damages does not obviate the need for thorough due diligence, because foreign courts may impose injunctions against manufacturing or selling particular products, potentially neutralizing the value of the acquisition. Of course, even in a standard acquisition, the acquirer must be aware of foreign liabilities and opportunities. In this sense, an acquisition out of bankruptcy is no different.

The global market requires companies to become IP savvy and to ask sophisticated questions during due diligence, within bankruptcy or without. The goals do not change. Unique complications in the bankruptcy setting may, however, make due diligence more difficult and may necessitate some revision to the standard due diligence checklist. - Ethan Horwitz And Adam Conrad

Ethan Horwitz is a partner at King & Spalding LLP and the editor of "Intellectual Property: Counseling and Litigation" (LexisNexis, 7 vols.); Adam Conrad is an Associate at King & Spalding and a former law clerk to Associate Justice Clarence Thomas of the United States Supreme Court.

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