16
Nov, 2015

Tax Strategies for Selling Your Company

The tax consequences of an asset sale by an entity can be very different than the consequences of a sale of the outstanding equity interests in the entity, and the use of buyer equity interests as acquisition currency may produce very different tax consequences than the use of cash or other property. This article explores certain of those differences and sets forth related strategies for maximizing the seller’s after-tax cash flow from a sale transaction.

Taxes on the Sale of a Business

The tax law presumes that gain or loss results upon the sale or exchange of property. This gain or loss must be reported on a tax return, unless a specific exception set forth in the Internal Revenue Code (the “Code”) or the Treasury Department’s income tax regulations provide otherwise.

When a transaction is taxable under applicable principles of income tax law, the seller’s taxable gain is determined by the following formula: the “amount realized” over the “adjusted tax basis” of the assets sold equals “taxable gain.” If the adjusted tax basis exceeds the amount realized, the seller has a “tax loss.” The amount realized is the amount paid by the buyer, including any debt assumed by the buyer. The adjusted tax basis of each asset sold is generally the amount originally paid for the asset, plus amounts expended to improve the asset (which were not deducted when paid), less depreciation or amortization deductions (if any) previously allowable with respect to the asset. Taxable gain is generally decreased, and a tax loss is generally increased, by transactional costs and expenses paid by the seller.

Ordinary vs. Capital Gains and Losses

The character of a taxable gain or loss can be vital in determining the amount of tax due upon the sale of corporate assets. Gain can be classified as ordinary income or capital gain. Gain upon the sale of assets that are characterized by the Code as “capital” is capital gain. The sale of a capital asset held for more than one year creates long-term capital gain and is, for sellers other than so-called “C corporations” (i.e., corporations for which an election to be subject to subchapter S of the Code has not been made), taxed at a much lower tax rate. Currently, for federal purposes, this rate is about half of that applicable to ordinary income. If a taxable gain from the exchange of a capital asset held for less than one year, it is a short-term capital gain, which is generally taxed like ordinary income.

C corporations are subject to identical federal income tax rates on their ordinary and capital gain income, so the character of a C corporation’s gain is often irrelevant. However, the capital losses of C corporations still may only be offset against capital gains, and such losses are also subject to far more restrictive carry-back and carry-forward provisions than are ordinary losses. So, if a C corporation has excess capital losses during a taxable year (or capital losses which have been carried forward from an earlier year), the corporation may prefer capital gains over ordinary income, because the excess capital losses may be used to offset the capital gains (but could not be used to offset ordinary income).

It is usually very important (and, in most instances, required) for the seller and buyer to agree upon an allocation of the sales price among the assets being sold, as such will determine the character of the gain recognized by the seller and also will determine the amount of sales, use and other transfer tax liabilities arising from the sale (which are usually imposed on the seller by law, but may be passed on to the buyer via contract). Although tax authorities are generally free to challenge such an allocation, they usually will respect an allocation agreed upon by the seller and buyer and negotiated at arm’s-length. For sellers that are not C corporations, how the sales price is allocated can save or cost substantial amounts of tax.

Tax Consequences Arising From Sale of Assets

In an asset sale, the buyer agrees to purchase all or a select group of assets from the seller, usually subject to either all or certain liabilities. If both the acquirer and the selling entity are corporations and the sales price consists or includes stock of the buyer, the transaction may constitute a tax-free “reorganization” (discussed below). Otherwise, the selling entity will recognize taxable gain or tax loss with respect to the sale of each asset equal to the difference between the amount realized for each asset sold and its adjusted tax basis.

A selling entity that is a C corporation will pay federal and state income taxes on the net taxable gain from the asset sale. If the corporation then wants to distribute the proceeds to its shareholders, each shareholder will then be taxed on the amount distributed to him or her. If the distribution is a dividend, the amounts distributed to the shareholders will be taxable as such (subject, in the case of C corporation shareholders, to a special exclusion known as the “dividends received deduction”). If the distribution is in liquidation of the distributing corporation, each shareholder will recognize taxable gain equal to the difference between the amount distributed to it over its adjusted tax basis in his or her stock in the distributing corporation. To avoid this “double-tax problem,” and also to minimize or avoid sales, use and other transfer taxes, a C corporation should avoid asset sales. Instead, the owners should seek to sell their stock.

But there is a potential problem with a stock acquisition for the buyer. If the buyer buys the corporation’s assets, virtually the entire purchase price can be deducted over time through depreciation and amortization deductions with the resulting tax savings essentially paying for a portion of the purchase price (usually a very material portion of the purchase price). If, on the other hand, the outstanding stock of the corporation (a non-depreciable and non-amortizable asset) is bought, the buyer will be limited to deducting depreciation and amortization based on the adjusted tax basis in the corporation’s assets immediately prior to the acquisition (in other words, any premium paid over book value cannot be deducted for income tax purposes). The foregone deductions essentially mean that the government will fund less of the buyer’s purchase price through future tax savings, which often means that the buyer will want to pay less for the stock of the corporation than it would want to pay for the corporation’s assets.

Where the seller is an “S corporation” (which is taxed similarly to a partnership in that it generally doesn’t pay income taxes), or is a subsidiary of another corporation, the buyer and seller may jointly elect to treat a purchase and sale of stock as an asset purchase and sale for income tax purposes. The benefit of this is that the buyer will obtain an increase in the adjusted tax basis of the assets of the corporation and may be willing to pay an increased price due to the increased tax savings available to the buyer in the future. Also, the making of this election is not taken into account for sales, use and other transfer tax purposes, so those taxes may be largely avoided.

Tax Consequences Arising From Sale of Equity Interests

In a sale of equity interests, the buyer agrees to purchase all or a portion of the outstanding equity interests in an entity from one or more of its owners. If both the acquirer and the entity to be sold are corporations, and the sales price is or includes the buyer’s stock, the transaction may be a tax-free reorganization (discussed below). Otherwise, each seller will recognize taxable gain or tax loss equal to the difference between the amount realized by it from the buyer and its adjusted tax basis in the interests sold. If gain is recognized, some or all of the gain may often be deferred through the use of seller financing, which can increase the seller’s after-tax yield because the seller is investing pre-tax instead of after-tax money at the interest rate provided in financing documents, but there can be a toll charge for this deferral in certain larger transactions.

Tax-Free Corporate “Reorganizations”

The Code sets forth a number of tax-free transaction structures known as “reorganizations” that are available where both the seller and the buyer are corporations (either C or S corporations) To qualify as a reorganization, a transaction must meet certain requirements, which vary greatly depending on the form of the transaction. If all applicable requirements for a reorganization are met, shareholders of the acquired corporation are not taxed on the portion of the sales price that consists of shares of the acquiring corporation. Of course, the threshold issue for the sellers will be whether they are willing to take stock of the buyer and, if so, how long they would be willing or required to keep it. If certain or all of the sellers are concerned about taking stock in the buyer due to investment or market risk, consider (i) requiring that the stock be freely tradable upon receipt, so that concerned sellers may sell all or a portion of the shares received by them immediately in open market transactions, (ii) negotiating price protection from the buyer, so that, if the buyer’s stock value goes down below a stated threshold over a stated period of time, the sellers would get additional consideration, and/or (iii) seeking an investment hedge arrangement from an investment bank. All of these arrangements may be structured in a manner that does jeopardize the tax-free quality of the reorganization.

A. Straight Merger

A straight merger is simply a merger of one corporation into another corporation pursuant to applicable state law. This is a relatively flexible form of reorganization because (i) shareholders of the entity being acquired may receive all stock or a combination of stock and other consideration (such as cash), (ii) shareholders receiving both stock and non-stock consideration are not taxable on the stock consideration provided the non-stock consideration is less than 60% of the total consideration, (iii) shareholders do not have to be treated equally (meaning some shareholders may receive cash, some all stock, others a combination of cash and stock), and (iv) certain restrictive provisions applicable to the other forms of reorganizations do not apply to straight mergers.

As a general rule, in a straight merger, some or all of the shareholders of the corporation being acquired may receive as much as approximately 60 percent of the sales price in cash or other non-stock consideration without being taxed on the stock portion of the consideration.

A potential non-tax problem with this form of reorganization is that the acquirer directly assumes the liabilities of the acquired corporation in the merger, which can pose a risk to the acquirer’s other existing businesses and assets. This can be solved, however, by simply merging the corporation to be acquired into a wholly owned limited liability company subsidiary of the acquiring corporation (which is still treated as a straight merger for income tax purposes).

In any event, a straight merger will result in sales, use and perhaps other transfer taxes, which could be avoided using certain other reorganization formats (discussed below).

B. Stock for Stock

A stock-for-stock reorganization involves the acquisition of at least 80 percent of the stock of the corporation to be acquired solely in exchange for voting stock of the acquiring corporation. The acquiring corporation cannot pay a single cent of non-stock consideration. Though less flexible than the straight merger, in this type of reorganization, sale, use and transfer taxes are generally avoided and the acquirer also avoids the problem of directly assuming the liabilities of the acquired corporation. This is so because those liabilities remain, encapsulated in the acquired corporation (which becomes a subsidiary of the acquired corporation). This same result may also be accomplished through use of a subsidiary merger format (discussed below), which is generally more flexible and therefore preferred to stock-for-stock reorganizations.

C. Stock for Assets

A stock-for-assets reorganization involves the acquisition of “substantially all” of the assets of the selling corporation solely in exchange for voting stock of the acquiring corporation. As is the case with the stock-for-stock reorganization, this format requires that solely voting stock of the acquirer be used; however, there is a special rule that permits non-stock consideration to be used so long as the total non-stock consideration given by the acquiring corporation (including assumption of the liabilities of the acquired corporation) does not exceed 20 percent of the total consideration given (including the liabilities assumed).

The stock-for-assets format offers the acquirer the benefit of not having to assume the unknown or contingent liabilities of the acquired corporation (either directly or via taking the acquired assets subject to such liabilities, as in a merger and a stock-forstock reorganization). But, like the stock-for-stock format, it is only feasible when all or virtually all of deal consideration will be stock of the acquirer. Also, it leaves the shareholders of the selling corporation with the task of cleaning up and liquidating the selling corporation. Finally, in contrast to the stock-for-stock format, this type of reorganization will result in sales, use and other transfer taxes.

D. The Favored Formats — Subsidiary Mergers

Subsidiary mergers are accomplished when the acquiring corporation forms a subsidiary corporation and either merges the corporation to be acquired into the subsidiary (known as a ‘‘forward subsidiary merger”) or merges the subsidiary into the corporation to be acquired (known as a “reverse subsidiary merger”). Although the merger is between a subsidiary and the corporation to be acquired, stock of the corporation that owns the subsidiary (its ‘‘parent”) is given as consideration to the shareholders of the corporation to be acquired.

The reverse subsidiary merger is the usual form of reorganization chosen, because (i) it protects the acquirer from the liabilities of the acquired corporation by keeping those liabilities separately encapsulated in the acquired corporation (which becomes a subsidiary of the acquirer), (ii) unlike all of the other reorganization formats except the stock-for-stock format, it avoids having to transfer legal title to assets (which, as a result, avoids sales, use and other transfer taxes), (iii) it often avoids anti-assignability provisions in the contracts of the corporation to be acquired, (iv) it permits up to 20 percent of the transaction consideration (without taking into account liabilities of the corporation to be acquired) to be paid in non-stock consideration, which is considerably more generous than available in the stock-for-stock and stock-for-assets formats.

The one drawback to the reverse subsidiary merger, compared to the straight merger and the forward subsidiary merger, is that the latter two permit as much as about 60 percent of the transaction consideration (without regard to the liabilities of the corporation to be acquired) to be paid in non-stock consideration. This advantage is often of limited benefit when the acquirer is a public company, since, subject to applicable securities laws and any contractual transfer restrictions that may be imposed by the acquiring corporation’s investment bankers, a shareholder of a corporation acquired by a public company may usually dispose of all or a portion of its public company shares received in the reorganization in open-market transactions at any time.

Where the consideration in the deal will include at least 40% stock consideration but greater than 20% non-stock consideration (so the reverse subsidiary format would be taxable), the forward merger would be the preferred subsidiary merger format. However, if any requirement of a forward subsidiary merger is not met, the potential tax downside is quite serious. Specifically, the transaction would be treated as a taxable asset sale by the target corporation and then a taxable liquidating distribution from the target to the selling shareholders (giving rise to the double-tax problem). Where there is concern about whether a requirement of a forward subsidiary merger may be met, there are two possible ways to avoid the serious potential downside.

The transaction could be structured as a straight merger using a wholly owned limited liability company subsidiary of the acquiring corporation to acquire the assets of the target (discussed above) or it could be structured as a so-called “two-step merger.” In the two step merger, the target is first acquired via reverse subsidiary merger and, shortly thereafter, the target is either merged into another subsidiary of its new parent.

Pursuant to IRS rulings, if it turns out that any requirement of a forward subsidiary merger is not met, the transaction will be treated as a sale of stock by the target shareholders (giving rise to only one level of tax). If there is any question about whether all of the requirements of a forward subsidiary merger can be met, or if the seller will not be performing sufficient diligence to determine whether every such requirement can be met, use of the two-step merger format is strongly recommended.

“Blown” Corporate Reorganizations

Any transaction that meets the requirements of any of the reorganization formats is non-taxable for income tax purposes, which is usually the desired result. However, ‘there the sellers would have a deductible tax loss if the transaction were not characterized as a “reorganization,” planning should be considered to intentionally fail to meet one or more requirements of each possible reorganization format.

Conclusion

The involvement of qualified counsel throughout the process is imperative in minimizing the tax liability that can result and in meeting both the buyer’s and the seller’s respective tax and non-tax goals for the transaction and going forward.

15
Nov, 2015

Arbitration Revisited: Are Your Employment Arbitration Agreements Safe from Scrutiny in California Courts?

Following conventional wisdom, many California employers have adopted the practice of requiring their employees to sign mandatory arbitration agreements. For such employers, the advantages of arbitration include (1) reduced publicity because arbitration is closed to the public and the press; (2) less exposure to punitive damages or runaway verdicts (juries tend to be more emotional and oftentimes award larger, punitive verdicts than do arbitrators); (3) more expeditious and streamlined discovery; (4) speedier resolution of the litigation as compared with the economically-challenged and overburdened court system; (5) ability to select an arbitrator with employment expertise; and (6) protection from potential class actions.

To benefit from such advantages, however, employers must diligently review their arbitration agreements with competent employment counsel to ensure that such agreements remain enforceable in light of the rapidly evolving body of law pertaining to arbitration agreements.

As recently as June 4, 2013, a California appellate court reviewed an employment arbitration agreement to determine its enforceability. Brown v. Superior Court (Morgan Tire & Auto, LLC), __ Cal. App. 4th __, 2013 WL 2449501. While the Brown case dealt with the narrow issue of whether representative claims under the California Private Attorneys General Act (“PAGA”) can be compelled to arbitration (apparently not), the key California Supreme Court case regarding enforceability of employment arbitration agreements is Armendariz v. Foundation Health Psychcare Services, Inc., 24 Cal. 4th 83 (2000).

In Armendariz, the Court held that employers can require employees to sign mandatory, pre-dispute arbitration agreements as a condition of employment so long as they are not unconscionable. To be conscionable, the agreement must be bilateral (meaning that it benefits and constrains both the employer and employee equally), fair, and employers must pay those costs unique to arbitration. If conscionable, an arbitration agreement can even contain a class action waiver.

In AT&T Mobility LLC v. Concepcion, 131 S.Ct. 1740 (2011), the United States Supreme Court held that arbitration agreements containing class action waivers are enforceable. However, since Concepcion was decided, California courts have grappled with the question of whether an employer may require employees to waive the right to file or participate in a class action. Significantly, California courts have attempted to circumvent Concepcion’s holding by concluding that various employment arbitration agreements were unconscionable for a myriad of reasons.

Recommendations for Employers

Given the ever-evolving case law and judicial resistance (in California state courts) to arbitration agreements that contain class action or representative action waivers, employers should be proactive in reviewing and revising their arbitration agreements to withstand judicial scrutiny. While employers can hope that a court will sever an unconscionable provision from an arbitration agreement, even one unconscionable provision could render the entire agreement invalid if the agreement is found to be permeated with unconscionability. Accordingly, it is strongly recommended that employers work with employment counsel to carefully review arbitration agreements to ensure they are conscionable and enforceable. Here are some “do’s” and “don’ts” to keep in mind when reviewing such agreements:

DO DON’T
Do ensure that provisions of the arbitration agreement are bilateral. In other words, the agreement should impose the same constraints and bestow the same benefits to both the employer and employee.

 

 Don’t require the employee to arbitrate certain claims while allowing the employer to go to court on certain claims (e.g., injunctive relief).

 
Draft the agreement in clear and unambiguous language, and put the jury and class action waiver provisions in bold and conspicuous font.

 

 Don’t forget to identify or attach the rules that apply to arbitration. At a minimum, provide a web link where employees can access the rules.

 
Provide an opportunity for employees to ask questions about the terms of the arbitration agreement. (E.g., include a sentence that says “If I have any questions about this document, I understand that I can contact the Human Resources department.”)

 

 Don’t shorten the statute of limitations for the employee to file a claim. For example, requiring an employee to file a wrongful termination claim within three months of termination instead of the two years provided by statute would be unconscionable.

 
Consider including a clear and conspicuous “opt-out” provision allowing the employee to change his or her mind within 30 days of signing the arbitration agreement. (Judges love this provision and employees rarely change their mind).

 

 Don’t limit discovery. Employees should be able to conduct reasonable discovery such as taking depositions and serving written discovery requests.

 
Employers should pay costs unique to arbitration (i.e., the employee should not be required to pay more than what he or she would incur for commencing a civil action in court).

 

 Don’t designate an inconvenient forum. For example, if the employee works in Los Angeles, the employee should not be expected to arbitrate a claim in Kansas.

 
Ensure that the arbitration agreement permits both parties to conduct discovery and file dispositive motions.

 

 Don’t use an unfair arbitrator selection process. The panel of arbitrators should be neutral and sufficiently populated to allow the employer and employee to select from a variety of arbitrators

 

 

Marie represents employers in wage and hour class and representative actions. She also defends employers against wrongful termination, discrimination, harassment, retaliation and unfair competition claims in court, arbitration and administrative proceedings. Marie has extensive experience counseling employers regarding all aspects of the employment relationship and works with employers to develop strategies to prevent employment claims and create effective defenses to litigation. Marie counsels employers regarding performance management, termination, contracts, workplace investigations, medical issues, leaves of absence and employment policies and practices.

Jaclyn focuses her practice on representing employers in federal and state court litigation involving discrimination, harassment, retaliation, wrongful termination, unfair competition and wage and hour claims. She also counsels employers on a broad spectrum of day-to-day employment matters, including employee discipline, terminations, leaves of absence and wage and hour issues. In addition, she assists employers in drafting policies, employee handbooks and employment-related agreements to ensure compliance with California and federal laws while also serving the employer’s individual business needs. Jaclyn has experience drafting international employment agreements, equity compensation plans, student/staff interaction polices and has created employer training materials.

15
Nov, 2015

Can Use of Another’s Trademark in an AdWord Constitute Infringement?

You have just negotiated a settlement between your client and a trademark infringer. The bad guy has admitted infringement, and you are drafting a settlement agreement when a dispute arises. The bad guy refuses to agree not to purchase AdWords containing your client’s trademark to advertise his products through various search engines, arguing that the purchase of AdWords containing your client’s trademark does not constitute infringement. You are skeptical, believing that the infringer is attempting to engage in further nefarious behavior. Your client wants to know: can a trademark owner prevent others from purchasing AdWords or “Sponsored links” containing his trademark?

To find your answer, it is important to first understand a few principles of U.S. trademark law. The legislative intent of the Lanham Act, 15 USC §1051 et seq, is to give trademark owners broad latitude to protect their trademarks from would-be infringers. A fundamental objective guiding this intent is to protect American consumers from fraud. Consumers readily identify particular brands with quality, based on a reputation built through a history of consistency, integrity and honesty. Consumers place their trust, and thus, their purchasing power, in certain brands. Simply put: the more famous the brand, the more likely it is that consumers will buy it. Consumers rely on the advertising and marketing of each brand to identify authentic goods from counterfeits. Accordingly, the touchstone of whether infringement has occurred is the determination of whether a consumer is “likely to be confused” between the trademarked product or service and the alleged infringing product or service, based on the infringer’s illicit use of a trademark or service mark, or of a confusingly similar mark, in commerce.1 Federal courts nationwide employ a multi-factor test to determine whether a likelihood of confusion exists, which generally include some iteration of the following: (1) the strength of the trademark; (2) the proximity of the trademarked products and the infringing products in the marketplace; (3) the similarity of the infringing mark to the registered trademark; (4) evidence of actual consumer confusion; (5) the marketing channels used; (6) the type of goods and the degree of care likely to be exercised by consumers when purchasing the goods; (7) the alleged infringer’s intent in selecting the mark; and (8) the likelihood of expansion of either the trademark owner’s product line or the alleged infringer’s product line.2

Internet Advertising With AdWords

With the advent of the internet age, brand owners increasingly employ digital means to advertise and market their products and services. Internet search engines have developed a method of digital advertising by permitting the purchase of AdWords. An AdWord is a keyword contained within a “Sponsored link,” a website link to a business owner’s website, offered for purchase. When purchasing an AdWord, an advertiser may specify the application of the keyword as a “broad match” (the advertiser’s Sponsored link will result anytime a consumer searches for “the keyword, its plural forms, its synonyms, or phrases similar to the word.”3); as a “phrase match”(the advertiser’s Sponsored link “will appear when a user searches for a particular phrase”4); as an “exact match” (the advertiser’s Sponsored link will appear “only when the exact phrase bid on is searched on [a search engine]”5 ); or as a “negative match” (the advertiser’s Sponsored link will “not appear when certain terms are searched”6 ). The same AdWord may be purchased by multiple buyers with no affiliation to each other. The prominence of an AdWord, i.e. its ranking in a results list, will be determined by the price a buyer is willing to pay.

Currently, no state or federal regulation defines the boundaries of the scope and substance of AdWords. Accordingly, over the last five years, a proliferation of litigation has resulted, driven by the commercial interests of trademark owners who fear the dilution and diminishment of their brands and an increase in consumer confusion between authentic and counterfeit goods, and the commercial interests of digital ad buyers seeking to capitalize on a highly lucrative revenue stream.

A tension between the First Amendment right to free speech and the right of Congress to protect trademarks as an element of interstate commerce lies at the heart of the debate as to whether the purchase and commercial use of a trademark as an AdWord by a buyer who is not the mark owner is licit. A few notable cases contributing to the outcome of this debate are described below.

Instructive Recent Cases

With its decision in Mary Kay, Inc. v. Weber, et al., the Northern District of Texas was one of the first courts to articulate the principle that it is not a foregone conclusion that the purchase of an AdWord by an entity other than the trademark holder for the online sale of goods is automatically an infringing use, but that it may rather be a nominative, non-infringing use.7 To qualify as a fair use, the mark must be used in a manner that does not “create a likelihood of confusion as to source, sponsorship, affiliation, or approval.”8 The relationship between search terms and Sponsored links in and of itself is not strong enough to create an impression of affiliation in a consumer’s mind.9

In Network Automation, Inc. v. Advanced Systems Concepts, Inc., the Ninth Circuit considered whether the use of another’s trademark as an AdWord linking a consumer to one’s own sponsored website or advertisement violates the Lanham Act.10 Importantly, the Network court recognized that a previous test to determine the likelihood of consumer confusion on the Internet, known as the “Internet troika,” is “appropriate for domain name disputes” but is not applicable to all Internet infringement disputes.11 In fact, the court concluded that the “Internet troika” test is inadequate for analyzing trademark infringement claims based on search engine keyword advertising.12 The Network court carved out an analysis using the Sleekcraft factors, enabling it to examine the sine qua non of trademark infringement, namely, whether a consumer would be confused, not merely diverted, by the use of the marks at issue. The Network court identified the following Sleekcraft as those worthy of the most consideration in the context of determining a likelihood of confusion in a keyword/Ad Word case: (1) the strength of the mark; (2) the evidence of actual confusion; (3) the type of goods and degree of care to be exercised by the purchaser; and (4) the labeling and appearance of the advertisements and the surrounding context on the screen displaying the results page.13 Placing heavy emphasis on the last of these four factors, the appearance of the advertisements and the context on the screen displaying the results of the keyword search, the Ninth Circuit overturned the district court’s finding of infringement and remanded the case. This Ninth Circuit decision places evaluation of the visual appearance of an AdWord or Sponsored link at the center of the determination whether a consumer will be confused, and ultimately, whether infringement has occurred.

The Tenth Circuit has arrived at a similar conclusion as the Ninth Circuit in Network, with adopted a different approach. In a recent case, 1-800 Contacts, Inc. v. Lens.com, Inc., the Tenth Circuit affirmed the District Court of Utah’s decision that the Defendant’s purchase of AdWords containing confusingly similar marks to Plaintiff’s “1800Contacts” mark did not constitute trademark infringement. The District Court held that “as a matter of law, a defendant’s purchase of a search-engine keyword cannot, by itself, create the likelihood of confusion that is necessary for infringement liability…keyword use can generate a likelihood of confusion only in combination with the specific language of the resulting impressions.” 1-800 Contacts, Inc. v. Lens.com, Inc., 722 F.3d 1229, 1241 (2013). The Court carefully articulated its reasoning for this determination, stating that consumers only view the results of their searches, having no idea which keywords a particular advertiser has purchased. Thus, a consumer might obtain the same list of advertisements by typing in a keyword containing a trademark, in this case, “1 800 contacts”, or by simply typing in a generic keyword, i.e. “contacts,” and among the list of advertisements, might be the Lens.com advertisement containing no reference to “1-800 Contacts.” The Court concluded that such a consumer is not likely to be confused into thinking that Lens.com has a business association with 1-800 Contacts merely because an ad for Lens.com appears in a results list for a search on the keyword “1-800 Contacts.”

Summary

In the context of these recent AdWord cases, it is clear that courts will carefully weigh an advertiser’s First Amendment right to free speech against a trademark owner’s right of ownership in a mark. The mere purchase of a trademark by a non-owner advertiser does not equate to an automatic finding of infringement. Trademark owners may still be successful in pursuing advertisers not sanctioned to use a given mark, but only after clearly demonstrating a likelihood of consumer confusion by meeting the burden of providing evidence to satisfy each factor in the multi-factor test adopted by whichever circuit the trademark owner brings suit.

In conclusion, trademark owners like your client should remain vigilant in efforts to monitor the use of their marks by third party advertisers. If any misuse or infringement is suspected, your client should conduct further investigation and pursue advertisers until resolution is reached — doing nothing will ensure the erosion of your client’s ability to mitigate the consequences of illicit activities by third party infringers, and will likely result in dilution of your client’s mark.