A few problems with licences and how to avoid them

It is said that those who do not learn from their mistakes are bound to repeat them. Over the author's years of practice in negotiating licence agreements and mediating, arbitrating or litigating disputes involving them, the same types of provision seem to cause a disproportionate amount of the trouble. This article identifies a few that not all readers are likely to have experienced and presents some ideas for avoiding them, in the hope that those who learn from the mistakes of others will not have to learn from their own.

Division of sub-licensing revenue
Licence agreements negotiated at an early stage of technology development (many years before a commercial product will reach the market) commonly provide for the sharing of revenues obtained by the licensee for the grant of sub-licences. Such provisions are especially common in licences between universities and start-ups: the start-up does not have the funds to pay a large upfront licence fee, and the university wants a piece of the action when and if the licensee flips the licensed technology to a bigger company. These licences are often encountered in due diligence on a former start-up, whether by potential investors, an acquirer or a prospective marketing/development partner.

For example, in the biotechnology and pharmaceutical field there is an expectation that the university's small (often start-up) licensee will partner with an established pharmaceutical company at some point in the development process to fund clinical trials and obtain sufficient sales and marketing capabilities. Such transactions often include substantial upfront payments and milestones paid on reaching certain development points (eg, initiation of Phase III clinical trials, submission of a new drug application or biological licence application and receipt of marketing approval in a major market country). Because the total consideration flowing to the university's licensee may consist in large part of such payments – or entirely so if the product does not ultimately obtain regulatory approval and reach the market – the university will often negotiate for a share of them.

The following example is largely drawn from an actual agreement that resulted in a contentious dispute over what categories of payment to the licensee were subject to division. Although this example is based on a university licensor, the issue is not confined to that context:

"Licensee shall pay University ten percent (10%) of all license fees, advances (other than research funding) and other payments received by Licensee in consideration for any sublicense granted by Licensee to Licensed Products."

The language is simple enough. But when the transaction between the licensee and its big-pharma marketing partner is complex – involving different types and categories of payment – how do the parties determine whether any given sum was "in consideration for" the grant of a sub-licence?

For example, if a licence to the licensee's own patents is included in the transaction, must an allocation be made to determine what payments are attributable to those patents as opposed to the university's patents, with the university entitled to division only of the latter part of the total payment? If so, does a stated allocation in the agreement between the licensee and its marketing partner control, thus giving rise to the potential for subterfuge (from the university's perspective) or permissible structuring (from the licensee's perspective) to reduce the amount of money attributable to the university's patents and thus divisible with the university?

If the transaction does not (and need not) include a sub-licence of the university's patents because the licensee will manufacture and sell products to its marketing partner, is there still a sub-licence of the "Licensed Products" that triggers the obligation to divide payments? And if the sub-licensee pays a large sum to acquire a stake in the licensee's equity or debt as part of the transaction, are such payments "in consideration for any sublicense" if the purchase occurs in the same transaction as the sub-licence?

Identifying possible ambiguities, anticipating potential problems and settling on the intended business terms guide the appropriate solution. For example, if the goal from the licensor's perspective is to make sure that all consideration, no matter how it is characterised or allocated in the agreements, is subject to division, the above-quoted provision could be redrafted in one of the following ways:

"Licensee shall pay Licensor ten percent (10%) of all payments and consideration received by Licensee from a sublicensee of the Licensed Patents or Licensed Technology."

"Licensee shall pay Licensor seven percent (7%) of all consideration received by Licensee or its Affiliates in any transaction or series of transactions that include the grant of a sublicense of the Licensed Patents or Licensed Technology."

A different approach is to confront the valuation problem head on. One way is to deem a minimum share of value attributable to a sub-licence of the licensor's patents:

"Licensee shall pay Licensor ten percent (10%) of all payments and consideration received by Licensee in consideration for any sublicense granted by Licensee to the Licensed Patents or Licensed Technology. If such any such sublicense is granted as part of a transaction or series of transactions which include the grant or transfer of other licenses, rights, or property, no less than ___ percent (__%) of the total of all payments and consideration received by Licensee in such transaction or series of transactions shall be deemed to be consideration for the grant of such sublicense."

Of course, using the deemed minimum approach virtually guarantees that the minimum will also be the maximum, at least in the eyes of the licensee. Yet another approach is to recognise that questions of valuation in a complex transaction are likely to be subject to dispute, and therefore to establish a mechanism to resolve them before litigation or arbitration. For example, each side could select a qualified valuation expert to determine what part of a deal is attributable to the sub-licence of the university's rights, with the two experts selecting a neutral expert to pick one valuation if the two sides' experts are more than 10% apart. However, such mechanisms are costly to employ because of the fees that must be paid to the valuation experts.

Finally, another problem that often arises in these situations is informational (ie, refusal by the licensee to give the university the entire agreement (or group of agreements) with its sub-licensee or marketing partner). The licensee sometimes justifies its refusal by claiming that the agreements contain confidentiality provisions that forbid it from giving the university copies of the agreements. Such claims are readily dealt with by including a provision along the following lines in the licence agreement:

"As a condition of granting sublicenses or in the event of any merger, acquisition, or reorganization that results in a Change of Control of Licensee or a new Affiliate of Licensee, Licensee shall provide Licensor with full and complete copies of all contracts and agreements between it and any sublicensee within five (5) business days after execution of same, including agreements that do not include the grant of a sublicense.

Licensor shall maintain such copies and their terms in confidence pursuant to Section ___ of this Agreement. No grant of a sublicense shall be valid if any agreement between Licensee and such sublicensee prohibits, restricts, or conditions Licensee's provision of such copies to University as required by this paragraph."

Provisions of this sort make it clear that the transaction will be subject to scrutiny by the licensor/university with respect to the division of sub-licence payments.

When conducting due diligence, consideration should be given to whether the target will be asked to address how it proposes to divide payments with the licensor/university. In the case of a straight sub-licence (as opposed to an acquisition), the prospective sub-licensee might reasonably take the position that this is none of its business and that it does not want to be involved (other than to obtain a warranty that the licensee has the right to grant the sub-licence and will take all actions required under the licence to keep the licence in force and avoid termination). This approach may be thought to minimise the sub-licensee's risk of being drawn too deeply into a dispute between the licensee and licensor.

However, ignorance is not necessarily bliss. In the case of an acquisition, problems between the licensee and licensor immediately become problems of the acquirer. But even in the case of a straight sub-licence, the sub-licensee's investment and stake may be greater than those of the licensee, and assets may not remain in the licensee to cure an alleged breach of the prime licence. While a well-negotiated sub-licence agreement will grant the sub-licensee the right to cure any alleged breaches of the prime licence at the licensee's expense, the cost of doing so may be high and recoupment from the licensee may not be easy.

De facto sub-licence in a merger or acquisition
Related to the above discussion is the acquisition of a licensee in a transaction that does not expressly grant a sub-licence. For example, the licensee could continue as a wholly owned subsidiary of the acquirer and continue to conduct the licensed activities, obviating the need for a sub-licence. If the licensee/subsidiary sells a licensed product to its parent, this is a 'first sale' that exhausts the licensed patent rights and the parent does not itself require a licence to resell the licensed products, or in the case of pharmaceuticals that are governed by the safe harbour provision of 35 USC § 271(e)(1), the licensee and acquirer may take the position that no sub-licence is required because the activities are within the safe harbour and would not infringe, even without grant of a licence. Finally, if the licence grant in the prime licence runs (as is common) to the licensee "and Affiliates", the licensee/acquirer may contend that no sub-licence has occurred because the parent is now a direct licensee.

A potential acquirer conducting due diligence should not expect its target's licensor to accept readily the position that no part of the acquisition payment is subject to division with it as sub-licence income. Rather, the licensor will contend that regardless of form, the economic reality of the transaction includes the grant of a de facto sub-licence that triggers the division of payment. Even if the licensee and acquirer consider this position to be unjustified, they must recognise both its substantial equitable appeal (especially if discovery will show that the transaction was structured in part with the intent of avoiding a sub-licence payment) and the substantial leverage that the licensor may have if it has the right to terminate in the event of breach.

Circular definitions leading to ongoing improvements
The grant of a licence is often part of a larger agreement providing for sponsored research. In such agreements, there is a definition of "licensed technology" or "licensed know-how" that usually embraces inventions that have not yet been made, but are expected to be made in the course of the licensor's ongoing research. Also common to such agreements are provisions that future improvements made by the licensor are also subject to the licence. Indeed, some licence agreements that do not provide for sponsored research nevertheless include such improvements provisions.

Drafting definitions that clearly distinguish between those as-yet-unmade inventions that will qualify as licensed improvements and those that will not is a challenging exercise. Although this issue covers many areas, one type of problem should be easy to avoid – that of circular or neverending improvements.

Consider the following improvement language adapted from a litigated contract between two major pharmaceutical companies:

"If Licensor improves the Licensed Know-How or Licensed Products, or makes improvements to the Licensed Process, all such improvements shall become part of the Licensed Know-How and shall be promptly transferred and/or communicated to Licensee, and by the provisions hereof shall be deemed to be a part of the Licensed Patents or Licensed Know-How as the case may be."

As can be seen, "improvements" become part of the licensed technology and thus are subject to their own improvements being made and included as well, resulting in a potentially neverending cycle of technology transfer.

Few clients would like to hear from their corporate counsel that a company that participated in or supported some research several years ago has the potential to claim rights in work that is now viewed as new or different. In the case of a university licence, an equally bad conversation would be telling an influential faculty member who has made great advances in what is to him or her a new field that an agreement reached with a company based on work done in someone else's laboratory has the potential to encumber his or her own independent work.

With the problems identified, several possible solutions are obvious:

• Avoid circularity by providing that improvements are licensed without adding them back to the previously defined "licensed technology".
• Set time limits such that only improvements made within a limited period of time are included in the licence.
• Restrict improvements to those made by the same group, laboratory, faculty member or research team involved in creating the original technology.

Using overblown claims of patent misuse to negotiate reduced or limited royalties 
Broadly speaking, patent misuse occurs when a patentee uses the power of its patents to obtain an agreement that requires a licensee to pay royalties on unpatented products or beyond the expiration of the licensed patents. The effect is that the misused patents are unenforceable until the misuse is purged. Potential licensees sometimes raise unjustified concerns about misuse to influence licence terms in the negotiation process. For example, when licences are being negotiated before patents have issued and the licence is to both know-how and patents that are expected (or at least hoped) to issue in the future, the potential licensees may contend that charging full royalties if the patents do not issue (or do not cover the product) would be patent misuse, and that the royalties need to be separately allocated and charged on know-how and issued patents.

Because meaningful claims of patent misuse are quite uncommon (and are rarely litigated to a judicial decision), licensing personnel may lack sufficient familiarity with this doctrine to dismiss confidently questions about patent misuse when it is raised by a potential licensee in negotiations. The result may be agreement to the licensee's demand for reduced royalties, especially because this is not uncommon as a business model even without questions of misuse.

A complete discussion of patent misuse is beyond the scope of this update, but in most cases such expressions of concern by potential licensees are either feigned or uninformed. In many cases the licensee will have an exclusive licence with at least some rights to enforce against third-party infringers. In those cases, the licensee would be shooting itself in the foot if it were to contend in a dispute with the licensor that the licensed patents were unenforceable for misuse. If raised by a third-party in defence of an infringement suit, a misuse defence is unlikely to get much traction if the licensor and licensee present a unified front in explaining that:

• The transaction was entirely rational from a business perspective.
• Any value received outside the scope of the patent rights was negotiated in good faith at a time of uncertainty over what patent claims would issue.
• There was a meaningful transfer of know-how and technology outside the four corners of the patents and patent applications themselves.

Reserved rights precluding sufficient exclusivity for licensee to sue 
As a general rule, only exclusive licensees have standing to sue for patent infringement. Depending on the circumstances, an exclusive licensee may be able to sue on its own or may be able to sue only if the patentee joins as a co-plaintiff.

A licence that reserves to the licensor the right to grant additional licences for research purposes that are otherwise within the licensee's exclusive field may not support suit by the licensee without joining the patentee.

Transactions by companies that already have a licence 
What happens if one existing licensee (Le1) is acquired by another existing licensee (Le2) that has a more licensee-friendly (cheaper) licence agreement? Depending on how the agreements are written, Le2 may claim that Le1's products are subject to the lower royalties of the Le2 licence because Le1 is now affiliated otherwise. If successful, this would diminish the revenue received by the licensor from sales of the Le1 products and possibly deprive it of the benefit of its bargain, especially if there were a good business reason to charge and receive a higher royalty rate on Le1 products.

A possible remedy is to include in all licence agreements a provision providing that in the case of such a transaction, the different product lines will continue to be subject to the royalties in effect immediately before the acquisition.

An earlier version of this update appeared in the May 2010 Licensing Journal.