In order to bring a product to market, a licensee may need to obtain rights from various rights holders. As a result, a licensee may be faced with a ‘stack’ of royalties to pay. A licensee will want its licensor or licensors to share some of the burden of the stack by requesting a deduction of some or all of the royalties paid by a licensee to third parties, from amounts payable to its licensor. A licensor will in turn want to minimise that burden.
It is rare for a court to consider the interpretation of provisions relating to royalty stacking. One such case did, however, recently occur in the UK.
Cambridge Antibody Technology v Abbott Biotechnology Ltd1
The relevant clause in part read as follows:
Royalties paid to third parties … in order to license rights needed to practice or to have practiced the technology claimed in the Patents, will be borne equally by the parties provided that CAT’s royalty…is not less than 2% of Net Sales … This offset shall not include royalties or licence fees which are beyond the scope of the technology described in the Patents, for example fees paid to third parties for delivery systems.
The parties agreed that this clause did not entitle the party paying the royalty to deduct all third party royalties and licence fees that needed to be paid to bring a final product to market. However, they disagreed about which third party royalties and licence fees could be deducted.
The licensor argued that that clause meant that the entitlement to deduct third party royalties and licence fees only extended to those necessary to pay for rights which would be infringed by the use of the technology claimed in the licensed patents.
The licensee argued that they should be entitled to deduct further third party royalties and licence fees up to a middle ground, at the point at which the relevant antibody was expressed from the host cell, not the final packaged form of product containing or derived from the antibody. That is, the middle ground was between those necessary to pay for rights which would be infringed by the use of the technology claimed in the licensed patents, and those rights which would be infringed by bringing a final product to market.
Because the clause did not expressly identify that middle ground, the court expressed the view that to adopt the construction referring to the middle ground would ‘make that line moveable or worse’. That is, the meaning would be uncertain. After examining evidence about the intention of each of the parties, the court adopted the licensor’s interpretation.
Why is this case significant?
This case is significant on two levels:
- It highlights the fact that the payment of third party royalties or licence fees by licensees must not be considered in general terms. Rather those payments must be separated into those third party payments that may need to be made because the relevant licensed rights are alleged to infringe third party rights and those that may need to be made irrespective of such infringement, in order to bring a product to market.
- It focuses on an area of the licensor/licensee relationship that is not often carefully considered in the negotiation process. That is, to what extent the licensor should bear the burden of bringing the product to market in order to share in the return that product brings?
Who needs to know about royalty stacking?
All technology licensors and licensees need to be aware of the issues around royalty stacking and ‘anti-stacking’ clauses—that is, provisions that seek to allow a licensee to deduct all or some of the royalties or licence fees payable to third parties to bring a product to market. This is because it is not uncommon for a licensee to require rights from more than one party to bring a product to market. Set out below are some tips for licensors and licensees in this area.
If a licensee seeks to include an ‘anti-stacking provision’ in a licence, then the licensor should systematically address the following:
- Who are the payments to be made to? One reason to ask this is to determine whether the licensee is seeking to deduct payments to related parties of the licensee. If so, then the licensor has a strong argument for not including such payments as allowable deductions.
- What rights are being paid for? One reason to ask this is to determine whether the rights relate to claims that the licensed subject matter infringes the third party’s rights, or whether it relates to other issues relating to getting the product on the market. A licensor can then clearly express its intent as to which of those options it is willing to agree to.
- What is to be the amount of the payments made to third parties and how are they to be calculated? This is one factor that is useful to prepare a financial model to determine the likely financial impact on a licensor of allowing the deduction.
- Is the amount that is sought to be deducted, to be deducted from the revenue earned by the licensee, or is it to be deducted from the royalty payable to the licensor? This again is one factor that is useful to prepare a financial model to determine the likely financial impact on a licensor of allowing the deduction. The former option is likely to have a smaller financial impact on the licensor than the latter, because in the case of the former, the deduction is from a larger amount.
- What is the likely impact of the licensee having to make such payments to third parties, with or without the deduction sought, on the competitive position of the licensee’s product in the market? This is to determine the extent to which such payments are just the cost of doing business for all players in the relevant market.
A licensor will also want to ensure that any agreed deductions are for amounts actually paid—not just amounts invoiced. The licensor should also ensure that there is in place an audit and verification process not only for the amounts paid, but also to ensure that those amounts relate to the relevant agreed rights. It is not uncommon for audit and verification regimes to focus on proper payment of royalties, rather than audit or verification rights to confirm that deductions being made relate to agreed categories of third party rights.
If one of the aims of the licensor is to secure a reliable and certain royalty stream, either for its own sake or for use as part of a securitisation program, then a licensor will need to know precisely what impact allowing anti-stacking deductions will have on its royalty stream. The appropriate caps on the amount of deductions (whether as an absolute amount or as a percentage) or setting an appropriate minimum royalty amount are therefore likely to be a significant feature of the licensor’s requirements.
A licensee will not necessarily have all the answers to the above questions at the time a licence is being negotiated. For instance, third parties’ rights may only come to light after the licence agreement is signed, perhaps when a relevant patent is published. Any figures provided by a licensee are likely to be best guess estimate only. A licensor should, however, clearly put the onus on the licensee to provide as much of that information as possible before the licence is signed. A licensee will in turn want to ensure that there is an opportunity for flexibility in adding other deductions to those identified to the licensor in the context of negotiating the licence and that any figures provided by a licensee are not to be considered other than as best guess estimates.
Before entering into negotiations for a licence, including an ‘anti-stacking provision’ that allows the licensee to deduct third party payments, the licensee needs to address the following issues:
- What is the pool of rights that the licensee will require from parties other than the licensor to bring a relevant product to market? How much will it cost the licensee to acquire those rights? This is to determine the likely extent of the third party payments that the licensee will want to deduct.
- What are the different strategies that the licensee could take to obtain those rights? In order to determine this, the licensee will need to prepare financial models to assess which strategies are viable. Those financial models could point the licensee in a number of directions: one being supportive of an ‘anti-stacking regime’; another being supportive of approaching all relevant parties to establish a patent pool from which to license and yet another indicating that the project is not likely to be viable under any circumstances.
- How is the licensor likely to respond to an ‘anti-stacking’ clause? A licensee will want to be in the position to be able to address the abovementioned issues likely to be raised from a licensor’s perspective.
- What if more third party rights are revealed after the licence is signed? A licensee will want to build into any licence a level of flexibility to ensure that it is not limited to claiming deductions only for third party royalties or licence fees that it is aware of at the time of entering into a licence. A licensee will also not want to be held to any figure that it may have supplied a licensor as part of its negotiation of this clause, and to include a disclaimer that it does not represent any figures that it may supply a licensor to be other than as best guess estimates.
Both licensors and licensees should ‘do their homework’ in dealing with the impact of royalty stacking on their deals. By doing that ‘homework’ the drafting of provisions relating to royalty stacking will be a much easier process, and result in a better outcome.
1.  EWHC 2974 (Pat).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.