Purpose of Paper
The purpose of this paper is to identify the issues of primary importance when determining the appropriate legal, governance and management structure for your CRC when putting together an application that complies with the guidelines to be applied by the Commonwealth in the 2006 CRC Selection Round ("2006 Guidelines") and, if successful, when establishing the CRC. The 2006 Guidelines emphasise the important of governance and management in successful CRCs and, like the 2004 round, the Commonwealth has mandated that applications for new CRCs or ‘new from existing’ CRCs must adopt an incorporated structure, unless the CRC Committee is convinced that there are compelling reasons why a particular CRC should depart from this incorporation requirement.
This paper is not designed to be a comprehensive account of all the legal issues relevant to the establishment of the CRC and the drafting of the legal documentation. In particular, it does not address the core business issues such as budgets and contributions by participants, which are documented in the Preliminary Business Case and Full Business Case that are submitted to the Commonwealth as part of the CRC application process and, for successful applicants, are incorporated as Schedules to the Commonwealth Agreement and/or the Participants Agreement. Applicants should obtain independent legal, taxation and financial advice on the various structures and their impact before making a final decision to adopt a particular model.
The Commonwealth requires that successful CRC applicants sign 2 formal agreements:
- an agreement between the incorporated CRC entity and the Commonwealth setting out the terms on which the funding is provided, reporting requirements and other obligations ("Commonwealth Agreement"); and
- an agreement between the individual CRC participants and the CRC incorporated entity establishing the CRC and dealing with all matters in respect of the governance and operation of the CRC, including project and intellectual property ("IP") management and IP commercialisation strategies ("Participants Agreement").
The Commonwealth must "sign-off" on the terms of the Participants Agreement before signing the Commonwealth Agreement and making the funding available to the CRC.
Major Issues for Structuring a New CRC
The Structure of the Company
The Commonwealth requirements for 2006 CRCs specify that the CRC must have an incorporated company to govern, manage and operate the CRC unless there is a compelling justification for an unincorporated structure.
An incorporated joint venture model involves the establishment of a company that enters into a joint venture arrangement (the Participants Agreement) with the participants to establish the relevant CRC. Under the Participants Agreement, the company takes on the responsibility for the governance, management and operation of the CRC, including ownership of the intellectual property and its commercialisation. In its role as the joint venture operator the company is the party to the Commonwealth Agreement and has the responsibility for accepting payment of the Commonwealth funds and ensuring they are utilised in accordance with the requirements of the Commonwealth.
Type of Company
In setting up the company the first issue for determination is the type of company that will be used. Generally such a company is set up either as a company limited by guarantee or a proprietary company limited by shares. Companies limited by guarantee are less flexible due to the inability to raise capital or to transfer membership and, as they are public companies, they have stricter regulatory requirements. However, in the context of CRCs, companies limited by guarantee have a number of advantages over companies limited by shares as the vehicle for the incorporated joint venture. These advantages include:
- wide acceptance by government, universities and others;
- facilitative of tax exempt status;
- public company (i.e. higher) regulation conducive of higher levels of corporate governance and audit, which some public sector entities prefer;
- members are required to subscribe to objectives of the company;
- members can join and leave without the added complication of transferring or buying-back shares; and
- facilitative of not-for-profit status.
After determining the type of company, the next critical issue is determining who will be the members/shareholders of the company. The position preferred by the Commonwealth is that all core participants are members of the company. However, some participants have regulatory constraints that make it difficult to become a member of a company. The inability to become a member of the company need not necessarily mean a participant is unable to be a full member of the CRC. The CRC is created by the Participants Agreement and accordingly, membership of the CRC may be linked to execution of the Participants Agreement rather than membership of the company. As all the participants are contractually linked to the company through the Participants Agreement, they are able to ensure the company carries out its role without being a member.
Another issue related to membership of the company is that of who should be entitled to become a member. The main discussion point on this matter for 2004 CRCs revolved around whether membership should be limited to just core participants of the CRC or should also include supporting participants. How critical an issue this is will depend on the rights that are given to members. For example: will only company members be entitled to elect the board or will all participants be able to take part in the process?
The final main issue of the structure of the company is in relation to the relative stake of the members in the company either by way of shareholdings or voting rights.
Some CRCs have explored the option of granting shareholdings and/or voting rights commensurate to a participant’s contribution. In the case of granting shares commensurate with contributions there are serious potential tax implications and expert advice should be sought. Many CRCs have elected to go with a model of one share/vote per participant to ensure that the large research organisations do not dominate the industry, and in particular SME, participants.
Key Questions: Structure of Company
Under the 2006 Guidelines the Commonwealth requires applicants to demonstrate that the proposed CRC model incorporates effective governance and management arrangements. Accordingly, applicants need to have an understanding of "governance". The Principles of Good Corporate Governance and Best Practice Recommendations developed by the ASX Corporate Governance Council provides a succinct explanation of the term:
"Corporate governance is the system by which companies are directed and managed. It influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised.
Good corporate governance structures encourage companies to create value (through entrepreneurism, innovation, development and exploration) and provide accountability and control systems commensurate with the risks involved."
An important element in establishing appropriate governance structures for a CRC is the appointment of the governing board ("CRC Board"). The CRC Board should be vested with the overall governance and management of the CRC’s activities. It will also have a strategic policy and planning focus.
Make-up of the Board
Previously it was thought that CRC Boards should be representative of all the CRC’s participants. Now, experience has shown that CRCs operate more effectively when managed by boards with a smaller composition and the CRC Secretariat has indicated it favours smaller boards. Also, smaller CRC Boards are more appropriate when adopting an incorporated CRC structure. Many of the 2004 CRCs therefore chose to go with a smaller skills based board rather than a representative board.
The Commonwealth has its own requirements regarding the composition of CRC Boards. The chair of the CRC Board must be independent of the CRC participants and the CRC Board itself should comprise a majority drawn from outside the research sector. Participants also need to consider how they will ensure that the CRC Board has the right mix of skills and experience necessary to ensure that they can carry out all the functions of the CRC. In this regard it is important to ensure that the CRC Board not only comprises persons experienced in research and industry in the field but also individuals with experience in commercialising intellectual property, finance and business development. The mechanism for selecting and appointing Board members therefore needs to be given careful consideration.
Appointment of Directors
Some CRCs use an election process to appoint directors to the board where each participant or group of participants (eg university, industry, government etc) nominates one or two persons and then a vote is taken for a specified number of positions. Other CRCs use an appointment process where nominations are called from the participants for skills based positions and then a selection committee determines the appointment of Directors. Depending on the number of participants involved, some CRCs allow all core participants to appoint a director each and then have supporting and associate participants elect one director between them. It is also possible to use combinations of these methods but in each case careful consideration needs to be given to the benefits and potential pitfalls of each method to determine which method is best suited to each individual CRC.
Involvement of Participants
If the CRC Board is not representative of all participants then consideration needs to be given as to how participants may be involved in the strategic planning of the CRC to retain its collaborative nature. Some CRCs have chosen to have rotating board positions but this can lead to issues with lack of continuity. Alternatives may be to hold annual or quarterly participants’ meetings or planning sessions. These meetings may function in a similar way to general meetings of the members/shareholders of the CRC company. Other CRCs operate by way of special sub-committees on which participants are given representation according to their particular interests and/or expertise. The sub-committees then provide advice and recommendations to the CRC Board.
Control over Decision-Making
One of the major issues that arose for 2004 CRCs was the level of control of the participants over decision-making in the CRC. A number of large research participants sought to include an extensive list of matters which the Board was required to refer to the participants to make decisions on as a way of exercising some control and managing their risk associated with participation in the CRC. The potential difficulties with this approach are:
- it effectively usurps the role of the Board and negates the Commonwealth’s objectives in requiring incorporation;
- it creates inefficiencies if the Board is required to refer too many issues to the participants; and
- it has the potential for participants to be liable as shadow directors of the CRC Company.
For 2006 CRCs there will be the added issue that only the CRC Company is a party to the Commonwealth Agreement and therefore only the CRC Company is directly liable to the Commonwealth for compliance with that agreement. This strengthens the case against the Board relinquishing too much control over decisions relating to the activities of the CRC to the participants. In most cases for the 2004 CRCs the list of matters that were required to be referred to participants were negotiated down to key strategic matters such as approval of the annual business plan and budget, election of directors and approval of financial statements.
Key Questions: Governance
Intellectual Property Management
The objective of the Commonwealth’s CRC programme is:
"to enhance Australia’s industrial, commercial and economic growth through the development of sustained, user-driven, cooperative public-private research centres that achieve high levels of outcomes in adoption and commercialisation."
These outcomes flow from IP created through the conduct of the CRC’s activities. Consequently, appropriate IP management is a key consideration in developing a CRC structure and is also a key factor that will be considered in assessing any application. IP rights should be clearly defined and appropriate arrangements included to deal with ownership. Clear IP arrangements are also necessary to attract added investment either in the form of new participants or investors for commercialisation of Centre IP. New investors/participants will be looking to see that Centre IP is well managed and adequately protected.
When creating an IP management scheme for a CRC, there are a number of factors that will be relevant. These are discussed below, together with an explanation of some of the terminology often used in a Participants Agreement.
When participants form a CRC, many will own or have access to know-how, patents and other intellectual property that may be relevant to the CRC’s proposed activities. This is often referred to as "Background IP". In establishing a CRC consideration needs to be given to what Background IP will be necessary for the CRC to carry out its research programs and how that Background IP will be secured. It should be noted that under the terms of the Commonwealth Agreement Background IP cannot be counted as part of a participant’s in-kind contribution.
Some of the issues relating to Background IP that need to be addressed include:
- the licensing of Background IP to the other CRC participants for the conduct of CRC research activities;
- the licensing of Background IP to the other CRC participants for the conduct of CRC commercialisation activities;
- the non-disclosure of Background IP to third parties without the approval of the participant-owner of the relevant Background IP; and
- the grant of warranties and indemnities by the participants confirming their power to deal with the Background IP and licence other participants to use the Background IP.
As a precaution an IP due diligence should be conducted by each participant to ensure that there are no underlying issues associated with Background IP which will be used for CRC activities. If a party, other than the participant, claims ownership of the Background IP, then any subsequent IP created using that Background IP may also be tied up in the ownership dispute. While the Participants Agreement will contain indemnities and warranties by each participant in respect of ownership of Background IP, this does not provide any practical comfort when the CRC is forced to resolve an ownership dispute with a third party.
Key Questions: Background IP
There is a strong emphasis in the 2006 guidelines on commercialisation and utilisation of intellectual property outcomes and the adequacy of intellectual property management arrangements as key considerations. As such the applications are expected to include detailed strategies for commercialisation and utilisation of IP and applicants will need to ensure that the framework adopted for the ownership of Centre IP will facilitate good commercialisation and utilisation outcomes.
Ownership of IP developed through the CRC can be quite complex and contentious. In an incorporated CRC the simplest approach is to have all the IP owned by the company outright. The difficulty with this is that some participants do not wish to contribute to a CRC unless their contributions are recognised by some form of ownership interest in the outcomes their contributions have led to. It can also create difficulties from a tax perspective and the availability of the s73B tax deduction for industry participants. Conversely, it does mean the CRC company itself can apply for tax exemption. This last factor was the primary reason some 2004 CRCs adopted this approach to ownership of Centre IP.
Many of the 2004 CRCs have opted for an ownership arrangement that allows the participants to take an interest in the IP outcomes commensurate with their contributions. However, giving participants a legal share in the IP means that the IP is jointly owned. Joint ownership is particularly cumbersome where there are a large number of participants, as the consent of all owners is required for any dealings with those IP rights. This impacts on commercialisation strategies and is particularly unattractive to potential investors. Joint ownership of Centre IP may constrain the conduct of the CRC’s on-going activities and impede the CRC meeting its objectives.
Therefore, there is a need to ensure that the ownership arrangements agreed upon for Centre IP, also:
- ensure the Centre IP is available for the CRC activities;
- do not impede the CRC’s ability to access and use the outcomes of the research work for the development functions of the CRC;
- are sufficiently flexible to allow contract research and consultancy arrangements with third parties;
- can be adapted to allow for commercialisation of the Centre IP should the opportunity arise;
- enable the CRC to ensure that the obligations under the Commonwealth Agreement in relation to use of IP and the publication of Centre IP are fully met;
- allow for the Centre IP to be distributed for use by participants and associates as required; and
- are tax effective.
For this reason many CRCs have chosen a trust structure to overcome the difficulties associated with joint ownership of Centre IP and some of the tax issues. Under a trust the CRC company holds the legal title to the Centre IP, while the beneficial ownership of the Centre IP rests with the CRC participants. The law recognises that the ownership of any property can be divided into two components – legal ownership (or title) and beneficial ownership. The entity holding legal title has the right to deal with and make transactions with the property. The holders of the beneficial ownership have the right to enjoy the benefits of the property. Where the legal and beneficial ownership are separated, the legal owner may only deal with the property, and create transactions that are for the benefit of the beneficial owner. The benefit of this structure is that it recognises the ultimate ownership of the participants but simplifies dealing with Centre IP by vesting legal title in a single entity, the CRC company, who can then deal with it in accordance with decisions of the CRC Board.
The trust structure therefore allows contributions of the participants to be recognised in the form of proportionate beneficial interests in the Centre IP. How those proportionate interests are determined is an issue applicants need to consider if adopting this approach to ownership of IP. Broadly there have been two approaches to determining those proportions. The first approach takes global approach and has all Centre IP beneficially owned by all the participants in proportions based on their total contributions to the CRC as a whole. This is the most administratively efficient and straightforward approach and does not disadvantage participants who do not contribute directly to research projects but do contribute to the overall operation of the CRC.
In recent times some research organisations have pushed for an alternative approach which sees proportionate ownership of IP arising from a particular project determined on the basis of the particular contributions made to that project. This creates a significant administrative burden on the CRC to monitor and track IP from each project. Some of the potential issues this gives rise to are:
- It would require the CRC to be able to clearly delineate IP from different projects as and when it is created which is not always possible, particularly when projects feed into one another.
- On the completion of one project, if the CRC decides to continue to develop that project’s IP through another project using contributions from different participants making different proportionate contributions it becomes almost impossible to determine at the end of the second project what the relative beneficial ownership rights are in the total IP outcomes from the two projects.
- Usually untied cash contributions are paid up front to the CRC at the beginning of each financial year or quarter and pooled together with the Commonwealth’s funds into the CRC’s account. When this cash is used to carry out a particular project it is difficult to attribute it to a particular participant and may result in untied cash contributions not being counted or create a disincentive to provide untied cash contributions.
- Some contributions are not made to particular projects but to the overall operation of the CRC. For example, a participant may second the CEO or the Business Manager to the CRC or may provide its financial and accounting systems or laboratory or office space as an in-kind contribution to the CRC. These contributions are not made to a particular project so the participant may not be credited with an interest in the IP for those contributions.
- All participants who make contributions to the CRC do not get to share equally in the commercially valuable outcomes that arise from the projects of the CRC. Only those participants who contributed to a project that resulted in IP that was commercialised will get the benefit. This will significantly disadvantage those participants whose contributions go mainly to public good projects or the education and training projects of the CRC and therefore acts as a disincentive for participants to participate in those projects over projects that create potential commercial IP outcomes.
- Where the Project IP is held on trust by the CRC company, it creates multiple trusts. That is, a trust for each project that must be administered separately for legal and taxation purposes.
This approach is favoured by the larger research bodies as it gives them greater ownership and control over the IP that their personnel produce. However, it is less favoured by industry participants as they usually expect to have access to the entire IP portfolio of the CRC in return for their investment.
An alternative manner of identifying and quarantining particular Centre IP for special treatment is to create a subcategory of Centre IP called "Participant IP". This mechanism is useful where an industry participant wishes to contribute to a particular CRC project but wants to have exclusive rights to use and commercialise the IP generated out of that project. It is also a useful tool where a CRC contains competing industry partners. It enables competitors to be involved in the CRC yet be able to protect IP developed in specific projects.
Under the Participant IP model, there is no change in the ownership structure. In that respect, Participant IP is owned the same way as Centre IP. However, with Participant IP, the CRC participants agree that the rights to use and commercialise Participant IP will vest solely with an identified CRC participant.
Participants’ Rights of Use
A particularly contentious issue with a number of the 2004 CRCs was the issue of what rights of use participants should be granted in relation to Centre IP both during the life of the CRC and after it ceases operation. Most research participants will want to access the IP for their own research purposes outside the CRC. While industry participants may require guaranteed rights of use in order to enable them to claim the s73B R&D Tax Concession on their contributions. Rights of use therefore need careful consideration and any rights granted must not undermine the overriding requirements of the Commonwealth in relation to ensuring the Centre IP is used and commercialised for the benefit of Australia.
Another issue for consideration by applicants is how the contributions of supporting and associate participants will be recognised. Often these participants are not party to the Participants Agreement making granting them ownership interests in the IP difficult. In some instances supporting and associate participants may be content simply with rights of use of the IP in their own businesses without taking an interest in the ownership of the IP.
Key Questions: Ownership of Centre IP
In order to enable IP to be commercialised effectively the CRC needs to ensure it has:
- A legal and IP ownership structure that facilitates commercialisation. This has been discussed above.
- Staff and Board members with the appropriate skills and experience to carry out commercialisation. The CRC Secretariat has indicated that they place considerable significance on the importance of the business manager/commercial manager role in a CRC. The issue of Board composition has been discussed above.
- Sufficient resources allocated to enable IP protection and commercialisation. The participants need to recognise that protecting IP can be a costly but necessary exercise in order to enable commercialisation. Some costs associated with protection and commercialisation may be recovered when/if a commercialisation arrangement is entered into in relation to that IP.
A system to ensure that all relevant Background and Centre IP is identified and appropriately captured. Such a system should include:
- regular reports by representatives of the research groups on progress of research with recommendations as to whether any IP is suitable for registered protection;
- regular reviews of the strength and validity of any protection and whether that IP remains strategically important; and
- ensuring that all legal rights of ownership and use are appropriately documented.
Having an effective system to ensure that IP is managed within the CRC ensures that when it comes to the commercialisation phase there is less likelihood of issues arising that delay or prevent commercialisation being implemented.
- A commercialisation plan. The obligations of the participants under the Commonwealth Agreement require each CRC to have in place a commercialisation plan and that IP is commercialised under that plan unless otherwise approved by the Commonwealth.
The template documents for the 2004 round included quite a complex process of obtaining approval of participants before the company was able to commercialise. Many CRCs elected to remove this process on the basis that it may potentially impede their ability to respond to the market effectively in commercialising their IP. Instead these CRCs elected to leave the discretion as to how the Centre IP was commercialised with the Board.
The other major issue to arise from the 2004 round CRCs was the use of income generated from commercialisation of Centre IP. Many CRCs took the view that this income should be used to further the objectives of the CRC for the life of the CRC and therefore elected to require reinvestment of that income in the CRC’s activities. Other CRC’s have elected to distribute all commercialisation income to the participants. A compromise position of requiring reinvestment up to a maximum amount and then distribution of the remainder is also an option that has been previously used. The 2006 Guidelines require the inclusion in the application of the details of any proposed arrangements to reinvest some of the returns from commercialisation of the Centre IP in the activities of the CRC.
Key Questions: IP Commercialisation
Getting a tax effective structure in place for CRCs is an extremely important issue made quite complex by the variety of different tax paying and non-tax paying organisations involved in CRCs that often have competing tax objectives. Unfortunately, the taxation consequences of operating a CRC as an incorporated joint venture remain largely unresolved after the 2004 round.
Key Questions: Taxation
Project & Research Management
Typically the research work of a CRC is divided into overlapping research programs. Within each of these programs, individual research projects will be carried out over the life of the CRC. One project may cover a number of different themes.
The projects and activities carried out by the CRC must be consistent with the Business Plan and the overall objectives of the CRC. The CRC Board is charged with approving CRC research projects.
The process for determining which projects are funded and carried out under the auspices of the CRC must recognise the need for participants to be involved in projects in a way that ensures the participants meet their promised in-kind contribution levels. Therefore some participant involved in project planning is usually required. Each CRC usually undertakes an annual planning and review process and this may involve all participants (both core and supporting). The selection and approval process for projects may be specified by the participants up front in establishing the CRC either in the Participants Agreement or part of operational guidelines for the Board. These provide the CRC Board with criteria and guidelines for the allocation of resources to projects to achieve the CRC’s objectives and to manage the number and type of projects that are directed to particular participants.
In addition to determining the process for selection of projects, consideration needs to be given as to the mechanisms by which a participant’s involvement and contributions to a particular project will be secured. Some CRCs deal with this issue by establishing a separate project agreement between the participants and the CRC company for each project. However, negotiating separate agreements for each project may be administratively inefficient and burdensome.
An alternative is for the Participants Agreement to provide that the participants must carry out projects in a manner as the Board determines and the Board may direct the contribution level of each participant. If the participants are uncomfortable handing this level of control over to the Board, the participants may require a right to sign off on a project schedule which details the project (including its level of commitment) before it is submitted to the Board for approval. Once approved by the Board the participant is then automatically bound to carry out the project on the terms set out in the Participants Agreement.
Key Questions: Project and Research Management
Core and Non-Core Participants
When determining a CRC’s structure, consideration will need to be given as to the distinction between Core and non-core participants and what rights will the various types of participants be granted. Some examples of the potential rights which may differ include:
- Entitlement to membership of the company;
- Involvement in election/nomination of board;
- Involvement in board committees or other decision-making processes;
- Ownership of Centre IP; and
- Rights of use to Centre IP.
The manner in which the involvement of supporting and associate participants will be documented also needs to be considered. The participants must decide whether non-core participants will be a party to the Participants Agreement or whether a non-core participant’s contributions and other on-going involvement in the CRC is secured by a separate agreement with the CRC Company.
Key Question: Core and Non-Core participants
Consideration needs to be given as to the exit mechanisms for participants who may wish to withdraw from the CRC during the funding term, or where a participant is expelled for default in performance of its obligations under the Participants Agreement or Commonwealth Agreement. It is usual to allow a participant to withdraw with 6-12 months notice, subject to Commonwealth approval.
This issue is particularly important for CRCs that have a lot of SMEs involved who may be unable or unwilling to commit for the full seven year funding period of the CRC. The 2006 Guidelines do contemplate the CRC having the flexibility to add or substitute participants during the life of the CRC.
On withdrawal or expulsion the most critical questions for resolution are how the exiting participant’s interests in the IP are to be dealt with as identified below.
Key Questions: Exit Mechanisms
New from Existing CRCs
Under the 2006 Guidelines new from existing CRCs are required to demonstrate in their application that they will undertake substantially new research and commercialisation activities. They must also include in their application strategies to deal with the transitional arrangements between the two CRCs. In most cases the new CRC will involve different participants so careful thought needs to be given to how the relative rights between existing participants and new participants are dealt with. Careful consideration needs to be given as to how projects can be transferred into the new CRC, how IP arrangements are managed and how liabilities will be apportioned. This is particularly important if the CRC is adopting a new legal structure. This will generally require a comprehensive audit of the CRCs activities to be undertaken.
Key Questions: New From Existing CRCs
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.