Canada: Do’s And Don’ts Of IT Licensing — Top 10 Tips

This article was originally published in Blakes Bulletin on Information Technology - November 2004

What are the risks, issues and contractual terms to be aware of for technology license agreements? To create effective licenses for both licensors and licensees, it is important to have an understanding of the common legal and business issues that arise in negotiating licenses by following these "Top 10" tips. Software, Web sites, e-commerce transactions and information technology generally can involve many different forms of intellectual property (IP). On a Web site, for example, copyrights can exist in software, content, multimedia and databases. Patent rights may exist in processes used in software, Web sites and e-commerce. And, trade-mark rights may exist in software product names, domain names, hyperlinks that reflect business or product names, logos, word designs or even sounds used to distinguish goods or services.

In Canada, these rights are largely conferred by legislation and sometimes the common law. The owner may assign, waive or license its rights wholly or partially, or subject to limitations such as territory, medium or market. One of the key methods for commercializing IP rights is the license grant or permission to do certain acts that might otherwise infringe the owner’s rights.

To minimize the risks of unauthorized use and infringement of IP rights, any person or entity planning to use software, databases, a Web site, content, e-commerce, hyperlinks, multimedia or other information technology, must ensure the owners or licensors of any rights have transferred or lawfully licensed their rights.

Do it and do it early. It is alarming to discover how many businesses leave due diligence to the end of the negotiating process and then try to rush through it to get the deal done. The due diligence process takes time and requires several different kinds of searches, such as corporate searches and IP searches, in multiple jurisdictions. Your legal counsel then needs time to get the results and analyze them.

A common question is who should conduct due diligence? The answer: both licensor and licensee. For example, a licensor (IP rights owner) needs due diligence on who the licensee is. If a licensee is a corporation, does it have affiliates and are they included in the license grant? Does the licensee actually have the ability to pay for or exploit the rights? The licensor also needs to ensure its technology is protected under foreign laws.

Similarly, the licensee (acquiror of IP rights) should conduct due diligence to determine the scope of rights, validity of ownership of the subject matter and underlying IP rights in relevant territories.

Note that the representations, warranties and indemnities commonly negotiated in a contract should not be a replacement for due diligence. They are merely tools to help manage residual risk after due diligence. In fact, the scope of the license grant, warranties and indemnities can be effectively used by legal counsel to address any concerns and issues raised during the due diligence process.

The license grant forms the heart of any licensing deal. The terms "licensor," "licensee" and "affiliates" should be clearly defined to minimize potential confusion. For example, as noted, apart from identifying affiliates or subsidiaries of the licensee, a licensor should consider whether bankruptcy, insolvency or restructuring of the licensee triggers the ability to terminate the license or whether the license should continue. It is important to ask and answer the following questions.

Who. Who is the Licensor? The Licensee? Are affiliates of the licensee included? Subcontractors? Outsourcers? Are there any other users or sublicensees?

What. What is the subject matter licensed (source vs. object code, modifications, enhancements, third party material, databases)? What IP rights exist in the subject matter and which ones are being licensed? For licensors, the goal will be to avoid giving more rights than what’s required by the licensee and to reserve all rights not expressly licensed. For licensees, the goal will be as broad a license as possible.

It is also important to take care in negotiating the word "use" in the license grant. Keep in mind the specific rights available under various IP statutes. Copyright can involve the right to copy, distribute, publish, perform, translate or transmit. A patent involves the right to make, use, sell or have made; and a trade-mark can involve reproducing or displaying. It is also important to clarify in the license what is not permitted and which rights are reserved by the licensor.

Classifications of sole, exclusive & non-exclusive rights may affect the royalty structure and tax implications of a license. "Sole" means the licensee will be the only one able to exercise that right during the term of the license, other than the licensor itself. The licensor and licensee may end up competing.

"Non-exclusive" means the licensor can license the same right to others and exploit the right itself during the license term. Both parties must consider the possible competition between the licensee and other licensees, in addition to competition with the licensor.

"Exclusive" means the right is given even to the exclusion of the licensor itself. Only the licensee will be able to exercise that IP right. For example, a licensor cannot license to others later or exercise the same right during the term. Even here, however, exclusivity can be limited or tied to:

• licensee’s duty to exploit, market effectively and advertise;

• channels of distribution and types of products;

• meeting quality standards, with required samples, inspections and testing;

• meeting minimum performance or volume goals; and

• achieving specific profits or royalty structure.

Other exclusivity issues to beware of include tax, regulatory and competition law issues. For example, negotiators may want to restrict the licensor or licensee from selling competitive products and must exercise caution when including non-compete covenants in the license.

There are specific words to watch out for in license grants that may, at first glance, seem inconsequential. First is the word "perpetual". The issue here is whether a license can ever be terminated. For example, if the licensee breaches the license, does the licensor have a clear right to terminate a license or is the only remedy to sue for damages?

Next, both sides should beware of "grant backs" regarding improvements. The licensee must consider provisions that grant back to the licensor rights or title for improvements to the licensed subject matter the licensee develops. Grant backs can be a licensor’s delight and a licensee effectively becomes an R&D provider. In the end, the licensee may end up paying for its own technology. The licensor must also be careful with grant back clauses. Some can raise anti-trust and competition law concerns. The body of law is loose in this area and not well-defined.

Another phrase to watch is "non-transferable". The license grant often states it is non-transferable, but the agreement itself may state that it can be assigned in certain circumstances. This confusion can be the subject of litigation later. Another notable word is "sublicenseable". For the licensor, particularly, consider to whom the license may be sublicensed? What rights are sublicenseable? Where and what level of control does the licensor want over sublicensees?

Finally, beware of silence. Do not assume that a license is transferable, assignable, sub-licensable or encompasses a specific right or scope simply because it does not expressly restrict it. This can affect future acquisitions and sales of businesses.

Be very specific on limitations on the scope of rights in a license grant. For example, rights can be restricted for any specified purpose, including evaluation, due diligence, beta testing, internal data processing, joint ventures, support services, maintenance, outsourcing, consulting and distribution.

Rights can also be restricted by the number of users or by site, such as allowing use on specific equipment or at a specific location. One should be careful when limiting rights by processing units (CPU), as many computers now contain multiple processors. Care is also needed in setting out copying restrictions. For example, will you allow back-up copies vs. production copies? Do you allow hosting, caching, networking, use of transient copies or translations? What about simultaneous vs. non-simultaneous use?

Other types of restrictions are also worth debating. Does a confidentiality covenant, for example, frustrate the exercise of licensed rights by the licensee? This is especially relevant in trade secret licensing.

The negotiation of representations and warranties should include discussions on corresponding limitations, remedies and damages. Loose or poorly-worded representations and warranties will cause problems down the road. Some examples of loose or bad representations include:

• Right to License: "Subject to any third party intellectual property rights in and to the Licensed Property, the Licensor either owns or has the right to provide the license to the Licensed Property"

• Right to Use: "The Licensor has the right to use and exploit the Licensed IP"

• Non-Infringement: "The Licensed IP does not infringe upon any third party IP"

• Confidentiality: "The Licensor has taken commercially reasonable steps (including measures to protect secrecy and confidentiality) to protect the Licensor’s right, title and interest in and to that portion of the licensed IP deemed by the Licensor to require such protection".

Creating the right incentives can make a license grant more successful. It is important to recognize there are many different ways to structure royalties in license agreements and not just straight percentages. An "ascending royalty", for example, requires the licensee to pay more as it makes more, while a "descending royalty" allows a licensee to pay less as it makes more revenue. Each has advantages or disadvantages for both sides, depending on the situation.

It is also important to distinguish between royalties and fees for other services. For instance, distinguish between royalties for different jurisdictions, base software and customizations, as these may have different tax treatments. Licenses should include minimum royalties and consequences for failure to meet payments, such as termination or change of licensee status (e.g., conversion from exclusive to non-exclusive status).

Royalty arrangements should also specify how the percentages apply. Is it sales, profits or volume? What happens in sublicensing situations? Does the royalty apply to net or gross amounts? Here, tax advice is important as it can affect the structure of the license. For example, software is generally subject to the federal Goods and Services Tax (with an exception for non-residents), but may also attract provincial sales tax in B.C., Manitoba, Ontario and P.E.I. as "tangible personal property" or in Saskatchewan as a "taxable service".

In B.C., Manitoba and Ontario, there is an exemption for "custom software" developed solely to meet the requirements of a specific person/entity. Note that this exemption can be lost if there is an intended use by an affiliate. There are also special tax rules for modifications to source code of taxable software.

Ways to deal with each of these situations include separate or additional software licenses and customizations, ensuring an affiliate is the licensee (not a sub-licensee or transferee), running or accessing software from a tax-favourable jurisdiction and preparing separate software licenses for each jurisdiction.

Other common compensation and tax issues can arise. Licenses generally are not considered capital property by tax authorities, but an exclusive, lump sum payment from an irrevocable license can be the equivalent of a transfer and result in capital gains to a licensor and acquisition of a capital asset by the licensee. Negotiators may also have to consider the impact on scientific R&D deductions and tax credits, transfer pricing rules for licenses between non-arm’s length parties, and payments to non-residents that may attract withholding tax.

Again, there are ways to deal with these situations. Legal counsel can draft specific fee and payment terms, and whether taxes are extra. Parties can ensure non-arm’s length transfers are at fair market value. Gross-up clauses can be included if withholding tax applies to royalties, depending on whether the provider wants to qualify for a refund of withholdings.

The basic problem for all parties to consider is what happens when insolvency issues arise and the statutory bankruptcy and insolvency regime intervenes? This often creates tension between the private rights of parties and the statutory scheme, which can vary depending on the jurisdiction.

For instance, the agreement may contain terms that automatically terminate the license upon the bankruptcy or insolvency of either party. However, in Canada, bankruptcy law and the powers of a trustee-in-bankruptcy may override such provisions. From a licensor’s perspective, in order to maximize the enforceability of termination in the event of the bankruptcy or insolvency of the licensee, the goal would be to include an additional termination clause that is conditional on not paying royalties, failing to meet quality standards, changes in key management personnel or failing to meet defined financial stability criteria.

On the other hand, trustees may also have the discretion to terminate contracts where the bankrupt would have had ongoing obligations (e.g., to provide maintenance services). If the licensor goes broke, this could be a problem for a licensee if the license is key to its business. To minimize problems, licensees can keep services separate from license agreements and try to get an irrevocable grant of exclusive license. If possible, the licensee can also try to take a security interest in the licensed property or an escrowed assignment. In the event of a default, the licensee might be able to enforce its security interest or assignment to obtain ownership.

In setting out the term or duration of the agreement, always state a start date. It could be when the IP is first delivered, used or copied. Terms may also differ as between subject matter, rights, territory, scope and exclusivity.

Always state a termination date and identify events that may prompt early termination. For example, upon request (even without cause), completion or failure to achieve a purpose, breach with cause or bankruptcy and insolvency. Parties should consider whether the termination should be immediate or after the other party has an opportunity to remedy the situation. Notice periods may be required, depending on circumstances. Another option to termination is a suspension.

Agreements must also contemplate renewal or term extensions. Finally, what are the responsibilities of the parties after termination? Should confidential information in possession of a party be destroyed or returned (including copies)? By what method and should there be an audit or certification by an independent officer? Do any license rights need to survive (e.g., to permit servicing customers that have received valid sublicenses prior to termination) or do all terminate? And, what are the reporting or audit requirements for final payments?

Which territory’s laws should apply to your agreement? In other words, if things go awry, which country’s or province’s laws will be applied by the courts to interpret the contract? The governing law of the agreement is open to discussion. As well, where do you want to get sued or bring an action? The parties can decide upon exclusive or non-exclusive forums or courts of competent jurisdiction. It is also important to consider arbitration or dispute resolution options.

For online or Internet licenses, it is very important to specify the location of parties and to restrict access to desirable jurisdictions. That said, for the Internet at the moment, there is no guarantee that foreign laws won’t apply. As well, keep in mind that regardless of which law and forum you choose in the contract to govern your licensing relationship, the local intellectual property laws will still be applicable to any IP that is created in those localities. Therefore, review of the license agreement by local legal counsel should be sought, to ensure that the terms of the agreement are drafted in compliance with, and that the desired effect is obtained under, the local laws.

A licensor would also want to ensure its IP and technology are protected in all applicable jurisdictions. The licensor should confirm in due diligence whether any IP registrations or import permits are needed and that local legal requirements are met, such as language, export controls, currency, distribution or other rules.

Other international and inter-provincial issues to consider include the application of conflicts of laws principles, international sale of goods laws and Québec implications (e.g., implied warranties and English language clauses).

As with other commercial contracts, what is most important in license agreements is to deal in writing with potential issues that could arise and to pay close attention to the wording. A clear and well-drafted license agreement can help ensure a successful and non-litigious business relationship.

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.