Licensing loopholes

Although many "template" licence agreements are available, it is seldom that changes are not required by at least one of the parties. Many proposed amendments initially appear innocuous. That is until one later falls through the resulting loophole.

Licensors should always be careful when granting licensees the right to sublicense the intellectual property (IP) rights. Consider that a standard royalty clause provides for a royalty calculated as a percentage (say 5%) of the licensee’s turnover. If the licensee sublicenses a sister company to make and sell the licensed products for a similar royalty, the licensor will receive an effective royalty calculated at 0.25% of turnover (i.e. 5% of 5%). To safeguard against this, licence agreements often provide for a royalty calculated on turnover relating to sales of licensed goods and a further, higher royalty applicable to sublicensing income. Alternatively, the licence may permit the licensee to sublicense the rights on similar terms as those contained in the parent agreement. But, now the licensor may end up having to administer the licensee's sublicensees. Should this not be the licensee's responsibility? Also, what happens if the parent licence is terminated or cancelled? Will all sublicences automatically terminate? Will termination or cancellation of the parent agreement expose the licensor to claims for damages by sublicensees? If payment in an international licence agreement is made by sublicensees directly to the licensor, who is the beneficial owner of the royalties and which double tax agreement (DTA) applies ‐ the one applicable between licensee and sublicensee or between sublicensee and licensor? If an exclusive licensee sublicenses its rights, can the licensee still join infringement proceedings as a co‐applicant and claim damages? Most probably not. If the sub‐licensee defaults in paying royalties, are those royalties included in the licensor's gross income and taxed, despite such amounts not having been received? These are only a few of the issues that should be considered and addressed before agreeing to grant the licensee the right to sublicense.

Preferably, where a licensee is entitled to sublicense the rights, the licensee should assume full responsibility for the sublicensees. A spread of approximately 10% on royalties received and royalties on‐paid is generally considered reasonable consideration for these services. The balance of the sublicensing income should flow back to the licensor without triggering any unintended tax consequences.

Licensors should also beware of licensees that wish to restrict the licensors' rights to bring infringement proceedings on the grounds that the licensees have formed sensitive relationships that may potential be damaged by threats of infringement by licensors. Should licensors consent to such an arrangement, they may find themselves in a position where licensees permit sister companies to "infringe" the licensed IP without sanction. In extreme cases, the licensee may not even commercialise the licensed product, resulting in royalties never becoming payable under the licence.

Another common mistake that licensors make is to grant unrestricted exclusive licences, i.e. licences without minimum performance / royalty or early termination clauses. For example, let's assume that your invention relates to a new way of making a widget. The widget has features that will severely undermine the market for existing products. However, considering the tooling costs, your widget is expected to yield a margin significantly lower than the margin currently enjoyed by a potential licensee from making and selling his existing widget. If you grant this entity an unrestricted exclusive licence, it may agree to a high royalty percentage but never commercialise the product, triggering no royalty payments. Your licence finds its way into file 13 and your widget never sees the light of day. For this reason, exclusive licences must include a minimum performance / royalty clause or a short initial period, renewable for further periods at your option. Merely inserting a "best endeavours" clause is woefully insufficient.

Licensors should also be careful to prevent the interposition of an intermediary. For example, where a licence provides for a royalty calculated at 5% of turnover from the sales of licensed products, the licensor must ensure that the licensee is not able to make and sell the licensed products to a sister company at cost, which then on‐sells the products at market value to end‐users. If not guarded against, you will only receive 5% of the cost instead of market price.

Never conclude a licence where the royalty is calculated as a percentage of profits. Profits are easily manipulated by drawing a larger salary or purchasing capital equipment (including sports cars, yachts and aircraft).

Where a royalty is calculated at an amount per product made or sold (i.e. R1.50 per widget), ensure that the licence includes an escalation clause that increases the amount annually by at least CPI. What may have been a large amount 10 years ago does not get you very far today.

Where possible, do not conclude a contract governed by a law you are not familiar with. Many clauses permitted in terms of South African law are regarded as anti‐competitive or abusive in terms of other countries' laws. For instance, should you be found to have abused your rights in terms of US law, you may well find your exclusive licence converted into an irrevocable, royalty‐free, exclusive licence.

Finally, when licensing patents always ensure that you obtain access to associated know how. In particular when licensing process patents or product patents where tolerances are important, if access to the know how has not been provided for in the patent licence, the licensee may well find himself having to conclude a second licence for the know how in consideration for an additional royalty.

After concluding the licence, seriously consider recording the licence on the intellectual property registers. Doing so will convert the personal rights enforceable between the parties into real rights attaching to the intellectual property licensed.

(Updated 2007)

Articles: Commercial