Royalties: reach for the sky

Royalties on unprotected products: a good thing or a bad thing?  Discuss.

This topic has a number of interconnected strands.  First, what does the IP actually protect?  In the case of assay kits, there may be patents protecting the technology of the assay.  Often, the patents will additionally claim any products identified through use of the assay (sometimes known as reach-through claims).  But are those claims valid or are they trying too hard?  Will they stand up to challenge? Your correspondent has tried, but failed dismally, to find a link to a recent article discussing the latest case law in this area (help, please, anyone?)  Suffice to say that such claims are (a) often asserted (sometimes, in our experience, by patent trolls), and (b) subject to considerable doubt as to their validity.

Even if such a claim is valid, is it reasonable to have to pay a royalty on products that are developed with an R&D spend of millions of dollars, where one small, early research tool used was a patented assay.  Will records be kept to show the link between use of the assay and the eventual, marketed product?

Next, which categories of IP are being licensed?  In the case of patent and know-how licensing, there may be situations in which a marketed product is outside the scope of the licensed patents, but was developed or made using licensed know-how.  Is it reasonable in such cases for the licensee to pay a royalty?  An earlier posting on this blog discussed know-how royalties.

For commercial reasons, parties may prefer to calculate royalties on products that are not protected by the licensed IP.  One example is where the IP protects a component, and the component is put into a larger product.  Only the larger product is sold by the licensee.  It is convenient sometimes to have a lower royalty rate on the complete product rather than try to separate out a notional price for the component.

Another example is where a patented reagent makes possible a new type of testing or treatment.  The treatment requires the use of a reagent (costing pennies) and more expensive, but unpatented, equipment (costing thousands of pounds).  If the royalty is charged only on the price of the reagent, the licensor will receive very little.  Therefore, the inclination is to charge a royalty on the sale price of the equipment.

Charging royalties on unprotected products may cause competition law problems in the EU, US and elsewhere.  When drafting a licence agreement that includes such a provision, the simplest approach under EU competition law may be to reach for your copy of the Technology Transfer Regulation and the associated European Commission Guidelines.  Paragraph 81 of the Guidelines provides as follows:

The hardcore restriction contained in Article 4(1)(a) [of the Technology Transfer Regulation] also covers agreements whereby royalties are calculated on the basis of all product sales irrespective of whether the licensed technology is being used. Such agreements are also caught by Article 4(1)(d) according to which the licensee must not be restricted in his ability to use his own technology (see paragraph 95 below). In general such agreements restrict competition since the agreement raises the cost of using the licensee’s own competing technology and restricts competition that existed in the absence of the agreement (42). This is so both in the case of reciprocal and non-reciprocal arrangements. Exceptionally, however, an agreement whereby royalties are calculated on the basis of all product sales may fulfil the conditions of Article 81(3) in an individual case where on the basis of objective factors it can be concluded that the restriction is indispensable for pro-competitive licensing to occur. This may be the case where in the absence of the restraint it would be impossible or unduly difficult to calculate and monitor the royalty payable by the licensee, for instance because the licensor’s technology leaves no visible trace on the final product and practicable alternative monitoring methods are unavailable.

Thus, under EU competition law it may be possible to justify royalties on unprotected products in limited circumstances, eg for ease of calculation of royalties, but careful thought is needed, and competition law advice may be required, before going down this route.  The following situations are all slightly different from one another, from a competition law perspective:

1. Doubts exist as to whether particular claims of the licensed patents are valid.

2. The licence is a mixed patent and know-how licence, but doubts exist as to whether the know-how is “secret, substantial and identified” as required by the Technology Transfer Regulation.

3. Royalties are claimed on products generated using a patented research tool.

4. A patented component is included in a larger product, and only the larger product is sold.

5. A patented reagent is used in an unpatented testing machine, and a royalty is charged on the price of the machine.

We have been involved in several licensing transactions recently where the licensor has sought a royalty on a product that is not protected by the licensed patents, and where the competition law analysis has been slightly different in each case.

Guinness widget

Detailed licence agreements often include provisions that address how royalties are to be calculated on components of larger, marketed products.  Other provisions may address what happens if the product is not protected by a licensed product in the country of manufacture or sale (eg a know-how royalty may be payable).  These and other provisions may provide a commercial solution to the problems described above, but they may require legal analysis to ensure that they meet the more exacting requirements of competition law.