Royalty-stacking clauses

When negotiating royalty-stacking clauses, make sure you don’t get fleeced!

One of the pleasures of teaching is learning from your audience. This happened in abundance recently when IP Draughts, presently in Australia, delivered his advanced IP licensing course to a group of in-house lawyers and licensing managers. In fact, he delivered the course twice to the same organisation: last Friday to a team in their close-to-Sydney office, and yesterday to another team in their close-to-Melbourne office.

IP Draughts’ knowledge of Australian suburbs has increased greatly, but this posting will focus on legal issues rather than the architecture of Melbourne bungalows, or the surprise felt by a Brit who learns that St Kilda is close to Richmond.

Royalty-stacking refers to the situation where a licensee must pay royalties to multiple parties in order to commercialise a product. The royalties are said to be stacked, one on top of another. A licensee may seek to negotiate a clause in his first licence agreement, stating that if he has to pay a royalty to another IP owner, the royalties payable under the first licence agreement will be reduced. These clauses are known as royalty-stacking clauses.

Two key issues arise when such clauses are negotiated:

1. In what circumstances will the clause operate. In particular, is its operation limited to the situation where the licensee must obtain the third party licence in order to practise the intellectual property licensed under the first agreement? Alternatively, may the clause apply even where the third party licence relates to “add-on” technology that is not strictly required in order to practise the licensed IP under the first agreement but which is useful for the final marketed product? Usually, a licensor will wish to limit the clause to the first of these alternatives. An example of the latter alternative might be where the first licence is in respect of a pharmaceutical drug, and the licensee combines the drug with a drug-delivery technology, licensed under the second agreement.
2. What is the formula for making deductions from the first royalty? Is all or only a part of the third party royalty deducted (eg 50%)? Is it deducted from net sales or directly from the first royalty? Is it subject to a cap or floor, eg that the first royalty should not be reduced by more than 50%?

Licence agreements vary significantly in how they address these issues, and not all licence agreements have royalty-stacking clauses. In IP Draughts’ experience, some parties negotiate tailored clauses while others rely on what they perceive to be a “standard” clause, culled from some earlier agreement or templeate.

Whatever the clause says, if enough money is at stake its correct interpretation may be litigated: see the leading UK case of Cambridge Antibody Technology v Abbott, decided in about 2003 (look it up on Google) which concerned a royalty-stacking clause in a licence agreement in respect of the market-leading product known as HUMIRA.

In IP Draughts’ Australian talks, several interesting points came up in discussion that he had not fully considered before. From a licensor’s perspective:

1. Should the licensee be required to satisfy the first licensor that he needed to take the second licence and that the terms of the second licence were appropriate? Should the first licensor be involved in the negotiation of the second license between the second licensor and the licensee, to ensure that the first licensor is not financially disadvantaged? (IP Draughts perceives a danger that if this is insisted upon, it may make the licensee inclined to put more of the onus on the first licensor to “sort out” third party IP problems.)
2. Should the first licensor have a right to audit the terms of the second licence to ensure that the correct deductions have been made? How will this be affected by the confidentiality terms of the second licence? Will the second licensee be willing to have the terms of its agreement disclosed to the first licensor?
3. Do these royalty stacking clauses make the assumption that deductions have to be made from the “first” licence agreement (in which the clause appears)? Are there situations in which it should be the other way around, ie any deductions should be made from the other licence agreement?

To IP Draughts’ mind, these are all good questions, which are not always addressed in negotiations. Readers, what is your experience? Should these clauses get more tailored negotiation than they typically receive at present? How, in your view, should they be structured? Should they be included at all?