Interpreting royalty clauses in the US pharma market

cycleThis article discusses an interesting case, reported this week, on the interpretation of a royalty clause. The case is Eteboxagu AB v Cycle Pharmaceuticals Ltd [2023] EWHC 462 (Comm) (06 March 2023).

If you have a major dispute over the interpretation of royalty language, and where the peculiarities of the US pharmaceutical market are involved, which part of the English court system should you choose to hear the dispute? The obvious alternatives are the Commercial Court (where this case was heard) or the Chancery Division, where many disputes about patents and pharmaceuticals are heard, including disputes over pharmaceutical licence agreements.

Perhaps you rely on counsel to choose for you, and if he or she is an IP specialist, they may choose the Chancery Division, whereas if they are commercial law specialists, they may prefer the Commercial Court. In this case, neither party’s counsel, nor the judge herself (a deputy High Court judge) appears to have a background in IP licensing or pharmaceuticals. They all appear to specialise in traditional areas of commercial law, such as shipping and insurance.

In IP Draughts’ view, this is a real dilemma. Barristers practising at the intersection of IP and commercial law are rare; really top-notch barristers doing so are even rarer. Having considered alternatives at the IP Bar, IP Draughts recently instructed Stephen Houseman KC, a commercial barrister, to advise on a dispute about a patent assignment. His advice was very helpful.

Anyway, back to this week’s case. The background to the agreement is a little unusual in that it wasn’t exactly a licence; the agreement was intended to give a chemist who helped to design a generic drug a fair share of revenues from sales of a related drug, after he and the defendant company had parted company. But the key issue before the court was one that is familiar to those of us who draft licence agreements: how do you interpret a definition of net sales, or here “Relevant Revenues”? Do you base it on the price actually charged to US customers, where there is subsequently a standard rebate of some of that price, or do you charge it on the price less the rebate?

The definition in this case included the following words:

Relevant Revenues shall be Cycle’s gross income from the sale of the Product excluding VAT and transport costs.

Readers who work in this field will immediately see that this definition is very brief, perhaps even amateurish. In fact, though it had no bearing on the judge’s decision, some time after the relevant agreement was signed, Cycle proposed an amendment to the definition, apparently drafted by the former London law firm SJ Berwin, which read:

“Relevant Revenues shall be Cycle’s gross amount invoicedincome from the sale of the Product excluding VAT and transport costs, and reduced by the following amounts (if not previously deducted from the amount invoiced):

(a) amounts actually allowed as trade, selling commissions, volume or quantity discounts, including early pay cash discounts;

(b) amounts repaid or credited by reason of defects, recalls, accrued or actual returns, rebates and allowances of goods or because of retroactive price reductions specifically identifiable to [nitisinone];

(c) rebates and administrative fees paid to medical health care organisations in line with approved contract terms; and

(d) rebates resulting from direct or indirect government (of an agency thereof) rebate programs or chargeback programs;

However, should Cycle outsource the selling of the Product to a distribution partner with the distribution partner recognising the revenues form the sale of the Product and then sharing those revenues with Cycle, then the Relevant Revenues, for the purposes of this agreement, shall be the distribution partner’s gross amount invoicedincome from the sale of the Product with the same exclusions and reductions applying as per the immediately preceding paragraph.excluding VAT and transport costs.

The latter wording makes clear that various types of rebates can be deducted from the amount of income received from the sale of products. But the amendment was not signed. So, one of the issues the judge had to decide was whether rebates under the US system could be deducted, when calculating royalties under the briefer definition set out above. In particular, she mentioned that “a fixed 23.1% rebate was mandatory in the case of the government backed Medicare and Medicaid programmes.”

The judge interpreted “gross income” in the definition above and concluded that the rebates could be deducted. She said:

In summary, both parties were well aware at the date of the Original Agreement of the way in which drugs were marketed in the United States and that rebates were inevitable if Cycle was to develop a branded drug (as it eventually did). I am therefore satisfied that the objective intention of reasonable commercial men in the situation of the parties would have been to regard Cycle’s “gross income” as its effective income from the product which, in the case of sales in the United States, was the price after deduction of rebates.

The judge was asked to decide several other points. Cycle sold the product in the US through third party companies – Cardinal and Diplomat are named in the judgment. There was a question over whether they were “distribution partners” as described in the definition of Relevant Revenues, which would have affected the amount due to the claimant. The judge dealt with this point very quickly, concluding “they were not”. IP Draughts doesn’t think it worth spending more time on it here.

More interesting for the contract drafter is the judge’s discussion of a clause in the agreement concerned with certifying royalties. The clause read:

2.1 Cycle shall provide to Strömberg within a period of 14 days following the earlier of the date of filing of Cycle’s annual audited accounts with Companies House or 30 September (the “Certificate Date”) a certificate from Cycle’s auditors certifying the aggregate Relevant Revenues for the preceding calendar year (the “Certificate”).

It seems that Cycle tried to arrange for its auditors, PWC, to provide such a certificate to the claimant. But PWC declined to do so unless the claimant “signs a letter of engagement which contains a wide-ranging disclaimer, such as to undermine the worth of the certificate almost entirely.”

How should Cycle comply with its obligation to provide such a letter? The judge thought PWC’s approach was standard in the industry. She pointed out that PWC could provide the letter to Cycle, and Cycle could then forward it to the claimant. She observed that PWC might well want an indemnity from Cycle in respect of claims from the claimant, before preparing the letter:

…but if that is the necessary precondition of obtaining a certificate, then so be it. It may be commercially unpalatable for Cycle to provide such an indemnity, but it is the author of its own misfortune in this respect. It could easily have consulted its auditors before agreeing to the obligation in paragraph 12.1 and if it failed to do so, it only has itself to blame.

There is a lesson here for all of us: don’t agree terms that involve a third party (no matter how “standard” the terms may seem) without checking first whether the third party will cooperate.

Finally, IP Draughts was interested to see the judge’s discussion of the principle of “estoppel by convention”. The claimant argued that the discussions between the two key individuals of each party about amending the definition of Relevant Revenues to make explicit reference to rebates prevented (estopped) Cycle from arguing that US rebates could be deducted under the original wording. The judge quickly rejected this line of argument. But it was interesting to IP Draughts to see the argument being made, not least because it was an argument that was used effectively in another case in which IP Draughts was recently involved. He may be wrong, but his impression is that estoppel by convention is a development in English law that has only become well-established in the last 10-15 years.


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3 responses to “Interpreting royalty clauses in the US pharma market

  1. t2000

    Thanks, that’s very interesting and not a term I’d ever heard of before this post. I will remember it everytime I come across a hole and wonder whether it may help fill it – subject to expert advice.

  2. t2000

    Personally, I am distracted by interest in the comment on the patent assignment dispute…..

    I was getting confused reading the case as the defintions of generics, branded drugs and orphan drugs appeared “non-standard”.

    • On patent assignment dispute, parties agree terms in correspondence but (before my involvement) fail to include one of them in final agreement. Estoppel by convention argument (strong argument according to leading counsel), plus letter before action, helps us to persuade other party to rectify agreement.

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