FORUM: Royalty management and enforcement
January 2018 | SPECIAL REPORT: INTELLECTUAL PROPERTY
Financier Worldwide Magazine
January 2018 Issue
FW moderates a discussion on royalty management and enforcement between Laëtitia Bénard at Allen & Overy LLP, Sonja London at Nokia Technologies, and Brian W. Gray at Norton Rose Fulbright Canada LLP.
FW: What are some of the common challenges that intellectual property (IP) owners are likely to face in terms of royalty collection and enforcement? Are these challenges multiplied if such agreements are international in scope?
Bénard: The day-to-day management of royalties can be particularly difficult for intellectual property (IP) owners, especially when they concern products with fast and growing sales. In this respect, specialised service providers of royalty management software can provide helpful assistance in analysing and tracking the relevant data and computing payments to ensure accurate collection of royalties. Over the duration of a licence agreement, it is quite common that the agreement is subject to a number of operations, whether it is a transfer, an assignment or even a security, such as a pledge. It could become difficult for the IP owners to assess from whom the royalties should be collected when such an operation happens. One particular area of concern for IP owners is the risk of insolvency of the licensee. The applicable rules and the scope of contractual freedom in the insolvency area may vary a lot from one country to another. The choice of the governing law of the licence agreement might be key to ensuring the enforceability of the contractual provisions in case of insolvency. IP owners should anticipate these situations in the licence agreement to the extent possible and permitted by applicable law.
Gray: The most common challenge in royalty collection is identifying and verifying the proper royalty base. All royalties should be collected as a percentage of some auditable number or as a set amount per unit sold. The royalty base for intellectual property will vary from industry to industry and can be widgets sold or software installed, but it is also frequently a percentage of revenues generated by the licensed product. In this case, typically the licensed product is generating gross revenues from which would be deducted expenses relating to producing the product. In cases where the revenues are being generated by sales of goods there will at least be the cost of goods sold. In some cases those expenses could in fact be royalties paid to another provider of intellectual property or some other input. Other deductions could include a portion of expenses from general operations, depreciation, amortisation and other non-cash expenses.
London: The challenges we face in most respects are no different to any customer focused business. We need to have processes in place to make it as easy as possible for our licensees to work with us on a day-to-day basis, and to ensure that any issues can be resolved quickly and in line with the terms of the agreement. While a common approach usually works, there may be situations where local business and legal cultures vary. If formal escalations are needed in such cases, then matters may become more complex across multiple jurisdictions.
FW: What do you consider to be the most significant legal developments to affect royalty management and enforcement over the past 12 months or so?
Gray: The most significant development in the last 12 months has been the US Supreme Court case in Lexmark v. Impression products which established “international exhaustion” for patents. The court held that a patentee or licensor from a patentee could not use patents to impose post-sale restrictions on a purchaser of a patented product. Thus, the court held that the patent rights were “exhausted” once a sale had been made by the patentee or its licensee anywhere in the world. This poses challenges for patent owners who might want to establish price differentiation in different countries. If the patent owner has patents all over the world and sells a product in, for example, Germany, with or without a licence restriction preventing such person from selling outside of Germany, the purchaser from such licensee can import the product into the US without fear of infringing the US patent since the patent rights have been “exhausted” worldwide once the first sale by the patentee has been made anywhere. This will make it difficult to use patent rights to establish separate pricing in separate jurisdictions.
London: Automation and digitalisation of the whole contract-to-cash process will have the most significant impact on royalty management. It will change the pace of the business, enabling closer monitoring and analytics of royalty compliance. Importantly, it will also enable us to bring new levels of customer service to our licensees. For example, we can offer our licensees an electronic reporting system which enables secure reporting, communications and support for the whole process, from reporting to invoicing, as well as the withholding tax process. For contract drafting, electronic systems provide speed of process, consistency of drafting and enhanced management reporting.
Bénard: While in most cases the parties are free to agree on a royalty rate, occasionally the rate must be determined according to certain parameters. For example, standard essential patents (SEP) licensing terms must be on fair, reasonable, and non-discriminatory (FRAND) terms. In this respect, the judgment of the High Court of England and Wales in Unwired Planet v Huawei provides a significant development in terms of royalty collection and enforcement. In this case, Lord Justice Birss ruled that in order to calculate FRAND terms for SEP there is only one set, rather than a range, of licence terms that are FRAND for a set of circumstances, and that it constitutes a global, rather than a local, licence. Importantly, the case shows that UK courts are disposed to quantify a FRAND rate should the parties fail to agree on one. For Lord Justice Birss, a FRAND rate can be set by computing the patentee’s share of SEP and applying that to the total aggregate royalty for a standard – which he quantified at 8.8 percent for 4G/LTE handsets – thus setting a benchmark for the industry to negotiate FRAND rates for their products and technologies portfolios.
FW: Have any recent, high-profile royalty-related disputes caught your attention? What lessons can IP owners learn from the outcome of these cases?
Bénard: The Unwired Planet v Huawei judgment stands as a noteworthy case in 2017 and teaches, at least as far as the UK is concerned, that in a royalty-related dispute there is not just a single adequate method to assess and quantity the value of an SEP portfolio, and that the courts are disposed to quantify a FRAND rate should the parties fail to agree on one. In this respect, initial offers are not expected to be FRAND, and negotiation of a licence that is worldwide in scope is sufficient to meet FRAND obligations and does not per se infringe competition rules. SEP holders are able to seek injunctions for the implementer’s refusal to accept worldwide licence terms). This will impact how the industry negotiates and quantifies FRAND.
London: It is difficult to comment on other companies’ situations without being directly involved, but from the limited amount of public information available, the BlackBerry-Qualcomm case seems interesting. There, a seemingly simple royalty management case may in the end have a huge financial interest. That said, this case seems to be more around interpretation of contracts rather than royalty calculation. If so, then it reinforces the importance of clarity when drafting agreements.
Gray: The Lexmark case is a recent patent licensing dispute that will affect royalties. Apple and Qualcomm are engaged in a dispute over the royalties to be paid for use of their chips in iPhones. There are many entertainment industry royalty disputes, such as whether rights are payable on derivative works regarding the Madden video game – Antonick v. Electronic Arts – and lawsuits against JayZ, Tidal and Spotify over mechanical royalties for music streaming services. On the trademark side, there is a dispute with the Kardashians as to whether a licensee can refuse to pay royalties in a trademark licence and still use the trademark during a contract dispute.
FW: What strategies can companies implement to ensure the accurate and timely receipt of royalty revenues?
London: The fundamental point is consistent drafting of licence agreements. When agreements are carefully drafted to consistently follow and support the contract-to-cash process, they are easier to manage and monitor. Reporting and payment processes must be clear and easy to follow for the licensee, and include time limits and due dates that are reasonable for both parties. Royalty management should be understood to be a customer service, helping licensees to easily comply with their reporting and payment obligations. For example, having your people respond quickly to questions and offering electronic reporting systems to make things easier.
Gray: The most important thing is to pick the right royalty base. In the entertainment industry, for example, intellectual property owners might be given a percentage of ‘net’ revenue. Unless this is very carefully defined, the royalty could be virtually meaningless. ‘Gross revenue’ can be known and is more visible and less easily manipulated but ‘net’ royalties for a movie can frequently be zero after deductions for all above the line and below the line production expenses. Whether the revenue base is ‘gross’ or ‘net’ in the end may not matter if the expenses which then can be deducted from revenue before the royalty is applied are very carefully spelled out. The licensor should insist that only those items specifically listed can be deducted from gross revenue. In addition, the licensor should consider if there is visibility for these deductions in an audit and if the amount can be easily manipulated.
Bénard: Companies may use the services of specialised providers of royalty management software to ensure adequate tracking of data and computing payments as well as the timely collection of royalties. Furthermore, companies may include in the IP licence agreements provisions with respect to payment obligations, such as a clause on payment terms and an indemnity clause providing for late payment penalties. In addition, the IP licence agreement may also provide for the right to terminate the contract ipso jure – per se, without requiring judicial ruling – in case of continuous or substantial late payment, after having sent a letter of formal notice to the defaulting party.
FW: Given the potential for significant revenue leakage over the life of a long-term licensing agreement, how should a company go about reviewing its agreements so that the royalty income is understood and properly audited?
Gray: Any advice about preventing leakage must take into account the relevant industry and intellectual property rights involved. Clearly, a one-time licence of some intellectual property rights to a movie is different from a long-term licence of trademark or copyright to a toy. However, there can be considerable overlap. This raises another issue which can frequently be a problem, and that is field of use. A trademark or copyright related to what could be called a ‘character franchise’ arising from, for example, a popular book or a movie, can have multiple licensees in multiple products or fields of use. Care should be taken to carefully delineate these respective fields of use to avoid disputes and to maximise licensor royalties. In the patent area, also the field of use becomes important if the technology has cross-industry value. Carefully defining the fields of use can result in multiple revenue streams. In addition, as technology evolves it is important to try to capture improvements in the revenue base. It is helpful to continue to review the patent portfolio to ensure that new products are captured by the licensor patents, if possible.
Bénard: Companies are advised to include in IP licence agreements a clause granting the right to conduct on a regular basis, announced or unannounced, audits of the financial accounts related to the products or services concerned. The audit report should be conducted by qualified accountant and technical experts and be used to improve future performance by the licensee. In this respect, the clause should also include the right to jointly modify or agree on a different method for computing the royalty rate when the audit report shows that the original method leads to inaccurate or undervalued rates. Likewise, the parties should include specific indemnity provisions when the licensee does not perform nor contribute, as expected under the contract, to the royalty value, such as, in terms of marketing investment. The parties should keep the audit related evidence in case future disagreement needs to be settled down according to the terms of the contract.
London: Understanding the income requires thorough reviews of the agreement, all royalty reports, invoices and payment data, together with thorough homework to understand the licensee’s business, including its products, sales, financials, market situation and so on. With this data, analysis can be made of the potential risk of revenue leakage or other compliance problems. Best practice is for most or all of this data to be available and analysed using a business intelligence system. An effective royalty audit programme is an absolute must have for any licensing business collecting running royalties. The design of the programme starts from contract drafting, so poor or unclear contract language can significantly impact the effectiveness of auditing an individual licensee. Worse than that, if the agreement base is inconsistent, badly drafted and poorly managed, it can impact the effectiveness and revenue of the overall licensing programme. My experience is that the return on investment in an audit programme can be a significant multiple of the resource invested. I would also recommend designing audit programmes to address different customer groups with a slightly different approach, balancing the costs of auditing against the overall value of the licence.
FW: What essential advice can you offer to companies in terms of optimising their revenues, capitalising on and protecting their IP and successfully managing related risk?
London: Build your own a team of professionals to handle the contract-to-cash process and royalty compliance. Set clear key performance indicators (KPIs) for effective royalty management and your audit programme. Understand what is needed for more effective cash flow management and to ensure a thorough understanding of licensees’ royalty compliance. Be prepared to invest in an annual royalty audit programme. Perhaps most importantly, invest in building electronic systems to support the whole process.
Bénard: Companies should consider using the services of specialised providers of royalty management software, as well as include contractual clauses providing for audits and modification of methods of computing royalty payments when the audit report shows that the original method leads to undervalued royalties. Indemnity clauses providing for penalties and the possibility to ask for damages in case of late, insufficient or lack of payment should also be included. In addition, companies should align their business strategy with the management of their IP portfolio to protect and reduce risks to the company’s IP portfolio. The best way to protect the company’s IP and business strategies is for in-house IP legal managers to be involved all along the company’s business strategy. This relates more specifically to the decision-making process of the entire product and technology life-cycle portfolio, from early conception to R&D and commercialisation stages.
Gray: It is necessary to conduct periodic intellectual property audits to review intellectual property of value that is not being exploited, or could be licensed to another territory or field of use. An internal culture that is sensitive to identifying and protecting intellectual property is important as well as internal controls to ensure that employees assign their intellectual property rights to their company. The nature of the internal culture and the nature of the steps that need to be taken will vary from company to company, depending on whether the company is developing technology that could be patented or kept as a trade secret or one that is generating artistic works. In all cases, persons with an understanding of the scope of intellectual property protection available should be employed to review the internal procedures and licensing arrangements.
FW: Do you expect royalty management and enforcement to become more important to businesses in the years ahead? In your opinion, do companies need to pay more attention to managing the licensing process?
Bénard: We do expect royalty management and enforcement to become more important to businesses in the years ahead, especially for certain sectors and certain types of technologies. This should be particularly true for SEPs. Parties should be required to pay more attention to the negotiation of FRAND rates, especially as certain courts have set a benchmark for the industry to negotiate and quantify FRAND rates for their portfolios and, in addition, have shown willingness to quantify such rates in the event that the parties fail to do so jointly. In this respect, the parties may want to include clauses in contracts resorting to arbitration or dispute resolution techniques before skilled experts should they consider that the courts may not have the necessary expertise in the area, more specifically, when it comes to quantifying royalties.
Gray: We can see a number of trends which will result in licensing become more important. At least in the developed world, knowledge development is the key to wealth and fast knowledge development is the key to competitive advantage. At least in some industries, particularly the software industry, shared cooperative development and open source software can result in greater wealth creation for all. What to keep proprietary and what to licence to generate market demand or increase revenue will increasingly be an issue. Patent owners in industries governed by standard setting bodies typically agree to licence their patents to such bodies to assist in the development of an industry standard. Industries as diverse as mobile phone manufacturers and oil and gas industry players frequently cross licence their intellectual property to each other at least as frequently as they sue each other over their respective rights. In a world where technical knowledge can be utilised by a wide range of players in wide ranging fields of use, which knowledge cannot necessary be exploited directly in all fields by the knowledge creator, licensing will play an increasing role.
London: Royalty management and enforcement will become more important for any licensing business. As the licensee base grows and becomes more international, licensees with very different contracting cultures and approaches may try to optimise their payments. Though licensing is generally a profitable business model, that is no excuse for not finding ways to make it more so through effective royalty management and enforcement. Digitalisation is one of the key drivers of change for any business. It is not possible to manage large amounts of projects and licensees manually using a simple spreadsheet, any more than in other parts of your business. Failing to digitalise will likely result in decreasing return from your licensing and ultimately a loss of competitive advantage.
Laëtitia Bénard leads the Paris Intellectual Property and Litigation department and is global co-head of Allen & Overy’s Life Sciences Group worldwide. She has a wealth of expertise in all intellectual property areas including patents, trademarks, copyright and unfair competition issues, both contentious and non-contentious. Ms Bénard has specific knowledge of the healthcare and technology fields, in which she also advises on various regulatory and contractual matters. She can be contacted on +33 1 40 06 50 33 or by email email@example.com.
Sonja London has over 10 years’ experience in intellectual property and licensing. She has global responsibility for licensing operations, business intelligence and analytics for all the licensing businesses of Nokia Technologies. Past roles have covered business development of licensing programmes, successful execution and negotiations, management of contracts, legal disputes, royalties, customers and compliance. She has been a member of the Board of Licensing Executives Society Scandinavia since 2013. She can be contacted by email firstname.lastname@example.org.
Brian W. Gray practises litigation and dispute resolution for patent, copyright, trademark, entertainment and advertising matters. He counsels and represents clients with large patent and trademark portfolios and has appeared before the Federal and Ontario courts on patent, trade-mark and copyright matters. His experience includes patent licensing, patent drafting and patent opinions, patent and trademark portfolio management and counselling, and advertising litigation and counselling. He can be contacted on +1 (416) 216 1905 or by email email@example.com.
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