Are Royalty Structures in Hybrid Licenses about to Get Simpler?

Are Royalty Structures in Hybrid Licenses about to Get Simpler?

By: Tim Reckart and Brendan Haberle, Rusing Lopez & Lizardi, PLLC, Tucson, Arizona

On March 31, 2015, the U.S. Supreme Court will hear arguments in Kimble v. Marvel Enterprises, Inc., a case with the potential to alter important aspects of patent and trade secret licensing profoundly. The petitioner in Kimble is appealing an adverse ruling from the Ninth Circuit, in which the Ninth Circuit court applied Supreme Court precedent from Brulotte v. Thys Co., decided in 1964, that established that license agreements providing for payments of royalties beyond the term of the licensed patent were per se unlawful. As the type of license in issue in Kimble—a “hybrid license” covering both patented inventions and unpatented know-how together—is common in many technology fields, a ruling overturning Brulotte or otherwise circumscribing it to ease restrictions on post-patent royalties could lead to major changes in technology licensing practice.

Brulotte was decided at a time when the Supreme Court was sympathetic to the characterization that patents enjoyed “monopoly power” by virtue of the rights given under applicable laws. While that characterization was misplaced, it did drive the Supreme Court’s decisions in many licensing cases at that time. In Brulotte, the Court was concerned that patent owners could extend their monopoly power beyond the patent term by requiring licensees to agree to post-patent royalty payments as a condition of licensing presently patented technology. Borrowing from anti-trust law, the Supreme Court created its per se rule invalidating provision in licenses that call for payment of patent royalties beyond the term of the pertinent patents. Fifty years of application of the rule by lower courts has left today’s licensing practitioners a labyrinth of fact- and circuit-specific precedent to navigate in crafting enforceable forward-looking licenses—a far cry from the bright line rule the Court intended.

In applying the Brulotte rule to hybrid licenses, courts have held that it bars enforcement of license provisions that assess one royalty for the licensee’s exercise of both patent and non-patent intellectual property rights before and after the expiration of the patent rights. Consequently, to avoid a Brulotte situation in their hybrid license agreements, many practitioners include language in their hybrid license agreements whereby royalties are apportioned between patent and non-patent rights or, if not apportioned, the stated royalty rate is materially decreased upon expiration of the licensed patent rights to reflect the “loss” of the benefit from the patent rights under the license.

On its face, this approach makes economic sense because, upon expiration of the patent rights, a patent holder may no longer enforce the expired patent rights. In the case of an exclusive license, the licensee no longer enjoys the market benefits that came with the exclusive grant under the patent rights and, consequently, should no longer need to pay for those expired benefits. In the case of a non-exclusive license, the licensee should no longer be required to pay royalties because it no longer needs to retain a license under the patent rights to avoid a potential claim of infringement of the now-expired patent rights.

However, in practice, the problems with this approach are formidable. Assuming the parties to a license recognize the need to differentiate between patent and non-patent royalties, they are thrust into a negotiation over the relative value of the patent and non-patent rights in the technology, and a battle over the assumptions used in, and the results of, any forecast of the market for the pertinent technology and future benefits attributable to each component of the IP. Brulotte, therefore, requires the parties to engage in an exercise that increases the risk that the prospective deal is stillborn and mandates practices that are economically and socially inefficient and incongruous with modern Supreme Court jurisprudence regarding antitrust and freedom of contract issues.

To exacerbate this, the parties will also have competing incentives. Trade secret royalties may be assessed for sales in all countries of the world and without any limit on the assessment period, whereas patent rights are limited by time (per Brulotte) and territory. For example, patent royalties must be tied to a country in which the patents are issued and the products covered by those patents are manufactured, used, sold or imported. Thus, a licensor may look to weight the royalty mix more heavily to the non-patent royalty, whereas the licensee, especially if it is an exclusive licensee who benefits particularly from the exclusive rights under the licensed patents, will look to tie its royalty obligation to activities in patent countries.

Not surprisingly, in light of these realities and its underlying flawed economic assumption, Brulotte has been heavily criticized. The decision fails to account for the modern realities of technology licensing, particularly the interdependence of patent and non-patent rights in many technology arts, especially in pharmaceutical licensing and software licensing, and the efficiencies to be gained by allowing licensors and licensees to determine the economic arrangement that is most beneficial to the parties.

Kimble gives the Supreme Court an opportunity to review Brulotte and its lower-court progeny. Given the potential impact on enforcement of technology licensing agreements and potential for tidal changes in the law, practitioners should keep a watchful eye for the Court’s upcoming decision in this case.

Tim Reckart is a partner at Rusing Lopez & Lizardi, PLLC in Tucson, AZ. His commercial and corporate practice focuses on the formation and financing of emerging-growth companies and intellectual property transactions. He is AV Preeminent Rated by Martindale-Hubbell and one of the 2014 Top-Rated Lawyers in Intellectual Property Law by Martindale-Hubbell.