Patent, Trade Secret, and Technology Licensing and Joint Ventures: A Few Practical Issues

© 2001, 1996, Deeth Williams Wall LLP. All Rights Reserved. By: Gervas Wall¹ (Presented at: The Canadian Institute, Licensing Intellectual Property, January 23 – 24, 1996)

A. INTRODUCTION

In this paper I would like to cover a few of the practical issues relating to technology licensing in Canada, and, to some extent, outside Canada.

I will not cover drafting to any extent, though, because Sheldon Burshtein is to deal with that tomorrow. Instead, I will deal with conceptual problems and common areas of vagueness in license agreements, and their close cousins, joint venture agreements.

A license is a permission to do something the licensee would not otherwise be allowed to do. It does not imply any ownership interest in the licensed technology, or licensed property, being granted to the licensee. Nevertheless, the most contentious issues in license agreements can be those that deal with the division of ownership interests between the parties.

A joint venture in the sense that I encounter it is an agreement to cooperate in the exploitation, and often development, of technology and the proprietary rights in the technology. This may involve the creation of a separate joint venture entity.

Sometimes licenses are referred to as strategic alliances - or strategic alliances include licenses.

The legal core of all of these is the bundle of proprietary rights that make up the licensable rights.

The first step for a lawyer involved in licensing is to understand the basic transaction that your client wants to accomplish. The second step for a lawyer involved in licensing is to understand the proprietary rights in the technology so that your client can get where it wants to go.

Typically, the proprietary rights in technology include patent and trade secret rights, and copyright. There may be other rights involved as well, though -- for instance, trade-marks, industrial designs, and plant breeders' rights. Each of these rights is different, and so each requires different treatment in a license agreement.

The terms of agreements are very flexible. Licensor and licensee start with a blank piece of paper. Exclusivity, for example, can be a flexible concept depending on what is exclusive, where is exclusive, and when is exclusive - exclusivity does not have to be completely exclusive.

As a person involved in licensing, you have to ask a lot of questions in order to be able to give guidance. Here are some questions that you may need to ask in order to understand the deal and the consequences of the deal.

B. QUESTIONS THAT NEED TO BE ASKED

1. What are you dealing with?

(a) Rights

The technology and the rights being licensed need to be described in detail, so that a third party looking at the deal years later will be able to describe clearly what happened.

What patents, trade secrets, and copyrights are included and what will be the scope of the licenses? Is there any excluded technology?

Problem area – Improvements

The agreement must specify whether future developments are included. Do any license rights granted include all rights, now or hereafter known?

What happens to improvements developed by the licensee? The licensee will believe that the improvement should belong to it because it developed it; the licensor will believe that the improvement should belong to it because the licensee wouldn't have made the improvement without knowledge of the licensed technology.

Laws of different countries differ considerably on whether grant backs of improvements are permitted.

What kind of constraint does the improvement provision of the agreement place on the future growth and financing of each party?

What kind of things are improvements? Can they be defined in a technical way (any widget including a left handed lugnut) or an economic way (any widget which is competitive with a licensed widget)?

Some agreements include a grant back of all improvements developed by the licensee to the licensor, subject to a license back, which may or may not be on the same terms as the main license; or perhaps a license back to the licensor, with ownership to remain in the licensee.

Some clients like to have "joint ownership" of improvements. What is this? How does this affect enforcement of the rights against third parties? What are the rights of the co-owners to account, to license others, to use themselves? These depend on the nature of the proprietary rights and the national law which applies.

(b) Parties, Funding and Structure

Taxation is vital to consider in establishing a structure, just as it is in determining payment.

Are affiliates of the parties included in the deal? What happens if they cease to be affiliates?

Can the parties assign their obligations? The identity and reputation of the parties may have been critical to the decision to enter into the alliance in the first place. Will inability to assign place financing at risk?

How will the venture and any development and marketing be funded? What are the obligations of each party to contribute? How often? How much? What if one party fails to pay? How are cost overruns handled?

The parties should think about how complicated they want to make this. Excess complexity and overhead can drag a venture into the ground, while, at the same time, too loose a structure can lead to misunderstandings later on.

The goal is to find just the right balance, with an agreement and structure that puts procedures in place for handling unforeseeable events and issues, rather than trying always to cover each possible scenario in the agreement.

2. How much do you want to give up?

(a) Problem area – Exclusive or Not?

Is the licensee going to be given an exclusive or nonexclusive right to distribute the product? This question is critical, since sometimes the only way to get and keep the attention of a valuable distributor is to offer an exclusive territory.

This brings with it however, a host of other issues, such as how the licensee retains those exclusive rights. Are there sales quotas or revenue targets that must be met?

Will the licensee be restricted from selling outside the exclusive territory and if so, how will this be enforced when selling to a multinational user with offices inside and outside the territory? Does the country in question allow prohibitions on export?

What kind of exclusivity can the licensor guarantee to the licensee when it may not be able to control gray market goods? For instance, in the EC countries, it may not be possible to police and enforce exclusive territories and the technology owner should not take on any liability for the entry into an exclusive territory by another European distributor of its products.

Will the exclusive licensee be prohibited from selling competing products? Is this permitted in the country in question?

How exclusive is exclusive? For instance, can the technology owner license portions of the technology to third parties in the territory who may want to bundle just part of the product with another? What about for an unrelated use?

The grant of an exclusive territory may also be in breach of the competition laws of the EC (or a particular country) and local counsel should be consulted to make sure that the agreement is not going to cause problems.

Exclusive arrangements can also be more difficult to terminate and the laws in the relevant jurisdiction should be examined to see what the rules are for termination of such an agreement.

(b) Realities

As part of the discussion of what you are giving up, if you are a small technology company you must also consider whether you are going to be required to give up control of your company or, at least, control of the 'dream'. Will you be able to handle the increased involvement of another entity in the way you run things and are you prepared for the fundamental changes in your business if the relationship is successful. This can be almost as terrifying as the prospect of the failure.

For a larger company that depends on a smaller partner for the success of the venture, there is always the risk that the main people behind the small company will lose interest or, worse, be incapacitated in some way. What if the small partner cannot keep up with the demand? The agreement must contain some contingency planning to cover these issues.

3. How do you protect your rights?

(a) Patents, Copyright

The technology owner has to decide whether the expense of obtaining and enforcing a patent is worth it. Patent protection can cost thousands of dollars and can take a considerable period of time to obtain. It may not be a wise choice if the "window" for the product is small.

On the other hand, a patent can make a useful "core" to a licensed technology because it is well defined and patent rights tend to be similar around the world. It does not have the problems associated with trade secrets. Patent rights tend to be more valuable as they protect even in the case of reverse engineering. In the US in particular, laws relating to knowing infringement make patent rights valuable.

Copyright protection is still relied on by many information technology companies. The courts in many countries now are struggling with just how far copyright goes. For a software product, does it protect the "look and feel" of the product, the icons, the user interface or just blatant copying of code?

(b) Trade secrets

Trade secrets, in common law jurisdictions, are protected by equity. A person who is imparted information in confidence cannot disclose the information to others without the permission of the person who confided the information. When information is published without restriction, though, it will no longer be protected as confidential information², although a collection of public information may still be considered proprietary if the collection is not available to the public.

The technology licensor's version of the prisoner's dilemma is that sometimes the only way to protect your rights in your product is to keep most of it secret, while the only way to make money is to put it into the hands of strangers.

Easy, you say: let's include a trade secret section that says that each party will keep the other party's information confidential, unless it becomes public, or is acquired freely from some other source.

The licensor may be happy with this provision, if it can also negotiate a non-competition agreement which extends beyond termination. But what if the licensor receives commercial trade secrets of the licensee? The licensee may seek to prevent the licensor from dealing with a competitor because the licensor has sensitive, confidential information of the licensee in its possession.

What if the secrets that pass to and fro are not in writing? Should these be excluded? Will their exclusion result in reduced communication between the parties?

Should the parties even accept an obligation of confidence, or will it so taint the recipient that it will preclude the recipient from carrying on in the field after termination? Will the lack of such a provision preclude the licensor from enforcing the trade secrets against a third party?

If the trade secrets are central to the technology, and so obligations of confidence must be accepted, how can they be managed? Which lucky employee will find herself ostracized in another department when the relationship terminates?

Trade secret rights vary considerably from one country to the next, much more than do patent rights. There are no international conventions on the scale of the Paris and Berne Conventions relating to trade secrets.

In some first world countries, trade secrets are not considered property rights at all. They may only be protected by contract and cannot be conveyed. In less developed countries there are severe restrictions on the enforcement of trade secrets, and thus licensing of trade secrets.

The surest line of defense is to ensure that the amount of proprietary material provided is kept to only those portions of the technology absolutely required by the party.

The technology owner must have a mechanism to inspect the other party's security measures and site, without notice.

Even with a nondisclosure agreement and attempts to limit the amount of information to which the other party is exposed, there is always the fact that some of the information disclosed will stay firmly planted in the minds of the other party's employees and may contaminate future work products. I refer to this as the "Lobotomy Issue". It is impossible to erase some ideas and techniques from the brains of those to whom they have been disclosed and this has to be recognized when deciding what and whether to disclose, and to whom.

It is always prudent to ask how security on the other party's computer system is handled, since your proprietary information will probably reside there. How many "hack" attempts have they had over the past year? How many of them have been successful? How have they dealt with them?

How often are employee passwords changed?

What procedures are in place to advise employees that there is third party confidential information on site that must be protected from disclosure?

If the other party uses the Internet or other public access network, how are they protecting the messages that are sent?

How does the other party handle security with respect to its own confidential information? If there are no procedures in place to protect their own trade secrets, this is a good indication of how they will handle yours.

Be aware of contract terms that provide only that the party to whom the information is disclosed will accord to your information the same protection it gives its own - it may not do anything even for its own information.

There is no substitute for thoroughly checking out the reputation and premises of a distributor or licensee before confidential information is disclosed.

When dealing with any party in a foreign country, it helps to have a consultant or other agent assist in the selection and investigation of potential partners in the area, since it is likely that they may be told something about the potential party when a "foreigner" may not.

(c) Protection

Once a product is prepared for market the agreement must provide for which party will be responsible for undertaking intellectual property registrations and protection, at home and abroad?

What security measures must be taken by the parties to protect old and new products?

Who is liable for infringements of third party rights and what are the indemnity obligations of the parties to each other? Who is responsible for prosecuting infringers of the rights of the partners?

If you say nothing, the licensee will likely have the right to sue for infringement. Sometimes, customers can have the right to sue, too.

4. What do you get back?

What is gained from a relationship depends to a large extent on the scope of the deal itself, but knowing what is hoped to be achieved prior to entering into the transaction is something that the parties must think about clearly, since knowing what you want is just as important as knowing how to get it.

It may be that you are getting access to manufacturing capacity or sources of supply that would be able to reach on your own. Sometimes all that is really desired is some much needed funding - but be aware that the price for that funding may be a loss of control.

Sometimes the motivation for the deal is a desire to share the risk in the development of a new product area and sometimes a party needs to be able to use a critical piece of technology and cannot justify developing it from scratch. In many cases where a small company partners with a large one, the small company needs to be able to advertise the relationship in order to give the small company some much needed publicity and credibility.

From distributors, in addition to a revenue stream, the technology owner may expect to receive an expanded customer list and a broader penetration of the product worldwide than it could achieve using its own affiliates or employees. Agreements with these parties must deal with the obligations of the distributor to report the names and addresses of all customers and must set out which party owns the customer list. Can the distributor use the customer list after termination?

5. What are the risks?

Risk factors can be both simple and extremely difficult to determine and cover in an agreement.

(a) Legal

The easy ones involve an examination of the local laws, including those dealing with consumer protection, warranties and liability (what warranties are implied, which ones can and cannot be waived); taxes; government approval requirements (in some cases, failure to comply can result in the technology being placed in the public domain); regulatory requirements; export/import regulations; trade-mark, advertising and labeling laws; and competition laws.

Product liability insurance may be a good idea in some areas.

What export controls should you be aware of and are there technology transfer laws that will result in your product being placed in the public domain in the partner's country?

Is this whole deal in breach of an anti-trust law?

(b) Other

The difficult risks to evaluate and cover may have more to do with local custom, personalities, culture and the past history of the other party than the merit of the deal from a technological, economic or legal standpoint.

What is the political climate in the countries and what are the relationships like between the two governments?

Are there restrictions on foreign ownership? Are there transborder data flow restrictions?

You may be required to use a local business agent to get the deal done at all. They work independently and know the ropes, but this may involve doing things that your company would not authorize in other circumstances. For example, it may be a local custom for your distributor to give a "gift" to a government official to smooth the approval process. Will this expose you to criminal liability? How do you stop it? Can you stop it?

(c) The Unknown

Other questions can keep you up at night. Will your licensee run off with the technology or know how; get bought out by your competitor; go bankrupt; or be "nationalized"? Will the market shift so rapidly that the carefully structured technology alliance becomes moot? Will your technology partner be hit with an infringement action for the technology that is a part of the alliance?

These are all unknowns and, absent some investigation of the other party beforehand, some careful due diligence and a lot of luck, there is not a lot that can be done to eliminate these risk factors.

(d) Due Diligence

Every significant technology alliance should be preceded by a due diligence check of the other party. Check to see whether they have patents issued or pending on the technology in question; determine whether their copyright has been registered and whether any trade-marks to be used have been properly registered and maintained. Have they entered into any licenses for the relevant technology and are any of them exclusive? Where did their technology originate?

Have any lawsuits or other claims been filed by or against the company? Has the company been involved in any other alliances and how did they turn out? Are you entering into an agreement with a company that has a history of failed alliances or of suing its technology partners?

6. How do you get paid?

This is not as simple as it sounds. Royalties, allowances, capital injections, discounts and cash can all form part of how the money gets to you. The combinations are many. However, getting the money into your hands can sometimes be a problem, particularly if you have not asked enough questions and thought out the issues ahead of time.

(a) Royalties

The agreement should provide for the frequency of payment and whether royalties are due in arrears or in advance. If there are prepaid royalties, the calculation of the crediting of those royalties must be specified. Are royalties calculated as a percentage of net revenue, gross revenue, a fixed fee per copy or otherwise?

Are sales to affiliates counted in sales made? What about product given out for evaluation? Will allowances for bad debts, returns and co-op advertising allowances be included in revenue figures? How will profits be accounted for? What audit rights do you have?

Do you have to allocate royalties between patented and unpatented technology? What happens when patent and other rights expire or are lost?

(b) Currency and Taxes

In many transactions, currency restrictions can severely hamper your ability to get money out of a jurisdiction and in some countries, arranging for an irrevocable letter of credit up front is the only way of ensuring that any money is received.

The parties also have to specify the currency of payment and which one of them will bear the risk of fluctuations in the exchange rate. What published rate of exchange will be used?

Many agreements allow for termination in the event currency restrictions impede the ability of the licensor to get money out of the country.

In some countries, the agreement must first be registered with a government agency or central bank, in order for currency to leave the country and before doing a transaction in any foreign country, this must be checked out. If the agreement must be registered, it should be clearly stated that the agreement is executory until this is completed.

In other countries, withholding taxes that must be taken off the top of license fees or royalties will disrupt the cash flow projections of the technology owner if not anticipated beforehand. Withholding taxes can sometimes be recovered as a tax credit, but many companies are a long way from being in a tax paying position and so this benefit is lost to them.

Tax issues can also be critical and require some advance planning so that the implications are understood by all sides. The last thing that either party needs is to find out that, regardless of what the agreement says, the parties have created a partnership for tax purposes, when they intended only a contractual venture.

Any agreement must provide for the liability of each party for the payment of custom and export duties, value added and sales taxes or other commodity taxes or tariffs.

7. How do you get out?

This is not always possible to do cleanly but it can be critical when dealing with any form of license.

(a) Distributors and OEM's

In some countries, agency termination laws will prevent the termination of contracts of indefinite duration, without the payment of significant termination payments to the terminated sales representative or agent. In a few jurisdictions, these termination restrictions may also apply to distributors.

Contracts with automatically renewing terms are particularly vulnerable and it is recommended that agreements with sales representatives and agents be for fixed terms and that they not be renewed automatically. The agreement should terminate at the end of the fixed term and a new agreement signed if the technology owner wants to continue the relationship.

(b) Terminating Events

The parties must work out what a reasonable period of notice will be for any termination.

Can the agreement be terminated without cause?

Will the only allowable terminating event be bankruptcy or material breach? Be aware that some jurisdictions may restrict a partner's ability to stop supplying in the event of receivership.

Can part of the agreement be terminated and the remainder remain in effect? Do all licenses terminate if the agreement ends?

One party may want to be able to terminate the deal if the other is taken over by or sells its rights in its technology to a company considered "unfriendly". The agreement should allow parties who feel threatened by new owners to bail out of the arrangement, particularly if the new owner is a direct competitor.

There may even be provision for one party to have a right of first refusal to buy the assets, shares or rights of the target company.

(c) After Termination

Besides providing for several avenues for termination, all agreements with third parties that have access to the technology should provide for what happens on termination.

For example, can the party keep a copy of the technology for the purpose of providing end user support after termination? Will the licensee be able to continue to fill orders for the product for a period after termination?

Many distributors want the ability to continue to fill orders if the product is listed in their product catalogue, until the next printing of the catalogue.

On termination, all proprietary information and all copies, that are not specifically permitted to be retained, should be returned to the technology owner and an officer of the other party should certify that this has been done.

Will there be royalties due to one or both of the parties for sales after termination?

Will there be a transfer of know-how required at the end of the relationship? Is it free?

(d) Dispute Resolution

Many agreements provide for escalating dispute resolution procedures that must be followed in good faith before either party can take steps to terminate the agreement and these should be carefully considered. Sometimes it does not make sense to even try to keep the parties together and sometimes it is imperative.

There are advantages to arbitration in the technology field that cannot be overlooked.

Endnotes

1. I would like to thank my partner, Amy-Lynne Williams, for her assistance with this paper.
2. Subject to the springboard cases.

Contact Gervas Wall or Amy-Lynne Williams for more information on Licensing and Joint Ventures.