Australasian Biotechnology (backfiles) AusBiotech ISSN: 1036-7128 Vol. 10, Num. 6, 2000, pp. 22-24

 Australasian Biotechnology, Vol. 10 No. 6, 2000, pp. 22-24

BIOTECH LAW

SPECIAL CONSIDERATIONS IN COMMERCIALISING BIOTECHNOLOGY AND HEALTH-CARE PRODUCTS: ROYALTY STACKING AND CO-OWNERSHIP

Adam Liberman, Partner, Freehill Hollingdale & Page, Sydney

Code Number: au00066

This paper is based on a presentation made by Adam Liberman at the Licensing Executives Society of Australia and New Zealand (LESANZ) Annual Conference 2000. That presentation also dealt with issues arising in the context of clinical trials. Those issues are not dealt with in this paper. Adam Liberman is also a past President of LESANZ and a past Chairman of the LESANZ Health Care Group.

INTRODUCTION

There are many issues to consider in the context of commercialising biotechnology and health-care products. Two of those issues - royalty stacking or reach through royalties and co-ownership will be considered in this paper.

Whilst royalty stacking is very likely to be a factor in biotechnology/ health-care product licensing, the co-ownership issues which I discuss are not unique to biotechnology/health-care products. My experience of those co-ownership issues does however arise principally in the context of biotechnology/ health-care products.

The development of life-science products is heavily dependent on the use of platform technology that is patented or otherwise alleged to be proprietary to a supplier. Where a supplier seeks a return on its platform technology in the form of a royalty referable to the final product that is developed with the aid of such technology rather than merely seeking to obtain a one-off fee for the supply of that technology, then from the developer’s perspective this can result in “royalty stacking”. From the supplier’s perspective it is seeking what is known as “reach through royalty”. That is, the developer of the relevant product may be liable not only to pay a royalty to the owner of the invention from whom it has obtained a development and commercialisation licence, but also to suppliers of platform technologies. It is not unusual in my experience even for sophisticated pharmaceutical companies not to take adequate account of the possibility of reach through royalties being sought in the development of products.

A US survey conducted by Recombintant Capital Inc covering the period of approximately 1989-1997, revealed that royalty stacking/reach through royalties (stacking) were most common in the following areas:

• screening alliances;
• combinatorial chemistry alliances;
• genomics alliances.

The application and consequences of stacking can be seen in the following example:

• A has an exclusive licence from B to develop and commercialise product X.
• A agrees to pay B a percentage of Net Sales Revenue arising from the commercialisation of X.
• A wants to conduct a clinical trial for which it requires a patented growth factor from C.
• C seeks a material transfer fee and a royalty referable to A’s return on X.
• A may require other enabling technologies to bring X to market - eg cell lines, monoclonal antibodies, reagents, etc.

The definition of “Net Sales Revenue” in A’s exclusive licence with B is as follows:

“‘Net Sales Revenue’ means gross moneys or the money equivalent of consideration ... received ... attributable to licensees ... sale of any licensed products less qualifying costs ... Such qualifying costs shall be limited to distributors’ discounts, credits or refunds ... packaging, returnable containers, commissions, prepaid transportation, insurance premium, promotional costs ... taxes ...”.

The above definition of Net Sales Revenue clearly does not allow for third party royalties to be deducted from A’s gross receipts - ie they are not a “qualifying cost” - and as such, it is a cost that A bears exclusively. A will be particularly concerned if this is only one of the materials that it requires and this in circumstances where the definition of Net Sales Revenue is not at all relevant to its needs.

B, on the face of it, will not care about A’s plight, except if the stage is reached where third party royalties eat into A’s incentive to develop and commercialise X and B is restricted in its ability to terminate A’s exclusive licence - eg if there are inadequate performance criteria to maintain the exclusive licence.

Set out below are the options that were identified in the Recombitant Capital survey mentioned above, in seeking to deal with stacking, applied to our example. The licence agreement between A and B results in:

1. A paying the royalty requested by C, without an entitlement to include it as a “qualifying cost” deduction; or
2. A paying the royalty requested by C but with an entitlement to include it in as a “qualifying cost” deduction; or
3. A paying the royalty requested by C but with an entitlement to include it as a “qualifying cost” deduction to a “certain amount” or “certain percentage”; or
4. a percentage of the royalty rate payable to C being creditable to limit the royalty payable to B; or
5. a requirement to renegotiate royalty payable to B.

The consequences of options (a) and (b) are self-evident, but option (b) has risks from B’s perspective because there is no limit on the amount of the deduction - ie the deduction could significantly erode B’s royalty stream.

Option (c) is interesting in that it is not clear how one sets the level of the “certain amount” or the “certain percentage” at the time the relevant exclusive licence is entered into, in any meaningful way, or whether this is purely an “educated guess”. The same comment applies to option (d), but option (d) has the potential to create greater unpredictability in a licensor’s returns. The way of option (d) works is that if A is obliged to pay B a 10% royalty and is entitled to apply say 50% of the royalty rate payable to a third party as a credit against the royalty payable to B, and if the third party royalty is 8%, 50% of 8% is 4%, the 4% is deducted from the 10% and results in B paying a 6% royalty.

There are obviously an enormous number of issues arising from the option (d) approach, including:

• What happens if there is more than one third-party royalty payable?
• What happens if the above formula results in a nil percentage royalty rate being payable to B?

The use of option (e) must be very carefully considered. Licences invariably take considerable time and effort to negotiate and as such allowing a contractual opportunity to renegotiate should be limited to exceptional circumstances. The trigger events giving rise to a contractual right to renegotiate need to be clearly identified - eg third party royalties reaching a certain threshold and this causing product X to be uncompetitive in the marketplace, or causing A’s activities to be unprofitable.

From B’s perspective, there must be proper safeguards in relation to the renegotiation process, including:

• A being obliged to provide B proper evidence of the relevant triggering events;
• The amount payable by A to B not capable of being reduced below a certain threshold;
• That the obligation is only to negotiate and not to involuntarily impose a position on B, eg through a third party using an expert dispute resolution process.

Similar safeguards would need to be built into a renegotiation process from A’s perspective if B requested a renegotiation. B would obviously only request a renegotiation where the method of dealing with stacking was adversely affecting its return.

1. Each of the licensor and licensee must carefully consider the extent to which enabling technologies are going to be required to develop and commercialise the product which is the subject of their licence, and must assess the extent to which “reach through royalties” are going to be sought to use those enabling technologies - that assessment will impact on the definition of “Net Sales Revenue” or other comparable term.
2. The definition of “Net Sales Revenue” is crucial to each of the licensor and licensee and accordingly should not, as is frequently the case, be treated as a “boilerplate” provision.
3. Without knowing what a royalty rate is applied to - eg the components of “Net Sales Revenue” - the royalty rate in itself is a misleading indicator of comparability between deals (Royalty Rate Myth).

Having explored some of the practical issues concerning reach through royalties, it is interesting to consider some current views on the topic:

Research institutions

“Reach through royalty ... rights impede the scientific process whether imposed by a not-for-profit or for profit provider of research tools. Whilst these Principles are directly applicable only to recipients of NIH funding, it is hoped that other not for profit and for profit organisations will adopt similar policies and refrain from seeking unreasonable restrictions ... when sharing materials.” (Principles and Guidelines for Recipients of NIH Research Grants and Contracts on obtaining and disseminating Biomedical Research Resources: Final Notice 23 December 1999.)

Irrespective of the commercial implications of reach through royalties, the National Institutes of Health in the US view reach through royalties as having the fundamental flaw of impeding the scientific process.

“Another practice that was roundly criticised, especially by pharmaceutical firms, was ... reach through royalties on future products ... stacking royalty obligations can make a significant dent in the profit expectations of firms that might develop and market the end products themselves, thereby undermining the commercial attractiveness of potential products.” (Report of the National Institutes of Health (NIH) Working Group on Research Tools for June 1998.)

“... the current manifestation of deals does not usually include “reach through” royalties payable to the platform company for the pharma companies’ sales of products derived from use of the platform. Platform companies have been forced to acknowledge that there is still tremendous work to be done between the use of their tool and commercialisation of a new drug. And because investment analysts no longer pay attention to royalties in constructing evaluation for a platform company, eliminating royalties is not perceived as a problem by the platform company.” (Michael Lytton “Advice of Counsel” in Startup, October 1999, at page 41.)

The preceding may mean that stacking/reach through royalties are likely to be less prevalent. If they are not, then at least if one is seeking to argue against them, some reasons mentioned here can be identified why they should not be used. For those seeking to argue for stacking/reach through royalties, then the preceding also gives an insight into the arguments that must be confronted.

The co-ownership issues will be considered in the context of the following example:

• A Pty Ltd (APL) and B Research Institute (BRI) jointly own a number of patents in Australia, USA and other countries.
• APL wishes to float a new company on the ASX and on NASDAQ through NEWCO, basing a significant portion of the value of NEWCO on rights it will acquire to the patents.
• APL and BRI have an agreement by which BRI receives a portion of APL’s revenue stream arising from APL’s exploitation of the patents. APL however is not granted any licensing rights under that agreement.

What does NEWCO require and what should BRI give?

Section 16 of the Patents Act (Cth) 1990 in relevant part provides as follows:

“Subject to any agreement to the contrary, where there are two or more patentees:

(a) ...;

(b) ...;

(c) none of them can grant a licence under the patent or assign an interest in it, without the consent of the others.”

Section 17 of the Patents Act (Cth) 1990, allowing co-owners to seek directions from the Commissioner of Patents may also be relevant, particularly if there is ample time in which to seek those directions. Such a position is not usually the case. One also has to be aware that there is no case law on section 17 to provide guidance as to its application and a co-owner may in any event not want to suffer the risk of being in the hands of the discretion of the Commissioner.

One also has to be careful to remember that sections 16 and 17 do not apply to “applicants for patents”, but rather “patentees”. It is therefore interesting to consider the following situations:

(a) Whether any agreement made between A and B during the application stage of a patent allowing B unfettered licensing rights would be view as an “agreement to the contrary” for the purposes of section 16, upon a patent being granted? The argument that it does not being that, at the time that agreement was entered into, the parties were not “patentees”. Such an argument if successful would be significant in circumstances where third party licensing was permitted in an unfettered fashion by such an agreement, but with the passing of time such an unfettered licensing right was not thought appropriate by one of the co-owners.

(b) Whether if, during the application stage of a patent, each of A and B or only one of A and B licensed third parties without obtaining the consent of the other, what impact the granting of a patent would have those licences being entitled to continue?

In the former case, if there is a doubt, it would be prudent to expressly provide that any agreement entered into during the application stage continued or was not affected by the patent being granted. As there is usually a significant period of time between applying for a patent and the granting of a patent, the commercial landscape invariably changes over that period of time, and could change in a manner detrimental to certain of the co-owners. The preceding argument could possibly be used as a mean of leveraging the renegotiation of an agreement between co-owners. The same argument does not arise in the context of where there is a single applicant for a patent or a single patentee.

In the latter case, it would be prudent for the co-owner who granted the licence during the application stage to have an ability to terminate that licence upon the patent being granted, otherwise he could be in breach of any licence granted to a third party, if the other co-owner’s consent is required, but not given.

The situation in the USA contrasts with the situation in Australia where the relevant law is summarised as follows:

• Title 35 USC section 262 provides:
  “In the absence of any agreement to the contrary, each of the joint owners of a patent may make, use, offer to sell, or sell the patented invention within the United States ... without the consent of and without accounting to the other owners.”
• Schering Corporation v Roussel UCLAF is authority for the proposition that section 262 means that each co-owner’s ownership rights carry with them the right to license others without consent of any other co-owner - ie unlike in Australia, in the US, the consent of co-owners is not required to one of the co-owners licensing rights to a third party. The preceding is therefore the context in which one has to consider the above example. The optimal position for NEWCO would be:
  1. that it has an unfettered right to exploit the patent itself in the jurisdiction;
  2. that no-one else can exploit the patent in the jurisdiction;
  3. that it can control rights to exploit the patent by third parties in the jurisdiction; and
  4. that it can institute legal proceedings for infringement without being reliant on the other co-owners.

This last point is usually not factored into the requirements of a company such as NEWCO.

1. Because, as the US courts put it, each owner is at the other’s mercy (Gibbs v Emerson Electric Manufacturing) and because it takes time and effort to agree and properly record the terms and conditions of a co-ownership relationship, co-ownership should not be lightly entered into.
2. The laws relating to co-ownership of patents differ from jurisdiction to jurisdiction and those differences should be clearly identified and factored into any negotiations concerning dealing with co-ownership.
3. Proper consideration must be given by a company proposing to float and which derives its rights to patents from a co-ownership foundation, to be able to commence legal proceedings for infringement without reliance on the favourable attitude of co-owners at the time proceedings need to be commenced.
4. In the US “(there) is significant confusion on whether a co-owner can be joined to co-infringement actions ... the majority of cases, however, hold one co-owner cannot join another. If courts refuse to join co-owners and dismiss patent actions unless all joint owners join voluntarily, jointly owned patents are at risk of effectively becoming worthless”. (“Dangers in Joint Patent Ownership” by David A Lowenstein, Les Nouvelle, March 1998 at page 3.)

The last two points mean that where legislation does not deal with the relevant issue, this issue needs to be dealt with as best as possible by contract. In Australia, section 120 of the Patents Act (Cth) 1990 deals with the position of exclusive licensees being entitled to commence infringement proceedings, and section 139 provides that in the context of compulsory licensing and revocation proceedings - not infringement proceedings - “the patentee and any person claiming an interest in the patent as exclusive licensee or otherwise are parties to” those proceedings. Thus in Australia, in order to make a reluctant co-owner party to any infringement proceedings, in the absence of contract, one appears to have to rely on revocation proceedings to be commenced by the defendant as part of a cross claim.

Copyright 2000 - Australasian Biotechnology