Revisiting Royalty Structures in Hybrid Licenses

In 2015, the U.S. Supreme Court heard arguments in Kimble v. Marvel Enterprises, Inc. and declined to alter important aspects of patent and trade secret licensing. Consistent with its earlier precedent, Brulotte v. Thys Co., decided in 1964, the Court confirmed that a pure patent license providing for payments of royalties beyond the term of the licensed patent is 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, the restrictions on post-patent royalties must be carefully navigated.

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. The Supreme Court’s decision in Kimble did nothing to assist attorneys in these circumstances, but merely affirmed the established per se rule.

In applying the Brulotte/Kimble 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/Kimble situation in their hybrid license agreements, practitioners should include language in their hybrid license agreements apportioning royalties 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 and Kimble, therefore, require 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 Kimble) 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.

Another approach is to amortize royalties over a time that extends beyond the patent term. This would seem to be within the invitation given by the Supreme Court in the Marvel Case to craft business arrangements that comply with the per se rule but deal with the economic challenges faced by the parties. Such arrangements are fraught with peril and require substantial justification to show that the basis is not to extend the royalty term as such, but to accommodate an alternative payment scheme with the restrictions of the rule. See, e.g., http://www.lesusacanada.org/featured-articles/2015/post-patent-term-royalty-amortization-after-kimble.

Not surprisingly, in light of these realities and its underlying flawed economic assumption, Brulotte and Kimble are worthy of heavy criticism. They fail 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. However, in Kimble, the Supreme declined to provide relief to practitioners, who still need to keep a watchful eye on the per se rule when drafting and negotiating hybrid license agreements for their clients.