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How monetizing intellectual property can lead to litigation

INSIGHT ARTICLE  | 

Not every owner of intellectual property (IP) has a robust licensing and compliance program. However, in an effort to monetize IP assets, many organizations are increasingly licensing IP to third parties. However, this third-party licensing brings with it several risks including fraud, the misinterpretation of complex licensing contracts and even the nonconsensual use of subject IP. Not surprisingly, the existence of these risks can lead to disputes or litigation. Highlighted below are these risk factors and what they mean for both the licensor and licensee.

Misinterpretation of complex license contracts

Licensing agreements are often complex in nature and misinterpretation of contractual terms and definitions can frequently lead to discord between the licensor and licensee. Inaccuracies relating to the exclusion of royalty-bearing products, calculations of royalties and incorrect interpretation of contract clauses can lead to errors in the royalty reporting process and, ultimately, to the underpayment of royalties due to the licensor. The flip side of this equation is that a licensee who has misinterpreted a key definition in a contract may not only be paying lower-than-appropriate royalties, but they may trigger penalty and interest clauses that can be substantial.

To illustrate this point, take the example of a university that patented certain vaccine technologies, and entered a license agreement with a large multibillion dollar pharmaceutical company to commercialize the product. In exchange for licensing the technology, the university received royalties on commercial products sold that incorporate the patent technology.

The license agreement stated that royalties were to be paid on net sales of licensed products. The contract dictated that deductions must be made based on actual amounts. During a routine royalty audit, it was discovered that for certain costs, the licensee used estimated costs instead of actual amounts incurred. The licensee never reconciled, and adjusted the estimated costs to the actual costs. The cumulative findings of underreported royalties from U.S. sales over a five-year period exceeded $1 million. For the full case study, read here.

Acts of fraud

In addition to misinterpretation of complex license agreements, fraud is also a major contributor to the rise in IP-related litigation. IP fraud can occur in various forms, but for the purposes of this article, we will focus on IP theft.

The most common example of IP fraud is the intentional underreporting of royalties when the licensee willfully disregards the license agreement and intentionally underpays royalties to the licensor. In extreme cases, this willful underreporting can even extend to falsifying sales or accounting documents.

From the outside looking in, it can be difficult to differentiate between a valid misinterpretation and a fraudulent act. However, making this distinction can be very important when determining how to handle these types of situations. An honest mistake, however egregious, can usually be overcome. But the discovery of a scheme to purposefully underreport royalties can damage relationships and lead to litigation.

For example, a Fortune 500 consumer products company with a number of patents on consumer products and trademarks on several well-known global brands entered a trademark licensing agreement with a large retailer. A few years into the agreement, the consumer products company began to consider a royalty review after questioning whether the retailer was reporting accurate sales figures. During the investigation, it was noted inconsistent procedures for how the retailer accumulated sales of products subject to royalties, not only for retail outlets, but also for online sales. If products were not sold in the retail stores, the licensee did not have any controls in place to make sure sales were included in the royalty report. Therefore, online sales were not tracked, and royalties were underreported. While perhaps unintentional in nature, proper internal controls are needed to ensure compliance with royalty payments. For the full case study, read here.

IP conversion

Similar to IP fraud, IP conversion is also an intentional act. This occurs when IP is used without the owner’s consent, and can occur when a license agreement has ended and the parties have not entered into a new agreement. Another example of IP conversion is when a licensee creates a variation of the subject IP. In this instance, the licensee is exploiting the subject IP without the licensor’s knowledge or permission.

Consider this example of a publicly-traded technology company with a number of patents over computer hardware and software. This public company developed a specific computer device technology, and agreed to license the technology to an unrelated third party. Five years after the execution of the agreement, concerns emerged as to whether royalties reported and paid were accurate.

It was uncovered, among several deficiencies, that a few years into the agreement, the licensee ceased royalty payments on three high-volume items. Through analysis and conversations with the licensee, it was learned the licensee had discontinued the original product numbers, and launched new products that utilized our client’s technology. However, the new products were not included in the royalty reports. Therefore, royalties were significantly underreported from that point forward. For the full case study, read here.

Final thoughts

While monetizing IP has its obvious advantages, it does not come without risks. And the risks highlighted here have increased in frequency. Therefore, many licensors are retaining outside consultants to perform royalty audits to ensure licensees are in compliance with the terms and conditions of the licensing agreement that govern the relationship between the two parties.

These consultants will often rely upon contracts, amendments, royalty statements and financial documents from both the licensor and licensee in determining whether the licensor has received the appropriate royalty payments. Understanding the contract and any amendments is the most important step in determining compliance. Also, due to the financially sensitive nature of these documents, a good working relationship between the royalty auditor and licensee is essential.

While these types of audits help to ensure proper compliance and royalty payments, royalty audits can also positively affect the licensee. A properly conducted royalty audit can open lines of communication between the licensor and licensee, and often unveil contract-related issues before they become insurmountable. Secondly, uncovering inadvertent misreporting by the licensee as early as possible can be a significant advantage for the licensee. Allowing significant underreporting to go unnoticed for years can result in large amounts of unreported royalties, which can damage the business relationship between the parties, and potentially place undue financial pressure on the licensee.

As an example of this, a multibillion dollar life sciences company developed and patented technologies for several self-testing conditions, such as strep throat, premature labor and mononucleosis. Their business strategy included licensing out certain patents, where a third party manufactures and sells commercial products incorporating the technology. In return, the life sciences company received significant royalties from those product sales.

Given the criticality of the royalties to their business, this life sciences company instituted a compliance program, which included a regular royalty audit. In the analysis of the separate licensees, underpayment of royalties were identified totaling nearly $4.5 million. The findings included omitted products, unallowable discounts and deductions and unreported sales in patent-covered countries. This example underscores the importance of having a compliance program in place should you choose to monetize your IP. For the full case study, read here.

In summary, the monetization of IP can benefit both the licensor and licensee, but should be accompanied by a robust compliance program. Each party must be cognizant of the attendant risks to avoid the potential for IP-related litigation and disputes. Properly executed royalty audits can be an essential tool in this process and should be incorporated into any well-run compliance program, both to uncover problems as well as to prophylactically prevent them from occurring.

The goal of a well-executed monetization and licensing program is to avoid these potential pitfalls (including disputes), while at the same time strengthening the relationship among the parties.

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