“Notice” When You May be Paying the Wrong Royalty
March 9, 2020
By Noel Courage
Royalties under a patent license can be set at different levels, for example, varying by product or by country. Sometimes licenses provide for royalty percentages to change on occurrence of specified business events, such as sales hitting a certain level, or issuance of licenses to competitors. A licensee may be able to detect many of the circumstances that cause a variable royalty. However, there may be situations where the change is complex to detect, for example, involving patent interpretation as to whether a product is covered by a patent. Other times, the circumstance may be peculiarly within the knowledge of the licensor. It can be helpful to have a contract clause specifically requiring the licensor to give notice of circumstances that will reduce their royalty. If there is no notice obligation, then it may not be prudent to rely on your licensor to gratuitously tell you of these circumstances, since the licensor may feel it is up to the licensee to identify the royalty change and put the issue in play. At the very least, a licensor may not be highly motivated to promptly bring up an issue that could affect their income, particularly if the circumstances are a little gray as to whether the royalty should change. A licensee who is aware of a potential royalty issue but does not pursue it aggressively risks either waiving their rights (through waiver or estoppel) or letting a limitation period extinguish the right to sue. At the very least, letting the issue sit unresolved sets the groundwork for a fight later on.
In the case of GAC International, LLC v. Orthoarm Inc.1, the parties had a disagreement about the proper royalty. The case is complex, involving a license of a patent for orthodontic braces. GAC sold In-Ovation brackets, and paid Orthoarm a 10% royalty on net sales. A subsequent agreement acknowledged that GAC was the only party selling a bracket under the patent, and the royalty would drop from 10% to 5% if another party sold under the patent in future.
A key clause in issue is:
Subject to the provisions below, GAC agrees to pay all past, present and future royalties from the sale of the Bracket at a rate of 10% of net sales for the life of the 715 Patent. Payment of royalties shall be consistent with section IV of the Licence Agreement. Although GAC is currently the only party selling a bracket that may be covered by the 715 patent, if any party in the future shall sell or offer to sell, without authority from GAC, a bracket that is covered by the 715 patent, then the Licence Agreement shall become nonexclusive with respect to the 715 patent and the royalty referred to in this paragraph shall drop to 5% provided that if such party discontinues selling such bracket within a period of not more than one (1) year, then the royalty hereunder shall revert to 10%.
There does not appear to have been a specific obligation on the licensor to notify the licensee about the circumstances that may lead to the royalty change. Presumably, the potential for a change in circumstances was left to be dealt with by informal communication between the parties, or detected by the licensee through marketplace monitoring and patent analysis.
Another company later began selling a bracket with similar features as the In-Ovation bracket. The inventor of the patent testified in a court proceeding that this new bracket used his patent2, and that the new seller was licensed to produce orthodontic appliances under the patent. This is a curious contrast to the analysis by GAC’s Director of Patents, who had previously determined that it did not appear the new competitor bracket was directly covered by the patent. This leaves the curious situation where apparently the inventor testified the new product is covered by the patent, but the licensee (who stands to save money if it is covered), has assessed that the product may not directly cover the new product.
GAC stated that it did not know the competing bracket was covered by the patent until the date of the inventor’s discovery. After learning the Empower bracket was covered by the patent, GAC believed that it was entitled to reduce the royalty to 5%. GAC sent a letter to Orthoarm stating that it would no longer pay any current or future royalties because it had overpaid royalties. GAC brought an action seeking a declaration that the royalties are 5% of the net sales of the In-Ovation bracket. GAC also claimed damages for all allegedly overpaid amounts. Orthoarm argued that it relied on GAC’s conduct in paying the 10% royalty, to Orthoarm’s detriment. If Orhtoarm had known that GAC was taking the position that the royalty amount was reduced to 5%, then Orthoarm said it would have licensed the patent to another entity.
In general, if circumstances change, there are certainly obligations of good faith on parties to a contract, and a party may not be improperly unjustly enriched - there can still be a breach of contract irrespective of whether there is a contractual notice requirement. However, a notice provision is still useful to try to minimize risk of a lack of communication. Failure to comply with the notice provision is also a more specific breach of contract that could be specifically tied to a remedy such as a right to terminate the contract, to repay allegedly royalties, or to set off allegedly overpaid amounts against future royalty payments (unilaterally withholding royalties could potentially give rise to a breach of contact if there is no clear right of set off).
Notice can be required promptly upon occurrence of a particular event. It can also be integrated into reporting, for example, a periodic brief report on licensor commercialization activities that affect royalty can be required by the contract terms.
The bottom line is that a notice requirement cannot make a licensor inform a licensee of a change in circumstance, but it can be a useful to trigger contract remedies once the situation comes to light.
1 2019 ONSC 289. The case was a motion for summary judgment to dismiss the action on the basis that GAC was allegedly estopped by its conduct from bringing the claim. The motion was dismissed. Orthoarm has not met the evidentiary burden of establishing that there is no genuine issue of material fact requiring a trial.
2 The inventor is not a patent attorney, and his own assessment is not determinative. The court did not go into its own patent analysis as to whether the patent did cover the product. It appears sufficient for the court’s contract analysis that a patent license was granted for the new product.
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