LICENSE AGREEMENTS - PITFALLS FOR LICENSEES
In many license transactions the licensee has the upper hand, simply because the licensor has few, if any, other options available to it. As long as the licensee continues to generate royalty income, the licensor is unlikely to complain, even if the licensee does not adhere to each and every term of the license agreement.
However, the tables are usually turned when the licensor is a big player, with a licensed property that is in great demand. Disney, Warner Brothers, Major League Baseball and other big name licensors with high value properties not only have the power to include strict terms in their license agreements, but they also have the resources to enforce those terms. A licensee who acquires a license for a high value property should review all of the terms of the license agreement carefully, and should never assume that the licensor will excuse or ignore a failure to comply with any of those terms.
With this in mind, before signing a license agreement a licensee should consider the following:
Calculation of the Royalty
The standard practice in licensing is to calculate the royalty as a percentage of net sales, where “Net Sales” equals the wholesale price invoiced to a retailer, after allowing for some specifically identified discounts. However, this model may not fit in industries where products are sold to distributors rather than directly to retailers, or where products are held on consignment by a distributor until sold. Also, in some industries, such as book publishing, it may be 90 days or more after a sale has been made by a distributor to a retailer before the distributor reports to and pays the licensee for that sale. Thus a licensee should carefully review the royalty calculation and payment terms in a license agreement to ensure that those terms will be consistent with industry practices for distribution, reporting and payment. For example, if a licensee does not receive reports of sales until 60 or 90 days after those sales have been made by its distributor, the license agreement should state that a royalty will accrue as of the date the licensee receives a report of a sale or receives payment for that sale.
License agreements often include voluminous provisions for submitting samples of licensed products at various stages of the design and manufacturing process, and licensees often skip over these provisions, in the belief that as long as the licensed products are of top quality and generate a royalty, the licensor will not care if a few technical approval steps were missed along the way. In some cases, a licensor may go along with this approach, but many license agreements also contain audit clauses which provide incentives for an auditor to uncover noncompliance with any term of the agreement. These clauses can include penalties to be assessed against the licensee if an auditor discovers that the licensee failed to obtain the required product approvals, and double or triple royalty payments for the sale of unapproved products. In addition, if an auditor can identify enough breaches of the agreement by the licensee, the licensee may be responsible for paying the costs of the audit. Thus even if the licensor was satisfied with the final products, the licensee may still incur substantial costs if it failed to follow the approval process set forth in the license agreement.
In order to avoid getting caught in any of these traps, a licensee should review the approval provisions of the agreement to ensure that:
- The licensee will be able to submit plans or samples at the times and in the formats and quantities required. The licensee may be able to convince the licensor that digital images will be appropriate in some cases rather than having to submit physical samples. Also, the licensee may be able to argue that a final plan and a finished product sample will be sufficient, without having to submit several initial and interim development plans and production prototypes. If a single product style will be sold in several different colors or patterns, the licensor may be willing to accept a single finished product sample in one color or pattern, without requiring multiple samples of each color or pattern. If the licensee is able to prevail on any of these points, the new terms should be included in the license agreement.
- The mechanism for submitting plans and samples are clearly identified and the agreement provides a clear path for approval. For example, if initial plans or two dimensional drawings can be submitted by email, that should be stated. The agreement should also identify the contact person with the licensor who is authorized to grant approvals, and the agreement should state that the licensee can rely on any written approval issued by that person. From an administrative standpoint, the licensee should keep records of all approvals received in order to refute any claim by an auditor that the licensee has sold unapproved products.
Under some license agreements, approval is never “final,” and the licensor may still have the right to revoke its approval at any time or to notify the licensee that the standards for approval have been changed. This may not be a problem for the licensee, as long as the agreement allows the licensee to sell off any products manufactured or in the process of manufacture at the time notice of such revocation or change in standards is given. Alternatively, the agreement can require the licensor to buy all such products at the licensee’s cost of manufacture. The licensee also may want to include a provision for a reduction of any minimum guarantee, as the licensee may be unable to meet a guarantee if it can no longer sell the licensed products.
Common Marketing Fund Contributions
Some license agreements require the licensee to contribute a fixed amount or a percentage of annual sales to a common marketing fund. This may be acceptable if the licensee’s contributions will be used specifically to promote the licensed products, or at least to promote the licensed properties in a way that is likely to benefit the licensed products. However, a licensee should reject any provision which gives the licensor the unrestricted right to use the common marketing fund in whatever manner it chooses.
Ownership of Licensed Products
Clearly a licensee cannot continue to use the licensed property after the term of the license has ended. Thus in cases where the licensed property and the licensed products are one in the same – such as a plush toy based on a licensed character – the licensor would own all rights in both its licensed property and in the product based on that property. However, in other cases the licensed products may contain elements which are separate from the licensed property. For example, a book may contain text or illustrations that are not specific to the licensed property and that could be used in other books, or a placemat or wall hanging may contain a design that is not specific to the licensed property and that could be re-used without the licensed property. In these situations the licensee may want to ensure that it will remain the owner of the copyright and other rights in the elements which the licensee has added to create the licensed product, and that it will have the right to re-use those elements.
As noted above, audit provisions often provide an incentive to the auditors to look for various violations of the agreement. It may not be possible to delete these incentives from the agreement, but in any case the licensee should confirm that it can comply with the substantive provisions relating to issues such as royalty calculations, reporting and payment and submission and approval of product samples in order to avoid any penalties which might arise upon an audit.
In addition, the licensee may want to impose some qualifications on audits. The licensor should be required to give adequate advance notice prior to conducting an audit, the audit should only be conducted during the licensee’s normal business hours, the records for any accounting period should not be subject to audit more than once, and any audit must be conducted within a specified period of time (usually not more than two or three years) after the date of the statement being audited.
Audit provisions also typically extend to a licensee’s contract manufacturer. Thus the licensee needs to ensure that its contract manufacturer is willing and able to comply with the applicable audit terms, and the licensee should include these terms as part of its agreement with the manufacturer. Also, the licensee may want to ensure that the licensor is responsible for the costs of auditing any manufacturer, especially if that manufacturer is located offshore.
Withdrawal of a Licensed Property
Many license agreements permit the licensor to withdraw a licensed property if that property is threatened with an infringement claim or if the licensor simply decides that it does not want to continue to include the property in its licensing program. A licensor is not likely to agree to delete this provision from the agreement, but if the licensor withdraws a property from the license, the licensor should be required to purchase all licensed products then in inventory or in process of manufacture which use the withdrawn property, at the licensee’s manufacturing cost. Also, if there is an advance or guarantee, the advance or guarantee should be adjusted to account for the removal of the property from the license.
In some cases, the licensed property will not be in use at the time the license agreement is signed. For example, a licensor may grant a license for a motion picture character prior to the time the picture is scheduled to be released. In these situations, the licensee should ensure that the agreement includes a date by which the licensor will have released the licensed property, and if there is any delay by the licensor, the term of the license and the dates for payment of any advances or guaranties should be extended to correspond to the later release date for the property.
Even if a licensee tries to ensure that all of the provisions of a license agreement conform to its standard practices and strives to comply with all of the terms of the license agreement, it is still possible that, during the term of the license, something will fall through the cracks. Thus the licensee should always have some period of time to cure any breach of the agreement before the licensor can terminate. Normally this will be at least 30 days after receiving notice of the breach from the licensor, but the cure period may be as short as 10 days for breaches of payment terms.
Also, license agreements often provide that, despite termination by the licensor, the guarantee obligations remain in effect for the balance of the term. The licensee should try to change this so that any guarantee obligation is prorated to the date of termination or does not continue beyond the year in which termination occurs.
Post Expiration Sales
The standard practice in license agreements is to allow for a sell-off period of 90 to 120 days after the expiration of the term of the license. This may be acceptable if no new licensed products are developed within the last year of the term, or if the costs of development are relatively low. However, for some types of licensed products, such as books and comic books, it is counter to the best interests of both the licensee and the licensor to have such a short sell-off period. For example, a licensee that has the right to develop new comic books each year during the license term will be unlikely to do so within one to two years of the expiration of the term because it will not have sufficient time to recoup its development costs. A reasonable compromise is often to leave the standard sell-off period in place for licensed products first introduced more than two years before the end of the term, but to allow for a one or two year sell-off period for products introduced within the last two years of the term.
A licensee should carefully review a license agreement before signing to ensure that it can comply with all of the terms of that agreement.