Recently, the Federal Court of Appeals for the Ninth Circuit upheld an injunction issued for the benefit of members of the Kardashian family against their cosmetic products licensee.
The Kardashians had terminated the license agreement due to the licensee’s alleged failure to pay royalties, among other alleged breaches. The licensee continued to exploit the license and sell products bearing the Kardashian trademarks, asserting, among other things, that “the Kardashians’ termination of the license agreement was invalid because the Kardashians breached the license agreement first . . . .”
The district court found for the Kardashians, holding, unremarkably, that a licensee has but two options when faced with a breach of the license agreement by the licensor: “First, the licensee can consider the contract terminated and stop performance. Second, the licensee can instead continue making royalty payments under the license agreement, continue using the trademarks, and then sue for damages. Regardless, the licensee cannot both stop paying royalties but nevertheless continue using the trademark.”
Although the options presented to a licensee by the district court decision are seemingly reasonable, they can present real risk to the licensee. For example, if the licensee had made significant investments and engaged a large staff to support the licensed business, terminating the agreement and closing down the licensed business not only will put any number of people out of work without advance notice, but also may result in defaults under the licensee’s banking arrangements and the loss of its entire business, thus giving rise to consequential damages potentially far in excess of any award for actual damages to which the licensee may be found to be entitled. Under the district court decision, the licensee’s option in these circumstances would be to continue the licensed business and bring an action against the licensor for damages, with the attendant relationship issues potentially adversely affecting performance, while continuing to make royalty payments with no guaranty that the licensee’s damages can be recouped, even after years of expensive litigation.
There is another quite unremarkable statement in the decision, which, although not in any way undercutting the ruling, may give some guidance as to how a licensee may attempt to protect itself in circumstances like those that the Kardashian licensee alleged it was facing. The court wrote, “like all contracts, trademark license agreements are governed by general principals of contract law.”
Among the most wonderful aspects of our contract laws is that the parties can, in effect and with few limitations, create their own law as to their rights and obligations under almost any circumstances. Accordingly, a licensee familiar with the Kardashian case might look to create a contractual structure whereby it would not have to pay royalties in the event of a significant breach by the licensor or, more realistically, a contractual structure by which it would not have to chase the licensor, at great expense, to recoup royalty payments in order to continue to exploit a generally valuable license agreement.
It is not uncommon to see license agreements in which the licensor has included a right for the licensor to set off amounts due and owing to it by a licensee against any outstanding payment obligations it may have to the licensee. However, even if a licensor would be willing to make this provision bilateral, these provisions are objectively problematic because they cannot be reliably drafted to prevent with certainty a party from merely alleging that the other owes it money in order to trigger the clause (unless, of course, a claimant party is required first to obtain a final judgment as to the amount allegedly owed, which brings us back to the problems with option number two). A better and more objective protection would be to allow the licensee to put its payments of royalties into escrow, with an obligation to take some formal legal action in accordance with the license agreement’s arbitration or litigation provisions before, or reasonably soon after, it notifies the licensor that the escrow account has been established. Assuming that the licensee establishes in the proceeding that it is entitled to damages, the escrow fund, even if less than the damage award, will be available to be applied toward the satisfaction of the judgment. It also is possible that establishing an escrow account and making payments into the escrow account will help relieve at least some of the tensions arising from awkward efforts to work together while the parties are adversaries in court or in an arbitration and perhaps even salvage the relationship after the legal action has ended.
Credit: Jonathan R. Tillem
Companies often place their trademarks in a separate subsidiary or affiliated company. And then, sometimes, rather than being the direct “licensor” of the trademarks, the owner will enter into a master license with another subsidiary or affiliate. Use of a master licensor/licensee structure is appropriate from an operational perspective if the sole business of the trademark owner is to own the trademarks, since it therefore would be unable to provide the services normally required of the “licensor” under any of the various license agreements it hopes will be consummated.
Just as a licensor should require representations from a guarantor of its licensee’s obligations and should seek to bind the guarantor to many of the restrictions imposed on the licensee, sometimes parties receiving licenses (technically, sublicenses) from master licensees will think to ask for various representations from the master licensor/trademark owner, such as those relating to the rights and authority of the master licensee, to the absence of grants of conflicting rights to any third parties, etc., and some of these sublicensees will think to bind the trademark owner to some of the restrictions imposed on the master licensee under the sublicense agreement, particularly in regard to honoring whatever exclusivity rights may have been granted to the sublicensee. But most sublicensees will not think to protect themselves against the potentially adverse effects of changes in the master license agreement itself. For example, if for some reason the master license is terminated during the term of the sublicense agreement, the trademark owner should be bound to substitute itself or a successor master licensee as the (sub)licensor under the (sub)license agreement. And similarly, the customary “binding on successors and assigns” provision of the sublicense agreement should be expanded so that, if ownership of the trademarks is transferred during the term of the sublicense agreement, it is clear that the sublicense agreement is binding on the new trademark owner; and it would not hurt also to bind the trademark owner to be required to cause the new trademark owner to agree that it (or its master licensee) automatically will be substituted as the (sub)licensor under the (sub)license agreement upon the closing of the transfer of the trademarks.
Credit: Jonathan R. Tillem
During the course of negotiating a license agreement, a licensee may propose certain changes that may appear logical and reasonable. However, a licensor should be on the lookout for seemingly innocuous proposals that could impede its ability to operate its business.
- “I need a longer sell-off period after termination and the types of customers to which I can sell during the sell-off period [e.g., only closeout accounts] is too limiting.” Agreeing to these requests may not be problematic if no new licensee is in place, but the license agreement must contemplate the possibility that there may be a new licensee; and extended and extensive sell-off rights may make it more difficult to conclude a new license and may increase the pressure to give financial and other concessions to the new licensee. (In a later post, we will discuss the substance of sell-off provisions, including circumstances of termination that could result in a bar to a sell-off beyond the date of a termination of the license agreement.)
- How much time does a licensee actually need, particularly considering that, for a seasonal business with a typical December 31 contract year/term end, sell-off actually could be starting as early as September?
- While selling off prior seasons’ inventory should not seriously compete with a new licensee’s business and while closeout accounts may be the only meaningful customers for closeouts, it cannot be good for the licensor’s brand or the new licensee’s business if the former licensee’s products, whether or not they include “basics,” are being offered to the new licensee’s regular customers at the same time that the new licensee’s business is being launched.
- “I would like an option to renew the license agreement.” While renewal options are quite common, and sometimes may even be offered by a licensor, accepting some common licensee complaints can have unintended consequences.
- “The date by which I have to exercise the option is too early.” Depending on the length of the term, this could be a fair point, but a licensor must keep in mind that, if the option is not exercised, it will need time to locate, negotiate with and conclude an agreement with a new licensee and the new licensee will need time to develop its initial collection, which, for a seasonal business, will have to go to market well before the end of the current licensee’s agreement. (In a later post, we will discuss the need for provisions in an exclusive license allowing the licensor to engage a new licensee during the term and the new licensee to start business before the end of the term.)
- “The conditions for renewal are not objective.” As noted in an earlier post, a licensee will want only objective standards when it comes to the conditions it will have to satisfy in order to exercise its option. However, is it unreasonable for a licensor to be able stop doing business with a licensee that, while not technically having defaulted in its obligations, has been a terrible partner and exceedingly difficult to deal with?
- “I would like a right of first refusal for additional products or countries or trademarks.” A right of first refusal, in effect, requires the licensor to make a deal with a prospective third party licensee and then offer the current licensee the right to match it. There is not much chance that a prospective licensee will be willing to devote the time and expense of negotiating a license agreement in these circumstances. If pressed, giving the existing licensee a first right to try to make a deal with the licensor – a right of first negotiation – is a better, and reasonable, alternative.
- “I want more countries in my licensed territory.” If a prospective licensee can demonstrate the wherewithal to properly exploit the proposed additional countries, the inclusion of the additional countries is often just a question of business judgment. (There may, however, be legal considerations to be addressed in the license agreement depending on the status of the licensor’s trademark rights in the additional countries.) If additional countries are included, though, a licensor should retain the right to take back countries that the licensee does not exploit adequately; and any such reversion right must be carefully drafted, particularly to take into account that getting back a few countries in a region may not be of any real value to the licensor. (What potential new licensee is going to be interested in a license for a few scattered Asian or European countries if the existing licensee retains the major markets in the region?) A possible compromise here might allow the licensee to keep the entire region if it is appropriately exploiting the major markets in the region, but to lose the entire region if it is not.
Credit: Jonathan R. Tillem
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Lately, I have been seeing some licensor counsel sending out first drafts of license agreements as PDFs rather than in Microsoft Word. Putting aside that it is getting easier and easier to covert PDFs accurately into Word, I must ask why. Are they seeking to avoid getting back a markup of their draft? Again, I must ask why. Do they really prefer the good old days when the licensee’s lawyer would send back a 50+ paragraph memo of comments to be followed by hours upon hours of give and take negotiations just to get to round 2?
To me, it is unquestionable that sending or receiving a track change or compare copy saves a tremendous amount of time (and psychic energy) in and within the process of documenting a license, particularly with experienced parties and counsel. (Note to sender – if you do a compare copy, send along a clean copy of the revised draft!) It takes me far less time to do even an overly comprehensive markup than it would to describe all of my proposed changes, with the associated reasoning, in a memo of comments (and this does not even factor in the time saved by effectively eliminating the first round of “live” negotiations). Similarly, as licensor counsel, much less time is involved in reviewing a markup and incorporating the acceptable changes into the draft than in talking through the comments with opposing counsel and then redrafting. Much gamesmanship is eliminated and the truly open issues are set; and, frankly, I have found that, at this point in the process, both lawyers tend not to revisit most items that, in a practical sense, are inconsequential and to focus on resolving larger issues and moving toward consummation. Sort of like seeing the forest!
Credit: Jonathan R. Tillem
When reviewing a license agreement, be on the lookout for provisions, whether boldly set forth in the “Default/Termination” section or sitting innocuously in the body of the agreement, that inappropriately (from the licensee’s perspective) may create potentially uncurable defaults or otherwise end the agreement. Some examples:
- “Licensee shall ensure that if (a contractor or a distributor or a retailer, etc. does/does not …..).” Although a licensee should be responsible for damages to its licensor caused by a third party with which the licensee chooses to deal, should it be subject to termination if one of these third parties fails to act properly? Yet “shall ensure” means that, if the third party acts in a way that violates the license agreement requirements, an uncurable default has occurred. Go for “seek to ensure” or, better, no termination for third party acts if the licensee stops dealing with the offending third party (unless the licensee was aware/involved).
- “Licensee may renew the license agreement if (among other things) it has maintained a performance standard acceptable to Licensor throughout the initial term.” Such a subjective standard could make the option illusory. If a licensor offers an option to renew, generally any conditions should be objective.
- “Licensor may terminate the license agreement if Net Sales on account of sales of Licensed Products to Closeout Accounts during a Contract Year are more than X% of all Net Sales during that Year.” Licensors do not want the licensed business to evolve into a special make-up/closeout account business so, hence, they propose termination as a disincentive. Good reason, but a bit heavy-handed, so long as the licensee doesn’t make a habit of it. (Assuming an 8% royalty rate, it is fair to say that a licensee is not closing out the Licensed Products at substantial discounts to cheat the licensor out of its 8% royalty on the discounted amount, while eating the other 92% itself.)
- “Licensor may terminate the license agreement if there are more than some number of late payments within a Contract Year or even within a period of months (even if no default notices have been sent).” Surely the licensor must have recourse if payments are habitually very late or, more clearly, if a licensee were to keep forcing a licensor to send out notices of default before curing payment defaults, but the words here also would cover a few payments arriving within a few days after they are due. I know – “no licensor would try to terminate” or “no arbiter would side with the licensor” in such a seemingly extreme case, but a line has been drawn in the license agreement. For a remedy as draconian as termination, something more should be required. While not perfect, a “no harm, no foul” window and a notice requirement would serve fairness.
Credit: Jonathan R. Tillem
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When reviewing a proposed license agreement that has been submitted by a potential licensor, Be On The Lookout for provisions that can artificially or inadvertently act to, in effect, increase the royalty rate. Some examples:
- Gross Sales based on the wholesale or list prices rather than the actual invoice price. Is the top line on your invoice always list?
- Unreasonably low caps on deductions permitted in calculating Net Sales. Some caps can be defensible but, if your historical rate of “discounts, allowances and returns” is higher than the cap …
- Quarterly caps on deductions. Some quarters will have disproportionately higher shipments and the others will have disproportionately higher returns. Any cap should be based on annual sales and deductions.
- Quarterly payments of earned royalty in excess of the quarterly minimums. If, as is common, minimum royalties will be paid quarterly in advance and if earned royalties are calculated and paid quarterly as well, the quarterly payments of earned royalty should be computed on the basis of Net Sales during the entire year through the end of the most recently completed quarter, with a credit for all minimum royalties and earned royalty previously paid for that year. (For belt and suspenders aficionados: While the formula accurately reflects the customary agreement of the parties, to avoid all possible confusion, some licensee lawyers will also request a provision to the effect that, at the end of the day, the aggregate royalty due for each year will be the higher of (a) the minimum royalty for the year and (b) the earned royalty that accrues on Net Sales during the year.)
- A chargeback is not an allowance (and, therefore, even though the license agreement may permit deductions for allowances in calculating Net Sales, a chargeback would not be deductible unless the license agreement says it is). The lesson is that a licensee must make sure that it understands all aspects of the definition of Net Sales and that the agreement allows it to deduct all items that it would expect to be deductible. Historically, auditors claiming significant underpayments of royalties are more likely to point to improper deductions than to underreported sales.
Credit: Jonathan R. Tillem
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