Considerations in Drafting Settlement and License Agreements—Part I

By Paul Morico

Previously published in the February issue of Intellectual and Technology Journal

As any (IP) attorney who has practiced for a number of years knows, drafting settlement and license agreements takes some skill. Most outside counsel do not have a lot of experience drafting such agreements, and even many in-house counsels only draft such agreements periodically. For those who have drafted more than a few such agreements, you know that it takes a lot of patience and, most importantly, requires great attention to detail. There are many provisions that need to be covered in these types of agreements, but equally important to making sure that all of the “bases are covered” is making sure that each of the clauses are comprehensive. The reason it is important for such agreements to be so comprehensive is that the goal of both types of agreements is to avoid future litigation. In some sense, pre-litigation license agreements can be thought of as a pre-nuptial agreement. In the case of a settlement agreement, the parties already have been in litigation and the goal is to keep the parties from going back to litigation.

Because many IP settlement agreements contain many of the same terms found in a license agreement and because settlement agreements have some unique aspects to them, the first part of this article focuses initially on license agreements. The second part of this article, which will appear in an upcoming issue of the Intellectual Property & Technology Journal, will address issues unique to settlement agreements. This article attempts to cover all of the major provisions in such agreements, but also some of the nuances in many of the key provisions. Much as most other aspects of practicing law, a great deal of our knowledge and wisdom is shaped by our experiences and this article naturally is confined to my limited personal experience.

The Grant Clause

Perhaps the most important provision of any IP license or settlement agreement is the grant clause. This is the clause where the IP rights are transferred from the grantor or licensor to the granteeor licensee.1 These clauses are the ones most often fought over by the parties. The tension that typically exists is that the licensor wants to retain as many of its underlying rights as possible while the licensee wishes to obtain as many of those rights as possible. The main question that needs to be asked by the licensor is whether licensor wishes to retain any of these rights for itself and whether it also wants to retain additional rights to license to other parties. Thus, the threshold question the parties typically face is will the license be exclusive, sole, or non-exclusive? A purely exclusive license grants all rights (except ) to the licensee, whereas a sole license allows the licensor to retain rights for itself to practice the invention. A non-exclusive license in contrast permits the licensor to grant rights to other licensees.

Even these various ways of dividing up rights, however, can be further parsed. For example, the licensor can grant the licensee an exclusive or sole license in a particular field of use and either no license at all or a non-exclusive license in other fields of

Austin Beijing Brussels Dallas Dubai Hong Kong Houston London Moscow New York Palo Alto Riyadh San Francisco Washington bakerbotts.com | Confidential | © 2016 Baker Botts L.L.P. use. For example, the owner of a to a certain Web site tool (assuming such a patent were valid these days under the Supreme Court’s decision in the Alice case) could grant an exclusive license to that tool for use in advertising vehicles only to a particular car company but then carve out other uses of the tool, for example, by other types of retailers. When parsing rights among different fields of use, it is critical to make sure that there is no overlap between such fields of use. That can lead to competing interests in the IP rights being licensed.

In order to illustrate other issues to take into account in dealing with grant clauses, let’s look ata sample clause:

Licensor hereby grants to Licensee and its Affiliates a perpetual, nonexclusive, royalty bearing (as provided in Article 3 below),non-transferable (except as provided below),irrevocable (such irrevocability subject only to Articles 4 and 5 and paragraph 6.1 below)license under the Licensed to make, have made, use, off er to sell, sell, import and export Products coming within the scope of any claim in any of the Licensed Patents (the Licensed Products) anywhere in the world.

As illustrated in this clause above, another term affecting scope in addition to exclusivity or field of use is territory. Will the license be worldwide, limited to the United States, or some other limited territory? One question the licensee should ask itselfis does it really need a worldwide license? It maybe that the licensor only has limited rights outside the United States or the licensee has no aspirations to expand outside a limited territory and thus does not need a license beyond a certain territory. The counter vailing consideration, however, is that often the cost for making the license worldwide is not any more or only nominally more at the time the license is being granted, whereas it may be much more costly at a later date.

Transferability is another major term of the grant clause. Does the licensor want the licensee to have the ability to sell or license its rights under the agreement to a third party? This provision can become particularly sensitive when the IP right sat issue are . The law requires that the holder police the quality of its mark. If the licensor is going to let the licensee grant third parties rights to their mark, the licensor will need to either police that third parties use of the mark directly or put into place certain standards and reporting required of the licensee. This can become quite cumbersome to manage. Transferability is sometimes less of a concern when the IP rights at issue are patents, especially when the licensor is not in the business and merely trying to extract value from its investment in the . Because of issues of moral rights and often an author’s desire to control the integrity of his or her work, copyright scan be similar to trademarks when it comes to the licensor’s willingness to allow the licensee to transfer those rights to third parties. Often, it is the licensee who needs to think hard about whether it needs the right to transfer rights to third parties. Frequently the licensee may not have the capacity or capability to manufacture the entirety of a product being licensed and thus may need the assistance of third parties in manufacturing the products at issue. In those scenarios, the licensee will want to insist on the ability to transfer the IP rights to third parties. The licensee will at the very least want to be granted “have made” rights so that it can have third parties manufacture all or part of the products at issue. This is an area in which the licensor may wish to exert some oversight.

One consideration concerning transferability that the licensor will need to watch out for is exhaustion. Is the right’s holder getting paid for the IP rights transferred? On the other side of the equation, are the licensee and/or sub-licensee paying twice for the rights transferred? Some thought needs to go into this question. The licensee/sub-licensee should not have to pay twice for the IP rights being granted, yet the licensor should at least get its fair share.

This issue was presented in Quanta Computer ,Inc. v. LG Electronics, Inc.2 In that case, the plaintiff, LG Electronics, owned three patents covering computer systems, including components and methods. LG had licensed these three patents to Intel. Under the license, Intel was permitted to manufacture and sell microprocessors and chipsets covered by the LG patents. The license contained a non-transferability clause, however, prohibiting third parties from combining the licensed products with components from another source.

BAKER BOTTS Quanta was a computer manufacturer that purchased microprocessors and chipsets from Intel.

Quanta combined the Intel products with non-Intel components to make computers that practiced LG’s patents. LG then sued Quanta for . The district court denied summary judgment, holding that the patent exhaustion doctrine did not apply to method claims, and therefore ,did not apply to LG’s patents because they contained method claims. The U.S. Court of Appeals for the Federal Circuit affirmed the district court’s decision holding that the patent exhaustion doctrine did not apply to method claims. Quanta then appealed to the U.S. Supreme Court.

On appeal, LG argued that the patent exhaustion doctrine should not apply to method claims because method patents are not connected to a product and cannot be exhausted by the sale of a product. Quanta argued that courts previously have applied the doctrine to method claims, and that, if the doctrine is not applied to method claims, patent owners could avoid the doctrine by including method claims in their patents.

The Supreme Court sided with Quanta holding that even though methods are not sold in the way that a product is, “methods may be embodied in a product, the sale of which exhausts patent rights.”3 The Supreme Court concluded:

The authorized sale of an article that substantially embodies a patent exhausts the patent holder’s rights and prevents the patent holder from invoking patent law control post sale use of the article. Here, LGE licensed Intel to practice any of its patents and to sell products practicing those patents. Intel’s microprocessors and chipsets substantially embodied the LGE Patents because they had no reasonable non-infringing use and included all the inventive aspects of the patented methods. Nothing in the License Agreement limited Intel’s ability to sell its products practicing the LGE Patents. Intel’s authorized sale to Quanta thus took its products outside the scope of the patent monopoly, and as a result, LGE can no longer assert its patent rights against Quanta. Accordingly, the judgment of the Court of Appeals is reversed.4

Thus, even though the agreement precluded transferability of the licensed patent rights, the doctrine of patent exhaustion applied. What was left as an open question, however, is the issue raised by the highlighted text above. The Supreme Court seems to suggest that LG could have dealt with the issue by precluding Intel from selling its products to certain entities, presumably computer manufacturers. As a practical matter, however, the license would have had no value to Intel and it likely would never have entered into the agreement on those terms in the first place.

The issue of international copyright exhaustion subsequently was addressed in the Supreme Court’s decision in Kirtsaeng v. John Wiley & Sons,Inc.5 The U.S. Supreme Court ruled in that case that the exhaustion doctrine applied to copies of a copyrighted work lawfully made abroad. Supap Kirtsaeng, a Thai citizen studying at Cornell, purchased foreign editions of English-language textbooks in Thailand and resold them in the United States. He sold the books on eBay. He made approximately $1.2 million in revenue selling these books. The publisher, John Wiley & Sons, argued that these foreign- edition textbooks were only authorized for sale in Europe, Asia, Africa, and the Middle East. The publisher then sued Kirtsaeng for . Kirtsaeng defended his actions by relying on the Copyright Act’s first sale doctrine as codified in 17 U.S.C. § 109. The Supreme Court ruled, in a 6-3 vote, “the ‘first sale’ doctrine applies to copies of a copyrighted work lawfully made abroad.”6 The court reasoned that because the ’s copyright exhaustion doctrine did not have a geographical requirement, the statutory version should not have one either. Accordingly, once a copy made anywhere with the copyright owner’s permission is sold, the copyright owner’s exclusionary rights end.

The question has now been raised; will the principle of international exhaustion apply in the patent context? As of the writing of this article, the Federal Circuit had just heard oral arguments in an en banc consideration of this issue in the case Lexmark International Inc. v. Impression Prods. Inc.7 The Lexmark case involves the foreign sale by Lexmark of toner cartridges used in Lexmark’s printers. Lexmark’s customers have the option to either purchase new cartridges at full price without any use

BAKER BOTTS restrictions, or to purchase discounted, single-use cartridges under Lexmark’s “Return Program.” Once the toner is depleted, a customer agrees to return the cartridge to Lexmark for remanufacturing or recycling. Lexmark’s cartridges included a computer chip to detect unauthorized reuse. A number of third parties ,including foreign entities, hacked and replaced Lexmark’s computer chips and then sold knock-off cartridges under non-Lexmark labels. Lexmark sued these companies in the U.S. District Court for the Southern District of Ohio. Most of the defendants settled with Lexmark. Impression did not. It claimed that Lexmark’s patent rights were exhausted upon the first sale of the cartridges. The district court found that exhaustion did not apply and so did at hree judge panel of the Federal Circuit. The Federal Circuit sua sponte raised the issue en banc, suggesting that it may decide the issue another way. The question that the Federal Circuit asked the parties to brief is whether the Kirtsaeng decision should extend tothe Lexmark case. Many believe that this expanding of the Kirtsaeng decision in the patent context would overrule the court’s previous decision in 2001 in Jazz Photo v. International Trade Commission.8 The Lexmark case is likely to be decided by the time this article is published.

Regardless of how Lexmark may be decided, it is critical to give due consideration to the issue of exhaustion in drafting license agreements. Licensees should be particularly vigilant to make certain that the licensor/patent holder is not getting paid twice for licensing of their patent(s). It is advisable for the licensee to try to ascertain what other entities in the product stream may have been licensed by the licensor/patent holder.

Another term within the grant clause that is important to focus on is the revocability term. Can the license be revocable and if so under what conditions? Virtually every license agreement should be made revocable for non-payment. If the licensor is not getting paid for a license it should be able to revoke the license. The easiest way to do this is to make the license automatically terminate. In the case of a trademark or copyright license, the licensor also may want to make the license revo cable in the event that the licensee is not maintaining the quality of the trademark (in the case of the trademark) or is not using the copyright consistent with the author’s wishes (in the case of the copyright).These issues generally are less problematic in the case of patents though if the licensor is in the business of manufacturing the licensed product quality control may be of concern to the licensee and it may wish to make failure to maintain quality as a basis for revoking the patent. The more common terms for revoking a patent license are failure to mark and challenging the validity of licensed patents. Marking is important to the licensor because of it provides notice to the world that the patent is being employed. More importantly, however, is that failure to mark can limit the licensor’s ability to obtain damages at a later point in time.

As for provisions precluding the licensee from challenging the validity of the licensed patents, such provisions generally are unenforceable under the principle laid out in Lear v. Adkins9 and its progeny. The only recognized exceptions are in cases where the issue has been litigated and either there has been a final judgment of validity, a consent decree or dismissal with prejudice.10

Definitions

An often underappreciated section of the license agreement is the definitions section. Usually this is the section of the agreement that defines the Licensed Patent Rights (or more generally Licensed Intellectual Property Rights), the Licensed Products, the Field of Use, who is an affiliate and similar provisions.

The most critical definition typically is the Licensed Patent (IP) Right definition. This is often an issue of scope and sometimes is addressed or defined in the grant clause. The question here, at least in the patent context, is whether foreign equivalents should be included in the definition, continuations, divisionals, reissues, continuations-in part, and related patents and applications. It is not unreasonable to expect that continuations, divisionals and reissues be included. The more fundamental question is whether to include continuations-in-part and related patents and applications. The difficulty here is that many of these rights have yet to be created. Not only does that require the parties to have a crystal ball but it also may cause the

BAKER BOTTS license to extend on for many more years than the parties may have bargained for. A way of dealing with this issue is to limit the term of the agreement or make it renewable after certain periods of time with the ability of the parties to be able to renegotiate its terms, though that creates its own issues. The following is a sample of such a definition:

“Licensed Patents” means the ’123 Patent and any and all patents, foreign and U.S., existing or subsequently issuing from applications which include the application for the ’123Patent directly or indirectly in the priority chain, including any and all patents, foreign and U.S. existing or subsequently issuing from applications for continuations, divisionals, continuations-in- part, reexaminations, reissues ,extensions, or renewals of the ’123 Patent.

This clause does not include, however, patents issuing from applications upon which the ’123 Patent may claim priority. One consideration is whether to include such patents in the definition. It also doesn’t include future patents. An exemplary definition may read:

“Future Patents” means any patents including claims relating to flexible widgets, including without limitation, claims related to packing or packaging materials for flexible widgets, or the manufacture, packaging or use of flexible widgets or related packing or packaging materials (Flexible Widgets), issued to or owned by Licensor between the Effective Date and {termination}.

The Licensed Product and Field of Use definitions also can be critical definitions, especially as noted above where the licensor is in the business or the license grant is non-exclusive in any way. The issue here that often arises is product creep. Successful licensees may want to be able to expand the scope of products under which they are licensed or their fields of use. The tension here for the licensor is balancing the need to reward successful licensees by being able to expand their licenses but also at the same time having the flexibility to spread their risk among different licensees. Part of this exercise also involves use of a crystal ball. Another way to address unsuccessful licensees is to permit termination when the licensees do not meet certain milestones or royalty payments. It also can be addressed by setting certain minimum payments/royalties.

The issue of Affiliates and which Affiliates to include in the license often can be very tricky, especially when the licensee is a large company. There also is risk that the licensee acquires a competitor. The question then arises does the acquired company become licensed? This is an issue that the licensor will want to address up front otherwise they could end up giving up a lot of revenue especially in the case of lump sum or fixed royalty-free licenses. Typically, the licensor only will want to include existing related entities in the definition. As for future acquired entities, that can be handled a number of different ways. Licensees generally will want them included at least no more than at a proforma increased rate. The licensor, however, may want the ability to renegotiate the rate given that a sizable part of the market may be captured by a future merger.

The territory and term of the agreement generally are addressed in the definition section of the agreements. In more complex agreements, those terms have their own sections. Term provisions are discussed in greater detail below.

The Term

Parties rarely give the term of an agreement much thought. Usually, the term will either be until the end of the last to expire patent or it will be for a set period of time with the option to renew. Licensees generally will prefer the former, so long as the royalty terms are reasonable. Licensors sometimes will prefer the latter. The problem with discrete term licenses for the licensee is that unless the terms automatically renew, the licensee could be stuck in a situation where it has made significant investments in the product and once the license terminates if the IP rights have not expired then the licensee can have a real dilemma on its hands. On the other hand, if the term is pegged to the last to expire licensed patent, that could cause the agreement to continual most indefinitely. That particularly occurs when the licensed patents include related patents that may not be limited to those in a chain of priority with the primary patents being licensed.

BAKER BOTTS Another issue to watch out for in drafting the language of the term provision is making sure that the agreement does not extend beyond the term of the patents. That can create a patent misuse issue for the licensor. This principle recently was reaffirmed by the Supreme Court in Kimble v. Marvel Entertainment, LLC.11 In Kimble, the Supreme Court declined to overrule the 50-year old proposition set forth in Brulotte v. Thys Co.,12 that a patent license agreement requiring royalties for the period beyond the life of the licensed patent was unenforceable under the Supremacy Clause, state law notwithstanding, because it involved a misuse of patent rights. One way around this rule, however, may be to craft the royalties as being incurred during the life of the patent even though the payments are made beyond the term of the patent. In other words, the payments are in effect treated as loan payments overtime. Also, there is no prohibition against having the payments remain the same over the life of the agreement even though some of the patents expire during the term. Neither Kimble nor Brulotte appears to require that all patents be valued equally. This issue also maybe avoided by including know- how or other trade secrets in the license grant. However, under that scenario it probably would be difficult to charge the same royalty rate after the patents have expired.

Enforcement and Maintenance Provisions

Two other important clauses in license agreements are the enforcement and maintenance provisions. The enforcement provision sets forth who has the rights and obligations to enforce the IP rights against third-party infringers. Sometimes the licensor wishes to control enforcement of the IP rights, other times the licensor is willing to turn over that right or responsibility to the licensee. Typically ,when the license is exclusive the right of enforcement is turned over to the licensee. In many cases, especially where the licensor is not in the business, the licensee has a great interest in enforcing the IP rights. It is important, however, when setting forth the rights and responsibilities of the parties concerning enforcement of the IP rights who will pay for the enforcement and who will share in the spoils of any successful enforcement action. Generally, the party granted the right to enforce the IP rights has to pay for the costs associated with enforcing the rights. In the case of the licensee, that may include the costs associated with joining the licensor into the lawsuit, for example, where licensor’s joinder is required for the licensee to have standing to sue the third party. Courts generally hold that an exclusive licensee has standing for infringement, provided that it joins the patent owner/licensor.13 It is not uncommon for the party paying the costs for enforcement to keep all or most of the proceeds from any successful litigation. Just as any other contractual provision it comes down to what the parties are willing to accept.

Who will pay for the maintenance of the IP rights and who has control over the filing and prosecution of those rights is also sometimes a point of contention. It is important that this issue is addressed up front in the agreement otherwise one or both parties may end up in a situation where they did not get what they thought they bargained for in the agreement. Many times, the costs for filing, prosecution, and maintaining the IP rights can be quite expensive. In some cases it can exceed the money paid under the license agreement. Thus, licensors need to be careful what they agree to here.

Likewise, the licensee has an interest in making certain that his or her market is protected and that the IP rights are obtained and maintained. It is not uncommon to have the agreement account for the changing circumstances and marketplace by allowing the burdens and responsibilities of paying for the IP rights to shift under the agreement. For example, it is common to include a provisio that allows for the licensor to pay for the obtaining and maintaining of the IP rights but if the licensor declines to do so the licensee is then provided with that right. That type of “shifting right” or responsibility also is used in enforcement clauses. That is, the licensor may initially be granted the right to enforce the IP rights against third parties ,but if the licensor declines to do so, then the licensee may step in and do so.

BAKER BOTTS Covenants Not to Sue

Many settlement agreements and some license agreements will include a not to sue in lieu of a license. There is some danger in using a covenant not to sue in place of a license. There are some differences between the two provisions, even though often they are treated the same.14 The Federal Circuit has noted that a license that grants to the licensee some of the proprietary rights of a patent, such as in an exclusive license, “does more than provide a covenant not to sue, that is, a ‘bare’ license.”15 Thus, a covenant not to sue is at most akin to a non-exclusive license. As a consequence, a patent licensee can grant a third party a covenant not to sue, but absent the right to sublicense, likely cannot grant a sublicense.16 There also are some limits placed on covenants not to sue by some courts when it comes to pending patent applications, and thus there are some circumstances where a covenant not to sue may be of even more limited use. At least one court has held that a covenant not to sue cannot be granted on a pending patent application on the theory that you cannot agree not to sue a party on a right that does not yet exist.17

Therefore, a license almost always is preferred over a covenant not to sue. However, there are some cases in which the parties only will be able to agree on a covenant not to sue. For example, because covenants not to sue are more limited, that may be all the grantor/IP owner is willing to grant. In other instances, the grantor may have no other rights to grant. It is important in entering into such agreements or using such clauses that the parties fully understand the limits of such provisions. As illustrated herein, covenants not to sue should never be used as a substitute for a license, especially when a license is what the parties want conveyed. Finally, covenants not to sue are generally not transferrable.

Thus, if the parties want the IP rights/freedom from suit to be transferable to a third parties, they would be well advised to use a license rather than a covenant not to sue.

There are some cases where all the parties will be able to agree upon is a covenant not to sue. Indeed, there are instances where the grantor has no other rights to grant. It is important in entering into such agreements or using such clauses that the parties understand the limits of such clauses. As illustrated herein, covenants not to sue should never be used as a substitute for a license unless the parties have no other choice.

Notes 1. For ease of reference, the grantor or licensor will be referred to as simply the licensor as in most cases the grantor is a licensor and the grantee as the licensee. 2. Quanta Computer, Inc. v. LG Electronics, Inc., 170 L. Ed. 2d 996 (2008). 3. Id. at 1005. 4. Id. at 1011 (emphasis added). 5. Kirtsaeng v. John Wiley & Sons, Inc., 133 S. Ct. 1351 (2012). 6. Id. at 1355-1356. 7. Lexmark Int’l Inc. v. Impression Prods. Inc., 2014-1617, 2014-1619 (September 24, 2015). 8. Jazz Photo v. Int’l Trade Comm’n, 264 F.3d 1094 (Fed. Cir. 2001). 9. Lear v. Adkins, 395 U.S. 653 (1969). 10. See Rates Tech, Inc. v. Speakeasy, 685 F.3d 163, 169 (2d Cir. 2012); Wallace Clark & Co. v. Acheson Indus. Inc., 532 F.2d 846, 849 (2d Cir. 1976), Am Equip. Corp. v.

BAKER BOTTS Wikomi Mfg. Co., 630 F.2d 544, 547-548 (7th Cir. 1980); Schegel Mfg. Co. v. USM Corp., 525 F.2d 775, 780-781 (6th Cir. 1975); and Flex-Foot, Inc. v. CRP, Inc., 238 F.3d 1362, 1367-68 (Fed. Cir. 2001) (finding that although a dismissal with prejudice did not rise to level of collateral estoppel, the settlement agreement nonetheless created a contractual estoppel). 11. Kimble v. Marvel Entertainment, LLC, 575 U.S. __, 135 S. Ct. 2401 (2015). 12. Brulotte v. Thys Co., 379 U.S. 29 (1964). 13. Independent Wireless Tel. Co. v. Radio Corp. of Am., 269 U.S. 459, 468 (1926). (“The presence of the owner of the patent as a party is indispensable not only to give jurisdiction under the patent but also, in most cases, to enable the alleged infringer to respond in one action to all claims of infringement for his act, and thus either to defeat all claims in the one action, or by satisfying one adverse decree to bar all subsequent actions”). 14. See generally, Marc Malooley, “Patent Licenses Versus Covenants No to Sue: What Are the Consequences?,” http://www. b r o o k s k u s h m a n . c o m / w p - c o n t e n t / uploads/2015/06/131.pdf (2015). 15. Id. at 1 (citing Ortho Pharm. v. Genetics Inst., Inc., 52 F.3d 1026 (Fed. Cir. 1995)). 16. Id. 17. Id. at 1-2 (citing 3M Innovative Co. v. Barton Nelson, Inc., 2003 WL 229890077 at *2 (D. Minn)).

BAKER BOTTS