Article: April 2014 EU Litigation Update

License Agreements Under Scrutiny—A New Challenge for Non-Challenge Clauses. In general, license agreements are deemed pro-competitive. Licensing leads to the dissemination of technology and promotes (follow on) innovation (cf. European Commission Regulation on Technology Transfer Agreements of 27 April 2004, para 5). Furthermore, if third-party technology can be licensed, research and development expenditures can be used more efficiently. Finally, commercializing goods via licensing is one of the key privileges of any intellectual property right. It is the very essence of an exclusive right, such as patents and copyrights, to permit the use of that property by others in exchange for consideration. As is also true for property in physical objects, however, the execution of this exclusive right is subject to restrictions set by competition law.

Recently, a growing number of provisions regularly found in license agreements have attracted the special attention of Europe’s competition authority, in particular provisions prohibiting the licensee from challenging the validity of the licensed intellectual property right. From a competition law perspective, invalid intellectual property rights may have anti-competitive effects to the extent that the access to (invalidly) protected technology is unjustly limited. The fear is that unjustified monopolization of a specific technology may result in undue royalty payments, ultimately harming competition. Any serious competitive analysis has to acknowledge the uncertainties that parties negotiating intellectual property licenses encounter with regard to the validity of intellectual property rights. In fact, parties will typically only know after litigation that an intellectual property right is considered valid by the courts. Before litigation, parties will only be able to make probability judgments in this regard. These probability judgments may change in the course of negotiations or even litigation, depending on the quality of prior art or other invalidity evidence the counterparty relies on.

In its revised set of rules governing the antitrust implications of license agreements—the Technology Transfer Block Exemption Regulation or TTBR—the European Commission promulgates a strict stance against restrictions that challenge the validity of intellectual property rights. This revised regulation, replacing the earlier TTBR dated 27 April 2004, is planned to become effective as of 1 May 2014. As was the case with its predecessor, the revised regulation provides a framework for assessing whether technology licensing agreements violate Article 101—the provision dealing with anti-competitive agreements—of the Treaty on the Functioning of the European Union (TFEU).

Still in line with its predecessor, the revised TTBR excludes non-challenge clauses from the safe harbor (Article 5 Nr. 1 b). Pursuant to a non-challenge clause, a licensee is prohibited from challenging the validity of the licensed intellectual property (e.g., by filing a nullity complaint). The practical purpose of such provisions is to gain patent peace between the parties. The parties agree to consider the licensed intellectual property as (bilaterally) valid, thus gaining certainty with regard to their mutual obligations and ensuring that no litigation will be initiated by either party to question the essence of the agreement (i.e., the legal existence of the licensed intellectual property).

However, such a non-challenge clause does not benefit from the safe harbor established by the TTBR. The underlying rationale, as described in the Commission’s revised guidelines (para. 123), is a stipulated public interest in eliminating invalid intellectual property rights. “Invalid intellectual property stifles innovation rather than promoting it.” Since the licensees would in many cases be best placed to determine the validity of the intellectual property right, they should not be excluded from bringing validity challenges before the competent courts. Consequently, the Commission considers (costly) litigation between private entities that could result in the elimination of a potentially invalid intellectual property right to be beneficial to the market in general, even if the intellectual property right had been awarded by a public authority in the first place (such as patents or registered design rights). This is close to being at odds with the presumption that patents are valid because of the thorough analysis conducted by the patent office during prosecution.

Going even further, the Commission intends to exclude provisions from the scope of the TTBR’s safe harbor that stipulate a right to terminate a license agreement if the licensee challenges the validity of the licensed intellectual property (Article 5 Nr. 1 b of revised TTBR). Again, it is the stipulated public interest in using the licensee as a “litigation vehicle” to challenge potentially invalid intellectual property rights that is put forward as justification. According to the Commission, termination rights can have the same effect as a non-challenge clause, in particular where the licensee has already incurred significant sunk costs for the production of the contract products or is already producing the contract products (revised guidelines, para. 125). Potentially, licensees may be deterred from challenging the validity of the licensed intellectual property as they would risk termination of the license agreement. However, if the licensees consider their invalidity arguments to be convincing, why should they then fear termination of the license agreement?

Any competitive analysis of non-challenge clauses has to take account of the practical purpose of license agreements. License agreements grant a licensee the right to use a specific technology. Superficially, this transfer will only make sense to the extent that the licensor has any rights to grant, i.e., the licensed intellectual property is valid. Also, the licensee will only be interested in licensing a patent if the licensee actually uses (or intends to use) the patented technology. Thus, from a superficial perspective, it seems that validity and infringement of the licensed patent are the basis of any license agreement. Although this conclusion may be persuasive in concept, it falls short both of practical requirements and the very doctrinal nature of license agreements. In fact, parties to a licensing negotiation will hardly ever be certain as to infringement and validity of the respective intellectual property rights. Unlike in a litigation context, the outcome of a licensing negotiation will not likely involve an agreement between the licensor and licensee either that an intellectual property right is infringed and valid or non-infringed and invalid.

The reason for this is simple. When analyzing the technical value of a patent, parties to a negotiation predict the outcome of a hypothetical litigation. However, predictions can never be certain—not only against the backdrop of possible value judgments by lay or professional judges but also because of prior art that the prospective licensee may have up its sleeve. In fact, any intellectual property right granted by public authorities, in particular patents, are only presumably valid. This entails the possibility of the patent being invalid. The probability judgments regarding validity and invalidity are subject to dynamics of negotiations and litigation proceedings. For instance, once validity has been confirmed by a neutral third party (i.e., a court), the probability is usually perceived as being higher than at the beginning of the negotiations.

Both parties to a licensing negotiation are thus faced with uncertainties as to the outcome of hypothetical litigation proceedings. It is a business decision whether a party wishes to endure these uncertainties. If it does, litigation is the route to go. If it does not, it is a license agreement that will create certainty. The licensee is certain not to infringe the respective intellectual property right and the licensor is certain to obtain the payment of royalties. Needless to say that this is a trade-off for both parties, depending on the respective probabilities of winning in court. Consequently, uncertainties are usually priced into the royalty rate or other consideration agreed to by the parties. A license agreement, therefore, results from bargaining based on probabilities. The same is true for settlement agreements, where parties to litigation proceedings bargain based on the perceived probabilities of losing or winning the case.

Challenging the validity of the intellectual property right after the license agreement has been concluded throws the parties’ bargaining give-and-take out of balance. The licensee claims both the chances of defeating the licensor in court and the certainty of having a right to use the technology at the same time—a classic case of having one’s cake and eating it too. Consequently, many license agreements include a termination clause for exactly these reasons. If the licensee chooses to litigate (i.e., challenge the patent), the licensor should have the mirror opportunity (i.e., to seek damages exceeding the royalty rate or to obtain a cease and desist order). There is hardly anything anti-competitive about such a provision. It is a fair balance of interests on which parties might choose to agree. And, it prevents the licensee from obtaining the benefits of the parties’ respective bargaining based on probabilities and then later challenging the basis of the parties’ probability judgments.

Somewhat surprisingly, but ultimately correctly, the Commission seems to share this view when it comes to settlement agreements. The Commission states in its revised guidelines (para. 226):

“In the context of a bona-fide settlement agreement, non-challenge clauses are generally considered to fall outside Article 101(1). It is inherent in such agreements that the parties agree not to challenge ex post the intellectual property rights which were the centre of the dispute. Indeed, the very purpose of the agreement is to settle existing disputes and/or to avoid future disputes.”

The Commission is correct in noting that one of the fundamental purposes of settlements is to avoid future disputes. Accordingly, even the Commission assumes that agreements ending a dispute are not anti-competitive, even if they include a non-challenge clause. But why should sophisticated parties wait until litigation is actually pending before being allowed to conclude an agreement that would efficiently avoid future disputes? There is no practical difference between a settlement agreement ending litigation and a license agreement entered into to avoid litigation in the first instance. In both situations, the parties anticipate their respective risks and chances of winning the already pending or anticipated proceedings.

The discussion about non-challenge clauses is clearly not at an end. Ultimately, the Court of Justice of the European Union will have to decide questions regarding the scope and validity of such clauses. Until then, it is critically important to evaluate potential competition law issues involving non-challenge clauses when negotiating intellectual property license agreements.