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The Hardest Part of a License to Negotiate:
Diligence Obligations Part 3
Part 1 looked at what diligence obligations are and why they are important. It also dealt with the implications to a licensor of overlooking or not securing diligence obligations if its licensee turned out to underperform or be idle. Mostly, it dealt with strategies to consider employing to successfully negotiate this hard issue, as well as some strategies that do not work and should be avoided.
In Part 2 examples and models of diligence obligations were described for licensing an early stage technology, a more mature technology, and a pharmaceutical technology. It also contained links to online publicly available licenses where some of these models and examples were employed.
This Part 3 concludes this series by considering the termination of a license for a licensee’s failure to meet diligence obligations. It describes four termination models, and what factors influence selecting one over the others on different occasions.
Why is termination necessary?
The point of diligence obligations is to protect a licensor from an underperforming or idle licensee that is not adequately commercialising.
Inadequate commercialisation, or no commercialisation at all means that a licensor is receiving little royalties, or even no royalties.
A licensor wants its licensee to be diligent, to maximise the commercialisation opportunity, and to maximise the financial return from the license.
If the licensee is not diligent and is not maximising the financial return to the licensor, a licensor can either do nothing and allow that to continue, or it can seek out another licensee that does have the capability to maximise the commercialisation opportunity, and to maximise the financial return from the license.
To grant an exclusive license to such an alternative licensee, the licensor must first terminate the license of the underperforming or idle first licensee.
Model 1 – immediate termination
In this model a licensor immediately terminates the license if the licensee fails to achieve a commercialisation milestone (see Part 2) by its due date. An “events of default” provision in a license is an example of this model.
This model might be considered for a commercialisation milestone that is on the short term horizon. An example is a milestone that the licensee enter into an agreement within 3 months of the date of the license for toxicology studies to be undertaken. Another example is that the licensee file an application for a regulatory approval within 3 months of the date of the license.
It is the certainty of the achievement of the milestone in the short term that makes this model one that may fairly be considered.
For other types of milestones, such as development, regulatory or clinical milestones, where there is uncertainty about the time for their achievement, this model would be considered draconian, and it would be very difficult to negotiate.
Model 2 – termination after notice to remedy
In this model the failure to achieve a commercialisation milestone by its due date is grounds to issue a notice to remedy, allowing an agreed period, such as 35 days, for the milestone to be achieved. If the milestone is not achieved within the period allowed, then on the expiration of that period, the license may be terminated.
This notice to remedy followed by termination model is a common termination provision in a license, and applies to all types of breaches.
While this model might be acceptable for commercialisation milestones on the short term horizon where there is certainty of their achievement, like in Model 1, it would be considered too draconian for other commercialisation milestones that are anticipated 1 or 2 years down the development path.
The achievement of commercialisation milestones that far down the path cannot be forecast with precision. To be fair, even a 35 day extension for the achievement of the milestone may be inadequate.
As with Model 1, this model will also be very difficult to negotiate for any commercialisation milestones other than the initial one (or two) milestones where there is certainty of achievement on the immediate short term horizon.
Model 3 – termination after extensions are exhausted
Where commercialisation milestones have dates for achievement that are 6, 12, 18 or more months down the track, and where there cannot be any greater certainty of their dates for achievement other than approximate dates, there is a need for a termination model that fairly treats the licensee, and allows for extensions of time for the achievement of milestones.
A licensee otherwise, faced with no mechanism for the extension of the due dates for the achievement of milestones will be disinclined to invest in the further development required, and perhaps even disinclined to take a license at all.
A model that builds in some flexibility for the licensee is one that permits extensions of time for the achievement of milestones.
An example is a model where the licensee may unilaterally determine the duration of the extension, as well as unilaterally invoke extensions on any number of occasions that the licensee decides – but with a proviso.
The proviso is that the aggregate duration of all extensions invoked by the licensee is an agreed period such as 6, 9, or 12 months, and that once the licensee has exhausted that aggregate duration, the licensor’s right to termination arises.
No termination is permitted until that period is exhausted. But once exhausted, with the licensee having no further right to unilaterally invoke extensions, the licensor can terminate the license and seek out an alternative licensee.
Model 4 – termination after discretionary and mandatory extensions
An alternative model relies on the licensee seeking extensions, which the licensor has a discretion to give or to decline, and with the licensee having the right to invoke a maximum number of mandatory extensions if the discretionary extension is declined.
The licensee can seek any number of extensions it decides. The licensor can agree to all of them, some of them, or none of them.
If the licensor declines to give a discretionary extension, the licensee can unilaterally invoke a mandatory extension of say, up to 3 months.
The licensee can invoke a mandatory extension in this way on an agreed number of occasions, such as three.
If the licensee has exhausted its mandatory extensions, a milestone is not achieved by its due date (or extended due date), and the licensor declines to give a discretionary extension, then the licensor may terminate the license.
As with Model 3, the licensee is assured that termination does not occur in a draconian or unfair manner.
It is critical that a license include diligence obligations to protect a licensor from an underperforming or idle licensee, and that those diligence obligations, if unmet, ultimately lead to the termination of the license.
But it is equally critical that termination operate fairly and not be draconian, nor disincentivise a licensee.