When a party breaches a licensing agreement, the harmed party must make a decision, either terminate the agreement or seek damages for the breach while continuing to perform under the agreement. But beware. Terminating the agreement is a high-stakes decision with significant legal and business consequences. Licensing parties are often unaware of the legal standards for justifying a contract termination.
A recent toy inventor’s case
A recent case illustrates this complicated issue. A toy inventor sold his entire line of baby toy products to a large toy company in exchange for royalties on the future sales of his products. The royalty agreement, which spanned many years, contained separate royalty rates for different categories of toys, including a rate for toys that had already been commercialized by the inventor (“original toys”), and another rate for toys that were “derived from” these original toys.
Although the toy company paid royalties on the sales of many toys, the inventor claimed that it deliberately misclassified toys to avoid royalty payments. According to the inventor, the toy company was taking an overly narrow interpretation of whether a toy was derived from the original toys so that it could exempt toys from the royalty agreement.
The inventor faced a choice. Sue for the past due underpayments (based on the misclassification of toys as non-royalty bearing), or terminate the agreement in its entirety and seek accelerated damages for the remaining term of the royalty agreement.
In this case, the inventor was concerned that, even if he sued for past due underpayments and prevailed, the toy company would look for other ways to deprive him of his royalties in the future. Accordingly, he chose to terminate the agreement and sued to recover the future royalties that he would have earned under the royalty agreement if the toy company had not breached the agreement.
Was the breach significant enough to justify the termination?
One of the first questions faced by the parties was whether the toy company’s breach was significant enough to justify the termination. In legal terms, the inventor must establish that the toy company’s breach was “material.” Although the precise test for “material breach” varies by state law, in essence, the terminating party must prove that the breaching party’s failure is so fundamental to the contract that it defeats the essential purpose of the contract. This is a fact-rich and flexible analysis. Generally, the court will consider a number of factors in determining whether a breach is material including, (a) the extent to which the injured party will be deprived of the benefit which he reasonably expected, (b) the likelihood that the party failing to perform will cure his failure, (c) the extent to which the party failing to perform will suffer forfeiture, and (d) the extent to which the behavior of the party failing to perform comports with the standards of good faith and fair dealing.
The purpose of this heightened standard of materiality is to avoid a total termination based on trivial breaches. It is understood, particularly in administering royalty agreements that mistakes and disputes will occur. The courts do not want to give one party an unfair advantage due to the types of minor mistakes and disagreements that regularly occur between long-term partners, like licensors and licensees.
But can there be a material breach where the licensee is accused of underpaying royalties (as opposed to withholding all royalties)? At times, underpayment of royalties justifies a termination, but other times it does not. There is no bright line rule. Some New York cases, for example, suggest that withholding even 75% of royalties due, alone, is not grounds for termination of the agreement. In the inventor’s case, he justified his decision to terminate the royalty agreement on a number of grounds, including the large percentage and dollar amounts underpaid. He also argued that the toy company deliberately set up a scheme to avoid paying him royalties, which was evidence of its bad faith, as well as the toy company’s refusal to correct what he contended were the erroneous classifications for royalty purposes. Moreover, in the inventor’s case, there was no risk of “forfeiture,” since the toy company retains the right to use the intellectual property even on termination of the agreement.
The consequences for wrongly terminating a contract can be severe.
The terminating party, which considers itself harmed, may actually create significant liability for itself. When a licensor terminates a royalty agreement the licensee may suffer damages and expenses. For instance, if the terminating party revokes the licensee’s right to use its intellectual property, the licensee may have to pull products off shelves. If the licensor’s initial termination was not justified, the licensor may be on the hook for the licensee’s damages. In the inventor’s case, the toy company countersued for breach of contract, in part based on what it claimed was the inventor’s improper termination of the contract.
One way to mitigate the uncertainty surrounding the right to terminate a royalty agreement is to include a “termination provision” in the agreement, specifying the cause or standard for termination. Courts generally enforce termination clauses. The termination provision may require only a “breach” of the contract, as opposed to a “material breach.” This can eliminate the need to prove “materiality” as a condition to termination, but leaves the parties vulnerable to contract termination for even minor breaches. Depending upon the type of royalty agreement and the issues of importance to the parties, the termination clause can specify particular types of conduct or events that justify termination, including underpayment of royalties, failure to comply with an audit, or certain misuses of intellectual property.
The termination provision ought to also explain what happens to the intellectual property on termination of the agreement. Does the intellectual property immediately revert back to the licensor? Or, as in the case of our inventor, does the intellectual property remain with the licensee?
Wrongful termination of a royalty agreement can have significant consequences. A well counseled party to a license agreement must carefully consider whether the wrongdoer’s conduct rises to the level of materiality before terminating a royalty agreement or otherwise meets the royalty agreement’s termination provision standards.