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Wolff & Samson PC
Counsellors At Law Intellectual Property Eighty-five years ago Benjamin Cardozo handed down Wood v. Lady Duff-Gordon, 222 N.Y. 88 (1917), and set forth the principle that an exclusive licensee has a duty to use best efforts to exploit the exclusive license when that license is granted in exchange for a promise to pay royalties to the licensor. Despite the many years that have passed, Wood remains the guideline that courts follow. Some courts, however, have refused to imply a best-efforts obligation in cases where the exclusive licensing agreement calls for a minimum guarantee or advance payment of royalties. Those courts have based their decisions on the assumption that a licensing agreement that calls for a substantial advance or guaranteed royalty payment always provides the licensee with an incentive to make the license profitable, thereby minimizing the chances that the licensee will neglect to exploit the license. This assumption is invalid. Although the invalidity of that assumption apparently has yet to be addressed in any published opinion, the weakness in the foundation of this line of case law could have significant implications both for those who face litigation over exclusive licensing agreements and those who are involved with the drafting of exclusive licensing agreements. In Wood, Lady Duff-Gordon, a famous fashion designer, granted Wood an exclusive license to permit others in the clothing and fabric industry to place her name on their products. In return, Wood was obligated to pay DuffGordon a percentage of the profits earned from the sale of her name. In violation of the exclusive license granted to Wood, Duff-Gordon began licensing to others the right to place her name on "fabrics, dresses and millinery" without Wood's permission and without paying Wood his portion of the profits. Wood sued Duff-Gordon when he discovered Duff-Gordon's violation of the exclusive license. In an attempt to establish that her agreement with Wood was unenforceable, Duff-Gordon argued that the agreement lacked mutuality of obligation because it did not explicitly state that Wood had a duty to exploit the license. Duff-Gordon argued that a promise to pay royalties without an obligation to bring those royalties into existence was no promise at all. The court rejected that argument, holding that the contract between the parties evidenced an implicit obligation on the part of Wood to use reasonable efforts to generate royalties. The court in Wood implied an obligation on the part of Wood to use reasonable efforts because Duff-Gordon's sole revenue from the subject matter of the license was dependent on Wood's efforts to make the license profitable. The court reasoned that the only way to give effect to the reasonable expectations - that is, the intent - of the parties was to imply a duty on the part of Wood to work the license. The justification for applying a different rule where an advance or guaranteed royalty is paid is based, at least in part, on the assumption that a licensee always has an incentive to work a license when the licensee pays a substantial advance to the licensor. It is also based on the assumption that Cardozo's opinion in Wood was influenced by the fact that, in the absence of an implied obligation, the contract in that case would have failed for lack of mutuality of obligation. As discussed below, the first assumption is not valid. The validity of the second assumption is a closer question, but Cardozo's opinion indicates that the intent of the parties as gleaned from the contract and the business context in which it was created was the foundation for the implication of a best efforts obligation in Wood, not a desire to create mutuality of obligation where the parties intended none. Given that the first assumption is invalid and the second is perhaps debatable, practitioners should proceed with caution when relying on decisions founded on that line of reasoning. The lead case discussing the propriety of the refusal to imply a best efforts obligation when a substantial advance or guarantee has been promised is Permanence Corp. v. Kennametal, Inc., 908 F.2d 98 (6th Cir. 1990). In Permanence, the plaintiff granted the defendant an exclusive license, subject to a pre-existing nonexclusive license, to patents relating to a process for forming an alIoy. The plaintiff received an up-front fee of $150,000 and an advance on royalties of $100,000 for the exclusive license. Seven years afterward, the plaintiff filed suit against the defendant for breach of contract, alleging that the defendant had not fulfilled its implied obligation to use best efforts to exploit the patents. The defendant moved for summary judgment, arguing that no obligation to use best efforts could be implied in its contract with the plaintiff. The district court agreed and the Sixth U.S. Circuit Court of Appeals affirmed. The Sixth Circuit based its decision on two assertions. First, it stated that the doctrine in Wood was born in the context of a contract lacking mutuality of obligation, while an exclusive licensing agreement that calIs for a substantial advance does not lack mutuality of obligation. Second, the court reasoned that by requiring a substantial minimum or advance, "the licensor, in lieu of obtaining an express agreement to use best efforts, has protected himself against the possibility that the licensee will do nothing" because the payment of a substantial advance provides the licensee with an incentive to work the license. In Emerson Radio Corp. v. Orion Sales, Inc., 253 F.3d 159 (3d Cir. 2001), the Third Circuit, predicting New Jersey law, followed the Permanence rationale and refused to imply a best-efforts covenant in an agreement granting an exclusive license to use the plaintiff's trademark in connection with the sale of the plaintiff's video and television equipment. The defendant agreed to pay the plaintiff a minimum royalty of $4 million per year, an amount the court reasoned was substantial enough to eviscerate the need for the implied covenant. The primary assumption upon which Permanence and Emerson rest is that the payment of a substantial advance will always provide the licensee with an incentive to work the license (alternatively referred to as the advance-equals-incentive rationale). This assumption is invalid. It is true that, absent any external influences, a licensee does have some incentive to attempt to recoup the advance paid to the licensor. But when one steps back and takes a look at the big picture, the reasoning of Permanence and Emerson fails. The fallacy of the advance-equalsincentive rationale is that it ignores the economic concept of opportunity cost - the value of the greatest benefit that is given up in order to engage in an alternative endeavor. A licensee will only have limited resources to devote to the exploitation of licenses. In order to maximize its profitability, the licensee will always direct its resources toward those licenses that it believes wilJ be the most profitable. Whenever a licensee believes that the opportunity cost of devoting resources to exploiting an exclusive license will be higher than the advance or guarantee paid for the exclusive license, the potential exists for the licensee to become indifferent to its obligation to use best efforts to work the license because the licensee is sure to recoup its advance by directing its resources toward the alternative endeavor. Moreover, where a licensee perceives the opportunity cost of exploiting a license to be greater than the projected profits from the license, it will invariably redirect its resources to the alternative endeavor because it believes that it will profit more by forsaking the license. Thus, under conditions where a licensee has a choice between exploiting one of two licenses for which the licensee has paid an advance or guarantee on royalties, the licensee will choose to exploit the license that it believes will provide it with the most profit. That same principle applies when a licensee holds a number of licenses. This, in fact, happened in a case involving the grant of an exclusive license to The Walt Disney Company to market and promote a cartoon character named "Marsupilami." Marsu v. The Walt Disney Co., 185 F.3d 932 (9th Cir. 1999). In August of 1990, the plaintiff Marsu agreed to license Marsupilami to Disney in exchange for $500,000 upfront and a guaranteed annual royalty payment of $2 million. The contract explicitly required Disney to use its best efforts to promote Marsupilami. Because of the success of Disney's "Aladdin" and "The Little Mermaid," however, Disney decided not to devote the promotional efforts needed to comply with its obligations to Marsu under their contract. An October 1992 internal memo to Disney's chief executive officer illustrates that Disney breached its contract with Marsu precisely because the opportunity cost of exploiting the Marsupilami license was too great: Our hot properties were consuming all of our attention (film properties alone will be $25 million over budget this year! !!). We couldn't divert attention from these major hits to do Marsu. ... We have more than enough to do to stay busy for years into the future. Internationally, we have neither the time nor the resources to do Marsu right - we'd be leaving millions of lost opportunity on film merchandise potentially on the table. In December of 1993, 15 months after the circulation of the memo, Disney exercised its option to terminate the contract, having paid Marsu $5 million in guarantees. Marsu subsequently sued Disney for, among other things, breach of Disney's express duty to use best efforts. The district court sided with Marsu, awarding over $8 million in lost profits and the Ninth Circuit affirmed. Economic theory and the facts of Marsu thus illustrate that courts cannot assume that a substantial advance or guarantee provides a licensee with a significant incentive to exploit a license. In addition to being erroneous, the assumption that an advance always protects a licensor's expectation interest can lead to unfair results. Most likely, a licensor's expectation under an exclusive licensing agreement that calls for a substantial advance on royalties is to receive the advance along with the licensee's employment of reasonable efforts to bring additional royalties into existence. As Cardozo stated in Wood, a promise to pay royalties tends to imply a promise to bring those royalties into existence. The licensor's expectation interest lies, at least in part, in the licensee's reasonable attempt to exploit the license, and any per se interpretation of the contract that ignores that expectation runs the risk of depriving the licensor of its benefit of the bargain. The Marsu court's award of over $8 million in lost profits to Marsu illustrates the need to protect that interest. In contrast to the advance-equalsincentive rationale, the assertion that the doctrine of Wood was born in the context of a contract that would lack mutality of obligation in the absense of an implied best efforts obligation is valid. It is by no means clear, however, that the court in Wood would not have implied a best efforts obligation if Wood had paid an advance to Lady Duff-Gordon. Although the issue before Cardozo was whether a court may provide an obligation to use best efforts on the part of a licensee under an exclusive license agreement that would otherwise lack mutuality of obligation, the issue was not whether such an obligation should be implied because an exclusive license agreement lacks mutuality of obligation. It is doubtful that a court would imply a contractual term that contradicts the intent of the parties solely for the purpose of saving a contract that otherwise would not be enforceable. Instead, courts imply contractual terms to give effect to the intent of the parties to the contract - it is a matter of contract interpretation. Indeed, Cardozo's opinion in Wood focuses almost exclusively on the intent of the parties: But in determining the intention of the parties, the promise has a value. It helps to enforce the conclusion that the plaintiff had some duties. His promise to pay the defendant one-half of the profits and revenues resulting from the exclusive agency and to render accounts monthly, was a promise to use reasonable efforts to bring profits and revenues into existence. Although, as previously stated, the Permanence court based its decision on at least one erroneous assumption, it apparently recognized that its endeavor was one of contract interpretation: In making the determination of whether a covenant to use best efforts should be implied as a matter of law, this court must focus its attention on the terms of the written contract between the parties, and the circumstances surrounding the making of the agreement. Interestingly, in discussing the intent of the parties, the Permanence court placed weight on the fact that the contract in that case contained a standard integration clause. Although the language of integration clauses can vary, such clauses generally state that the contract embodies the entire agreement of the parties, thereby ensuring the full effect of the parol evidence rule. Courts apply the parol evidence rule to exclude evidence of extraneous agreements and representations of the parties to a contract made prior to or contemporaneous with the execution of the written contract. The parol evidence rule, however, does not preclude a court from engaging in contract interpretation where a court considers evidence tending to explain the terms of a contract when the intent of the parties is not clear. This is a fundamental principle of contract law, so it is difficult to determine why the Permanence court thought the existence of an integration clause necessarily precluded the implication of a best-efforts term. An integration clause that does not explicitly exclude implied terms should be given little or no weight in the determination of whether a court should imply a best efforts obligation in an exclusive licensing agreement. In light of the foregoing analysis, there is no guarantee that a court will refuse to imply a best-efforts obligation into contracts calling for substantial advance or guaranteed royalties. Indeed,Wood suggests that courts should engage in a meaningful inquiry into the intent of the parties. As stated in Permanence, a court should look to the terms of the contract along with the circumstances surrounding the contract's formation. Similar to Cardozo's reasoning in Wood, significant weight should be given to the notion that because a licensee has agreed to pay royalties in exchange for an exclusive license, the licensee has also implicitly promised to use reasonable efforts to bring such royalties into existence, despite any advance paid by the licensee to the licensor. Of course, other considerations may militate against a finding that the parties intended the licensee to be bound by a duty to use best efforts. For instance, a contract could provide that if royalties do not exceed. the advance within a given number of payment periods, then the licensor and licensee will have the option of terminating the agreement. Although not conclusive of the parties' intent, such a provision might suggest that the parties did not intend for the licensee to be bound to use reasonable efforts. In all, the weakness of the rationale of Permanence and its progeny suggests that attorneys, licensors and licensee should proceed with caution when drafting or negotiating exclusive license agreements. Those who are drafting or entering into exclusive licensing agreements should be aware of the implications of not explicitly spelling out the licensee's duties with respect to the exploitation of the license. Although the trend with respect to exclusive licensing agreements calling for the payment of a substantial advance or guaranteed minimum royalty payment appears to favor the licensee, the preceding discussion illustrates that there is a legitimate basis to call that trend into question, or at least to avoid it in cases where the licensor can show conduct on the part of the licensee that is akin to that of the defendant in Marsu. For attorneys involved in litigation over exclusive licensing agreements, the considerations will vary depending on which side of the dispute they represent. Attorneys representing licensees should be prepared for the argument that the doctrine followed in Permanence and Emerson is inapplicable or invalid for the reasons stated above. Where possible, the licensee's attorney should press the argument that the intent of the parties in signing the exclusive licensing agreement was that the licensee would have no obligation to use best efforts. Of course, the defenses the licensee can assert will turn on the facts of the particular case. The resolution of certain questions, however, could have a significant impact on the potential liability of the licensee. For example, did the licensee actually use reasonable efforts to exploit the license? Also, if a significant attempt was not made to exploit the license, was there an excuse other than that the licensee wanted to direct its resources to more profitable endeavors? For example, the argument could be made that reasonable efforts do not include making attempts to exploit a license that clearly would not be profitable (that is, if less costly, superior technology renders the subject matter of the license obsolete). Not unexpectedly, much of the licensor's ability to press its case will turn on whether it can establish that the licensee abandoned efforts to exploit the license not because the license would not have been profitable, but because the licensee chose to invest its resources in more profitable endeavors. Any evidence tending to show that the parties intended that the licensor have an obligation to use reasonable efforts to generate profits would also be helpful to the licensor. Because the court's analysis in a given case could be very fact intensive, the discovery phase of the litigation should be particularly important for both parties. Considering the weaknesses of the Permanence and the Emerson rationales, it is uncertain how courts will treat a licensor's suggestion that an implicit obligation exists on the part of the licensee to use best efforts to exploit the license. Given the analysis set forth above, a court would be justified in deviating from the rationales based on the inapplicability of the assumptions upon which those decisions were founded or factual distinctions elucidated in the course of litigation that render the Permanence rationale inapposite. Attorneys and businesspeople should be mindful of that possibility and prepared to deal with its implications. This article is reprinted with permission from the July 22, 2002 issue of the New Jersey Law Journal. @2002 ALM Properties, Inc. Further duplication without permission is prohibited. All rights reserved. © |