The recent lawsuit filed by the Board of Regents of the University of Texas System is an example of multitiered royalty payment dispute due to contract interpretation.

June 21, 2018

Many license agreements involve multitiered royalty payment structures. Some are based straight on volume, while others are based on product-specific criteria. We have seen interpretations by the licensees that were not consistent with the expectations of the licensors, irrespective of the types of multitiered structures. The recent lawsuit filed by the Board of Regents of the University of Texas System is yet another example of multitiered royalty payment dispute due to contract interpretation.

In February 2018, the Board of Regents of the University of Texas System sued its exclusive licensee, Indexx Laboratories Inc. (“Indexx”), for aggregate royalty underpayment of more than $1 million. The exclusive license agreement was entered in September 2000 relating to veterinary diagnostic technology used to detect Lyme disease in animals. The agreement included the following multi-tiered royalty structure based on the type of licensed products sold by Indexx:

  1. 4% of net sales generated from all licensed products sold to detect Lyme disease alone
  2. 1% of net sales generated from all licensed products sold to detect Lyme disease in combination with one other veterinary diagnostic test or services (for example, a canine heartworm diagnostic test or service). Furthermore, the 1% royalty rate can be reduced by a percentage rate equal to the percentage rate paid to a third party for products or components used by Indexx exclusively in the combination testing product with the royalty rate reduction not to exceed 0.5% 
  3. 2.5% of net sales generated from products sold to detect Lyme disease in combination with the testing of one or more other tick-borne diseases 

The University of Texas System claims that Indexx breached the license agreement for the following reasons:

  • Indexx misapplied the royalty rate to its SNAP tests at issue, which include testing for Lyme disease, heartworm, and at least one test for another tick-borne disease. Specifically, rather than paying a 2.5% royalty rate on these SNAP tests, Indexx paid a royalty rate of 0.5%. 
  • Indexx improperly apportioned the net sales of the combination product in calculating royalties due, whereas the entire net sales figure should be used.

The parties’ dispute regarding which royalty rate to use is clearly a result of differences in interpretation of certain contract terms by the licensor and the licensee. In this case, there is no specific royalty structure explicitly addressing a test that includes a combination of Lyme disease, heartworm, and other tick-borne diseases. The fact that Indexx calculated the royalty based on a 0.5% royalty rate is likely because it sees the SNAP test at issue as a test for Lyme disease in combination with one other veterinary diagnostic heartworm test (assuming that Indexx also pays royalty to a third party, resulting in a reduction from the 1% royalty rate). However, the University of Texas System focuses on the fact that the SNAP test at issue includes Lyme disease in combination with the testing of one or more other tick-borne diseases, and, therefore, should be subject to a royalty of 2.5%.

As previously discussed here and here, contract interpretation is a very common problem in royalty disputes.  To ensure proper royalty reporting, it is important for the licensor and licensee to have the same understanding at all times during the entire licensing relationship. The terms may be clear to both parties at the time when the agreement was entered into, but as the products and services evolve and expand, it is crucial for the licensor to check back with the licensee periodically throughout the life of the license agreement. For a multitier royalty structure license agreement, licensors may want to consider the following steps to ensure compliance.

  • Request a more detailed royalty report that lists products and/or services included in each of the royalty tiers.
  • Review public disclosure of the products and/or services reported under each of the royalty tiers to confirm the appropriateness of the tier applied.
  • Discuss with your licensee the active components of a combination products and/or services covered or likely covered by the license agreement.
  • Communicate with your licensee immediately if you disagree or are unsure about how the royalties are calculated by the licensee.

According to the University of Texas System, Indexx began paying royalties under the agreement in April 2004, and Indexx has since been paying 0.5% royalty on the SNAP combination test products. It is unclear how far back the University of Texas System is able to recover from the alleged breach, if the claims are found valid by the court. Regardless of the outcome of the case, this is a reminder for licensors that active and timely communications with your licensee is the key to ensuring that you receive what you’ve bargained for.