This article outlines red flags that brand owners and licensees should look for, consider, and address if they find such flags in a brand license agreement. These top ten red flags are in no particular order, each being important in its own right.
These red flags are not meant to be exclusive or comprehensive to cover all the important terms in a brand license agreement. Indeed, there may be other important considerations for your business that are not discussed. But, hopefully the below discussion will help with your future brand license negotiations and relationships.
- Scope of the Grant.
If the scope of the license grant is not clear, this is a red flag.
a. Exclusive vs. Non-Exclusive. Careful consideration should be given to whether the licensee receives exclusive rights or whether the licensor can allow others (or itself) to operate in the field.
b. Territory. The licensee may wish to verify that the licensor has registered (or holds at least common law) trademark rights in the territories for which rights are purportedly granted. Special attention should be given to online uses, which are often worldwide (so may not comply with territory restrictions). However, online uses can be directed to a certain territory by limiting shipping options, currency accepted, and language. To help avoid downstream resale of licensed products outside of the territory (i.e., gray market goods), a cautious licensor may also add requirements for the licensee to monitor or obligate its buyers to sell only in the territory.
c. Channels. The licensor may want to limit or clarify the sales channels in which this licensee may operate. Licensees may not like this approach, but many times a licensee that sells to big box stores may not have the capability to also sell to luxury and/or e-commerce. A licensor may also want to vary the trademark licensed in this situation as noted below.
d. Assignability/Transferability/Sublicensability. The licensor usually wishes to retain some control over the parties to whom the license can be assigned, transferred, or sublicensed (e.g., to avoid rights falling into the hands of competitors or incompetent third parties). On the other hand, the licensee may need transferrable or sublicensable rights (e.g., if using a third-party manufacturer to build the product or for certain types of advertising agreements). If the agreement is silent on transferability, many jurisdictions have a default rule that the rights are not assignable.
e. The Trademark. Often overlooked, and many times thrown in at the last minute is the definition of the trademark(s) being licensed. Generally, an exhibit or provision lists the marks. But, does the license agreement itself include a term that limits the trademark definition to just those listed, and/or expressly excludes any other version, derivative, or other form of the mark? If not, this should raise a red flag to the brand licensor, especially if it has other plans for the brand – perhaps with a different licensee in a different distribution channel for the same or similar licensed products, and where licensor wants to license a different version of the trademark for that purpose. These rights can be expressly reserved to the licensor in a separate reservation of rights provision, or in the trademark definition provision. Licensees will almost always pursue a broad trademark definition term, and claim (in some cases rightfully so, but not always) that any other license of a trademark derivative will hurt the licensee’s ability to capitalize on the license granted. But this licensee concern is usually addressed with other carefully defined terms around distribution channels, territory, and/or suggested price points.
2. Quality Control and Compliance.
Quality control and compliance brand license provisions are distinct, yet complement one another. They are also arguably the most important provisions in any brand license agreement, and the absence of such provisions, or the failure of such provisions to serve the purpose of protecting the licensed brand, should serve as a red flag to any licensor.
Most licensing parties know that, in the US, a brand license agreement that does not contain quality control provisions may be considered a “naked license.” This can also happen if no quality control is exercised by the licensor. Naked or uncontrolled licensing may result in abandonment of rights in the mark, a break in the chain of continuous use necessary to prove priority of use over another, a finding that the license is void, or a finding that the licensor is barred from challenging the licensee’s uncontrolled use.
It is imperative to build in the requisite, locally appropriate level of quality control into trademark license agreements. To mitigate the risk posed by insufficient quality control, a trademark license should have, at a minimum, express terms giving the licensor the power to engage in quality control via the licensor’s right to approve/disapprove, inspect, and review the goods and services offered by the licensee in connection with the mark.
Compliance provisions are also crucial for quality control in a brand license agreement. In the marketplace today, a licensee’s failure to abide by the applicable laws and regulations for matters concerning privacy, child or prison labor, manufacturing and the environment, product and consumer safety, recycling, animal testing, wages, and workplace conditions could severely harm the brand and should be grounds for termination.
All licensees should represent and warrant that they are complying and will comply with all laws and regulations associated with the marketing, sale, manufacture, distribution, and supply of the branded licensed products. If a licensee refuses to do so, or questions its obligation to do so, or refuses to provide or allow verification of compliance, this should serve as a red flag.
3. Avoid the Franchise Surprise.
Beware of potential franchise issues that may be associated with any trademark license, and which may arise depending on just how much control the licensor exerts over the licensee’s business operations. Franchising is governed by state and federal laws that, while somewhat inconsistent, are generally clear on one point: a franchise requires: (1) a trademark license, (2) payment of a fee, and (3) the exercise of significant assistance and/or control by the licensor over the licensee’s business.
Thus, every trademark license generally satisfies at least one, and usually two (trademark license and fee), of the statutory elements needed to find the existence of a franchise arrangement. And if the licensor is, in fact, franchising, and has not complied with the relevant state and/or federal laws, then its licensee, in its role as a franchisee, may be entitled to remedies, including, for example, rescission of the license, monetary damages in the form of restitution for money invested, and protection against improper termination of the license.
Additionally, the surprised franchisor/trademark licensor may be subject to significant penalties for not following the statutory franchise requirements of the federal or applicable state law. The key distinction between a trademark license and the franchise lies in the control exerted by the licensor.
The brand licensor can exert control over the brand. It should not exert control over the licensee’s business, such as hiring and firing decisions, hours, training, vendors, and other matters related to the licensee’s operation of its business. The trademark lawyer and the brand owner cannot afford to ignore the implications that the trademark license arrangement may have under relevant franchise law. But, to the best of the authors’ knowledge, absent control over the business, there is no case that has held a trademark license alone to be a franchise.
4. The Transition (Winding Down).
Most license relationships eventually come to an end. The absence of terms governing that termination and setting out what a brand can do to transition to a new licensee is a red flag in any agreement. Many brand license agreements do not account for how the licensing parties should wind down, but the inclusion of a carefully crafted wind-down provision can benefit both parties not only to avoid disputes about pre/post-termination conduct; but also, to facilitate the transition in the marketplace.
Wind-down provisions anticipate the expiration or termination of the license term. Such provisions could include: (a) limits on volume of licensed products that licensee can produce or purchase in the last season or a certain time period before the end of the license term; (b) an option for licensor to buy back remaining inventory at the end of the term; (c) a requirement to destroy inventory at the end of the term or the sell off period; and/or (d) prohibitions on dumping (i.e., selling at prices far below usual or in certain unacceptable channels, such as to a liquidator).
This helps the licensee plan for termination, and helps the licensor sign a new licensee. From the licensor’s perspective, it can also be beneficial to add a non-renewal caveat in the provision which expressly provides that, in the event the licensee does not renew, the licensor may seek out new licensees and negotiate a new license even before the old license or the sell-off period expires.
5. Securing payment.
Every license agreement has an obligation to pay, but it is a red flag if the license agreement does not provide a mechanism for securing payment. To secure payment, licensors can mandate (a) a certain level of cash on-hand for the licensee to cover the annual royalty or total royalty for the term; or (b) an upfront advance payment each year to cover expected royalties or agreed upon minimum annual royalty each year or for the term; or (c) a letter of credit obligation to cover each year’s expected or minimum royalty obligation, or the entire term’s royalty obligation.
Another method of securing payment would be via a reasonable, non-punitive liquidated damages provision that is tied directly to the licensor’s loss of royalties owed if there is breach or other non-performance. The licensor should conduct extensive due diligence of any prospective licensee to examine its creditworthiness and ability to meet its payment obligations under the brand license agreement, even if the licensed products do not sell well or where there is a poor economy.
Moreover, provisions for mandatory inventory and forecast/actual sales reporting should be covered in any license agreement so a licensor can monitor a licensee’s ability to comply with the agreement’s performance and payment obligations.
6. Maintaining Brand Value and Image.
Sales, marketing, and advertising are ways a licensee helps to maintain and grow brand value via the license agreement. But a red flag should be raised if the agreement does not have provisions for protecting brand value and image against licensee misconduct.
If the licensee is tied to illegal manufacturing or labor practices, or accused/convicted of criminal activity or other conduct that could ruin the reputation of the brand by association with the licensee, the licensor should have recourse to terminate the license relationship and/or take other steps to protect the brand from such licensee misconduct.
It is important to have these requirements stated in the license agreement specifically, and not just as part of a “comply with all relevant laws” clause, so that the licensee’s failure to comply would result in a breach allowing immediate termination for cause.
7. Dispute Resolution.
In the US, brand license agreements usually provide for applying the licensor’s local state law to govern licensee disputes and to have the local federal or state courts be the venue for those disputes. This is good practice if both parties are based in the US. But if one of the parties is a foreign corporation, a red flag should arise, and consideration should be given to using mediation and/or arbitration to resolve and govern disputes.
The reason for such consideration stems from the difficulties the US party may have in serving a complaint on the foreign party, or in having the foreign party show up to litigate the dispute. Even if you receive a US court’s default judgment for that party’s failure to show up, enforcing the judgment in a foreign country may be difficult and costly.
Mediation and, if unsuccessful, arbitration, can be a more collaborative means for dispute resolution, and are usually less expensive that court litigation. Whether conducted via self-mediation or with a formal mediator, even for a short period of time, mediation can be very effective for hearing the parties’ respective positions and evaluating whether court litigation or arbitration are necessary.
And if you cannot settle, and arbitrate the dispute under a respected arbitration administration, your chances of having the arbitration decision enforced in the other party’s local country are much higher than a ruling received from a local US court, which the foreign country courts may deem biased or unfair.
8. Audit and Inspection Rights.
Auditing is another form of control that the licensor can exert to monitor quality in manufacturing and compliance with the licensee payment and other obligations. An audit of a licensee’s books and manufacturing logs, facilities, or other documents and evidence bearing on the license, is something a licensor should never feel reluctant to mandate or request.
Thus, red flags should be flying if a brand license agreement does not have clear and strong licensor audit and inspection right provisions. Audits can disclose crucial underpayments of royalties or other key inconsistencies in reporting or issues with quality in manufacture.
Audit/inspection provisions are often touchy topics, and legitimate concerns may exist about audits being too intrusive, creating mistrust, and interfering with the licensing operation. Nevertheless, effective auditing is crucial to maintaining a licensing relationship, and not merely a useful vehicle to ensure the licensee complies with its license obligations.
Usually, audits make the relationship stronger and contractual obligations clearer, as they build trust and provide for more open communication between licensor and licensee. If the audit is a statutory or regulatory compliance obligation, explaining this to the licensee can establish that the audit requirement is not at the licensor’s whim and this should help to obtain the licensee’s cooperation.
9. Licensee Commitments to the Brand.
A licensee’s advertising and marketing commitments are crucial terms in most brand license agreements, and a red flag should be raised if they are missing or diluted. Generally, licensees should be committing 1-4% of the annual net sales toward advertising/marketing.
The usual touch point is when the licensor mandates that the licensee contribute an additional percentage of net sales to the licensor for the licensor to spend on advertising the licensed brand. But licensors should insist on this added payment, as they are in the best position to promote the brand and can most effectively help the licensee enter the marketplace and increase sales of the licensed products.
However, not every situation calls for this additional licensee payment; for example, if the licensor has no experience with the licensed products or the marketplace for such products. Nonetheless, licensors are generally in the best position to spend advertising/marketing dollars, and any money they spend to promote the brand will likely benefit the licensee.
10. Termination and Material Breach.
The termination of any license agreement is never an easy topic to negotiate, but both parties know they must address it. Red flags generally arise when terms like “material breach” are not defined or described sufficiently.
While termination provisions for a material breach of failure to pay or improper use of the licensed mark are commonplace, other situations are often left out, e.g., failure to comply with applicable laws and regulations, or licensee misconduct (criminal activity or other acts that bring disrepute to the brand). The material breach term should be carefully considered and clearly defined so there is no dispute on the materiality or impact of the breaching conduct.
A sometimes overlooked, matter is a licensor’s desire to obligate the former licensee to refrain from contesting, or assisting others in contesting, the validity or strength of the licensor’s marks once the license is terminated. The former licensee may have information concerning the licensor’s enforcement practices (or the lack thereof), or the licensor’s failure to truly exercise quality control.
Although the doctrine of licensee estoppel (which is relevant in the US and certain other jurisdictions) will, in many instances, prevent the licensee from directly attacking the licensor’s rights, it is preferable to memorialize these termination obligations in the agreement to avoid any ambiguity in the application of that doctrine.
Another important post-termination topic concerns the respective parties’ interest in continuing to identify that it had a relationship with the other party. This is especially true if the licensor was a celebrity or a famous brand that the licensee may want to reference in its general marketing material. Although the doctrine of nominative fair use may provide some cover for making such a reference, it is preferable to address this issue explicitly in the termination provision.
It is common practice for a licensor to prohibit any use of the licensed trademark by the licensee after termination. In other circumstances, however, the former licensee may have an interest in ensuring that it can use the formerly licensed trademark in its own promotional materials to simply state that it is a former licensee of the brand.
Author: Marc A. Lieberstein (Kilpatrick Townsend LLP, Co-Chair Retail Consumer Goods Industry Team; Co-Chair Franchise Group)
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