European Technology Transfer Regulation Embraces Software Licences – but is it all good news?

May 1st 2004 is an important date for companies licensing IP in Europe. On that day, the European Commission will be introducing a package of measures designed to improve the functioning of the common market in an expanded European Community of 25 Member States. There will be an overhaul of the procedures for the enforcement of the competition rules, in particular the rules which regulate contractual agreements to ensure that the consumer is protected from unfair business practices, such as raising prices, partitioning markets and other forms of collusion which adversely affect free and fair competition in the common market.

The recent high-profile Microsoft decision[1] showed the EC competition laws at work. In that case, the Commission fined Microsoft €497 million for leveraging its near-monopoly in the market for PC operating systems into other markets for workgroup server operating systems, and for tying its Windows Media Player with its ubiquitous Windows operating system. However, the competition rules do not just catch unilateral, abusive market behaviour by companies with dominant market shares. They are wide-ranging enough to catch many common business contracts, including intellectual property licences.

In order to avoid overburdening companies with regulation and in recognition of the fact that many IP licences serve to foster innovation and to promote competition, the Commission issued a “block” exemption from the competition rules for certain categories of IP licences. It is called the Technology Transfer Block Exemption Regulation. In an important measure to be introduced simultaneously with its other procedural reforms on May 1st, the Commission is revising and updating its Technology Transfer Block Exemption Regulation. For the first time, software copyright licences will be brought within the block exemption.

The old block exemption

The old block exemption[2] covered only firms entering into bipartite patent and know-how licences. It provided a roadmap which, if followed carefully, would ensure that patent and know-how licence agreements were automatically competition law compliant and therefore legal and enforceable. For example, certain “naked” anti-competitive contractual restrictions such as price-fixing clauses were black-listed. The exemption also listed some acceptable provisions in a white list, such as certain exclusivity grants, minimum royalties and minimum quality specifications.

The old block exemption was often criticised. Its coverage was limited to certain licences of patents, know-how and other rights such as plant breeders’ rights and semiconductor topographies. Software copyright licences were not covered. It was also described as a “legal straitjacket”, since its prescriptive format of “black” and “white” clauses lacked the flexibility to cover many modern licence agreements. On the positive side, companies at least knew clearly where they stood with the old block exemption. Although software copyright licences were excluded from its scope, the old block exemption could be used as a template for drafting competition law compliant licences, by tracking the form of clauses in the white list and avoiding the types of clauses featured in the black list.

Extension to software copyright licences

With the shortcomings of the old block exemption in mind, the Commission has decided to implement a new technology transfer block exemption. The new block exemption has been expanded to include software copyright licences, which is a positive development for the IT industry.

The Commission frequently intervenes in the area of IP law, with the aim of harmonising and simplifying the laws throughout Europe so as to encourage growth in Europe‘s knowledge-based economy. The Software Directive,[3] which harmonises copyright law protecting computer programs in the European Union, is one of the EC instruments which focuses on software copyright. This Directive establishes a number of exclusive rights comprising the subject matter of copyright for computer programs (eg permanent or temporary reproduction, translation and adaptation). The Software Directive strives to get the balance right between the rights of licensors to protect their IP and the need for interoperability and competition in the software industry.

The extension of the Technology Transfer Block Exemption to include certain software copyright licences reflects the Commission’s desire to encourage software licensing in what is seen as an important sector for Europe’s future economic growth. Yet not all types of software licence are included within the scope of the new block exemption. Only software copyright licensed for the manufacture or provision of specific contract products or services is included. For example, a licence of a computer program for the production of car components would meet the criterion for inclusion. Software licensed by one company to another for the purpose of providing on-line shopping services would also (in principle) fall within the scope of the new block exemption. Software used as an adjunct to a patented process and any software programs licensed along with confidential know-how will continue to be included within the scope of the new block exemption (as they were under the old).

Licences of software for the purposes of R&D (eg research tools) are excluded from the scope of the new block exemption, because the software is not being licensed for the manufacture or provision of specific contract products or services. Licences of databases are also excluded, which is perhaps unfortunate given the increasing complexity and importance of databases in modern applications such as bioinformatics.

No more white lists – a market-based approach instead

One of the difficulties with the new block exemption (compared to the old) is that the list of “white” approved clauses has gone. The new block exemption is intended to work by companies assessing their market position, in particular their market shares, so that they can decide for themselves whether their licence agreement is covered by the block exemption. It should be stressed that if an agreement is not covered by the block exemption, this does not necessarily mean that it is not competition law compliant and therefore illegal. It does, however, mean that the agreement will need to be checked carefully, in order to ensure that any contractual restrictions in the agreement are outweighed by pro-competitive economic benefits. Despite the Commission’s good intentions, the new block exemption may therefore result in a more complicated regulatory regime, with additional compliance costs for businesses.

Defining the market

Perhaps the most significant change from the old regime is the introduction of market share thresholds in the new block exemption. The new block exemption will apply only if the contracting parties’ market shares are below certain levels. If the parties’ market shares are above certain specified levels, the “safe harbour” of the block exemption will be closed to them. Markets are an economic concept, which involve defining a set of products which are substitutable for one another by reason of their characteristics, price and intended use. Defining relevant markets and calculating market shares can be a difficult exercise, which may require help from professional economists or accountants. This is particularly the case in innovative and fast-changing markets, such as markets for specialised high tech products, which can often be in a constant state of flux. In particular, for early stage technologies, markets can be difficult to define and reliable market data can often be hard to find.

Market share thresholds

Only companies with market shares of 30% or less will qualify for automatic exemption of their licence agreements under the new block exemption. Companies with bigger market shares, who may often be larger players with extensive patent portfolios and who license out their technology the most, will be excluded from the automatic protection of the block exemption. Parties may, for example, have larger market shares in certain software product markets, such as the market for interface technology, which is characterised by a small number of players with high market shares.

Licence agreements entered into by competitors in the same market for products or services will be subject to a lower, combined market share threshold of 20%. According to the Commission, licence agreements entered into between competitors are most likely to result in cartel-like allocation of markets and customers, which can lead to higher prices for consumers and reduce innovation.

What kinds of contractual restrictions can raise competition law concerns?

Even if companies are safely within the market share thresholds of the new block exemption, there are still lists of certain contractual restrictions which companies must not include in their licence agreement if they want to ensure that their agreement is competition law compliant. The following is a list of some of the kinds of clauses which can arouse the competition authorities’ concern. It is important to emphasise that the Technology Transfer Block Exemption will sometimes permit these restrictions, and one must look carefully at the agreement and the rules in order to work out when the agreement might be exempt and when it might not.

Field of use restrictions

Field of use restrictions in licence agreements are commonplace. For example, in the context of software licences, field-of-use restrictions are often necessary and pro-competitive, because they may provide a means for a technology to reach smaller, more specialised markets. Sometimes, a licensor may want to ensure that a licensee restricts the use of the licensed software to a market where the licensee (and not the licensor) is active. For example, technology covering branch prediction, which is a method used to accelerate computation, could have applicability to general-use microprocessors, digital signal processors that are used in mobile telephones, communications processors for networking equipment, and graphics accelerators, among other applications. A licensor that wishes to license the use of its technology in some but not all of these fields of application would have to specify fields of use in his licence agreement. Because these clauses can restrict the ability of the licensee to do as he pleases with the licensed technology, they are potentially restrictive of competition.

Exclusive cross-licensing

Cross-licensing allows firms to use each other’s technology to improve their existing products and perhaps to invent new products. It is common in the software industry for companies to have broad cross-licences with one another, to increase each company’s freedom to operate. Arguably, this enhances competition. Cross-licences can reduce transaction costs because, by licensing portfolios of technology and IP rights, companies are able to avoid having to engage in complex disputes about the validity and enforceability of each other’s IP rights. In the eyes of the Commission, cross-licences between competing firms can raise competition law concerns, by allowing companies to carve up markets between them.

Feedback of improvements and modifications to the licensed technology

Parties to technology licensing agreements, including software licences, may sometimes allocate ownership of improvements or modifications arising out of the use by the licensee of the licensed technology. In particular, grant-back clauses may require the licensee to grant back to the licensor a licence to any improvements or useful modifications to the licensed technology. Some types of grant-back clauses will fall within the scope of the new block exemption. For example, an obligation on a software licensee to assign to the licensor any modifications it makes to a licensed computer program will fall within the block exemption, provided that the modification is not “severable” (if the licensee cannot use its modification without infringing the licensor’s IP, the modification is not severable). On the other hand, a licence which contains an obligation on a licensee to assign or exclusively licence back severable improvements to the licensor will not fall within the block exemption and will have to be justified on economic grounds (eg perhaps where the licensee pays less in royalties, by way of compensation).

Licences of future IP

The new block exemption does not cover clauses which grant automatic licences of future IP, even though cross-licences of future IP are common in the semiconductor industry, for example. These clauses will need to be assessed individually for competition law compliance (it is thought that limited future IP licences may be acceptable, in certain circumstances, depending on the duration of the capture period and the degree to which the parties are prevented from competing with each other in the future).

Reciprocal running royalties

Running royalties are used in many IP licences as a fair means of compensating the licensor, based on the value of the licence to the licensee. Companies can use a per-unit royalty to solve the problem of valuing their technologies and to spread the risks associated with a given project over time (eg where it is not certain that the technology will succeed). Likewise, a %-of-sales based model will directly link the licensor’s compensation to the licensee’s success.

In the drafting stage, the Commission was cautious about exempting IP cross-licences between two competitors containing reciprocal running royalties because it feared that such an arrangement could be used to disguise a price-fixing cartel. After pressure from industry, the Commission has softened its approach and such an arrangement can be exempted and will be outlawed only where the agreement is devoid of any pro-competitive purpose and it does not constitute a bona fide licensing arrangement.

It is likely that IP licence agreements containing reciprocal running royalty clauses would be acceptable provided that, for example, the royalty rates would not have a significant impact on the market price of the products, they balance out the differences in value between each party’s IP portfolio and they are otherwise proportionate to the means to be achieved by the licence (ie they do not go beyond the term of the licence, and a lump sum payment would not be possible or appropriate).

Tying

The new block exemption does not prohibit a licensor from tying certain other IP into the licence (eg bundling a suite of software into a licence when the licensee may only require certain programs). Even when a licence agreement falls outside the scope of the block exemption (perhaps because the parties’ market shares exceed the threshold), tying may still be justifiable where, for example, the tie is necessary for a technically proper exploitation of the licensed technology or for ensuring that production under the licence conforms to quality standards respected by the licensor and other licensees.

Multiparty licences

Like its predecessor, the new block exemption will not apply to licence agreements between three or more companies, although the Commission has issued guidance on the application of EC competition law to technology pools and other multipartite arrangements which reflect the Commission’s practice in this area.

Practical implications: Is my licence agreement competition law compliant?

The Technology Transfer Block Exemption is there to help companies draft their IP licence agreements so that they automatically comply with EC competition law. It is important to remember that often IP licence agreements will have little or no effect on competition. Competition law (in general) impacts most often on the activities of companies in relatively concentrated markets for certain products when they hold significant market shares. In highly competitive markets with many products and many incumbents, it may be that the market is functioning well and no one company has a position of significant market power. Broadly, one must therefore first ask the question whether a particular licence agreement is likely to have any more than a de minimis effect on competition. Broadly, only if the answer is “yes” is it necessary to look at the new Technology Transfer Block Exemption in order to see whether automatic exemption is still available.

Even then, it is important to remember that a licence agreement which falls outside the “safe harbour” of the block exemption is not automatically deemed illegal. A further, deeper economic analysis will need to be done in order to see whether the pro-competitive benefits of the agreement outweigh the anti-competitive effects of any restrictions. The Commission has produced a detailed and comprehensive set of guidelines to assist in this process.

A fair compromise?

Many businesses license the use of their IP in order to recoup their investment and to make profits. The licensing of patents, know-how and software is very common in the IT and other high tech industries. Although the Commission has expressed its desire to preserve the balance between the monopoly rights that IP rights give to innovators and the need to keep prices competitive and the quality of products high for consumers, the result is a complicated new block exemption for IP licences.

The inclusion of software copyright licences in the new block exemption is to be welcomed, but the old white list of template clauses has gone. There are now market share thresholds to be considered and some hardcore contractual restrictions to be avoided. For companies with significant market shares in Europe, caution will need to be exercised when negotiating licensing deals in order to ensure competition law compliance.

Duncan Curley is a partner in McDermott, Will & Emery’s Intellectual Property Group. Davina Garrod is a solicitor in McDermott, Will & Emery’s European Competition Group.