Trademark licensing can create valuable revenue streams for your business. Licensing has the advantage that your business retains possession of the trademark and can create more than one licensing regime over the life of your business. Licensing is also a method of expanding the reach (and value) of your trademark without the need to invest in new products, services, markets, etc.

But, trademark licensing must be done carefully. As the owner of the trademark, you must demand contractual quality control over the licensee’s use of your trademark and must police that use. At the same time, quality control is a fine line: too much quality control can be just as bad as no quality control.

From the standpoint of no quality control, the highest danger is that your licensee will misuse your trademark to such a degree that the trademark will be so eroded that it loses its function as a trademark. If, for example, your licensee puts your trademark on 100 different products, your trademark will no longer identify a single commercial source for a unique product. Further, if the trademark is placed on low-quality goods, your trademark will lose any association with quality. The trademark is diluted. Another possibility is that your trademark might become generic. Yet additional dangers are that your trademark will be deemed abandoned or become vulnerable to legal challenge by licensees or third parties. Any of these will endanger the registration of the trademark.

From the standpoint of over-policing, the dangers are that your company could be deemed legally to be in a joint venture, partnership, and/or franchise relationship with the licensee. These generate their own sets of legal problems including potential for liability for employee and contractual relationships, product liability, and more.

With this background in mind, here are a few top priorities as you consider entering a trademark licensing agreement:

• Do your due diligence on potential licensees — look to their track records in other licensing arrangements, financial resources, business operations, etc.
• Establish quality control standards clearly in the licensing agreement
• Avoid default provisions that involve anything that would suggest major control over any part of the licensee’s business operations — possibly limit default provisions to cancellation of the license and the ability to sue for money damages not only for the breach of the licensing agreement but also for reputational damage to the trademark
• Include audit and inspection contractual provisions that are limited to what is needed — again, avoid anything that might suggest major control over the licensee’s operations
• Contractually disclaim any intent to create a partnership, joint venture, franchise relationship, or anything similar
• Ensure inclusion of solid and enforceable indemnification, hold-harmless, and insurance coverage provisions
• Consider fee and cost-shifting provisions in the event that litigation must be initiated
• And more

In terms of policing, expect and plan for non-contractual monitoring and policing beyond what is specified in the licensing agreement. This helps defeat any legal argument that the trademark owner is exercising excessive control over the business operations of the licensee but is proof that you ARE policing the use of your trademark. Further, expect and plan for the termination of the license in the event of a violation of the quality control requirements. Finally, expect and plan for litigation where it becomes necessary.

Contact the Trademark Attorneys at Revision Legal

For more information, contact the experienced Trademark Lawyers at Revision Legal. You can contact us through the form on this page or call (855) 473-8474.

The ‘Naked License’ Doctrine: When Insufficient Quality Control Destroys Your Trademark

The most severe consequence of failing to exercise adequate quality control over a licensee’s use of your trademark is what courts call a “naked license” — a license with no meaningful quality control provisions or where the licensor has failed to police the licensee’s performance. A naked license can result in outright cancellation of the trademark registration, depriving the licensor of all trademark rights in the mark it has spent years developing.

The leading case is FreecycleSunnyvale v. Freecycle Network, 626 F.3d 509 (9th Cir. 2010), where the Ninth Circuit upheld a jury finding that the trademark owner’s failure to enforce quality control provisions resulted in an invalid naked license and cancellation. Similarly, in Barcamerica International USA Trust v. Tyfield Importers, Inc., 289 F.3d 589 (9th Cir. 2002), the court found a naked license where the licensor exercised no actual quality control despite contractual provisions purporting to require it.

The lesson: contractual quality control provisions are necessary but not sufficient. The licensor must also actually enforce those provisions — conducting periodic inspections, reviewing licensed products or services, and terminating licenses when quality standards are not met. Documentary evidence of active policing is essential to defeating a naked license challenge.

Structuring Quality Control to Avoid Both Naked License and Franchisor Liability

Drafting quality control provisions requires threading a needle between two dangers: provisions that are too weak invite a naked license attack, while provisions that are too strong risk characterizing the relationship as a franchise — triggering the FTC’s Franchise Rule (16 C.F.R. § 436) — or a joint venture, exposing the licensor to the licensee’s liabilities. The FTC’s Franchise Rule applies when the licensor grants the right to use its trademark, imposes significant control over or provides significant assistance to the franchisee’s method of operation, and the franchisee pays a franchise fee. Inadvertent franchise status is a significant legal liability.

Quality control provisions that are appropriately balanced include:

• Product or service specifications. Specify the materials, ingredients, processes, or service standards required for licensed products or services — enough detail to enable meaningful enforcement without dictating the licensee’s overall business operations.
• Right of inspection. Retain the right to inspect samples or observe service delivery on reasonable notice — limited to confirming quality control compliance, not supervising general business operations.
• Reporting obligations. Require periodic compliance reports — with samples, photographs, or other documentation — creating a paper trail demonstrating active quality control.
• Approval rights for new uses. Retain approval rights before the trademark is used on any new product category, in any new geographic market, or in connection with any sublicense.
• Termination for cause. Provide for termination upon a quality control violation, with a defined notice and cure period (30 to 60 days for non-material violations). Retain the right to terminate immediately for material violations involving consumer safety or reputational harm.

Royalty Structures and Tax Treatment of Trademark Licensing Income

Trademark licensing income is taxable ordinary income to the licensor. Royalties are typically structured as a percentage of net sales (the “running royalty”) or as a fixed per-unit fee. A minimum royalty — a floor payment due regardless of the licensee’s sales performance — protects the licensor from situations where the licensee is using the trademark but generating minimal royalties.

For cross-border licensing arrangements — where the licensor is a U.S. entity and the licensee is a foreign entity, or vice versa — the royalty rate must satisfy arm’s-length transfer pricing requirements under IRC § 482 and the OECD Transfer Pricing Guidelines. Using a royalty rate below arm’s length in a cross-border transaction can trigger IRS adjustments and penalties. Revision Legal’s trademark attorneys draft and negotiate licensing agreements that protect trademark rights, maximize licensing income, and avoid the pitfalls of naked licenses, inadvertent franchises, and inadequate policing. Contact us at (855) 473-8474.