Life Sciences Licensing and M&A Update: Catching Up on Recent Decisions Affecting Commercially Reasonable Efforts Definitions and Post-Patent Expiration Royalty Obligations

Recently, the Delaware Chancery Court and the Third Circuit issued three significant decisions on key issues affecting licensing and M&A transactions in the life sciences industry.

In the Delaware Chancery Court last week, the SRS v. Alexion and Fortis v. Johnson & Johnson decisions provide back-to-back findings that a buyer in an M&A transaction failed to use commercially reasonable efforts to develop the seller’s pharmaceutical product, in the case of Alexion, or medical device, in the case of J&J. Meanwhile, in the Third Circuit in August, the Ares decision addressed an exception to the Brulotte doctrine, upholding a post-patent expiration royalty obligation on the cancer treatment, Bavencio.

The Alexion and J&J decisions may have ripple effects on risk allocation when negotiating buyers’ or licensees’ diligence obligations in both licensing and M&A transactions in the life sciences industry. These decisions are notable as they were litigated in open court—frequently, parties resolve disputes related to diligence efforts on a confidential basis, either through confidential arbitration proceedings or directly between the parties. The decisions give contracting parties a peek behind that curtain to see how jurists address these frequently-contested issues in the life sciences industry.

Commercially Reasonable Efforts

(1) Shareholder Representatives LLC v. Alexion Pharmaceuticals, Inc.

Background

On September 5, 2024, following trial, the Delaware Court of Chancery found Alexion Pharmaceuticals, Inc. (“Alexion”) failed to use commercially reasonable efforts to support the development of a pharmaceutical product following Alexion’s acquisition of the product’s original developer, Syntimmune, Inc. (“Syntimmune”).

Prior to its acquisition by Alexion in November 2018, Syntimmune discovered, researched and developed a monoclonal antibody, ALXN1830. As consideration for the acquisition of Syntimmune, Alexion agreed to a total purchase price of $1.2 billion—$400 million upfront and $800 million in earnout payments, to be paid to the former shareholders of Syntimmune following closing of the acquisition upon the achievement by Alexion of eight milestones relating to its development or progression of ALXN1830. The merger agreement required Alexion to use commercially reasonable efforts to achieve each milestone for seven years after closing of the transaction. The merger agreement used an “outward-facing” or “objective” definition of commercially reasonable efforts, under which Alexion’s efforts were measured by what a hypothetical, similarly-situated company to Alexion would do under the circumstances.

Following closing of the acquisition, the ALXN1830 program faced a series of setbacks arising from the COVID-19 pandemic and in July 2021, Alexion was acquired by AstraZeneca. Following the AstraZeneca merger, Alexion began to question ALXN1830’s safety and commercial viability. While experts opined that the available data did not show evidence of safety concerns, Alexion decided to terminate the ALXN1830 program in December 2021 after achievement of only one of the eight earnout milestones.

The representative for Syntimmune’s former stockholders, Shareholder Representative Services (“SRS”), alleged that Alexion breached the merger agreement by failing to use commercially reasonable efforts to achieve the remaining milestones. Before reaching this question, the Court determined that the former stockholders of Syntimmune were entitled to the first milestone payment of $130 million for completion of a successful Phase 1 Clinical Study, as defined in the merger agreement.

The Court’s Decision

The Court held that Alexion breached its obligation to use commercially efforts when it terminated the ALXN1830 program. The Court analyzed Alexion’s decision based on several factors that a hypothetical company using commercially reasonable efforts would likely consider important under the circumstances:

• Safety. The available clinical data and expert analyses showed only “hypothetical” safety risks but no firm “evidence” that ALXN1830 was in fact causing safety issues. A hypothetical company using commercially reasonable efforts “would respond by gathering further data . . . not by terminating the program.”
• Efficacy. The available clinical data indicated that ALXN1830 had a beneficial effect but would likely struggle to compete “solely” on the basis of efficacy against similar, more effective products developed by competitors.
• Likelihood of Regulatory Approval. Neither party provided a prediction for ALXN1830’s chances of obtaining regulatory approval that the Court found helpful, because the contemporaneous record supported at most speculation that future studies might show grounds for denial.
• Order of Entry. Alexion was generally lagging behind competitors in entering a “relatively crowded field,” though Alexion believed it could be first in certain indications.
• Other Advantages and Disadvantages. ALXN1830 had a “slight advantage” over essentially all competitors to the extent that its exclusion of certain components could appeal to certain subpopulations. ALXN1830 also had strong patent protection until 2036.

Considering these factors holistically, the Court concluded that ALXN1830 “was not the strongest” of its type to come to market, would not have the highest efficacy, would be the fifth to market overall (though potentially first for certain indications), and although progress was slowing, “that did not mean ALXN1830 could not compete” based on its present lack of safety concerns and its advantage in treating certain subpopulations. The Court also determined that the trial record did not support Alexion’s claimed reasons for the termination, but rather showed that the termination was “influenced, motivated by, or driven by” AstraZeneca’s pursuit of merger synergies following its acquisition of Alexion.

The Court will address the damages that Alexion must pay in a future decision.

(2) Fortis Advisors LLC v. Johnson & Johnson

Background

On September 4, 2024, following trial, the Delaware Court of Chancery held Johnson & Johnson (“J&J”) liable for more than $1 billion in damages to the shareholders of Auris Health Inc. (“Auris”) for failing to support the development of a surgical robot.

Auris developed two market-leading surgical robots, iPlatform and Monarch. J&J was attempting to develop its own surgical robot, Verb, but progress was stalling. J&J decided to acquire Auris, and the parties agreed to a purchase price of $3.4 billion upfront and earnout payments in a total amount of $2.35 billion, to be paid to the former shareholders of Auris following the closing of the acquisition upon the achievement of various regulatory and commercial milestones tied to J&J’s progression of iPlatform and Monarch. The merger agreement required J&J to devote commercially reasonable efforts befitting a “priority medical device” to achieve the milestones. Under the merger agreement, J&J was not permitted to take into consideration the amount of the earnout payments when making decisions on its development of the iPlatform and Monarch. J&J’s efforts were measured by an “inward-facing” or “subjective” definition of commercially reasonable efforts, under which J&J measured its efforts against J&J’s own standards tied to its usual practices for “priority medical devices.”

The Court’s Decision

The Court found that J&J deliberately impaired iPlatform’s development to benefit J&J’s competing Verb device.

• First, within weeks of closing the merger between J&J and Auris, J&J announced that Verb and iPlatform would compete in a series of in-house, head-to-head surgical challenges. This competition, which had not been forecast in the merger documents, caused “needless setbacks and resource drains” for iPlatform while allowing J&J to identify synergies between the robots so that aspects of iPlatform could be used to optimize Verb. The Court pointed to this competition to find that J&J breached its commercially reasonable efforts obligation, because a “priority” device would not have had to endure a “costly battle to remain operative.”
• Second, although iPlatform won the competition, J&J decided to mesh the iPlatform system with Verb components, including certain hardware. These integration efforts hampered iPlatform’s launch and milestone achievements, and the iPlatform team lacked functionality as it was forced to support the Verb group in developing Verb’s capabilities. The Court found that a “priority” device would not “have its system, technology, and team diluted to fix another device’s problems.”
• Third, for iPlatform’s initial regulatory clearance, J&J insisted that iPlatform pursue a more complex RYBG procedure, rather the industry-standard and more efficient MVP strategy that iPlatform was better positioned to obtain. The Court found that J&J’s “insistence that iPlatform focus on a complex umbrella procedure” was not commercially reasonable in view of J&J’s obligation to devote efforts befitting a priority medical device.
• Fourth, J&J revised its employee incentive program with targets different from the milestones in the merger agreement. These scaled-back inducements, coupled with J&J’s communications that the milestones were “canceled,” negatively affected employees’ motivation to work towards the milestones. This conduct breached J&J’s efforts obligations because it was not consistent with J&J’s “usual practice” for a “priority device.”

By contrast, the Court found that J&J had not breached its obligations with respect to the development of the Monarch device. Unlike iPlatform, Monarch was not forced to compete for survival, joined with another robot, or barred from pursuing an MVP strategy. Instead, the alleged breaches were primarily just “disagreements with how J&J engaged with the FDA and prioritized aspects of the Monarch program.” J&J’s handling of the milestones, though occasionally “flawed,” did not rise to the level of commercial unreasonableness.

Learnings

In M&A deals with post-closing earnout payments, “[a] seller may be loathe to agree to an earnout structure without contractual assurances from the buyer and a strong belief in the value of its business,” as the Court observed in Fortis v. J&J. On the other hand, buyers place great importance on negotiating post-closing diligence obligations (if they agree to them at all) that allow them “to freely manage the post-closing activities of the business and to minimize earnout payments.”

Despite disputes regarding diligence obligations arising in a significant number of life sciences deals with earnout payments (both M&A and licensing), it has been relatively rare for a buyer or licensee to be found to have breached its diligence obligations. As such, the Fortis v. J&J and SRS v. Alexion decisions are highly significant, as the Court found two breaches of commercially reasonable efforts in rapid succession, looking at both an objective diligence standard and a subjective one.

What does this mean for negotiating diligence standards going forward?

• Though the determination may be fact-specific, we may find buyers and licensees pushing for a subjective standard for commercially reasonable efforts (i.e., the level of efforts that such buyer or licensee typically uses) rather than an objective standard (i.e., the level of efforts a similarly-situated company uses) as Alexion agreed to in the Syntimmune merger agreement. The Court in Alexion found that a hypothetical “similarly situated” company would have continued to move forward with a similar program. The Court characterized Alexion’s termination of the program in connection with seeking synergies following its acquisition by AstraZeneca as part of an “idiosyncratic corporate initiative,” failing to satisfy the objective CRE standard based on typical efforts of similar companies.
• Rather than agreeing to any seller- or licensor-friendly exception to the definition of commercially reasonable efforts (including, for example, that the buyer or licensee may not take into consideration the amount of an earnout payment when determining whether progression of development is commercially reasonable), we may see an increase in buyers or licensees sticking to buyer- or licensee-friendly definitions, potentially only agreeing to a softer, customary seller/licensee-friendly proviso that they will not act in a manner intended to thwart payment of an earnout.
• Parties negotiating transactions with earnout payments should carefully consider the comparable reference points used in subjective commercially reasonable efforts definitions. Because the definition of commercially reasonable efforts in the merger agreement did not clearly define a “priority product,” the Court in J&J had significant latitude in its interpretation to find that J&J had not exercised commercially reasonable efforts. A buyer or licensee might consider specifically naming its comparable product or products under a subjective commercially reasonable efforts definition, rather than agreeing to vague language (e.g., “priority product”).

Royalty Obligations and Expired Patents – Ares Trading S.A. V. Dyax Corp.

Background

On August 14, 2024, a federal appeals court held that a patent licensee’s royalty obligations arising from its sale of a cancer drug remained enforceable despite the expiration of certain upstream patents involved in the drug’s development.

Specifically, Dyax Corporation (“Dyax”) performed research for Ares Trading S.A. (“Ares”) and licensed several patents to Ares, including some held by Cambridge Antibody Technology (the “CAT Patents”). The research that Dyax conducted for Ares involved phage display technology used for the discovery of antibody therapeutics. Here, Dyax used the patented phage display technology to identify an antibody fragment that binds to a target molecule called PD-L1. Ares then used such antibody fragment to develop and commercialize the product Bavencio (avelumab), a cancer treatment.

To achieve “freedom to operate” while performing phage display, Dyax had obtained licenses to third-party phage display patents, including the CAT Patents. Under the collaboration and license agreement between Dyax and Ares, the duration of Ares’ obligations to Dyax mirrored the duration of the royalty that Dyax owed upstream to CAT. Both obligations were triggered by the same condition—sales of Bavencio—and continue for at least ten years from the launch of that product or patent expiration, whichever is later. When Ares sells Bavencio, it owes a percentage of Bavencio’s sales to Dyax, and Dyax owes a smaller percentage of Bavencio’s sales to CAT. The last CAT Patent expired in 2018, but the first sales of Bavencio occurred in 2017. Thus, the two royalty obligations on Bavencio’s sales will last until 2027, long after the CAT Patents expired.

Ares first relied on Brulotte v. Thys Co., 379 U.S. 29 (1964), under which a patent licensee’s post-expiration royalty obligation is unenforceable, in an effort to negotiate a reduction in its royalty obligations to Dyax. After those negotiations were unsuccessful and again relying on Brulotte, Ares sued Dyax for a declaratory judgment that the expiration of the CAT Patents rendered its royalty obligation unenforceable. After a bench trial, the District of Delaware found in favor of Dyax, holding that the royalty obligation was best understood as deferred compensation for Dyax’s pre-patent expiration phage display research, thereby falling within a recognized exception to the Brulotte doctrine as articulated in the more recent Kimble v. Marvel Entertainment, 576 U.S. 446 (2015). Ares appealed.

The Court’s Decision

The Third Circuit held that Ares’ royalty obligation was not unenforceable under Brulotte. The Court interpreted Brulotte as “requiring courts to determine whether patent licensing agreements provide royalties that are calculated based on activity requiring post-expiration use of inventions covered by the licensed patents.” Here, Brulotte did not apply because Ares’ royalty obligation was “not calculated based on activity requiring post-expiration use of inventions covered by the CAT Patents,” but rather based on sales of drugs that Ares developed from antibodies that Dyax discovered using phage display at a time when the CAT Patents were still in force. By finding that Brulotte did not apply, the Third Circuit did not reach the question of whether the Kimble exception was applicable here. The Court also rejected Ares’ policy-based arguments for why its royalty obligations should end early. Thus, under the Court’s decision, Ares must continue to pay royalties on Bavencio sales until the end of the royalty term set forth in the negotiated collaboration and license agreement.

Learnings

The Brulotte Court declared a royalty obligation unenforceable post-patent expiration because it conflicted with the federal policy favoring limited patent duration. The Ares decision clarifies the scope of Brulotte by holding that post-patent expiration royalty obligations may be enforceable if the royalties are owed for activity that occurred prior to expiration of the licensed patents.

What does this mean for negotiating royalty terms and royalty reductions going forward?

• Parties should consider at the time of entry into a license agreement whether the exploitation of the royalty-bearing product will require post-expiration use of inventions covered by the licensed patents or whether the value of the royalties is based on activities that occurred prior to expiration of the licensed patents. To make those facts clear, we expect to see that the parties will (i) memorialize such determination in the license agreement, (ii) acknowledge whether the royalty payments are understood to be deferred compensation for pre-patent expiration activities, (iii) tie the term of the license grant to the term of the activities requiring the practice of the patents, or (iv) decouple the royalty term from the term of the patents. 
• Alternatively, if it is unclear at the time of entry into the license agreement whether the royalty-bearing product will require post-expiration use of inventions covered by the licensed patents, the parties may consider a reduction in the royalty rate or cessation of the royalty obligations upon patent expiry in case Brulotte were to apply.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.