Companies considering out-licensing deals with a Chinese counterparty often have questions on what goes into the license agreement, to what extent the Chinese regulatory system and laws play into the terms and more broadly the cultural and softer factors that need to be taken into account when negotiating such transactions. Our panelists addressed these and other important issues and provided practical insights into what makes operating with parties in this market unique. In the article below, we summarize key takeaways from the third session.

Kicking off the webinar, Lu Zhou, partner in the Hogan Lovells General Corporate and M&A practice, noted that life sciences and health care companies contemplating an out-licensing deal with a Chinese counterpart often have questions and concerns before entering such an agreement. Ms. Zhou noted that these concerns touch on regulatory issues, data security, intellectual property (IP), and enforceability. Our panelists addressed each of these considerations in turn, drawing on extensive “in the field” experience.

Recent regulatory developments make China an even more attractive life sciences market

Wensheng Ren, senior associate in Hogan Lovells Fidelity¹ Corporate practice, first gave a brief overview of recent business trends in the pharmaceutical market in China, highlighting the expanding number of cross-border licensing deals on drug products, as well as in other hot areas such as artificial intelligence (AI) and COVID-19 vaccines. In recent years, Mr. Ren noted, there has been an uptick in interest in the Chinese market for early-stage products from licensors based predominantly in the U.S., Canada, Europe, and South Korea. There has also been a shift from product-based to technology-based licensing.

Factors encouraging the in-licensing of products to China, Mr. Ren noted, include access to a large pharma market with huge growth potential as well as the availability of a large participant population and the ability to organize large scale clinical studies. Mr. Ren also noted that Chinese companies have increased their technological capabilities and are often seeking to diversify their investment risk and to boost profitability. Moreover, China has a policy focus on innovative drugs and other favorable government initiatives in this area. This includes an improved regulatory landscape, such as the Drug Administration Law (DAL), effective from 1 December 2019 which expanded the market authorization holder (MAH) system nationwide, allowed greater participation by offshore entities, and which permitted the online distribution of drugs. As part of the DAL implementation, the Drug Registration Regulation (DRR) effective 1 July 2020 set forth the criteria and requirements for a foreign licensor to become an MAH, as well as adopting accelerated review and approval processes for certain MAH applications.

Key considerations for structuring pharmaceutical deals

Addressing the nuts and bolts of structuring a deal with a Chinese counterparty, Andrew McGinty, partner in the Hogan Lovells General Corporate & Finance practice, provided an overview of exemplary deal structures. Mr. McGinty highlighted that the most common structure is a licensing deal whereby a foreign licensor gives a Chinese partner the right to commercialize an in-development drug, in China, in exchange for payments and royalties based on agreed milestones. Commonly involving a foreign MAH holder, these licensing structures require an agent on the ground to navigate local cultural and regulatory challenges.

Mr. McGinty emphasized that “finding the right partner” can be key to a successful license deal. Important questions to answer include: does the partner have the ability to deliver what you are trying to do? Do they have a track record of deals? Can they pay in a timely manner? Can they negotiate the Chinese foreign exchange controls system (which is the key to the unlocking payments in foreign currency)? Diligence in the form of a Chinese company search can provide insights into, for example, the number of employees a company has, whether they are involved in any litigation, as well as important data points on ownership structure of the company and any related entities. Public filings that the prospective licensing partner has made, such as via the U.S. Securities and Exchange Commission (SEC) can also provide helpful information. Mr. McGinty also highlighted the importance of having advisors with Chinese expertise and language skills on both sides of the potential transaction, as while deals often get documented in English, as the deal gets closer to  finalization, negotiations often shift into Chinese. Understanding why the Chinese counterparty is taking up a given position is essential to getting the deal “over the line”.

Once an appropriate partner has been identified, Mr. McGinty elaborated upon a number of key issues that may arise in structuring an productive deal:

Regulatory pathways. In short, Mr. McGinty explained, China has two parallel regulatory tracks driven by where the drug is manufactured. An imported drug registration is required for drugs made outside of China while a domestic drug registration is for drugs made locally in China. Obligations and responsibilities will vary accordingly, with an imported drug having an offshore licensor MAH and an onshore licensee agent, while a domestic drug will have an onshore licensee MAH who may or may not be the manufacturer (often outsourced). In additional to control and liability differences, tax considerations as well as manufacturing costs and flexibility may also contribute to the advantages of one structure over the other.

Exclusivity and scope. In the Chinese market, exclusive licenses are the most common, Mr. McGinty pointed out. Regarding scope, the parties should be clear on whether the license is as to technology, IP, or both and the licensor must consider upstream obligations (with in-licensed IP) and possible downstream uses by the prospective licensee, as discussed further below.

Sublicensing. Mr. McGinty posed a key question for the licensor; namely, how much control are they willing to give up? As also discussed in more detail below, it can be important to maintain some degree of control over key IP assets. He also noted that these provisions are often intensely negotiated.

Improvements. Mr. McGinty pointed out that the default position is that a licensor will retain ownership of any improvements it makes to the licensed technology. Similarly, improvements by the licensee are also, by default, owned by the licensee. A back license of licensee-developed improvements requires substantive consideration, otherwise it may raise enforceability issues due to Chinese rules restricting non-reciprocal ownership or licensing of improvements. Mr. McGinty emphasized that these provisions are also often heavily negotiated.

Technology import and export. Chinese law recognizes three categories of technologies under China’s Technology Import and Export Regulations (TIER), those that are prohibited, restricted, or unrestricted. Mr. McGinty noted that while most licenses fall in the “unrestricted” category, regulatory treatment depends on this categorization and it is therefore important to work out the relevant category early in the negotiation process. In the case of unrestricted technologies, proper registration with the PRC Ministry of Commerce (MOFCOM) of the license agreement will also be important as a compliance matter and to facilitate payments even if failure to do so does not invalidate the license.  Restricted technology licenses, conversely, require prior approval from MOFCOM and failure to obtain such approval will invalidate the license.

Other regulatory issues. Additional regulatory considerations include those related to merger control and competition law, as well as any home country restrictions e.g. export controls for certain sensitive technologies, especially for U.S.-based licensors.

Termination. While these are often fairly standard provisions, Mr. McGinty emphasized that a licensor should consider how to transition out of an arrangement. Importantly, the parties should consider what will happen to MAH held by a licensee and whether it can be transferred to the licensor in the event of termination, as there is no simple transformation path from domestic drug to imported drug registration: it is more akin to a fresh application.

Unenforceable provisions. Mr. McGinty highlighted several provisions that may be deemed unenforceable in China e.g. non-mutual provisions on ownership or licensing of improvements. While “slightly counterintuitive”, Mr. McGinty noted that China tends to think about these provisions from the perspective of protecting the licensee given China’s history of being more of an importer than an exporter of technology. Other provisions to be mindful of in this vein include no IP validity challenge covenants.

Data transfer. Data transferred out of China may require a security assessment, particularly if it involves personal data or the more politically-driven category of “important data”. See also our earlier discussion on China’s data protection regime and risk management for handling HGR.

Foreign exchange and tax. Cross-border payments are subject to foreign exchange controls, with “current account” payments made through the license somewhat more liberalized and easier to work through the system than those on the capital account. Tax considerations often require specialized advice.

Governing law and dispute resolution. Governing law is commonly New York, Hong Kong or Chinese law, with dispute resolution often governed by arbitration, such as in Hong Kong. In response to an audience question, Mr. McGinty noted that these provisions can often be contentious and heavily negotiated but Hong Kong and China’s recent agreement on the mutual enforcement of (among others) interim measures (which are the closest China gets to the common law injunction) giving Hong Kong a unique advantage over other jurisdictions.

Prevailing language. Mr. McGinty noted that there is no restriction on the use of language, and no legal requirement that the Chinese version of the agreement must prevail. English is commonly used for cross-border transactions because a lot of the language is quite standardized. However, it is important for external counsel to be fluent in both languages and proficient in Chinese for oral communications and negotiations, as decision-makers of the licensee may be more comfortable in Chinese.

Intellectual Property provisions

Building upon this framework, Yu-An Chang, counsel in the Hogan Lovells Intellectual Property, Media, and Technology practice, provided more detailed guidance on IP considerations, which participants had identified as an area of “biggest concern” in prospective licensing deals with a Chinese counterparty. Mr. Chang emphasized the importance of preparation, noting that a licensor needs to identify its IP assets, secure protection by registration, assess IP related risks, and prepare for any necessary reps and warranties that might be requested from a licensee – all before setting foot in China. Licensors should be aware that IP licenses can be registered under TIER, and this is often requested by a Chinese licensee. Here as well, the corporate background checks on the prospective licensee outlined above can also help in managing IP-specific risks.

Other key considerations, Mr. Chang noted, are in the area of trade secrets. It is critical to have a robust non-disclosure agreement (NDA) in place before starting discussions or providing samples to a prospective licensee. Notably, Chinese law does not prohibit reverse engineering, so any obligation to this effect would need to be addressed contractually. In addition, Mr. Chang noted, licensors should consider requiring licensees to impose confidentiality provisions on “all persons” having access to the information, to capture both current employees and others involved in the transaction should they later leave the company. Appropriate physical and technical measures can be implemented to protect confidentiality, such as employee training and vetting, as well as controlled access to facilities, documents, and stand-alone offline computer systems.

Picking up on the themes noted by Mr. McGinty, Mr. Chang also pointed out that restrictions on the use of licensed IP are among the most important terms to clarify and are often heavily negotiated. It is important that a licensor defines carefully the scope and applicable field of use, possibly including non-compete or territorial limitations. Mr. Chang also pointed out that under Chinese law, some otherwise common terms, such as no IP challenge clauses, may have enforceability issues. It is also critical to come to agreement on use of future improvements and their possible joint ownership, as well as provisions related to breach of the agreement. Mr. Chang also noted that the term of a license will generally need to end at patent expiry and may otherwise be unenforceable.

As is clear from the above highlights, life sciences and health care companies interested in out-licensing to Chinese partners can face potential challenges but also have the potential for great rewards, particularly as Chinese technology licensees are hungry for deals, have cash and can provide support to an early stage licensor who wants to focus on developing other products or on sales outside the licensed territory. China’s zero-COVID policy has also added to complexities in negotiations and document execution. However, by thinking ahead, having a Plan B, and working closely with skilled external counsel, interested parties can still make licensing deals work in this unique market.