Top legal issues to think about in China-related licensing transactions | Hogan Lovells

Introduction

Through much of 2023, the fundraising environment for private biotechnology companies in China was challenging.1 The year ended with total investment of US$6.159 billion, down 75% from 2021. Against this backdrop, biopharma companies have turned to licensing and collaboration deals to seek external financing that is non-dilutive to their shareholders. Notably, there were 80 Out-Licensing deals in 2023 involving US$4.63 billion in total upfront payments, representing an increase of 205% compared to 2022.2

It was a different story for In-Licensing—there were only 36 deals in 2023 and the total upfront payments were US$263 million, which was a fraction (~23%) of the deal value in 2021.3 The reasons for subdued In-Licensing activity include:

• Chinese pharmaceutical companies have been focused on preserving cash flow;

• concerns about clinical trial performance and domestic demand have prompted Chinese licensees to become more cautious about introducing early development stage products to China; and

• the broad economic slowdown has created a certain hesitancy on the part of Chinese life sciences companies when it comes to entering into major new transactions.

Issues

Given the unsteady environment, deal dynamics for licensing transactions have been impacted to varying degrees. We have highlighted below a list of preliminary legal, regulatory and commercial issues that should be considered in advance of any collaboration or licensing transaction with a Chinese counterparty.

Pre-deal due diligence

The risk profile of the Chinese licensors or licensees may have changed quite significantly in recent years and will significantly impact the deal structure, negotiation strategy, and transaction timeline. Foreign pharmaceutical and biotechnology companies should perform a high-level due diligence to understand:

• whether the Chinese party is a private company or public company, as the latter may trigger certain disclosure or reporting obligations and will add complexity for any guarantee given by the Chinese party;

• whether the Chinese party is a private company or a state-owned enterprise; as this may affect the approvals required to consummate the transaction;

• whether the Chinese party has had any experience with In-Licensing or Out-Licensing, as there will be a steep learning curve for a counterparty that lacks licensing experience;

• the IP portfolio of the Chinese party, such as what IP the Chinese party owns, whether any third-party licenses are required to develop the licensed products, and what restrictions the Chinese company is subject to that may affect its ability to grant licenses or receive benefits in Out-Licensing transactions; and

• whether the Chinese party is represented by experienced licensing counsel who can structure and negotiate commercial agreements; often overlooked in international transactions is the extent to which differences in language, communication protocols, and the role of transaction advisors will affect the quality of engagement and efficiency of the deal process.

Applicability of Chinese law

Cross-border license or commercialization agreements can be governed by non-Chinese laws. Where one of the contracting parties is a foreign entity, Chinese law allows the agreements to be governed by foreign law, such as New York law, Delaware law, or the laws of England and Wales. As a matter of practice, it is not uncommon to choose foreign law to govern a license agreement in which one party is a foreign company, mainly because the foreign licensor or licensee is more familiar with such foreign law and is more comfortable with how the terms are interpreted under such law. For example, an indemnity is a well-established concept under US or English common law, but there is no equivalent under Chinese law where an indemnity is purely a “creature of contract”.

However, even where a license agreement is governed by foreign law, Chinese law will apply in certain circumstances, and such application cannot be contracted out of by the parties thereto. Specifically, compliance with Chinese law with respect to the following issues is mandatory:

• protection of workers’ rights and interests;

• food or public health safety;

• environmental safety;

• financial security, such as foreign exchange control;

• anti-monopoly or anti-dumping; and

• other issues where Chinese mandatory provisions should be recognized.

In addition, a license agreement cannot be governed by foreign law if such application will “damage the social and public interests of the PRC”. There is no detailed guidance as to what constitutes “damaging the social and public interests of the PRC”. Nonetheless, in practice, Chinese courts rarely invoke the foregoing rule to invalidate foreign governing law. As long as the license and collaboration agreements are in compliance with mandatory Chinese laws, the likelihood of such agreements not being granted enforcement in China is relatively low.

It is worth noting that there are places where Chinese law, which is a civil law jurisdiction, conflicts with foreign law, in particular if such foreign law is based on the Anglo-American system. Although Chinese law is a civil system and so court cases do not give rise to a binding precedent as they do in common law jurisdictions, cases in China do give an indication of judicial policy. For example, a well-drafted covenant not to sue (i.e., an agreement whereby one party agrees not to sue the other party or postpone a lawsuit for an agreed period of time) may be enforceable under Delaware law, but its validity and enforceability have been challenged by several courts in China. Advice from Chinese legal counsel should be sought as to how to reconcile foreign governing law and enforceability against a Chinese counterparty (the latter will turn on the dispute resolution method chosen, but it should not be forgotten that China will only enforce a foreign court judgment on the basis of either (i) reciprocity or (ii) bilateral treaty or international convention).

Marketing authorization holder (MAH)

When it comes to regulatory approval, China maintains a dichotomy between pharmaceutical products manufactured in China and those outside China. In general, the MAH for drugs manufactured outside China and commercialized in China must be a foreign entity, whereas the MAH for products manufactured and commercialized in China needs to be a Chinese entity. There is an exception for MAHs who are based in Hong Kong or Macau, as they can contract-manufacture drugs in certain regions in China.

The practical implication of the bifurcated regulatory pathway means that in an In-Licensing transaction, the foreign licensor will be the MAH, even it is the Chinese licensee that is obligated to commercialize the products in China. In this case, the foreign MAH can appoint the Chinese licensee as its local agent (a role mandatorily required under Chinese laws) to handle product registration with the National Medical Products Administration (NMPA) on behalf of the foreign licensor, perform certain obligations, such as coordinating recalls and responding to NMPA’s questions. The agent will also bear joint liability with the foreign MAH.

That said, foreign companies are still wary of being registered as the MAH for drugs imported and distributed in China, as the MAH is responsible for the safety and efficacy of the licensed products throughout the product life cycle and is exposed to various legal and compliance risks. There are a variety of ways to mitigate such risks, including putting in place a transition arrangement whereby the foreign licensor will act as the MAH for the benefit of the Chinese licensee until the manufacturing technology transfer is completed and the Chinese licensee can be the MAH for the locally manufactured drugs, as well as the Chinese licensee indemnifying the foreign licensor for all liabilities resulting from the licensor being the MAH.

Technology import or export restrictions

In the context of cross-border licensing, In-Licensing is generally deemed to be a form of technology import, while Out-Licensing is deemed to be technology export. Broadly speaking, China divides the underlying technologies into three categories: prohibited, restricted or permitted.

For In-Licensing, there are no relevant technologies in the life sciences sector in the prohibited category, and most technologies are permitted and thus are unrestricted to import into China. However, technologies relating to highly pathogenic microorganisms are restricted from import and require both pre-signing approval, i.e., Letter of Intent on Technology Import Approval (in Chinese: 技术进口许可意向书), and post-signing approval, i.e., Technology Import Approval Certificate (in Chinese: 技术进口许可证), from the provincial-level Ministry of Commerce (MOFCOM). In this scenario, the license agreement cannot become effective until receipt of the Technology Import Approval Certificate.

In Out-Licensing transactions, technologies that are prohibited from export include certain traditional Chinese medicine-related resources and manufacturing technologies and cell cloning and gene editing technologies for human use. Technologies in the restricted category include certain strain or virus selection and breeding technologies related to vaccine manufacturing and tissue engineering medical device manufacturing technologies. Exporting restricted-category technologies is also a two-step process: first, obtaining a pre-signing approval, i.e., Letter of Intent on Technology Export Approval (in Chinese: 技术出口许可意向书), before entering into the license agreement, and then obtaining a post-signing approval, i.e., Technology Export Approval Certificate (in Chinese: 技术出口许可证), before the agreement comes into effect.

For technologies that are permitted to be imported or exported, the Chinese licensor or licensee only needs to register the underlying license agreement with MOFCOM within sixty (60) days after the effective date of the agreement. Note that failure to register does not affect the validity of the agreement.

Data and human genetic resources (HGR)

A license agreement, especially an In-Licensing agreement, usually involves the development and commercialization of pharmaceutical products in the licensed territory. Therefore, scientific research or clinical trials relating to the licensed products will normally be required in China for product registration purposes. If the development entails the use, storage or transfer of human genetic resources (HGR) or data (such as blood data) of Chinese patients generated in clinical trials in China, such research and development may trigger regulatory approval requirements regarding HGR.

Under applicable law, sponsors and the Chinese sites must record-file with or obtain approval from the National Health Commission with respect to the use of Chinese HGR materials or data before conducting clinical trials or sharing or transferring the trial data with foreign parties. As part of the record-filing or approval application, the following information will need to be submitted to the National Health Commission: protocols, clinical trial agreement, license agreement, ethics committee approval, informed consent form, application form and data-flow-related information.

Two-invoice requirement

China has a specific rule relating to drug distribution called the “two-invoice requirement” which is designed to streamline supply chain and restrict drug price gouging. Specifically, under the “two-invoice requirement,” there can only be two invoices (fapiao) during the distribution process from a drug manufacturer to the hospital—one invoice issued by the manufacturer to the distributor, and the other invoice issued by the distributor to the hospital.

In connection with exclusive In-Licensing, the exclusive China licensee/distributor (which is limited to one entity) of imported drugs can be considered a “manufacturer”. As a result, the invoice from the foreign licensor/manufacturer to the exclusive Chinese distributor will not be counted as one invoice under the “two-invoice requirement”. This means the exclusive Chinese distributor can use an additional layer of sub-distributors to commercialize and distribute the licensed products in China.

In light of the “two-invoice requirement”, the licensee’s distribution capability has become increasingly important—foreign companies need to partner with licensees/distributors capable of covering a broad geographical area who do not need to rely on myriad layers of sub-distributors.

Foreign exchange controls

Cross-border licensing deals are subject to China’s foreign exchange controls if they involve payments in or out of China. If the license agreement is not properly registered with the competent authorities in China where required to be so registered, there is a risk that the banks handling wire transfers to the foreign licensor may reject payments.

In addition to the technology import or export registration certificate, the license agreement, and the tax clearance certificate, banks may also require other supporting documents to assess the lawfulness of the transaction. To avoid any payment delays or difficulties, the Chinese counterparty may offer to use its subsidiary registered outside China as the licensee, with a sublicense from the offshore subsidiary to the Chinese parent. Given that such subsidiary is likely a holding company with no operations or assets, a foreign licensor may require the Chinese parent to provide a parent guarantee in support of the performance obligations of its offshore subsidiary under the license agreement.

To ensure the guarantee can be enforced against the Chinese parent, it will need to be registered with China’s foreign exchange regulator (the State Administration of Foreign Exchange) once the guaranteed amount is determined. As the guarantee relates to the performance of the licensee’s obligations under the license agreement, it is difficult to put a dollar value on the guaranteed amount at the signing. As such, the guarantee agreement should include covenants pursuant to which the Chinese parent should register the guarantee as soon as feasible under Chinese law.

Dispute resolution

China is a party to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards, a.k.a., the New York Convention. This means that arbitral awards rendered outside China in a New York Convention member state are prima facie enforceable against Chinese companies in China, unless there is a procedural defect in the arbitration, or the award violates PRC public policy (which is typically very narrowly interpreted by the courts—we are only aware of one case in the public domain in which the public policy principle was invoked).

While foreign pharmaceutical and biotechnology companies, as well as research institutions, may be more familiar with the American Arbitration Association (AAA) and International Chamber of Commerce (ICC), the Hong Kong International Arbitration Centre (HKIAC) has become a more popular forum to resolve licensing disputes arising out of cross-border license agreements. Compared to other arbitral institutions, the advantages of HKIAC include cost efficiency, excellent track record of its awards being recognized and enforced in China, a wider pool of arbitrators who are well versed in Chinese and foreign languages and cultures, and HKIAC allows the parties to apply for interim relief in the PRC courts to support the arbitration proceeding (the relief covers a range of orders, including the freezing of bank accounts, seizure of assets, as well as preservation of evidence). This benefit only exists in arbitrations seated in Hong Kong.

Bankruptcy risks

China does not have the equivalent of Section 365(n) of the U.S. Bankruptcy Code, which grants a safe harbor to a non-debtor licensee, i.e., the licensee can continue using the license notwithstanding the debtor-licensor seeking to reject the license agreement. In China, if a company is in bankruptcy proceedings and the underlying license agreement is executory (i.e., under which the performance is due on both sides), the court-appointed administrator has absolute authority to determine whether to assume and continue to perform the agreement or to terminate the agreement. In other words, there is no statutory protection afforded to an IP licensee.

In In-Licensing transactions, from the foreign licensor’s perspective, bankruptcy of the Chinese licensee is usually a termination event that allows the licensor to terminate the license agreement unilaterally. In an Out-Licensing agreement, the foreign licensee will need to use drafting mechanisms to maximize its right to continue using the license if the Chinese licensor becomes an bankruptcy debtor. They include provisions pursuant to which the foreign licensee can continue using the licensed IP royalty-free notwithstanding the termination and the Chinese licensor covenants not to sue; ownership of data will be assigned to the foreign licensee; liquidated damages will be imposed on the licensor to disincentivize termination; and requiring the Chinese licensor to transfer the licensed IP to a bankruptcy-remote entity.

Conclusion

As in M&A transactions involving Chinese parties, the Chinese rules applicable to China-related collaborations and licensing deals are often ambiguous and scattered around various laws, regulations and judicial interpretations. Simply repurposing a Western-style form license agreement is not going to work, given the long-term nature of a licensing partnership, complexity of the Chinese market, and various risks associated with dealing with Chinese counterparties. Taking extra care when drafting the deal terms will help avoid common pitfalls. More so than ever in the face of the escalating geopolitical uncertainties, legal and regulatory challenges in cross-border licensing transactions should be addressed together with the counterparty in consultation with experienced counsel.

This is an article in our “Life Sciences Transactional Insights” series, which aims to provide key practical takeaways for our transactional colleagues by anticipating the needs of their regulatory, intellectual property, and business stakeholders. Our dedicated team of life sciences and health care licensing and commercial transactions lawyers understand the challenges and opportunities that strategic alliances and other partnering relationships present. We draw on the depth of our life sciences practice and work seamlessly with our regulatory team to provide unparalleled transactional and commercialization support. Ensure you are subscribed to Hogan Lovells Engage to receive our insights.

References

1 For purposes of this memo, “China” or “PRC” means the mainland of the People’s Republic of China, excluding Hong Kong, Macau and Taiwan.

2 The data citied in this paragraph are based on the report of MyBio Capital available at

3 Same as footnote 2.

Story originally seen here