Issues of Unfair Trade Practices to Consider in Transactions with Korean Pharmaceutical Companies Publication of the Guidelines for Fair Trade in the Pharmaceutical Industry by the Korea Fair Trade Commission and its Influence on the Market 1. Introduction It is common practice for Korean pharmaceutical companies to import drugs developed by foreign pharmaceutical companies or obtain a license from foreign pharmaceutical companies to manufacture or sell the products in Korea. In addition, many foreign pharmaceutical companies which have entered the Korean market sell their products through co-marketing or co-promotion arrangements with Korean pharmaceutical companies for lack of a well-organized internal system to engage in marketing and distribution in Korea. For such reasons, Korean and foreign pharmaceutical companies enter into various commercial agreements such as supply agreements, distribution agreements, license agreements, co-marketing agreements, co-promotion agreements, joint development agreements, etc. Under the Monopoly Regulation and Fair Trade Act of Korea (the “MRFTA”), transactions under duress, abuse of dominant position in trade, trading under unfairly restrictive terms and conditions, excluding competitors, or disrupting business activities are defined as unfair trade practices and constitute unlawful activities.1 In certain aspects, unfair trade practices under the MRFTA may have a broader scope of application than those in other advanced countries regulated by their respective antitrust laws. In fact, in cases dealing 1 Article 23(1) of the MRFTA 2 / 11 with unfair trade practice issues raised by the Korean Fair Trade Commission (the “KFTC”), the KFTC probes into whether the relevant transactions’ terms and conditions are not only anti-competitive in the relevant market but also commercially fair. Therefore, some of the specific terms and conditions of such various commercial agreements that are lawful in other countries may be in violation of the MRFTA. Another unusual feature of the MRFTA is that it explicitly prohibits an enterprise from entering into an international agreement with provisions that fall under unfair trade practices or resale price maintenance.2 If any enterprise violates the MRFTA, the KFTC may take corrective measures, impose an administrative fine or in some cases, file a criminal complaint with the prosecutor’s office.3 In many cases, the governing law of such international contracts is the law of another country. However, the MRFTA may still be applicable to such cases as it is a mandatory law of Korea. According to Article 2-2 of the MRFTA, the MRFTA applies to any act that affects the domestic market even if it is performed abroad. In this regard, if a party of such international contract is a Korean pharmaceutical company, the terms and conditions of such contract must comply with the MRFTA. Thus, any foreign pharmaceutical company executing a contract with a Korean company must carefully review such terms and conditions in order to ensure that the provisions are not in violation of the MRFTA. Recently, the KFTC published guidelines for fair transactions in the pharmaceutical industry (the “Guidelines”) in the form of a model supply agreement. After reviewing a variety of commercial agreements, the KFTC included in the Guidelines model clauses that would not violate the law which could serve as a substitute for contract conditions that are likely to violate the MRFTA.4 Although the Guidelines are for supply agreements, it may be applied to other types of commercial agreements such as distribution agreements, license agreements, co-marketing agreements, co-promotion agreements, joint development agreements, etc. 2 Article 32 of the MRFTA 3 An administrative fine not exceeding 2% of the turnover of the concerned enterpriser may be imposed (Articles 24-2 and 34-2 of the MRFTA). Also, any person subject to criminal punishment may be punished by imprisonment for not more than two years or by a fine not exceeding 150 million won (Article 67 of the MRFTA). 4 The KFTC announced that the Guidelines were drafted based on a research project, survey, experts’ opinions and opinions of the relevant organizations including the Korea Pharmaceutical Manufacturers Association. It also stated that 429 agreements obtained in the course of the survey were analyzed. According to the KFTC’s analysis, contract conditions that are likely to be in violation of the MRFTA and the percentage of such conditions in the agreements are as follows (page 2 of the press release by the KFTC dated January 9, 2013) 3 / 11 The Guidelines have no binding effect as a regulation and noncompliance with the model clauses in the Guidelines itself would not automatically result in a violation of the MRFTA, but there is a high possibility that the conditions that significantly deviate from the Guidelines will be deemed as a violation of law by the KFTC.5 Therefore, special attention must be given to the Guidelines. The model clauses provided in the Guidelines contain conditions favorable to the Korean pharmaceutical companies which are, in many cases, purchasers, licensees or distributors under such agreements. Therefore, after the announcement of the Guidelines, there have been an increasing number of cases where Korean pharmaceutical companies demand their foreign counterparties to revise the existing agreement in compliance with the Guidelines. With regards to contract conditions listed in the Guidelines as the ones likely to be in violation of the law, the following section will explain what makes each type of contract condition unlawful and what the KFTC suggests as a model clause. As explained below, the standard conditions provided by the KFTC are generally more focused on protecting the purchaser, licensee and distributor rather than the supplier and licensor. Therefore, strict compliance with the standard terms may result in inadequate protection of the commercial interests of foreign pharmaceutical companies, which are often suppliers or licensors under the agreements. In such case, it would be advisable to create terms and conditions that are less likely to violate the law while protecting the reasonable interests of the foreign counterparty as much as possible. The explanation below will provide assistance in formulating such alternative terms and conditions. - Prohibiting activities related to competing products (37%) - Fixing sales target or minimum sales (18%) - Restricting suppliers of raw materials (12%) - Fixing minimum purchase quantity (10%) - Prohibiting entering into generic drug market (8%) - Restricting sales region and customer base (5%) - Prohibiting research and development (3%) - Providing R&D outputs free of charge (2%) - Others (5%) 5 The KFTC continues to monitor whether the Guidelines are well followed and has announced that any violation of the law that has been pointed out in the Guidelines will be strictly punished (page 4 of the above press release). 4 / 11 1. Review of Terms and Conditions that are Likely to Violate the Law6 A. Prohibiting Activities Related to Competing Products In many agreements, there are clauses setting forth that Y shall not conduct R&D, produce or sell any competing products without X’s prior written consent (the consent is at the absolute discretion of X) and such obligation of Y shall survive for a considerable period of time after termination or expiration of the term of the agreement. In addition, in many cases, competing products are broadly defined enough to include not only the ones with the same or similar ingredients but also the same or similar indication. With respect to such a contract provision, the Guidelines provide a model clause as set forth below. The KFTC recommends not including such a provision without reasonable grounds such as preventing Y’s free riding. Article ** Prohibiting Activities Related to Competing Products ① Y shall not participate in the promotion or sales activity of any product in competition with the Products during the term of this Agreement without X’s prior consent, and X shall not unreasonably withhold its consent upon Y’s request in connection with a competing product without reasonable grounds. ② “Any product in competition with the Products” as referred to in Paragraph 1 above shall mean products that have the same active pharmaceutical ingredients and indication as the Products. ③ Prohibition of activities related to competing products under this Agreement shall not apply to Y’s products that are already under production or on the market when this Agreement comes into effect.7 6 For the sake of convenience, “X” stands for supplier or licensor and “Y” stands for purchaser or distributor. 7 The products for which R&D is in progress on the execution date of the Agreement may also be exempted from the prohibition upon mutual agreement of both parties. 5 / 11 As evident in the above model clause, the KFTC takes the position that if a non-competition clause is included in an agreement, it should be applied only during the term of the agreement, and the scope of competing products should be minimized as much as possible. Furthermore, in principle, Y may be relieved of this obligation unless there are reasonable grounds not to do so. However, it is always commercially reasonable for X to prevent Y’s free riding or Y’s dealing with competing products which would prevent maximum sales of X’s products. Furthermore, there is no objective criteria to determine what constitutes “commercially reasonable” and it may be different in each case depending on X’s commercial interests. Accordingly, the phrase in the model clause which states, ‘X shall not unreasonably withhold…” appears to excessively restrict X’s rights. Therefore, if X is not willing to accept such a phrase, an alternative would be to specify a justifiable reason under specific circumstances where Y’s non-competition cannot be waived. In other words, the agreement may include a provision explaining the types of consequences that would result from Y’s dealing in competing products and stating that Y agrees to the non-competition obligation with full understanding of the explanation. Furthermore, it is recommendable not to use any expression that may be viewed as obviously favorable to X, such as “X’s absolute discretion” because X’s consent or approval right will not be restricted even without including such expression. Considering the position of the KFTC, it seems that the definition of “competing products” would have to be restricted as suggested in the Guidelines. In particular, it is necessary to refrain from expanding the scope of competing products to ‘similar’ and ‘indirect’ products from ‘the same’ and ‘direct’ products as suggested in the Guidelines. However, in many cases, it will not be easy for X to accept setting limits on the competing products to those with the same ingredients “and” indication. Products with different ingredients but the same indication can be competing products. Therefore, it would be reasonable to revise the above model clause to “the same ingredients “or” indication.” As an alternative, products that have a materially adverse effect on the sales of the relevant products even though it does not have the same ingredients and indication may be specifically listed as a competing product subject to non-competition clause in the agreement. The KFTC will most likely have a negative view on the application of this clause for a period exceeding the term of the agreement. An alternative to consider could be the prohibition of Y’s R&D for competing 6 / 11 products during the term of the agreement since it would take a while for Y to develop new products after the termination or expiration of the contract term. However, if Y imports and distributes products from other competitors immediately after the termination or expiration of the contract term, such activities will likely result in a material adverse effect on the sale of X’s relevant products. X may reduce such risk by prohibiting not only R&D, production and sales of the competing products but also negotiation or bargaining with other competitors during the term of the agreement. B. Fixing Minimum Purchase Quantity, Sales Target and Minimum Sales Many supply agreements or distribution agreements include clauses that set forth predetermined purchase quantity or sales volume for Y to achieve and gives X the right to terminate, give disadvantages to Y in the transaction or deprive Y of its exclusive right if Y fails to meet the goal. With respect to such provision, the Guidelines provide the following model clause. The KFTC views it as a violation of the law to terminate the agreement or suspend the product supply for Y’s failure to achieve target sales, or transfer X’s economic loss caused by target shortage to Y through adjustment of purchase price or imposition of penalties. Article ** Termination of Agreement (Immediate Termination) Either party may immediately terminate this Agreement by giving written notice to the other party when any of the following events occur. However, a party shall not immediately terminate this Agreement for any reason related to failure to meet the minimum purchase quantity or target sales: A. Where the other party applies for insolvency or rehabilitation proceedings; B. Where the other party is declared bankrupt; or C. Where it is deemed that the other party is not able to perform its obligations under this Agreement due to financial hardship caused by any disposition order including provisional attachment, provisional injunction, compulsory execution, delinquency disposition or other similar disposition. 7 / 11 However, the statement prohibiting X from terminating the concerned agreement for any reason related to failure to meet the minimum purchase quantity or target sales should not be the only option for the clause to be lawful, and it is understandable that it would not be easy for X to commercially accept such a clause. If the target sales is achievable in X’s perspective and yet Y fails to meet the amount of sales due to Y’s lack of business ability, it may be a commercially important factor for X in deciding to terminate business relationships with Y. If X has to waive such right, it would not be easy for X to find an alternative to address the risk of Y’s business failure. This situation would be particularly challenging for X if Y is an exclusive distributor in Korea. Therefore, if Y is an exclusive distributor, it should be reasonable to insert a clause providing that if Y fails to meet the target sales, X may deprive Y of its exclusive distribution right. In addition, if X’s termination right is absolutely necessary for Y’s unsatisfactory performance, X could include a clause that gives such termination right not immediately upon the first occurrence of Y’s target shortage but after Y’s continued failure to meet annual target sales. Having a short initial term of the agreement with the option to renew can be another alternative for X to be able to immediately terminate in case of Y’s poor performance. In other words, if the contract term is short and Y’s performance is not satisfactory, X may terminate the agreement without violating the law by refusing to renew such agreement. Furthermore, if X’s refusal to supply due to Y’s failure to achieve the target goal is likely to be in violation of the law, X may reasonably reduce the volume supplied to Y. Any clause intended to transfer X’s economic loss resulting from Y’s failure to meet the goal to Y in the form of a penalty is likely to be in violation of the law and should be avoided. C. Ownership of Improvements or Derivative Technology In general, a supply agreement or distribution agreement does not contain a clause for licensing of any intellectual property rights other than the trademark rights related to the concerned products. Rather, such agreements usually provide that Y does not have any right to X’s intellectual property rights other than the licensed rights. Therefore, issues regarding ownership of improvements or derivative technology or the existence of a license arise in cases where Y directly produces and distributes a product of which technology has been licensed by X to Y. 8 / 11 With regards to such matter, the KFTC provides the following model clause in the Guidelines: However, it is understandable that not many Xs will accept the above model clause. Even if such invention or discovery is made by Y, it would be unreasonable to completely exclude X’s rights that touch upon the licensed intellectual property rights or licensed products. In particular, X would most likely refuse to pay fees to Y for improvements or derivative technology. The KFTC states that the purpose of the above model clause is to rectify the commercial practice of requiring the technology invented or discovered by Y to be transferred to X free of charge. However, the above model clause seems to grant excessive protection to Y beyond its purpose. If following the model clause is the only way to avoid violating the law, it is highly likely that X will not grant a license to Korean pharmaceutical companies or prohibit Y from conducting R&D of licensed intellectual property rights or products. Accordingly, the interests of X and Y may be balanced by granting Y ownership of improvements or derivative technology and granting X a non-exclusive license free of charge. Thus, the KFTC’s Guidelines on this matter should be amended to guarantee the balanced interests of X and Y as the Article ** Improvements ① Y If Y makes an invention or discovery in connection with the Products, Y shall have the right to obtain a patent for such invention or discovery. ② If Y obtains a patent for such invention or discovery pursuant to Paragraph 1 above, X shall have a non-exclusive license for such patent; provided, however, such non-exclusive license shall be automatically granted if it is inevitable for X to use such patented invention in order to manufacture, sell or promote the Products under this Agreement. In the event that it is not inevitable, whether to grant a license or not shall be determined upon mutual agreement of the parties. ③ X shall pay reasonable fees to Y in return for the non-exclusive license granted under Paragraph 2 above. ④ X shall not transfer to a third party the non-exclusive license granted under Paragraph 2 above. 9 / 11 current clause provides protection only to Y. Also, the possibility of various alternatives should be recognized. D. Restricting Suppliers of Raw Materials The clause restricting suppliers of raw materials can be found in cases where Y manufactures and sells the products using licenses granted by X, although such clause is not used very often in actual transactions because there are many suppliers that provide good quality raw materials for pharmaceuticals. The KFTC views provisions restricting suppliers as an excessive restriction on Y’s freedom to choose its own suppliers. Therefore, the KFTC suggests the following provision in the Guidelines: However, it is questionable whether the second sentence of the above clause is necessary as a condition in the contract. If X desires to require Y to purchase raw materials from X or any other person whom X designates, in most cases, X will try to convince Y of why it must do so by presenting objective data during the negotiation process. In addition, even if the quality or safety of raw materials is not a matter of concern, it would not be uncommon for X to achieve its economic goals by having Y purchase raw materials from X in exchange for reduced license fees, while Y can secure stable supply of raw materials which would be commercially and economically advantageous to Y as well. Therefore, it is advisable to determine whether the provision restricting raw material suppliers violates the law or not only after a comprehensive review of the reasons and process behind such contract condition. The KFTC’s Article ** Supply of Products In order to guarantee consistent quality and safety of the Products, Y shall purchase all necessary raw materials from X or any other person designated by X. X shall provide Y with the information on how using such raw materials contributes to the quality and safety of the Products and the risk associated with using other raw materials based on objective data, such as test results. 10 / 11 suggestion of a model clause should not place a restriction on the parties’ freedom to choose among various alternatives based on their commercial interests. 2. Conclusion As explained above, the Guidelines do not seem to perfectly reflect the well-balanced economic interests of X and Y. It is foreseeable that in many actual agreements, alternative clauses other than the model clauses in the Guidelines will have to be used. The difficult question is how to determine the probability of such alternative clauses violating the law. Accordingly, a foreign pharmaceutical company entering into a commercial agreement such as a supply agreement with a Korean pharmaceutical company should carefully check the contract conditions for which the KFTC raises special concern in the Guidelines and the grounds therefor, as well as the matters that the KFTC strictly restricts or allows flexibility for alternatives. With such information, foreign pharmaceutical companies should make an effort to negotiate an agreement that would minimize the risk of the KFTC’s complaint for violation of the law while protecting their commercial interests to the greatest extent possible. In particular, multinational pharmaceutical companies who usually use the same form agreement throughout the world pursuant to their internal policy tend to be hesitant to revise such form agreements in the course of negotiation with their counterparties. If that is the case, such form agreement is likely to contain a clause that is in violation of the MRFTA. Therefore, in cases where the counterparty is a Korean pharmaceutical company, it is necessary for the multinational pharmaceutical company to reconsider its internal policy and try to localize its form agreement or revise it in consideration of the regulations in Korea with the help of a Korean legal expert. Most importantly, if the counterparty is a Korean pharmaceutical company, even if Korean law is not the governing law, caution should be taken by fully reviewing the contract with Korean legal experts to see if any clause may be in violation of the MRFTA. The KFTC should also be careful not to apply the Guidelines too strictly as to restrict the negotiability for 11 / 11 various conditions reflecting commercial interests between the parties, which are common in all kinds of transactions. The KFTC should keep in mind that its excessive involvement to maintain superficial fairness of the contract provisions may go beyond the purpose of the MRFTA of regulating anti-competitive practices and undermine the principle for private transactions such as freedom of contract.