Controlling Intellectual Property: The Supreme Court Rules on Patent Exhaustion

05 June 2017 Bankruptcy Talk Publication

Last week, the United States Supreme Court issued a decision dealing with the doctrine of “patent exhaustion.”  The case dealt with the sale of a patented product and the degree of control a patent holder (known as a patentee) can, or cannot, exercise over the product following the initial sale.  The case did not involve a patent license, but the Supreme Court discussed patent exhaustion in the context of licensing as well.  While the case dealt with the rather prosaic issue of printer cartridge sales, the broader issue of patentee control has wide-ranging implications on supply chain commerce.  The case did not involve bankruptcy law.  But, because this is a bankruptcy law blog, the case provides an opportunity to explore the issue of how intellectual property rights are affected by a bankruptcy filing.

The case, Impression Products, Inc. v. Lexmark International, Inc., involved printer manufacturer Lexmark.  Lexmark is the patentee of patents related to printer cartridges.  The U.S. Patent Act granted Lexmark, as with any patentee, the right to exclude others from using, offering for sale, or selling its invention.  Patent restrictions are designed to temporarily provide a patentee with “monopoly” powers in order to allow the patentee to maximize its profits.  The prospect of being able to profitably exclude others from using an invention (typically for a period of twenty years) theoretically encourages parties to spend their time, effort, and money on new and useful innovations.

Lexmark’s profitable cartridge sale venture was being undercut, however, by third parties known as remanufacturers.  Remanufacturers would purchase empty cartridges from Lexmark customers, refill the cartridges, and sell them as “refurbished” for less than the cost of a new cartridge.  Lexmark sought to restrict this practice by enacting a “Return Program” that allowed a customer to buy cartridges at a lower price, in exchange for contractually agreeing not to transfer empty cartridges to anyone other than Lexmark.  Lexmark also installed a microchip in the cartridges that physically prevented reuse.  The remanufacturers developed methods to disable the microchip and Return Program customers continued to sell them the empty cartridges.  Lexmark responded by suing certain of the remanufacturers, including Impression Products, for patent infringement, arguing that the remanufacturers’ tinkering with the empty cartridges violated the terms of the Patent Act because it made use of the product in express violation of Lexmark’s prohibitions.  Lexmark also argued that the remanufacturers’ importation into the United States of cartridges purchased abroad violated the Patent Act.

Impression Products filed a motion to dismiss in the district court, which was granted as to domestic cartridge sales, but denied as to imported cartridges.  On appeal to the Federal Circuit, the court (sitting en banc) ruled in favor of Lexmark on both issues, stating that a patentee who clearly communicates restrictions can reserve the right to enforce its patent following a sale.  The issue of patent exhaustion was then taken up to the Supreme Court.  The Court noted that the doctrine of patent exhaustion has existed for over 160 years.  The doctrine provides that a “patentee is free to set the price and negotiate contracts with purchasers, but may not, by virtue of his patent, control the use or disposition of the product after ownership passes to the purchaser.”  Put another way, a patentee may restrict use of the product to the party who initially purchases the product.  But, once that initial purchaser sells the product to a third party, the patent restrictions are “exhausted” and the patentee cannot use patent law to restrict how the third party uses the product.

The policy reasoning behind the doctrine is that if a patentee were permitted to exercise its restrictive patent rights beyond the first sale, it “would clog the channels of commerce, with little benefit from the extra control that the patentees retain.”  The Supreme Court held that the application in the case was fairly simple because it was undisputed that Lexmark sold a patented product to customers and that the customers thereafter sold the product to third parties.  The fact that the second sale was contrary to the terms of the contract between Lexmark and its customers was not an issue of patent law.  Lexmark likely had a viable breach of contract claim against its customer (a claim Lexmark was unlikely to ever pursue).  But, as to its rights as a patentee under the Patent Act, which was the issue before the Court, Lexmark had no claim against the remanufacturers.  The Court therefore ruled in favor of Impression Products with respect to both the domestic and international issues.

Selling a patented product is not the only means for a patentee to maximize profits.  The patentee could, instead, enter into a license agreement whereby something less than full ownership is conveyed by the licensor/patentee to the other party (the licensee).  Licenses typically convey rights upon a licensee for a limited period of time.  The licensee agrees to use the product only in a specified way and to make royalty payments to the licensor during the term of the license.  Once again, while the Impression Products, Inc. v. Lexmark International, Inc. case involved the sale of a patented product, rather than a patent license, the Court nevertheless took the opportunity to discuss patent exhaustion in the context of licensor/licensee rights.  The Court made clear that a license is different than a sale because a patent licensor “is exchanging rights, not goods, [and thus] is free to relinquish only a portion of its bundle of patent protections.”  Therefore, if a licensee violates the terms of a patent license by, for example, selling the product in a manner prohibited by the license, the licensor can bring a patent infringement action not only against the licensee, but also against any party who knowingly violated the restrictions.  But, if the license contemplates sale of the product and the licensee sells the product in compliance with the license, the sale is considered authorized by the licensor and the patent exhaustion doctrine applies.

The Court provided the following example to illustrate patent exhaustion with respect to licenses: assume a patent licensor has licensed the manufacture and sale of computers to a licensee on the condition that the computers only be sold for commercial use.  The licensee requires all purchasers to sign a contract stating that they will only use the purchased computer for commercial purposes.  The licensee thus is in compliance with the license as each sale is made.  In other words, the law views each sale as authorized by the licensor.  Thereafter, if a customer who purchased the computer violates his contract with the licensee by making non-commercial use of the computer, the licensor has no recourse under patent law against the customer because the licensor’s patent rights were exhausted by the authorized sale.  The licensee would have a breach of contract claim against the customer, but no viable patent infringement claim would exist.

The Impression Products, Inc. v. Lexmark International, Inc. case did not involve a bankruptcy filing or otherwise involve the application of bankruptcy law to intellectual property rights.  Because bankruptcy and intellectual property law issues are complicated, and subject to a number of different exceptions to the general rules, the matter deserves its own blog post (coming soon).  That said, the case should lead patentees to carefully review their sale agreements and licenses to determine what restrictions may and may not be enforceable under patent law.  As part of that review, patentees, as well as other owners of other intellectual property (including copyrights and trademarks), should also be mindful of how a bankruptcy filing may affect intellectual property rights, including the licensor’s ability to control the use and assignment of their property.

Bankruptcy cases very often deal with the going concern sale of a business free and clear of all liens, claims, and encumbrances under Bankruptcy Code section 363.  In fact, obtaining the clean title associated with such “free and clear” sales can be the primary motivation for a company (known as the “debtor”) to file bankruptcy.  Bankruptcy provides a forum for parties to assert rights in the debtor’s property, such as lien rights or rights under intellectual property law to restrict the use or assignment of the property.  Intellectual property issues arise just about every time a business is sold substantially intact.  These issues affect every industry, from computer software licenses to oil refinery processes.  While the intersection of bankruptcy and intellectual property law can give rise to many and complicated matters, a few important issues stand out.

First, a licensor cannot simply contract around the problem of a bankruptcy filing by including a term stating that the license automatically terminates upon the licensee filing bankruptcy.  Such clauses are deemed “ipso facto” clauses and they are unenforceable under bankruptcy law.  Second, bankruptcy law has the potential to affect the licensor’s ability to prevent the assignment of the license.  The general rule under bankruptcy law is that clauses prohibiting assignment are not enforceable in bankruptcy.  There is a significant exception to the general rule providing that if “applicable law” allows the non-bankrupt party to refuse to accept services under the agreement from anyone other than the original party, then the non-bankrupt party can prohibit an assignment.  Licensors of patents, copyrights, and trademarks have generally been successful at citing to federal intellectual property law statutes (the Patent Act, the Copyright Act, and the Lanham Act) as applicable law that allows the licensor to prevent assignment by a bankrupt licensee to another party.  But, depending on the jurisdiction, the case law is not entirely clear on the point.  In addition, a licensor must assert its rights in order to enforce the restrictions.  Bankruptcy cases can move quickly and a licensor who does not understand the issue and who does not raise it quickly, can find itself bound by bankruptcy court order to a license with an undesirable assignee.

The assignment issue also has the potential to provide licensors with incredible leverage over a bankrupt licensee, even if the licensee has no intention of assigning the license.  Due to a linguistic ambiguity in the Bankruptcy Code, courts in a number of jurisdictions have held that if applicable law would prohibit assignment of a license, then the license cannot be assumed in the bankruptcy case, even if the licensee never sought to assign the license in the first place.  Assumption is a bankruptcy law term of art meaning that the bankrupt party has agreed to comply with the terms of an agreement (such as a license) going forward.  Depending on the facts, a licensee prohibited from assuming a license may be unable to reorganize in bankruptcy and essentially would be driven out of business for that reason alone.

As to the issue of control, the Impression Products, Inc. v. Lexmark International, Inc. case tips the scales against patentees, at least with respect to using patent law to enforce rights against subsequent purchasing parties.  In the context of a bankruptcy filing, control – and therefore leverage – has the potential to swing back and forth between the bankrupt and non-bankrupt party, depending on things such as applicable non-bankruptcy law, where the case was filed, and the degree of engagement by the respective parties.  The ultimate lesson of the case is that paying attention to and understanding these issues is critically important in order to maximize a party’s rights under the law.

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