The Supreme Court Puts Patent Royalties in Play

This article was first published in the January 31, 2007 edition of The Legal Intelligencer.

On January 9, 2007, the Supreme Court issued a landmark decision in Medimmune, Inc. v. Genentech, Inc., 549 U.S.___(2007) that confirms federal court jurisdiction in a declaratory judgment action brought by a patent licensee who is not in breach of the license agreement. It shields licensees from the consequences of an infringement claim while they seek to avoid future royalties by attacking the validity, enforceability or infringement of a licensed patent in a declaratory judgment action. This decision will likely lead to an explosion of litigation and renegotiations between licensors and licensees and possibly of infringement actions filed by patentees against alleged infringers. Lawyers will surely study the substantive law handed down in Lear v. Adkins 395 U.S. 653 (1969) and its progeny to recapture, in future license agreements, the pre-Medimmune licensor-licensee relationship. 

Prior to Lear, licensees were often estopped under state contract law or the terms of the license from challenging the validity of the licensed patents. This “licensee estoppel” was a tradition having its origin in the early 19th century, but the Lear Court noted, that licensee estoppel had been so inconsistently applied that “there has been a chaos of case law, proceeding on inconsistent premises.” 395 U.S. at 668. The Court then set down clear policy considerations and a holding that affirmed the right of a patent licensee to challenge the validity of the licensed patent.

In Lear, the licensor granted a license to the licensee while the patent application was still pending. Before the patent issued, the licensee took the position that the licensed invention was anticipated by the prior art and ceased paying the required royalties. When the patent issued, the licensor brought suit in a California state court for breach of contract. Ultimately the California Supreme Court applied California’s law of licensee estoppel and precluded the licensee from asserting the invalidity of the licensor’s patent.

The U.S. Supreme Court, in a review of the California Court’s decision, announced a “strong federal policy favoring the full and free use of ideas in the public domain.” 395 U.S. at 674 and held “that Lear must be permitted to avoid all royalties accruing after Adkins’ 1960 patent issued if Lear can prove patent invalidity.” 395 U.S. at 674. The Supreme Court took no position on pre-patent royalties and left that issue to the California courts.

In Gen-Probe, Inc. v. Vysis Inc., 359 F.3d 1376 (Fed. Cir. 2004), the Court of Appeals for the Federal Circuit (CAFC) issued an opinion that handed down the law that was tested in Medimmune. In Gen-Probe, the licensee notified the licensor that the licensed patent was invalid and not infringed by any product the licensee was selling and that they (the licensee) had, simultaneous with sending the notice, filed a declaratory judgment action to have the licensed patent declared invalid and not infringed. The licensee’s notice also stated that in order to maintain the status quo, they would continue to pay royalties and, indeed, they made the required payments. Eventually, the District Court hearing the declaratory judgment action conducted a two week jury trial that resulted in a finding of noninfringement and invalidity.

On appeal, the CAFC vacated the District Court’s judgment and remanded with instructions to dismiss the suit because both the District Court and the CAFC lacked jurisdiction to hear the merits of the case. According to the Gen-Probe court, “The Declaratory Judgment Act only supports jurisdiction in the event of an ‘actual controversy.’ 28 U.S.C. 2201(a). This requirement effectuates Article III of the Constitution, which only authorizes the federal judiciary to hear justiciable cases and controversies.” 359 F.3d at 1379. The CAFC reasoned that the licensee was not in breach of the contract and, with the license still intact, the licensee was not under “a reasonable apprehension of a lawsuit” 359 F.3d at 1380. With no reasonable apprehension of suit, the CAFC held “that no actual controversy supports jurisdiction under the Declaratory Judgment Act.” 359 F.3d at 1382.

Under Gen-Probe and before Medimmune, a licensee seeking to challenge the licensed patent and avoid future royalties had to breach the agreement by discontinuing its royalty payments, suffer termination of the license and defend the licensor’s subsequent suit for unpaid royalties and post-termination infringement. If the licensee lost, the licensor could seek an injunction under 35 U.S.C. 283, treble damages under 35 U.S.C. 284 and attorneys fees under 35 U.S.C. 285.

Medimmune is similar to Gen-Probe in that the licensee continued to pay royalties “under protest and with reservation of all [its] rights.” and brought a declaratory judgment action challenging the licensed patent. The District Court and the CAFC relied on Gen-Probe and dismissed the action.

On review, the Supreme Court discussed: a plaintiff’s right to bring a declaratory judgment action when threatened by action of the government; lower court decisions allowing a plaintiff to bring a declaratory judgment action when threatened with an enforcement action by a private party; and, their decision in Altvater v. Freeman, 319 U.S. 359 (1943). The Court then held that the licensee “was not required, insofar as Article III is concerned, to break or terminate its 1997 license agreement before seeking a declaratory judgment in federal court that the underlying patent is invalid, unenforceable, or not infringed.”

Moreover, the Court distinguished between federal jurisdiction and substantive law and made clear that it was not addressing substantive law: “even if the respondents were correct that the licensing agreement or the common-law rule precludes this suit, the consequence would be that the respondents win this case on the merits–not that the very genuine contract dispute disappears, so that Article III jurisdiction is somehow defeated.”  

After Medimmune, a licensee who continues to pay royalties under protest and has not otherwise committed a material breach is insulated from a termination of the license agreement, post-termination infringement and the consequences of losing its challenge to the licensed patent. The licensee now has nothing to lose by challenging the licensed patent except for legal fees. The licensor, on the other hand, faces legal fees merely to maintain the payment of the royalties to which the licensee had originally agreed. 

Medimmune may have other consequences that will impact business planning, borrowing and investments. Any business having a significant royalty income can no longer confidently rely on its royalty stream projections as it plans its business. A licensor’s potential lenders and investors may be advised to scrutinize the licensed patents to see how secure the projected royalties really are.

With respect to existing licenses, licensees are expected to evaluate the licensed patents on which they are now paying or expect to pay significant royalties. If they find any basis for challenging the licensed patents, they will likely seek to reduce or avoid their royalties through negotiation or in a declaratory judgment action. 

Licensors receiving or expecting significant royalties may try to pre-empt the licensee by evaluating the validity of their licensed patents after a new prior art search. If new relevant prior art is discovered, the licensor may be advised to cite this new art to the U.S. Patent and Trademark Office with a Request for Reexamination under 35 U.S.C. 302. A successful reexamination could be a very useful answer to a licensee’s validity challenge.

In future license agreements, licensors will surely address Lear, its progeny and the policy considerations announced in them to determine what enforceable approaches are available to address Medimmune. One obvious approach, if commercially feasible, is for the licensor to seek a large, non-refundable up-front payment in return for a paid-up license.

Another obvious approach is for the licensor to require a clause in the agreement that gives it an option to terminate the license if the licensee challenges the patent. If such a clause is enforceable, the licensor will have put the licensee back in jeopardy of an injunction, treble damages and attorneys fees.

Still another approach may be that the parties negotiating a license will participate in a due diligence investigation before concluding an agreement. The parties could jointly or independently conduct a prior art search and identify to each other all prior art not cited by the U.S. Patent and Trademark Office that is or may be relevant to the validity of the licensed patent. If the parties proceed to an agreement, the licensor may negotiate for the right to terminate the license agreement if the licensee challenges the validity of the licensed patent based on this known prior art.

What about the licensee who improves his leverage by taking a license today and challenging the validity of the licensed patent tomorrow. To protect against this, licensors may negotiate for a representation and warranty that the licensee has identified to the licensor all prior art known to licensee that is or may be relevant to the validity of the licensed patent. For a breach of this representation and warranty, the license agreement may include, in addition to all other remedies available at law or in equity, the licensor’s option to terminate the agreement. 

The following disincentives may also be tried to discourage licensees from challenging the licensed patent: different royalty rates, a higher rate during the challenge or a higher rate if the licensee’s challenge is unsuccessful; an undertaking that the royalties paid during the challenge will not be recoverable if the licensee is successful; an award of attorneys fees and costs to the prevailing party in the challenge; and, an agreement that any challenge to the licensed patent must be adjudicated in a designated court of licensor’s choice. 

In international transactions, we could see arbitration clauses designating a foreign country as the place of the arbitration and licensor friendly foreign law as the governing law.

In hybrid agreements including the transfer of patented technology, we may see the license grant and royalty obligation limited to the use of the transferred technology. Rather than grant a license or require royalties under the patents, the licensor may simply promise not to assert its statutory intellectual property without identifying any such property.

In a contentious patent dispute, the patentee may now be more likely to file an infringement action against the prospective licensee during negotiation. The vast majority of such suits are, in fact, settled and the patentee’s strongest negotiating leverage is before signing a license and ceding the Medimmune advantage to the infringer. As part of any settlement, licensors will surely insist that the settlement include a consent judgment finding the licensed patent valid and infringed. Such a judgment could form the basis of a res judicata defense in those certain circumstances where this defense has been found applicable. 

At this time we cannot know which, if any, of these approaches will be enforceable. We do know, however, that developing a path through the thicket of decisions and policy considerations announced in Medimmune and Lear will challenge business persons, both licensors and licensees, to determine what is commercially feasible and their lawyers to determine what is legally defensible.

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