It's an easy way to boost revenue. It allows businesses to squeeze additional value from their patents, garnering royalties at every step down the supply chain. No wonder a large–and growing–number of companies use this technique.

There's just one small problem. It may be illegal.

The U.S. Supreme Court was expected to decide the issue in Quanta Computer Inc. v. LG Electronics Inc. Instead, however, the court handed down a surprisingly narrow ruling. The June decision narrows patentees' rights, but not by much. It outlaws two techniques for asserting patent rights against downstream purchasers but leaves the door wide open to another, far more common way for patentees to achieve the same end. At least the door remains open for now.

“It is a very disappointing decision from the court,” says Joshua Sarnoff, who teaches patent law at Washington College of Law, American University, in Washington, D.C. “It decided so little, and it was such an important case.”

Businesses and their counsel are left scouring the court's ruling for clues as to what might happen next. “You are left reading tea leaves,” Sarnoff says.

Exhausting Patents
The issue comes down to this: How powerful is the first sale doctrine? This long-established rule, also known as patent exhaustion, mandates that a patentee's rights in an invention are exhausted once that invention is sold. The patentee cannot demand an additional royalty if the buyer subsequently resells the invention.

But there's an exception to this rule. In the 1938 case General Talking Pictures Corp. v. Western Elec. Co., the Supreme Court ruled that a patentee can sometimes use a conditional license to avoid patent exhaustion. The patentee in that case authorized the licensee to make and sell amplifiers embodying the patented invention–but only for home use. Despite knowing this restriction, the licensee sold and the defendant purchased some amplifiers for use in its commercial movie theaters.

Such an unauthorized sale, violating the terms of the patent license, does not exhaust the patent right, the court held. The court then upheld a trial court verdict against the defendant for patent infringement.

However, the Supreme Court has held that conditional licenses do not provide blanket authority to escape patent exhaustion. General Talking Pictures ruled such licenses can create downstream field of use restrictions (limiting sales to commercial versus residential, or to certain geographical areas). Other Supreme Court rulings have held conditional licenses do not exhaust patent rights if the conditions attempt to extend the patent monopoly beyond the scope of the patent–for instance, by mandating a minimum resale price or tying
the purchase of the patented item to the purchase of another nonpatented item.

Supreme Sidestep
The situation changed dramatically when the Federal Circuit issued its ruling in Mallinckrodt Inc. v. Medipart Inc. That decision expanded the types of conditions that patentees could put in their licenses, allowing a much wider range of downstream restrictions.

“Until 1992 … the imposition of post-sale conditions on use of the [patented] product … was widely thought to be unenforceable,” says James Dabney, a partner in Fried, Frank, Harris, Shriver & Jacobson. “That was changed by Mallinckrodt.”

Over time, an increasingly large number of businesses have relied on Mallinckrodt to impose downstream restrictions on their inventions. The Supreme Court, in Quanta, was widely expected to rule on whether Mallinckrodt was good law. But the Court sidestepped the issue by narrowly interpreting the license agreement so that it was not a conditional license.

Quanta did, however, foreclose two other avenues patentees might use to escape patent exhaustion. The court ruled that method patents were subject to exhaustion. Had the court ruled otherwise, patent exhaustion would have been seriously undermined since the overwhelming majority of patent claims can be written as method claims. “A patent drafter could shield practically any patented item from exhaustion,” the court wrote.

Nor can patentees escape exhaustion by selling something that is just short of the patented invention and allowing the purchaser to take a relatively simple action that makes the invention complete. Quanta held that exhaustion occurs when there is a sale of a product that “substantially embodies” the inventive aspect of the patent.

Falling Short
Many companies are expected to change their licensing agreements in response to Quanta. The Supreme Court made it clear that for a license to be conditional, the condition must be imposed on both the licensee and the downstream purchaser of the licensee's products.

The patent license in Quanta didn't do this. It gave the licensee an unconditional right to sell the patented items but imposed stringent conditions on the ability of downstream purchasers to use the patented items. This did not create a conditional license, the court held. The licensee had an unconditional right to sell, so the sale to the downstream purchaser was authorized and unconditional, and this sale exhausted the patent right.

To impose restrictions on downstream purchasers, patent owners will need to ensure that the conditions in their license agreements bind both licensees and downstream purchasers. Licensees won't like this, however, because if a licensee's customer fails to abide by the license conditions, the licensee could be liable for patent infringement.

“If a patentee wants to go after downstream purchasers, it must retain the right to go after [licensees such as] Intel, and companies like Intel may not accept terms like that,” says Greg McAllister, of counsel at Merchant & Gould. “[Licensees such as] Intel might refuse or demand to pay a much smaller royalty.”

Even if a patentee can conclude these tough negotiations successfully, the resulting conditional license is open to legal challenge. Because the Supreme Court sidestepped the issue, it remains unclear to what extent a patentee can use a conditional license to impose restrictions on downstream purchasers. For the moment, however, the law supports patentees' use of these licenses.

“Given the Federal Circuit's approach, patentees will still be free to do most of what they have done in the past, until the Supreme Court rules again. … And who knows when that will be?” says Mark Patterson, who teaches patent and antitrust law at Fordham Law School.

It's an easy way to boost revenue. It allows businesses to squeeze additional value from their patents, garnering royalties at every step down the supply chain. No wonder a large–and growing–number of companies use this technique.

There's just one small problem. It may be illegal.

The U.S. Supreme Court was expected to decide the issue in Quanta Computer Inc. v. LG Electronics Inc. Instead, however, the court handed down a surprisingly narrow ruling. The June decision narrows patentees' rights, but not by much. It outlaws two techniques for asserting patent rights against downstream purchasers but leaves the door wide open to another, far more common way for patentees to achieve the same end. At least the door remains open for now.

“It is a very disappointing decision from the court,” says Joshua Sarnoff, who teaches patent law at Washington College of Law, American University, in Washington, D.C. “It decided so little, and it was such an important case.”

Businesses and their counsel are left scouring the court's ruling for clues as to what might happen next. “You are left reading tea leaves,” Sarnoff says.

Exhausting Patents
The issue comes down to this: How powerful is the first sale doctrine? This long-established rule, also known as patent exhaustion, mandates that a patentee's rights in an invention are exhausted once that invention is sold. The patentee cannot demand an additional royalty if the buyer subsequently resells the invention.

But there's an exception to this rule. In the 1938 case General Talking Pictures Corp. v. Western Elec. Co., the Supreme Court ruled that a patentee can sometimes use a conditional license to avoid patent exhaustion. The patentee in that case authorized the licensee to make and sell amplifiers embodying the patented invention–but only for home use. Despite knowing this restriction, the licensee sold and the defendant purchased some amplifiers for use in its commercial movie theaters.

Such an unauthorized sale, violating the terms of the patent license, does not exhaust the patent right, the court held. The court then upheld a trial court verdict against the defendant for patent infringement.

However, the Supreme Court has held that conditional licenses do not provide blanket authority to escape patent exhaustion. General Talking Pictures ruled such licenses can create downstream field of use restrictions (limiting sales to commercial versus residential, or to certain geographical areas). Other Supreme Court rulings have held conditional licenses do not exhaust patent rights if the conditions attempt to extend the patent monopoly beyond the scope of the patent–for instance, by mandating a minimum resale price or tying
the purchase of the patented item to the purchase of another nonpatented item.

Supreme Sidestep
The situation changed dramatically when the Federal Circuit issued its ruling in Mallinckrodt Inc. v. Medipart Inc. That decision expanded the types of conditions that patentees could put in their licenses, allowing a much wider range of downstream restrictions.

“Until 1992 … the imposition of post-sale conditions on use of the [patented] product … was widely thought to be unenforceable,” says James Dabney, a partner in Fried, Frank, Harris, Shriver & Jacobson. “That was changed by Mallinckrodt.”

Over time, an increasingly large number of businesses have relied on Mallinckrodt to impose downstream restrictions on their inventions. The Supreme Court, in Quanta, was widely expected to rule on whether Mallinckrodt was good law. But the Court sidestepped the issue by narrowly interpreting the license agreement so that it was not a conditional license.

Quanta did, however, foreclose two other avenues patentees might use to escape patent exhaustion. The court ruled that method patents were subject to exhaustion. Had the court ruled otherwise, patent exhaustion would have been seriously undermined since the overwhelming majority of patent claims can be written as method claims. “A patent drafter could shield practically any patented item from exhaustion,” the court wrote.

Nor can patentees escape exhaustion by selling something that is just short of the patented invention and allowing the purchaser to take a relatively simple action that makes the invention complete. Quanta held that exhaustion occurs when there is a sale of a product that “substantially embodies” the inventive aspect of the patent.

Falling Short
Many companies are expected to change their licensing agreements in response to Quanta. The Supreme Court made it clear that for a license to be conditional, the condition must be imposed on both the licensee and the downstream purchaser of the licensee's products.

The patent license in Quanta didn't do this. It gave the licensee an unconditional right to sell the patented items but imposed stringent conditions on the ability of downstream purchasers to use the patented items. This did not create a conditional license, the court held. The licensee had an unconditional right to sell, so the sale to the downstream purchaser was authorized and unconditional, and this sale exhausted the patent right.

To impose restrictions on downstream purchasers, patent owners will need to ensure that the conditions in their license agreements bind both licensees and downstream purchasers. Licensees won't like this, however, because if a licensee's customer fails to abide by the license conditions, the licensee could be liable for patent infringement.

“If a patentee wants to go after downstream purchasers, it must retain the right to go after [licensees such as] Intel, and companies like Intel may not accept terms like that,” says Greg McAllister, of counsel at Merchant & Gould. “[Licensees such as] Intel might refuse or demand to pay a much smaller royalty.”

Even if a patentee can conclude these tough negotiations successfully, the resulting conditional license is open to legal challenge. Because the Supreme Court sidestepped the issue, it remains unclear to what extent a patentee can use a conditional license to impose restrictions on downstream purchasers. For the moment, however, the law supports patentees' use of these licenses.

“Given the Federal Circuit's approach, patentees will still be free to do most of what they have done in the past, until the Supreme Court rules again. … And who knows when that will be?” says Mark Patterson, who teaches patent and antitrust law at Fordham Law School.