The U.S. Supreme Court Clarifies Patent Exhaustion

Article by

John C. Paul , Kia L. Freeman, Bart A. Gerstenblith

and Jessica R. Underwood

1. Introduction1

   In the United States, the doctrine of patent exhaustion cuts off

   a patent owner's rights to enjoin, control, or extract

   royalties from a patented product after an initial authorized sale

   of that product in the U.S. While the basic policy of preventing a

   patent owner from repeatedly extracting compensation for the same

   product seems straightforward, the law developed by the courts over

   the past two centuries in response to efforts by patent owners to

   preserve and control their rights is more complex. For example,

   patent owners have tried to avoid exhausting their rights in a

   patented product by characterizing their disposition of the

   patented product as a license rather than a sale, only to see that

   courts have uniformly concluded that patent rights are exhausted in

   such instances. Patent owners have also sold or licensed patented

   products with various restrictions on their subsequent use by

   companies at various levels in the supply chain.It is in those

   situations where the courts have most frequently discussed the

   exhaustion doctrine.

   Patent owners who license a component manufacturer often desire

   to retain their rights to obtain all or a large portion of their

   compensation from their licensee's customers who produce

   higher-value finished products by processing the component further

   or combining the component with other components to produce

   finished goods. While it would appear to be simple to accomplish

   this objective and avoid patent exhaustion by allowing a licensee

   to sell its components only to customers who were licensed by the

   patent owner at the time of sale, it is easier said than done. A

   component manufacturer would likely object to such a restriction

   because it creates a significant hurdle to making

   sales—limiting the component manufacturer's ability

   to sell only to customers who are already licensed or who are

   willing to take a license prior to the sale. Therefore, only

   licensors with significant negotiating power may be able to obtain

   such conditions in their agreements.

   As a result, during the negotiation process, licensors and

   licensees often reach a compromised resolution which allows the

   licensee to sell its components to all customers, regardless of

   whether they are licensed, and to agree to a lesser obligation that

   attempts to address the issue of patent exhaustion. The nature of

   such lesser obligations usually hinges on the relative negotiation

   power of the licensors and licensees and can include, for example:

   (1) conditioning the sale to its customer on the customer taking a

   license from the patent owner before processing the component

   further or combining the component with other parts to produce

   finished goods, (2) providing notice to the customer that the

   customer must take a license from the patent owner before

   processing the component further or combining the component with

   other parts to produce finished goods, (3) providing notice to the

   customer that the customer is not licensed to process the component

   further or to combine the component with other parts to produce

   finished goods, or (4) simply including in the license agreement

   between the licensor and licensee a provision that the

   licensee's customers are not licensed to process the

   subcomponent further or combine the component with other parts to

   produce finished goods.

   Part of the calculus for the licensor during the negotiation

   process is evaluating the likelihood that a court would find that

   the negotiated obligation allowed the patent owner to retain its

   rights to obtain some or all of its compensation from its

   licensee's customers, and whether the licensee's customers

   would be convinced that the patent owner retained such rights such

   that they would agree to take a license and pay the compensation

   desired by the patent owner. The U.S. Supreme Court recently

   provided further clarity and guidance on this point in Quanta

   Computer, Inc. v. LG Electronics, Inc., No. 06-937, 2008 U.S.

   LEXIS 4702 (U.S. June 9, 2008).

   Prior to Quanta, the last United States Supreme Court

   decision involving the patent exhaustion doctrine occurred more

   than 60 years ago in United States v. Univis Lens Co.

   Since that time, U.S. case law has been developed by the United

   States Court of Appeals for the Federal Circuit, which has

   exclusive jurisdiction over patent appeals.

   This article discusses the history of the exhaustion doctrine

   and concludes with a discussion of the arguments and issues raised

   and addressed in Quanta and some practical implications of

   the Court's decision.

2. Establishing the Exhaustion Doctrine

   In creating the patent exhaustion doctrine, the Supreme Court

   started with the Constitutional limitation that patents must serve

   "[t]o promote the progress of science and useful

   arts,"2 and recognized that the reward of inventors

   is merely a means to promote progress. Thus, it found that patent

   rights should be recognized only to the extent that they serve the

   larger purpose of the patent system—to promote

   progress.3 It concluded that patent rights in a patented

   article are exhausted whenever "there has been . . . a

   disposition of [a patented] article [such] that it may fairly be

   said that the patentee has received his reward for the use of the

   article."4

   The exhaustion doctrine thus operates to allow patentees to

   extract full consideration for a patented article, but no more.

   Accordingly, once a patent has been exhausted with respect to an

   article, the patentee has no further patent rights that can be

   exercised with respect to that article.5 The form of a

   transaction does not determine whether exhaustion

   applies,6 and thus the doctrine has been applied even

   though a transaction is not characterized as a conventional

   sale.

   1. Exhaustion Requires an Authorized Sale or Other Disposition

      of the Patented Article

      In determining whether patentees had received their just reward

      under their patents, the Supreme Court has looked to see whether an

      authorized sale or other disposition of a patented article had

      occurred. Purchasers of patented articles are generally subject to

      the terms of the sales or license agreement through which they

      acquired the articles. But a purchaser who acquires a patented

      article through an authorized sale takes it free from any patent

      rights.

      This principle is illustrated by comparing two cases involving

      the sale of a patented article under a limited license. In each,

      the Supreme Court focused on whether the sale of the patented

      article was within the scope of the license, and therefore

      authorized. If the sale was authorized, the doctrine applies, and

      the patent rights are exhausted in the licensed product. Otherwise,

      the doctrine does not apply, and the patent rights are not

      exhausted.

      In Adams v. Burke, the Supreme Court considered a sale

      by a licensee who was authorized to make, use, and sell patented

      coffin lids within a designated geographical area of the United

      States.7 Although an undertaker purchased the lids from

      the licensee within the designated area of the licensee, he used

      them outside the designated area.8 The patentee objected

      to the undertaker's use of the patented lids, presumably

      because the undertaker was competing with the patentee in an area

      reserved for the patentee. The Court recognized that, since the

      value of the patented article was in its use, the patentee should

      have received full consideration from the sale of the lids whether

      they were used within the designated area or elsewhere.9

      The Court therefore concluded that the licensee's sale of the

      lids to the undertaker was authorized and exhausted the patent

      rights in those lids.10 Thus, the patentee could not

      enforce the patent against the undertaker with respect to the lids

      purchased from the licensee, even though the lids were used outside

      the area in which the licensee was authorized to use them.

      In General Talking Pictures v. Western Electric, the

      Supreme Court considered a sale by a licensee who was authorized to

      make and sell patented amplifiers within a designated, private use

      market in the United States.11 The licensee admitted to

      selling the amplifiers to a customer knowing that the customer

      planned to use the amplifiers for commercial use in the motion

      picture industry, rather than in the private use market for which

      the license was granted.12 The patentee had licensed the

      use of his patent in the commercial market to different licensees,

      who sought to preserve the patent's separate value in that

      market by attempting to prevent the private use licensee from

      encroaching on the commercial use market in which they were

      licensed.13 The Court found that movie theaters were

      outside the private use market, and that the private use

      licensee's sale of the patented amplifiers for use in movie

      theatres violated the terms of his license and was therefore an

      unauthorized sale.14 As a result, the rights of the

      patentee in the amplifier were not exhausted.15 The

      purchaser, having bought the amplifier subject to the terms of the

      private use license, was therefore only authorized to use the

      amplifier in the private use market16 —and

      consequently, the patent could be asserted against use of that

      amplifier in the commercial market.

   2. Conditional Sales and Questionable Enforcement Under Patent

      Law

      Before articulating the exhaustion test in Masonite,

      the Supreme Court allowed for the possibility of an authorized, but

      conditional sale17 while suggesting that conditions

      imposed by the authorized seller at the time of sale might be

      enforceable under contract law, but not patent law.18

      This limitation to enforcement under contract law may suggest that

      a patentee could only enforce license or sales conditions against

      original and subsequent purchasers who had notice of the conditions

      or who agreed to the conditions, making it more difficult or

      problematic for the patentee to enforce the conditions against all

      downstream purchasers in the...