Patent Exhaustion: The United States Supreme Court Decision in LG Electronics v Quanta

In 1992, the United States Court of Appeals for the Federal Circuit held in the case of Mallinckrodt v. Medipart that not every sale of a patented article by a patent owner exhausts the right of the patent owner to bring an action for patent infringement against those who subsequently sell or use that article. Controversy has raged ever since. On the one hand are those who take the view that the decision jettisoned over a century of settled law to the effect that once the patent owner had sold a product, and presumably received a price for it that reflected its patented status, its rights were exhausted. On the other are those who take the view that if at the time of sale one attaches lawful conditions to what the purchaser can do with the article and those conditions are breached, the patent owner should be entitled to treat further dealings in the article as going beyond what was bargained for and so actionable, like other unauthorized dealings in a patented article, as being a patent infringement.

It was hoped that the Supreme Court might resolve this controversy when it decided the case of Quanta Computer Inc. v. L.G. Electronics. Unfortunately although its decision of June 8, 2008 made it clear that the Court of Appeals for the Federal Circuit had been wrong in holding that the exhaustion doctrine could not apply to method claims and that the exhaustion doctrine could apply even if multiple patents were involved, it did not address some of the key issues in the criticism of Mallinckrodt, deciding that on the particular facts of the case before it that there had been an unconditional rather than a conditional sale of the articles in question.

LG Electronics (LGE), the plaintiffs in the case owned patents on microprocessors, chipsets, systems containing such microprocessors and chipsets and methods of operating systems containing such chipsets and microprocessors. LGE had granted a license under the patents to Intel which contained no limitations on how Intel could exploit its rights under the license and specifically stated that “notwithstanding anything to the contrary contained in this Agreement, the parties agree that nothing herein shall in any way limit or alter the effect of patent exhaustion that would otherwise apply when a party hereto sells any of its Licensed Products”. By a separate agreement, Intel agreed that it would give notice to its customers that the license given to Intel by LGE and which covered the product sold by Intel to its customers “does not extend expressly or by implication to any product you make by combining an Intel product with any non-Intel product.”

Intel manufactured microprocessors and chipsets under the agreements and sold them to Quanta which incorporated them into “systems” (i.e. computers) covered by the licensed patents. Intel gave Quanta the notice required under its agreement with LGE, but Quanta nevertheless combined the purchased microprocessors and chipsets with parts not obtained from Intel. LGE sued Quanta for infringement of its claims relating to the systems and methods but not for infringement of patents relating to the microprocessors or chipsets themselves.

The district court found that LGE’s rights in the system patents had been exhausted by Intel’s sale of microprocessors that could effectively only be used in the patented systems, but, relying on some bald statements in earlier Federal Circuit decisions, held that sale of a product could not exhaust rights in a method patent. In this context, the court pointed out the differences between the exhaustion doctrine and that of an implied license in the following terms:

the patent exhaustion doctrine applies when a patentee has, in essence, sold its statutory right to exclusivity through the unrestricted sale or license of the patent. A patentee who has not abandoned its statutory right to exclude others from the use of its patent may nevertheless, through conduct that induces reliance, grant to particular parties an implied license to practice the patent.

The court held that there was no implied license in the present case because of the notice given to Quanta by Intel.

On appeal to the Court of Appeals for the Federal Circuit, that court simply stated that the Mallinckrodt case applied and held that there was no exhaustion of rights in patents to either the systems or the methods. Unfortunately, the Federal Circuit did not look at the specifics of the Mallinckrodt case and simply stated that the “exhaustion doctrine does not apply to an expressly conditional sale or license”, which is what the Court of Appeals for the Federal Circuit perceived to be the situation. In fact in its decision in Mallinckrodt, the Court of Appeals for the Federal Circuit had not gone that far. In Mallinckrodt, the issue had been whether reconditioning a medical device for delivery of an active material to the lungs and which had been sold subject to a “single use” limitation was a patent infringement. The Court of Appeals for the Federal Circuit held that it was an infringement and that a condition on a sale could be effective to prevent application of the exhaustion doctrine, if the condition itself did not violate law or policy (for example a patent misuse or a breach of antitrust law – the examples given being price fixing and tying) and the condition was reasonably within the patent grant. Possibly, the Court of Appeals for the Federal Circuit felt that there was no longer a need to address these issues in view of the Supreme Court’s decisions in Independent Ink Inc v. Illinois Tool Works, Inc. (2005) and Leegin Creative Leather Products, Inc v. PSKS, Inc. (2007) holding that tying and price fixing in vertical relationships were no longer to be regarded as per se antitrust violations.

The Supreme Court granted Quanta’s application for certiorari and agreed to review the Federal Circuit’s decision.

Quanta basically argued that the Federal Circuit’s decision in Mallinckrodt, and therefore necessarily in the present case also, was inconsistent with Supreme Court precedent, especially United States v. Univis Lens Co. (1942) and had in fact been expressly repudiated by the Supreme Court in Motion Picture Patents Co. v. Universal Film Manufacturing Co. (1917) when it overruled its earlier decision in Henry v. A. B. Dick Co. (1912) which had held that a patent right was not exhausted when the purchaser of a patented good breached a condition of sale. According to Quanta, LGE’s and Intel’s rights to restrict the use of articles after an authorized sale, were confined to what could be secured under contract law in the same way as for articles that had not been patented. Such a rule was also correct in making sound economic and policy sense: it required the patent owner (or manufacturing licensee) “to extract the full value of its patent rights in one negotiation with the first purchaser, which can then share the burden with the rest of the distribution chain by charging a higher price”. Down-stream purchasers were then safe to use what they had bought without fear of being sued for patent infringement. Quanta also argued that the exhaustion doctrine was equally applicable to method claims and system claims when the articles sold had no other reasonable use than in the systems and methods claimed and that this had been found by the district court and was unchallenged by the Federal Circuit.

LGE did not seek to defend the Federal Circuit’s decision on the basis that Mallinckrodt was rightly decided but rather on the grounds that LGE was not seeking to enforce patents on the actual items sold by Intel but rather to enforce patents relating to the use of such items. LGE pointed out that in the Univis case, the court had held that there was exhaustion where a single patent covered the products in question. According to LGE the traditional exhaustion doctrine is that the unconditional sale of a patented article exhausts patent rights in that article, but not in other patented systems of which that article might become a component. LGE further argued that the exhaustion doctrine could only apply to acts of selling or using a patented article obtained from the patent owner or its licensee. It could not apply to the separate right of making a patented system, which of necessity had to be a different invention from the invention embodied in the article that had been sold. What Quanta was doing in the present case was making the systems covered by the patents in suit. What Quanta was seeking to do was to trivialize the value of combination inventions by requiring patent owners to extract full economic value of all their the patent rights from the original purchaser of any component that was to be used in a patented combination. This would discourage innovation and rational risk and cost allocations among different users of technology. Similar arguments applied to patents covering methods of use of the component.

The United States government filed an amicus brief in support of Quanta arguing that any restrictions on “downstream use or resale” of an article “embodying patentees invention” had to be a matter of contract law rather than patent law. Those who acquired valid title to such an article also acquire the right to use it and sell it without fear of patent infringement claims. According to the government’s argument, the Court of Appeals for the Federal Circuit had been wrong to create an exception from the traditional rule on patent exhaustion by holding that it could be avoided by imposing conditions on the sale. Creation of such an exception meant that the patent owner could demand royalties along the entire length of the distribution chain. This went beyond what the patent statute was intended to provide and gave inadequate scope to the antitrust laws.

In addition to the brief filed by the United States, at least nine other amici briefs were filed in support of Quanta. At least fourteen amici briefs were filed in support of LGE together with three neutral briefs (including a rather plaintive one by the Licensing Executives Society simply asking the Supreme Court to issue a clear decision on what the law is).

The amici briefs supporting Quanta for the most part raised the same points as Quanta had done itself, attacking the Mallinckrodt decision as providing a basis for unjustifiable extension of the patent owner’s powers by a simple ruse of imposing conditions on the initial sale. Some went further than the United States had done by pointing out that contract law traditionally refuses to recognize the transfer of equitable servitudes on chattels and the need for privity of contract between the parties for an action for breach of contract to succeed.

Amici briefs supporting LGE were less squeamish about supporting the Mallinckrodt decision arguing that the right to grant limited user rights clearly fell within the patent grant and that patent owners should have as much right to contract freely without giving up other rights as anyone else.

The Supreme Court’s decision was unanimous and delivered by Justice Thomas. It succinctly disposed of arguments that there could be no exhaustion of patent rights just because the claims in question were directed to a combination including the article sold or to a method involving use of the article sold.

On the question of whether sale of an article by the patent owner or its licensee could exhaust rights in method claims, the court held:

Nothing in this Court’s approach to patent exhaustion supports LGE’s arguments that method patents cannot be exhausted. …Eliminating exhaustion for method patents would seriously undermine the exhaustion doctrine. Patentees seeking to avoid patent infringement could simply draft patent claims to describe a method rather than an apparatus. … This case illustrates the danger of allowing such an end run around exhaustion. On LGE’s theory, although Intel is authorized to sell a completed computer system that practices the LGE patents, any downstream purchasers of the system could nevertheless be liable for patent infringement. … We therefore reject LGE’s argument that method claims, as a category, are never exhaustible.

The next part of the decision applied both to method claims that use and claims to combinations that incorporate a part sold by the patentee or a licensee. On the question of whether sale of a component in a patented combination could exhaust rights in such method or combination patents, the court held that the products sold by Intel:

constitute a material part of the patented invention and all but completely practice the patent. … the incomplete article substantially embodies the patent because the only step necessary to practice the patent is the application of common practices or standard parts. Everything inventive about each patent is embodied in the [products sold by Intel]. … Quanta was not required to make any creative or inventive decision when it added [these products]. Indeed Quanta had no alternative but to follow Intel’s instructions in incorporating [such] products into its computers because it did not know their internal structure, which Intel guards as a trade secret.

The mere fact that the microprocessors and chipsets were claimed in different patents from those which were being sued upon did not help either. The Court noted:

With regard to LGE’s argument that exhaustion does not apply across patents, we agree on the general principle. The sale of a device that practices patent A does not, by virtue of practicing patent A exhaust patent B. But if the device practices patent A, while substantially embodying patent B, its relationship to patent A does not prevent exhaustion of patent B. (Emphasis in the original).

This then left the question of whether the initial sale was of a type that could trigger patent exhaustion. The court chose not to address the Mallinckrodt decision at all, but rather concluded that because the license from LGE to Intel (as opposed to any other agreement) did not in itself impose any conditions on Intel and because Intel did not impose any conditions on its purchasers, the initial sale was an unconditional one and so clearly fell within any definition of the type of sale that would trigger patent exhaustion.

It is, perhaps, just as well that the Supreme Court proceeded as it did. The facts were not the ideal ones for dealing with the general issue. At the time of the Mallinckrodt decision, price maintenance and tying were both likely to be found to be antitrust violations. Consequently conditions of these types fell outside the types of conditions that could be imposed to avoid patent exhaustion and created limits on the degree to which a patent owner could profit from any extension of its rights that the decision may have created. The exhaustion doctrine may not be a situation where a one size fits all answer is appropriate. The issues arise between differing situations, for example, (1) where a patented chemical compound has more than one use and the patent owner wishes to keep one use to itself but is willing to sell the compound to others for a different use, (2) the situation in Mallinckrodt itself where there may well have been health and liability reasons giving the patent owner legitimate reasons to impose a single use limitation and (3) situations such as those in the LGE case itself where, had no exhaustion been found, there was a risk of end users having to pay twice for the same component, once for the physical object to the person from whom title is acquired and again to the patent owner for the right to use it, when there is no other possible use for it. In the first case it might seem quite reasonable for the patent owner to be able to stop unauthorized use of the chemical by use of its patent rights. In the second, the issues seem more nuanced. In the third, economists would probably argue that allowing the patent owner multiple bites at the apple would not be economically efficient and so would not promote the useful arts which, according to the United States Constitution, is the purpose of the patent system.