Invalidity Counterclaims in IP Litigation: Supreme Court Rules on Effect of Covenants Not to Sue

By: John Richards, Caroline Camp, and Cassidy Merriam

On January 9, 2013, the Supreme Court issued its opinion in Already, LLC v. Nike, Inc., holding that a broad covenant not to enforce a trademark against certain products of a competitor moots the competitor’s action to invalidate the trademark. The unanimous ruling will impact the way intellectual property owners react to competitors, pursue litigation, and mitigate the risk of invalidation of their IP rights.

At issue in the case was whether Nike could remove counter claims raised in a trademark infringement action that one of its trademarks was invalid from the jurisdiction of the federal courts by withdrawing the infringement action and giving the defendant in the infringement action a broad covenant not to sue again. Article III of the United States Constitution, as implemented by the Declaratory Judgment Act, limits the jurisdiction of the federal courts to deciding cases or controversies. Therefore, in contrast with many other countries, the power of the federal courts to decide on the validity of an IP right is limited to situations in which such a case or controversy exists.

In most of the world, any party may challenge the validity of IP rights through the court system. In the U.S., however, Article III of the Constitution requires that a “case or controversy” exist in order for adjudication in court. This article will consider what this requirement means in the context of challenges to the validity of IP, particularly with regard to invalidity counterclaims raised in IP infringement suits.

The Facts of the Case and Procedural Context

Nike owns a federal trademark registration for the design of its Air Force 1 athletic shoe (the ‘905 Registration). Nike’s adversary, Already, LLC d/b/a Yums, also designs and markets athletic footwear, including shoe lines known as “Sugars” and “Soulja Boys.” In July 2009, Nike sued Already in federal district court in New York alleging that the designs of the “Sugars” and “Soulja Boys” shoes infringed the ‘905 Registration. In response to the complaint, Already filed a counterclaim seeking a declaratory judgment that the ‘905 was not a valid trademark under federal law, on the ground that the registration was not for a “mark” used on a product but was for the design of the product itself, and also for cancellation of the registration.

Nike then delivered an extremely broad unilateral covenant not to sue, in which they agreed to refrain from making any claims or demands involving trademark infringement against not only Already, but also any of its successors or customers, for any of Already’s past or present product designs, or for future “colorable imitations” of the shoes. After issuing the covenant, Nike requested that the court dismiss its claims as well as Already’s invalidity counterclaims on the ground that in such circumstances, a case or controversy no longer exists.

In response to Nike’s request for dismissal, Already argued that its invalidity counterclaims were not subject to dismissal because they created an independent case or controversy under the Declaratory Judgment Act.

In January 2011, the District Court dismissed both Nike’s claims and Already’s counterclaims without specifying which rule, if any, it was invoking. On appeal, the Second Circuit Court of Appeals decided de novo that Nike’s Covenant divested the District Court of subject matter jurisdiction and Already’s counterclaims were properly dismissed, as the case or controversy requirement cannot be satisfied by a “difference or dispute of a hypothetical or abstract character;” the covenant was so broad that Already should have no reasonable apprehension of liability.

Already petitioned the Supreme Court for a writ of certiorari seeking review of the decision of the Court of Appeals, arguing that there existed a split among the Second and Ninth Circuit Courts of Appeals with respect to the jurisdictional effect of a covenant not to sue issued after filing suit. The petition also maintained that the Second Circuit ruling was inconsistent with the Supreme Court’s precedent in Moore v. New York Cotton Exchange, (1926), and Cardinal Chemical v. Norton Intl, Inc., (1993), where plaintiffs’ waivers or dismissals of their claims against defendants’ were irrelevant to district courts’ jurisdiction to hear compulsory counterclaims. The Supreme Court agreed to review the Second Circuit’s decision.

Already’s Arguments

In proceedings before the Supreme Court, Already argued that where a party to a lawsuit withdraws the main action and seeks dismissal of counter claims, such dismissal should be permitted only when it is “absolutely clear” that a dispute “could not be reasonably expected to recur” (thus invoking the “voluntary cessation” doctrine). Furthermore, Already argued that the burden of proof should rest on the party seeking dismissal.

On January 9, 2013, the Supreme Court held that the case was moot on the basis of Nike’s covenant not to sue. Despite disagreeing with the lower courts’ allocation of burden on Already, the Court upheld the result of the Second Circuit, finding that the breadth of the covenant encompassed all of the allegedly wrongful conduct, thereby removing Article III jurisdiction, and that Nike had shown that “[i]t [was] hard to imagine a scenario that would potentially infringe Nike’s trademark and yet not fall under the Covenant.”

Once Nike satisfied the burden showing that infringement could not recur, Already was required to demonstrate that it was currently engaged in, or had concrete plans to engage in activity not covered by the Covenant. With “no indication” of such intent, the Court held that it was “absolutely clear” that the case was moot.

Already also put forward alternative theories of Article III injuries by asserting that as long as Nike’s ‘905 Registration remained valid, investors would be apprehensive about conducting business with Already. The Court, citing Lujan v. Defenders of Wildlife, (1992), responded that where it is “absolutely clear that the challenged conduct cannot reasonably be expected to recur” the fact that some potential investors fear suit and therefore choose not to conduct business with Already, “does not give rise to the sort of concrete and actual injury necessary to establish Article III standing.”

Already further argued that it had inherent standing to challenge Nike’s registered trademarks because it was a direct competitor. This argument was understood by the Court as “boiling down” to a policy objection, that dismissing the case would allow Nike to “bully” small companies. The Court responded that this concern was not sufficient to adopt Already’s broad theory of standing and stated that (1) in order to challenge Nike’s ‘905 Registration, there still must have existed a particular injury beyond the fact that Nike and Already compete in the same market; and (2) granting covenants not to sue may be a risky long-term strategy for trademark owners because naked licensing may result in a loss of significance of the mark and even cancellation of the federal registration. The Court thus affirmed that no case or controversy existed and the district court lacked jurisdiction over Already’s counterclaims.

The Concurring Opinion

In the concurring opinion, Justice Kennedy, joined by three other members of the Court, agreed that the case was moot, but warned against future trademark bullying. The concurrence underscored that it was Nike that bore the “formidable burden of showing that it [was] absolutely clear [that] the allegedly wrongful behavior could not reasonably be expected to recur,” and warned that covenants not to sue should not become a means for plaintiffs to automatically avoid counterclaims challenging validity. Covenants should not be panaceas and careful consideration must be given to the consequences of using a covenant not to sue as the basis for a motion to dismiss counterclaims as moot. The concurrence urged that the “formidable burden” ought to require the trademark holder, at the outset, to make a substantial showing that the business of the competitor will not be disrupted or weakened by litigation over mootness, or by any threat latent in the terms of the covenant itself.

The “Case or Controversy” Requirement

The Supreme Court’s Already v. Nike decision will undoubtedly affect the strategies employed in IP cases in the United States in the future.

Under the Declaratory Judgment Act 1934 (28 USC §2201), a party fearing suit for trademark or patent infringement has the right to seek a declaratory judgment of non-infringement or invalidity for the trademark or patent in question if it can show the existence of a “case or controversy” and to continue a counterclaim on such basis even after withdrawal of an infringement action, if it can meet the test set out in Already v. Nike.

In determining whether a “case or controversy” exists, Courts apply a test set out by the Supreme Court in Maryland Casualty, 1941, known as the “totality of the circumstances” test.  In that case, the Court explained that “[b]asically, the question in each case is whether the facts alleged, under all the circumstances, show that there is a substantial controversy, between the parties having adverse legal interests, of sufficient immediacy and reality to warrant the issuance of a declaratory judgment.” Additionally, an actual case or controversy must remain throughout the course of the suit (Preiser v. Newkirk, 1975). After a validity challenge is raised, many intellectual property owners seek to eliminate the case or controversy at issue.

In 1995, the Federal Circuit decided a monumental patent case, Super Sack, where the court considered whether a promise not to sue divested the court of Article III jurisdiction. Super Sack Mfg. Corp. v. Chase Packaging Corp. In that case, Super Sack brought an infringement action against its competitor, Chase, which filed a counterclaim for declaratory judgment of both non-infringement and invalidity. Super Sack withdrew its infringement allegations and promised not to sue Chase in a statement of counsel and motion papers and briefs. Despite the promise not being in a covenant filed with the court, the court held that the promises were sufficient to estop Super Sack from suing Chase for past acts of patent infringement, which rendered Chase’s declaratory judgment counterclaim nonjusticable under Article III. The court implemented a two-pronged standard for applying the “totality of the circumstances” test and held that, in order to show an actual controversy for jurisdictional purposes, (1) there must be an explicit threat or other action by the rights holder that creates a “reasonable apprehension” on the part of the declaratory plaintiff that it will face an infringement suit; and (2) there must be present activity by the declaratory plaintiff that could constitute infringement or concrete steps taken with the intent to conduct such activity.

The decision sparked a litigation tactic known as “Super Sack’ing,” whereby a (usually powerful) company files infringement claims against a competitor, and then issues a covenant not to sue in the event that a competitor should file a declaratory judgment counterclaim for invalidity, and it appears possible or likely that the patent would be invalidated by the court. If the party’s promise not to sue is sufficiently broad, this strategy removes the Court’s Article III jurisdiction to hear the counterclaims. Although the company can no longer sue that specific competitor, it retains the IP rights that were in danger of invalidation and is able to enforce those rights against third parties.

In 2007, the Supreme Court decided MedImmune, confirming the application of the “totality of the circumstances” test, but expressly rejecting the “reasonable apprehension of suit” prong in the application of the test. In MedImmune, the Court reiterated the language of Maryland Causality, indicating that whether an Article III case or controversy exists must be determined on a case-by-case basis. The Court held that the adversity of legal interests between the parties must be “real and substantial,” and suggested that threat of future litigation was relevant in the determination, but left unclear what acts are sufficient to constitute a threat. The Court found that a “case or controversy” existed when MedImmune (a patent licensee) continued to pay royalties to Genentech (the licensor) and challenged the validity of a licensed patent, because if MedImmune had chosen not to pay royalties, it would have faced the risks of injunctive relief and treble damages for willful infringement.

Despite removing the “reasonable apprehension of suit” standard, MedImmune therefore maintained the requirement that there must be a sufficient risk of litigation by the licensor to create a case or controversy. Simply keeping litigation in abeyance will be insufficient to moot the case if “under all the circumstances, [the facts] show that there is a substantial controversy, between the parties having adverse legal interests, of sufficient immediacy and reality to warrant the issuance of a declaratory judgment.”

MedImmune also clarified that an injury-in-fact may be sufficient to for Article III jurisdiction, even where there is no apprehension of suit. This is particularly relevant where the injury consists of continuing to pay a license fee when the matter should actually be in the public domain. In 1969, Lear, Inc. v. Adkins overturned the doctrine of “licensee estoppel,” which had previously prevented licensees from contesting the validity of a licensor’s patent. Lear held that the public interest is served when licensees are freely allowed to challenge potentially invalid patents, and made it clear that a licensee can refuse to pay royalties and then challenge the validity of the licensed patent. MedImmune further clarified the ability of licensees to challenge validity of intellectual property, by holding that licensees do not need to stop paying royalties in order to raise validity challenges, so long as there is nevertheless a sufficient risk of litigation adequate for Article III jurisdiction. In that case, Genentech had sent a letter to MedImmune, stating that a drug made by MedImmune was covered by a Genentech patent and that MedImmune owed royalties under the agreement. MedImmune paid royalties “under protest” and challenged the validity of the licensed patent. The court found the letter to be a sufficient threat of litigation by Genentech if MedImmune stopped paying royalties.

The MedImmune decision thus enables licensees to challenge validity without breaching their license agreement and infringing the subject patent, thereby eliminating risks that many licensees are not willing to take. Accordingly, the decision helps protect “full and free competition in the use of ideas [that] are in reality a part of the public domain.”

Expanded Article III Jurisdiction

Accordingly, it has become easier to show that a case or controversy exists for purposes of Article III jurisdiction, and for third parties to challenge the validity of intellectual property. Furthermore, in order to eliminate such a case or controversy, a covenant not to sue must be extremely broad.

In Super Sack, the promise not to sue covered alleged past infringement, however, it did not cover products that could be made, sold, or used in the future. At the time Super Sack was decided, the court still determined the “totality of the circumstances” test based on the “reasonable apprehension of suit” standard. Even though future acts could be subject to infringement claims, at the time of the case, the promise not to sue for past infringement removed any “reasonable apprehension of suit,” thus removing the court’s Article III jurisdiction.

It is likely that the promise not to sue in Super Sack—which did not include future alleged infringement—would not be sufficient to remove Article III “controversy” if the case was decided today. Following MedImmune and Nike, jurisdiction is proper if case or controversy exists under the “totality of the circumstances” test, without applying the “reasonable apprehension of suit” standard. Therefore, in order to remove jurisdiction over Already’s counterclaims, Nike drafted an extremely broad covenant in order to remove all possible instances of controversy, not just to remove “reasonable apprehension of suit”.

Despite this lower jurisdictional threshold, the MedImmune decision does not allow licensees and other interested parties to challenge the validity of IP for just any reason. In Hewlett-Packard Co. v. Acceleron LLC, (2009), the Federal Circuit explained, “Like it or not, MedImmune may have lowered the bar for determining declaratory judgment jurisdiction in all patent cases; certainly it did so in the licensor-licensee context. But a lowered bar does not mean no bar at all.” Only rights holders who assert their rights against third parties may face a declaratory judgment claim for invalidity.

However, there is no bright-line rule to determine what constitutes a sufficient “assertion of rights” to merit standing. In SanDisk v. ST Mircoelectronics, (2007), the Federal Circuit stated, “We need not define the outer boundaries of declaratory judgment jurisdiction…We hold only that where a patentee asserts rights under a patent based on certain ongoing or planned activity of another party, and where that party contends that it has a right to engage in the accused activity without a license, an Article III case or controversy arises and the party needs not risk a suit for infringement by engaging in the identified activity before seeking a declaration of its legal rights.” Article III jurisdiction may be met where the rights holder takes a position that puts the other party in a position where they must either (i) pursue arguably illegal behavior, i.e. infringing, or (ii) abandon that which they claim a right to do, i.e. something that should be free to do because it should be in the public domain.

Conclusion

While many questions remain about the application of the “totality of the circumstances” test, post-Medimmune decisions have shed light on certain aspects of the “case or controversy” jurisdictional requirement. First, the dispute must be definite and concrete and there must be an affirmative act on the part of the rights holder, though there need not be an express threat to sue for infringement. Second, a case or controversy must be based on a real and immediate injury or threat of future injury, caused by the defendant, not a purely speculative fear of future harm. Finally, post-MedImmune and Nike, it is clear that public policy concerns of removing invalid or fraudulently-obtained patents or trademarks do not trump the Constitutional requirement that an “actual controversy” exist in order for the court to have jurisdiction over the matter.

The decision in Nike v. Already further allows powerful IP owners that fear invalidity counterclaims to essentially blunt challenges to their IP rights by contractually immunizing their smaller adversaries with unilateral covenants not to sue. However, it seems that in order to do this, following the logic in MedImmune, they need to relinquish their ability to bring suit on a much broader basis than required hitherto.