Resale Royalties

Quanta Computer's troubles began seven years ago with a warning letter from Intel, one of its major suppliers. It informed Quanta that Intel was licensing certain patent rights from LG Electronics but this license "does not extend ... to any product that you may make by combining an Intel product with any non-Intel product." In other words Quanta could continue purchasing computer chips and chipsets from Intel, but Quanta--as well as other Intel customers--wasn't allowed by the patent license to use these products to make computers.

Quanta thought the limitation wasn't enforceable, but LG soon attempted to prove otherwise. In early 2001 the South Korean firm filed patent infringement suits against Taiwan-based Quanta and eight other Intel customers.

If enforceable, this limitation would be a serious problem for Quanta, the world's largest manufacturer of notebook computers, whose customers include Dell, Compaq, Apple, Hewlett Packard and Sony.

Quanta Computer Inc. v. LG Electronics Inc. is now before the Supreme Court, and the stakes are huge. If it wins LG could assert its patent rights against a wide range of computer companies, as well as the buyers of those computers. More importantly other patent owners could follow LG's example and use patent licenses to impose conditions on and demand royalties from everyone along the supply chain--from licensees all the way down to the consumer.

"There are few users of patented products on whom this will not have an impact," says Mark Patterson, who teaches patent and antitrust law at Fordham Law School in New York.


Third-Party Protection
The crux of the lawsuit is the "first-sale doctrine," also known as "patent exhaustion." Under this well-established legal principle a patent licensor's rights in a product are exhausted once the licensee sells the product to a third party; the third party can then use or resell the product free of any restrictions that the patent owner imposes.

Quanta claims that, because of this doctrine, it can use the computer chips it purchased from Intel (the patent licensee) without worrying about the patent rights of LG. But the Federal Circuit has ruled otherwise.

A three-judge panel unanimously held in 2006 that patent exhaustion occurs only when there is an unconditional sale, and Intel's sale of computer chips was conditional: Because of the September 2000 letter, Quanta knew that any use of Intel's chips was subject to LG's patent rights.

The Federal Circuit's position in this case isn't exactly new. Since 1992 the court has held repeatedly that the first-sale doctrine applies only to unconditional sales and that "private parties retain the freedom to contract concerning conditions of sale."

This line of cases, however, may conflict with prior High Court rulings. "The Federal Circuit cases don't directly violate the old Supreme Court cases," says Robert Yorio, an IP litigator at Palo Alto, Calif.-based Carr & Ferrell. "Do they violate any of the reasoning in these Supreme Court cases? That's the real issue. There are good arguments both ways."


Economic Turmoil
In recent years more and more businesses have used the Federal Circuit's limit on the first-sale doctrine to impose licensing restrictions on downstream purchasers.

"These use restrictions have arisen in all sorts of industries and all sorts of contexts," Patterson says. "In the past few years, the number and scope of these restrictions have been accelerating. They are broad and getting broader."

This trend is expected to increase if the Supreme Court upholds the Federal Circuit's ruling in this case.

"We'll continue down the road of having more and more restrictions placed on sales," says Katherine Strandburg, a professor of patent law currently teaching at New York University Law School. "More and more things will be treated as licenses rather than sales."

This will boost patent holders' revenues but may hurt the economy because it would require everyone down the supply chain to pay royalties. Moreover, downstream businesses and consumers would be unsure whether they could legitimately use patented items they have purchased.

"Every time you buy a patented product you would have to wonder if the seller is licensed to sell it for your particular purpose," Patterson says. "Downstream purchasers won't know what they are getting." And what about companies that purchase patented components from a variety of suppliers? "They can get lots of overlapping, and perhaps inconsistent, [patent] obligations," Strandburg warns.


Likely Outcome
There's still a chance that these difficulties will not come to pass. In recent years the Supreme Court has repeatedly overruled the Federal Circuit and cut back on the rights of patentees. Most patent experts expect the High Court to repeat this pattern in Quanta--but no one knows how broad the Court's ruling will be.

"[The Court] will limit patentees' freedom to impose restrictions on downstream purchasers, but how far the Supreme Court will go in imposing those limits, I'd hesitate to guess," Patterson agrees. Even if the Court rules that the first-sale doctrine completely prohibits patent owners from imposing patent restrictions on downstream purchasers, patentees could effectively circumvent this rule by using contract law (such as shrink-wrap agreements) to impose restrictions on downstream purchasers. Violators wouldn't be liable for patent infringement, but they could be liable for breach of contract.

The battleground may thus move from patent law to contract law. "You will have a lot of disputes about what kind of contracts you can have," Patterson says. But the Court may attempt to close that loophole. "The Solicitor General's amicus brief certainly raises the possibility that the Court will speak to the issue of whether patentees can enforce downstream restrictions via contract law," says Alan Fisch, a patent litigator at the Washington, D.C., office of Kaye Scholer.

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Steven Seidenberg

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