By Steven Seidenberg for Intellectual Property Watch
The United States has once again chipped away at patent rights. The country’s highest court recently handed down a ruling that makes it harder for patent owners to impose limits on downstream users of their inventions.

The US Supreme Court’s decision in Quanta Computer Inc. v. LG Electronics Inc., No. 06-937 (June 9 2008) is, however, surprisingly narrow. It fails to address a major issue facing patent owners and their legal counsel: Can patent owners use conditional sales or licensing agreements to impose restrictions on downstream users?

“They ducked the question that everyone wants to know the answer to,” said Mark Davies, an IP litigator in the Washington, DC office of O’Melveny & Myers. “For a practitioner, it is a frustrating opinion.”

In the United States, as in many other countries, patent owners’ rights are limited by patent exhaustion (also known as the first sale doctrine). This well-established legal rule mandates that a patentee’s rights in a patented item end the first time the item is sold. The buyer is then basically free to use or resell the patented items as it wishes.

But many companies in the United States have found a way around this doctrine. Instead of selling their patented products outright, a growing number of businesses are selling or licensing their products with strings attached. A purchaser must comply with specified conditions in order to be licensed to use the patented invention. Failure to meet the conditions terminates the patent license and makes the purchaser liable for patent infringement.

This type of end-around patent exhaustion was approved by the US Federal Circuit Court of Appeals (often called the country’s patent court) in a seminal 1992 case, Mallinckrodt, Inc. v. Medipart, Inc., 976 F.2d 700. Prior to this ruling, the courts had allowed only certain, limited post-sale conditions.

“Until 1992, if a person sold a product that embodied a patented invention, a statement by the seller that the product can only be used in a certain way – the imposition of post-sale conditions on use of the product – was widely thought to be unenforceable,” said James Dabney, a patent attorney in the New York office of Fried, Frank, Harris, Shriver & Jacobson. “That was changed by Mallinckrodt. …It was a very controversial decision.”

The ruling remains controversial, and many patent experts expected the US Supreme Court to decide, in Quanta Computer, whether Mallinckrodt was good law. The high court, however, took a different tack.

Background to Case: Computer Chips

At issue in Quanta was LG Electronics’s attempt to impose restrictions on downstream purchasers. LG owned three patents on computer chip components and licensed these patents to Intel. The licence agreement gave Intel the right to make and sell computer chips which use the LG patents, but this agreement also stated that neither LG nor Intel licensed third parties to use the patents by combining Intel’s chips with other computer components. Moreover, a separate agreement between LG and Intel required Intel to inform its customers of this licensing restriction.

In short, LG was telling purchasers of Intel’s computer chips that they could not use these chips for their only intended purpose (in computers) unless they first purchased a licence from LG.

Quanta Computer did not comply. The Taiwan-based company is the world’s largest manufacturer of notebook computers. Its customers include Dell, Sony, Compaq and Apple. Quanta used the Intel chips to make computers that were sold in the United States, and in 2001, LG sued for patent infringement.

Quanta argued that LG’s patent rights were exhausted by the time Quanta put the chips into its computers. The Federal Circuit disagreed. Quanta appealed to the US Supreme Court.

In its July 2006 ruling against Quanta, the Federal Circuit stated that method patents, such as the LG patents at issue, were not covered by patent exhaustion. The Supreme Court unanimously rejected this contention, explaining that:

Eliminating exhaustion for method patents would seriously undermine the exhaustion doctrine. Patentees seeking to avoid patent exhaustion could simply draft their patent claims to describe a method rather than an apparatus. …[A] a patent drafter could shield practically any patented item from exhaustion.

LG also argued that exhaustion did not apply in this case because the chips sold by Intel did not completely embody the three LG patents. In order for the patents to be used, the chips needed to be connected to computer memory and buses (which transmit data between a machine’s central processing unit and other computer components, such as a video card).

The Court rejected this argument, too, ruling that exhaustion occurs if a sold product “substantially embodies” the inventive aspect of the patent – and that was the case here. “Everything inventive about each patent is embodied in the Intel products,” the Court said, adding that:

Here … the incomplete article substantially embodies the patent because the only step necessary to practice the patent is the application of common processes or the addition of standard parts. …[T]the final step to practice the patent is common and noninventive …connecting a microprocessor or chipset to buses or memory. LG’s last argument was that exhaustion did not occur because its licence of patent rights to Intel was conditional and Quanta failed to comply with the conditions. The Federal Circuit agreed with this position. The Supreme Court did not.

The Court held that LG’s licence agreement with Intel imposed no conditions on the latter’s right to sell computer chips:

Nothing in the Licence Agreement restricts Intel’s right to sell its microprocessors and chipsets to purchasers who intend to combine them with non-Intel parts. It broadly permits Intel to ‘make, use, [or] sell’ products free of [LG's] patent claims.

A second agreement required Intel to notify purchasers that they were not licensed by LG to use the chips in combination with other computer components, but this requirement was separate from Intel’s right to sell the chips. The Court stated, “Intel’s authority to sell its products embodying the [LG] Patents was not conditioned on the notice or on Quanta’s decision to abide by [LG's] directions in that notice.”

Intel’s sale of chips to Quanta thus was authorised and unconditional – and this sale exhausted LG’s patent rights in the chips. Because of this exhaustion, the Court held, it was irrelevant that LG’s licence agreement with Intel did not authorise third parties, such as Quanta, to use the patents by combining the Intel chips with other computer components. Quanta did not need any licence to use LG’s patents, since LG’s patent rights in the chips were exhausted by the sale of the chips to Quanta.

Overall, the Court’s ruling shuts down certain methods used by patent owners to impose restrictions on downstream purchasers. But these methods have been used only infrequently. The court sidestepped any examination of the most common way patentees limit the rights of downstream purchasers – by making conditional sales.

“The Court avoided the issues of what sorts of restrictions a patentee can impose and what constitutes a violation of such restrictions,” said Mark Patterson, who teaches patent and antitrust law at Fordham Law School in New York City. “It still remains unclear to what extent a patentee can use upstream contracts to avoid causing the exhaustion that terminates patent rights.”

Steven Seidenberg may be reached at info@ip-watch.ch.