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Licensee Estoppel: Coping With The Licensee's Dilemma
Published By Intellectual Property & Technology Law Journal December 2003

Reprinted with permission from Aspen Publishers, Intellectual Property & Technology Law Journal, Volume 15, Issue 12, Pages 1-5. Copyright 2003© www.aspenpublishers.com.   


After careful consideration, the licensee has taken a license to a patent in order to use the technology developed by the patent owner. The royalty rate is reasonable and the scope of the license permits the licensee to fully practice the technology free from fear of a patent infringement suit for infringing the licensed patent. Everything is going along nicely when someone alerts the licensee to the fact that the owner publicly disclosed the patented subject matter more than one year before the patent's filing date. The patent is invalid under 35 U.S.C.§102(b).

The licensee is suddenly stricken with the realization that it has been paying royalties to practice technology in the public domain, free to everyone. The next royalty payment is coming due. The licensee checks the license agreement only to find that there is no mention of potential invalidity of the licensed patent. Despite the lack of any mention of invalidity, the failure to continue to pay royalties is clearly stated in the license as a breach of contract. The licensee's attorney advises that under the waiver principal of licensee estoppel established many years ago by the U.S. Supreme Court, a licensee can contest the validity of the licensed patent. But, unless the licensee stops paying royalties, a court may refuse to hear the case because there is no 'case or controversy.' So the licensee is faced with a choice: stop paying royalties and breach the contract, and concomitantly bring a declaratory judgment action for patent invalidity, or continue to pay the licensor for essentially free technology. The problem presented by this situation is known as the licensee's dilemma.

This article reviews the law relating to licensee estoppel and describes procedures that can ward off the predicament described above. Some common situations where the waiver of licensee estoppel does not apply are also discussed.

LEAR V. ADKINS: THE WAIVER OF LICENSEE ESTOPPEL

The principal case governing the licensee's right to contest validity of the licensed patent was decided by the Supreme Court in 1969.1 In Lear Inc. v. Adkins, the Supreme Court waived the doctrine of licensee estoppel and opened the door to the licensee to contest the validity of the licensed patent. Since the Lear decision, numerous licensees have grappled with the difficult situation thrust upon them when they discover that the licensed patent, or patents, are most likely invalid. In addition to setting the stage for the Court to address licensee estoppel, the facts of the Lear case demonstrate the interplay between contract and patent law that arises in litigation involving a patent license.

Lear Inc. retained Adkins to do development work on the company's aircraft navigational systems at its California plant. Adkins developed a new gyroscope production method, which Lear, Inc. began using immediately. On Feb. 4, 1954, Adkins filed a patent application and began negotiating a licensing agreement with Lear. At that time the parties entered into an initial license agreement. Later, the parties concluded a full licensing agreement. The agreement contained a termination provision providing that Lear could terminate the agreement if the PTO refused to grant a patent on Adkins' pending application, or if the patent was later held invalid. In 1957, after conducting a patent search, Lear became convinced that Adkins' idea was not novel, and refused to pay royalties on gyroscopes manufactured at its plant in Michigan. After his patent issued in Jan. 1960, Adkins filed suit against Lear, Inc. in California state court claiming breach of contract.

In Lear, the Court addressed the issue of whether a licensee of patent rights can attack the validity of a licensed patent and stop making royalty payments to the licensor. In reaching its affirmative decision, the Court overruled the doctrine of licensee estoppel set forth in Automatic Radio Manuf. Co. v. Hazeltine Research Inc.2 In reaching its decision, the Court applied two areas of public policy. First, the Court recognized a public interest in free access to technology in the public domain. Second, the Court found a corresponding public interest in flushing out invalid patents through litigation of patent validity earlier rather than later. Hence the Court's decision to allow a licensee to stop making royalty payments and challenge patent validity at any time.

The Court also recognized that a license agreement is a contract and considered the contract rights of a licensor to enforce payment of royalties for unpatented ideas. Traditionally, the federal courts applied state law to contract disputes. Despite the contact aspects of a patent license, later decisions required federal preemption of state law relating to patent rights.3 Further, although the issue was clearly presented in Lear, the Court declined an invitation to rule on whether a state court could enforce a contract requiring royalty payments for access to unpatented ideas. This issue was later resolved in favor of allowing a licensor to collect royalties for an unissued patent under state contract law.4 The Court determined that the question was governed by state law, and federal patent law does not attach until a patent actually issues.

After the Lear decision, licensees were no longer bound to continue paying royalties to the licensor despite the licensee's determination that the licensed patent was invalid. As discussed below, the right to contest patent validity - while responsive to important public policy concerns for early judicial action against invalid patents - poses risk to the licensee should the validity attack fail.

LICENSEE'S RIGHT TO STOP PAYMENT OF ROYALTIES AND THE LICENSEE'S DILEMMA

While the Court's ruling in Lear opened the door for the licensee to challenge validity of the licensed patent, the question of the licensee's liability for an unsuccessful challenge remains a serious issue. If the licensee is unsuccessful in its attack on the validity of the patent, the licensee could be precluded from further practice of the invention by the licensor. In the typical situation, the licensee has invested a great deal of money to produce the patented article or practice the patented process. All of this investment is at risk when the licensee stops paying royalties and challenges the patent. In addition, the licensee faces high litigation costs for a prolonged patent dispute in federal court. The alternative for the licensee is to continue to pay the royalty for rights to a patent of questionable validity. This is the licensee's dilemma.5

One possible solution for the licensee: bring a declaratory judgment action for a declaration of patent invalidity while continuing to pay royalties to the licensor. Federal courts, however, require that a live case or controversy exist before recognizing the standing of the licensee to bring suit. A federal court will not rule on the validity of a patent in the absence of an actual and concrete dispute.6 In a declaratory judgment action related to a patent license, the Court of Appeals for the Federal Circuit has set forth two jurisdictional standing requirements: 1) that an explicit threat of an infringement suit exist creating a reasonable apprehension in the licensee, and 2) that the licensee be involved in present activity constituting infringement, or be taking concrete steps with the intent to conduct infringing activity.7

Since most licensees are already practicing the invention, or planning to take steps to practice the invention, the second requirement is usually met. The first prong of the jurisdictional standing requirement will most likely be met if the licensee stops making royalty payments and the licensor threatens to sue for patent infringement. Whether the licensee's concern rises to the level of reasonable apprehension where the licensee continues to make royalty payments, however, depends on the conduct of the licensor. Furthermore, the reasonable apprehension of the licensee is evaluated under an objective, reasonable person standard. Accordingly, mere licensing negotiations are not grounds for reasonable apprehension.8 Also, the licensor's assertion that the licensee's product is covered by one of the licensor's patents during licensing negotiations is not grounds for reasonable apprehension.9 Nor is the licensor's announcement to the industry of the addition of a specific patent to the licensor's portfolio grounds for the licensee's reasonable apprehension.10

The issue of the licensee's reasonable apprehension often arises during licensing negotiations. Although no royalty payments are usually paid by the licensee before signing the license, the court will examine the licensor's conduct during the licensing negotiations to determine whether grounds for reasonable apprehension exist. Any conduct by the licensor that appears intended to force the licensee to take a license will be carefully scrutinized by a court. The Federal Circuit has ruled the licensee to be in reasonable apprehension where the licensor actually charges the licensee with infringement.11 Also, threats made by the licensor during licensing negotiations may give rise to reasonable apprehension if they appear to intended to compel the licensee's acceptance of the license.12 Granting the licensee standing in the face of threats during licensing negotiations operates to discourage the licensor from coercing the licensee into taking a license under an invalid patent.

The availability of a declaratory judgment action does not resolve the licensee's dilemma. The uncertainty in satisfying the standing requirement compounds the licensee's risk when faced with the decision to stop paying royalties and contest patent validity. In addition, declaratory judgment actions are expensive, can be lengthy, and can ruin the relationship between the parties.

DISPOSITION OF THE LICENSEE'S ROYALTY PAYMENTS WHILE CONTESTING VALIDITY

In Lear, the Court held that a licensee is not required to pay royalties while contesting patent validity. The licensee can simply stop paying royalties at the time that it brings an action to declare the patent invalid. The licensee cannot, however, recover any royalties paid to the licensor prior to a declaration of invalidity. Allowing the licensee to recover paid royalties would contravene the policy of early litigation expressed in Lear. Also, the licensee could simply wait for another party to contest validity, or delay suit until the patent neared its expiration date.13 Moreover, if the licensee fails to prove the patent invalid, all accrued royalties will be due and payable at the time the court rules the patent valid. This situation raises the question of whether the license can escrow royalty payments instead of paying the licensor while contesting patent validity.

Several aspects of the licensor's grant to the licensee justify the licensee's payment of royalties to the licensor. First, the licensee continues to benefit from the licensor's forbearance from asserting its patent rights against the licensee. Second, the licensee is given a right to manufacture a patented product, or to practice a patented process free from the threat of a lawsuit by the patentee. In the case of an exclusive license, the licensee can occupy a market position free from competition in the licensed technology. In addition, often the licensee obtains other forms of intellectual property from the licensor, such as know how, technical assistance, marketing assistance, and the like. These advantages do not terminate when the licensee brings a suit seeking a declaration of invalidity. Accordingly, courts have been reluctant to allow the licensee to escrow royalty payments.

In view of the ongoing consideration given to the licensee, the Federal Circuit ruled that Lear contains no authority for establishing an escrow account pendente lite.14 This situation further exacerbates the licensee's dilemma, because, when the licensee stops paying the royalty, the licensor is entitled to terminate the license and counterclaim for patent infringement and for breach of contract.15 The licensee is best advised to obtain an escrow provision in the license agreement to avoid the harsh results under the relevant case law.

The foregoing reasoning for not allowing escrow of royalty payments is somewhat weakened where the licensee has a non-exclusive license. In a non-exclusive license, the licensee is not protected from other licensed competition. Even in a non-exclusive license, however, non-payment of royalties carries risks for the licensee. Anytime the licensee does something with the royalty besides pay it to the licensor, a court may find the licensee in breach. The Lear policy of early patent validity litigation would be thwarted by the licensee's action. Escrowing royalties permits the licensee to gamble at the licensor's expense. To limit abuse by the non-exclusive licensee, the courts require that the licensee's actions be directed toward prompt and early adjudication of validity. For example, the licensee must give clear notice to the licensor that royalty payments are being withheld pursuant to a question of patent validity.16

Once the licensee decides to stop paying royalties, in the absence of specific provisions in the license, the licensee must obtain a court order to protect itself from retaliation by the licensor. The licensee typically brings the issue of royalty payments before the court under a motion for a preliminary injunction. The licensee should seek a court order establishing an escrow account and blocking the licensor from suing for patent infringement. The court examines the facts and weighs each party's position against the four equitable considerations applying to injunctions. These are the likelihood of licensee's success on the merits, the irreparable harm on the licensee of not granting the injunction hardship on the licensor if the injunction is granted, the balance of hardships on the parties, and the public interest in the outcome.17 The licensee's argument is strengthened if the licensee can show that the licensor is in financial trouble and unlikely to repay accrued royalties, or that the licensee used coercion to obtain the license agreement.18 Accordingly, there will be circumstances under which the licensee can force involuntary escrow of royalty payments when the licensee can meet the heavy burden of proof. The equitable issues analyzed by a court in deciding a motion for preliminary injunction, however, often make the outcome anything but certain.

The inability of the licensee to obtain an order establishing an escrow account is often related to the licensee's failure to meet its burden of proof for a preliminary injunction. The problem for the licensee is compounded where the licensor is financially unstable and the license agreement grants rights to several patents. An Oregon district court case illustrates several pitfalls faced by the licensee in such a situation.

In Cascade Pacific, the court declined the licensee's request for an order establishing an interest bearing escrow account where the licensee wished to maintain the license but could not meet the requirements for a preliminary injunction against the licensor.19 The licensee, Cascade, sought a judicial declaration of invalidity against one of three licensed patents, and an injunction enjoining the licensor, Interplay, from terminating the license agreement in view of its use of the other patented technology. Cascade asserted that the patent at issue was obvious over the prior art and presented several prior art references and an affidavit from an industry expert. Cascade also argued that it would be irreparably harmed without the escrow account if Interplay was allowed to terminate the license because Interplay would have insufficient assets to satisfy a judgment. Further, the balance of hardship favored Cascade, because the escrow money would be readily available if Interplay prevailed. Interplay countered that the royalties were its only source of income and that Cascade had not shown a likelihood of success in proving invalidity of the challenged patent. The court held that Cascade had not shown that it had a probability of success, but only that serious questions existed as to the validity of the patent at issue. The court did not find that Cascade's potential failure to recover royalties outweighed the severe financial burden to Interplay from an interruption in royalties. In this case, the financial instability of the licensor worked against the licensee to frustrate its attempt to establish an escrow fund. Where the licensor's only assets are its patents and its only income stems from royalty payments, the potential for preventing royalty payments to an escrow account will always exist.

LIMITATIONS ON THE WAIVER OF LICENSEE ESTOPPEL

Although Lear broadly swept away the doctrine of licensee estoppel, some situations remain in which a licensee is estopped from contesting validity of a licensed patent. The doctrines of res judicata and assignor estoppel, where applicable, will prevent a licensee from contesting patent validity. The issue of res judicata often arises where there has been an earlier consent decree between the licensee and the licensor.

Normally, res judicata created by a consent decree will bar the licensee from contesting the validity of the patent. The requirements for a consent decree in the licensing context are: 1) the decree must be approved and filed with a court, 2) the licensee must admit both validity and infringement, and 3) the decree must meet the res judicata eligibility requirements of the Federal Circuit.20

The requirement for court approval may discourage the licensor from introducing a no contest clause in a private settlement agreement in order to bar the licensee from contesting patent validity at a later time. The requirement for admission of validity and infringement stems from the public policy served by the finality of a court judgment. If consent to patent validity formed the sole basis of the decree, the licensee would be free to argue non infringement at a later time.

In an attempt to bring uniformity among the federal courts and to discourage forum shopping, the Federal Circuit requires that the parties litigate the issue of validity prior to reaching a consent decree. In Foster, the court set forth its interpretation of Lear in the context of a consent decree. In the absence of a validity determination, the licensee could simply accept a license under a consent decree and wait for more favorable circumstances to litigate validity.21

A binding consent judgment encourages parties to settle their dispute. Moreover, requiring validity litigation prior to the consent decree supports the Lear policy of early determination of patent validity. By requiring that parties to a consent decree to litigate the issue of validity, the court balances the policies of Lear with the policy of encouraging settlement of disputes and putting an end to litigation.

The doctrine of assignor estoppel also was not affected by Lear. Indeed, assiginor estoppel continues to be a viable legal principle that can arise in a number of business contexts. An assignor can become a licensee, for example, by selling its patent, and retaining a license to practice the claimed invention. This is similar to a sale and lease-back arrangement.

Assignor estoppel is an equitable doctrine that prevents an assignor from later contending that the assigned patent is actually invalid. A policy of preventing unfairness and injustice underlies assignor estoppel and courts typically view the issue in terms of a buyer seller context. A seller should not be allowed to later assert the subject matter of the sale to be worthless. Accordingly, an assignor is in a distinctly different position from a licensee. Unlike the licensee, who must continue to pay royalties to use the patent, the assignor has already been fully paid for the patent.

The foregoing rationale compelled the Federal Circuit to rule that the waiver of licensee estoppel established in Lear does not apply to an assignor, or to those in privity with the assignor.22 The Federal Circuit has reasoned that the balance of equities outweighed the Lear policy of early litigation. Later, the court extended its ruling to situations where the assignor becomes a licensee under a backlicense.23 There, the court reasoned that an assignor-licensee is still asserting that what he sold is worthless, and, as such, is barred from contesting validity of the patent.

Even the unwary are sometimes captured in the net cast by this doctrine. In Mentor, the defendant, Quickturn, bought hardware emulation technology from Mentor and received an assignment to a related patent.24 Quickturn later determined that several claims of the patent were invalid in view of an earlier conception date of one of its own patents.25 Meanwhile, Mentor bought all the outstanding shares of a French company, Meta, that manufactured hardware emulation technology and began importing Meta's products into the U.S. Quickturn brought an action in the International Trade Commission to stop Mentor from importing the Meta products and Mentor, in turn, moved for a declaratory judgment of patent invalidity in district court. The district court held that Mentor was barred by assignor estopple. Meta asserted that it should not be barred because it developed the imported hardware emulation technology before being acquired by Mentor.26 Despite the earlier development of the technology by Meta, the court found Mentor and Meta to be parties in privy. Applying its previous ruling in Diamond Scientific, the court held that Meta could not challenge validity of a patent assigned by Mentor. The Mentor case points out the need for effective and extensive patent due diligence before any merger or acquisition is undertaken.

CONCLUSION

While the doctrine of licensee estoppel is dead, the licensee who finds itself paying royalties for patent rights of questionable validity faces a tough choice. In view of the balance of equities applied by a federal court, the licensee that chooses to attack validity should make a thorough analysis of the costs and potential benefits before embarking on a course of action having an uncertain outcome. Clearly, the equities will lie in the licensee's favor where the licensor has applied coercion in getting the licensee to take the license. Absent evidence of wrongdoing by the licensor, the cost of litigation will, however, often prevent the licensee from contesting patent validity. The licensee is well advised to negotiate an escrow provision and the licensor's forbearance from bringing an infringement suit should evidence of patent invalidity be discovered after entering into the license agreement. Despite the end of licensee estoppel, the licensor is still in a commanding position in the patent licensing arena.

Jasper W. Dockrey is a patent attorney at the intellectual property law firm Brinks Gilson & Lione in Chicago. He can be reached at 312-321-4710 or jdockrey@brinkshofer.com.

Endnotes

1 Lear Inc. v. Adkins, 395 U.S. 653, 162 USPQ 1 (1969)

2 Automatic Radio Manuf. Co. v. Hazeltine Research Inc., 339 U.S. 827, 85 U.S. 524, (1950).

3 See, Sears. Roebuck v. Stiffel Co., 376 U.S. 225, 140 USPQ 524 (1964); Compco Corp. v. Day Bright Lighting, Inc., 376 U.S. 234, 140 USPQ 528 (1964). A federal court has jurisdiction, however, only if a federal claim is raised in the complaint. Holmes Group Inc. v. Vornado Air Circulation Sys. Inc. 122 S. Ct. 1889, 62 USPQ2d 1801 (2002).

4 Aronson v. Quick Point Pencil Co., 440 U.S. 257, 201 USPQ 1 (1979).

5 See, Jay Dratler, Jr., Licensing of Intellectual Property § 2.0 (1994).

6 Int'1 Med. Prosthetics Research Assoc. v. Gore Enterprise Holdings, Inc., 787 F.2d 572, 229 USPQ 278 (Fed. Cir 1986).

7 Shell, Oil v. Amoco Corp., 970 F.2d 885, 23 USPQ2d 1627 (Fed. Cir 1992).

8 BP Chemicals, Ltd. v. Union Carbide Corp., 4 F.3d 975, 28 USPQ2d 1124 (Fed.Cir. 1993).

9 Shell Oil, USPQ2d at 1630.

10 Spectronics Corp. v. H.B. Fuller Co., 940 F.2d 631, 19 USPQ2d 1545 (Fed. Cir. 1991).

11 Arrowhead Indus. Water, Inc. v. Eclochem, Inc., 846 F.2d. 731, 6 USPQ2d 1685 (Fed Cir. 1988).

12 Shell Oil, Id.

13 See, Troxel Mfr. Co. v. Schwinn Bicycle Co., 465 F.2d 1253, USPQ (6th Cir. 1972); St. Regis Paper Co. v. Royal Indus., 552 F.2d 309, 194 USPQ 52 (9th Cir. 1977).

14 Cordis Corp. v. Medtronic Inc., 780 F.2d. 991, 228 USPQ 189 (Fed. Cir. 1985).

15 Id.

16 PPG Indus., Inc. v. WestWood Chemicals, Inc., 530 F.2d 700, 189 USPQ 399 (6th Cir. 1976).

17 Mentor Graphics Corp. v. Quickturn Design Sys. Inc., 150 F.3d.1374, 47 USPQ2d 1683 (Fed. Cir. 1998).

18 See, Precision Shooting Equipment Co. v. Allen, 646 F.2d 313, 10 USPQ 184 (7th Cir. 1981); Cordis Corp. at USPQ 191.

19 Cascade Pacific Lumber Co. v. Interplay Design Ltd., 16 USPQ2d 1870 (D.C. Ore. 1990).

20 Foster v. Hallco Mfg. Co., 947 F.2d 469, 20 USPQ2d 1241 (Fed. Cir. 1991). See also, Jay Dratler, Jr., Licensing of Intellectual Property §2.02[1] (1994).

21 See Foster (citing Schlegel Mfg. Co. v. USM Corp., 525 F.2d. 775, 187 USPQ 417 (6th Cir. 1975)).

22 Diamond Scientific Co. v. Ambico, Inc., 848 F.2d 1220, 6 USPQ2d 2028 (Fed. Cir 1988).

23 Accoustical Design Inc. v. Control Electronics Co., 932 F.2d 939, 18 USPQ2d 1707 (Fed. Cir. 1991).

24 Mentor at USPQ2d 1684.

25 Id. at USPQ2d 1684-85.

26 Id.

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