Patent Exhaustion for the Exhausted Defendant: Should Parties Be Able to Contract Around Exhaustion in Settling Patent Litigation?
37 Pages Posted: 6 Sep 2014 Last revised: 28 Jan 2015
Date Written: September 4, 2014
The first sale doctrine provides that when a patent holder unconditionally authorizes another party to sell a patented item, the patent holder’s right to exclude with respect to the patented item is “exhausted.” The licensee can then sell the patented item to a third party — a downstream purchaser — and the patent holder will not be able to sue the third party for patent infringement based on the resale or other use of that item. A principal animating policy behind the exhaustion doctrine is to prevent patent-holders from receiving overcompensation for their patented inventions by, for example, aggregating royalties along multiple points in the production and distribution chain.
Patent-holders settling infringement litigation often seek to draft a license agreement that precludes application of the exhaustion doctrine, so that they may continue to pursue licensed products downstream. Such provisions are likely ineffective if drafted as post-sale restrictions on what downstream purchasers may do with their patented products. However, it is possible to contract around exhaustion by limiting the scope of the authorized sale (a “pre-sale restriction”) or through other clever licensing devices that are described in this paper.
But should such provisions be enforceable? The prevailing view in the academic literature argues from a law and economics perspective that it is economically efficient to allow patent holders to license their patents at multiple points along the production chain, and that the free market will curb patent holders’ ability to receive double-recovery.
This article counters the law and economics literature to argue that such provisions should not be enforced if they are brokered as part of a litigation settlement. The litigation settlement context distorts the economic efficiencies allegedly created by contracting around exhaustion and can prevent free market checks on double-recovery. The expense and risk of litigation, the threat of injunctions, and the pressure to settle can weigh heavily on the patent infringement defendant. The license fee that is negotiated may not be sufficiently discounted to account for the reservation of downstream rights preserved by the patent holder. This is particularly true in light of research in cognitive psychology indicating that litigants do not engage in economically rational behavior in making settlement decisions. Defendants will likely favor a lower settlement price in exchange for a provision contracting around exhaustion, and take the risk that litigation against downstream customers will be defeated or that indemnification can be avoided. If there is a clear rule against contracting around exhaustion, the parties will set the license fee at a rate that gives the patent holder full compensation up front, and the defendant can simply pass along this extra cost to downstream purchasers. This efficiently avoids the costs of additional litigation against downstream purchasers.
Keywords: patent exhaustion, first sale doctrine, patent licensing, litigation settlement, patent litigation settlement, Quanta, Quanta v. LG
JEL Classification: K00, K12
Suggested Citation: Suggested Citation