The US Supreme Court’s unanimous decision in Quanta Computer, Inc. v. LG Electronics, Inc., 128 S. Ct. 2109 (2008)1, reaffirming the patent exhaustion doctrine (also known as the first sale doctrine), was promptly followed by a line of cases testing this doctrine’s reach. One line of cases held that patent exhaustion is territorial, and sales outside of the United States do not exhaust a patentee’s US patent rights. A second line held that the doctrine has no territorial limits and a patentee’s sales anywhere in the world exhaust its rights in the United States. Given these diametrically opposing views on an issue with significant implications for patentees, licensees and manufacturers doing business both inside and outside the United States, many were hopeful that the Supreme Court’s decision on this issue in the copyright context in Costco Wholesale Corp. v. Omega, S.A. (argued in November 2010) would have provided some much needed guidance. Unfortunately, none was given. On December 13, 2010 the Supreme Court issued a split 4-4 affirmation of the Ninth Circuit decision. The split was due to Justice Elena Kagan’s2 recusal. With no Supreme Court precedent, the issue of whether the exhaustion doctrine has a territoriality requirement ultimately remains unsettled.

In its simplest terms, the patent exhaustion or first sale doctrine is premised on the notion that a patentee should be rewarded for the “first authorized sale” of its patented product, but once the product is sold the patentee’s rights as to the product are “exhausted” – the patentee has no further right to interfere in or control the downstream purchasers’ use or enjoyment of the product.3 Exhaustion is, therefore, a common defense to claims of various IP infringement including patent and copyright infringement.

The question is, however, whether it matters where the first authorized sale took place. Proponents of the “territorial exhaustion” argument advocate that an authorized sale must have occurred in the jurisdiction where the exhaustion defense is being asserted. In contrast, those who claim that exhaustion has no territoriality requirement take the view that once a patentee has authorized sale of its product anywhere in the world, a patentee’s rights as to those products are exhausted worldwide.

One Point of View: Only First Authorized Sale in United States Exhausts US Patent Rights

The territorial exhaustion argument is based on the idea that patent rights are fundamentally territorial in nature (e.g., a US patent alone does not confer any patent rights outside the United States) and, therefore, such rights cannot be exhausted by acts or conduct outside the relevant countries or territories. The often, albeit rather ill-advisedly, cited case for this argument is Boesch v. Graff, 133 U.S. 697 (1890). The case, however, was more accurately about whether a third party had the requisite right or authority to sell the patented products in the United States, and not about whether a patentee had exhausted its rights by a prior sale – in fact, in Boesch there was no first authorized sale by a patentee.4

Yet subsequent cases relying on Boesch have interpreted the case as standing for the proposition that patent exhaustion has a territoriality requirement, and by sheer momentum this has spawned a series of opinions reiterating the same.5 Examples include Jazz Photo Corp. v. Int’l Trade Comm., 264 F. 3d 1094, 1105 (Fed. Cir. 2001) (Jazz 2001) (citing Boesch “[t]o invoke the protection of the first sale doctrine, the authorized first sale must have occurred under the United States patent”) and Fuji Photo Film Co., Ltd. v. Jazz Photo Corp., 394 F.3d 1368, 1376-77 (Fed. Cir. 2005) (Fuji 2005) (broadly construing Boesch: “the patentee’s authorization of an international first sale does not affect exhaustion of that patentee’s rights in the United States”). In fact, most recently in Fujifilm Corp. v. Benun, No. 09-1487 (Fed. Cir. May 27, 2010), the Federal Circuit6 made it abundantly clear that in its opinion there is a territorial requirement to the exhaustion doctrine, and “Quanta did not eliminate the first sale rule’s territoriality requirement.”

An Alternative Point of View: First Authorized Sale Anywhere Exhausts US Patent Rights

In LG Electronics, Inc. v. Hitachi, Ltd., 655 F. Supp. 2d 1036 (N.D. Cal. March 13, 2009), after reviewing the same license agreement that was at issue in Quanta, the court unequivocally held that the exhaustion doctrine has no territoriality requirement, and that once a patentee authorizes the sale of its products anywhere in the world, the patentee’s rights as to those products are exhausted.7 The Hitachi court reasoned that a territoriality requirement would in effect give a patentee the right to pursue downstream purchasers and users for infringement even though the product was initially “lawfully” acquired, which would be contrary to the fundamental tenet of the Supreme Court’s decision in Quanta – that the exhaustion doctrine “prevents the patent holder from invoking patent law to control postsale use of the article” and “the danger of allowing such an end-run around exhaustion … would violate the longstanding principle, that, when a patented item is once lawfully made and sold, there is no restriction on its use to be implied for the benefit of the patentee.” Id. at 1044. Squarely addressing the Federal Circuit’s opinions in Jazz 2001 and Fuji 2005, the Hitachi court noted that Quanta undercut and overruled these decisions,8 and the patentee’s first authorized sales of the products anywhere exhausted the patentee’s rights as to those products. LG did not appeal the ruling and the case was subsequently terminated by the parties’ stipulation in October 2009.

[R]eading Section 109 to include a territoriality requirement would effectively incentivize foreign outsourcing or manufacturing outside the United States.

Supreme Court’s Review of the Exhaustion Doctrine in the Copyright Context: Costco v. Omega

Against this backdrop the Supreme Court received briefs and heard argument in Costco v. Omega, which considered whether the exhaustion or first sale doctrine has a territoriality requirement in the context of copyrights. The dispute in Costco revolved around a common problem faced by manufacturers – gray market goods or parallel imports – which primarily takes advantage of differences in manufacturers’ pricing systems in different countries and markets (i.e., arbitrage).

In Costco, Omega made and sold watches to authorized distributors outside the United States. The watches subsequently passed through other third party dealers and distributors, and were eventually available for sale at Costco’s California stores at a steep discount. Omega sued Costco for infringing distribution and unauthorized sale of watches that bore Omega’s copyrighted designs, and argued that the exhaustion defense was unavailable to Costco because Omega made and sold the watches outside the United States. The Ninth Circuit agreed. In doing so, however, the Ninth Circuit essentially challenged the Supreme Court’s unanimous decision in Quality King v. L’anza Research International Inc., where the Court upheld the exhaustion doctrine for imported goods, and distinguished Quality on the grounds that the Omega watches were made and first sold abroad (and outside the “territorial” reach of the exhaustion doctrine), whereas in Quality the products were made in the United States.

During the Costco oral arguments, the Court seemed skeptical of both sides’ positions on whether the “first sale” statute9 (Section 109) implicitly included a territoriality requirement, repeatedly asking the lawyers to point out where in the text or legislative history support could be found for their respective arguments. The Justices appeared to agree that reading Section 109 to include a territoriality requirement would effectively incentivize foreign outsourcing or manufacturing outside the United States, and Congress certainly would not have enacted Section 109 with such an intent – “what earthly sense would it make to prefer goods that are manufactured abroad over those manufactured in the U.S.” (J. Ginsburg).

On December 13, 2010 the Court issued a per curiam order affirming the Ninth Circuit’s ruling against Costco. This order was issued because the court split 4 to 4 on the question and so by rule the lower court opinion was affirmed by an equally divided court. This division resulted after Justice Kagan had recused herself because she had participated as Solicitor General in submitting a brief to the Court urging it to not take the case because the decision of the Ninth Circuit was correct. In effect, the Supreme Court’s action left the Ninth Circuit’s ruling against Costco undisturbed (i.e., the exhaustion doctrine is subject to a territoriality requirement), but it provided no clarification or further precedent to guide lower courts and interested parties. Thus, the conflicting views about the territorial scope of the exhaustion doctrine remain unsettled (at least outside of the Ninth Circuit).

Negotiating and Drafting the License Agreement (“First Authorized Sale”)

Notwithstanding the uncertainty surrounding the territoriality requirement, one thing Quanta makes clear is that the parties are free to limit the rights granted in the agreements they negotiate and execute. Notably in Quanta, the Court observed that the LG-Intel license agreement did not in any way restrict Intel’s (the licensee’s) right to sell the products, and LG (the licensor) “overlooked” an important aspect of the structure of the transaction that the parties negotiated. The Court indicated that the parties are free to negotiate and draft license agreements imposing certain conditions on sale and use of the products, which were incidentally missing in the LG-Intel license agreement.

In fact, license agreements can often have “field of use” conditions; geographic, regional or term limitations; conditions based on frequency of use; varying royalty structures contingent on, for instance, who the product is sold to (e.g., sales to licensee versus non-licensees); or any number of other such conditions to limit the use and/or sale of a patented product. If these conditions were violated, a licensor could have a potential breach of contract claim against a licensee – a point the Supreme Court raised in Quanta. This, however, is easier said than done, and can be challenging to negotiate and enforce, not only from a commercial perspective, but also because such terms may implicate antitrust, trade or other consumer protection laws.