A New Jersey court recently applied the doctrine of patent exhaustion in dismissing a patent holder's infringement suit against the customer of a manufacturer. The patent holder had previously offered a covenant not to sue to the manufacturer in order to obtain dismissal of the manufacturer's declaratory judgment claims for patent invalidity and noninfringement. The court concluded that the patent holder's offer of the covenant not to sue constituted an "authorized sale," which exhausted its patent rights against the customers, despite the fact that the covenant was never entered into and the patent holder never intended the offer to extend to the manufacturer's customers.
The doctrine of patent exhaustion acts to terminate a patent holder's rights in a patented item after an initial authorized sale of that item, allowing a purchaser to freely use, repair, modify, and resell the item. In a recent case, In Re TR Labs Patent Litigation,1 the U.S. District Court for the District of New Jersey applied the doctrine of patent exhaustion to bar a patent holder's claims of infringement against a manufacturer's customer based on the patent holder's previous offer of a covenant not to sue to the manufacturer. Even though the parties never ultimately agreed to the terms of such covenant, the patent holder had used the covenant to obtain dismissal of a declaratory judgment action brought against it by the manufacturer and the court found this sufficient to apply the exhaustion doctrine.
Alberta Telecommunications Research Centre ("TR Labs") sued multiple national and regional telecommunications network providers for patent infringement. Several of the telecommunications network providers, including AT&T, purchased telecommunications equipment from Cisco Systems, Inc. TR Labs' infringement allegations against the telecommunications network providers specifically referenced their use of Cisco's products. As a result, Cisco filed suit against TR Labs on June 26, 2012, seeking a declaratory judgment of invalidity and non-infringement of U.S. Patent No. 6,404,734 ("the '734 patent") and U.S. Patent No. 7,260,059 ("the '059 patent").
TR Labs offered Cisco a covenant not to sue. Though TR Labs and Cisco had not finalized the scope of the covenant, the court in the Cisco case dismissed Cisco's declaratory judgment action, finding no sufficient controversy remained between the parties for the court to adjudicate. The Federal Circuit affirmed, based in part on TR Labs' offer to Cisco of a covenant not to sue. Ultimately, TR Labs and Cisco did not enter into the covenant.
Because TR Labs' infringement theories against AT&T wholly relied on AT&T's use of Cisco's products, AT&T moved for summary judgment for patent exhaustion. AT&T argued that, as a Cisco customer, TR Labs' prior offer to Cisco of the covenant not to sue shielded AT&T from infringement liability. After AT&T filed its motion, the district court held that the '059 patent was invalid for indefiniteness, so the court's summary-judgment analysis focused only on the '734 patent.
The first requirement under the doctrine of patent exhaustion is that an authorized sale exists. The court observed that a patent grant provides only a right to exclude, not a right to practice the patent. Noting that a patentee can convey by license or other agreement its right to exclude, "which is simply a promise not to sue for infringement," the court equated a non-exclusive patent license to a covenant not to sue. The court further reasoned that a covenant not to sue "operates in the same way" as an authorized sale or license, and carries the same legal effect under the patent-exhaustion doctrine. Citing prior cases, the court also noted that even a mere offer of a covenant not to sue "qualifies as an authorized sale and has the same effect as a covenant that has been executed and agreed upon between the parties."
TR Labs acknowledged that it offered a covenant not to sue Cisco but emphasized that they never executed the covenant because TR Labs refused to extend the covenant to Cisco's customers, such as AT&T. TR Labs thus argued that the offer did not extend to AT&T. TR Labs additionally claimed that it received no consideration for the offer, precluding a finding of patent exhaustion based on the offer of the covenant not to sue.
The court rejected TR Labs' position, stating that it was undisputed that TR Labs offered to Cisco a covenant not to sue, which rendered irrelevant whether TR Labs intended to extend the offer to Cisco's customers. The court explained that under patent exhaustion, the only relevant point is whether Cisco's sale to AT&T was authorized, which it was. As Cisco's downstream customer, therefore, AT&T received the right to practice the patent. The court also rejected TR Labs' argument that it had received no consideration for the offer. Where an authorized sale occurs, the lack of consideration does not preclude application of patent exhaustion. The court nevertheless observed that TR Labs received consideration for offering the covenant, as TR Labs used it to defeat Cisco's declaratory judgment action.
Product Must Substantially Embody the Patent
The second requirement under the doctrine of patent exhaustion is that the sold product must substantially embody the patent. According to the court, a product substantially embodies a patent when the reasonable and intended use of the product is to practice the patent and when the product embodies essential features of the patented invention. The court noted that a substantial embodiment further exists where the only steps necessary to practice the patent are "the application of common processes or the addition of standard parts." Substantial embodiment thus may be found where the product 1) has no reasonable non-infringing use and 2) includes all inventive aspects of the claimed method.
AT&T argued that TR Labs' infringement contentions could be used to demonstrate that Cisco's products substantially embody the '734 patent. The court agreed, finding that TR Labs itself alleged through its infringement theories that Cisco's products satisfy every limitation of the '734 patent. The court was not persuaded by TR Labs' counter-argument that Cisco's products had substantial non-infringing uses because they were not reasonable given the state of the technology, and AT&T's actual use of the product was the use contemplated by the '734 patent.
Strategy and Conclusion
This case illustrates the potential unintended consequences of a patent holder's offer of a covenant not to sue as a strategic tool to obtain dismissal of a declaratory judgment claim. Even if no agreement is ultimately entered into, a court may find that the offer combined with the ultimate dismissal of the case exhausts the patent holder's rights to enforce its patent against not only the offer's recipient but also the recipient's downstream customers.