On March 3, 2009, Judge Claudia Wilken of the Northern District of California held in LG Electronics, Inc. v. Hitachi, Ltd. that the Supreme Court’s decision in Quanta Computer, Inc. v. LG Electronics— which held that patent exhaustion applied to method claims and was triggered by the authorized sale of an article that substantially embodied a patent—applied to authorized foreign sales, as well as authorized domestic sales.1 Judge Wilken held that, in Quanta, the Supreme Court silently overruled two prior Federal Circuit cases (Jazz Photo Corp. v. ITC2 and Fuji Photo Film Co., Ltd. v. Jazz Photo Corp.3) that held just the opposite; namely, that a patent holder’s foreign sales of products did not serve to exhaust the patent holder’s U.S. patent rights, as foreign sales could never be “authorized” under a U.S. patent, given the proscription against extra-territorial application of U.S. patents. If upheld on appeal, Hitachi has the potential to upset long-held expectations regarding the ability of patent holders to protect their U.S. market while licensing others abroad.

Quanta: Patent Exhaustion Applies to Method Claims

By way of background, in Quanta, LG Electronics (LGE) granted Intel a fully paid, worldwide license to, among others, the same patents that are in issue in Hitachi.4 The license permitted Intel to manufacture components that practiced the LGE patents and authorized Intel to “make, use, sell (directly or indirectly), offer to sell, import or otherwise dispose of” its own products. However, the license stated that third parties to the license could not combine the licensed parts with non-Intel parts to make computers in a manner that practiced the patents-at-issue. Nevertheless, the defendant computer manufactures purchased microprocessors and chipsets from Intel and then manufactured computers using Intel parts in combination with non-Intel memory and buses in ways that practiced the LGE patents.5 LGE brought suit accusing the manufacturers of infringing its patents.6 The defendants asserted that LGE could not sue for infringement because it had exhausted its rights to enforce the patents by licensing the patented methods to Intel.7 LGE argued that patent exhaustion did not apply to method claims.8 The Supreme Court rejected LGE’s argument, stating that the traditional bar on patent restrictions following the sale of an item applies when the item sufficiently embodies the patent—even if it does not completely practice the patent—such that its only and intended use is to be finished under the terms of the patent.9

Hitachi Extends Patent Exhaustion to Foreign Sales

In Hitachi, LGE similarly accused Hitachi of infringing the patents in the same way that was alleged against the Quanta defendants: by combining the Intel parts that are subject to the license agreement with non-Intel parts in a way that practices the methods taught in the patents.10 Despite the factual similarity, LGE attempted to distinguish the facts in Hitachi from those in Quanta by arguing that Quanta applied only when the first authorized sale of patented items occurred in the United States, whereas the first sale in Hitachi was of foreign origin.11 In this regard, LGE urged the district court to follow Federal Circuit precedent, laid out in Jazz Photo and Fuji Photo, that held that foreign sales of products covered by a United States patent do not serve to exhaust the patent holder’s rights with respect to those products.12 The district court declined, holding that Fuji Photo and Jazz Photo were inconsistent with Quanta, which prevents patent holders from doing an end-run around the exhaustion doctrine by authorizing a sale and reaping the benefit of a patent, then suppressing acts by downstream purchasers.13 The court held that Quanta dictated that patent exhaustion flows from any authorized sale, both foreign and domestic.

The district court also noted that Boesch v. Graff, the Supreme Court case relied on in Jazz Photo and Fuji Photo, was not to the contrary.14 As indicated by the district court, the Boesch case involved allegations of infringement of a U.S. patent against a dealer that imported the infringing products from a German company. Importantly, the German seller was a stranger to both the U.S. patent and to three German patents covering the same invention. The German seller had authorization to sell the patented invention in Germany under a German prior use statute. The question before the Court in Boesch was whether the defendant could purchase German products from a person authorized to sell them in Germany, and import them into the United States without the license or consent of the owners of the U.S. patent. The Court held that it could not: the German seller had the right to make and sell the accused products in Germany (not by license, but by statute), but had no authority to make and sell the accused products in the United States. Therefore, “purchasers from him could not be thereby authorized to sell the articles in the United States in defiance of the rights or patentees under a United States patent.”15

Without noting (at least expressly) that the seller in Boesch was a stranger to the U.S. patent in question, the Federal Circuit expanded Boesch in Jazz Photo and Fuji Photo to products sold abroad under the authority of the U.S. patent holder. In contrast to the facts of Boesch, the defendants in Jazz Photo and Fuji Photo were downstream customers that were purchasing products originally sold by the holder of the U.S. patent or by someone with authorization from the holder of the U.S. patent. It just so happened that the original sale occurred in a foreign jurisdiction. Nevertheless, the Federal Circuit held that the foreign sale did not give rise to patent exhaustion, as the U.S. patent had no extraterritorial effect. In essence, the Federal Circuit switched the focus from whether the accused product was purchased from someone with authority to sell the product in the United States to simply whether the sale did or did not occur in the United States. The Federal Circuit held that authorized domestic sales gave rise to patent exhaustion while authorized foreign sales did not.16

According to the district court in Hitachi, the distinction drawn in Fuji Photo and Jazz Photo between authorized domestic sales and authorized foreign sales would negate the Supreme Court’s stated intent in Quanta to eliminate the possibility of a patent holder doing an end-run around the exhaustion doctrine by authorizing a sale, thereby reaping the benefit of its patent, then suing a downstream purchaser for patent infringement. As explained by the Court in Quanta:

This case illustrates the danger of allowing such an end-run around exhaustion. On LGE’s theory, although Intel is authorized to sell a completed computer system that practices the LGE Patents, any downstream purchasers of the system could nonetheless be liable for patent infringement. Such a result 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.17

The district court also stated that the Supreme Court’s rationale for stating that authorized sales exhaust the patent holder’s rights and prevent the patent holder from invoking patent law to control post sale use of the article applied equally to foreign sales as to domestic sales. The district court even noted that the Supreme Court in Quanta was aware that some sales under the license agreement were made oversees. Specifically, the district court noted that, in considering whether the Intel parts had reasonable non-infringing users, the Supreme Court stated in a footnote:

LGE suggests that the Intel Products would not infringe its patents if they were sold overseas, used as replacement parts, or engineered so that use with non-Intel Products would disable their patented features. But Univis teaches that the question is whether the product is ‘capable of use only in practicing the patent,’ not whether those uses are infringing. Whether outside the country or functioning as replacement parts, the Intel Products would still be practicing the patent, even if not infringing it. And since the features partially practicing the patent are what must have an alternative use, suggesting that they be disabled is no solution.18  

According to the district court, because the Quanta Court declined to limit its holding to sales in the United States, interpreting Quanta so as to impose such a limitation would be incorrect.19

The district court also provided an alternative justification for its holding; to wit, since LGE received a fully paid-up, lump sum royalty in exchange for granting Intel use of its patented methods, it had received its full reward for use of the patented method when it licensed the patents to Intel.20 The first “sale” by LGE was thus the Intel license, which occurred in the United States. The district court’s alternative justification provides a policy rationale for abolishing the distinction between foreign and domestic sales, as an authorized foreign sale is no different from an authorized domestic sale since, in both cases, the patentee receives its full reward for the use of the patented product.

The district court’s decision in Hitachi is interlocutory, but will almost certainly be appealed to the Federal Circuit, which otherwise has not ruled that Quanta overrules Jazz Photo and Fuji Photo. Thus, for now, the Federal Circuit precedent clearly states that foreign sales do not exhaust domestic patent rights. The Hitachi decision, however, forecasts one possible future—a future in which foreign sales by the patent holder trigger patent exhaustion. That result would amount to a fundamental change in the law that could have a dramatic impact on current licensing regimes. Where companies could once simultaneously protect their U.S. market and profit from sales made by others abroad, a rule that foreign sales trigger patent exhaustion would expose such intellectual property holders to domestic competition from foreign imports.

How Patent Holders Can Address the Possible Change in the Treatment of Foreign Sales

The possibility of a sea-change in the treatment of foreign sales raises the question of what steps patent holders can take now to continue with current licensing regimes. Outlined below are two possible means of protection.

One possibility is to impose a jurisdictional condition on all foreign sales and on all downstream customers. Both Quanta and Hitachi involved the unconditional authorization to sell the patented products.21 Thus, rather than granting the unconditional authority to sell or participating as the seller in such a sale, patent holders can condition sale on foreign soil such that all purchasers agree not to import the product into the United States. The Federal Circuit has previously upheld and enforced express, aftermarket conditions on sales.22 And the Supreme Court has stated that patent exhaustion itself stems from the “unconditional sale” of a patented article.23

Patent holders could further require the purchaser or licensee to similarly obligate all downstream purchasers and to clearly mark the product with the subject restriction. This may help prevent any future issues that arise from enforcing the patent against bona fide purchasers, as the Federal Circuit has noted that a licensee cannot grant authority that it did not originally possess.24 Indeed, the Federal Circuit in Transcore highlighted the patent holder’s ability to limit authorization.25 Moreover, the patent statute itself separates out the right to sell from the right to import, suggesting that patent holders have the power to separately offer the right to sell from the right to import.26

A second possibility is to structure any patent holding companies along geographic lines. Holdings companies may be arranged such that any authorization of foreign sales comes from an entity that cannot grant similar authority under the U.S. patent. This makes the licensing situation somewhat analogous to the situation in Boesch, where foreign sales were made by a stranger to the U.S. patent. According to Boesch, which was endorsed by the Federal Circuit in Jazz Photo and Fuji Photo and by the district court in Hitachi, such sales do not give rise to patent exhaustion.

Finally, it is worth noting that the Federal Circuit may reverse the district court in Hitachi and continue to follow the holding of Jazz Photo and Fuji Photo. Indeed, the Federal Circuit had an opportunity to address the issue in Transcore, but refused to do so. In Transcore, the patent holder argued against exhaustion, asserting that the sale-at-issue may have occurred outside of the United States. Although the Federal Circuit concluded that the sale did in fact occur inside the United States, the location of the sale would have been irrelevant had Quanta overruled Jazz Photo and Fuji Photo. The Federal Circuit’s consideration of the locality of the sale therefore suggests that it may follow its holdings in Jazz Photo and Fuji Photo.

In sum, Hitachi raises the specter that current expectations regarding the effect of foreign sales on patent exhaustion may soon be upset. Until this issue is resolved by the appellate courts, patent holders may elect to take extra precautions to protect their domestic market, such as including express conditions on any authorized foreign sales or by structuring patent holdings companies such that any authorization of foreign sales comes from an entity that is a stranger to the U.S. patent.