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How the Law Distorts Incentives To Litigate or To Settle Patent Disputes

TECHNOLOGY ADR / PART 2 OF 2

By John W. SchlicherFebruary 4, 2013 | Print
Agreements Needed

The issue: The rule of law is failing when it comes to patents.

What’s wrong? Patent laws promote lengthy, expensive litigation.

The law decides. It doesn’t encourage settlement. It should be so oriented for patents. It’s efficiency. It’s common sense.

Last month, the author explained why settlement and license agreements are more important to a well-functioning patent system than decisions of the patent office and the courts, and summarized five reasons why agreements are more efficient. (John Schlicher, “Improving the Patent System by Removing Legal Obstacles to Agreements,” 31 Alternatives 1 (January 2013).) In this concluding Part 2, the author discusses some of the specific obstacles the law places in the path of patent agreements.

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If all patent disputes had to be resolved by litigation to the bitter end, the patent system could not function and would be abolished. The patent system makes a positive contribution, and survives, only because business people avoid or resolve privately an extraordinarily high percentage of potential and actual disputes.

For that reason, we would expect the law to develop at every opportunity to facilitate and encourage patent agreements. At the most abstract level, the law says the policy in favor of settlement of litigation applies to patents. The law, however, developed in ways that discourage private resolution of patent disputes, particularly by the most efficient form of settlement, a license prior to a lawsuit.

To secure the benefits of settlement and license agreements, the law should facilitate the discussions needed to negotiate agreements, provide sensible incentives for patent owners and product suppliers to reach agreements, enforce these agreements, and limit enforcement costs and risks. These are some of the ways the law does not.

LICENSE ROYALTIES AND THE VALIDITY OF THE PATENTS. The law should encourage patent owners and producers to enter settlement and license agreements, and permit all such agreements to be true alternatives to litigation. Instead, the law sometimes forces people to litigate patent issues rather than resolve them by agreements.

In almost every patent dispute, the potential infringer contends the patent is invalid. Before the late 1960s, patent owners and their licensees could resolve a patent validity dispute with a license requiring payment of royalties without regard to validity, and requiring the licensee not to commence an action to have the patent declared invalid.

Under those terms, the parties could agree to payments discounted to reflect their views of the likelihood that the patent would be found valid if litigated. They could also take into account the lower costs each would bear operating under the agreement rather than litigating, and the lesser risk each would bear because future payments would not depend on validity issues.

This changed shortly after the U.S. Supreme Court’s decision in Lear v. Adkins, 395 U.S. 653 (1969). See “Judicial Regulation of Patent Licensing, Litigation and Settlement under Judicial Policies Created in Lear v. Adkins” (1985)(available at http://bit.ly/VXRgG4). After Lear and lower court decisions extending Lear, if a patent owner grants and a potential infringer accepts a license to avoid litigation, the law insists that the license not prevent litigation of validity.

Properly understood, the Lear decision merely eliminated a contract rule on royalty obligations called licensee estoppel. Where a license did not provide for the effect of validity on payments (as in the Lear license), the estoppel rule was that payments must be made without regard to validity. The law sensibly assumed that is what the parties intended.

Lear eliminated that default rule. The effect was that, where the agreement was silent, payments were dependent on validity and the licensee could defend a contract action for royalties based on invalidity. Lear did not say or necessarily imply that patent owners and licensees could not lawfully provide for a different result. The lower courts, however, read Lear to mean that license agreements to make royalties independent of validity or to require that the licensee not challenge validity were unenforceable.

This interpretation prevents patent owners and potential infringers from eliminating the risk and cost of validity litigation and agreeing to a license with payments at discounted rates based on their views of the likely outcome of validity litigation. The law prevents them from achieving several of the benefits of agreements discussed in Part 1 last month.

Curiously, the law insists on that inefficiency only if they enter a license before litigation begins. The day after an action is filed, the law permits these agreements. In short, the law disfavors licensing when the benefits are greatest—that is before litigation is possible or before litigation begins—and favors licensing only when the benefits are smaller, after litigation begins.

The result is more litigation.

DECLARATORY JUDGMENT ACTIONS BY POTENTIAL INFRINGERS OR LICENSEES. The ability of a patent owner and potential infringer or licensee to discuss a patent dispute and resolve it without litigation also depends when the law permits the potential infringer or licensee to commence a declaratory judgment action to have the patent declared invalid or not infringed. Until the middle 1960s, patent owners and suppliers could discuss possible agreements without creating the conditions for the suppliers to commence declaratory judgment actions.

Today, declaratory judgment jurisdiction rules permit settlement and licensing discussions to be used as the basis for a supplier to commence a declaratory judgment action. If the patent owner says during those discussions that the supplier is infringing, the supplier may start litigation, even if the patent owner has not threatened to sue.

Because it nearly is impossible for a patent owner to negotiate without in some way indicating that it believes an agreement is necessary, this rule poses a major obstacle to holding these discussions. This leads to fewer discussions and, with fewer such discussions, fewer agreements and more unnecessary litigation.

DECLARATORY JUDGMENT ACTIONS BY EXISTING LICENSEES. The law also attempts to define the circumstances in which an existing licensee may commence an action to have the patent declared invalid.

As discussed, Lear has been interpreted to mean that license royalties must depend on validity. Lear, however, does not necessarily mean that patent owners lose all control over how much validity litigation will occur. The patent owner and licensee are entirely free to agree that the owner may terminate the license if the licensee stops paying. With termination rights, a licensee that stops paying and continues selling products may face an infringement action and post-termination damages not necessarily limited to the amount of pre-termination royalty rates.

Under those conditions, many licensees will continue to pay. Validity litigation, with its risks and costs, may be rare. This changes if the jurisdiction rules permit a licensee to start an action to have the patent declared invalid without non-payment that jeopardizes the continuation of the license. Before the early 1970s, the law seemed clear that the federal courts had no jurisdiction to decide an action begun by a company that was operating under a license and paying the royalties.

Unfortunately, the Supreme Court’s MedImmune Inc. v. Genentech Inc., 127 U.S. 764 (2007) decision may be read to say that any patent licensee may commence an action to have a licensed patent declared invalid after simply objecting to further payments on the basis of invalidity, and without stopping payment. See “Patent Licensing, What to Do After MedImmune v. Genentech” (2007) (available at http://bit.ly/SoPC4v).

While this author believes MedImmune is more limited and applies only where the license expressly makes the royalty obligation conditional on validity, others may disagree. Under the broader view, any licensee may force litigation to eliminate its payment obligation without jeopardizing the continuation of the license. This jurisdiction rule removes the disincentive to litigation provided by possible termination.

Combined with Lear, this rule poses a great obstacle to providing royalties at discounted rates and rates based on the assumption there will be no litigation costs or risks. A patent owner would be foolish to agree to the lower rates when even the lower rates may not be paid and it may be forced to litigate. Again, this poses an unnecessary barrier to licensing.

LICENSING MAY LIMIT DAMAGES. The law measures patent damages in several ways that discourage agreements. See “Patent Damages, the Patent Reform Act and Better Alternatives for the Courts and Congress,” (2009) (available at http://bit.ly/UViCBQ). Only one is discussed here.

The law permits royalty terms of existing licenses to be an important and occasionally decisive factor in determining damages against other infringers. If a patent owner grants licenses to avoid litigation, the law insists that the licenses may be used by infringers to limit their damages. Since the 1850s, a so-called established royalty has been an available measure of damages. In general, an established royalty exists when a patent owner has granted a number of licenses at a uniform rate for the same activities that constituted the infringement. In addition, since the early 1900s, damages also may be measured by a so-called reasonable royalty, and other licenses granted by the patent owner may be considered in arriving at a reasonable amount.

Patent damages should be measured by the difference between (1) the value an invention would have had to the owner, if there had been no infringement by the defendant in a particular case or anyone else, there were no uncertain patent issues and no litigation, and the invention was used in the most productive and profitable manner (the “full economic value of the invention”), and (2) the value the invention had to the owner with infringement. Limiting damages based on royalties in past licenses is a problem because those royalties are highly likely to be less than the full economic value of some invention.

When the courts began measuring damages by an established royalty, they did so by observing that market transactions are the best measure of the value of things. Market transactions in patents, however, will almost invariably undervalue inventions for purposes of damages.

For a moment, put aside the possibility of infringement and litigation. As with any agreement, a patent owner and potential licensee will enter a license if each perceives that the profits it will earn under a license exceed the profits that it would earn without the license. Those profit levels depend on the economic value of the invention, when used by the licensee, the patent owner, or some other potential licensee. Agreed royalties, however, are unlikely to be the same as the full economic value of an invention.

One disconnect between license royalties and damages is that damages should be based on an invention’s actual value during the period of past infringement and license royalties are set not based on past value. They are based on expected future value. License royalties depend on the future economic value of an invention the patent owner expects to capture without licensing, and the future value the potential licensee expects to capture with licensing.

It is difficult for a patent owner and potential licensee to predict future economic value due to uncertainty about future economic conditions and technological changes. Their estimates of an invention’s future value are highly likely to be different from the value the invention proves to have.

In addition, where a patent owner or licensee or both are averse to risk, they will perceive the risk-discounted value of the invention to be less than its expected value and will license for royalties measured by the lower risk-discounted value. For that reason, the agreed payment is likely to be lower than the value an invention proves to have.

More important, royalties do not merely measure the economic value of the invention to a patent owner or a licensee. Litigation provides an option unavailable in almost all other commercial transactions.

A potential licensee often has the option to obtain a license or risk infringement litigation, and a patent owner has the option to license or engage in infringement litigation. If the owner believes a potential licensee will use the invention without a license, the patent owner will license only if the expected royalties are greater than (1) the economic value of the invention to it without licensing and (2) the risk-discounted expected value of an infringement action. Likewise, a potential licensee will accept a license only if expected royalties are less than (1) the economic value of the invention to it with licensing, and (2) the risk-discounted expected cost of an infringement action.

The patent owner’s expected value and in-fringer’s expected cost of a patent infringement action depend on their perceptions of the likely outcome and remedies of litigation. Just as future market conditions are uncertain, the outcome of future patent litigation is uncertain.

The expected value and cost of infringement litigation are based on the parties’ perceptions of probabilities of winning and losing. When royalties are agreed to in some amount greater than the patent owner’s expected value of litigation and less than the infringer’s expected cost of litigation, those royalties are likely to be less than the actual value of an invention, because the probabilities are usually significantly less than one.

For example, assume there is an invention that would permit a potential licensee to earn an additional $30 per unit profits. If the potential licensee proceeds without a license and is sued for infringement, assume there is a 50% chance that the patent owner will prevail. At first approximation, the potential licensee will pay no more than $15 per unit for a license (that is, $30 per unit times its probability of losing, 0.5).

If a risk-neutral patent owner and potential licensees generally believed that a particular patent owner had about a 50% chance of winning the infringement action, and we observe established royalties for licenses of $15 per unit, the value of the invention is more likely to have been around $30 per unit (that is, $15 per unit divided by 0.5).

Third, a royalty is deemed “established” only where licenses have been granted to a number of companies, and the royalty provisions of those licenses are the same.

If a patent owner licenses a number of companies with the same royalty terms, those terms are likely to underestimate the invention’s value to a particular licensee where the invention contributes different amounts to the expected profits of different licensed companies.

If different licensees value the use of the invention in different amounts, a uniform royalty amount for each of them will understate the invention’s value to some of them. This is because the royalty terms must be acceptable to the marginal licensee having the lesser value for the invention. Since the profits different companies make as the result of using an invention are likely to differ, an established royalty satisfying those two legal requirements is likely to understate the invention’s value to some companies.

For these and other reasons, actual royalties are likely to be lower than the values of inventions. Hence, damages derived from rates in actual licenses create another unnecessary barrier to licensing. A patent owner considering granting licenses to one or a few licensees limits damages against infringers. For that reason, patent owners will be less willing to grant licenses. If the patent owner litigates against later infringers and wins, the damages may be limited by the lower amounts given to licensees without litigation.

A patent owner may have the same concerns if it grants a license to even one licensee. Suppose a patent owner believes that the amount specified in that license will limit the amount of damages available against that licensee, if the license terminates and the former licensee infringes. If the owner agrees to a lower rate dictated by expected value and cost of litigation, this rate may limit infringement damages even after a court has found the patent valid and infringed. The lower rate may apply to a time period for which that rate is inappropriate.

Again, the result is less licensing and more litigation than there should be.

UNCERTAINTY ABOUT INJUNCTIVE RELIEF AND THE EFFECT OF LICENSING ON THE AVAILABILITY OF AN INJUNCTION. Injunctive relief is vital to provide proper incentives for patent settlement and license agreements. The Supreme Court’s 2006 eBay decision has caused unnecessary confusion about how judges decide whether to issue permanent injunctions. eBay Inc. v. MercExchange LLC, 547 U.S. 388 (2006)(available at http://bit.ly/UdQnuV). See Comments for FTC Hearings on the Intellectual Property Marketplace (2009)(available at http://bit.ly/UViRg5).

As noted in Part 1 last month, one reason agreements produce better results than litigation is that settlement with a license for the future negotiated by the parties free of judicial compulsion produces greater benefits than any of court orders. Consider the possibilities.

If the court grants an injunction against future infringement, either an infringer will not use the invention in the future or there will be an agreement in which the patent owner grants the infringer a license. After an injunction, a patent owner will grant a license only where future use by an infringer will generate larger profits than available under any alternative state of affairs, such as use only by the patent owner or some other licensee. The parties will license when a license increases the value of a patented invention. An injunction alone does not produce this beneficial result.

If the courts deny an injunction, the incentives to license are lower, profits generated from future use of an invention are likely to be lower, and the invention’s value is likely to be lower. With no injunction, there are two basic outcomes.

First, the infringer may continue to sell the infringing product, and a series of lawsuits follows in which the patent owner captures some of the value of its invention as damage awards. The infringer’s continued sales, unrestrained by any payment obligation, continue to depress the value of that invention the patent owner may capture by licensing others or using the invention itself.

The portion of the remnant of the invention’s value ultimately captured by the patent owner will depend on patent damages standards and in all events will be reduced by the added litigation costs. Even in this situation, the parties may agree to license. The license payments, however, will no longer be based on the full economic value of the invention when used by the licensee. They will depend on expected damages awards and litigation costs.

Second, the court orders the parties to attempt to enter a license on agreed terms or on terms the court orders if they fail to agree. In these actions, federal district judges become the government regulators of patent licenses. Judges decide which companies obtain licenses, the prices for licenses, and perhaps even other non-price terms.

For many reasons, private negotiations between patent owners and potential licensees will produce much better outcomes than orders by judicial regulators. Again, the parties may agree to a license to avoid having to operate under whatever license the court might order them to enter. But again, the payments will no longer be based on the full economic value of the invention. They will depend on whatever the parties think the court might order.

Uncertainty about when an injunction will be granted and the role of the court if an injunction is denied has a profound affect on agreements because the parties do not know what will happen if they litigate. The patent system is designed so that decisions by a patent owner and users of inventions, and not judges, govern by whom and how inventions are used and at what prices. Subject to one special situation, only injunctions provide those people with the right incentives to make those decisions.

The eBay decision has a second effect on agreements. While the Court expressly declined to decide the effect of a patent owner’s willingness to license on the availability of an injunction, the decision permits a patent owner’s expressed willingness and incentives to grant an infringer a license for the future to be considered as a factor pointing to denial of an injunction.

Suppose a patent owner would be willing to license an infringing company without litigation, if an injunction was certain to issue in litigation against that infringer absent a license. If an injunction is certain to issue and the patent owner and infringer believe that patent owner is virtually certain to win, the value of litigation to the owner and its cost to an infringer for the period after judgment are equal to the full value of the invention.

If successful litigation will give the owner an injunction, the owner will license only if the value the owner captures from the license is greater than the value the owner may capture by exploiting the invention in any alternative way, such as using it or licensing someone else. In that situation, the infringer will be willing to license for payments slightly less than the full value of the invention.

If successful litigation may not result in an injunction, the value of litigation to the owner and its cost to the infringer are lower, and the payments from licensing and therefore the incentives to license are lower. Again, the consequence is more litigation and fewer agreements.

Consider the simple situation of a patent owner with one potential licensee. If the patent owner expresses a willingness to license that company, this reduces the owner’s ability to obtain an injunction if the settlement or licensing discussions fail. Without an injunction, the value of the invention the owner may obtain by licensing is lower. The natural response for the owner is not to express a willingness to license, because this increases the likelihood that no injunction will issue after litigation. The unfortunate consequence is again fewer licenses and more litigation.

Subject to a special class of situations mentioned below, the law should be that a patent owner’s willingness to license some infringer is not a reason to deny an injunction. It is the reason to grant an injunction. Judges should not be regulators of patent licensing. The choice between private control of licensing and judicial control should be easy. As U.S. Circuit Judge Frank Easterbrook observed in Matter of Mahurkar Double Lumen Litigation, 831 F. Supp. 1354, 1396-97 (N.D.Ill. 1993),

A patent conveys the right to exclude others from making, using, or selling the invention, and this right implies the propriety of an injunction enforcing exclusivity. The injunction creates a property right and leads to negotiations between the parties. A private outcome of these negotiations—whether they end in a license at a particular royalty or in the exclusion of an infringer from the market—is much preferable to a judicial guesstimate about what a royalty should be. The actual market beats judicial attempts to mimic the market every time, making injunctions the normal and preferred remedy. See Schlicher, Patent Law: Legal and Economic Principles §§ 1.14, 9.03[1].

The only difficult issue is whether an injunction should be denied where it is clear that it is in the patent owners interest to grant the infringer a license and in the infringer’s interest to operate under a license, and there is good reason to believe an injunction would distort the amount of the royalty upward in an undesirable way. The potential distortion is that an injunction would permit a patent owner to negotiate a higher royalty simply due to an infringer’s large past invention-specific investments, and this prospect would adversely affect the incentives of patent owners and producers in the future.

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The laws that pose unnecessary barriers to resolving patent disputes should be changed. Changing these laws would encourage agreements and avoid litigation and administrative procedures, costs and risks. The courts devised every law mentioned in this article. None were required by the Patent Act or any other act of Congress. Therefore, the courts have the power to correct these and, indeed, most other legal obstacles.

Judicial change, however, comes slowly and with considerable institutional resistance. Unfortunately, legislation is probably needed to achieve many of them. Also unfortunately, the America Invents Act, P. L. 112–29, 125 Stat. 284-341 (2011), as noted at the outset of Part 1, tries to improve the patent system only by more government rather than a better way, more agreements.

The author is a Lafayette, Calif., attorney who works with companies involved in patent disputes. This article is based on Chapter 10 of his book, “Settlement of Patent Litigation and Disputes: Improving Decisions and Agreements to Settle and License” (American Bar Association 2011). The book describes tools and data to help people make better, quicker, and cheaper settlement and licensing decisions.

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