December 9, 2022

Why Patent Exhaustion Matters

In Tuesday’s post, I explained why I thought Quanta v. LG was a good decision as a matter of law. Today I’d like to talk about why it’s an important outcome from a policy perspective.

The function of the patent exhaustion doctrine is to ensure that the lanes of commerce do not become clogged with excessive legal restrictions. It has parallels in other areas of the law. Copyright has the first sale doctrine, which says that copyright holders’ rights in a particular copy of a creative work end when the work is sold (or given away) by the copyright holder. Similarly, in property law, the law tends to look skeptically on what the lawyers call “servitudes running with chattels.” In plain English, this means that if someone sells you a car together with a contract stipulating that it never be driven on Tuesdays, and you turn around and sell that car to me without making me sign a similar contract, I’m not bound by the no-driving-on-Tuesdays rule. The original owner may be able to sue you for breach of contract, but nobody would say I’m guilty of theft for using the car in contravention of a contract I didn’t sign, even if you signed a contract saying otherwise.

To see why this is important, imagine trying to run a pawn shop or used bookstore in a world where every item comes with a license agreement limiting how the property may be used. Tracking, complying with, and enforcing such restrictions would be prohibitively expensive, both for the parties involved and for the legal system, so the courts naturally frown on efforts to encumber property with restrictive covenants.

The same considerations apply in the patent system. One of the biggest challenges facing the patent system right now—especially in the IT industry—is the fragmentation of patent rights. The combination of more patents, broader patents, and increasingly complex products has made patent clearance extremely difficult for high-tech firms. Patent exhaustion helps because it reduces the number of times a given patent needs to be licensed for any given consumer product. A firm can be reasonably certain that if an upstream supplier has already licensed a particular patent, that firm doesn’t need to negotiate a license itself. That’s a good thing because negotiating patent agreements is far from costless. Licensing a patent at one point in a supply chain is almost certainly more efficient than a system that requires a fresh patent license for every step in the supply chain.

It’s important to remember that the purpose of the patent system is to ensure inventors are adequately rewarded for their inventions, not to give patent holders the power to micro-manage the entire production process. The patent system should ensure patent holders get the royalties to which they are entitled, but it should otherwise stays out of the way so that downstream manufacturers can spend their resources on engineers rather than patent lawyers. The Supreme Court’s decision in Quanta was a step in the right direction.

Quanta Case Preserved the Distinction Between Patent Law and Contract Law

Thanks to Ed for the invitation to contribute to FTT and for the gracious introduction. In addition to being a grad student here at Princeton, I’m also an adjunct scholar at the Cato Institute. Cato recently released the latest edition of its annual Supreme Court Review, a compilation of scholarly articles about the most recent Supreme Court term. It includes interesting articles on a broad range of topics considered by the high court this year, including the Second Amendment, detainee rights, and federalism. Arguably the most important decision from a technology perspective—and the case that was of most interest to me personally—was LG v. Quanta, which dealt with a doctrine known as patent exhaustion. Ironically, I have a somewhat different take on the decision than F. Scott Kieff, the legal scholar who contributed an article to the Review. In today’s post I’ll discuss where I think Kieff’s legal analysis goes astray. Tomorrow, I’ll discuss why the Supreme Court’s ruling turns out to be a good thing in policy terms.

What happened, in a nutshell, was this: Intel wanted to manufacture some chips that were covered by some patents held by LG electronics. Intel obtained a patent license from LG, manufactured the chips, and sold them to Quanta. The contract between LG and Intel stated that the patent license covered only Intel’s manufacturing of the chips, but did not extend to the use of those chips by downstream customers. And so LG sued Quanta for patent infringement, arguing that even though the chips had been manufactured with LG’s consent, Quanta was still guilty of patent infringement for using the chips in its own products.

At the heart of the case is the patent exhaustion doctrine, which says that once a patent holder has allowed the manufacture of a product covered by one of its patents, it exhausts its rights with regard to that product: the patent holder can’t sue downstream customers for patent infringement for using those same products. In a unanimous decision, the Supreme Court ruled that patent exhaustion applies in this case, and Quanta was not required to pay royalties to LG, despite explicit language in LG’s contract with Intel stating otherwise.

Kieff argues that this was a case about freedom of contract. He argues that by limiting the flexibility of patent licensing, it will force the initial licensee to pay the licensing fees for the entire supply chain. As a libertarian, I’m certainly a supporter of freedom of contract. But I think this analysis puts the cart before the horse. Remember that Quanta was accused of patent infringement, not a breach of contract. Therefore, an analysis of the case has to start with patent law. We must first determine whether Quanta’s actions constitute patent infringement under patent law, and only once we’ve determined that Quanta needed a license does it make sense to turn to contract law to see if it had one.

On the other hand, if patent law says that Quanta’s actions are non-infringing, then it’s completely irrelevant what a contract between LG and Intel might have said, because Quanta doesn’t need a license and wasn’t a party to Intel’s contract with LG. Freedom of contract means that parties are free to sign contracts with one another with the confidence that they will be faithfully enforced. It does not mean that contracts can bind third parties who never consented to them. And in this case, the only relevant contract was between LG and Intel. Whether Quanta infringed LG’s patents is a matter of patent law, not contract law.

One reason it’s important to clearly distinguish patent law from contract law is that the law provides patent holders with much stronger remedies than parties to contract disputes. Probably the most important difference is the one I’ve already alluded to: a patent is binding on everyone, whereas contracts only bind those who have explicitly consented to them. On top of that, patent holders can often get injunctive relief—an order from the judge to stop infringing—whereas breaches of contract often result only in money damages. Contract law also frowns on punitive contract terms, whereas patent law offers treble damages for willful infringement.

One way of looking at patent exhaustion, then, is as a doctrine designed to preserve the fundamental distinction between patent law and contract law. LG attempted to bootstrap its patents into an alternative contract-enforcement mechanism. The Supreme Court rejected this gambit, holding that patent law doesn’t allow patent holders to slice their patent licenses infinitely thin in order to force third parties to enter into an implicit contractual relationship with them.

LG is still free to use ordinary contract law to achieve the same result. It could, for example, contractually prohibit Intel from selling its chips to anyone who didn’t already have a licensing agreement with LG. But it must do so under the ordinary rules of contract law. In this case, that would mean requiring Intel to obtain consent to LG’s terms before selling chips, and it would be enforced by filing a lawsuit against Intel for any breach of contract. An important difference is that under this strategy, most of the transaction costs fall directly on LG, rather than being foisted on third parties through the magic of patent law. I think that’s the right result from a legal point of view. In my next post, I’ll explain why this turns out to be an important outcome from a policy perspective.