Secured Parties Still Must Be Aware of Patent Rights in Goods

5 Min Read By: John F. Hilson, Stephen L. Sepinuck

IN BRIEF

  • A recent U.S. Supreme Court decision adopts an expansive view of patent exhaustion, and is welcome for secured parties that finance distributors or retailers that have purchased patented goods.
  • Disposition of such goods by a secured party would not violate the patenteeís patent rights because those rights will have been exhausted by the patenteeís prior sale of the goods.
  • The court was quite clear that the doctrine of patent exhaustion applies only when the patentee sells patented goods, however, not when the patentee licenses its patent rights.

The U.S. Supreme Court’s May 30, 2017 decision in Impression Products, Inc. v. Lexmark International, Inc., 137 S. Ct. 1523 (2017), should provide some comfort for secured parties and the lawyers who advise them, but not too much comfort. Caution is still needed before lending against inventory manufactured pursuant to a patent, particularly if the debtor is a manufacturer.

The Lexmark case involved a claim of patent infringement against Impression. Lexmark manufactured toner cartridges.  It sold some at full price and free of restrictions on resale and reuse. It sold other cartridges at a discount but subject to restrictions on resale and reuse. The restricted cartridges had a microchip that made them inoperative if they were refilled. Impression bought restricted cartridges, allegedly with knowledge of the restriction, altered or removed the microchip, and then refilled and resold the cartridges. Lexmark sued for patent infringement.

The district court had ruled that Lexmark’s initial sale exhausted its patent rights pursuant to the so-called first-sale doctrine. The Court of Appeals for the Federal Circuit reversed. It acknowledged the existence of the first-sale doctrine, but concluded that a sale made under a clearly communicated, otherwise-lawful restriction as to post-sale use or resale does not confer on the buyer—or on a subsequent purchaser with knowledge of the restriction—the authorization to engage in the use or resale that the restriction precludes. The decision created a potential problem for secured parties. A secured party is not normally bound by the debtor’s contractual promises to third parties that limit the debtor’s rights to use or sell the collateral (see U.C.C. §§ 9‑406, 9-408). The circuit court’s decision did not alter that rule, but by preserving and extending a patentee’s patent rights in goods sold to the debtor, it subjected a secured party that knew of and violated those patent rights to statutory damages and injunctive relief, even if the patentee had no provable damages under contract law (with possible treble damages for a willful violation under 35 U.S.C. § 284).

The Supreme Court, in a near unanimous decision, reversed the circuit court. In so doing, the Court adopted an expansive view of patent exhaustion: “a patentee’s decision to sell a product exhausts all of its patent rights in that item, regardless of any restrictions the patentee purports to impose,” and “[t]he purchaser and all subsequent owners are free to use or resell the product just like any other item of personal property, without fear of an infringement lawsuit.”

The Court’s decision is welcome news for secured parties that finance distributors or retailers that have purchased patented goods. Even if the patentee has imposed restrictions on the borrower’s resale of the goods, such as by limiting sales to a specified geographic area or to transactions in the ordinary course of business, the borrower would be free—as a matter of patent law, not contract law—to ignore those restrictions. More importantly, the secured party would not, when enforcing its security interest, be bound by those restrictions. Any disposition of the inventory by the secured party that did not comply with those restrictions would not violate the patentee’s patent rights because those rights will have been exhausted by the patentee’s prior sale of the goods. Moreover, the secured creditor will not be in privity of contract with the patentee, and thus, presumably will have no contract liability for breach of the restrictions.

It bears emphasizing that Lexmark does not prohibit patentees from restricting their buyers’ resale or reuse of the goods by contract. As a result, if a borrower purchases patented goods pursuant to a contract that imposes restrictions on resale or reuse, and if the borrower breaches those restrictions, the borrower might have undisclosed liabilities that will affect its creditworthiness and, indirectly, affect the likelihood of repaying the secured lender. Nevertheless, that risk is far less significant than the risk of subjecting the secured party to patent liability if it were to dispose of the goods.

Unfortunately, related but different risks survive. The Supreme Court was quite clear that the doctrine of patent exhaustion applies only when the patentee sells patented goods. It does not apply when the patentee licenses its patent rights. As a consequence, if a secured lender is financing a manufacturer, rather than a distributor or retailer, and if that manufacturer has made goods that are subject to a patent license, the secured lender must be cognizant of the restrictions imposed in the patent license. For example, a prohibition on sale in specified geographic areas or to specified types of buyers would not only limit the borrower’s ability to sell the goods, but could also apply to a disposition of the goods by the secured lender. Any unauthorized sale of the goods will expose the seller—whether the borrower or the secured lender—to liability for patent infringement.

Moreover, the risk of patent infringement exists even if the license does not impose a restriction on resale or reuse. If the borrower breaches the patent license (e.g., by failing to pay license fees), that breach might result in the termination of the license. In such a circumstance, the borrower might lose all rights to sell the goods, such that any sale would also be an infringement of the patentee’s patent rights. Unless the secured party obtains an independent right or license directly from the patentee, the secured party’s right to dispose of the goods would be subject to the same patent limitations. A security interest in goods that cannot be sold, either by the borrower or by the secured party, is not a very valuable security interest.

Finally, secured lenders and the transactional lawyers who advise them should note that the Lexmark decision does not deal with a situation in which the borrower is the owner of the patent rights. In such a case, the secured lender should consider whether it needs a security interest in the patent itself. Irrespective of whether the patent is available as collateral, the secured lender should consider having the borrower grant the secured lender, in the security agreement, a royalty-free, noncancelable license to use the patent in connection with any post-default disposition of the goods.

ABOUT THE AUTHORS

Los Angeles, CA

John F. Hilson

John F. Hilson is an Adjunct Professor of Law at UCLA School of Law where he teaches Transactional Skills and Business Deals. He is a former partner and chair of the Finance &…

Spokane, WA

Stephen L. Sepinuck

Stephen L. Sepinuck is the Frederick N. & Barbara T. Curley Professor of Law at Gonzaga University, where he has taught for 26 years. He has an A.B. in history from Brown University, a J.D. cum…

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