Challenging A Patent Under License

Agreeing to pay a running royalty for a patent license can be a sensible business decision for a company accused of infringement. The license may subsequently look less attractive, however, if information later comes to light that calls into question the patent’s scope or validity.

May a patent licensee use its license as an “insurance policy,” continuing to pay royalties to prevent accrual of infringement damages or entry of an injunction, while simultaneously bringing a declaratory judgment action challenging the patent?

A recent Federal Circuit Court of Appeals ruling, Gen-Probe Inc. v. Vysis, Inc. (359 F.3d 1376 (Fed. Cir. 2004), said no to this question. The court held that before bringing such an action, the licensee must first materially breach its agreement with the patent owner by ceasing its royalty payments.

Having Cake And Eating It Too

At the time the subject patent issued, Vysis (the patentee) and Gen-Probe (the patent challenger) were involved in litigation regarding other patents. As part of the settlement of that litigation, Gen-Probe elected to license the subject patent from Vysis for an up-front payment of $1.5 million and a running royalty of 3 percent on sales.

A year and a half after taking the license, Gen-Probe changed its mind. Gen-Probe informed Vysis that, upon further analysis, it believed that Vysis’ patent was both invalid and not infringed, and filed a lawsuit in federal court to challenge the patent’s validity and scope.

A declaratory judgment lawsuit to challenge a party’s patent can be filed when the patent challenger can demonstrate a “reasonable apprehension of being sued” for infringement if it does not launch a preemptive strike.

When it filed its declaratory judgment action, Gen-Probe simultaneously communicated to Vysis an intention to continue paying under its license throughout the litigation to preserve the status quo.

In other words, Gen-Probe wanted to limit its downside risk. If it lost the declaratory judgment challenge, it could still continue to sell the infringing products and pay a 3 percent royalty to Vysis. If it won, it would have no further obligation to Vysis with respect to the subject patent.

Vysis moved to dismiss Gen-Probe’s declaratory judgment complaint, arguing that, as a licensee in good standing, Gen-Probe could not have had a reasonable apprehension of suit (because a licensor cannot, by definition, sue a licensee in good standing).

The district court judge denied Vysis’ motion to dismiss, and the case was litigated for two and a half years, culminating in a jury trial at which the Vysis’ patent was found invalid and not infringed.

On appeal, the Federal Circuit reversed, holding that “a licensee must, at a minimum, stop paying royalties (and thereby materially breach the agreement) before bringing suit to challenge the validity or scope of the licensed patent.”

The Pendulum Swings Back

In C.R. Bard, Inc. v. Schwartz, the leading case on licensee declaratory judgment actions before Gen-Probe, the Federal Circuit had taken a different tack, suggesting that licensees should be able to challenge licensed patents without “bearing the risk of liability of infringement.” This would encourage licensees to challenge the validity of licensed patents, thus putting them in the public domain if successful, the court said.

In point of fact, the licensee in Bard had ceased making royalty payments before filing suit, a material breach of the license that entitled the patentee to terminate the license at will. Thus, the court’s implicit suggestion that licensees should be able to “have their cake and eat it too” was, strictly speaking, dicta. Nevertheless, subsequent district court decisions interpreted Bard as standing for that proposition.

In deciding Gen-Probe, the Federal Circuit apparently concluded that the pendulum had swung too far in favor of licensees. Whereas Bard emphasized the policy consideration of encouraging licensees to challenge licensed patents, Gen-Probe raised the opposite concern – that a playing field tilted too strongly in favor of licensees would discourage patentees from granting licenses in the first place.

Squaring Gen-Probe with Bard

At first glance, the language of the Bard and Gen-Probe decisions seems difficult to reconcile. Upon closer inspection, however, the core holdings of the cases are consistent, with their inconsistent statements constituting dicta that were not essential to either decision.

A strict reading of the facts in Bard establishes only that a licensee’s material breach of the license agreement creates declaratory judgment jurisdiction, so long as such breach entitles the patentee to terminate the license and bring an infringement suit. The court’s broader statement about insulating licensees from “bearing the risk of infringement” was dictum.

Similarly, the statement in Gen-Probe that “a licensee must, at a minimum, stop paying royalties (and thereby materially breach the agreement)” was also dictum because Gen-Probe had continued to carry out all of its obligations as a “faithful licensee,” including – but not limited to – paying royalties due Vysis. There was no breach of the license agreement and no basis upon which Vysis could have terminated that agreement or sued Gen-Probe for patent infringement.

Strictly speaking, then, Gen-Probe should not be read to necessarily require that the licensee “stop paying royalties,” but merely – as the earlier Bard decision had required – that the licensee materially breach the agreement in a manner that entitles the patentee to terminate the agreement and bring an infringement suit.

The licensee may certainly commit such a “material breach” by withholding royalty payments, in which case it forfeits its “insurance policy.”

Alternatively, the licensee may choose to breach the agreement in some other way (e.g., by refusing to mark licensed products with the patent number as required). In this case, the licensee maintains its “insurance policy” so long as the patentee accepts the licensee’s ongoing royalty payments and chooses not to terminate the license based on the licensee’s breach.

That decision is the patentee’s to make. It can continue to accept royalty payments for the duration of the litigation, forfeiting its rights to infringement damages and an injunction if it wins (but maintaining its ongoing royalty stream in the interim), or it can decline to accept the royalty payments, terminate the license, and maintain its full range of remedies if it succeeds in court.

Naturally, this decision will be driven by the patentee’s need for ongoing royalty revenue and its assessment of the strength of its infringement case.

Implications

In short, a careful reading of the Federal Circuit’s cases on licensee declaratory judgment actions shows that both the licensee and licensor have roles to play in determining how a patent licensing controversy is resolved. Under the right circumstances, the parties may effectively agree to the licensee maintaining its “insurance policy” while prosecuting a declaratory judgment action.

It remains to be seen, however, how district courts will parse the nuances of Gen-Probe and Bard. Uncertainty remains, and the cost of an adverse decision on declaratory judgment jurisdiction can be high.

Gen-Probe, for instance, litigated its declaratory judgment action all the way through trial, only to have the verdict vacated on appeal. Until the Federal Circuit clarifies its jurisprudence on licensee declaratory judgment actions, both licensees and licensors should tread carefully.