Contract Promises Not to Challenge Patent Validity Are Unenforceable Prior to Litigation

The Second Circuit Court of Appeals has held that promises in a contract, such as covenants, which prohibit the licensed party to challenge the patent’s validity, when the contract is entered into prior to litigation, are unenforceable, regardless of whether the agreements containing such covenants are styled as settlement agreements or simply as license agreements. Rates Technology Inc. v. Speakeasy, Inc., Case No. 11-4462 (2d Cir. July 10, 2012) (available here).

The issue in this case was whether a clause in a settlement agreement which bared a patent licensee from later challenging the patent’s validity is void for public policy reasons under the Supreme Court’s decision in Lear, Inc. v. Adkins, 395 U.S. 653 (1969), where the parties entered into the agreement after an accusation of infringement by the patent owner but prior to any litigation.  The Second Circuit Court of Appeals held that the “no challenge” clause is unenforceable.

Rates Technology Inc. (“RTI”) is the owner of two patents for the automatic routing of telephone calls based upon cost.  In April 2007, RTI asserted that Speakeasy was infringing its patents but offered to release Speakeasy if it agreed to RTI’s tiered pricing structure.  RTI and Speakeasy entered into an agreement, which included a  “Covenant Not to Sue” and a one-time payment of $475,000 to RTI.  The Agreement further provided that “Speakeasy acknowledges the validity, and enforceability of the Patents.  Speakeasy does not admit that it has infringed the Patents.”  In the event that these Speakeasy representations were incorrect, the parties agreed that liquidated damages in the amount of $12 Million was reasonable.  Best Buy bought Speakeasy.

Later Best Buy announced a plan to sell Speakeasy and merge it into entities associated with the various Covad defendants.  On June 25, 2010, RTI notified one of the Covad Defendants that they were infringing the patents.  Covad responded by filing a declaratory judgment action.

During due diligence conducted in anticipation of the proposed merger, another Covad Defendant, Covad Group, learned of the Agreement between RTI and Speakeasy.  RTI then sued and alleged that Speakeasy and/or Bust Buy “provided certain information relating to the RTI patents” and Covad used the information in formulating the invalidity allegations.  RTI alleged that Speakeasy and Best Buy breached the Agreement’s no-challenge clause – which included a prohibition on “assist[ing]” any challenge to the Patents’ validity.

Covad voluntarily dismissed the declaratory judgment action when RTI brought suit.  In the RTI suit, Covad  moved to dismiss the case for failure to state a claim arguing that the doctrine of licensee estoppel is “unenforceable in the context of challenges to the validity of patents.”  The trial court agreed and dismissed the suit and RTI appealed to the Federal Circuit Court of Appeals.  Covad moved to dismiss the appeal to the Federal Circuit for lack of subject matter and the appeal was transferred to the Second Circuit because it did not require the resolution of a related question of patent law, such as inventorship, infringement, validity, or unenforceability.

The Second Circuit acknowledged that Lear stands for the proposition that no challenge clauses in patent licenses are not enforceable.  However, Lear is noted for establishing a “balancing test” for weighing the “public interest in discovering invalid patents” against other competing interests.  The Appellate Court then discussed four scenarios when parties enter into agreements surrounding patent litigation.  (1) If the case is fully litigated, the final decision is res judicata, or at least subject to claim preclusion, with respect to the patent’s validity.  (2) The validity may be resolved through the entry of a consent decree following litigation.  Such consent decrees, entered into with the approval of the litigants, estop a party’s subsequent challenge to validity.  Wallace Clark & Co. v. Acheson Indus., Inc., 532 F.2d 846, 849 (2d Cir. 1976).

A third scenario occurs when the parties privately settle the dispute after the initiation of litigation.  In Warner-Jenkinson Co. v. Allied Chemical Corp., 567 F.2d 184 (2d Cir. 1977), the court ruled that this settlement did not estop a patent licensee.  “We suggested, however, that the result in Warner-Jenkinson might have been different if the agreement had contained a no-challenge clause.”  The Federal Circuit Court of Appeals has held that a settlement that resolves pending patent litigation which includes a no-challenge clause is valid under Lear.  Flex-Foot, Inc. v. CRP, Inc., 238 F.3d 1362, 1367-70 (Fed. Cir. 2001).

“[O]nce an accused infringer has challenged patent validity, has had an opportunity to conduct discovery on validity issues, and has elected to voluntarily dismiss the litigation with prejudice under a settlement agreement containing a clear and unambiguous undertaking not to challenge validity and/or enforceability of the patent in suit, the accused infringer is contractually estopped from raising any such challenge in any subsequent proceeding.”  Flex-Foot, Inc.  at 1369-70.

In the fourth scenario, when disputes are settled prior to any litigation, the Ninth Circuit Court of Appeals has held that the “‘strong federal policy’ referred to repeatedly in Lear” required it to hold that the covenant barring Golden State from contesting the validity of MCA’s patent was “void on its face and unenforceable.” Massillon-Cleveland-Akron Sign Co. v. Golden State Adver. Co., 444 F.3d 425, 427 (9th Cir. 1971).

In conclusion, the Second Circuit held “that covenants barring future challenges to a patent’s validity entered into prior to litigation are unenforceable, regardless of whether the agreements containing such covenants are styled as settlement agreements or simply as license agreements.”

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