On July 10, 2012, the Second Circuit issued a noteworthy opinion in Rates Technology, Inc. v. Speakeasy, Inc. (No. 11-4462-cv) regarding the enforceability of no challenge clauses in agreements settling patent infringement allegations prior to litigation between the parties. The Court, in an opinion by Judge Lynch, held that a no-challenge clause—that is, a clause that bars a patent licensee from later challenging the patent’s validity—in an agreement settling allegations of patent infringement prior to litigation is void for public policy reasons under the Supreme Court’s decision in Lear v. Adkins, 395 U.S. 653 (1969).
According to the complaint, Rates Technology (“RTI”) is the owner of two patents that relate to the automatic routing of telephone calls. In April 2007, RTI notified Speakeasy, Inc. (“Speakeasy”) that it believed Speakeasy was infringing these patents. On April 20, 2007, RTI and Speakeasy entered into an agreement (the “Agreement”) settling the alleged infringement. In the Agreement, Speakeasy denied infringing the patents, but acknowledged their validity and agreed to make a one-time payment to RTI in exchange for a release and covenant not to sue from RTI. The Agreement also included a provision in which Speakeasy—defined in the Agreement to include Best Buy, which was in the process of acquiring Speakeasy—represented that it would not “challenge, or assist any other individual or entity to challenge, the validity of any of the claims of the Patents.” The Agreement provided for liquidated damages if Speakeasy did not meet to this representation.
On June 10, 2010, Best Buy announced it planned to sell Speakeasy and merge it into entities associated with Covad Communications Company (“Covad”). Shortly thereafter, RTI notified Covad that it believed Covad was infringing its patents. On July 23, 2010, Covad responded by filing a declaratory judgment action against RTI seeking a declaration that the patents were invalid.
On August 31, 2010, RTI brought a lawsuit against Covad, Best Buy, and Speakeasy in which it alleged that Best Buy and Speakeasy breached the Agreement’s no-challenge clause by providing information to Covad that was used in formulating the declaratory judgment action. RTI sought to enforce the Agreement’s liquidated damages provision. Thereafter, Covad voluntarily dismissed the declaratory judgment action, and the defendants moved to dismiss RTI’s lawsuit.
The District Court (Cote, J.) granted the motion to dismiss RTI’s lawsuit, holding that under Lear v. Adkins, the no challenge clause was invalid as it was contrary to the “public interest in litigating the validity of patents.” RTI appealed the dismissal to the Federal Circuit, which transferred the appeal to the Second Circuit because the District Court’s jurisdiction did not arise under the laws governing Federal Circuit’s appellate jurisdiction and because the contract dispute did not require the resolution of a related question of patent law.
The Second Circuit began its analysis with a discussion of Lear v. Adkins, the decision in which the Supreme Court abandoned the doctrine of licensee estoppel for patent cases. In Lear, the Supreme Court found that because the position of the patent licensor was already buttressed by the presumption of patent validity, the equities did not compel a bar on validity challenges by a licensee; instead, the Supreme Court established a “balancing test” between the equities of the licensor and “the important public interest in permitting full and free competition in the use of ideas which are in reality a part of the public domain.” The Lear Court also held that a licensee could not be required to comply with a contractual provision requiring it to pay royalties until the patent was actually held invalid.
The Second Circuit considered subsequent decisions applying the Lear “balancing test” in view of the methods by which patent disputes can be resolved. First, such a dispute could be litigated to a final decision, which would ordinarily trigger the doctrine of res judicata. The Second Circuit agreed with the Federal Circuit’s statement in Foster v. Hallco Manufacturing Co., 947 F.2d 469 (Fed. Cir. 1991), that it was aware of no decision even suggesting that Lear abrogated the principle of res judicata in patent litigation.
Second, a patent dispute could be resolved through a consent decree issued by a court following litigation. The Second Circuit noted that it, along with other courts, has held that consent decrees estop future challenges to a patent’s validity.
Third, a dispute about patent infringement and validity could be settled privately following the initiation of litigation. In Warner-Jenkinson Co. v. Allied Chemical Corp., 567 F.2d 184 (2d Cir. 1977), the Second Circuit held that a settlement that did not contain a no-challenge clause did not preclude a later validity challenge. While the Warner-Jenkinson decision also suggested in dictum that a no-challenge clause might change the result, the Second Circuit observed that it has never reached that question in the context of a post-litigation settlement agreement. But the Second Circuit recognized that in Flex-Foot, Inc. v. CRP, Inc., 238 F.3d 1362 (Fed. Cir. 2001), the Federal Circuit concluded that a “clear and unambiguous” no-challenge clause in a settlement entered after the accused infringer had an opportunity to conduct discovery on validity issues was enforceable.
Lastly, a patent dispute could be resolved privately by agreement between the parties prior to any litigation. The Ninth Circuit addressed this situation in Massillon-Cleveland-Akron Sign Co. v. Golden State Advertising Co., 444 F.2d 425 (9th Cir. 1971), and found a covenant that purported to bar a licensee from challenging the licensed patent’s validity void in light of the strong public policy of facilitating the free and full use of ideas in the public domain. The Second Circuit found Massillon persuasive on the balance of policy concerns, and noted that enforcing no-challenge clauses found in any patent license agreement would effectively render Lear dead letter law.
Turning to the merits of RTI’s appeal, the Second Circuit found it particularly significant that Speakeasy never had an opportunity to conduct discovery regarding the validity of RTI’s patents. The Court contrasted the situation addressed by the Federal Circuit in Flex-Foot, and observed that discovery suggests that the alleged infringer is making an informed decision to give up its validity challenge and evidences the resolution of a genuine dispute over the patent’s validity—rather than an attempt by the patent owner “to prevent its monopoly from being challenged by characterizing ordinary licensing agreements as settlement agreements.” The Second Circuit left the door open for a different rule with respect to no-challenge clauses in post-litigation settlements, but held that “covenants barring future challenges to a patent’s validity entered into prior to litigation are unenforceable, regardless of whether the agreements are styled as settlement agreements or simply as license agreements.”
The Court rejected RTI’s various arguments that the no-challenge clause should be held enforceable, including that the Court’s rule would require parties to go through the “charade” of filing and settling a lawsuit in order to obtain a comprehensive settlement. The Court noted that nothing in its opinion prevents a patentee from settling an infringement dispute or collecting royalties without engaging in litigation, and that “to the extent our rule may discourage the insertion of such [no-challenge] clauses into licenses or settlement agreements, that is a desirable consequence for the reasons stated in Lear.”
In ruling that no-challenge clauses in pre-litigation settlements are unenforceable, the Second Circuit also declined to follow dicta in Baseload Energy, Inc. v. Roberts, 619 F.3d 1357 (Fed. Cir. 2010). In Baseload, the Federal Circuit suggested that if a release settling a contract dispute had contained a no-challenge clause, it would have enforced the clause provided the waiver was clear and unambiguous. In a footnote, the Second Circuit stated that the Federal Circuit’s earlier decision in Flex-Foot, which blessed a no-challenge clause where the accused infringer had an opportunity to conduct discovery on validity, “seems to us to strike a more plausible balance between the policies of patent law articulated in Lear and policies favoring the resolution of disputes.”
The Second Circuit’s ruling effectively requires a patent holder to take on the risk of a future validity challenge if it wishes to settle with an accused infringer without resorting to litigation. Although the Court “doubt[s] that parties would find it desirable to conduct expensive discovery in order to validate a no-challenge clause,” Rates Technology leaves a fundamental question unanswered: how much discovery—if any—is required to validate a no-challenge clause in a settlement entered following the filing of a lawsuit? As long as this question remains unanswered, even patent holders eager to settle patent disputes amicably are likely to file lawsuits because the mere initiation of a lawsuit should not affect the willingness of an accused infringer to settle the dispute. In fact, the filing of a lawsuit ought to encourage settlement as a party accused of infringement will still be able to avoid the cost of discovery if it settles immediately, and the patent holder will be able to offer a discount if the accused infringer agrees to a no challenge provision that remains—potentially at least—enforceable.
The calculus for patent holders would change, however, if courts were to enforce no-challenge clauses only following discovery on validity issues. Because patent holders would not be able to obtain the value of a no-challenge clause without burdening the accused infringer with discovery costs, there would be no advantage to the “charade” of filing a lawsuit if the parties were eager to settle. However, a rule that only enforced no-challenge clauses following the “expensive discovery” envisioned by the Second Circuit would present administrability problems. And until the courts provide clarity about how much discovery it takes to validate a no-challenge clause, patent holders will have an incentive to file lawsuits to resolve infringement disputes. Nevertheless, parties accused of infringement may be heartened by the Second Circuit’s decision to the extent it maintains another avenue to challenge invalid patents.