Study: Restricting Patent Challenges May Ease Royalty Inflation

Removing "bad" patents is considered a public good, so federal law provides broad challenge right that allow anyone from the public to challenge a patent's validity almost any time. But federal law goes further than just making patent challenges easy; it also makes them nearly impossible to contract away. Federal patent licensing policy, which preempts state contract law, has created a situation where no pre-litigation patent licenses are final, leaving licensees free to avoid royalties at any time.

Professor Michael Risch, in his upcoming paper titled "Patent Challenges and Royalty Inflation," examines this phenomenon and finds that the inalienability of patent challenge rights creates a "patent challenge tax":

This inalienability of patent challenge rights comes at a cost, a cost borne by many patent licensees and their downstream customers. Patent holders quite rationally increase the royalties licensees must pay to offset their costs if the patent is challenged: litigation costs and loss of royalties if the patent is invalidated. Licensees, it follows, might seek a lower price by agreeing not to challenge the licensed patent, but the law will not allow them to do so.

The result is royalty inflation; the policy favoring elimination of bad patents costs every licensee by providing an inalienable challenge right that might never be exercised. This cost is a tax of sorts, what this article calls the “patent challenge tax.” In addition to inflated royalties, the tax causes trickle-down costs to consumers and disincentives to create and license patented technology.

One of the issues that Risch tackles off the bat is the "No Challenge Clause" for licenses that became suddenly in vogue after the SCOTUS MedImmune decision. While some argue that it is "unsettled" whether a no-challenge clause is enforceable, Risch quickly points out that the law is quite settled in that such provisions are void.

Cases in several circuits make clear that no-contest clauses are void, and those opinions rely not only on Lear (which does not actually hold that such clauses are void), but also on several prior Supreme Court decisions, including one that explicitly held a no-contest clause void.

It is unclear where the belief that the law is unsettled originates, but there are a couple of possibilities. First, the cases striking such clauses are for the most part more than 25 years old, pre-dating the Federal Circuit. There have been few cases since 1982 to address the issue, and most of those cases are limited to a very particular circumstance – whether no contest clauses are void as part of consent judgments or settlement agreements that terminate litigation. No court considering an ordinary license has upheld such a provision.

So what can patentees do to mitigate their risks, and thus minimizing the effects of the tax? Risch analyzes numerous options in detail including royalty continuations, royalty escalation, combination licenses (couple trade secret license with patent license), and fee-shifting (licensee pays attorney fees if challenge is unsuccessful). After his analysis, Risch concludes:

The terms that are most likely to be effective – other than the explicit promise to challenge which is now unenforceable – are those that most increase the cost to the licensee in case of challenge. For example agreeing to pay non-refundable escalated royalties during the pendency of the challenge or agreeing to pay, win or lose, for all the patentee’s attorneys’ fees are likely to have the most impact on the challenge tax. Unfortunately, these highly effective methods are also most likely to be void.

The difficulty is identifying those methods which are both effective and legal. This article suggests that the best alternatives also increase costs through escalating royalties and fee-shifting, but only do so when the licensee loses the challenge. These strategies have the benefit of lowering the patentee’s expected cost, but they are also likely legal because they only increase the licensee’s costs if the challenge is unsuccessful. These choices are also likely to be more palatable to both parties than terminate-on-challenge provisions.

Risch also highlights a number of policy issues in the paper, and even provides some (very handy) sample license language in the appendix. Avery interesting paper that is worth a read.

Read/download the paper here (link)