Patent Exhaustion Still Applies when Licensees Fail to Pay Royalties

The U.S. Court of Appeals for the Federal Circuit has concluded that patent rights are exhausted even when the licensor has not received royalties under a patent license. Tessera, Inc. v. Int’l Trade Comm’n, Case No. 10-1176 (Fed. Cir., May 23, 2011) (Linn, J.).

Tessera licensed the patent in suit and required royalties from its licensees. However, some of Tessera’s licensees sold products under the license without paying royalties on the sales. Tessera initiated an ITC action against Elpida, a downstream customer of these non-paying licensees.

Elpida asserted a patent exhaustion defense in the ITC. Elpida argued that Tessera may not recover damages because Tessera exhausted the patent rights when Tessera licensed the patent to the licensees. In response, Tessera argued that because some licensees failed to pay royalties, Tessera’s patent rights had not been exhausted—although patent exhaustion prevents “double recovery,” Tessera had not even received a “single recovery.” After the ITC agreed with Elpida, Tessera appealed.

The Federal Circuit affirmed, focusing on a single question: did Tessera authorize the sales? In Quanta, the Supreme Court explained that the “patent exhaustion [doctrine] provides that the initial authorized sale of a patented item terminates all patent rights to that item.” Thus, if the sales were authorized, then Tessera’s rights were exhausted; if the sales were unauthorized, then Tessera’s rights were not exhausted. The Court read the licenses to have authorized the licensees’ sales. Specifically, Tessera had authorized its licensees to sell first, then pay royalties later. As the Court explained, nothing in the licenses converted the initially authorized sales into unauthorized sales upon nonpayment of royalties.

To hold otherwise would create an “absurd result” contrary to the purpose of the patent exhaustion doctrine. Namely, the doctrine “prohibit[s] postsale restrictions on the use of a patented article.” The Court noted that Tessera should have pursued an action against its licensees, not those licensees’ customers. For example, Tessera should have sued its licensees to recover for breach of contract for failing to pay royalties.