Epstein on Patents and the Supreme Court

Richard A. Epstein

July 19, 2006

One of the great intellectual busts of the past United States Supreme Court was its short and uninformative decision in Ebay v. MercExchange. Ebay's bottom line was that the right to exclude in patent law does not quite mean what it says. Rather it amounts to the opening move in an elaborate balancing act, where the award of an injunction depends on a range of public interest factors that are easy to state and hard to apply. One dire consequence if (as is not yet clear) this lax attitude hardens into law is that patent holders will be forced to issue compulsory licenses to willful infringers in some indeterminate number of cases. In my view, this substitution of state-created arrangements comes out second best to the detailed voluntary arrangements between sophisticated commercial parties just about every time.

It is an old legal maxim that whenever property rights are put at risk, the same fate awaits the contract rights that depend on them. Within the arcane world of patent, this drama is now playing out in a case before shall the Supreme Court in the coming October term. MedImmune Inc. v. Genentech, Inc. has an enormous bearing on the intellectual integrity of patent licenses. This saga starts with the famous 1969 decision in Lear v. Atkins, where the Supreme Court held that the then venerable doctrine of licensee estoppel was no longer good law. What that means in plain English is that any party who takes a license from a patentee is entitled to throw down the license, only to use information acquired under it to attack the validity of the underlying patent.

Lear flies in the face of freedom of contract in commercial contexts. The effort to justify the outcome rests on the ground that the greater social good lies in invalidating dubious patents in order to push more patented technology into the public domain. To my mind this rationale has always been defective because it only looks at one side of the problem, not both. Of course the doctrine will increase the number of dubious patents that are invalidated. But it will also reduce the value of valid patents whose owners have one more annoyance to overcome. In addition, by allowing licensees to challenge patents, it reduces the willingness of patentees to entertain licenses in the first place. Lear thus reduces the return from licensing generally, and hence undermines at the margin the incentive to create.

Furthermore, this approach to licensing makes it harder for the parties to price their licenses. One way to understand the Supreme Court rule in Lear is to think of it as giving the licensee an option to rescind the agreement at any time. That option is worth much, but it is very hard to price when it is unclear which licensees are likely to take advantage of the opportunity and which could care less. The situation therefore is wholly unlike one where the patentee might give the licensee that option explicitly (which I doubt ever happened), for then its value can be priced into some initial lump sum payment or into the periodic payments required. Without some way to sort out cooperative from traitorous licensees, there is no single pricing structure that covers both cases well. In sum, Lear reduces the ex ante gains to the contracting parties without having any clear, or indeed any, positive effect for society at large.

So we now have to face this puzzle. Without question, the licensing market in patents has increased vastly in volume and sophistication since Lear. How is that increase in activity consistent with the above economic critique? One simple explanation is that other factors have changed as well, so that now the cost of identifying potential trading partners and fashioning agreements has gone down. And the risks associated with Lear could be mitigated in part by the use of lump sum payments that are forfeited in the event of an early termination of the license.

It is for just this reason that we have to be concerned about the possibility that the Supreme Court will extend the Lear rule one step further, where the result could compound mightily the current dislocations. Once again think about the various options open to the licensee. If MedImmune's view is accepted, then all licensees will have the option to keep the contract in place on the one hand while suing for patent invalidity on the other. But the MedImmune licensee doesn't face any of the risks that bore heavily on the Lear licensee. That party knew that once it threw up a license, it to do without the product or take the risk of being hit with heavy damages and an injunction - in those pre-Ebay days, remember - that would send it into a deep tailspin.

MedImmune's proposed extension of Lear makes that same option to attack licensee available to the licensee at bargain prices. The licensee can keep on paying the license fee and sue to invalidate the license. Who knows when the dust settles the licensee may be able to recover the previous licensee fees on the ground that the patent was invalid from the outset. No longer can the patentee head off an attack on the license by asking for lump sum payments at the front end. So as the option to repudiate the contract is exercisable at an ever lower price, the gains from licensing diminish still further than they did in Lear, perhaps dramatically so. The Supreme Court is not likely to undo Lear. But it should not roll the dice a second time, when it could easily harm the entire fabric of licensees on patent value depends. David Hume and Jeremy Bentham understood the importance of settled expectations in contract relationships. Let us hope that the new Roberts court after its sorry performance in Ebay is listening.

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law at the University of Chicago and the Peter and Kirsten Senior Fellow at the Hoover Institution. He coauthored an amicus brief on behalf of MercExchange in the Ebay case and is helping to prepare an amicus brief for Genentech in its upcoming litigation with MedImmune.