2nd Cir. Applies Lear Doctrine to Pre-Lititgation Settlement Agreement

The Second Circuit has held that “a clause in a settlement agreement which bars 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.”  Rates Technology Inc. v. Speakeasy, Inc., No. 11-4462-cv (July 10, 2012).

Rates Technology Inc. ("RTI"), owner of two telecommunications patents, accused Speakeasy of infringement, and offered Speakeasy a release from liability “in exchange for a one-time payment consistent with RTI's tiered pricing structure.”  The parties thereafter entered into a “Covenant Not to Sue” that included a release and promise that RTI would not sue Speakeasy (but evidently did not include the grant of a patent license).  Without admitting infringement, Speakeasy acknowledged the patents' validity and enforceability, and agreed not to challenge the validity of the patent claims.  The no-challenge clause was supported by Speakeasy's agreement to a $12 million liquidated damages provision.

In the agreement, “Speakeasy” was defined to include Best Buy, which had announced plans to, and subsequently did, acquire Speakeasy.  However, three years later, Best Buy sold Speakeasy to Covad.  Around the same time, RTI accused Covad of infringement, and offered Covad an agreement similar to Speakeasy's.  Covad thereupon sued RTI for a declaratory judgment of invalidity and unenforceability in the Northern District of California.  A month later, RTI brought the present case in the Southern District of New York, alleging that Speakeasy and Best Buy breached the no-challenge provision by allegedly assisting Covad in the California action, and further alleging that Covad was “liable for the breach of contract by virtue of the merger.”  RTI sought to enforce the liquidated damages provision against all defendants on a joint and several liability theory.

Covad voluntarily dismissed the California action shortly after this case was filed in New York.  The New York District Court, relying on the doctrine of licensee estoppel set forth in Lear, then granted a motion to dismiss RTI's complaint.  RTI originally appealed to the Federal Circuit, which held that it lacked jurisdiction because this was a contract dispute that did not require a resolution of a question of patent law.  The appeal was then transferred to the Second Circuit.

RTI argued that the District Court should have followed appellate decisions “which recognize that the strong public interest in settling ongoing litigation can justify the enforcement of no-challenge clauses that might otherwise be deemed invalid under Lear.”  However, the Second Circuit distinguished these cases “because the RTI-Speakeasy Agreement was entered into prior to any litigation between the parties.”

The original holding in Lear, which ran counter to the notion that a contracting party should not later be able to challenge its agreement, was based on the notion that the typical patent licensee, faced with the Patent Office's grant of a patent, and the presumption of validity, was not on an equal playing field with the licensor.  Further, Lear established a balancing test, under which “lower federal courts have repeatedly been asked to balance the public interest in identifying invalid patents with federal policies favoring the resolution of disputes.”

In reviewing the various ways in which patent disputes can be resolved (a final court judgment, consent decrees, pre-litigation and litigation settlements), the court noted that in Warner-Jenkinson Co. v. Allied Chemical Corp., 567 F.2d 184 (2d Cir. 1977), the Second Circuit held that a settlement of litigation “did not estop a patent licensee from later challenging the validity of the patent in a later dispute over royalties.”  However, this result might have been different with “an explicit prohibition on licensee suits during some future period.”  Further, “the Federal Circuit has held that a no-challenge clause in [a litigation] settlement is valid under Lear.

Nonetheless, the Second Circuit here decided to follow Massillon-Cleveland-Akron Sign Co. v. Golden State Adver. Co., 444 F.2d 425 (9th Cir. 1971).  There, the Ninth Circuit held that the strong policy considerations of Lear required holding unenforceable a covenant not to contest patent validity.  The Second Circuit reasoned that pre-litigation settlements after an initial accusation of infringement are common.  Patent owners have a strong incentive to include no-challenge clauses, and should not be allowed to avoid challenges to validity, and to evade the strictures of Lear, by clever draftsmanship.

The court also thought that it was important that parties settling before litigation would not have conducted discovery.  Before litigation commences, accused infringers will have had limited opportunities to obtain information with which to challenge validity.

RTI argued that there was “a strong judicial policy favoring the settlement of litigation.”  The court agreed, but thought that this policy was outweighed, in the patent context, because licensees were the only parties with sufficient economic incentive to challenge patent validity, and should therefore not be “muzzled.”  Further, the court disagreed that its holding would encourage litigation.  Patent owners are not prohibited from collecting royalties without litigation; they are simply prevented from shielding themselves forever from an invalidity action that accused infringers may wish to bring or assist.

The Second Circuit further declined to follow dicta in Baseload Energy, Inc. v. Roberts, 619 F.3d 1357 (Fed. Cir. 2010), a case holding that a release in an agreement settling a breach of contract action did not prevent a party from later challenging the validity of the other party's patents “because the release lacked 'the clear and unambiguous language necessary to effect a release of patent invalidity defenses.'”  Baseload had nothing to do with patents, and therefore the Federal Circuit in that case did not consider patent owner's “incentive to 'couch licensing arrangements in the form of settlement agreements' in order to prevent licensees from later challenging the validity of their patent.”  Further, the Second Circuit would not have been bound by a holding, much less dicta, of the Federal Circuit.

The court also dismissed RTI's argument that Lear was distinguishable because it involved continuing royalty payments.  The issue was whether Speakeasy could have a continuing obligation “not to assist others in asserting invalidity, and RTI fails to explain why that continuing obligation should be exempt from analysis under Lear.”  Lear applied not simply to “licensee estoppel and royalty payments, but also established a 'balancing test' that has been applied in patent cases and in other areas of intellectual property law.”