Introduction

Marriage is like a contract. Maybe that's not how Hallmark sees it, but the fundamentals are the same - two parties who agree to work together under a given set of expectations. Of course, expectations are not always met, and marriage contracts can often end in divorce. In the U.S., a remarkable 40 to 50% of marriages end in divorce. This number could be higher, as often couples stay together because of the kids, or financial considerations. However, imagine if unhappy spouses could obtain a pre-settlement ruling detailing what their divorce settlement would entail if they chose to file. How many more marriages would end ugly?

Just a few months ago, the Supreme Court made the equivalent option a reality for parties engaged in patent-licensing contracts. Licensing contracts between patent-holders and manufacturing firms are a key institution in the high technology industry, making it possible for inventors to profit from their patents without needing the means to take a product to market.
However, by allowing a licensee in good standing to challenge the validity of its licensor's patent without first breaching their contract, the Supreme Court's decision in MedImmune v. Genentech threatens the stability of all current and future licensing agreements. It dramatically increases the uncertainty of licensing contracts, which increases the potential for litigation, reduces the value of valid patents, and hinders the overall efficiency of the U.S. patent system. This article will first summarize the facts of MedImmune v. Genentech, analyze and highlight flaws in the Supreme Court's reasoning, and then address the implications of this decision for future and current licensing agreements. Most importantly, in the context of patent theory, the article will conclude by showing why weakening the patent-licensing structure will likely impede overall levels of innovation.

Facts of the case

The case of MedImmune v. Genentech addresses the relatively simple dispute between patent-holder Genentech and licensee MedImmune regarding the validity of their licensing contract.

In 1997, MedImmune and Genentech entered into a licensing agreement involving the production of various antibody products covered by both an issued patent held by Genentech and another pending patent. However, not until 2002 did the pending patent issue (to be known as Cabilly II), giving Genentech the ability to enforce the licensing agreement.

Upon receiving notice that Genentech's patent had now issued and that they expected royalties, MedImmune claimed that the new patent was invalid, unenforceable, and if so did not cover their product, Synagis.
Not wanting to fork over the royalties, but also not wanting to risk an infringement suit by breaching the contract, MedImmune filed a Declaratory Judgment Action against Genentech, seeking to clarify its rights and obligations regarding their original contract and indirectly challenging the validity of the Cabilly II patent.
The federal circuit dismissed the case as there was no explicit "case or controversy" according to Article III of the constitution and case precedent in Gen-Probe Inc. v. Vysis, Inc. (359 F.3d 1376). The Supreme Court, however, overruled this decision by reasoning that MedImmune ought not to have to risk litigation fees and potential treble damages in order to challenge a patent it deemed invalid.

The key question proposed by the case is simple: should a licensee in good standing be able to file a declaratory judgment action against its licensor charging either patent invalidity or non-infringement? While the Supreme Court offered a resounding yes, the following analysis will demonstrate that the Court made a substantial and dangerous departure from previous case precedent by allowing a licensee must to file a declaratory judgment against its licensor without at least ceasing to make royalty payments.

Precedent

The central issue in this case concerns the interpretation of Article III, Section 2 of the Constitution s statute limiting the jurisdiction of federal courts to cases and controversies wherein there is an actual controversy between two legal parties. So as to not overburden the courts with frivolous cases, the Article III limitation has been interpreted to prevent the courts from issuing opinion[s] advising what the law would be upon a hypothetical state of facts . However, the Declaratory Judgment Act enacted in 1934 allows courts to, [i]n a case of actual controversy within its jurisdiction declare the rights and other legal relations of any interested party seeking such declaration, whether or not further relief is or could be sought. Declaratory judgments enable a party to obtain judicial ruling on a controversy without having to wait for the opposing party to take legal action. As for when declaratory judgments are applicable, the Supreme Court interpreted Article III s limitations in Maryland Casualty v. Pacific Coal (1941). Basically, the question in each case is whether the facts alleged, under all circumstances, show that there is a substantial controversy, between parties having adverse legal interests, of sufficient immediacy and reality to warrant the issuance of a declaratory judgment.

More specifically, the Court of Appeals for the Federal Circuit (CAFC) had developed a two-pronged test for determining whether there was actual controversy in patent-based declaratory judgment suits: There must be both (1) an explicit threat or other action by the patentee, which creates a reasonable apprehension on the part of the declaratory plaintiff that it will face an infringement suit, and (2) present activity which could constitute infringement or concrete steps taken with the intent to conduct such activity. This test had been confirmed and applied in Gen-Probe Inc. v. Vysis, Inc. (359 F.3d 1376), where the CAFC determined there was no reasonable apprehension of suit by a patentee if the licensee was in good-standing and making all royalty payments. By not breaching its contract, the licensee knows it will not face an infringement suit, and thus has no actual controversy with the licensor. Therefore, when the Cabilly II patent issued and Genentech informed MedImmune of the expected royalties, MedImmune could claim no reasonable apprehension of suit regardless of whether royalty payments for the Synagis product were made under protest and with reservation of all of [its] rights.

Supreme Court Reasoning

However, as straightforward as the precedent appeared before the district court and the court of appeals, the Supreme Court took into consideration a much broader set of circumstances in eventually overturning the decision. The main deciding factors in this case rested on two questions. First, did the declaratory judgment really concern a contractual dispute (as claimed) or was it simply challenging the validity of the Cabilly II patent? Second, how much risk ought a licensee be expected to bear in order to assert its rights? Unfortunately, in resolving these questions, the Court removed almost any limitation to the scope of actual controversies with respect to patent-licensing agreements.

The first controversial condition was of the scope of MedImmune's declaratory judgment action. Gen-Probe made it fairly clear that a licensee must, at a minimum, stop paying royalties (and thereby materially breach the agreement) before bringing suit to challenge the validity or scope of the licensed patent. However, MedImmune's declaratory judgment sought to avoid this road block by seeking to define its contractual rights and obligations according to the licensing agreement, thereby making the suit about a contractual dispute and not directly about patent validity. However, as Justice Thomas correctly asserts in his defense, Nowhere in its complaint did MedImmune state why sale[s] of its Synagis product d[o] not infringe any valid claim of the [Cabilly II] Patent.

Therefore, the only reason MedImmune offers for why it owes no royalties according to the current contract is because the patent is invalid and unenforceable. This circular reasoning abides by the letter of the law but ignores the spirit of the precedent established in Gen-Probe, which deliberately set forth that a licensee cannot file a suit alleging patent invalidity unless it has breached the original contract. MedImmune's alleged contract dispute hinges entirely on whether or not the patent is valid, and so is really just a patent validity suit. While the Court s majority opinion posits that the nature of the dispute probably makes no difference in their ultimate decision, the loosely based identification of the controversy as a contract dispute made it significantly easier to ignore the Gen-Probe precedent.

Regardless of whether or not the dispute was contractual, the Supreme Court considered the issue a technicality and focused on what ought to be given the totality of circumstances. The key issue at hand: is it fair to require a licensee to bear the risk of considerable financial harm in order to assert its rights? MedImmune's choices were very simple, either (a) continue to pay royalties to Genentech despite its suspicions, or (b) cease royalty payments and face Genentech in court, at the cost of litigation fees and potential damages if it were to lose in court. This choice boils down to evaluation of expected costs and benefits. The first option is low risk, low reward. The second option is high risk high reward. Unfortunately, the Supreme Court unnecessarily exaggerates the high risk scenario, stipulating that to cease royalty payments creates significant potential for an injunction and/or treble damages for willful infringement, which would cause irreparable harm to the company. Willful infringement damages, assessed when a firm knowingly infringes a patent, are generally three times the standard royalty rate. As the MedImmune product Synagis constitutes more than 80% of its revenue, the court considers such risk similar to betting the farm, and judges that MedImmune should not be expected to accept such significant risk.

The court then recalls many other case opinions holding that a citizen should not have to break a law in order to challenge its constitutionality. However, the opinion fails to elaborate on the actual likelihood of MedImmune being charged with willful infringement. Infringers have often defended against willfulness accusations by proving that they sought legal consultation and had a well-reasoned legal opinion indicating that the patent is unenforceable, invalid and/or not infringed. Assuming that MedImmune could demonstrate reasonable grounds for challenging the Cabilly II patent, it would have a strong defense against charges of willfulness. As the court makes no effort to explain the likelihood of treble damages, the court s comparison to betting the farm is like advising someone against flying because if their plane crashes they d lose everything. In this context, MedImmune's options are perfectly legitimate. If it ceases payment, enters into an infringement suit, and loses, it will likely accrue damages on a comparable level to what its reasonable royalties would have been had it paid them voluntarily. However, the Supreme Court s blindly assumes that the slightest chance of treble damages is unbearable. As such, the court concludes that with regards to establishing an Article III case or controversy, MedImmune was not required to break or terminate its 1997 license agreement before seeking declaratory judgment in federal court that the underlying patent claims [are] invalid, unenforceable, or not infringed.

Licensing implications of MedImmune

The major implication of MedImmune is that potential and current licensees will find it incredibly easier to file a declaratory judgment action. Unfortunately, as the dissent notes, the line of reasoning that the Supreme Court applies in this case contains no limiting principle whatsoever, essentially giving licensees a blank check to take their licensors to court. After MedImmune, licensees will be able to recklessly challenge contracts knowing that the worst possible consequence is that the contract is upheld. To compare to a less technical analogy, imagine if the fine for a parking ticket cost no more than the price of parking legally in a nearby lot. If such were the case, what s to keep a rational individual from parking illegally? Even if there were only a 10% chance of avoiding a ticket, it is worth the risk to park illegally because worst possible scenario is no worse than parking legally. Only the minor transaction costs of paying the fine matter as deterrence. With respect to patent-licensing, this reasoning has the potential to create massive chaos, as it will be rational for licensees to file for declaratory judgment unless they re absolutely positive they have no case.

However, the total impact of MedImmune will likely be felt differently by current licensees than by potential licensees. First, with current licensing agreements, if a licensee is in good standing but then discovers a patent may be invalid, unenforceable, or not infringed, it may file for a declaratory judgment at a moment s notice. However, the likelihood of this scenario happening is rather small. Firms that typically enter into a contractual licensing agreement only do so if they believe that the licensor has a strong case and that their patents have sufficient validity and coverage. While filing for declaratory judgment relief is considerably less risky than waiting for an infringement suit, transaction costs still do exist and ought to be sufficient to dissuade a licensor from filing unless new evidence has surfaced providing a reasonable chance of success. While current licensees will theoretically have the potential for surprise declaratory judgment actions that could catch their licensors off-guard, a surprise attack will still fail if it lacks legitimate substance. Therefore, the majority of established licensing agreements will likely remain intact in the aftermath of MedImmune.

Of course, the MedImmune case itself involved the unraveling of an established licensing agreement, and so such contracts should not be considered completely secure. However, when the MedImmune case is looked at carefully, one can see that MedImmune s actions can be explained by an unusual circumstance often overlooked in the case. As mentioned previously, the licensing agreement between MedImmune and Genentech went into effect in 1997. It covered both an already issued patent as well as the pending Cabilly II patent. However, for the first five years of the agreement, Cabilly II remained in prosecution and no royalties were owed. During that time, MedImmune developed the product Synagis, and its success had accounted for 80% of the company s revenue since 1999. Only after the patent issued did Genentech demand royalties for the Synagis product. This unusual sequence of events explains why MedImmune sought to assert its rights and obligations regarding a licensing agreement that had been in effect for five years. While the agreement itself did not change, the context surrounding it transformed drastically with the issuing of Cabilly II, and the impact of such change prompted MedImmune to respond with the declaratory judgment action.

As for future licensees, the implications of MedImmune are already taking shape. Since the MedImmune ruling only four months ago, the Federal Circuit Court of Appeals has begun to clarify the impact of MedImmune by dropping the reasonable apprehension clause of its subject matter jurisdiction test in its decision in SanDisk Corporation v. STMicroelectronics, Inc. In the case, patent-holder ST approached SanDisk concerning the potential for a licensing agreement between them, providing them with a detailed presentation of why they believed SanDisk was infringing on ST s patents. While SanDisk had no reason to fear an immediate infringement suit, the CAFC explained that such a test had been invalidated by MedImmune. The CAFC pointed to footnote 11 of the MedImmune opinion, which characterized the old test as contradicting one Supreme Court opinion, conflicting with two others, and in tension with yet another.

Therefore, in its decision on March 26 of this year, the CAFC established a new test that holds that where a patentee asserts rights under a patent based on certain identified ongoing or planned activity of another party, and where that party contends that it has the right to engage in the accused activity without license, the party may bring a declaratory judgment action. Furthermore, the consenting opinion woefully predicts that under [this] standard virtually any invitation to take a paid license relating to the prospective licensee s activities would give rise to an Article III case or controversy if the prospective licensee elects to assert that its conduct does not fall within the scope of the patent. Furthermore, even though ST had explicitly stated it did not intend to file suit against SanDisk, the court ruled that such promises not to sue do not neutralize an otherwise justiciable case or controversy. As a result of this interpretation, future licensing contracts will be exponentially harder to negotiate, as potential licensees will have the immediate option of suing for declaratory relief as soon as they are approached by a patentee. This gives potential licensees much more negotiating power, and will inevitably result in smaller royalty rates and decreasing the overall average value of patents.

Impact of MedImmune on innovation

While the analysis of MedImmune v. Genentech thus far as demonstrated why the Supreme Court s decision will bring chaos and uncertainty to the world of patent-licensing agreements, what will the net effect be on technological progress? After all, patent-licensing contracts themselves are a relatively new phenomenon. At the same time, patents have often been credited as the driving force behind the biotech and pharmaceutical industries. In order to gauge the overall impact MedImmune will have on innovation, it is first necessary to understand the role of patents in inspiring innovation. The remainder of the article will review basic patent theory and how the licensing implications of MedImmune will most likely hinder the rate of innovation in certain industries.

While no central patent theory dominates scholarly discourse, three major theories have been identified for the purposes of this article. While it is acknowledged that other more specific theories exist, most can be derived from these three. The first and most commonly understood theory for why patents exist is that patents motivate innovation by allowing those who invest the time and energy required to develop new technology to recoup the sunk costs of innovation. Designated the economic theory, by Alexander Tabarrok, it stipulates that because imitators have low costs of reproduction compared to the initial cost in research and development, an original inventor will not be able to generate profit from his invention if competitors are allowed to copy his invention as soon as it is released. Therefore, patent-holders receive a limited period of exclusivity with which they can take advantage of monopoly pricing to generate a profit. However, the proper length of this period of exclusivity is a matter for debate.

As all inventions have different potential values and varying sunk costs associated with them, it is difficult to determine the appropriate time period that will allow all inventors to recoup their sunk costs. However, in looking at past changes to United States patent policy that have lengthened the exclusivity period, empirical studies have shown that stronger patent protection induces an significant increase in patent production. As Nancy T. Gallini overviews the research, she attributes the increased patent propensity to the creation of the centralized Court of Appeals. By enforcing patents more strongly, they argue, the court created incentives for inventors to use litigation as a means of extracting royalties from prospective infringers. While some have raised the issue that increased quantity of patents does not necessarily imply increased quality, analyzing the quantity of patents is the most objective method of evaluating overall innovation activity.

The second theory behind patents is that they induce commercial development. Due to the sometimes extraordinary costs of pushing through an invention from initial idea to final product, patents allow inventors to attract investment from companies and firms with the means of furthering the development of an invention so that it can become commercially available. This theory addresses the needs of society as a whole, by seeking to maximize the utility of new inventions. So while the role of patent protection in stimulating innovation remains debatable, the evidence that strong patent protection encourages disclosure and technology transfer is persuasive. Unfortunately, due to the transaction costs of licensing patents to production-capable firms, the monopoly rights granted to the inventor can sometimes detract from the invention s maximum benefit to society. Finally, the third theory is that patents facilitate technology disclosure among competitors and allow for follow-up innovation. Without patent protection, the only way for inventors to save themselves a chance of profiting from their invention would be to maintain secrecy. However, an invention that remains secret to society for many years is going to be severely limited in the rate at which it can progress. Patent protection provides that the original inventor receives credit for his role in the initial work, but also allows others to collaborate and improve the invention so that maximum innovation is achieved.

Given these three theories, the total value for a patent can be approximated based on the projected returns to the inventor from monopoly privileges and the projected returns to society from commercial development and technology transfer. For the purposes of this article, the higher the total value of the patent, the better. If the total value of an average patent declines, the average inventor will have less incentive to innovate, and thus innovation will slow across society. Finally, given these premises, the question regarding the implication of MedImmune can more properly be defined. Does increasing the power of licensees to imitate an invention without paying royalties increase or decrease the net value of an average patent to society?

While the net value of an average patent is expectedly subjective, the changes in value of certain types of patents can be more easily analyzed. With respect to inventions by small inventors, the implications of MedImmune make the value of a patent considerably weaker for the inventor. As the inventor can only recoup sunk costs from either monopoly production or licensing, small inventors (that generally lack production capabilities nor) will find it much more difficult to profit from their work after MedImmune, as potential licensees will be able to file declaratory judgment actions on almost any grounds in defense of their product. Without the means to withstand an actual infringement suit, small inventors will at best be able to sell their patent to a larger patent-pooling firm with the means to negotiate license agreements. Of course, while small inventors will always have intangible incentives motivating them to invent, the decreased propensity for monetary rewards will likely result in decreased overall innovation.

Along with small inventors, MedImmune will likely impact even some large firms, such as those in the biotech and pharmaceutical industries, in which patents are incredibly valuable due to their licensing potential, In fact, any industry that depends heavily on the ability to license intellectual property will be severely hampered by MedImmune. With pharmaceuticals, considering the incredible costs that often go into developing a new drug or treatment, the potential for a generic producer to reproduce it while paying little to no royalties will put a huge dent in profits. While the initial impact will be on individual firms and inventors, the net result will be fewer resources invested in innovation in the biotech and pharmaceutical industries, and tremendous loss to society that such innovation could potentially provide.

Conclusion

In conclusion, the Supreme Court's MedImmune decision weakened the stability of both future and current licensing agreements. While the federal circuit s precedent had been rather unambiguous, the Supreme Court accepted the circularly reasoning and exaggerated risk claimed by MedImmune and allowed it to file for declaratory judgment relief against its licensor without first ending their licensing agreement. The decision gives a blank check to licensees to challenge their licensor on patent invalidity charges if they feel they have any chance at success. As lower court decisions have already made clear, this rationale will make it considerably more difficult for patent-holders to negotiate licensing contracts, making it less likely that inventors will profit from their inventions. As a result, given the results predicted by the three dominant theories of patents and innovation, this decreased incentive for individual inventors will cause a decline in innovation across American society. And with the technological prowess of India and East Asia on the rise, the U.S. cannot afford to miss a step. Assuming innovation, like marriage, is something that the government ought to promote across society, why has the Supreme Court chosen to weaken it?

Endnotes

Hurley, Dan. Divorce Rate: It's Not as High as You Think. The New York Times. April 19, 2005. Available Online. http://www.divorcereform.org/nyt05.html

Aetna Life Ins. Co. v. Haworth, 300 U.S. 229, 240-241 (1937).

MedImmune v. Genetech 549 U.S. Pp. 7, majority (2007).

Maryland Causalty Co. v. Pacific Coal & Oil co., 312 U.S. 270,273 (1941)

Sierra Applied Scis., Inc. v. Advanced Energy Indus., Inc., 363 F.3d 1361, 1373 (Fed. Cir. 2004)

MedImmune v. Genetech 549 U.S. Pp. 3, majority (2007).

Gen-Probe Inc. v. Vysis, Inc., 359 F. 3d 1376 (2004) Available Online. http://www.ll.georgetown.edu/federal/judicial/fed/opinions/02opinions/02-1617.html

MedImmune v. Genetech 549 U.S. Pp. 4, dissent (2007).

MedImmune v. Genetech 549 U.S. Pp. 3, majority (2007).

Henry, Mark. Patent Licensing After MedImmune v. Genentech. Intellectual Property Today. April, 2007. Available Online. http://www.iptoday.com/pdf/2007/4/Henry-Apr2007.pdf

MedImmune v. Genetech 549 U.S. Pp. 18, majority (2007).

MedImmune v. Genetech 549 U.S. Pp. 10, dissent (2007).

SanDisk Corporation v. STMicroelectronics, Inc. No. 05-1300 (Federal Circuit Court of Appeals, 2007).

Buchanan, Matthew. SanDisk Corporation v. STMicroelectronics. FedCirc.us Published Online. 3 April 2007. http://www.fedcirc.us/case-reviews/sandisk-corporation-v.-stmicroelectronics.html

SanDisk Corporation v. STMicroelectronics, Inc. No. 05-1300 (Federal Circuit Court of Appeals, 2007).

Buchanan, Matthew. SanDisk Corporation v. STMicroelectronics. FedCirc.us Published Online. 3 April 2007. http://www.fedcirc.us/case-reviews/sandisk-corporation-v.-stmicroelectronics.html

Tabarrok, Alexander. Patent Theory versus Patent Law. Contributions to Economic Analysis & Policy. Volume 1, Issue 1. Article 9. George Mason University, 2002.

Gallini, Nancy T. The Economics of Patents: Lessons from Recent U.S. Patent Reform The Journal of Economic Perspectives, Vol. 16, No. 2. Spring, 2002 p. 131

Gallini, Nancy T. The Economics of Patents: Lessons from Recent U.S. Patent Reform The Journal of Economic Perspectives, Vol. 16, No. 2. Spring, 2002 p. 140

Gallini, Nancy T. The Economics of Patents: Lessons from Recent U.S. Patent Reform The Journal of Economic Perspectives, Vol. 16, No. 2. Spring, 2002 p. 145