Alert September 29, 2009

Epistar Decision Highlights No-Challenge Provisions in the M&A Context

A recent Federal Circuit decision, Epistar Corp. v. International Trade Commission, No. 2007-1457 (Fed. Cir. May 22, 2009), may have important implications for the scope of contractual covenants that restrict a patent licensee’s right to challenge the validity of a licensor’s patents (so-called “no-challenge provisions”) in the context of M&A transactions. Epistar may also influence how no-challenge provisions, and possibly other covenants, are interpreted by other courts in other circumstances. Regardless of its ultimate impact, the decision highlights the importance of carefully considering and addressing the potential M&A consequences of covenants in technology licenses and other contracts.

A Brief Introduction to No-Challenge Provisions

In its most prevalent form, a no-challenge provision is a covenant made by a patent licensee that it will not assert in court (or other government forum) that patents licensed to it are invalid. While a no-challenge provision can be an important tool in the patent licensor’s toolbox, it should be noted that the enforceability of no-challenge provisions has not been universally settled, other than in connection with patent licenses granted to settle litigation. If a no-challenge covenant is granted in the settlement of litigation, courts have generally held that it is enforceable (see Flexfoot, Inc. v. CRP, Inc., 238 F.3d.1362 (Fed. Cir. 2001)).

The Epistar Case

In Epistar, Philips Lumileds Lighting Company (“Lumileds”) owned a patent relating to a technology used to increase the brightness and efficiency of a light-emitting diode. Lumileds sued United Epitaxy Company (“UEC”) in 1999 for patent infringement and the parties settled the litigation in 2001, with Lumileds granting UEC a license to the patent at issue. Under that license, UEC agreed to a no-challenge provision protecting that patent. The no-challenge provision expressly applied to UEC’s successors and was not expressly limited to any particular set of products.

Two years later, Lumileds separately sued and settled with Epistar Corporation in connection with Epistar’s alleged infringement of the same patent. Lumileds granted Epistar a license to that patent in connection with a settlement and required Epistar to agree to a no-challenge provision that was limited to a particular set of products (i.e., the products licensed under the agreement). Moreover, for Epistar’s no-challenge provision, Epistar explicitly retained its right to challenge the validity of the patent if Lumileds sued Epistar in the future for infringement of any other patent with respect to any licensed products.

In 2005, UEC merged into Epistar, and Epistar, as the surviving entity, assumed all of the liabilities and contractual obligations of UEC, including UEC’s license agreement with Lumileds. Lumileds sued Epistar in the International Trade Commission, alleging that the importation by Epistar of certain products – products which were not at issue in either of the prior lawsuits – infringed the same patent that was the subject of the prior litigations. Epistar asserted that the patent was invalid. Lumileds argued in response that Epistar was prevented from asserting invalidity due to the no-challenge provision in the Lumileds-UEC license agreement that Epistar had assumed and that was not expressly limited to any particular set of products. The ITC agreed with Lumileds and found that Epistar was precluded from challenging the validity of the patent.

On appeal, the Federal Circuit reversed with respect to the applicability of the Lumileds-UEC no-challenge provision and held that “Epistar’s right to contest validity of the … patent with respect to its products is governed by its own separate agreement with [Lumileds].”  Thus, the no-challenge provision contained in UEC’s license agreement only applied with respect to UEC’s products that were in existence before the merger, and Epistar was free to challenge the validity of the patent with respect to its own (non-licensed) products. Again, the Federal Circuit arrived at this conclusion even though UEC’s license agreement expressly stated that it bound UEC’s successors and prohibited challenges against the patent with respect to any products.

Applicability in Other Contexts

The circumstances surrounding the relationship among Lumileds, Epistar and UEC are somewhat unusual, and it is not yet clear how the ruling in the Epistar case will be applied by other courts or in other contexts. Epistar could be interpreted narrowly, since the court placed significant weight on the fact that Epistar had negotiated its own, more limited, no-challenge provision with Lumileds prior to its merger with UEC, and that this no-challenge provision manifested a clear negotiated intent between Epistar and Lumileds sufficient to override UEC’s no-challenge provision that Epistar had assumed. In fact, the court in Epistar expressly stated that this result ensures that “Lumileds cannot fortuitously gain rights against Epistar that it could not secure pre-merger.”  Under this narrow interpretation, if Epistar had not already negotiated its own no-challenge provision, the court may have applied UEC’s no-challenge provision against Epistar as the successor entity.

Alternatively, other courts may take a broader view of Epistar and read into the decision that, whether or not the surviving entity had already negotiated its own no-challenge provision, no-challenge covenants made by non-surviving entities should not apply to products developed post-merger by the surviving entity. A court taking this broader view would not be surprising given the public policy goals enunciated by the Supreme Court in Lear, Inc. v. Atkins, 395 U.S. 653 (1969), which stated that “[i]t is as important to the public that competition should not be repressed by worthless patents as that the patentee of a really valuable invention should be protected in his monopoly” (see also MedImmune, Inc. v. Genentech, Inc., 549 U.S. 118 (2007), which held that a licensee can challenge the validity of licensed patents while maintaining its license intact).

Moreover, other courts may also apply the reasoning in Epistar to licenses, covenants not to sue or other types of covenants since much of the same reasoning discussed in Epistar could arguably apply to these other license provisions. For example, the court in Epistar cited Medtronic AVE, Inc. v. Advanced Cardiovascular Systems, Inc., 247 F.3d 44 (3d Cir. 2001), in which the Third Circuit refused to extend an agreement to arbitrate entered into by the assignor to a dispute involving the assignee’s patents, since the assignor never owned those patents.

Finally, while the facts in Epistar involved a direct merger whereby one merger party, Epistar, survived, and the other merger party, UEC, did not, the reasoning in Epistar could apply in the context of an assignment of a license or other agreement in an asset purchase transaction. The court in Epistar cited the contract law treatise Corbin on Contracts for the principle that “the assignment of a contract to an assignee, such as from UEC to Epistar, only changes the obligated party, not the scope of the obligation.” 

Practical Implications in Light of Epistar

Regardless of how the Epistar case is interpreted by other courts going forward, it is important in the course of negotiating a no-challenge provision to be mindful of the possibility of a future M&A event, and to draft any no-challenge provision in line with one’s current and prospective business plans and goals. Similarly, when considering the potential acquisition of a target company that is a licensee under one or more license agreements, it is important to review the license agreement(s) carefully and examine the scope of any no-challenge provisions in the context of the proposed transaction with a goal of avoiding any unintended consequences in relation to the acquirer’s patent portfolio.