Does Qualcomm’s Value Chain Licensing System Survive Its Settlement With Broadcom? (Part One)

Sean O’Connor is a Professor at the University of Washington School of Law and Chair of the Law, Technology & Arts Group, specializing in intellectual property and business law involving biotechnology, cyberspace/information technology, and new media/digital arts.  Professor O’Connor is an IP Osgoode Research Affiliate.

Qualcomm and Broadcom finally seem to have ended their long running, epic patent litigation war — or at least executed a truce for the time being.  With battle fronts in the U.S., Korea, Japan, and the EC, this conflict has been a poster child for patent reform advocates.  But as a multi-jurisdictional affair, any reform lessons to be learned from it need be multi-jurisdictional as well.  My interest, however, is the effect (if any) the settlement will have on Qualcomm’s hotly contested value chain licensing system that secures royalties from both upstream and downstream parties in the chip and handset manufacturing and distribution chain.  While many might have believed the U.S. Supreme Court decision in Quanta Computer, Inc. v. LG Electronics, Inc., 128 S. Ct. 2109 (2008), overturned the validity of such licensing systems under the doctrine of patent exhaustion, a careful analysis of both Quanta and Qualcomm’s actual system refutes this easy assumption.

Because Broadcom deemed the Settlement and Patent License and Non-Assert Agreement (“Settlement Agreement”), executed on April 26, to be a material agreement under U.S. securities laws, it released a redacted version on April 29 as an exhibit to a SEC material event report on Form 8-K.  Qualcomm appears to have taken the position that the Settlement was not a material agreement to it, as it has not released even a redacted version even in SEC filings that mention the Settlement, such as its Quarterly Report on Form 10-Q filed on April 29, the same day as Broadcom’s 8-K filing.  Admittedly, Qualcomm is a much bigger entity than Broadcom, and thus under U.S. securities cases what is material to Broadcom in terms of value and scope of an agreement is not necessarily material to Qualcomm.  Nonetheless, because of the extent of the litigation across multiple jurisdictions, the distraction it provided to management, and the final settlement payments totaling US$891M, I might have expected Qualcomm to file the Settlement Agreement itself with its 10-Q that disclosed the existence and outline of the Agreement.

The Settlement Agreement is quite long and detailed, and the SEC-permitted redactions in the publicly released version obscure what may be some key terms and provisions.  Nevertheless, what seems fairly clear is that Qualcomm’s licensing system remains intact as to everyone other than Broadcom and its customers.  And even as to Broadcom’s customers, the Agreement makes distinctions as to “exhaustive licenses” vs. “non-exhaustive licenses”, “cellular products” vs. “non-cellular products”, and the existence or absence of “pass through rights” in different circumstances.  At the same time, Broadcom had earlier brought a declaratory judgment action against Qualcomm arguing that the latter’s licensing system was illegal, especially in light of the Quanta decision.  The case was filed in the U.S. District Court for the Southern District of California as Broadcom Corporation v. Qualcomm Incorporated, Case No. 08cv1829-WQH-LSP (October 7, 2008). The case was dismissed without prejudice on March 12, 2009 based on the court’s decision that Broadcom presented insufficient claims showing an immediate and actual case or controversy.  Thus, it did not rule on the merits of Broadcom’s allegations that Qualcomm’s licensing system was illegal.

So what is Qualcomm’s licensing system?  Qualcomm described it in an amicus brief it filed in the Quanta case:

“Qualcomm has provided chipmakers nontransferable, worldwide, nonexclusive, restricted licenses to its portfolio of technically necessary patents through licensing agreements called ASIC Patent License Agreements (“APLAs”).  Chipmaker-licensees typically pay Qualcomm an up-front license fee and a running royalty (paid quarterly) that is an agreed upon percentage of the defined Net Selling Price of the chips produced by the licensee.  As is common in the industry and has been found by the Court plainly to be within the rights of patent holders, see, e.g., Gen. Talking Pictures Corp. v. W. Elec. Co., 305 U.S. 124, 127 (1938) (“That a restricted license is legal seems clear.”) (citing Mitchell v. Hawley, 83 U.S. (16 Wall.) 544 (1872)), the license that Qualcomm has granted in APLAs is limited in both scope and conditioned upon the licensee acting within the bounds of its limited license. An APLA provides the chipmaker-licensees with a license to make (or have made) its own ASICs [ed. “Application Specific Integrated Circuits”]. An APLA also provides the chipmaker-licensee with a restricted license to sell ASICs, but only to handset makers that that APLA defines to be an “Authorized Purchaser” for incorporation into fully assembled handsets.  Authorized Purchasers are those handset makers that themselves have a license from Qualcomm through their own Subscriber Unit License Agreement (“SULA”) to make, use and sell fully assembled handsets that, in the absence of a SULA, would infringe Qualcomm’s patents.  Importantly, by their express terms, APLAs do not grant a license to the chipmaker to use the ASICs–i.e., licensed chipmakers may not themselves use or pass on to others the right to use the chipmaker’s ASICs to make, operate or sell handsets or any other product. APLAs explicitly state that the rights to use the ASICs to make, operate or sell handsets are only conferred by licensing agreements between Qualcomm and Authorized Purchasers (i.e., by SULAs). APLAs also expressly state that the license granted is only for the limited scope laid out, that no other license is granted or implied and that if the chipmaker-licensee sells ASICs to entities that are not Authorized Purchasers, the licensee has materially breached the APLA, which gives Qualcomm the right to terminate the agreement, including the license granted.”

“As previously mentioned, producers of chips that are licensed through APLAs are granted, inter alia, a license to sell such chips only to handset makers that have entered into a SULA with Qualcomm. The standard terms of the SULAs have granted handset makers a nontransferable, worldwide, nonexclusive, unrestricted license to Qualcomm’s patents to make (and have made), import and use handsets, and to sell (and offer to sell) completed handsets. SULAs typically provide for an up-front licensing fee to be paid to Qualcomm, along with a running royalty (paid quarterly) that is set as a percentage of the Net Selling Price of the handsets sold. The broad license typically provided in Qualcomm’s SULAs exhausts Qualcomm’s patent rights when handset makers sell finished handsets to their customers–typically wireless carriers such as Verizon Wireless–and pay Qualcomm the royalties due under the SULA. Qualcomm has not sought to license its patents to or receive royalties from wireless carriers or end users.”

“Qualcomm is also in the business of developing and selling its own chips and software for wireless handsets. Qualcomm typically sells chips only to those handset manufacturers that are licensees to Qualcomm’s patents under a SULA. Such chip sales are pursuant to Components Supply Agreements, in which handset makers agree to pay Qualcomm an agreed upon price for the chips sold by Qualcomm. Components Supply Agreements provide that the buyer-handset makers may only incorporate the chips purchased from Qualcomm into fully assembled handsets that are the subject of the SULA between Qualcomm and the handset maker.  The sale of Qualcomm chips pursuant to Components Supply Agreements does not provide the buyer-handset makers any license to Qualcomm’s patents, and Components Supply Agreements expressly state that no patent license, express or implied, is granted by the sale of the chips or the Components Supply Agreement.  Rather, all patent licensing is covered by the SULA.  Components Supply Agreements contain a representation and warranty by the buyer-handset maker that the chips purchased pursuant to the Components Supply Agreement will be used solely to develop and manufacture handsets for sale subject to and in accordance with the SULA between Qualcomm and the buyer-handset maker.”

Because this system allows Qualcomm to collect royalties on the same patents from both chip makers (under the APLA) and handset makers (under the SULA), it has been criticized by others and alleged to be invalid or illegal after the Quanta ruling, such as by Broadcom in its declaratory judgment action. But I think that the Supreme Court left exactly enough space in its Quanta holding for Qualcomm’s system to remain valid.  Despite what I sometimes hear as an interpretation of Quanta that the Supreme Court invalidated all “double royalty”, multiple licensing, or value chain licensing systems, it does no such thing.  The case instead turned on whether there was an authorized and unconditional sale of products substantially embodying the patents at issue. If so, then exhaustion applies and the patent owner cannot bring an infringement action against the purchaser of the product, or demand that it take a license.  In the LG-Intel license at the heart of the Quanta case, the parties had an unlimited license to make and sell chips embodying each other’s patents. A separate agreement required Intel to notify its customers that it (Intel) had no authority to grant a license to them to use the chips.  Intel did so and thus complied with this separate agreement.  The problem was that the customers, including Quanta, realized that because Intel was fully licensed to make and unconditionally sell chips to them, the patents were exhausted upon such sale and thus no license was needed from LG.  The Supreme Court agreed with this position, but was quite careful to explain that this holding rested on the exact nature of the unlimited make and sell license.  The Court seemed to endorse some of its earlier holdings, such as General Talking Pictures (see above), that allowed for restricted or limited licenses to cut off exhaustion defenses by certain classes of end users or other downstream purchasers.  This rests on the need for the sale to be “authorized”.  Thus, in General Talking Pictures, the patent owner licensed a manufacturer to make and sell amplifiers but only to amateur users and not to commercial users.  The Supreme Court in that case held that when the manufacturer knowingly made and sold amplifiers to commercial users as well (who also knew the license limitation on the manufacturer), these actions were the same as if the manufacturer were operating with no license at all (as to these sales). And because the sales were not therefore authorized, then the purchasers were treated as having knowingly purchased what were essentially counterfeit goods, and thus no exhaustion had occurred and the patent owner could sue them for infringement as well.

Accordingly, following Quanta, my advice to patent owners has been to make sure that they limit the scope of their licenses to only the activities and sales they truly wanted to authorize, with the understanding that whatever was authorized would then be subject to the exhaustion doctrine.  Essentially, this was just a reminder that the “make” (“have made”), “use” (“have used”), and “sell” (“have sold”) patent rights are indeed severable and can be individually limited.  An open question is whether “conditioned sales” under the U.S. Court of Appeals for the Federal Circuit’s decision in Mallinckrodt Inc. v. Medipart, Inc., 976 F.2d 700 (Fed. Cir. 1992) can still hold off the application of exhaustion to goods sold under those terms after Quanta.  But that could easily be the topic for another blog entry.  When asked whether Quanta “changed” the law as to any of this, I have generally said no.  Intel and LG’s licensing counsel should have known that an unlimited make and sell right was an invitation for exhaustion claims by downstream purchasers when they established the cross license in the first place.  Yet, before we rush to judge them too hastily, keep in mind that any negotiated deal can have certain sticking points that the parties cannot resolve and the resultant memorialized agreement may intentionally contain vague or suboptimal clauses (from a legal perspective). And indeed at a conference in which I mentioned this very point in the context of the LG-Intel license, an audience member stated that he knew one of the attorneys involved and that there were indeed business and negotiation issues that precluded the use of what we as licensing lawyers would have seen as the optimal make and sell right grant language, given the goal to limit some downstream uses.

In the second part of this feature blog post, Professor O’Connor will examine Broadcom’s declaratory judgment action and further discuss Qualcomm’s value chain licensing system.