Date: 09-05-2007

Case Style: ZILA, INC., a Delaware Corporation v. James E. Tinnell

Case Number: 05-15031

Judge: Marsha S. Berzon

Court: United States Court of Appeals for the Ninth Circuit on appeal from the District of Nevada, Clark County

Plaintiff's Attorney:

William H. Drummond, Newport Beach, California, for the appellee.

Defendant's Attorney:

Larry C. Johns and John H. Pilkington, Las Vegas, Nevada, for the appellant.

Description:

Appellant James Tinnell developed a liquid solution to treat lesions caused by the herpes virus. He applied for a patent on the treatment and acquired a defunct corporation, now named Zila, as a vehicle for marketing and selling the product, now called Zilactin. Tinnell subsequently entered an agreement with Zila that assigned all rights in his invention to the company in return for royalty payments and company stock. The royalty payments provided for in this contract are the subject of the present dispute.

The contract at issue is unambiguous as to the duration of the royalties, and the parties agree on their intent at the time it was formed. All the evidence is thus in accord with a single interpretation - that Tinnell would relinquish all rights to Zilactin, patent or otherwise, and, in return, receive in perpetuity a five percent royalty on Zila's sales of the invention. The difficulty in this case arises because Zila asserts, and the district court agreed, that the doctrine announced in Brulotte v. Thys, 379 U.S. 29 (1964), displaces, because of federal patent policy, the parties' intent and renders the royalty obligation unenforceable, either entirely or upon the expiration of the first patent that issued on Tinnell's invention. We confront, consequently, not simple questions of contract law but rather issues concerning the impact and bounds of Brulotte, in the context of an otherwise unremarkable case.

I.

Tinnell first developed his liquid solution to treat lesions caused by oral and genital herpes in 1976. He applied for a patent on the treatment the following year and soon thereafter acquired a defunct California corporation, which he renamed Zila, Inc.,1 as a vehicle for marketing and selling the product. The product has been improved since it was developed in 1976 and is now sold under the brand name Zilactin.

On September 5, 1980, Tinnell and Zila entered into an agreement ("1980 Agreement") that began by noting that "Tinnell has invented a treatment composition for herpes virus infection, which is the subject of a patent application," and "Tinnell is desirous of assigning all of his right, title and interest in the application and invention, improvements thereon and Letters Patent thereon" for consideration including royalties and stock. The 1980 Agreement

assign[ed] all of [Tinnell's] right, title and interest in the [patent] application and invention, improvements thereon and Letters Patent thereon, when granted in the United States or foreign countries, to [Zila], including any present or future improvement whether the same being made by Tinnell or [Zila], and whether presently existing or made in the future, and as may be granted in the United States or any foreign country or otherwise, including each patent granted on any application which is a division, substitution or continuation of any of the applications specifically identified herein, and each reissue or extension of any of the same.

In return, and without any temporal or other limitation, the contract provided Tinnell with "a five percent (5%) royalty on gross sales of [Zila] of the invention," as well as company stock. Tinnell obligated himself to "cooperate with [Zila] to the extent that [Zila] may enjoy to the fullest extent the rights conveyed hereunder . . . ."

The officers who signed on behalf of Zila testified that when they executed the 1980 Agreement, it was not known whether any patents would issue on Tinnell's invention. According to their uncontested statements, the duration of Zila's obligation to pay Tinnell royalties was not related in any way to the patents that might or might not be obtained by the company as a result of his previously-filed patent application. Instead, the signatories understood the 1980 Agreement to provide Tinnell with a 5% royalty on gross sales of Zilactin for as long as the company sold his product.

Zila subsequently secured patents in the United States and Canada.2 The first of these patents, U.S. Patent ‘934, was issued in August 1981. Zila also secured a continuation patent, ‘236, for the 1981 patent and, in December 1985, Canadian Patent ‘494. The primary improvement that transformed Tinnell's original solution into the present-day Zilactin was the addition of a thickener that made the product into a gel. The patent for the addition of this thickener was approved as U.S. Patent ‘158 in January 1992.

There is a dispute as to who invented the 1992 patent. In 1987, Zila filed a patent application which described an improvement to the original chemical compound and named Tinnell as the inventor. Because Zila's patent counsel erred in the technical description of the chemical compounds involved, however, the company withdrew the application. When the company resubmitted the application, it inexplicably named Edwin Pomerantz, Zila's regulatory specialist, as the inventor. The patent office subsequently issued the patent in 1992 to Zila, crediting Pomerantz rather than Tinnell with the invention.3

Zila's royalties to Tinnell grew exponentially from 1987 to 2000. In 1987, gross sales of Zilactin amounted to only $321,000, which pegged royalties at $6,426. By 2000, however, Zilactin had gross sales of over $8 million, and Zila owed Tinnell half a million dollars in royalties annually.

In July 2000, Zila's patent counsel advised the company to terminate Tinnell's royalties, on the grounds that, under Brulotte, Tinnell's right to royalties expired on August 1998, when the 1981 patent expired. Two months later, Zila stopped making royalty payments on all sales of Zilactin. Although the Canadian patent did not expire until December 2002, Zila justified its withholding of the Canadian royalties on the ground that it had overpaid Tinnell nearly a million dollars in American royalties over the previous two years.

Shortly after it stopped paying royalties, Zila filed a twocount complaint in federal court requesting a declaratory judgment that Tinnell's right to royalties under the 1980 Agreement ceased after August 25, 1998. The suit also sought reimbursement for the royalties paid to Tinnell for the two years after the 1981 patent expired. Tinnell filed a counterclaim for declaratory relief, contending that his entitlement to royalties under the Agreement did not terminate with the expiration of the 1981 patent but, instead, continued in perpetuity. He added counterclaims for breach of contract, fraud, and other state law claims.

After discovery, the parties made cross-motions for summary judgment on the over-arching question of whether royalties were owed after August 1998. Applying Brulotte, the district court held that the 1980 Agreement was "unlawful per se under federal patent law," because it "project[ed] beyond the expiration date of the patent." Accordingly, the district court granted summary judgment "to the extent that Zila requests declaratory relief from liability under the Agreement." The court explained that, "[s]ince the Agreement is unenforceable after the expiration of the patents on August 25, 1998, Zila cannot be forced to pay royalties after that date." Zila subsequently filed a further motion for summary judgment on its demand that Tinnell repay royalty payments from 1998 to 2000, arguing that the payments amounted to unjust enrichment. The district court denied summary judgment to Zila on this claim and, instead, dismissed it.

Tinnell did not sit idle after the district court's first order. He filed his own demand for entry of judgment, arguing that Zila owed him at least $56,753 in royalties for Canadian sales of Zilactin from August 2000, when he stopped receiving payments, until December 3, 2002, when the Canadian patent expired. Zila admitted to owing the money but claimed it was entitled to offset the amount against the American royalties it paid Tinnell from September 1998 through August 2000. The district court agreed with Zila's bottom line and went further: Tinnell had no rights to royalties in the United States or Canada, the district court held, because, although the 1980 Agreement "purports to require the payment of royalties based upon the Canadian patent, that agreement is unenforceable." The court noted that this result appeared inequitable but read Brulotte to require it.

On December 1, 2004 the parties stipulated to dismissal of Tinnell's outstanding counterclaim for breach of contact. The district court then declared all previous orders and the judgment ripe for appeal, and this timely appeal followed.

* * *

We first consider Brulotte. The case involved various patents held by the Thys Company, which sold farmers a hoppicking machine for a flat sum but required them to purchase a license for the patents on the machines in order to use the product. Id. at 29. The license contract demanded that, in addition to the initial purchase price of the machines and onerous restrictions on their assignment or use, the farmers pay the larger of a $500 annual royalty or a set royalty rate tied to the amount of hops they harvested each year. Id. The last patent incorporated into the machines expired in 1957. Id. at 30. When the farmers subsequently refused to pay the royalty, the Thys Company sued to enforce the licensing contract. Id.

The Supreme Court ruled for the farmers, holding that the royalty agreements were unenforceable to the extent that they extended "beyond the expiration date of the patent[s]." Id. at 32. The Court explained its holding in part by noting that

[t]he present licenses draw no line between the term of the patent and the post-expiration period. The same provisions as respects both use and royalties are applicable to each. The contracts are, therefore, on their face a bald attempt to exact the same terms and conditions for the period after the patents have expired as they do for the monopoly period.

Id. As a result, the Court "conclude[d] that a patentee's use of a royalty agreement that projects beyond the expiration date of the patent is unlawful per se," and held the farmer's royalty obligation under the license unenforceable. Id.

[1] Simply put, Brulotte indicates that under some circumstances patent owners cannot exact royalties for use of patented devices beyond the duration of their patents. Id. at 33- 34. The doctrine appears straightforward enough, but its application runs counter to the usual task in a contract case - to interpret the terms agreed to by the parties. That is, Brulotte renders unenforceable some aspects of an otherwise valid contract. And it does so for a reason that many courts and commentators have found economically unconvincing, namely, that "the free market visualized for the postexpiration period would be subject to monopoly influences" if "a royalty agreement [was allowed to] project[ ] beyond the expiration date of the patent."4 Id. at 32-33. No matter how unconvincing Brulotte's foundation may be, however, we are bound to apply its holding if it applies to the case before us. See, e.g., Agostini v. Felton, 521 U.S. 203, 237 (1997) ("Court[s] of Appeals should follow the [Supreme Court] case which directly controls, leaving to this Court the prerogative of overruling its own decisions."); Scheiber v. Dolby Labs., Inc., 293 F.3d 1014, 1018 (applying Brulotte despite stinging criticism of its logical underpinnings because "we have no authority to overrule a Supreme Court decision no matter how dubious its reasoning strikes us."). At the same time, our task is not to expand Brulotte's holding beyond its terms. So, except as required by Brulotte and its progeny, we shall endeavor to give effect to the intent of the parties and the bargain that they struck.

[2] A central difference between this case and Brulotte is that here, although the contracting parties contemplated the possible future issuance of a patent, the royalty provision did not depend on it, either on its face or as reported by the contracting parties. Whether that difference is material is a difficult question that largely turns on the interpretation of a post- Brulotte Supreme Court case that had this same feature, Aronson v. Quick Point Pencil Co., 440 U.S. 257 (1979), and that enforced the contract's royalty provision.

[3] Aronson concerned an inventor who filed an application for a patent on a design for a keyholder. Id. at 259. While the patent application was pending, she negotiated a contract with a manufacturer to make and sell the product. Id. The agreement between the inventor, Aronson, and the manufacturer, Quick Point, consisted of two documents. Id. In the first, Quick Point agreed to pay a 5% royalty in return for an exclusive license to sell the invention described in the patent application; the duration of the royalty was not detailed. Id. In the second, the parties agreed that if the patent application "was not allowed" within five years, Quick Point would pay a 2.5% royalty so long as it sold the invention. Id. After five years passed and Aronson had failed to obtain a patent, Quick Point reduced its royalties to the lower rate, which it paid for 14 years. Id. at 260. As sales of the keyholder rose and competitors entered the market, Quick Point sought a declaratory judgment that the royalty agreement was unenforceable. Id. at 260-61. Although Quick Point persuaded the appeals court, the Supreme Court disagreed, holding that the Brulotte doctrine and similar federal patent principles "do not bear on a contract that does not rely on a patent, particularly where, as here, the contracting parties agreed expressly as to alternative obligations if no patent should issue." Id. at 262.

In so holding, the Court stated that enforcing the perpetual royalty of 2.5% was "consistent with the principles treated in Brulotte." Id. at 264. The distinction between the contract in Brulotte and the one in Aronson rested, according to the Court, on the fact that the extended royalty term in Aronson was not "negotiated ‘with the leverage' of a patent [but] rested on the contingency that no patent would issue within five years." Id. at 265. The Court recognized that "a pending patent application gives the applicant some additional bargaining power for purposes of negotiating a royalty agreement," but observed that "the amount of leverage arising from a patent application depends on how likely the parties consider it to be that a valid patent will issue." Id. Because the parties in Aronson negotiated a two-tier royalty, with a contingency for the acceptance or rejection of the patent application, the court concluded that "[i]t is clear that whatever role the pending application played in the negotiation of the 5% royalty, it played no part in the contract to pay the [2.5%] royalty indefinitely." Id.

Aronson thereby added an additional wrinkle to the Brulotte analysis and has been read to create two bright-line rules: (1) If a patent ever issues on an invention, Brulotte applies, and no contract can properly demand royalty payments after the patent expires; and (2) a contract that provides for royalties either when a patent expires or when it fails to issue cannot be upheld unless it provides a discount from the alternative, patent-protected rate. See Meehan v. PPG Industries, Inc., 802 F.2d 881, 884-85 (7th Cir. 1986); Boggild v. Kenner Products, 776 F.2d 1315, 1319-20 (6th Cir. 1985); Pitney Bowes, Inc. v. Mestre, 701 F.2d 1365, 1372-74 (11th Cir. 1983). This understanding, however, may well overread both Brulotte and Aronson, by glossing over the unique and onerous contractual restrictions at issue in Brulotte and relying on a sentence in Aronson that is really only dicta.

Brulotte indicates that it is because of post-patentexpiration contractual restrictions other than royalties that the Thys Company could not collect the royalties after the patents expired. Specifically, the Court in Brulotte noted that, although the farmers bought the hop-picking machines outright and title transferred, they were forced to obtain a license to actually use the machines; the licenses could not be assigned, making the machines the farmers purchased worthless for subsequent sales; the farmers were forbidden from moving their machines out of the county, whether or not they intended to use them elsewhere; and the license charged both a sliding royalty rate and a minimum fee, depending on use. 379 U.S. at 29.5 It is only "in view of [these] other provisions of the license agreements" that the Court found the unchanging royalty rate to be "peculiarly significant." Id. at 31-32 (emphasis added). The Court emphasized that the presence of "[t]hose restrictions," rather than the royalty alone, in the "post-expiration period [was] a telltale sign that the licensor was using the licenses to project its monopoly beyond the patent period." Id. at 32 (emphasis added). In other words, the Thys Company was not simply attempting to charge a royalty after the patent expired; it was acting in all respects as if the patent remained in place. See id. ("The same provisions as respects both use and royalties are applicable [during the term of the patent and the post-expiration period] . . . . We are, therefore, unable to conjecture what the bargaining position of the parties might have been . . . .") (emphases added).

Moreover, Brulotte involved the sale of a physical machine along with a use license, where the machine was separately paid for and owned outright by the farmers. Id. at 29. As the Court noted, id. at 33 n.5, the sale of intellectual property alone, as here, is a considerably more complex matter than the contract at issue in Brulotte, and the concepts underlying Brulotte do not necessarily transfer to that context readily. An invention can have value to a manufacturer as a trade secret, or as an opportunity to exploit brand identified or market share, quite aside from any patent that could issue on it. In Brulotte, in contrast, the farmers had no interest in the invention other than its physical embodiment - which they owned - and the right to use the intellectual property included in it, which could not be exploited by the patent holder once the patent expired.

Aronson, on the other hand, involved a sale of purely intellectual property to a manufacturer, and recognized the value of other intellectual property besides the patent. See 440 U.S. at 261-62 ("Quick Point apparently placed a significant value on exploiting the basic novelty of the device, even if no patent issued."); id. at 263 (noting that, even without patent rights, the contract allowed Quick Point "to preempt the market"); id. at 265 ("[Quick Point] agree[d] to pay for the opportunity to be first in the market"). This recognition was both necessary and sufficient to the holding in Aronson that Brulotte "does not bear on a contract that does not rely on a patent," as it was essential to the demonstration that the "[lower] royalty was explicitly independent of federal law." Id. at 261-2. Although the court stated in passing that, if Aronson had received a patent on her keyholder, "she would have received a 5% royalty only on keyholders sold during the 17-year life of the patent," this example was counterfactual dicta, neither supported by any analysis nor necessary for the decision.

In short, were we writing on a clean slate, we might be inclined to read the dicta in Aronson as nonbinding in light of what appears on its face to be a very limited holding in Brulotte. By doing so, we would largely avoid attributing to the Supreme Court in Brulotte and Aronson the lack of economic logic laid at its feet by Scheiber and a bevy of commentators.

[4] Nonetheless, every other circuit to consider Brulotte has ignored the relevance of the restrictions on use and, in the process, read Aronson as turning not on the absence of such restrictions or on the fact that the agreement was enacted before any patent issued but on the facts that (1) a patent did not issue in that case; and (2) the underlying agreement provided for a lower royalty if no patent issued than if one did. See Meehan 802 F.2d at 884-85; Boggild, 776 F.2d at 1319- 20; Pitney Bowes, 701 F.2d at 1372-73. This consensus view may overread both Brulotte and Aronson for the reasons we have surveyed, and gives rise to the trenchant criticisms of the commentators and of the Seventh Circuit in Scheiber. But the Supreme Court opinions are sufficiently opaque that we cannot say with any certainty that the consensus view is wrong. As patent matters give rise to particularly strong national uniformity concerns, see S. Rep. No. 97-275, at 4 (1982) (citing the "special need for national uniformity" in the interpretation of patent law as support for the creation of the Federal Circuit), we hesitate more than is ordinarily the case to open up an intra-circuit conflict, see Hale v. Arizona, 993 F.2d 1387, 1393 (9th Cir. 1993) (en banc) ("For prudential reasons, we avoid unnecessary conflicts with other circuits . . . ."). We therefore adopt the majority approach and consider not whether but the extent to which Brulotte preempts state law with regard to a contract for payment of royalties on the sale of an invention that may be patented, if a patent indeed issues on the invention.

III

Applying Brulotte, the district court in this case found that the 1980 Agreement was "unlawful per se under federal patent law." It therefore granted summary judgment "to the extent Zila requests declaratory relief from liability under the Agreement." In the subsequent order, however, the district court expanded its previous rulings. It interpreted Brulotte as rendering the entire patent assignment agreement null and void, not just its provision of royalties after 1998. Faced with the question whether Zila must pay Tinnell royalties it admitted were due under a valid Canadian patent, the district court determined that it need not, because, although the 1980 Agreement "purports to require the payment of royalties based upon the Canadian patent, that agreement is unenforceable."

[5] Contrary to the district court's conclusions, Brulotte does not render an entire contract void and unenforceable merely because it includes an invalid licensing agreement. Rather, Brulotte renders unenforceable only that portion of a license agreement that demands royalty payments beyond the expiration of the patent for which the royalties are paid. See 379 U.S. at 30 (reversing the judgment below only "insofar as it allows royalties to be collected which accrued after the last of the patents . . . had expired") (emphasis added); id. at 33-34 (holding unenforceable "an attempt to project" the payment monopoly into a term "after the expiration of the last of the patents") (emphasis added). We previously referenced this interpretation of Brulotte's scope in passing, see Atlas-Pacific Eng'g Co. v. Geo. W. Ashlock Co., 339 F.2d 288, 289 n.1 (9th Cir. 1965), and it is not seriously in dispute. The parties agree, as has every appellate court to consider the question. See, e.g., Scheiber v. Dolby Labs., Inc., 293 F.3d 1014, 1022 (7th Cir. 2002); Pitney Bowes, Inc. v. Mestre, 701 F.2d 1365, 1373 n.13 (11th Cir. 1983); Modrey v. American Gage & Machine Co., 478 F.2d 470, 474 (2d Cir. 1973).

[6] The district court, however, read Scheiber to support its conclusion that Brulotte can render void contractual obligations to pay royalties on valid patents. In Scheiber, the plaintiff owned a U.S. patent and a Canadian patent. 293 F.3d at 1016. As part of a settlement agreement with the defendant, Scheiber agreed to receive royalties on both patents through the end of the Canadian patent's term, which ended two years after the U.S. patent. Id. The defendant, however, "refused to pay royalties on any patent after it expired." Id. at 1016 (emphasis added). The Seventh Circuit, applying Brulotte, found the contract unenforceable to the extent that the "patentee extends the patent beyond the term fixed in the [U.S.] patent statute." Id. at 1017; see also id. at 1022 (describing Brulotte as "refusing enforcement to contracts for the payment of patent royalties after expiration of the patent") (emphasis added). Accordingly, the relief granted by the court was not voiding the entire contract but rather a "partial rescission of the license agreement." Id. at 1021 (emphasis added). Although Scheiber states later in the opinion that the contract is "voided on grounds of illegality," id. at 1022, and "unenforceable," id. at 1023, the context provided by the previous lengthy discussion, as well as the limited relief sought, makes clear that this is true only of the portion of the contract "seeking to ‘extend' [the] patent," id. at 1021, and not anything else. There is thus no support that for the notion that Brulotte erects a general barrier to the enforcement of otherwise valid contract terms unless and until that last applicable patent expires.

* * *

Outcome: We therefore remand to the district court for a determination whether Tinnell should be credited with invention of the 1992 patent.10 If he should be, summary judgment in his favor is appropriate to the extent that it declares him entitled to domestic royalties until the 1992 patent expires. If not, summary judgment in Zila’s favor is appropriate to the extent that it declares the company released from liability for any domestic royalties after the 1981 patent expired in 1998.11

REVERSED and REMANDED for proceedings consistent with this opinion.

Plaintiff's Experts: Unknown

Defendant's Experts: Unknown

Comments: None