Enforcing Post-Sale Restrictions After Lexmark: Contracts and Antitrust Issues

In a unanimous opinion issued on May 30 in Impression Products v. Lexmark, the Supreme Court invalidated long-standing precedent allowing a patent owner to bring infringement claims to enforce post-sale rights to restrict the manner in which patented products are used or resold. Instead, the Supreme Court took a broad view of patent exhaustion and held that all patent rights are exhausted when a product is first sold.

As a result, companies that adopt a razors-and-razor-blades business model will no longer be able to rely on patent rights to protect aftermarket revenue streams, as Lexmark attempted to do with its patented toner cartridges. In exchange for a 20 percent price reduction, Lexmark customers agreed that they would use its toner cartridges only once before either returning or destroying them; customers unwilling to accept these conditions could pay a higher price. Adopting this business model allowed Lexmark to sell printers to consumers at lower prices and earn higher margins on recurring aftermarket revenue from the sale of toner cartridges.

Like Lexmark, many technology companies rely on aftermarket revenue streams to fund ongoing investments in research and development needed to remain competitive in hotly contested technology markets. This model is prevalent in the software industry, where customers pay ongoing fees for software support, and in other industries in which manufacturers that sell durable goods offer aftermarket maintenance or service contracts.

But high-margin aftermarket revenue streams frequently attract competition. In Lexmark’s case, independent companies like Impression Products began to refill and resell its toner cartridges at significantly lower prices. To protect its business model, Lexmark sued these companies for patent infringement. Two federal district courts in Kentucky and Ohio relied on the first sale doctrine to conclude that Lexmark had no post-sale patent rights. But Lexmark then won a huge victory in the Court of Appeals for the Federal Circuit, which upheld its right to sue Impression Products for infringement in an en banc opinion joined by all but two judges on the court. Lexmark International v. Impression Products, 816 F.3d 721 (2016).

Consistent with a recent trend to curb patent litigation, however, the Supreme Court reversed and held that Lexmark could not sue Impression Products for patent infringement, because all of its patent rights were exhausted when consumers purchased its toner cartridges.

Without post-sale patent rights, Lexmark and others will need to alter their razors-and-razor-blades business models or adopt different strategies to safeguard the aftermarket revenue upon which they rely to remain competitive in fast-paced technology markets. Contract rights provide one avenue to protect aftermarket revenues, but companies that take this approach should proceed with caution to avoid antitrust liability.

Enforcing Contract Rights

In the Lexmark opinion, the Supreme Court made clear that Lexmark has contract rights that might be used to enforce its post-sale contract restrictions. Contract claims will not, however, be nearly as effective as patent infringement claims, which in some cases can result in injunctions, multiple damages, and fee shifting. There are several problems with this alternative approach.

To illustrate, it is impractical to suggest that Lexmark sue the many customers that allowed their toner cartridges to be refilled and resold by Impression Products. Lexmark might select a few identifiable consumers to target with lawsuits in a public effort to protect its rights, but companies are understandably reluctant to sue their own customers.

It is much more efficient for Lexmark to sue reprocessors like Impression Products, which operate in willful disregard of contracts between Lexmark and its customers. Lacking a direct contractual relationship, however, Lexmark would need to rely on business tort claims, such as tortious interference with contract or unfair competition. But such claims are difficult to win, and the governing standards vary from state to state.

For example, a party claiming tortious interference with contract must prove not only that a third party intentionally interfered with a contract, but also that the third party used improper means. There are no bright line tests to identify improper means, and a company like Impression Products will argue that it merely competes to offer consumers more choices and lower prices in the secondary market. Pro-consumer arguments tend to appeal to juries and courts. Indeed, the Supreme Court’s opinion in Lexmark features an analogy to the automotive repair business, rhetoric which is frequently deployed in opposition to efforts to limit aftermarket competition from independent providers.

Antitrust Risk

In addition, efforts to limit aftermarket competition can raise antitrust issues, and companies like Lexmark will need to proceed with caution now that they are unprotected by post-sale patent rights.

A patent grants a government-sanctioned monopoly, and a patent owner generally is free to exploit that monopoly without violating the antitrust laws. Consequently, a post-sale restriction that falls within the protection of a patent generally does not violate the antitrust laws. A restriction that goes beyond the scope of a patent grant, however, may be an antitrust violation if there are anticompetitive effects (e.g., restricting competition for a product not covered by the patent).

The Supreme Court held in Lexmark that all patent rights are exhausted upon the first sale of a patented good. It follows that post-sale restrictions will no longer fall within the scope of any patent, and companies that seek to impose such restrictions will no longer be protected by their patent rights.

Market power is a key factor for evaluating antitrust risk in a post-Lexmark world. A company that lacks a dominant position in the market in which it sells its patented product will face less risk and can protect itself from antitrust liability through disclosure. Absent market power, a post-sale restriction disclosed in a sales contract generally will not offend the antitrust laws. This is because customers can recognize and account for transparent restrictions while considering their options in the upstream competitive marketplace. Thus, post-sale restrictions disclosed in contracts entered into in a competitive primary market (e.g., the market for printers) are generally safe from claims that the restrictions violate antitrust rules that apply in derivative, single-brand aftermarkets (e.g., the aftermarket for Lexmark-compatible print cartridges).

A company that has a dominant position in the market in which it sells a patented product, however, could face material antitrust risk from any kind of post-sale restriction. When patent owners seek to extend a lawful patent monopoly beyond the scope of the patent grant through exclusionary conduct, they may violate Section 2 of the Sherman Act, which covers monopolization and attempted monopolization.

To illustrate, Lexmark is almost certainly safe, because it faces vigorous competition to sell printers, and its single-use restrictions are disclosed to consumers at the time of sale. If Lexmark had market power in the market for printers, however, its single-use restriction might violate Section 2. In particular, Lexmark could be accused of using market power to unlawfully exclude aftermarket competition from companies that sell refilled print cartridges, causing consumer harm by increasing prices and reducing output.

Final Thoughts

The Lexmark decision will have a profound impact on companies that have relied on patent rights to impose post-sale restrictions that protect aftermarket revenues and enable a razors-and-razor-blades business model. Without the infringement remedy and facing elevated antitrust risk, companies like Lexmark will need to proceed with caution to enforce post-sale restrictions, and their business models may need to change.

In contrast, the Lexmark decision is a boon to reprocessors like Impression Products, which are now at liberty to compete in aftermarkets without fear of infringement claims—although they may still face business tort claims. Because such companies do not invest in developing, marketing, distributing, or selling primary technology like printers, they are able to offer substantially lower aftermarket prices that may fuel rapid growth at the expense of companies that do invest in innovation.

While there are some obvious winners and losers among the parties in Lexmark, the impact on consumers is less clear. In the short run, consumers are freed of post-sale patent restrictions and are likely to enjoy more choices and lower prices for toner cartridges and other aftermarket goods. The only short-term downside appears to be a heightened risk of liability for breach of contract claims, in the unlikely event that companies like Lexmark begin to sue their own customers.

In the long run, however, the Lexmark decision may harm consumers. For example, Lexmark might change its business model and charge more for printers, because it can no longer depend on high margin toner cartridge sales to fund the ongoing research and development needed to innovate and maintain market share in a highly competitive business. If so, consumer savings in the aftermarket could be offset by increased costs in the primary market for printers. If the total cost to buy a printer from Lexmark is front-loaded and not spread over the lifecycle of the printer through toner cartridge sales, it will be more difficult for many consumers to afford printers. Indeed, Lexmark’s current business model effectively allows consumers to finance their printers, with low-use consumers who purchase fewer toner cartridges paying less than high-use consumers.

Overall, while the impact on competition and consumers is uncertain, there is no doubt that the Lexmark decision will be disruptive in a number of different industries, and there is a real question about whether the short-term benefits for consumers are worth the long-term costs.