In a recent ruling (Halo Elecs., Inc. v. Pulse Electronics, Inc. and Stryker Corp. v. Zimmer, Inc.[1]), the Supreme Court adopted a relaxed and more plaintiff-friendly standard for determining whether to award enhanced damages in patent infringement litigation.  This ruling should be taken into account when considering allocation of patent infringement risks in M&A transactions, including in connection with representations and warranties and associated indemnities.

The case.  After patent infringement has been established, the U.S. Patent Act allows courts to impose enhanced damages by “increas[ing] the damages up to three times the amount found or assessed.”[2]  Under the Seagate test developed by the Federal Circuit in 2007, which guided courts before the Supreme Court’s recent Halo/Stryker decision, enhanced damages for patent infringement were only available if a plaintiff could show by “clear and convincing” evidence both that the infringement was “objectively reckless” and that the defendant subjectively knew of the risk of infringement.[3]  However,  in Halo/Stryker the Supreme Court unanimously rejected the demanding Seagate test in favor of a far more plaintiff-friendly standard, under which a plaintiff need only demonstrate by a “preponderance of the evidence” that the defendant’s conduct was sufficiently egregious under the circumstances to warrant the imposition of enhanced damages.  A typical example of such egregious conduct is when the defendant knew of the patent and may have even intentionally copied the patent owner’s product without a good faith basis for believing that doing so was permissible.  In other words, the Supreme Court rejected the objective standard previously applied, such that a defendant with subjective intent to infringe can no longer escape enhanced damages by showing, post infringement, that the conduct may not have been “objectively reckless” (e.g., because, by the time of trial, the defendant was able to raise substantial questions as to the validity of the patent or existence of infringement, even if it was unaware of these issues when it engaged in the infringement).  (For additional background on the Halo/Stryker decision, please refer to our alert memo here).

Departure from recent trend of weakening plaintiffs’ position in Supreme Court patent cases.  Interestingly, Halo/Stryker stands in marked contrast to other recent defendant-friendly Supreme Court rulings that made the risks associated with patent infringement more manageable.  For example, the Court’s 2014 decision in Octane Fitness, LLC v. ICON Health & Fitness, Inc.[4] lowered the bar for prevailing parties to win attorneys’ fees under the Patent Act, enabling prevailing defendants to more easily shift their attorney’s fees to the plaintiff (if the trial court deems the losing plaintiff’s suit to be “exceptional” in either its substantive weakness or the unreasonable manner in which the plaintiff litigated).  In Nautilus v. Biosig Instruments, Inc., decided the same year, the Court relaxed the standard for finding “patent indefiniteness,” which results in invalidation of the patent.[5]  And, most importantly, in Alice Corporation Pty. Ltd. v. CLS Bank International,[6] the Court made it easier to challenge software patents by ruling that implementation of an abstract idea on a computer or using software does not render that idea patentable.  Taken together, these decisions, coupled with legislative changes that made it easier to challenge patents post grant, armed defendants with strong protections in patent infringement cases.  Halo/Stryker represents a notable departure from the Court’s defendant-favorable trend, since defendants are more likely to be faced with enhanced patent infringement damages following this ruling.

Implications for M&A.  Potential patent infringement now involves a heightened risk that must be seriously considered in any M&A transaction.  For buyers, Halo/Stryker highlights the importance of conducting thorough due diligence so as to adequately minimize their exposure to the risks associated with patent infringement.  They must consider not only whether the M&A target has potentially infringed third-party patents, but also the circumstances surrounding such infringement, including the target’s subjective knowledge of the patent at the time of infringement and whether any bad faith can be found that raises treble damages risks.  In this context, a favorable legal opinion from the target’s outside patent counsel (finding non-infringement and/or invalidity of the asserted patent) would be helpful in mitigating enhanced damages risks.  (However, it is important to note that the absence of such an opinion is not, as such, a factor that should lead to the conclusion that the target had subjective knowledge of the infringement; a 2011 change to the Patent Act in fact clarified that the failure to obtain an opinion may not be used to prove that the accused infringer willfully infringed the patent[7].)

Moreover, Halo/Stryker has implications for IP reps and indemnification provisions in M&A agreements.  Naturally, non-infringement and sufficiency reps have now become all the more important.  While “knowledge” qualified reps could arguably protect a buyer against treble damages risks (on the assumption that infringement without knowledge is not likely to result in such damages), in reality, the definition of “knowledge” in M&A agreements is often significantly more narrow than the knowledge of infringement sufficient for a finding of egregiousness that can support enhanced damages (e.g., because of the limitation in M&A agreements to the knowledge of specific individuals).  Additionally, the potential for triple damages should be reflected in the negotiation of the indemnity caps that apply to breaches of non-infringement and sufficiency reps (at least those relating to patents).  From a seller’s perspective, now that damages can be amplified by a staggering amount, agreeing to an uncapped indemnity could be extremely problematic.

Word of caution.  While Halo/Stryker has changed the landscape of patent infringement risks, it will still be difficult to assess whether a court will in fact award enhanced damages.  The new test provides significant leeway to a district court to “exercise [its] discretion” and consider “the particular circumstances of each case in deciding whether to award damages, and in what amount.”[8]  Moreover, it is still difficult to estimate even the base amount of damages (without tripling it).  Calculation of patent damages is an evolving area of the law, and courts are giving stricter scrutiny to damage theories to ensure they are grounded in the value conferred by the patent at issue and are not overstated.  Any educated assessment of patent infringement damages requires not only legal expertise but also specific knowledge of other factors, such as the accused products and their sales and the royalty rates applicable to the asserted patents or prevailing in the industry.

Despite the uncertainty inherent in calculating patent infringement damages and assessing the likelihood of an award of enhanced damages, it is clear that Halo/Stryker brings enhanced risks to buyers and sellers in M&A transactions, especially those involving technology, life sciences or other patent-heavy industries.  For both parties, exposure is high, so Halo/Stryker should spark a renewed focus on thorough diligence and careful consideration and drafting of IP reps and indemnities.

[1] 2016 WL 3221515 (June 13, 2016).

[2] 35 U.S.C. §284.

[3] In re Seagate Technology, LLC, 497 F.3d 1360, 1374, 1384 (Fed. Cir. 2007) (en banc).

[4] 134 S. Ct. 1749 (2014).

[5] 134 S. Ct. 2120 (2014).

[6] 134 S. Ct. 2347 (2014).

[7] 35 U.S.C. §298.

[8] Halo/Stryker, at *9.