Yesterday, Dec. 5, 2012, in Cummins, Inc. v. TAS Distributing Company, Inc., No. 2010-1134, the Federal Circuit (Newman, Bryson, and Reyna) affirmed a decision by the Central District of Illinois that patent invalidity and unenforceability claims were precluded by a prior contract action arising from a patent licensing dispute concerning the contractual terms of the license to the patent.  This case cautions that not raising patent challenges in a breach of contract action over a license under the patent may bar challenging the patent in a later action.

Prior Actions (TAS I and TAS II).  Cummins licensed TAS’s patents for use in its diesel engines.  The license required Cummins to make a minimum annual royalty payment, to pay ongoing royalties per unit sold, and to use all “reasonable efforts” to market and sell licensed units.  Cummins could terminate the license after the fifth year.  Sales of licensed units were far fewer than Cummins estimated during negotiations.

TAS filed a first lawsuit (TAS I) against Cummins in federal court under diversity jurisdiction for breach of contract, claiming Cummins failed to make all “reasonable efforts” to sell licensed units.   Cummins disagreed and further argued that its ongoing royalty obligations should expire after the five-year period.  TAS lost on its “reasonable efforts” claims, but Cummins was required to continue making royalty payments after the five-year date.  During the case, the inventor admitted in deposition that a variant of the invention was sold nearly five years before he filed his patent application, which might be prior art that invalidates the patent.

TAS filed a second lawsuit (TAS II) in diversity for breach of contract for failure to pay per-unit royalties.   Deposition testimony from the inventor again revealed the same potential prior art.  After this deposition, Cummins sought to amend its Answer to include patent-based affirmative defenses and counterclaims related to the prior sales.  The district court denied leave to amend, finding the patent claims barred by res judicata.

The Instant Action (TAS III).  Cummins then filed the instant lawsuit (TAS III) seeking (i) to dismiss TAS II, (ii) to hold the patents invalid and unenforceable, and (iii) to hold the license agreement void for patent misuse.  The district court  ruled that Cummins’ invalidity/unenforceability claims were barred by res judicata.

This Appeal.  On appeal, Cummins raised three arguments to avoid res judicata.

First, Cummins argued that there was no case or controversy regarding patent infringement in TAS Ibecause Cummins had kept paying royalties to TAS, so there was not any declaratory judgment subject matter jurisdiction.  Absent subject matter jurisdiction in TAS I over a patent infringement claims, there could be no preclusive effect from TAS I.  The Court summarily dispensed with this argument for two reasons.  First, continued royalty payments do not render a dispute nonjusticiable.  Second, regardless of any declaratory judgment counterclaim, Cummins could have raised its patent invalidity claims as a defense to TAS’s contract claims—no patent, no basis for contract.

Second, Cummins argued that res judicata did not apply because the instant action was not based on the same transactional facts as TAS I and TAS II.  The Court applied Illinois res judicata law that bars a second action if there has been an earlier final judgment on the merits in a suit between the same parties or their privies involving the same cause of action.  Under Illinois law, whether causes of action are the same is based on the transactional test from the Restatement (Second) of Judgments § 24 (the same test adopted under federal law by almost all Circuits, including the Federal Circuit).  The Court stated that separate claims are the same cause of action if they arise from a single group of operative facts.  The Court ruled that contract validity was an implicit operative fact inTAS I and that a successful claim by Cummins of patent invalidity, unenforceability, or misuse would have led to contract invalidity, a complete defense in TAS I.  Res judicata barred this instant case (TAS III), because the bar extends to what was decided or could have been decided in an earlier suit (TAS I).  The potential that a  judgment inTAS III could nullify the TAS I judgment also favored res judicata.

Third, Cummins argued that it was entitled to the declaratory judgment or misrepresentation exceptions from res judicata.  The Court ruled that the declaratory judgment exception did not exist under Illinois law and applies only when declaratory judgment is the only relief sought, but TAS sought damages in TAS I.   Further, Cummins was not entitled to the misrepresentation exception because Cummins was aware of the basis for the invalidity and unenforceability claims  during the course of the TAS I discovery.  For the misrepresentation exception to apply, the supposed misrepresentation must have caused Cummins’ failure to raise patent invalidity inTAS I.  But the alleged misrepresentation was the contractual representation by TAS that it knew of no basis for any legal action against it based on its patents.  While TAS was aware that potentially invalidating prior sales had occurred, rendering its contractual statement potentially misleading, Cummins was equally aware of the prior sales during negotiations.  The court concluded that TAS’s contractual representation therefore could not have misled Cummins into failing to press its patent invalidity claims in TAS I.