After nearly 20 years of controversy and litigation, the question of first sale and patent exhaustion was ruled on by the United States Supreme Court as it held that "the authorized sale of a patented product, anywhere in the world, exhausts the patent holder's rights in that product." The Supreme Court reversed the Federal Circuit on domestic exhaustion (8-0) and international (7-1).
Quoting Professor Sarah R. Wasserman Rajec:
"The Court overturned Federal Circuit case law holding that post-sale restrictions and foreign sales preserve a U.S. patent-holder’s right to sue for infringement. As a result, Impression Products was deemed not liable for patent infringement when it bought used Lexmark toner cartridges abroad from lawful purchasers, refilled them, and then imported and sold them in the United States, nor did the post-sale restrictions Lexmark placed on its goods give rise to patent infringement liability."
First, what constitutes an authorized sale abroad?
Quoting Professor Sarah R. Wasserman Rajec, "An authorized sale is not the same as a lawful sale—it requires an entity capable of authorization in the United States, and requires this entity grants authorization in the foreign market."
This point may raise questions about whether companies will attempt to get around international exhaustion by structuring their businesses so that the U.S. patent holder does not authorize foreign sales.
For example, Lexmark U.S., the patent holder and wholly owned subsidiary of Ninestar, may choose not to "authorize" its parent's overseas sales of its patented technology. If this tactic were to be pursued, it could represent an opening for patent holders (such as Lexmark) to effectively "opt-out" of international exhaustion.
Of course, such action would most likely become the subject of legal challenges in the courts; after that, "authorized sale" may eventually be interpreted more broadly to include sales by related entities. However, it would take even more legal time and money to get to that point before the outcome would be finally decided.
For those hoping the Court's decision has provided a clear path forward on using cores sourced from overseas markets, that may not necessarily be so. It's possible that years of legal uncertainty could still lie ahead.
Could there be an impact on pricing strategies in different global markets?
As explained in the same excellent article by Professor Sarah R. Wasserman Rajec, in the absence of international patent exhaustion, patent holders can set different pricing strategies according to the purchasing power of the market the product is being sold. A lower-income geographic market may typically be able to purchase the product less expensively than a higher-income geographic market. It is clear Lexmark, and other imaging supplies OEMs have long implemented pricing strategies of this nature.
The conventional argument is that under an international exhaustion regime, patent holders will restrict sales to selected markets or market the product at a globally uniform price. However, in the case of ink and toner cartridges, many of the products are differentiated for specific markets through technology (chips). It's, therefore, unlikely the Court's decision will impact the current global pricing strategies for ink and toner.
The Grey Market
Regionalized pricing can, and has, led to development of "grey" markets.
Printer 123 sold (for example) into the Brazil market requires toner cartridge A to be installed for printing purposes. When printer 123 is also sold into other global markets such as the United States, Cartridge A, may be regionalized for the Brazil market and sell for $50 whereas Cartridge A, regionalized for the U.S. market, may sell for $100.
In such circumstances, it doesn't take long for an entrepreneur in Brazil to realize the possibilities for arbitrage. Purchasing as much as possible in Brazil for $50 and exporting to the United States for resale at $100 is likely to more than cover the costs of transportation and distribution, besides leaving a handy profit left over!
However, there are significant obstacles to executing this strategy:
Firstly, the OEM may package the product differently to make it unsuitable for the market the entrepreneur wishes to remarket it in. Repackaging the product for the target market is illegal as the marketer would not be authorized to obtain the style of locally branded OEM packaging necessary to get the target selling price.
Secondly, the planned sale of a product for arbitrage purposes may be determined to be unauthorized by the patent owner, and therefore, the patent rights would not be exhausted. This may place the burden of a patent infringement claim on the reseller of the "grey" product in the U.S. market.
Thirdly, all OEMs most likely have significant control over the distributors of their products in the different geographical markets. A distributor may be tempted to participate in arbitrage. Still, it would be foolish to imagine that the OEM wouldn't eventually become aware of such activities that would probably result in a termination of the relationship. The arbitrage could only be sustained if the OEM looked the other way.
Bottom line, I don't see how the Court's decision will impact how and why grey markets develop.
US Market Implications and Probate
What does the ruling mean so far as the Prebate program is concerned?
Many may assume that Prebate is now automatically dead and buried, gone forever, and the first major intellectual property victory for the aftermarket in over twenty years of industry litigation. However, this may not necessarily be the case.
Although the Lexmark ruling strikes a decisive blow against post-sale restrictions on products by negating the threat of infringement to enforce those restrictions, it does not eliminate them. In fact, to the contrary, the Court is clear Lexmark, as the patent owner, may continue to impose contractual restrictions on its cartridges. However, those restrictions now become contract law, not patent law.
For example, if Lexmark continues to sell a Prebate cartridge (at a lower price on the condition it's returned to Lexmark when empty) and the customer does not honor that agreement instead sending the empty cartridge to an aftermarket remanufacturer then, that customer may be opening itself up to the threat of litigation from Lexmark for failing to comply with the license terms (contract) agreed at the time of the first sale.
What will happen to the pricing differential between Prebate and Non-Prebate?
Surely Lexmark must abandon the two-tier pricing strategy on new-build Lexmark branded cartridges. Sure, they could continue to sell a private product. Still, the aftermarket remanufacturers who target recovery of the cores will do so with impunity knowing they are safe from patent litigation.
Should the aftermarket successfully recover Prebate cartridges for remanufacturing purposes, Lexmark's only remedy would be to sue their customers for breach of contract. However, imagining they would undertake such a drastic course of action is difficult. Not only would the brand be irreparably damaged, but they would also find themselves mired in multiple lawsuits initiated against their customers. Ultimately, that would be a battle they would surely lose, if not legally, then certainly commercially!
Quietly dropping the Prebate program and the dual pricing structure appears to be a logical path for Lexmark. In conjunction with their increased core recovery efforts, doing so would appear to be their most effective strategy for limiting aftermarket attempts to win market share.
Let's face it, in a time frame covering more than 30 years; HP has given up maybe 30% of its monochrome market and 10% of its color market without implementing a "Prebate" style strategy. There should be no reason to anticipate the Supreme Court decision will significantly impact Lexmark's market share unless they make substantial missteps adjusting to the new market conditions.
What is clear so far as the United States market is concerned?
Any OEM cartridges sold into the U.S. market under the Lexmark Prebate program and subsequently obtained by a remanufacturer to rebuild and resell in the U.S. may now take place without fear of a patent infringement action by Lexmark. Any remanufacturer of Lexmark cartridges with a stockpile of probate cores may use them without fear of litigation.
However, after nearly 20 years of private / non-probate conditions, customer habits have long been established. Lexmark's infrastructure for recovery of their cores is firmly in place and, combined with many remanufacturers having abandoned the Lexmark segment of the market because of the prior litigation risks; it will be necessary for the aftermarket to disrupt the existing, "OEM biased" core flow before it can successfully increase market share.
What may the implications be for Ninestar?
A lower core cost could help the aftermarket improve its value proposition. This could be leveraged to increase demand from prospective customers purchasing OEM brand cartridges from Lexmark. Increased core supply has the potential to fulfill the increase in demand.
Ninestar has to try to act in the best interests of its OEM business (Lexmark) as well as its aftermarket business, and, at times, this is likely to prove to be a tricky balancing act. Recent news that prices for certain aftermarket "Lexmark compatible" chips they provide to the remanufacturing industry are increasing by 200% or more appears to be a calculated decision to offset potential core cost reductions.
Ninestar is sending a clear message to the aftermarket that, should a market share threat emerge, they have a powerful weapon to deal with it.
Of course, this will be a highly unpopular move, but like it or not, it's probably an innovative strategic action from their perspective. Any aftermarket companies thinking about investing to increase recovery of Lexmark cores will indeed have second thoughts if chip price increases from the primary aftermarket supplier may nullify that effort.
What will happen to the Lexmark "Compliant" Remanufactured Cartridge Program?
Lexmark is already recovering cores, and that core flow is not likely to be disrupted by the Supreme Court decision - at least not in the short term. They have two choices: to continue with the compliant program or terminate it and start destroying cores to prevent them from getting into the hands of the aftermarket remanufacturers.
I don't expect them to terminate the program. However, subject to their independent sources for Lexmark cartridge cores, I hope the compliant partners exit the Lexmark program as quickly as possible to establish more control and improve their margins.
There is logic for Ninestar to keep the concept of the "compliant" program in place, as it provides Lexmark with the option of offering a lower-priced alternative. This may offset some of the competitive threats from the aftermarket while helping maintain the existing price structure for their Lexmark branded new-build cartridges.
Although not directly related to the Court's decision, it's logical to assume that Ninestar, as a remanufacturer of laser cartridges, will bring 100% of the "compliant" remanufacturing activity into their Chinese facilities for control and cost purposes. Combined with the likelihood of the complaint partners' desire to exit, this will surely end the current aftermarket "compliant" partnerships.
All the other OEMs were closely monitoring the outcome of this case - what, if any, impact does it have on them?
I don't think the decision will impact the go-forward strategies of the other OEMs. It's possible that, had the Federal Circuit decision been upheld. Emboldened by the Lexmark victory, others would have implemented similar tactics to make life even more difficult for their aftermarket competitors. However, given that no one but Lexmark had implemented the Prebate strategy, there's nothing for other OEMs to unwind and nothing to implement beyond what they're already doing.
So, what difference will all this make?
There are many moving parts, so to help understand them, I've embedded a calculator below to enable readers to simulate different scenarios. The default settings in the first column are my educated guess of where the market is, and the second column is a projection for a plan. Everyone is likely to have their own opinion on what the market looks like today and what it may look like in the future, so feel free to experiment by changing the variables in the green-colored cells.
Click on row titles in the first column for explanation tips and modify any cell in green to experiment with different scenarios—key results are highlighted in orange cells.
Some legal uncertainty remains about the matter of international exhaustion. We will watch with interest the developments over the next few months.
It's difficult to see how either Ninestar/Lexmark or the aftermarket will be a significant winner or loser in the post-Supreme Court ruling environment. Resellers hoping this highly anticipated ruling may lead to an office products growth opportunity may be disappointed.
So long as Ninestar executes the relocation of its "compliant" program to its factories, captures the extra margin dollars, and effectively manages the future role of its "remanufactured/compliant" product in the market, the net impact on its margin dollars is likely to be negligible.
There will likely be pocket shifts in the aftermarket. The big winners stand to be those with independent access to Lexmark cores. The big losers stand to be the "compliant" partners who have relied on Lexmark for their core flow and who lack independent sources of supply. Assuming Ninestar relocates production of the "compliant" cartridges to China, the core supply to the partners will be terminated.
In the default model (shown in the calculator), the aftermarket has to recover nearly 120,000 cartridges yet will achieve no overall net gain in revenue or margin dollars. This is explained by the pocket shift I just mentioned, as the "compliant" partners lose their core flow from Lexmark, and the probate cores that couldn't be used in the past now can.
Ninestar will likely lose some aggregated volumes after accounting for the current total of Lexmark's new build and compliant remanufactured cartridges. However, by capturing more margin dollars on the balance of the compliant product they bring in-house, I expect they'll end up with similar revenues and gross margins to those they have today.