Recharger Magazine

A Decade Later: Prebate is Out...And That Isn't All

• By Tricia Judge
• Jun 01, 2009

In 1997, when prebate was introduced, the remanufacturing industry in North America was made up of 6,000 remanufacturing companies. Most of these companies were small and run by aggressive, fiercely-independent entrepreneurs. A company that remanufactured more than 20,000 cartridges per month was unique.

However, cartridge remanufacturing was mainstream and had become reasonably scientific and high-tech. Remanufactured cartridges were now being built that could perform well against an OEM version, and they provided a cost-saving alternative. The sale of such cartridges had cut deeply into the market share of cartridges sold by the OEMs.

In other ways, the industry was still very young. There were regional associations of remanufacturers, most only about a year old, whose members were learning to come together as peers instead of competitors. This process was an uneasy one — akin to herding cats.

The legal landscape looked very different too. The right to repair, or remanufacture, cartridges had only recently been confirmed by courts in the Nu-Kote and Repeat-O-Type cases. While victorious, the two aftermarket companies had paid a high price in the litigation.

Patents were freely granted on the most obvious or minor changes to cartridges by the OEMs. The heretofore unshaken principle of patent exhaustion came under fire. In the 1992 decision in Mallinckrodt v Medipart, the court validated a single-use restriction on some medical equipment. This meant that all patent rights might not be exhausted on the first sale of an item.

It was against this backdrop that Lexmark introduced its prebate program. With much fanfare, it heralded the prebate program as great for consumers. And it threatened to sue any third-party remanufacturer that interfered with the so-called "contract" that the up-front discount (the prebate) created.

The prebate program was an admirable effort to take advantage of the prevailing laws and legal atmosphere. Lexmark claimed that its patents were the underpinning of the contractual obligation for single use as well, just as Mallinckrodt had claimed. And those patents were the reason it could reach out and sue third parties, like remanufacturers, not just the customers to whom it had sold the cartridge subject to the prebate terms.

This was a novel and ingenious approach. It also smacked of being an unlawful tying arrangement. So Lexmark made sure that an alternative cartridge without restrictions was also available, and then did everything in its power to make sure that those unrestricted cartridges were unavailable.

The industry immediately rose up in response. In April 1998, on Earth Day, New York Assemblyman Joe Morelle convened a hearing and grilled the Lexmark representative about the prebate program and its deleterious effects on both competition and the environment. He called the program “disingenuous,” and began his own crusade to pass legislation in New York to stop the sale of prebate-restricted products to the state of New York.

From New York to South Dakota, from California to Connecticut, and in every corner of Texas, remanufacturers and vendors took days off to visit with legislators and lawyers. Funds were raised and lobbyists were hired. Laws were drafted, lobbied for and passed in amazing numbers.

By 2001, the laws were implemented and purchasing rules changed in California, New York, Connecticut, Massachusetts, North Carolina, Texas and many other places. The stigma attached to prebate became so great that Lexmark had to change its name to the “return” program.

As late as 2004, laws were being enacted around the globe. That year, Toronto passed pro-remanufacturing legislation. And as recently as early May, state, federal and municipal agencies have been working with the International Imaging Technology Council (Int’l ITC) to implement the laws.

Lexmark had to turn to a more receptive venue than the court of public opinion. And it found that venue in the courts.

A single-use restriction was tested early on in the 1999 case of Fuji v Jazz Photo. Fuji manufactured disposable, “single-use” cameras. Jazz Photo collected these cameras and remanufactured them. Fuji contended that the single-use restrictions were binding, but the federal circuit court disagreed. It found that there was no valid contract between the consumer and Fuji, because there was no “meeting of the minds” as required by contract law. The court also decided that the patent rights were exhausted on first sale, so Fuji couldn’t prevail.

The court went further however, and decided that the patent rights were not exhausted on cameras first sold outside of the United States. This created a loophole that other OEMs would later exploit.

The case looked like a precedent that could be used against Lexmark. Undaunted, Lexmark continued to sell its restricted cartridges.

In September 2001, the Arizona Cartridge Remanufacturers Association (ACRA) brought a case against Lexmark. ACRA’s position was that the statement that Lexmark makes that it is “licensing” its cartridges is misleading, deceptive and false. ACRA argued that Lexmark has placed post-sale obligations on the purchasers either through the license of its patent rights or through a contractual agreement between the user and Lexmark.

They claimed that Lexmark’s argument in both instances should fail. In the case of the patent protection, Lexmark had conceded in its pleadings that it sold the cartridges. ACRA therefore argued that once the cartridge is sold, the patent rights are exhausted.

The second facet of ACRA’s position was to argue that the prebate provisions were a contract, but given the numerous intermediaries between the seller (Lexmark) and the ultimate buyer (the user), there could be no privity of contract, or validity to the contract’s requirements because the buyer doesn’t know what the conditions are when he/she bought the cartridge from an intermediary.

On September 29, 2003, Federal Judge Saundra Armstrong ruled in favor of Lexmark’s motion for summary judgment in the Arizona association lawsuit. The judge also denied ACRA’s motion for summary judgment on the issue of whether a cartridge is sold (rather than licensed). This decision validated prebate and created an unfavorable first precedent in the prebate matter.

The case fared no better on appeal in 2005. The California appellate court, relying heavily on the Mallinkcrodt decision, affirmed the lower court’s ruling.

Lexmark v Static Control, filed in December 2002

When Lexmark sued Static Control over its chips, it did not sue under patent or contract law. It sued using copyright law and the Digital Millennium Copyright Act. It waited until just after the DMCA became law to bring the suit.

On New Year’s Eve 2002, Lexmark filed the suit over Static’s Smartek chip for use in the Lexmark T520/522 and T620/622 printers. In the lawsuit, filed in Lexington, Ky., Lexmark asked the court for immediate injunctive relief that would stop Static Control from selling these chips.

The complaint alleged that Static Control’s technology infringes Lexmark’s copyrights for software that controls the “handshake” between the printer and the cartridge. The siren song that the printer and cartridge sing to one another is protected, according to Lexmark, even though it is but a line of code (and one that exists only to exclude all others from joining in for a chorus).

It also alleges that Static Control’s Smartek chips violate the DMCA, which was enacted by Congress in 1998 to protect recorded works, such as music and films, from being copied and pirated on the Internet.

The law was never intended to be applied in circumstances like these. And many critic spoke harshly of its use in the lawsuit. A reporter from the Boston Globe wrote an article entitled “Time to rethink digital copyright act,” in which he reported: "So a law designed to keep hackers from distributing stolen digital merchandise is now a law against using a different brand of toner cartridges. Because the printer contains Lexmark code, only Lexmark cartridges can access it, and using off-brand replacements is now a form of hacking. Lovely as a snake, isn’t it?"

Regardless, Lexmark won the first round. They successfully obtained a preliminary injunction against Static Control in early 2003.

That victory would be short-lived. The following year, the Sixth Circuit U.S. Court of Appeals overturned that decision and vacated the preliminary injunction against the sale of Smartek chips.

The 32-page decision included a scathing rebuke of Lexmark’s monopolistic misuse of the DMCA. “We should make clear that in the future companies like Lexmark cannot use the DMCA in conjunction with copyright law to create monopolies of manufactured goods for themselves just by tweaking the facts of this case … .”

As originally filed, the appellate decision would have completely decimated Lexmark’s entire case since it relied solely on copyright law and the DMCA. However, the case had evolved since its original filings. In February of 2003, Static Control countered with a $100-million antitrust lawsuit against Lexmark. The counterclaim included causes of action for violations of the Sherman Act (both restraint of trade and monopolization), patent invalidity and non-infringement, false advertising, product libel, unfair competition, and conspiracy between Lexmark and Dallas Semiconductor (the manufacturer of the Lexmark chips, who was by then no longer a part of the case).

Only days before the appellate court’s ruling, Lexmark added new parties and counterclaims to the lawsuit, perhaps in anticipation of the appellate court decision. The new claims were for breach of — or tortious interference with — prebate contract provisions. So now the validity of prebate was a central issue of the case. And a half-dozen remanufacturers, and their issues, were also party of the lawsuit. But not for long.

June 2007 — The jury weighs in

In the ensuing years, the case moved forward towards a trial. Many of the remanufacturers settled with Lexmark; the terms of the settlements were not disclosed. In the end, it was once again Static Control and Lexmark. Both parties went to trial with a mixed bag of pretrial decisions from Judge Gregory F. Van Tatenhove. He had invalidated a couple of the patents that Lexmark laid as the foundation for the prebate restrictions. However, he deemed others valid and infringed upon by Static Control or the remanufacturers (who settled and were no longer in the case). He also deemed the prebate terms to be a valid contract.

Chief among the issues that went to the jury was this: Although Static Control infringed one of Lexmark’s patents, was that infringement excused by any of the defenses Static raised? The jury overwhelmingly disapproved of Lexmark’s business tactics and accepted Static Control's defenses. It was now up to the judge to take the jury’s findings and craft his decision.

Enter Quanta — and a new era

While the Static Control case was pending, the U.S. Supreme Court had agreed to review a case involving the doctrine of “patent exhaustion.” Quanta Computer Inc. v LG Electronics Inc. involved five patents originally obtained by Wang Laboratories relating to systems and methods for receiving and transmitting data in computer systems. The patent owner, now LG Electronics, licensed the patents to Intel for its own use, but the license contained a restriction stating that Intel’s customers, chiefly computer manufacturers, were not licensed to resell Intel components (chips and chipsets) with non-Intel products or components (motherboards, computer systems, etc.). Several computer makers, including Quanta, incorporated the Intel components in non-Intel computer systems and LG Electronics sued.

The question presented to the Supreme Court was whether the patent exhaustion could be overridden by agreement between the parties or a unilateral “shrink-wrap” notice (e.g. the prebate restrictions), or whether the doctrine was absolute. The U.S. Solicitor General filed a brief in support of the computer makers, arguing that the Supreme Court’s most recent precedents on this issue (from the early part of the 20th century) hold that the patent exhaustion is absolute. The Solicitor General further argued that allowing patent owners to create exceptions on how downstream purchasers are permitted to use patented products is bad public policy.

In accepting the Quanta case for review, the U.S. Supreme Court signaled its readiness to change the course of things in the area of patent law. For the past 25 years, patent law was moving in the other direction — strengthening and expanding the rights of patent holders.

On June 9, 2008, the U.S. Supreme Court unanimously decided in favor of Quanta Computer (and therefore the aftermarket). The Supreme Court ruled that the patent holder’s rights to use its patents were exhausted by the first sale of its products. So terms attached to an agreement were unenforceable when patents were the underlying reason to support the validity of that agreement.

In ruling in Quanta’s favor, Justice Clarence Thomas upheld 150 years of legal precedents favoring patent exhaustion over a patent’s grant of monopoly.

Justice Thomas’ ruling left no doubt as to the unanimous opinion of the Supreme Court. He refuted each of LG’s efforts to carve out exceptions to the patent exhaustion doctrine. He even specifically thwarted LG’s efforts to impose the restrictions through third-party implied license agreements, akin to those used by Lexmark.

The Prebate Program is invalidated

Within days of the decision in Quanta, Static Control filed a motion for reconsideration of the court’s pretrial finding that the prebate contract was valid. After waiting with bated breath for nine months, the court ruled favorably on the motion and determined that “the Prebate Program is invalid under patent law.”

This is a big victory, and Static Control will now be looking to secure a finding that Lexmark’s activities have been anti-competitive. And both sides will no doubt appeal. But the rhetoric in this decision and other recent decisions has an impact that reaches beyond Lexmark’s prebate to other OEM activities, like those of Epson and even HP.

During the decade plus of prebate, the industry changed as well. The young regional associations came together to form the International Imaging Technology Council. The Int’l ITC has filed a brief in support of Static Control in its case, and provided testimony in early stages of the trial. The Int’l ITC also filed a brief in the Quanta case, and others before the U.S. Supreme Court. The Int’l ITC has also been involved in passing anti-prebate, pro-remanufacturing legislation as well as working to get the legislation properly implemented.

This article originally appeared in the June 2009 issue of Recharger.