Broad Covenant Not To Sue Does Away With Invalidity Counterclaims In Trademark Litigation

In Already LLC. v. Nike, Inc. the Supreme Court recently held that a broad covenant not to sue hinders defendant’s counterclaims of trademark invalidity. Therefore, by choosing to proffer a covenant not to sue, Nike eliminated any legal controversy between the parties such that Already was not able to raise counterclaims of invalidity and cancellation of Nike’s trademark. This trademark case grapples with the “case or controversy” requirement under Article III, Section 2, Clause 1 of the United States Constitution, as well as the Declaratory Judgment Act. It also gives trademark holders pointers for drafting effective covenants that can shield them from defendants’ challenges to the trademark validity and potential loss of the mark. However, this may not be an entirely helpful litigation strategy in every context, and trademark holders should proceed with caution if they choose to take advantage of such covenants as they may give rise to naked licensing and abandonment of the trademark.

Background of the Dispute

Nike brought suit against Already in the Southern District Court of New York in 2009, alleging that Already’s sneakers named “Sugar” and “Soulja Boy” infringed and diluted of Nike’s trademark on its Air Force 1 sneakers (the “905 registration”). Already counterclaimed, seeking to invalidate and cancel Nike’s trademark.

In 2010, Nike proferred a “covenant not to sue” to Already. The covenant provided that since Already’s actions no longer infringed or diluted Nike’s trademark at a level sufficient to warrant the substantial time and expense of continued litigation, Nike would conditionally and irrevocably agrees to refrain from making any claim(s) or demand(s), or from commencing, causing, or permitting to be prosecuted any action in law or equity against Already or other related entities.

In light of this covenant, Nike petitioned the District Court to dismiss its lawsuit as well as Already’s counterclaims. Although Already consented to dismissal of the lawsuit with prejudice, it did not, however, consent to the dismissal of its counterclaims.

The District Court subsequently found that it no longer had any subject matter jurisdiction over the defendant’s counterclaims, and was unable to grant declaratory relief to Already since an “actual controversy” no longer existed between the parties. The court applied Medimmune v. Genentech, which originated from a patent dispute regarding declaratory judgments and replaced the reasonable apprehension of suit test with a totality of circumstances test to determine the existence of a case or controversy. The totality of circumstances test requires courts to examine the language of the covenant, scope of the covenant and evidence of continuing infringing activity on the part of the defendant. After Medimmune, defendants can no longer bring declaratory actions against trademark or patent holder plaintiffs based solely on the concern that such plaintiffs may bring infringement actions against them.

Because of the covenant, Already was unable to demonstrate that a substantial controversy existed between the parties to warrant declaratory judgment. The covenant was broad enough to include future sales of Already’s current footwear designs, including the Sugar and Soulja Boy shoes, as well as to future sales of “colorable imitations” of such shoes. Therefore, this eliminated any controversy between the parties, since Already would not be subject to suit now or in the future.

The court also rejected Already’s argument that cancellation of the 905 registration would keep the controversy alive, since the covenant had already removed the court’s ability to have jurisdiction over the matter in the first place. Despite the inefficiency, the court suggested that Already take the cancellation claim to the USPTO instead. Even though Already submitted affidavits from investors and argued that potential investors could refrain from investing into a company that could be plagued by litigation from Nike, this hypothetical scenario did not rise to the level of a legal and concrete controversy between the parties.

On appeal, the Second Circuit affirmed the District Court’s holding. It affirmed that the application of the Medimmune test in trademark cases, since the requirements for declaratory relief are sufficiently similar to patent cases. Both the trial and appeals court agreed that Already did not come forth with sufficient evidence of continuing infringing activity, and both underscored the breadth of the covenant covering Already’s present and future sales. However, the Second Circuit noted that at oral argument Nike did not completely foreclose future litigation against Already. If, for example, Already were to market and sell counterfeit sneakers (looking like exact replicas of Nike’s Air Force 1 Shoes, possibly also bearing Nike’s Swoosh logo) that are different from “colorable imitations” of Already’s current products, Nike could potentially still litigate against Already. The Second Circuit also decided to abide by the Federal Circuit and Third Circuit and concluded that action for cancellation of the mark failed to create an independent basis for subject matter jurisdiction.

The Supreme Court unanimously affirmed the Second Circuit’s holding, and added another layer of complexity to the case, the voluntary cessation doctrine. The lower courts did not consider this doctrine. This doctrine essentially asks whether the allegedly wrongful behavior could reasonably be expected to recur. The allegedly wrongful behavior alluded to in this question is not that of Already’s, as one would normally associate with defendants. Instead, it refers to action by Nike, namely its trademark enforcement litigation against Already. The Supreme Court concluded that Nike demonstrated the “formidable burden” to overcome application of this doctrine by issuing a broad, unconditional and irrevocable covenant not to make any claim or demand form Already, its distributors and customers.

The Not-So-Hidden Risk of Covenant Not to Sue for Trademark Holders

Importantly, the majority opinion in the Supreme Court decision acknowledged that covenants not to sue could pose a risk for trademark holders, since uncontrolled and ‘naked’ licensing can result in such a loss of significance of a trademark. “Naked licensing” occurs when the trademark holder fails to place appropriate quality controls on a licensee’s use of the trademark. The covenant not to sue essentially gives a license to Already to manufacture and market products like Sugar and Soulja Boy that possibly infringe on the Air Force 1 sneaker without requiring Already to enter into a proper written license agreement that would have express restrictions on quality control. Potentially, this could allow future defendants targeted by Nike for infringing the trademark to make a successful argument that Nike abandoned its trademark by failing to exercise quality control over the mark. If successful, this would open up the trademark for all to use, potentially pushing Nike out of the market and resulting in the loss of a valuable business asset.

Justice Kennedy’s concurrence further cautions trademark holders that they should not interpret this decision as giving them an automatic way out of a lawsuit without being subject to claims of trademark invalidity. Neither the majority nor the concurrence bought Already’s David vs. Goliath argument, namely that policy reasons should shield small companies like Already from a giant corporation like Nike’s whimsical use of trademark enforcement. However, the concurrence did recognize that trademark holders could employ this litigation strategy to push a competitor out of the market and interfere with their business plans. The concurrence saw the “formidable burden” on the trademark holder to ensure that the defendant will not face any more lawsuits as providing a checks and balances against such aggressive and harmful business maneuvers between competitors, big and small alike.

Tal S. Benschar, David Kalow, and Milton Springut authored an informative article about this case, titled “Covenant Not to Sue: A Super Sack or Just A Wet Paper Bag?”  before the Supreme Court issued the decision. They argue that while the premise for rejecting invalidity claims in the presence of a covenant not to sue was borrowed from patent law, it should not be imported directly into trademark law. From the patent holder’s perspective, if the patent is invalidated, it would bring a tremendous loss to years of research and development, patent prosecution, and attorney’s fees that go into obtaining a patent in the first place. Thus, patent holders have a huge incentive to create covenants not to sue in order to escape the blow of patent invalidity brought by defendants.

Even though trademark holders would rather not see their trademarks invalidated, as they engage in substantial marketing to maintain the trademark’s source-identifying function, the covenant not to sue can result in a failure to enforce trademark rights. Since trademark holders have to enforce their rights to maintain their trademark, they could lose the mark through “naked licensing” brought by a covenant not to sue. Thus, by trying to contractually shield themselves from a trademark invalidity counterclaim, mark holders may find themselves in a bigger mess by having no trademark to enforce at all. Trademark holders should thus carefully evaluate such bargains.