United States: The Eastern District Of Texas Shifts Fees To Nonparty In Exceptional Case

The Eastern District of Texas is by far the most popular venue for patent litigation, and it has been for many years. Indeed, since 2010, between 25 and 30 percent of all patent cases have been filed in the district, according to online sources. The U.S. Supreme Court on March 27 heard oral argument in a case involving patent venue rules, and the debate included discussion about the Texas district's reputation as a patent-friendly jurisdiction. TC Heartland LLC v. Kraft Foods Grp. Brands LLC, No. 16-341, oral argument held (U.S. Mar. 27, 2017). Thus, it is fair to say that anything notable that has happened in a patent case over the past half decade has probably happened in Texas. And maybe this explains why, even in the wake of the Supreme Court's decision in Octane Fitness LLC v. Icon Health & Fitness Inc., 134 S. Ct. 1749 (2014), which lowered the fee-shifting standard for exceptional cases under Section 285 of the Patent Act, 35 U.S.C.A. § 285, to apply to those that simply stand out from others, Texas Eastern District has remained relatively conservative in awarding attorney fees. In a district that seemingly has seen it all, little stands out. But, occasionally, a case serves as a reminder that it has not seen everything.

Meanwhile, since Congress enacted the America Invents Act in 2012, reform-minded politicians have been trying to fix everything perceived as wrong with U.S. patent law. Legislators have introduced a litany of reform bills, from ambitious overhauls to surgical fixes, but none have made it through Congress. Two of the omnibus bills—the Innovation Act and the Patent Act—propose a variety of fixes aimed at curbing perceived abuses in the patent litigation system. In particular, they seek to rein in so-called nonpracticing entities, or NPEs. Both bills include mechanisms requiring patent plaintiffs to disclose information about their corporate structure and ability to satisfy any damages awards against them.

For instance, the Innovation Act would require plaintiffs to provide "initial disclosures," which must identify any assignee of the patent, any entity with the right to sublicense or enforce the patent, any entity known to have a financial interest in the patent, and the ultimate parent entity of the patent owner. Another provision would require plaintiffs to certify their ability to pay compensatory fees upon request of the defendant. Likewise, the Patent Act empowers defendants to force plaintiffs accused of being NPEs to certify that they have sufficient funds to pay an award of attorney fees. Alternatively, plaintiffs can show their primary business is something other than patent enforcement or licensing. They may also identify an interested party that may be held accountable for fees, to the extent one exists and does not renounce its interest. These provisions are intended to address concern among reformers that some NPEs have been recklessly filing unsubstantiated suits through underfunded shell companies to shield themselves from liability.

The Iris Connex Case

Enter Iris Connex LLC. NPE Iris Connex sued Dell Inc. and several other companies in the Eastern District of Texas on Nov. 30, 2015. The suit accused the defendants of infringing U.S. Patent No. 6,177,950, a single patent related to personal communication devices with camera features. As is typical in such cases, Dell moved to dismiss Iris Connex's complaint for failure to state a claim upon which relief could be granted. Atypically, however, after the parties briefed the motion, the court ordered early claim construction sua sponte. At the claim construction hearing, the court converted Dell's motion to dismiss into a motion for summary judgment, meaning that any dismissal of the case based on the motion would be "with prejudice" and thus bar future suits.

The court found that the decision hinged on a single issue: whether the claim term "an internal multi-position and multi-function reading head" could read onto multiple cameras with fixed heads. The court found it could not because "no reasonable juror could find the accused camera system—the dual fixed front-facing and rear-facing cameras employing a software toggle—as equivalent to the single multi-positional camera recited in the claims." Accordingly, the court dismissed Iris Connex's complaint against Dell with prejudice. Iris Connex LLC v. Acer Am. Corp., No. 15-cv-1909, 2016 WL 4596043 (E.D. Tex. Sept. 2, 2016). It also ordered the parties to conduct post-judgment discovery regarding Iris Connex's organizational structure.

Two weeks later, Dell moved the court to find the case exceptional under Section 285 and to sanction Iris Connex based on 28 U.S.C.A. § 1927 and the court's inherent authority. The motion focused on Iris Connex's allegedly unreasonable claim construction and infringement positions. After Dell filed its motion, the court ordered the parties to conduct post-judgment discovery regarding Iris Connex. Almost immediately, Iris Connex, which had previously represented that it was a Texas resident with no corporate owner, declared bankruptcy in California and simultaneously amended its corporate disclosure statement to reveal that it was owned by Q Patents Inc., a California corporation. Iris Connex filed both a suggestion of bankruptcy and an updated corporate disclosure statement Oct. 6, 2016. On Oct. 14, Iris Connex sought to stay the case to obtain substitute counsel. Four days later, its attorney, Craig Tadlock, sought to withdraw.

The court issued an order Oct. 25 denying Iris Connex's request for a stay and prohibiting Tadlock from withdrawing. However, on Nov. 2, the court decided to temporarily stay the cases anyway, which permitted Dell to complete post-judgment discovery regarding Iris Connex. After completing the discovery, Dell informed the court Nov. 28 that, in addition to Iris Connex, nonparties Q Patents, Q Patents owner Brian Yates, Tadlock and Nicolas Labbit, who was the manager and organizer of Iris Connex, were all interested parties. The court issued a show cause order Dec. 6 that lifted the stay and joined nonparties Q Patents, Yates, Tadlock and Labbit to the proceedings for the purpose of determining which, if any, should be subject to liability or sanctions.

At the court's request, Dell on Dec. 15 supplemented its motion for fees and sanctions, emphasizing the allegedly frivolous nature of Iris Connex's infringement and claim construction positions and also highlighting the false residency claims revealed by Iris Connex's attempted bankruptcy and Iris's nuisance-value settlement demands. Dell explained that Yates, through Q Patents, created deliberately underfunded shell entities like Iris Connex to collect funds from patent settlements and shield the principals from liability—the exact behavior the would-be patent reformers sought to regulate and eliminate. Indeed, according to Dell, Q Patents had orchestrated the filing of about 600 similar cases without ever disclosing the shell entity's ownership entity or principals to the court. Dell also revealed that Iris Connex's contingency fee arrangement with Tadlock included a "fee shifting" provision that triggered a higher fee if Rule 11 allegations or other liability claims were made against Iris Connex. This arrangement existed despite Tadlock's representation in his motion to withdraw that he had no obligation to represent Iris Connex in defending fee-shifting or Rule 11 allegations.

Given this conduct, Dell argued that fee awards under Section 285 should directly attach to any entity joined as a third party and to any corporate parents whose actions cause tortious harm to others. Thus, while piercing the corporate veil—and reaching nonparties indirectly—would be appropriate, it is not necessary for liability. Dell concluded that Iris Connex, Q Patents, Yates, Tadlock and Labbit should all be held liable, both directly and indirectly, under Section 285, and that all should be sanctioned.

Iris Connex and Cadre Respond

Tadlock on Jan. 4 filed a response to Dell's sanctions motion and the court's show cause order. He argued that his representation of Iris Connex was limited, saying he was engaged only to enforce patents and not to defend fee-shifting counterclaims that exposed him or his client to liability. Tadlock also claimed that he made no misrepresentation in the corporate disclosure statements because he understood at the time that Yates directly owned Iris Connex. He also said he correctly identified Q Patents as soon as he learned of its involvement. Additionally, Tadlock attempted to establish the sincerity and substance of his pre-suit investigation, arguing that "most telling [that the investigation was reasonable] to any attorney is that he was willing to invest his time and resources in pursuing the claim on a contingency fee basis." Tadlock also challenged the application of the exceptional case standard, pointing out that, even though reportedly 33 percent of patent cases are filed in the Eastern District of Texas, only one has been found exceptional. According to Tadlock, "Just as a matter of statistics, if there were a large number of exceptional cases, they would be found in this court."

On Jan. 5, Iris Connex, through new outside counsel, responded to Dell separately, arguing that its claim construction and infringement positions were sound and its litigation tactics were reasonable. Iris Connex's brief relitigated the claim construction issues that had already been argued and lost. It also attempted to justify their settlement demands with back-of-the napkin royalty calculations. Seeking to exculpate itself and its manager, Labbit, from culpability under Rule 11 in particular, Iris Connex claimed to have reasonably relied on Tadlock's strategic advice and provided input to support the presuit investigation. Iris Connex also fully shifted blame to Tadlock for the discrepancies in the corporate disclosure statements, declaring that it did not draft, review or approve the statements and that "[Tadlock] did not provide the... disclosure to Iris Connex before it was filed and did not discuss it with Labbit or Yates before filing."

In addition to its arguments that its infringement positions and litigation tactics were substantively justified, Iris Connex maintained that, as a matter of procedure, nonparties Q Patents, Yates and Labbit could not be directly liable for Dell's attorney fees under Section 285. It also said Rule 11 sanctions would be inappropriate because Dell never served a Rule 11 motion as required by Federal Rule of Civil Procedure 11(c)(2). Instead, Iris Connex argued that the court must first pierce the corporate veil to find nonparties liable. It further asserted that nonparties Q Patents, Yates and Labbit had a due process right to a trial on the veil-piercing issues.

Also on Jan. 5, the joined nonparties Q Patents Yates and Labbit filed their own separate response. They argued that they could not be subject to Rule 11 sanctions because they were not parties or attorneys of record at the time of the filing. They also argued that Iris Connex's litigation positions were reasonable. Further, they claimed that the court improperly joined them under Rule 19. According to the joined nonparties, joinder is proper only if: 

  • The existing parties cannot obtain relief without the joined parties.
  • The joined parties' interests are entwined with the litigation such that disposing of the action without the party would affect the party's interests or expose the party to multiple or inconsistent judgments.

Neither scenario, they said, applied in the case.

The Court's Exceptional Case Finding

After considering the arguments from all sides, on Jan. 25, the court issued a final judgment declaring the case "exceptional" and finding both Iris Connex and Yates directly liable under Section 285. The court ordered Iris Connex and Yates to jointly pay $355,000 of Dell's fees. That amount included fees incurred prior to the court's summary judgment order and in briefing Dell's Section 285 motion; a sanction of $152,000 against Yates, payable to Dell and issued pursuant to the court's inherent power; and a sanction against Tadlock of $25,000, payable to the court under Rule 11(b)(2). The court noted a number of troubling facts that led to its exceptional case finding, including:

  • Iris Connex's objectively "nonsensical" claim constructions.
  • Its inaccurate corporate disclosure statements and insufficient "initial disclosures," which obfuscated the "real but hidden party in interest."
  • The simultaneous bankruptcy filings of Iris Connex and Q Patents in California.
  • Iris Connex's low settlement demand in view of the broad patent covered
  • The fact that only one of the hundreds of suits filed by the "Yates collective" reached claim construction.
  • Yates's intentional decision to undercapitalize Iris Connex.
  • The general "sloppiness" that manifested in "disclosure errors, assignment issues, misuse use of form documents, conflicting sworn testimony, and a failure to properly communicate among Mr. Yates, Mr. Labbit, and Mr. Tadlock."

In view of these facts, the court found that "Iris Connex is the first level of two shell corporations which were intended to shield the real actor, Mr. Brian Yates, from personal liability... [and that] Mr. Yates and those in active concert with him exploited the corporate form to operate largely in secret and to insulate the true party in interest from the risk associated with dubious infringement suits—that risk being fee shifting under Section 285." The court emphasized that the "entire thrust of Section 285 is to deter," finding specifically that the court had "a real concern that this entity is so structured that it would effectively avoid any deterrence by the simple granting of the 285 motion, without more." The court also found that there were no due process concerns with finding Yates directly liable because he had ample opportunity to defend himself. It further noted that he made all the decisions that rendered the case exceptional in the first place. In fact, the court believed that the case "never would have been filed but for Mr. Yates' calculated assumption that he could insulate himself personally from the possible application of Section 285." Tadlock, for his part, escaped liability for his involvement in Yates' "shell corporations" scheme, but he was sanctioned for his frivolous claim construction positions. Finally, the court found that, while Labbit exercised "extremely poor judgment," sanctions against him were not warranted.

The New Test for Non-Party Liability in Exceptional Cases

Importantly, the court created a test for attaching direct liability to nonparties in exceptional cases, noting that "the statutory text, current case law, and statutory purpose behind the Patent Act and Section 285 all support assessing direct Section 285 liability against nonparties, so long as:

  • The actor is responsible for conduct that makes the case exceptional.
  • The actor is afforded due process.
  • It is equitable to do so.

In sum, to find nonparties directly liable, "[i]t is not necessary that [the nonparty] have controlled every substantive aspect of the litigation. It is only important that [its] conduct made this case exceptional." Similarly, the court found that nonparties could be sanctioned under its inherent authority if, as explained Helmac Products Corp. v. Roth (Plastics) Corp., 150 F.R.D. 563, 568 (E.D. Mich. 1993), "the nonparty has a substantial interest in the outcome of the litigation and substantially participates in the proceedings in which he interfered." Finally, recognizing other avenues for attaching liability to nonparties, the court noted that "the court, the other parties and the public have a right to know who is the real party in interest in any case.... [and Iris Connex's faulty disclosure statement] deprived Dell and the other defendants from pleading an alter ego theory of recovery or a direct liability theory against Mr. Yates early in the case."

Court's Solution Protects Litigants Against Underfunded, Sham Plaintiffs

The Iris Connex case shows that courts on the front lines of patent litigation, and particularly the Eastern District of Texas, are more adept at addressing potential systemic abuses than reform-minded politicians in Washington. Proponents of both the Innovation and Patent Acts sought to increase transparency in cases involving NPEs to address situations similar to that which arose in the Iris Connex case, though Congress could not agree on what measures to implement. But when faced with a "shell corporation" scheme centering around abuse of the corporate form to elude creditors and mislead the judiciary, as found by the court, the Eastern District of Texas created a solution—and set an example for other courts and patent litigants to follow. The test promulgated by the court sets out a roadmap for defendants in exceptional NPE cases to recover their fees from sham plaintiffs, regardless of the corporate minefields potentially fabricated by all-but hidden principals. If other courts follow the lead of the Eastern District of Texas, another problem identified by patent law reformers might be solved before they—and Congress—get around to fixing it.

Originally printed in Westlaw IP Journal on March 29, 2017.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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