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The Federal Circuit Again Moves To Subject Damages In Patent Cases To Closer Scrutiny

1/13/2011 Articles

As damages awards in patent infringement cases have skyrocketed, courts have taken a more active role in scrutinizing the methodologies used by experts that lead to such large damages calculations.  For example, recent decisions have excluded expert opinions that have utilized royalty rates based on (1) existing licenses that did not bear any relation to the invention at issue (ResQNet.com v. Lansa Inc., 594 F.3d 860 (Fed. Cir. 2010)); (2) the total value of the product in which the patented invention is a component without evidence that the patented component was a basis for consumer demand for the product (Lucent Technologies, Inc. v. Gateway, Inc., 580 F.3d 1301 (Fed. Cir. 2009) and IP Innovation L.L.C. v. Red Hat, Inc., 705 F. Supp. 2d 687 (E.D. Tex. 2010)); and (3) the inclusion in the royalty base of products which do not incorporate the allegedly infringing invention (Cornell University v. Hewlett-Packard Co., 609 F. Supp. 2d 279 (N.D.N.Y. 2009)).

Continuing this trend with its decision in Uniloc USA, Inc. v. Microsoft Corp. (Jan. 4, 2011), the Federal Circuit began the New Year by forcefully rejecting the "25% rule of thumb" applied by many experts, and accepted by some courts, as a starting point for determining a reasonable royalty rate in patent cases.   

Background Facts and Proceedings

Uniloc sued Microsoft in the District of Rhode Island claiming Microsoft's Product Activation feature, which prevents copying in some versions of Word and Windows products, infringes a patent owned by Uniloc.  The jury rendered a verdict that the patent is valid and infringed and awarded Uniloc $388 million in damages.  Microsoft moved for judgment as a matter of law and for a new trial, as to which the district court upheld the jury's finding of validity, but granted the motions for a new trial on infringement and damages.  Both parties appealed.

The Federal Circuit's comprehensive opinion affirmed the district court's holding that Uniloc's patent is valid, but reinstated the jury's verdict of infringement.  The portion of the Court's decision that will probably have the greatest impact on patent litigants is its wholesale rejection of the methodology employed by Uniloc's expert in calculating damages.

The 25% Rule of Thumb in Reasonable Royalty Calculations

In most patent cases, damages are based on "a reasonable royalty for the use made of the invention by the infringer."  35 U.S.C. § 284.  To determine what might constitute a reasonable royalty in a given case, courts attempt to divine what kind of rate the parties would come up with if they conducted a successful "hypothetical negotiation" before the initiation of litigation.  Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538 (Fed. Cir. 1995).  Courts construct this hypothetical negotiation by considering some 15 different factors that were first articulated by the court in Georgia-Pacific Corp. v. United States Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970). 

The 25% rule of thumb was developed by damages experts for plaintiffs as a tool to use as a starting point in the hypothetical negotiation.  The premise of the rule is that a licensee would be willing to pay a patent owner 25% of its expected profits from the "isolated value" of the component that uses the patented invention in a product.  The licensee would retain 75% of the profits to account for the other things that go into generating revenue from a successful product - such as, integration of the component into the product, manufacturing and marketing.

As applied by Uniloc's expert in its case against Microsoft, the 25% rule works as follows:  Based on evidence obtained from Microsoft, the expert took the "isolated value" of the Product Activation feature to be $10 per product.  Next, he assumed that 25% of that value is attributable to the patented technology, which would result in a base royalty rate of $2.50 per unit of software licensed.  The expert then looked at the Georgia-Pacific factors to determine whether the circumstances called for increasing or decreasing that base rate, and ultimately concluded that the net effect of those factors was to leave the rate at $2.50  He then multiplied the rate by the number of units licensed and arrived at a damages number of $565 million, which the jury reduced to $388 million.

The Federal Circuit's Rejection of the 25% Rule of Thumb

The Federal Circuit began its discussion of the propriety of the 25% rule by noting that it had never directly ruled on the issue, but "has passively tolerated its use where its acceptability has not been the focus of the case."  The Court also recognized that the rule has attained "widespread acceptance" among some experts and courts.  It nevertheless concluded, as a matter of law, that "the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation."

The foundation for the Federal Circuit's decision is a consistent body of Federal law that holds that a damages expert's use of a general theory to compute damages must tie the general theory to the particular facts of the case.  The Court drew a parallel with the recent rulings in ResQNet and other cases in which courts excluded from consideration of a reasonable royalty rate rates in licenses unrelated to the technology at issue:

The meaning of these cases is clear:   there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case.  The 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement.  The rule does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party.  Relying on the 25 percent rule of thumb in a reasonable royalty calculation is far more unreliable and irrelevant than reliance on parties' unrelated licenses . . . .

The Court brushed aside Uniloc's argument that its expert's calculation was appropriate because it only used the 25% rule of thumb as a starting point for the application of the Georgia-Pacific factors:  "Beginning from a fundamentally flawed premise and adjusting it based on legitimate considerations specific to the facts of the case nevertheless results in a fundamentally flawed conclusion."  That being the case, the Court affirmed the district court's order granting Microsoft a new trial on damages.

Uniloc's Improper Use of the "Entire Market Rule"

At trial, as a "check" on his final number Uniloc's expert did an "entire market" analysis.  He divided the $565 million damages number he calculated using the 25% rule of thumb by Microsoft's total revenue from the applicable Word and Windows products - $19.28 billion -  which yielded an entire market value rate of 2.9%.  The expert thus concluded that his $565 million amount was reasonable because it represented "only" 2.9% of the entire market value of the Word and Windows products.

The Federal Circuit rejected this application of the entire market rule - as it had previously rejected the rule in the Lucent case - even as simply a check on the expert's calculation using the 25% rule of thumb.  The Court agreed with the trial court's observation, in granting Microsoft's motion for a new trial, that Uniloc had not presented any evidence that consumers purchased Word or Windows products because of the Product Activation feature.  Therefore, it was improper for Uniloc to use the entire market rule for any purpose.

Conclusion

The decision in Uniloc marks another step in the Federal Circuit's efforts to rein in the opinions of damages experts in patent cases.  By unambiguously disallowing the 25% rule of thumb, as a matter of law, in determining a reasonable royalty, the Court reiterated recent holdings that emphasize the importance of tying evidence used to calculate a royalty rate to the particular circumstances involved in the case.  It also reaffirmed the inapplicability of the entire market rule in the absence of evidence that the patented invention drives consumer demand for the allegedly infringing product.  The Court's clear message:  damage calculations must be based not only on an accepted methodology, but also on facts that relate to the specific case.

This information is provided as a service to our clients and friends. It should be viewed only as an overview of the law, and not as a substitute for legal consultation.

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