Proving Patent Damages after Uniloc
By S. Christian Platt and Bob Chen – June 1, 2011
On January 4, 2011, the Federal Circuit affirmed a district court’s decision to grant a new damages trial for Microsoft in a patent infringement action, finding that the 25 percent rule of thumb used to calculate damages was “a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation.” Uniloc USA, Inc. v. Microsoft Corp., No. 03-CV-0440, slip op. (Fed. Cir. Jan. 4, 2011). In addition, the Federal Circuit found that the patent holder’s use of the entire market value rule to “check” its damages calculation was unwarranted, rejecting the proposition that the entire market value can be used as long as the royalty percentage is “low enough.” This decision has significant implications for patent infringement damages, marking the end of the debate over the blanket applicability of the 25 percent rule in reasonable royalty analyses and confirming that patentees must demonstrate that the patented feature forms the “basis for customer demand” or “substantially creates the value of the component parts” of a product to obtain damages based on the entire market value of the accused products.
The Federal Circuit’s rejection of the 25 percent rule will require patent holders to more rigorously tie evidence proving their damages to the parties, patents, and accused products at issue in their cases. The Uniloc decision is representative of the Federal Circuit’s recent decisions that have closely scrutinized the methodologies used by damages experts and demonstrates the court’s willingness to reverse speculatively large damage awards.
Assessing Patent Damages
In successful patent infringement suits, plaintiffs may be awarded damages in the form of lost profits, reasonable royalties or some combination of the two. To recover lost profits, the patent owner must establish a causal relationship between the act of infringement and its lost sales by showing with reasonable probability that “but for” the act of infringement, it would have made the infringer’s sale. The analytical framework set forth in Panduit Corp. v. Stahlin Brothers Fibre Works, Inc., 575 F.2d 1152, 1156 (6th Cir. 1978), comprises a commonly used but nonexclusive method by which the patent owner may meet the but-for standard. Under Panduit, a patentee must prove that there is a demand for the patented product, there is an absence of acceptable noninfringing substitutes, the plaintiff has the manufacturing and marketing capabilities to exploit demand, and the plaintiff’s economic damages can be reasonably quantified.
Where a plaintiff cannot meet the evidentiary burden required to recover lost profits or chooses not to seek lost profits, 35 U.S.C. § 284 expressly provides that a plaintiff should in no event recover “less than a reasonable royalty for the use made of the invention by the infringer.” Under Panduit, a reasonable royalty is the amount an infringing party would have been willing to pay the plaintiff to make and sell a patented article at a reasonable profit. A reasonable royalty may be paid in a lump sum, a running royalty, or various other combinations.
Calculating a Reasonable Royalty and the Hypothetical Negotiation
To determine a reasonable royalty, the law envisions a “hypothetical negotiation” between a willing patentee licenser and licensee conducted prior to the first instance of infringement. Underlying this negotiation is the presumption that the patents at issue are both valid and infringed. Under this legal fiction, the royalty the two parties would have reached is the reasonable royalty. Panduit, 575 F.2d at 1159.
To guide the trier of fact in determining a reasonable royalty under this framework, damages experts typically present evidence in accordance with the 15 factors outlined in Georgia-Pacific Corp. v. United States Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970). The factors roughly take into consideration the prior and current licensing rates for the patents in suit or comparable patents, the duration of the patents and the terms of the license, the commercial success and profitability of the patents, and the extent to which the infringer has made use of the patented invention.
The Entire Market Value Rule
In some cases, a patent holder may seek a reasonable royalty based on a running royalty that is calculated by multiplying a royalty rate by a royalty base. A royalty base may be defined as the gross revenue of the allegedly infringing product. The calculation is more complicated when the defendant sells a product that incorporates a patented invention as only one component in a complex device. Under such circumstances, plaintiffs should generally use a royalty base that comprises the value of the component alone rather than that of the final product.
A notable exception to this rule exists in cases where the entire market value rule applies. Under the entire market value rule, a patentee may assess damages based on the entire market of the accused product when the patented component creates the basis of consumer demand for that product or substantially creates value for the component parts. Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538, 1550 (Fed. Cir. 1995).
The 25 Percent Rule of Thumb
Damage calculations can be factually intensive and mathematically complex. To simplify such calculations, experts have at times made use of simpler rules of thumb. Of particular note is the 25 percent rule, formulated by economist Robert Goldscheider after an empirical study of 18 commercial licenses in the late 1950s. The rule allocates 25 percent of an infringer’s profit for use of the patented article to the patentee as a baseline royalty rate. Slip op. at 37. The remaining 75 percent is retained by the licensee, who incurs the most risk in developing, manufacturing, and marketing the infringing products for commercial use.
Using the 25 percent rule, the baseline 25 percent rate is then adjusted up or down as necessary after consideration of the relevant Georgia-Pacific factors. District courts have at times advocated for, criticized, or merely tolerated the use of the 25 percent rule. Prior to the Uniloc decision, the rule had never been squarely rejected by the Federal Circuit.
Background of the Uniloc Decision
The Federal Circuit’s Uniloc decision centered on Uniloc’s rights to U.S. Patent No. 5,490,216 (the ’216 patent), covering a software-registration system designed to prevent users from installing multiple copies of a program on different computers in violation of software-licensing agreements.
Uniloc alleged that Microsoft’s Product Activation Feature, present in Windows XP, Word XP, and Word 2003, infringed the ’216 patent. After a certain period of time, to continue using Microsoft software equipped with the Product Activation Feature, users had to elect to initiate a digital license request to Microsoft. The software could not afterwards be installed and used on a different computer without the purchase of an additional license.
At trial, Uniloc based its damage assessments on an internal Microsoft document that valued a product key as anywhere between $10 and $10,000. Taking the low end of this range, $10, Uniloc’s expert applied the 25 percent rule to obtain a baseline royalty rate of $2.50 per license issued—reasoning that the 25 percent rule had been previously accepted by courts as an appropriate methodology in determining damages.
The baseline royalty rate was then multiplied by the number of licenses issued for the accused products to obtain a reasonable royalty of $564,946,803. As this figure was significant, the expert purportedly performed a reasonableness check comparing the royalty with the gross revenue of the accused products (obtained by multiplying the number of licenses with the average sales price per license). As a result, $564,946,803 in damages corresponded to a royalty rate of 2.9 percent, given Microsoft’s gross revenue of $19.28 billion from selling the accused products.
A jury found the ’216 patent infringed and not invalid and awarded Uniloc $388 million in damages. In its post-trial motions, Microsoft asked for a new trial on damages given Uniloc’s improper use of both the 25 percent rule of thumb and the entire market value rule in its damage calculations. The district court conditionally granted the motion as to Microsoft’s arguments on the entire market value rule but rejected it as to Microsoft’s arguments on the 25 percent rule of thumb. Microsoft appealed that decision to the Federal Circuit.
Rejection of the 25 Percent Rule as a Baseline Royalty
In the Uniloc decision, after outlining the history of the 25 percent rule, a Federal Circuit panel comprising Chief Judge Rader and Judges Linn and Moore noted that the “admissibility of the bare 25 percent rule has never been squarely presented to this court” but only “passively tolerated . . . where its acceptability has not been the focus of the case.”
The Federal Circuit discussed its recent decisions in ResQNet.com, Inc. v. Lansa, Inc., 594 F.3d 860 (Fed. Cir. 2010); Lucent Technologies, Inc. v. Gateway, Inc., 580 F.3d 1301 (Fed. Cir. 2009); and Wordtech Systems, Inc. v. Integrated Network Solutions, Inc., 609 F.3d 1308 (Fed. Cir. 2010), which rejected the use of unrelated licensing agreements as evidence to support a reasonable royalty rate a plaintiff would reach with a defendant in a hypothetical negotiation. Under this precedent, the Federal Circuit concluded that some basis must exist to associate evidence used to establish a reasonable royalty with the facts at issue in a case. Slip op. at 45. The court ultimately concluded that the 25 percent rule failed to satisfy this fundamental requirement because it lacked even a minimal connection to any of the parties, products, or patents at issue—but served merely as a generic rule of thumb:
This court now holds as a matter of Federal Circuit law that the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation. Evidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.
The fact that the 25 percent rule was used only as a starting point to be adjusted using the Georgia-Pacific factors was immaterial. The Federal Circuit reasoned that an expert who starts from a fundamentally flawed premise, even after using legitimate factors to adjust the baseline, still ends with a final flawed royalty.
Uniloc’s Improper Use of the Entire Market Value Rule
The Federal Circuit additionally rejected the Uniloc expert’s use of the entire market value rule as a check to determine the reasonableness of the royalty amount. The Federal Circuit held that the entire market value rule had been inappropriately used where the patent holder failed to demonstrate that Microsoft’s Product Activation Feature drove consumer demand for the Microsoft software products.
The Federal Circuit rejected Uniloc’s argument that the entire market value could be used in circumstances when the royalty rate was sufficiently low based onthe Lucent decision, which had suggested that “the base used in a running royalty calculation can always be the value of the entire commercial embodiment, as long as the magnitude of the rate is within an acceptable range.” In Uniloc, the Federal Circuit held that this language, read in context, did not support a proposition that the entire market value rule could be used by simply asserting a low enough royalty rate. It noted specifically that just before this language, the court in Lucent held that the entire market value had been improperly used in that case because there was a lack of evidence that the patented feature was a basis for consumer demand of the accused product. The court concluded that “[t]he Supreme Court and this court’s precedents do not allow for consideration of the entire market value of accused products for minor patent improvements simply by asserting a low enough royalty rate.”
The Federal Circuit went on to hold that Uniloc’s improper emphasis on Microsoft’s $19.28 billion in gross revenue from the accused products necessarily prejudiced the jury as to the reasonableness of asking for $564,946,803 in damages. As such, the district court did not abuse its discretion in granting a conditional new trial on the basis of this violation of the entire market value rule.
Consequences of the Uniloc Decision
As a practical matter, the rejection of the 25 percent rule of thumb as a baseline will make it more difficult for patent plaintiffs to be awarded substantial damages without specifically connecting their analyses of royalty rates with evidence related to the actual patents, parties, and products at issue in their cases. Consistent with more recent Federal Circuit decisions on damages, parties should look to licenses covering the patents in suit or comparable patents and technologies. In addition, prior to invocation of the entire market value rule or offering evidence of a defendant’s entire revenue generated from accused products, the patent holder will need to demonstrate that the patented feature forms the “basis for customer demand” or “substantially creates the value of the component parts.”
Rather than dramatically shifting the basis of damages calculations in patent suits, the Uniloc decision emphasizes the importance of the already existent Georgia-Pacific factors. Plaintiffs must ensure that the evidence used to calculate damages not only conforms to the factual circumstances of their case, but also ties to the Georgia-Pacific factors.
Keywords: litigation, trial evidence, patent damages, Uniloc
S. Christian Platt is a partner and Bob Chen is an associate in the litigation department of Paul, Hastings, Janofsky & Walker, LLP.
“Proving Patent Damages after Uniloc,” by S. Christian Platt and Bob Chen, 2011, Proof 19:3, p. 1. Copyright 2011 © by the American Bar Association. Reprinted with permission.