Federal Circuit Finds 25% Damages Rule Is Too Unreliable to be Used In Calculating Patent Damages
In Uniloc USA, Inc. v. Microsoft Corp., Civ Case No. 2010-105, -1055 (Fed. Cir. January 4, 2011), Uniloc owns U.S. Patent No. 5,490,216 (“’216 patent”), which is drawn to a registration system designed to prevent illegal software copying. Specifically, the ‘216 patent discloses a program which only allows software to run without restrictions on a system when the system determines that the software is legitimate. Microsoft includes a Product Activation feature in its Windows XP software and accompanying software which requires the use of a product key which, if valid, allows unrestricted use of the software, and if not valid, only allows use of the software in a demo mode.
Uniloc sued Microsoft in the District of Rhode Island alleging that the Product Activation feature infringed the ‘216 patent. After a first remand from the Federal Circuit rejecting the District Court’s initial claim construction, the jury found that Microsoft had infringed the ‘216 patent, that the infringement was willful, and awarded damages of $388 million based in part on testimony from a damages expert using a “25% rule” as a basis for determining a reasonable royalty. Microsoft filed six post trial motions including motions JMOL for invalidity, non-infringement, and no willfulness, as well as a motion for a new trial on the issue of damages for improper use of the 25% rule. The District Court denied the motion JMOL on the issue of invalidity, granted the motion JMOL of non-infringement as well as no willfulness, and granted the motion JMOL new trial on the issue of damages.
On appeal, the Federal Circuit reversed the District Court grant of the JMOL motion of noninfringement and sustained the denial of the JMOL motion on the issue of invalidity, thus sustaining the jury verdict on the issue of infringement of a valid claim. The Federal Circuit also upheld the District Court grant of JMOL on the issue of no willfulness, noting that the District Court was correct in finding that Uniloc had not presented any evidence of subjective or objective recklessness, especially as the claims involved complex issues relating to equivalencies. As such, the Federal Circuit found no need for a new trial on the issue of willfulness such that the issues of infringement and willfulness were resolved.
On the next issue of damages, the Federal Circuit also upheld the District Court’s grant of a new trial on the issue of damages. In order to arrive at the $388 million dollar award, the jury evaluated the testimony of Uniloc’s expert, Dr. Gemini. As summarized by the Federal Circuit, Dr. Gemini testified that damages should be $564,946,803, which is based upon a hypothetical negotiation using the factors outlined in Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970).
As a starting point, Dr. Gemini noted that a Court-accepted methodology used a 25% “rule of thumb”, whereby 25% of the value of a product would go to the patent owner. In this case, Dr. Gemini valued each Product Activation feature as being worth $10 to Microsoft given the importance of preventing piracy, such that the rule of thumb began with a royalty rate of $2.50 per Product Activation. From this, Dr. Gemini arrived at a reasonable royalty of $564,946,803.
As a check to ensure that this royalty rate was within industry standards, Dr. Gemini testified that this resulted in a royalty rate of 2.9% relative to the $19 billion gross revenue for Windows XP and related software. In comparison, Dr. Gemini indicated the industry rate was above 10%. Based upon this analysis as well as the comparison of the resulting award against the gross revenue, the jury awarded the $388 billion in damages.
The Federal Circuit, in upholding the District Court’s grant of the motion JMOL to reverse the award and allow a new trial on damages, reviewed the history and use of the 25% rule of thumb utilized by Dr. Gemini. The Federal Circuit noted that 35 U.S.C. § 284 allows a damages in the amount of a reasonable royalty, which is determined according to a hypothetical negotiation between the parties. Wang Labs Inc. v. Toshiba Corp., 993 F.2d 858, 869-70 (Fed. Cir. 1993). The Federal Circuit noted that legal scholars have reasoned that the 25% rule of thumb approximates the reasonable royalty by leaving the infringer with sufficient remaining profits (75%) to reward the infringer for the risk of developing and marketing the product. Robert Goldscheider, John Jarosz and Carla Mulhern, Use Of The 25 Per Cent Rule in Valuing IP, 37 les Nouvelles 123 (Dec. 2002). While enjoying widespread acceptance as a starting point, others have criticized the rule as not correlating to the relative importance of the patent to the product, or any unique relationship between the parties. Gregory K. Leonard and Lauren J. Stiroh, Economic Approaches to Intellectual Property Policy, Litigation, and Management, 949 PLI/Pat 425, 454-55 (Sept.-Nov. 2008); Richard S. Toikka, Patent Licensing Under Competitive and Non-Competitive Conditions, 82 J. Pat. & Trademark Off. Soc’y 279, 292-93 (Apr. 2000); Ted Hagelin, Valuation of Patent Licenses, Tex. Intell. Prop. L.J. 423, 425-26 (Spring 2004). The Federal Circuit then noted that, while never formally approved, the Federal Circuit has nevertheless “passively tolerated” its use since the issue was never squarely before the court.
As the issue was now squarely before the court, the Federal Circuit now held “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.” Importantly, the Federal Circuit went so far as to hold that any use of evidence related to the rule is “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.” Specifically, the Federal Circuit noted that the Supreme Court in Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 589 (1993) interpreted Federal Rule of Evidence 702 as requiring that expert testimony be based on a firm scientific or technical grounding. Daubert, 509 U.S. at 589-90.” Where the testimony does not tie a general rule well to the specific facts of a case, the evidence and testimony is inadmissible.
The Federal Circuit further noted that it has, in the past declared that licenses which were radically different from the facts of a given case were similarly inadmissible in attempting to find a reasonable royalty since these can result in damages in excess of the statutory award. ResQNet.com, Inc. v. Lansa, Inc., 594 F.3d 860, 869 (Fed. Cir. 2010); Lucent Techs., Inc. v. Gateway, Inc., 580 F.3d 1301, 1324 (Fed. Cir. 2009); Wordtech Systems, Inc. v. Integrated Networks Solutions, Inc., 609 F.3d 1308 (Fed. Cir. 2010). According to the Federal Circuit:
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.
Since the 25% rule is not even related to a real negotiation as much as the licenses at issue in ResQNet.com, Inc, Lucent Techs., Wordtech Systems, Inc., the Federal Circuit found that the link between this rule of thumb and any hypothetical negotiations was even more attenuated.
The Federal Circuit further noted that, while the 25% rule was only a starting point, it was a starting point that neither reflected the parties and industries involved, nor the importance of the patents to the infringed products. As noted by the Federal Circuit, “[b]eginning 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.” Moreover, the Federal Circuit noted that Dr. Gemini had only used the 25% rule as a starting point once in his non-litigation negotiations. As such, the Federal Circuit found that Microsoft should be allowed a new trial on the issue of damages.
In addition, the Federal Circuit took issue with Dr. Gemini’s use of the $19 billion gross sales figure as the entire market in order to “check” whether the royalty rate of 2.9% was reasonable in the industry. The Federal Circuit noted that the use of the entire market is only appropriate where the patented feature is the “‘basis for customer demand’ or ‘substantially create[s] the value of the component parts.’ Lucent Techs., 580 F.3d at 1336; Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538, 1549-50 (Fed. Cir. 1995).” As such, the Supreme Court has allowed the entire market to be the basis for a reasonable royalty where there is evidence that the patented feature is what gives value to the entire machine. Garretson v. Clark, 111 U.S. 120, 121 (1884). The Federal Circuit next noted that it was undisputed that the Product Activation feature did not create the consumer demand for Windows XP and the accompanying software. Thus, the $19 billion gross sales figure was irrelevant as a check as to whether the calculated damages were within industry norms for licensing royalty rates. As such, the Federal Circuit agreed with the District Court that the comparison of the entire market for Windows XP and the accompanying software as a check for whether the award was reasonable in the industry was an inappropriate use of the entire market rule and a new trial was an appropriate remedy.
Significance for Patent Owners and Applicants
Given the reliance on commercial practices for royalty rates, the Uniloc decision at the very least is going to require use of true license comparisons to arrive at damages. Short cuts, such as the now-discredited 25% rule of thumb, will not be usable as a matter of law. In theory, starting without this 25% rule should result in lower royalty rates. For instance, in Uniloc, there was evidence that the actual starting royalty rate used in licensing within the industry was rarely 25%. However, this does not necessarily mean that all industries experience the same lower royalty rate, and it is further likely that certain technologies as well as pioneering patents could well demand rates in excess of 25%. All that is certain is that whatever the starting point will be, there must be evidence that it comports with actual commercial standards.