On January 4, 2011, the Federal Circuit in Uniloc USA, Inc. v. Microsoft Corp., 632 F. 3d 1292, made two significant rulings on recurring issues in the area of patent damages: (1) It eliminated the criticized 25 percent “rule of thumb” frequently used as a baseline for determining reasonable royalty damages, and (2) It clarified that evidence of entire market value calculations—where the plaintiff attempts to tie the reasonable royalty to the full value of a product containing the patented invention—will not be permitted in absence of clear economic justifications.

Uniloc is another installment in the trend marked by the recent ResQNet.com, Inc. v. Lansa, Inc., 594 F.3d 860 (Fed. Cir. 2010) decision where the Federal Circuit pronounced that plaintiffs in patent cases “must carefully tie proof of damages to the claimed invention’s footprint in the market place.”

In Uniloc, the plaintiff asserted U.S. Patent No. 5,490,216, relating to anti-piracy software registration. Uniloc accused Microsoft’s product activation feature for Windows XP and Word 2003 of infringement of the ’216 patent. At trial, the jury found one claim of the ’216 patent valid and infringed, and awarded Uniloc $388 million.

Uniloc’s damages theory was based on an internal Microsoft document ascribing a $10 to $10,000 value to product keys. From that document, the expert took the lowest “isolated” value of Microsoft’s product activation feature, $10, and then applied the 25 percent “rule of thumb” as a baseline royalty rate. This rule, which the expert invoked based on its past “accept[ance] by Courts as an appropriate methodology in determining damages,” allocates 25 percent of product value to the inventor and 75 percent to the licensee.

The expert then considered the factors outlined in Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970), to determine whether they necessitated any adjustments to the presumptive rate and concluded they did not. Multiplying $2.50 (25 percent of the $10 “isolated” product activation value) by 225,978,721, the total number of licenses for the accused products, the expert arrived at a total damages figure of more than $564 million. Finally, the expert performed what he termed a “reasonableness check” on the ultimate damages figure—because it was “a significant amount of money”—by multiplying the total number of accused product licenses by their average sales price. The jury was presented with a demonstrative comparing the proposed damages award with this total revenue figure, $19.28 billion.

Following the jury verdict, the district court granted a new trial on damages on the basis that the jury had been improperly presented with entire market value calculations, noting that the “$19 billion cat was never put back into the bag,” but rejected Microsoft’s contention that the expert’s use of the 25 percent rule of thumb also warranted a new trial.

The Federal Circuit observed that it had not squarely addressed the admissibility of the 25 percent rule previously, but had “passively tolerated its use where its acceptability has not been the focus of the case.” Relying on other recent Federal Circuit decisions, which require evidence of a reasonable royalty to be closely tied to the technological area under discussion, the court noted more generally that there must be a basis in fact to associate royalty rates used in prior licenses to the particular hypothetical negotiation at issue. The “25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement,” because it does not provide evidence of what would happen in a particular hypothetical negotiation or a particular technological area. In the illustrative example provided by the court, the 25 percent rule makes the same royalty rate prediction for a negotiation involving a portfolio of foundational patents over hard drives as it would for a single patent to a small improvement in film emulsion. Accordingly, the court concluded:  

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 court went on to hold that the use of the Georgia-Pacific factors to adjust the rate could not remediate the underlying error of using the 25 percent rule.

The court also ruled that evidence of entire market value calculations should be inadmissible when the entire market value rule is not applicable. The entire market value rule provides that, where a patented component is the basis for consumer demand of a larger product, the revenues for that larger product may properly be used as the royalty base when determining a reasonable royalty. Here, the entire market value rule was unavailable: the Microsoft product activation feature is not what drives demand for Microsoft’s word processing software or operating systems. Nonetheless, Uniloc had presented the jury with Microsoft’s $19 billion revenue figure as a “check” on its damages calculation. The Federal Circuit agreed with the district court that this was inappropriate. In particular, it criticized the cross-examination of defendants’ damages expert using the $19 billion figure and effective royalty rate of 0.000035 percent. It noted that these numbers “cannot help but skew the damages horizon for the jury, regardless of the contribution of the patented component to this revenue.”

Uniloc and the other recent Federal Circuit damages cases place significant pressure on patent plaintiffs. Now that Uniloc prevents a patent plaintiff from relying on a case-independent presumption about bargaining behavior, one would expect to see greater reliance on comparables to meet the burden to prove damages. However, the court’s simultaneous insistence both on the date of the hypothetical negotiation as a cutoff for relevant evidence, and a close relationship between comparables and the technology at issue, may well leave many plaintiffs with a dearth of available evidence to prove damages. Regardless, patent cases will see an increased use of economists to give a grounded assessment of the incremental value contribution of the patent in suit, and, at least in the short term, an increase in Daubert motions to weed out bad damages theories.

In Uniloc, the court did not find the 25 percent rule improper because it was empirically inaccurate. Rather, the court found use of the rule improper because it was inadequately tied to the facts of the case. This reasoning has clear application to any presumption about behavior in the hypothetical negotiation that is not based on record evidence, and thus threatens many other types of damages presentations that do not rely on the 25 percent rule.

One example is the use of the Nash bargaining solution to determine the outcome of the parties’ behavior at the hypothetical negotiation. The Nash bargaining solution is essentially a framework to solve a two-sided bargaining problem by using a set of conditions reasonable to any bargaining situation. Experts have used the Nash bargaining solution to argue for a 50-50 split of the incremental contribution of the patent to the licensee’s product.  

The Nash bargaining solution, however, has many of the same characteristics underlying the court’s rejection of the 25 percent rule: it is a presumption about bargaining behavior to be applied in absence of any case-specific knowledge about the parties, the technology, or any other factor affecting leverage in the hypothetical negotiation. It should not matter that the Nash bargaining solution has better theoretical grounding than the 25 percent rule; it still fails to satisfy the fundamental requirement that there be a basis in fact to associate the royalty outcome to the particular hypothetical negotiation at issue, and barring further refinements of Uniloc, its use should be limited.

So far, however, the only court to confront the issue has limited the Uniloc holding to the 25 percent rule, refusing to extend its reasoning to the use of the Nash bargaining solution. (See Sanofi-Aventis Deutschland GmbH v. Glenmark Pharms., Inc., USA, No. 07-cv-05855 (D.N.J. Feb.3, 2011)).

The recent passage of the Patent Reform Act of 2011 (S. 23) shows that Congress is similarly attuned to problems with patent damages methodologies. The Act purports to provide a new “procedure for determining damages,” instructing that:

The court shall identify the methodologies and factors that are relevant to the determination of damages, and the court or jury shall consider only those methodologies and factors relevant to making such determination.

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Prior to the introduction of any evidence concerning the determination of damages, upon motion of either party or sua sponte, the court shall consider whether one or more of a party’s damages contentions lacks a legally sufficient evidentiary basis. . . . [T]he court shall identify on the record those methodologies and factors as to which there is a legally sufficient evidentiary basis, and the court or jury shall consider only those methodologies and factors in making the determination of damages under this section.

From the language of the Patent Reform Act itself, this new “procedure” does not look substantially different from a Daubert motion directed to an expert’s damages methodology. Further, the Patent Reform Act only specifies that the parties outline their damages theories to the court by the date of the final pretrial order, meaning that, in many cases, the parties will have already used the Daubert procedure to make their challenges to damages methodology. At any rate, courts determining patent damages will now likely do so in a new statutory context.  

Uniloc marks another important step towards requiring patent plaintiffs to rigorously prove damages with facts logically connected to the value of the patented invention. Going forward, because of the clear pronouncements from the Federal Circuit in ResQNet, Lucent and now Uniloc, it is expected that district courts will more strictly scrutinize patent damages evidence and will be more likely to exclude material not directly tied to a sound damages theory.