The Federal Circuit has issued an important patent damages opinion that will be useful for patent infringement defendants generally, but particularly for companies whose high-revenue, highly bundled products are accused of infringing patents addressed to only a small portion of the accused product or method. Uniloc USA, Inc. v. Microsoft Corporation, — F.3d —, 2011 WL 9738 (Fed. Cir. Jan. 4, 2011). The opinion’s most significant initial substantive effect will be on the results in, and the risk profiles of, patent litigations: it effectively terminates patent-holders’ use of the so-called “25% rule” — a damages methodology often used by grasping plaintiffs to obtain inflated damages awards. Uniloc should reduce the damages award in all cases in which the rule would have otherwise been asserted, and should reduce the number of shockingly large patent verdicts, which have spiked upwards in the last decade.

But the opinion is also important because of what it holds, and what it implies, about opportunities to exclude otherwise damaging expert opinion testimony. Patent litigation is rife with expert testimony across a variety of issues: claim construction; infringement (especially doctrine of equivalents analysis); validity; inequitable conduct; and laches. Expert testimony is often critical in persuading a jury; indeed, it is often determinative. Through its repeated emphasis on Supreme Court precedent that insists that theoretical basis for expert opinion testimony be tethered to the facts of the case — and that when it is not, the opinion testimony must be excluded — Uniloc signals an era of more rigorous critical assessment of the propriety of expert testimony.

The patent law: actual damages should be realistic

The baseline for all patent damages awards is 28 U.S.C. § 284, which instructs that patent damages shall be “adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use made of the invention by the infringer.” To obtain that adequate compensation, plaintiffs typically assert one of two kinds of damages claims. First, for lost profits, analyzed under the test in Panduit, later adopted by the Federal Circuit.1 Panduit prescribes a four-factor test designed to measure, with a fair degree of precision, the profits that a practicing patent-holder actually lost because of the infringement. In other words, the lost profits methodology is both realistic and reasonable. As a practical matter, however, lost profits can be difficult and expensive to prove; and as a matter of law, lost profits are not available to patent-holders who do not sell a product that competes with the accused product.2

Thus plaintiffs more typically invoke the so-called Georgia-Pacific “reasonable royalty” approach adopted soon after the Federal Circuit’s creation, in which a “hypothetical negotiation” between a willing licensor and a willing licensee is reconstructed.3 “A reasonable royalty is the predominant measure of damages in patent infringement cases.”4

As a normative matter, neither measure of damages is supposed to be punitive; each is supposed to put the patent holder in the position it would have occupied absent the infringement.5 In other words, a damages award is supposed to bear — with some tolerance for inherent imprecision — a reasonable relationship to what would have actually happened in the real world.

The 25% rule: actual damages should be high

Under the 25% rule, however, there were yawning gaps between the normative and the actual: so-called “reasonable royalty” claims sometimes represented little more than what critics called “lottery ticket litigation” — the effort to transform the seven-digit patent number into a larger-digit patent damages award.6 At least in the district courts, resistance to the rule was essentially futile, because district courts invariably admitted evidence based on the rule.7 According to the rule’s critics, who have been widespread, the so-called “25% rule” yielded too many jackpots.8

And little wonder, because it was structured to do so. Damages analysis under the “rule” typically proceeds thusly: (1) Estimate the licensee’s expected profits for the accused product. (2) Divide those expected profits from the expected net sales to arrive at an expected profit rate. (3) Multiply the expected profit rate by 25%. (4) Adjust, if needed, the resulting number up or down based on the Georgia Pacific factors. If a product enjoyed large revenues or a high profit margin — or, as can be true for blockbuster biopharma products, both — that methodology generally yielded very large damages awards, both absolutely and relatively.

Even on its face, the rule was analytically suspect. Under it, a product that was successfully accused of infringement in separate lawsuits (not, over time, an uncommon circumstance for highly successful products) would have had profits conveyed, through 25% damages awards, to the first four plaintiffs. The meat having been consumed by the first four plaintiffs, successive plaintiffs would be digging into the bone. Before Uniloc, it was not clear that the inequities of that situation would find a sympathetic appellate audience.9

The rule’s methodology also allows for manipulation to ratchet up a damages award even further. “Profits” can be a malleable concept, in terms of both economics and accounting, and grasping plaintiffs and their experts often look for ways to exclude costs (for example, significant fixed costs or overhead) to increase “expected profits.” Worse, the rule allows a grasping plaintiff to pick and choose among the net sales that were projected and those that were actually realized to maximize the profit rate calculation. If the expected profits turn out to have been optimistic — as can happen, because employees associated with and enthusiastic about a product sometimes overestimate market demand for it — the plaintiff will emphasize that the rule focuses on expected profits. And if expected profits turn out to have been understated, the plaintiff will emphasize the actual profits, because the patent tent damages law “permits and often requires a court to look at events that occurred thereafter and that could not have been known to or predicted by the hypothesized negotiators.”10

Those post-hoc facts are sometimes referred to as “the book of wisdom.” One would expect that as a normative matter “the book of wisdom” would favor neither plaintiffs nor defendants. However, in practice that rule — that post-negotiation events can be taken into consideration — tends to operate to the plaintiff’s benefit. In other words, besides being structurally plaintiff-friendly, the rule also inherently included a one-way ratchet that benefitted the patent-holder.

But not anymore. Uniloc put an end to the rule.

Uniloc: the 25% rule is not reliable

In Uniloc, the holder of a patent directed to a software registration system to deter the copying of software accused highly bundled, highly successful products of infringement: Microsoft’s Word XP, Word 2003, and Windows XP software programs. At trial, over Microsoft’s Daubert-based in limine motion objecting to his testimony, the plaintiff’s damages expert invoked the 25% rule, concluded that the Georgia Pacific factors did not change his analysis, and opined that damages should be $565 million. The jury awarded $388 million, but the trial court overturned the verdict and granted a new trial. Uniloc appealed.

It found an audience emphatically unsympathetic to the 25% rule. In its lengthy and thoughtful analysis of the 25%-rule-based damages award, the opinion repeatedly emphasizes the teachings from Daubert and its progeny that underscore the obligation, shared by trial counsel and by the district court, to ensure that under Federal Rule of Evidence 702 expert opinion testimony be both reliable and tied to the facts of the case.11 The court unambiguously held that the rule was not reliable, and that evidence proffered under it was not admissible:12

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 per-cent 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 also instructed that using the rule simply as a starting point, to which the Georgia-Pacific factors are applied, was no less improper: “It is of no moment that the 25 percent rule of thumb is offered merely as a starting point to which the Georgia-Pacific factors are then applied to bring the rate up or down. 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.”13

In rejecting the rule, the court invoked the three categories of criticisms, each quite expansive in its own right, to which the rule had been subjected. First, the rule failed to account for what the court called the “unique relationship” between the patent and the accused product. The rule took “no account of the importance of the patent to the profits of the product sold, the potential availability of close substitutes or equally noninfringing alternatives, or any of the other idiosyncrasies of the patent at issue that would have affected a real-world negotiation.”14 Second, the rule did not factor in what the court called the “unique relationship between the parties.” It did not address, for example, the different levels of risk assumed by a licensor and a licensee; and the rule was unlikely to have any basis in the accused infringer’s industry, in the technology involved in either the patent or the accused product or service, or in the claimed invention’s contribution to the infringing product or service.”15 Third — and perhaps most trenchant — the rule was “essentially arbitrary and does not fit within the model of the hypothetical negotiation within which it is based.”16

That the rule was subject to such withering criticisms was hardly a surprise, given the rule’s genesis: the asserted observation, in the late 1950s, of a 25% royalty rate in commercial licenses entered into with 18 licensees by a Swiss subsidiary of a large American company.17 Comparing the results of that antique study, conducted some 25 years before the Federal Circuit’s creation and its adoption of the hypothetical negotiation methodology, does more than compare apples and oranges. It compares apples and fish.18

Uniloc: the entire market value rule is not a backdoor for applying the 25% rule

Consistent with rejecting the 25% rule’s direct application, the court forcefully rejected the use of the entire market value rule as a backdoor for applying the 25% rule.

Under the entire market value rule, a patentee can obtain damages based on the entire market value of the accused product — but only where the patented feature creates the “basis for customer demand” or “substantially create[s] the value of the component parts.”19 As an asserted “check” on his reasonable royalty/25% rule analysis, Uniloc’s expert testified that his calculated royalty represented only 2.9% of Microsoft’s $19.28 billion in revenues — a point he emphasized with a demonstrative, and that Uniloc’s counsel emphasized in cross-examination. However, Uniloc had conceded that customers did not buy the accused products because of the patented invention, and had represented in in limine practice that it would not base a royalty calculation on the entire market value rule.

In a wisely pragmatic assessment of the realities of trial practice and jury persuasion, the court emphasized that “[t]he disclosure that a company has made $19 billion dollars in revenue from an infringing product cannot help but skew the damages horizon for the jury, regardless of the contribution of the patented component to this revenue.”20 Indeed the jury’s damages verdict made the case “a good example of the danger of admitting consideration of the entire market value of the accused where the patented component does not create the basis for customer demand.”21 The fact that the entire market value was asserted simply as a “check” on his analysis did not persuade the court, because “[e]ven if the jury's damages calculation was not based wholly on the entire market value check, the award was supported in part by the faulty foundation of the entire market value” — notwithstanding a jury instruction not to base its damages determination on the entire market value.22

Uniloc: lessons for the future

Whether viewed in isolation or against the backdrop of other recent Federal Circuit cases, Uniloc conveys important lessons for patent infringement litigants — particularly with respect to damages claims, but also more generally.

  1. Damages theories and testimony will receive closer judicial examination. Particularly when viewed against the backdrop of other recent cases, Uniloc signals a renewed judicial focus on damages awards. Indeed, it is striking that the court in Uniloc struck down the 25% rule — but had, less than a year earlier, affirmed a damages award that was likewise premised on the 25% rule: the Microsoft/i4i case.23 But Microsoft/i4i contained clear signals that the court was ready to take a hard look at the 25% rule; the court seemed to go out of its way to signal that, had the defendant brought post-trial motions challenging the damages expert’s methodology, the outcome might have been different. Indeed, the court said just that: “Had Microsoft filed a pre-verdict JMOL, it is true that the outcome might have been different.”24
  1. Other areas of expert testimony likely will also receive closer judicial examination. The significant expert issues in Uniloc arose in the context of damages testimony, and thus its immediate lessons apply in that context. But given the court’s repeated emphasis on Daubert and its progeny, the opinion holds lessons for other areas of expert testimony, too. Expert testimony figures prominently in patent litigation, from beginning to end: to establish the characteristics of the hypothetical person of ordinary skill in the art (claim construction and validity); to establish what a particular claim term of phrase would have meant to one of ordinary skill in the art (claim construction); to establish that the claim’s limitations are found in the accused product or method, particularly under the doctrine of equivalents (infringement); to show that the claim would have been obvious to one of ordinary skill, or that the claim’s limitations are found in a prior art reference or device (invalidity); to show that a reference would have been material to a reasonable examiner (inequitable conduct); to show the royalty base and reasonable royalty (damages); and to show irreparable harm (injunctions).

In many of these areas, the foundation of the expert testimony rests on a particular theory. Uniloc’s return to first principles — its dissection of the 25% rule’s lack of an accepted theoretical basis — appears to signal a renewed judicial focus on the requirement that expert testimony be, as FRE 702 requires, reliable and relevant. Is the theory underlying the testimony accepted in the relevant scientific community? If not, what are the reasons that it should be accepted in this case? Have the methods used to implement the theory been tested? How does the expert’s general theory tie to the specific facts of the case? Whether developing or attacking expert opinion testimony, each of these linchpin questions deserve more careful attention now.

Uniloc’s focus on reliability occurs at an interesting point in patent law’s ongoing development, because the use of surveys — long used in, for example, trademark litigation — is on the rise. When they have been used at all, surveys have traditionally been used in patent litigation only to help establish facts relevant to infringement (for example, use of an infringing method to make a product) or damages (for example, to justify application of the entire market value rule by showing that the patented feature created the demand). Increasingly, however, surveys are being used in other areas. In obviousness, for example: to survey persons of ordinary skill to see whether a particular invention would have been obvious, given the asserted art. Or in willful infringement, to address whether the “objectively-defined risk . . . was either known or so obvious that it should have been known to the accused infringer.”25 Surveys are presented through experts, and carry with them their own issues regarding reliability and relevance. As their use increases, Uniloc’s emphasis on Daubert’s strictures will create opportunities for those who would challenge such surveys.

  1. Preserve your rights — make the right motions. The Uniloc court’s sharp treatment of the 25% rule should not obscure an antecedent point: the court was able to rule as it did because the defendant in Uniloc had preserved its rights by objecting to the 25% rule’s use. The court had biting, substantive criticisms of the 25% rule, but the conduit for those criticisms — the reason the court was able to strike down the rule’s use — was that the defendant had made Daubert-based objections to them. This point is driven home by comparing i4i, where the Federal Circuit affirmed a damages award based on the 25% rule, and Uniloc, where the Federal Circuit took a pith knife to a damages award based on the 25% rule. In the former, the defendant had not made what the Federal Circuit viewed as a critical motion: a pre-verdict JMOL. In the latter, however, the defendant had preserved its rights through motion practice. The point seems obvious, but it gets overlooked: Daubert defects in expert testimony are not self-correcting. Litigants need to make the right motions to preserve their Daubert-based objections.