“Aggression, by an opposite if not always equal reaction, stimulates defense.”
—John Keegan, A History of Warfare 139 (2d ed. 2004)
In medieval times, castle defenders developed countermeasures to thwart siege tactics. For example, large fortified gatehouses, or “gate keeps,” often were used to prevent attackers from breaching the castle’s gate.
Modern patent law involves a similar concept of a “gate keep,” at least in the damages context. As plaintiffs in patent cases have introduced expert testimony based on new patent damages theories, defendants have asked courts to fulfill their gatekeeping role by preventing certain types of expert testimony from reaching the jury. In its recent VirnetX, Inc. v. Cisco Sys., Inc., decision, the Federal Circuit reinforced the damages “gate” in patent cases by further clarifying the district court’s responsibility for ensuring that unreliable expert testimony on purported patent damages does not reach the jury. Vacating a $368 million jury award against Apple, the Federal Circuit concluded that the district court should have excluded expert testimony on damages because: (1) the purported royalty base was predicated on the “smallest salable unit” of the accused product and failed to apportion between patented and unpatented features, and (2) the purported royalty rate was determined using the assumption that the parties would have agreed to a 50/50 split of incremental profits as a starting point, without showing that such assumption was tied to the facts of the case.1
The VirnetX decision resolves discrepancies that had arisen among various district courts regarding apportionment and the use of generic assumptions such as the Nash Bargaining Solution in determining a proper royalty rate. The VirnetX decision, however, leaves open new potential strategies to be employed (and countered) by parties and their damages experts, which will have to be addressed by district courts in their role as gatekeepers.
The “Smallest Salable Unit”
The term “smallest salable unit” was introduced in Cornell v. Hewlett-Packard.2 Judge Rader, sitting by designation in the Northern District of New York, granted the defendant’s motion for judgment as a matter of law on damages because the plaintiff used CPU brick revenues as the royalty base rather than processors, which were “the smallest salable infringing unit with close relation to the claimed invention.”3 The Federal Circuit subsequently explained in LaserDynamics, Inc. v. Quanta Computer, Inc. that calculating royalties on a multi-component product “carries a considerable risk that the patentee will be improperly compensated” for the non-infringing components.4 Thus, “it is generally required that royalties be based not on the entire product, but instead on the ‘smallest salable patent-practicing unit.’”5
District courts soon split on the issue of whether further apportionment was required when an accused product has multiple components—some of which are infringing and others that are not—when the multi-component product is the smallest salable unit. Some courts concluded “additional apportionment is unwarranted” if the damages expert used revenues from the smallest salable unit as the royalty base.6 Other courts, however, concluded that “apportionment is required even where . . . the accused product is the smallest salable unit.”7 In those cases, if the patentee did not apportion, the patentee could alternatively “show that the patented feature drives demand for the entire product.”8
VirnetX, Inc. v. Cisco Systems, Inc.
In VirnetX, the district court instructed the jury that it may not use the entire market value of the accused product to determine the royalty base, unless “the product in question constitutes the smallest saleable unit containing the patented feature.”9 The district court allowed VirnetX’s damages expert to identify the iPhone, iPod, and iPad as the smallest salable units and use their entire base price as the royalty base, even though VirnetX only accused the “FaceTime” video calling and VPN On Demand features thereof infringement.10 The district court rejected Apple’s arguments to exclude this expert testimony, noting that Apple “failed to advance a credible alternative” for an appropriate royalty base.11
The Federal Circuit vacated the damages award because the district court’s erroneous jury instruction tainted the jury verdict.12 In doing so, the Federal Circuit clarified that, “[w]here the smallest salable unit is, in fact, a multi- component product containing several non-infringing features with no relation to the patented feature . . . the patentee must do more to estimate what portion of the value of that product is attributable to the patented technology.”13
The Federal Circuit also concluded that the district court should have excluded the testimony of VirnetX’s damages expert on the applicable royalty base because he failed to remove unpatented features—such as the touchscreen, camera, processor, speaker, and microphone—from the iOS devices’ base price.14 Rejecting VirnetX’s argument that the iOS software created the largest share of the iOS product’s value, the Federal Circuit reiterated, “[w]hether ‘viewed as valuable, important, or even essential,’ the patented feature must be separated.”15
As in LaserDynamics, the Federal Circuit rejected the excuse that “‘practical and economic necessity compelled [the patentee] to base its royalty on the price of an entire [device].’”16 Although Apple’s sales model did not charge separately for the accused FaceTime and VPN On Demand features, the Federal Circuit reiterated that “[t]here is no ‘necessity-based exception to the entire market value rule.’”17 Even when faced with the difficulty of assigning value to a feature that may not have been sold, “[t]he law requires patentees to apportion the royalty down to a reasonable estimate of the value of its claimed technology, or else establish that its patented technology drove demand for the entire product.”18
NASH BARGAINING SOLUTION
The VirnetX court also reinforced the requirement that the methodology employed to calculate royalty damages must be tied to the specific facts of the case. In particular, the court addressed VirnetX’s use of the Nash Bargaining Solution. Damages experts had applied this mathematical model, which assumes a 50/50 allocation between the parties of incremental profits attributable to the patented technology, as a starting point for determining a royalty rate.19 While some district courts have accepted the use of the Nash theorem,20 other courts have rejected it as “indistinguishable from [the] 25% rule rejected in Uniloc,” which assumed a 25/75 split of the entire profits for an infringing product.21
In determining a royalty rate for the accused FaceTime feature alone, VirnetX’s damages expert relied on the Nash theorem to assume a 50/50 split of incremental profits associated with FaceTime as the starting point.22 He then adjusted the split to allocate 45% of the incremental profits to VirnetX because of its “weaker bargaining position.”23 The Federal Circuit concluded that such testimony was improper.
The Federal Circuit further concluded that reliance on the Nash Bargaining Solution was akin to the “25 percent rule of thumb” rejected in Uniloc, which assumed a 50/50 profit split regardless of the industry, technologies, parties, size of patent portfolio, or value of the patented technology.24 While the court did not foreclose use of the Nash theorem if a damages expert can show that the premises of the theorem fit the facts of the case, VirnetX’s damages expert failed to do so.25 Noting that “‘[b]eginning from a fundamentally flawed premise’” results in “‘a fundamentally flawed conclusion,’” the Federal Circuit found that the expert’s “thin attempts” to explain his 10% deviation from the 50/50 baseline based on “conclusory assertions” actually highlighted how this methodology is “subject to abuse.”26 The use of the 50/50 baseline would risk “skewing the jury’s verdict” because juries would “hesitate to stray” from that baseline.27 Such testimony should therefore have been excluded.28
While the VirnetX decision provides important clarification, the decision leaves open several strategies that plaintiffs may now attempt to employ in attacking the patent damages gate—and which defendants must now counter.
One strategy plaintiffs may employ is to argue that an accused product is not a “multi-component” product. Though the VirnetX court noted that the patentee must apportion between patented and unpatented features “‘in every case,’”29 its holding was directed to situations “[w] here the smallest salable unit is, in fact, a multi-component product containing several non-infringing features.”30 It remains to be seen how this holding will be applied in cases involving certain technologies. In Astrazeneca, for example, the district court rejected defendant’s attempt to apportion damages to the infringing subcoating of a delayed-release capsule for treating heartburn, accepting instead the value of the entire accused capsule as the royalty base.31 According to the district court, “there is little reason to import these [apportionment] rules for multi-component products like machines into the generic pharmaceutical context.”32 In light of VirnetX, some form of apportionment is likely required, but there may be limited “precedent for doing so” especially for certain types of technologies.33
Another potential strategy for plaintiffs is to argue that substantially all of the components within an accused product are necessary to practice the asserted claims and are therefore the features with sufficiently close relation to the patented functionality. The VirnetX decision offered no opinion on whether the alternative royalty base, a $29 software upgrade for Mac computers that added FaceTime functionality, was sufficiently related to the claimed feature.34 Given this silence, plaintiffs may argue, as the district court found in Personalized Media Communications, that the damages expert could not have further divided the accused product and “still remained consistent with [plaintiff’s] theory of infringement.”35 Defendants, however, may rely on other decisions rejecting attempts to use the entire accused product as the royalty base, particularly when there is only a “cursory recitation of the entire device in the asserted claims.”36 As in GPNE, defendants may succeed by proposing a smaller royalty base, notwithstanding the recitation of generic “node” and “memory” elements, if the patented invention is directed to a specific feature.37
Plaintiffs who wish to rely on the Nash Bargaining Solution or similar generic assumptions must now show how the underlying premises of the Nash Bargaining Solution (or any similar theorem) fit the facts of the case. The VirnetX decision cites several district court decisions where the plaintiff’s damages expert appropriately considered “the facts of the case, specifically the relationship between the parties and their relative bargaining power, the relationship between the patent and the accused product, the standard profit margins in the industry, and the presumed validity of the patent.”38 The Federal Circuit, however, did not elaborate on the specific factual circumstances under which the use of the Nash Bargaining Solution or similar types of assumptions would be appropriate.
Multiple Siege Attempts
Although risky, plaintiffs may attempt to wage successive siege campaigns by taking aggressive initial positions on damages and arguing for a second chance if their expert testimony is excluded. They may cite to Cornell, where Judge Rader allowed the expert a second chance to testify and apportion damages to a smaller component,39 or other district court decisions that similarly allowed new expert reports.40
Defendants, however, may point to Rembrandt, where the Federal Circuit declined to hear an interlocutory appeal on the exclusion of a plaintiff’s damages expert’s testimony on the eve of trial, noting:
[G] iven the nature of the [apportionment] inquiries involved, the rules are not so precise in their application or scope as to make a single opportunity for compliance clearly or always enough—though, in the right circumstances, a district court may well decide that it is.41
The Federal Circuit has also previously held that reasonable royalty damages can be awarded even without expert testimony.42 Defendants may raise this precedent to argue that “giving a second bite simply encourages overreaching on the first bite” on damages.43
The Federal Circuit in VirnetX has reinforced the district court’s gatekeeping role against unreliable expert testimony that (1) fails to apportion damages even when an accused multi-component product is the “smallest salable unit,” or (2) relies on the Nash Bargaining Solution or similar generic assumptions without tying the underlying premises to the facts of the case. The VirnetX decision, however, also leaves open several potential strategies for plaintiffs to maximize damages (and potential counter-strategies for defendants), thereby creating further opportunities for district courts to exercise their gatekeeper role.