In its recent decision in VirnetX Inc. v. Cisco Systems, the Federal Circuit clarified the standard for determining damages in a patent infringement lawsuit.  Specifically, the Court held that reasonable-royalty damages must take into account the portion of the product or sales attributable to the patented feature, and must not be based on arbitrary “rules of thumb.” VirnetX Inc., and Science Applications International Corp., v. Cisco Systems, Inc., and Apple Inc., No. 2013-1489 (Fed. Cir. Sept. 16, 2014).

The four patents at issue relate to technology for providing secure data transmission over networks.  VirnetX accused Apple of infringing two such patents (the ’504 and ’211 Patents) based on the “FaceTime” feature of Apple’s iPhone, iPod, iPad, and Mac products, specifically the mechanism by which FaceTime establishes a secure connection between the caller and receiver.  VirnetX also accused Apple of infringing two other such patents (the ’135 and ’151 Patents) based on the “VPN On Demand” service built into its iPhone, iPad, and iPod Touch products. 

At trial, VirnetX’s damages expert presented three potential mechanisms for determining reasonable-royalty damages.  One involving a royalty based on the total price of the product, and the other two being based off the incremental profit attributable to the patented features.  The district court instructed the jury that in determining the royalty base, it “should not use the value of the entire apparatus or product unless either the patented feature creates the basis for the customers demand. . .” or “the product in question constitutes the smallest saleable unit.”  VirnetX at p.28. 

After a five-day trial, the jury found all of the asserted claims valid and infringed, and awarded VirnetX $368,160,000 in reasonable-royalty damages.

On appeal, the Federal Circuit affirmed the jury’s finding that none of the asserted claims were invalid, as well as that Apple’s VPN On Demand product infringed a many of the claims of the ’135 and ’151 Patents (while reversing the jury’s finding as to claim 1 of the ’151 Patent).  However, the Federal Circuit reversed the district court’s claim construction ruling for the ’504 and ’211 Patents, and remanded for further proceedings to determine whether the claims of those patents were infringed.  The Court also vacated the jury’s damages award, finding a number of impermissible flaws in the way it was determined.

  1. The Smallest Saleable Unit

The Court explained that when calculating reasonable-royalty damages, “a patentee must take care to seek only those damages attributable to the infringing features.”  Id. at p. 26.  The Court further explained that “when claims are drawn to an individual component of a multi-component product, it is the exception, not the rule, that damages may be based upon the value of the multi-component product.”  Id. at 27.

Although the Court agreed that it is possible for a royalty base to be correctly calculated from the total value of the product when that product is the smallest saleable patent-practicing unit, it found that the district court’s jury instruction on this issue was legally erroneous.  The particular wording of the jury instruction “suggest[ed] that when the smallest salable unit is used as the royalty base, there is necessarily no further constraint on the selection of the base.”  Id. at p. 28.  The Court considered this contrary to the idea that a patentee must only seek damages attributable to the infringing features of the product.  According to the Court:

[T]he requirement that a patentee identify damages associated with the smallest salable patent-practicing unit is simply a step toward meeting the requirement of apportionment.  Where the smallest salable unit is, in fact, a multi-component product containing several non-infringing features with no relation to the patented feature (as VerinetX claims it was here), the patentee must do more to estimate what portion of the value of that product is attributable to the patented technology.”

Id. at 29. 

Based on the same rationale, the Court found that the testimony of VirnetX’s expert witness regarding the royalty base for the first of his three theories should have been excluded.  Under this theory, VirnetX’s expert calculated the royalty as 1% of the total price of Apple’s products, without regard for what portion of the product was infringing, or what percentage of the sales were driven by the infringing feature.  As explained by the Court, “a patentee’s obligation to apportion damages only to the patented features does not end with the identification of the smallest salable unit if that unit still contains significant unpatented features.”  Id. at 32.

The Court acknowledged the difficulty in assigning an accurate value to the patented feature however, noting that it has “never required absolute precision in this task” and that the “process may involve some degree of approximation and uncertainty.”  Id. at 29-30.

  1. Tied to the Facts

The Court found that the testimony of VirnetX’s expert with regard to the royalty calculation under the second and third theories should have been excluded as well.  Under these theories, the expert determined the additional profits that were associated with the patented features, and then invoked an economic theory called the Nash Bargaining Solution to estimate the percentage of the profits that each party would have taken during a negotiation.  The expert assumed that each party would have taken a 50/50 split.  He then adjusted the percentage based on each party’s relative bargaining power. 

According to the Court, the Nash theorem is inappropriate unless it is demonstrated “that the premises of the theorem actually apply to the facts of the case at hand.”  Id. at 38.  Absent a justification based on the facts of the case, the choice of the starting point for the split is merely an “inappropriate rule of thumb.”  Id. at 38.  Here, the Court found that VirnetX’s expert had failed to provide any justification for picking the 50/50 starting point.  Accordingly, the Court held that the use of the Nash theorem for the royalty calculations was “insufficiently tied to the facts of the case, and cannot be supported.”  Id. at p.41.