25% Rule for Patent Damages Rejected; $19 Billion Cat back in bag

California – 35 U.S.C. § 284 provides that upon finding infringement of a valid patent, damages shall not be “less than a reasonable royalty for the use made of the invention by the infringer, together with interest and costs as fixed by the court.”

Often, during litigation, the “reasonable royalty” rate is arrived at through imagining a hypothetical negotiation has taken place between the parties at the time infringement began. (Wang Labs. Inc. v. Toshiba Corp., 993 F.2d 858, 869-70 (Fed.Cir.1993)).

The 25% rule is a tool that has been used to approximate the reasonable royalty rate that the manufacturer of a patented product would presumably be willing to offer to pay to the patentee during a hypothetical negotiation. The Court of Appeals for the Federal Circuit has tolerated its use where its acceptability has not been disputed. Lower courts have invariably admitted evidence based on the 25% rule, due either to its widespread acceptance or because its admissibility was not contested.

Critics of the rule point out three main flaws. First, the relationship between the patent and the accused product is ignored. Consequently, the particular importance of the patent to the profits of the product, the availability of close alternatives, and other potentially important factors likely to be taken into account in real negotiations are not. Second, the relationship between the parties is ignored. For example, degree of risk cannot be explicitly apportioned between the licensor and licensee of a particular technology. Third, the rule is arbitrary and does not relate necessarily to the results of a negotiation hypothesized to have taken place before the infringement. Recently, Uniloc USA, Inc. v. Microsoft Corp., ___ F.3d ___ (2011 WL 9738) gave the Federal Circuit a chance to revisit damages.

Uniloc alleged that Microsoft’s “Product Activation” authentication feature found in Word XP, Word 2003, and Windows XP programs infringed its ‘216 patent covering an anti-pirating software registration and licensing system utilizing a particular algorithm and the jury agreed. They awarded Uniloc $388 million in damages for patent infringement, relying upon Uniloc’s expert, Dr. Gemini, who testified that damages should be $564,946,803 based upon a hypothetical negotiation between the parties (and the Georgia-Pacific factors).

Dr. Gemini applied the 25 percent “rule of thumb” to the $10 estimated value of each infringing Product Activation key on Microsoft licensed software, yielding a value of $2.50 per key. He then multiplied this number by the number of new Office and Windows product licenses (225,978,721) sold, which resulted in the $565 million value. He then “checked” his valuation by calculating that against the $19 billion total market value of Microsoft product sales, his $565 million represented only a 2.9% royalty rate. He even presented a pie chart to the jury displaying information to this effect, noting that 2.9% was reasonable.

On appeal, the Federal Circuit, faced for the first time with a chance to rule squarely on the rule, seized the opportunity:

“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.”

Id. at 19. Thus, under the Daubert standard for expert testimony and FRE 702, general theories are permissible only if the expert sufficiently ties the theory to the specific facts of the case at hand.

The court went on to review numerous cases, from Kumho Tire and Joiner to ResQNet and Wordtech and held that their meaning was clear: “[T]here 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% rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement.”

At trial, Microsoft argued that Uniloc’s use of the entire market value rule was not proper since the Product Activation key did not create the basis for customer demand or substantially create the value of the component parts, and Dr. Gemini’s testimony tainted the jury’s damages deliberations. The district court agreed and granted a new trial on damages. The “$19 billion cat was never put back into the bag” and the jury may have “used the $19 billion figure to ‘check’ its significant award of $388,000,000.” Uniloc II, 640 F.Supp.2d at 185. The Federal Circuit affirmed, holding that the district court did not abuse its discretion in granting a conditional new trial on damages for Uniloc’s violation of the entire market value rule.

The Federal Circuit did not propose improved methods of calculating damages but seems intent on continuing to modify awards.