Patent Damages Case Affects Litigants and Dealmakers

January 19, 2011

How much should a company pay to license someone else’s patent? The question arises in business, where introducing a product may require access to third-party patent rights, as well as in litigation: courts often assess infringement damages based on a “reasonable royalty” that compensates the patent owner for the infringer’s activities. In either context, what is fair or reasonable obviously depends on a wide range of business factors. A court considers such factors in framing a “hypothetical” license negotiation between patent owner and infringer, while business entities looking to strike a licensing deal engage in actual negotiations based on these factors.

More than 40 years ago, in the case of Georgia-Pacific Corp. v. United States Plywood Corp., a lower federal court attempted to catalogue the business considerations that most strongly influence the outcome of a licensing negotiation — in particular, the royalty rate applied to sales that infringe the licensed patent. These factors have become widely accepted as a basis for calculation of infringement damages as well as in real-world licensing negotiations. They include the marketplace advantage of the patented invention over non-infringing alternatives, the portion of realizable profit attributable to the invention as distinguished from unpatented elements, whether the parties compete in the marketplace…and a dozen other factors.

Sometimes, to avoid the difficult and uncertain work of evaluating these factors for a given situation, licensors have adopted — and courts have tolerated — a shortcut based on a split of profits rather than situation-specific legal and business factors. Sometimes referred to as “Goldscheider’s Rule” after its originator, the 25% rule of thumb posits that, when all is said and done, the manufacturer of a patented product should be willing to pay the patentee 25% of the profits derived from the invention. Estimate the infringer’s profit margin, take 25% of that, and you have your license royalty rate. Very simple.

Far too simple, ruled the Court of Appeals for the Federal Circuit in Uniloc USA, Inc. v. Microsoft Corporation, decided January 4, 2011. Noting that although it had previously “passively tolerated” Goldscheider’s Rule where its appropriateness was uncontested, the court now rejected the 25% rule of thumb as a “fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation.” The court held that it cannot even be considered for purposes of assessing infringement damages “because it fails to tie a reasonable royalty base to the facts of the case at issue.” In other words, henceforth there shall be no shortcuts, at least in litigation.

In the Uniloc case, the patent owner’s reliance on Goldscheider’s Rule resulted in a jury verdict of $388M against Microsoft, even though the patent covered only a minor product feature. That such significant damages could nonetheless arise concerned the court, which, in addition to rejecting the 25% rule, also limited the ability of juries to consider the full price of the infringing product — the “entire market value” — when computing royalty-based damages. The court held consideration of the entire market value to be appropriate only where the patented feature creates the basis for customer demand. It also rejected the notion that a low enough royalty rate could justify basing damages on the full product price in all circumstances, saying, “The 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.”

The case provides guidance both to patent litigants and businesses involved in license negotiations. Many patent litigators see the Uniloc case as the latest in a recent line of decisions requiring a clear connection between the value actually added by a patented invention and damages awarded by a jury — damages that can, as in this case, soar if the product is widely sold.

Dealmakers, on the other hand, might not dismiss the 25% rule entirely. Particularly where the patent covers an entire product or its market-differentiating feature, the rule has long provided a useful starting point for discussion. Focusing attention on a split of profits anchors negotiations on bottom-line business factors — the “tool up” work necessary to take advantage of the patent and the suitability of non-infringing alternatives, for example — that dictate the patent’s value to the licensee.

Similarly, while the “entire market rule” has sometimes misled juries, it can be essential in deal making when there is no separate market for a patented feature of a larger product. Think intermittent windshield wipers: unless the parties can base royalties on the price of the entire vehicle, using a suitably small royalty rate, the “price” of the feature to which the rate is applied will inevitably be arbitrary.

The Uniloc case has curtailed the ability to base royalty damages in litigation merely on a percentage of profits and/or the price of an entire product. These approaches will, however, continue to find widespread application outside the courtroom doors.

For more information on this alert, please contact any of the lawyers listed below:

Steven J. Frank, Partner, Corporate, M&A and Securities Group

Steven C. Browne, Co-chair, Corporate, M&A and Securities Group

This article was originally published by Bingham McCutchen LLP.