Court Finds 25 Percent "Rule of Thumb" to Be a Fundamentally Flawed Patent Damages Tool

05 January 2011 Publication
Authors: Cynthia J. Rigsby Rebecca J. Pirozzolo-Mellowes

Legal News Alert: IP Litigation

In Uniloc USA, Inc. v. Microsoft Corp., ___ F.3d ___ (Fed. Cir. Jan. 4, 2011), the Federal Circuit addressed arguments relating to a number of damages issues. Most notably, the Federal Circuit held that the 25 percent rule of thumb often used by damages experts in patent infringement cases “is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation” and “inadmissible under Daubert and the Federal Rules of Evidence.”

Background

United States Patent No. 5,490,216, assigned to Uniloc, relates to “a software registration system to deter copying of software.” Uniloc accused Microsoft of infringing the ’216 patent. In 2007, the district court granted summary judgment of non-infringement. Specifically, the district court concluded that the algorithm used in Microsoft’s technology was different from that claimed in the ’216 patent. On appeal, the Federal Circuit reversed and remanded the case. Thereafter, a jury found: (1) the ’216 patent valid and infringed, and that (2) Microsoft’s infringement was willful. The jury then awarded Uniloc $388 million in damages. Microsoft filed a number of post-trial motions, including a motion for a new trial on damages based on its assertion that Uniloc’s expert improperly relied on the 25 percent rule of thumb and the entire market value rule. The district court granted Microsoft a new trial on damages based on the improper use of the entire market value rule, but rejected Microsoft’s arguments regarding the 25 percent rule.

Rejection of the 25 Percent Rule

In its most significant holding, the Federal Circuit held that “[e]vidence relying on the 25 percent rule of thumb” is inadmissible under Daubert “because it fails to tie a reasonable royalty base to the facts of the case at issue.”

Uniloc’s expert had based his damages opinion on a hypothetical negotiation between Uniloc and Microsoft wherein he “applied the so-called ‘25 percent rule of thumb’” and “justified the use of [it] because it has ‘been accepted by Courts as an appropriate methodology in determining damages.’” The Federal Circuit examined the history behind the 25 percent rule of thumb, noting that it was based on the idea that a hypothetical licensee should pay the patentee a royalty rate equal to 25 percent of the profit the hypothetical licensee expects to receive on the product incorporating the patented technology. In examining the rule the Federal Circuit reasoned that it “fails to account for the unique relationship between the patent and the accused product,” “fails to account for the unique relationship between the parties,” and “is essentially arbitrary and does not fit within the model of the hypothetical negotiation within which it is based.” The Federal Circuit further acknowledged that while “[t]he admissibility of the bare 25 percent rule has never been squarely presented to [it] … [it] has passively tolerated its use” in a number of situations and that “[l]ower courts have invariably admitted evidence based on the 25 percent rule, largely in reliance on its widespread acceptance or because its admissibility was uncontested.”

In explaining its holding in this case the Federal Circuit noted that Daubert requires that the patentee “must ‘sufficiently [tie the expert testimony on damages] to the facts of the case.’” To underscore this point, the Court pointed to a number of its recent decisions where it “determined that a patentee could not rely on license agreements that were ‘radically different from the hypothetical agreement under consideration’ to determine a reasonable royalty.” Specifically, citing its decisions in Lucent Technologies, Inc. v. Gateway, Inc. 580 F.3d 1301 (Fed. Cir. 2009), ResQNet.com, Inc. v. Lansa, Inc., 594 F.3d 860 (Fed. Cir. 2010), and Wordtech Systems, Inc. v. Integrated Networks Solutions, Inc., 609 F.3d 1308 (Fed. Cir. 2010), the Federal Circuit stated, “[t]he meaning of these cases is clear: there 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.” Elaborating from its own prior decisions, the Federal Circuit explained, “[t]he 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement … [because it] does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party.”

Examination of Use of the Entire Market Value Rule

Addressing the entire market value rule, the Federal Circuit held that Supreme Court and Federal Circuit precedent “do not allow consideration of the entire market value of accused products for minor patent improvements simply by asserting a low enough royalty rate.” It further found the use of the entire market value rule as a “check” to be improper.

Microsoft had claimed that Uniloc’s damages expert improperly used the entire market value rule as a “‘check to determine whether’” his royalty figure “was reasonable.” At trial, Uniloc’s expert “testified that his calculated royalty accounted for only 2.9% of Microsoft’s revenue,” which totaled $19.28 billion. Uniloc’s expert further testified that 2.9% was reasonable given his experience with software royalty rates. Microsoft asserted that because there was no dispute that the accused product “did not create the basis for customer demand or substantially create the value of the component parts,” Uniloc’s use of the entire market value rule was improper and the use of the $19 billion figure tainted the jury.

Uniloc argued that “the entire market value of the product can be used if the royalty rate is low enough.” It also argued that “the $19 billion figure was used only as a ‘check,’ and the jury was instructed not to base its damages determination on the entire market value rule, an instruction it should be presumed to have followed.”

Microsoft prevailed. The Federal Circuit further explained that “[t]his case provides 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 ... . 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 Federal Circuit also rejected Uniloc’s claim that it was using the $19 billion figure “only as a check,” stating, “[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 rule.”

Future Considerations

The Court’s decision underscores the importance of grounding damages calculations in the facts of the particular case. Moreover, while the industry awaits patent reform from Congress, this decision signals the Federal Circuit’s continuing interest in damages matters in patent cases.


Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and our colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or the following:

R. Jan Pirozzolo-Mellowes
Milwaukee, Wisconsin
414.297.5717
jpirozzolo-mellowes@foley.com

Cynthia Franecki
Milwaukee, Wisconsin
414.297.5580
cfranecki@foley.com