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CAFC Opinion on 25% Rule

A Federal Circuit panel comprised of Chief Judge Rader and Circuit Judges Linn and Moore held today in Uniloc USA, Inc. v. Microsoft Corp. that:

“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.” (p. 41).

The court also found that use of the entire market value rule as a reasonableness check by Uniloc’s expert was not supported because there was no evidence that the patented component was the basis for customer demand.

Accordingly, “Because the jury’s damage award was fundamentally tainted by the use of a legally inadequate methodology, [the] court affirms the grant of a new trial on damages.” (p. 3).

The patent in suit “is directed to a software registration system to deter copying of software.”   (p. 3).

Uniloc’s Damage Calculation:

Uniloc’s damages expert began with a baseline of $10 per unit as “the isolated value of Product Activation” (p. 34) based on the low end of a range presented in an “internal pre-litigation Microsoft document” noting that “[a]n appraisal process found that a Product Key is worth anywhere between $10 and $10,000 depending on usage.” (p. 33).

Uniloc’s expert then applied the 25% rule of thumb to this baseline (not against a measure of Microsoft profits) (p. 34) as a starting point before application of the Georgia-Pacific factors. Applying the Georgia-Pacific factors against the $2.50 ($10 x 25%) baseline, Uniloc’s expert determined that the factors balanced out between the parties and did not change the initial royalty rate. He therefore concluded that $2.50 per unit was the proper reasonable royalty rate. (p. 34). Finally, Uniloc’s expert multiplied the accused units by $2.50 to arrive at total damages of $564,946,803. (p. 34).

Next, Uniloc’s expert performed a reasonableness check “estimating the gross revenues for the accused products” of $19.28 Billion and determined that the claimed damages resulted in an implied royalty rate of 2.9% of the gross revenues of Office and Windows relevant accused sales. (p. 34). Uniloc’s expert opined that in his experience royalty rates for software average above 10% or 11%. (p. 35).

Microsoft’s Damage Response:

“Microsoft had challenged the 25% rule in limine and attempted to exclude” Uniloc’s expert’s testimony. (p 35). Additionally, “Microsoft contested [Uniloc’s] use of the entire market value rule ‘check’ because Product Activation was not the basis of the consumer demand” for relevant products. (p. 35). Alternatively, Microsoft’s expert opined to a lump sum damages amount of $7 million. (p. 52)

25% Rule:

The court cites significant historical debate on the 25% rule of thumb including advocating references to origination of the rule by Robert Goldscheider (p. 37) and “in a 1997 study of licensing organizations, 25 percent of the organizations indicated that they use the 25 percent rule as a starting point in negotiations.” (p. 37-38). The court also cited a number of sources which criticize the 25% rule in three categories:

  1. “First, it fails to account for the unique relationship between the patent and the accused product.” (p. 38)
  2. “Second, it fails to account for the unique relationship between the parties.” (p. 38)
  3. “Finally, the rule is essentially arbitrary and does not fit within the model of the hypothetical negotiation within which it is based. (p. 38-39).

 

“The admissibility of the bare 25 percent rule has never been squarely presented to this court. Nevertheless, this court has passively tolerated its use where its acceptability has not been the focus of the case”. (p. 39). “Lower courts have invariably admitted evidence based on the 25% rule, largely in reliance on its widespread acceptance or because its admissibility was uncontested.” (p. 39).

Entire Market Value Rule:

“This court agrees with Microsoft and the district court that Uniloc’s use of the $19 billion “check” was improper under the entire market value rule.” (p. 49). “The Supreme Court and this court’s precedents do not allow consideration of the entire market value of accused products for minor patent improvements simply by asserting a low enough royalty rate.”   (p. 51).

“Uniloc’s final argument is that the use of the $19 billion figure was only as a check, and the jury must be presumed to have followed the jury instruction and not based its damages calculation on the entire market value rule. This argument attempts to gloss over the purpose of the check as lending legitimacy to the reasonableness of [Uniloc’s] $565 million damages calculation. Even 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. ... Thus, the fact that the entire market value was brought in as only a “check” is of no moment.” (p. 53).

Result:

The jury found Microsoft’s infringement to be willful and awarded $388 million in damages. In response, “[t]he district court agreed with Microsoft, and granted a new trial on damages, because 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’”. (p. 35).

The court noted that “[t]he patentee bears the burden of proving damages. To properly carry this burden, the patentee must “sufficiently [tie the expert testimony on damages] to the facts of the case.” (pp. 41-42). “[O]ne major determinant of whether an expert should be excluded under Daubert is whether he has justified the application of a general theory to the facts of the case.” (p. 43). To further this point, the court cited recent decisions of Lucent Technologies and ResQNet. (p. 44).

“The 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. The 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement. The rule does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party. Relying on the 25 percent rule of thumb in a reasonable royalty calculation is far more unreliable and irrelevant than reliance on parties’ unrelated licenses, which we rejected in ResQNet and Lucent Technologies. … Lacking even these minimal connections, the 25 percent rule of thumb would predict that the same 25%/75% royalty split would begin royalty discussions between, for example, (a) TinyCo and IBM over a strong patent portfolio of twelve patents covering various aspects of a pioneering hard drive, and (b) Kodak and Fuji over a single patent to a tiny improvement in a specialty film emulsion.” (pp. 45-46).

“It is of no moment that the 25 percent rule of thumb is offered merely as a starting point to which the Georgia-Pacific factors are then applied to bring the rate up or down.” (p. 46). “To be admissible, expert testimony opining on a reasonable royalty rate must ‘carefully tie proof of damages to the claimed invention’s footprint in the market place.’ This court has sanctioned the use of the Georgia-Pacific factors to frame the reasonable royalty inquiry. Those factors properly tie the reasonable royalty calculation to the facts of the hypothetical negotiation at issue. This court’s rejection of the 25 percent rule of thumb is not intended to limit the application of any of the Georgia-Pacific factors. In particular, factors 1 and 2—looking at royalties paid or received in licenses for the patent in suit or in comparable licenses—and factor 12—looking at the portion of profit that may be customarily allowed in the particular business for the use of the invention or similar inventions—remain valid and important factors in the determination of a reasonable royalty rate.” (p. 46).

“In this case, it is clear that [Uniloc’s] testimony was based on the use of the 25% rule of thumb as an arbitrary, general rule, unrelated to the facts of this case.” (p. 47). “[Uniloc’s expert] did not [testify] that the parties here had a practice of beginning negotiations with a 25%/75% split, or that the contribution of Product Activation to Office and Word justified such a split. He did not base his 25 percent baseline on other licenses involving the patent at issue or comparable licenses. In short, [Uniloc’s expert] starting point of a 25 percent royalty had no relation to the facts of the case, and as such, was arbitrary, unreliable, and irrelevant.” (p. 47).

Today’s decision follows generally a trend by the Federal Circuit to require a fact specific nexus between a claim for damages and the patents in suit.

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