Patent Litigants — the 25% Rule is Dead!

In patent infringement cases, damages are often calculated by determining a reasonable royalty rate for the use of the protected invention.  Typically, such damages are calculated based upon a hypothetical negotiation for a license between the patent owner and the infringer at the time the infringement began.  For many years, patent litigants and courts alike have attempted to calculate such a royalty by using the “25% Rule” to approximate the reasonable royalty rate that the infringer/licensee would be willing to offer to pay to the patent owner during the hypothetical negotiation. Generally, the 25% Rule suggests that the infringer/licensee pay a royalty rate equivalent to 25% of its expected profits for the product that incorporates the intellectual property at issue, with the remaining 75% belonging to the infringer/licensee for its development, operational and commercialization risks, contributions of other technology / IP, etc.

On January 4, 2011, however, the Federal Circuit issued a decision in the Uniloc v. Microsoft case.  While the decision involves a wide variety of issues, one stands out as having the most potential impact. In short, the Federal Circuit held that the 25% Rule is no longer acceptable for damage calculations.  The Court noted that the Rule “is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation.”  Evidence based upon the Rule is now inadmissible at trial.  Accordingly, the 25% Rule is dead!

Background

Uniloc is the owner of Patent No. 5,490,216 (the ‘216 patent), a patent directed a software registration system to deter copying of software.  In the suit, Uniloc alleged that Microsoft’s product activation feature that acts as a gatekeeper to Microsoft’s Word XP, Word 2003, and Windows XP software programs infringed the ‘216 patent.  The jury agreed, finding that Microsoft not only infringed the patent, but did so willfully.  The jury also awarded Uniloc $388 million in damages, relying on the testimony of Uniloc’s expert, who opined that damages should be $564,946,803 based on a hypothetical negotiation between Uniloc and Microsoft as a starting point and later relying upon certain factors first set forth in Georgia-Pacific Corp. v. U.S. Plywood Corp. (the Georgia-Pacific factors).

Using an internal Microsoft document relating to the value of product keys, Uniloc’s expert applied the 25% “rule of thumb” to the minimum value reported ($10 each), obtaining a value of $2.50 per key.  After applying the Georgia-Pacific factors, which he concluded did not modify the base rate, he multiplied it by the number of new licenses to Office and Windows products, producing the $564,946,803 million amount.  He then confirmed his valuation by using the Entire Market Value Rule, i.e., checking it against the total market value of sales of the Microsoft products (approximately $19 billion), noting that it represented only 2.9% of the gross revenue of the products.

In various post-trial motions, Microsoft asked the District Court to reverse many of the jury findings and asked for a new trial on the issue of damages based upon the alleged improper use of the 25% Rule and the Entire Market Value Rule.  In a lengthy decision, the District Court granted Microsoft’s motion with regard to the Entire Market Value Rule, but denied Microsoft’s motion with regard to the use of 25% Rule.  Both parties filed appeals on different grounds to the Federal Circuit.

Damage Calculations

On appeal, the Federal Circuit rejected the use of the 25% Rule to calculate patent damages even though it acknowledged that in the past the “court has passively tolerated its use where its acceptability has not been the focus of the case.”   The Court held:

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.

The court based its reasoning on Fed. R. Ev. 702 and the Daubert standard for expert testimony, concluding that general theories are only permissible if the expert adequately ties the theory to the specific facts of the case.  Under the cases of Kumho Tire Co. v. Carmichael and General Electric Co. v. Joiner, the Court noted that “one 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.”  According to the Court, the application of the 25% Rule is improper because there was no link between the rule and the specific case.  The Court noted:

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.

In addition to the above, the Court pointed to the lack of testimony by Uniloc’s expert suggesting that the starting point of a 25% royalty had any relation to the facts of the case, and thus the use of the rule was “arbitrary, unreliable and irrelevant,” failing to satisfy the Daubert standard and tainting the jury’s damages calculation.

Based upon the forgoing, the Court granted Microsoft a new trial on damages.  The ultimate result remains to be seen.  Notwithstanding, litigants and their experts are now advised that mere reliance upon “rules of thumb,” such as the 25% Rule, are no longer acceptable. Care should be taken when performing damage calculations to ensure that the conclusions made correspond to the facts of the case, and that the evidentiary burdens are met.

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