Tuesday, January 4, 2011

25% “Rule of Thumb” Rejected in Determining Patent Damages

Over the last several years, we have seen more and more damages experts rely on a so-called "25% rule" as a starting point in determining a “reasonable royalty” in patent cases. The 25% rule was applied as a “rule of thumb” that  allowed an accused infringer to retain 75% of the profits and awarded 25% of the infringer's profits to the patent holder. This 25% figure would typically be used as a starting point that would then be massaged using the Georgia Pacific factors to arrive at some final royalty rate, that was often very close to the 25% value. The problem with this approach is that while it sounds like a “reasonable” division of profits at some superficial level, and is certainly expedient in arriving at some starting point for analysis, it is universally divorced from reality in any specific case. Nonetheless, the 25% rule kept finding its way into articles, court decisions and expert reports...until now.

In Uniloc USA v. Microsoft Corp., 2010-1035, a case involving a patent on a software registration and copy protection system for products such as Microsoft Word, the Federal Circuit squarely rejected the use of this analytical fiction as being improper under Daubert. The Court held 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. Opinion at 41
In criticizing the 25% rule, the court pointed out that “[t]he  rule does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party."  

The Court recognized that the 25% rule was being used as a "starting point" rather than a final calculation but found that this made no difference: 
In short, Gemini’s starting point of a 25 percent royalty had no relation to the facts of the case, and as such, was arbitrary, unreliable, and irrelevant. The use of such a rule fails to pass muster under Daubert and taints the jury’s damages calculation. Opinion at 47

The court specifically reaffirmed use of the Georgia Pacific factors as an analytical tool in determining a reasonable royalty rate but emphasized that “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 Court also rejected Uniloc’s use of the “entire market rule” as a “check” to show how the royalty rate  arrived at using the 25% rule was "reasonable." In rejecting the use of the entire market value rule in this case, the Federal Circuit again emphasized that “damages based on the entire market value of the accused product [are appropriate] only where the patented feature creates the ‘basis for customer demand’ or ‘substantially create[s] the value of the component parts.’” The court found that Uniloc had offered no evidence that customer demand was driven by the patented software registration feature.

The elimination of the 25% rule may make the damages analysis more complicated in many cases, especially for plaintiff's experts seeking an easy way to justify a high valuation for a particular patent. It will, however, help to insure that the royalty rates that are offered by damages experts are based on facts that are applicable to the case at hand and are rationally based on the value of the patented invention.

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