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January 25, 2011

Long-Standing "25 Percent Rule of Thumb" for Calculating Reasonable Royalty Damages Rejected by Federal Circuit Panel

Damages for patent infringement are required by statute to be "in no event less than a reasonable royalty." 35 U.S.C. § 284. For the past four decades, the Federal Circuit has endorsed a set of 15 factors, referred to as the "Georgia-Pacific" factors, as guidelines for determining a reasonable royalty award. One of these factors considers the royalty amount likely resulting from a hypothetical negotiation between parties at the time the infringement began, had both parties been reasonably trying to reach an agreement. Though periodically questioned, the Federal Circuit has admittedly "passively tolerated" application of a "25 percent rule" as providing a basis of such an arms length negotiation. The rule's premise is that a licensee would generally be willing to retain 75 percent of its profits and pay 25 percent of its profits to the licensor in exchange for the right to use the patented technology. Now turning against years of passive toleration, a three member panel of the Federal Circuit has held in Uniloc USA Inc. v. Microsoft Corp. that the 25 percent rule is "fundamentally flawed"¦because it fails to tie a reasonable royalty base to the facts of the case at issue."

Uniloc sued Microsoft over a software security patent allegedly infringed by Microsoft's product activation process for several of its popular products. A district court jury found Microsoft liable for willful infringement and rejected its invalidity defenses thereby resulting in an award of $388,000,000. As to the issues of damages, the jury was presented evidence from Uniloc's damages expert, Dr. Gemini, relying on a Microsoft internal document indicating that a product key is worth at least $10 and a baseline royalty should be 25 percent thereof, or $2.50 per product license. As Microsoft had licensed 225,978,721 software products that included Uniloc's patented invention, an award of $564,946,803 was reasonable according to the expert. To check the reasonableness of the award, Dr. Gemini then multiplied the number of licenses by the sales price of each licensed product resulting in gross revenue of $19.28 billion. Accordingly, the damages calculation, based on the 25 percent rule, resulted in an overall reasonable royalty rate of 2.9 percent.

Microsoft, on appeal, challenged the draconian use of the 25 percent rule as well as the check of the rule's application using the entire market value of the infringing products, as performed by Dr. Gemini. Relying on Supreme Court precedent requiring that experts justify the application of a general theory to the facts of the case at hand, the Federal Circuit concluded that the 25 percent rule as a theoretical construct fails to take proper account concerning any particular technology, industry, or party and is therefore irrelevant, arbitrary and unreliable as a basis for determination of patent infringement damages under a reasonable royalty theory.

Moreover, the rule is well established that for the entire market value of a product to form the basis of a reasonable royalty calculation, the patented feature must create the basis for consumer demand for the product. Ironically, as an activation feature limiting casual copying or multiple installation of a Microsoft product, there was no dispute that the activation feature did not form the basis for consumer demand. Accordingly, the court held that Uniloc could not put the proverbial cat back in the bag with the instructions provided to the jury requiring that it ignore the entire market value as a basis for an award and its continued reference to the $19 billion figure had tainted the jury's decision. Therefore, the court affirmed the district court's grant of a new trial on damages.

It is believed the Federal Circuit's decision will reject all draconian applications of the 25 percent rule in the near term, and cause damages experts to refocus on the language of the Georgia-Pacific factors. Notably, such reasonable royalty calculations primarily arise in actions by non-practicing entities incapable of proving any lost profits, a generally preferable method of calculating patent infringement damages. Accordingly, the Federal Circuit's decision is not likely to have a substantial impact in subsequent infringement suits by practicing patent holders against market competitors. Moreover, the decision is the opinion of only a three judge panel of the Federal Circuit and it is believed an en banc or even a subsequent Supreme Court decision is very plausible.

If you require further information regarding the information presented in this Legal Alert and its impact on your organization, please contact any of the members of the Practice Area.


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