Background of Recent Patent Damages Reform Activities
Patent legislation has been proposed every year since 2005, with the most recent bill (S.23, Patent Reform Act of 2011) introduced by Sen. Patrick Leahy (D-VT) on January 25, 2011. This current version of the Patent Reform Act follows earlier versions that have been proposed annually since 2005.
However, despite years of attempts to develop legislation to provide patent damages reforms, the result is that the current Patent Reform Act of 2011 focuses on other reforms and does not directly address the calculation of lost profits or reasonable royalty damages.
The reason why the Patent Reform Act of 2011 does not address damages calculation is primarily twofold. First, even though the majority of patent reform legislative efforts since 2005 had been focused on damages issues, they were a constant sticking point due to highly fractionalized and entrenched opposition to the various damages legislative initiatives. Second, since patent reform legislation efforts began, the courts have proved adept at making adjustments to damages methodologies and concepts, significantly lessening the concerns of those seeking patent reform addressing damages issues.
While efforts to reform patent damages via legislation may have slowed or even halted, it does not mean that other government agencies are required to keep silent as to any recommendations concerning patent damages reform. In fact, the Federal Trade Commission (FTC) held eight days of hearings in December 2008, addressing the evolving IP marketplace as it related to the interplay of patent notices, remedies, innovation and competition. In addition, in May 2010, the FTC co-sponsored a workshop with the Patent and Trademark Office and the Department of Justice. These activities involved more than 140 participants, and, additionally, the FTC received in excess of 50 written submissions. Based on the above activities and materials, the FTC prepared and then issued on March 7, 2011 a report entitled "The Evolving IP Marketplace: Aligning Patent Notice and Remedies with Competition" (FTC Report).
The FTC Report includes several recommendations, many of which directly address the determination of lost profits or reasonable royalty damages in patent infringement matters. Damages in patent infringement matters are defined according to the United States Code, Title 35, Section 284:
"Upon finding for the claimant, the court shall award the claimant damages adequate to compensate for the infringement but in no event less than a reasonable royalty ..."
In general, based on the above law, the determination of damages in patent infringement matters will be either in the form of lost profits or in reasonable royalties, with reasonable royalties representing the default appropriate measure, if satisfactory evidence of lost profit damages cannot be provided. Presented below is a summary of the subset of the FTC Report recommendations focused on the determination of damages as it relates to the calculation of lost profits and reasonable royalties (the FTC Report also provides recommendations concerning other topics such as the gatekeeper role of the court in considering the testimony of expert witnesses addressing damages; use of comparable licenses; and rules of thumb, permanent injunctions and notice; however, these recommendations are not discussed below).
A) Lost Profits Damages
Chapter 5 of the FTC Report includes three primary recommendations concerning the calculation of lost profits damages in patent infringement matters:
1. Allow Flexibility in Creating the "but for" World
In determining lost profits damages, it is important to consider the market environment during the period of infringement and to envision what would have happened in an alternative world in which the alleged patent infringement did not occur. This alternative world absent infringement often is referred to as the "but for" world as an abbreviated reference to consideration of what would have happened "but for the actions of the infringer." The FTC Report recommends focusing on an economically sound assessment of the resulting "but for" world absent infringement and suggests evaluating factors based on the specific matter in hand rather than application of rigid tests or rules. This includes a recommendation to move away from traditional considerations that have been relied upon in patent infringement matters for decades, such as the Panduit Test, a framework that requires the patent holder to meet each of four requirements or prongs in order to claim lost profits damages.
2. Reject the Entire Market Value Rule
In assessing damages, the issue of apportionment of profits or the relative importance of the patented technologies in suit to the infringing product as compared with other factors contributing to the manufacture, distribution and sale of the product often needs to be addressed. The Entire Market Value Rule assumes that the entire value of the product (e.g., the entire incremental profit from sale of the product) should be awarded as lost profits damages when the patented feature is the basis for customer demand of the infringing product and the patented and unpatented components together represent a functional unit. The FTC Report recommends that the Entire Market Value Rule be rejected as a basis for awarding a patentee lost profits damages. A main concern with the Entire Market Value Rule as described in the FTC Report is that it requires an analysis that concludes with a yes or no answer to the question of whether or not the patented feature is the basis for customer demand. The FTC Report recommends replacing the Entire Market Value Rule based on a yes or no conclusion with a requirement to address and prove the degree of consumer preference for the patented invention over alternatives.
3. Reject Dual Amounts Awarding Both Lost Profits and Reasonable Royalty Damages
Based on the patent damages law, which requires that damages be in the form of "no less than a reasonable royalty," courts occasionally have awarded lost profits damages on a subset of the total infringing unit sales and applied a reasonable royalty to the remaining infringing units. Following this approach, courts have ensured that the patent holder receives compensation in the form of a minimum of a reasonable royalty for each infringing unit sold. The FTC Report position argues that, in some cases, the decision to limit the award of lost profits to a subset of the infringing units is based on the assumption that in the "but for" world, the infringer would have been able to sell a non-infringing alternative to a subset of its customers and that not all of the infringer's sales would have been lost to the patent holder. The FTC Report recommends that in those cases where lost profits are limited to a subset of infringer sales because the infringer would have made some product sales using an alternative non-infringing substitute instead of the patented invention, the damages should be limited to lost profits because the remainder of "but for" world sales of the infringer, therefore, would have been non-infringing units.
B) Reasonable Royalty Damages
Chapters 6 and 7 of the FTC Report, in addition to reviewing recent trends in patent infringement damages and summarizing the positions of those arguing for and against patent damages reform, include several primary recommendations concerning the calculation of reasonable royalty damages in patent infringement matters:
1. Focus on Hypothetical Negotiation and Willing Licensor/Willing Licensee Assumptions
Courts rely on a hypothetical negotiation framework when calculating reasonable royalty damages based on the precedent set in the Georgia-Pacific Corp. v. United States Plywood Corp. case. In Georgia-Pacific, the court ruled that the appropriate royalty rate and base should be determined by assuming that the patent holder and infringer, in the hypothetical roles of willing licensor and willing licensee, participated in a hypothetical negotiation as of the date of first infringement with the parties in agreement that the patent in suit was valid and that the potential licensee would be infringing without a license (assumption of validity and infringement). Georgia-Pacific also provided a list of 15 factors that represented categories of information that the court considered to be relevant to determining an appropriate royalty rate. In general, the FTC Report agrees with the path followed by the courts of awarding reasonable royalty damages consistent with the hypothetical negotiation analysis and willing licensor/willing licensee model. However, the FTC Report also recommends that courts be more careful in avoiding tendencies to include in the reasonable royalty award inflated amounts based on punishing or deterring infringement, the counterfactual nature of assuming that the two litigating parties would have sat down and willingly negotiated a license at the time of first infringement, or the inability of the patent holder to prove lost profits that it likely might have suffered. In other words, the FTC Report recommends that the reasonable royalty award be based on what the willing licensee would have paid to obtain rights to the patent known to be valid and to be infringed by the willing licensee, absent a hypothetical negotiated license agreement.
2. Georgia-Pacific Factors Only a List of Evidential Categories — Factor 15 Is Framework
The FTC Report recommends that courts distinguish between the list of Georgia-Pacific factors and the 15th factor, which describes the concept of the hypothetical negotiation and the willing licensor/willing licensee model. In other words, the FTC Report concludes that the conceptual framework is provided by factor 15 and not by the other 14 factors. The FTC Report, therefore, recommends that the court clarify, in particular in communications with juries, that the 15th factor describes the hypothetical negotiation and willing licensor/licensee assumptions representing the conceptual framework for the damages assessment and that the other 14 factors represent a list of categories of information that may or may not be useful as applied to the conceptual framework.
3. Incremental Value over Next-Best Alternative Provides Damages Ceiling
The FTC Report highlights the economic importance associated with the choice between licensing the technology in suit and the use of the next-best alternative available to the potential licensee/infringer, thus reinforcing the economic theory that the willing licensee would choose to license as long as licensing was an economically superior choice over the next-best alternative. Therefore, the incremental amount by which licensing value exceeds the value of the next-best alternative represents the ceiling or maximum amount that a licensee would be willing to pay for rights to use the patented invention. The FTC Report recommends that courts rely on the incremental value of the patented invention over the next-best alternative as the maximum amount of reasonable royalty damages that should be awarded, assuming, of course, that reliable information is available and provided concerning the incremental value of the patented invention as compared with the next-best alternative.
4. Hypothetical Negotiation Should Occur at Early Stage of Product Development
The FTC Report addresses concerns related to the timing of the hypothetical negotiation, noting that an infringer's ability to choose between alternatives to the patented technology and the costs associated with the switch to an alternative are linked to the timing of the hypothetical negotiation. As the infringer becomes more and more invested in use of the patented technology over time, the ability to switch to an alternative becomes more costly and increasingly difficult to implement. The FTC Report recommends that damages awards should not be based on high switching costs resulting from the infringer's economic investments in the patented technology and, instead, recommends that damages awards should focus on the incremental value of the patented technology as compared with available alternatives absent consideration of the infringer's potential switching costs.
5. For RAND Commitments, Incremental Value over Alternatives at Time of Standard Definition
The FTC Report considers the unique situation when the technology in suit is a recognized industry standard technology with agreements incorporating terms requiring that the technology be licensed under reasonable and non-discriminatory (RAND) terms. For these technologies, the FTC Report recommends that the court cap royalties at the incremental value of the patented technology over alternatives available at the time the standard was defined.
6. Entire Market Value Rule Is Not Relevant to Reasonable Royalty Base
In an earlier section of this article addressing lost profits, there was some discussion of the Entire Market Value Rule and an explanation of why the FTC Report concluded that this rule not be applied as a basis for estimating lost profits damages. Therefore, it is not surprising that the FTC Report recommends that the Entire Market Value Rule not be used as the basis for determining the appropriate royalty base in reasonable royalty damages calculations.
7. The Appropriate Royalty Base Is the Base That Likely Would Have Been Negotiated
The FTC Report recommends that the appropriate base to use in calculating reasonable royalty damages is the royalty base that would have been the one most likely to have been chosen in the hypothetical negotiation as the base best suited for accurately valuing the invention. The FTC Report further recommends that, due to the difficulty in identifying a royalty rate that accurately reflects the invention's contributions to a much larger, complex product, the smallest price component that incorporates the invention is the most reasonable choice for the royalty base.
The courts clearly have managed to thwart the threat of legislative control of damages awards via the demonstration that they are able to adeptly address patent reforms by making relatively swift adjustments even in the absence of congressional action. As the courts continue to review and rule on damages awards in patent infringement matters, it will be interesting to note how much the courts' rulings may be influenced by the FTC Report recommendations reviewed here.
ABOUT THE AUTHOR
Brian Blonder is a managing director in the Forensic and Litigation Consulting practice of FTI Consulting, Inc.. Based in Washington, D.C., Mr. Blonder has more than 25 years of consulting experience. During the past 20 years, his consulting engagement focus has been on damage estimation and valuation in matters involving intellectual property (IP) or other intangible assets. Mr. Blonder has been designated as an expert and has testified in various court venues on matters involving intellectual property damages and valuation, and he frequently has presented and authored materials on these subjects.
The views expressed herein are those of the author and do not necessarily represent the views of FTI Consulting, Inc. or its other professionals. (c)FTI Consulting, Inc., 2011. All rights reserved.
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