Th e most politically sensitive issue in patent damages law, and the one that has caused the most controversy, both in the courts and in Congress, is under what circumstances damages can be awarded with respect to products — or components of products — which indisputably do not infringe. How do we award damages when the patented invention covers only a small component
New Developments for the Entire Market Value Rule 115 of a larger product? How do we make sure that inventors are properly compensated for the infringement of their patent without giving them a windfall by awarding damages on components they had nothing to do with inventing?
Until recently, the courts had utterly failed in setting out a clear, easy-to- apply, and economically rigorous solution to this problem. Litigants, judges and juries were left at sea to fi gure out the proper equitable way to compensate an inventor for infringement. With damage awards regularly in the hundreds of millions of dollars, Congress tried to bring some order to this chaos — but with no greater success.
However, in a pair of decisions by the two Federal Circuit judges who
have taken the lead in dealing with this issue — Judge Rader and Chief
Judge Michel — the court is fi nally providing the direction needed to bring order and economic reality to the process of awarding damages for patent infringement.
When the patented invention is truly the reason that consumers purchase the product, it is fair — as well as economically realistic — to award damages based on an entire product. For example, in a case involving Bose’s patent on its design for loudspeakers, Bose was able to show that the basis for customer demand for its products was the improved bass performance made possible by the patented invention. Bose Corp. v. JBL, Inc., 274 F.3d 1354 (Fed. Cir. 2001). Th e Federal Circuit held that, as such, Bose was entitled to recover damages based on the entire value of its loudspeaker product, rather than simply the value of the particular feature covered by the patent.
However, in the technology marketplace, this situation rarely presents itself. Most technology products contain a legion of components and features provided by hundreds, if not thousands, of suppliers. For most of these products, it is folly to assume that the “entire market value” of the overall pro- duct is represented by a particular component or a particular feature. Where infringement results from the inclusion of a minor component or feature, “allocation,” if improperly applied, can cause economically absurd results.
An example from the soft ware industry demonstrates this problem: Say you are Microsoft . You are being sued by the inventor of a particular word processing program feature — one that enables the user to change the color of the font on a selected passage with just a keystroke, rather than laboriously highlighting the text and using the menu. In your last version of Word, you implemented this feature, along with 1,200 other changes, some of which were intended to provide new functions to the user and others that, behind the scenes, made the soft ware work more effi ciently.
Assume further that your latest version of Word is held to infringe this patent and that the patent is held to be valid.
Assume fi nally that this latest version of Word sold 300 million copies and that the retail price was $100.
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What is the most equitable way of awarding damages in this situation? And the solution that makes the most economic sense?
Clearly, the best way would be to determine the “value” of the patented feature to Microsoft and its customers. Th e more valuable Microsoft would have considered the feature to be to the users of Word, the more Microsoft
would have paid the patentholder to be permitted to use it. Th e more
important the feature, the higher the royalty rate.
Th e parties could have determined the value (or the popularity) of this feature in a number of ways. Th ey could have looked at Microsoft ’s advertising and marketing literature to see if Microsoft highlighted the “color changing” feature as a way of selling its product. Th ey could look at reviews of the product to see if the press thought that the feature was valuable or would be popular with consumers. Th ey could commission consumer surveys to determine the importance that Word customers gave to this feature and whether the presence or absence of this feature made any diff erence to their buying decision or to the price they would have paid to buy the product.
Indeed, using the same economic measure tools used in antitrust cases, the parties could have obtained a fairly accurate measure of the economic value of the patented feature by determining the eff ect of the feature on the price that a signifi cant group of consumers would have spent on the product.
Th us, if including the patented feature increased Microsoft ’s profi ts on Word by 2 percent, there would be a solid basis to argue that Microsoft would have paid a royalty representing half of those profi ts to the patentholder. Such a result would be equitable, sensible, and would make complete economic sense.
However, nobody does this. Nobody.
Yet, as a result of two 2009 decisions written by Judges Rader and Michel, which give litigants, courts, and juries two very diff erent — but economically valid — ways of allocating damages, the tide may be turning
Judge Rader’s analysis of this issue came out of his sitting by designation as the trial judge in Cornell University’s patent litigation against Hewlett- Packard. Cornell v. Hewlett Packard , 609 F. Supp. 279 (N.D.N.Y. 2009) Th is case posed a fairly typical situation — where the unit accused of infringement was only a tiny component of a much larger product.
Specifi cally, the patent claimed technology that covered only a small part of what HP calls the “instruction reorder buff er” (IRB), which is itself a part of a computer processor. Th e computer processor, in turn, is part of a CPU module that, combined with other components, becomes a “CPU brick.” Sets of CPU bricks are, in turn, incorporated into a “cell board,” which is then inserted into a server.
Th e primary question for Judge Rader in making a determination as to a reasonable royalty award was the breadth of the royalty base.
Initially, Cornell had sought damages based on the revenue from HP’s entire server and workstation systems, which, as Judge Rader noted, “include
New Developments for the Entire Market Value Rule 117 vast amounts of technology beyond the infringing part of the processors.” Despite Judge Rader’s pre-trial warning that he would closely scrutinize Cornell’s damages case, when trial commenced, Cornell had not revised “its attempts to prove damages far beyond the scope of the claimed invention.” Id . at 283.
Alarmed, Judge Rader interrupted the trial to hold a Daubert hearing to determine whether Cornell’s damages expert’s use of the entire market value rule was proper.
At that hearing, Cornell was unable to prove that the patented invention “drove demand for HP’s entire server and workstation market” and “did not off er a single demand curve or attempt in any way to link consumer demand for servers and workstations to the claimed invention.” Judge Rader thus excluded the damages expert’s testimony that the value of HP’s entire server and workstation line should be used as the royalty base. Id. at 284.
Since, as a result of this ruling, Cornell was left without a damages case, Judge Rader allowed them to come back the next day and to off er damages testimony based on the fact that the invention covered only a component of the overall system.
Th e next day, however, Cornell fared no better. Instead of constructing their royalty base using servers and workstations, Cornell based it on “CPU bricks,” assuming that each infringing processor had been sold as a separate CPU brick, using the catalog price for the CPU brick, sold separately.
Th is solution was equally unacceptable to Judge Rader, who noted that “Cornell simply stepped one rung down the HP revenue ladder from servers and workstations to the next most expensive processor-incorporating product without off ering any evidence to show a connection between consumer demand for that product and the patented invention.” Cornell’s selection of the “CPU brick market” as a basis for its royalty claim was fatally fl awed, according to Judge Rader, since, by “Cornell’s own admission, any market for HP’s CPU brinks was imaginary.” Id . at 287.
Aft er an eight-day trial, the jury awarded damages using a 0.8 percent royalty rate and a $23 billion royalty base — founded on Cornell’s theory that the royalty base should be composed of HP’s hypothetical sales of CPU bricks. HP asked that the court strike the damages award, requesting that the court hold that Cornell could not collect damages under the entire market value rule and reduce the royalty base to “account only for the value of the processors incorporating the patented technology.” Judge Rader granted that motion and proceeded, with an analysis of the scope and application of the entire market value rule along the way, to award damages to Cornell based only on the infringing processors.
Perhaps refl ecting his frustration with Cornell’s disregard of his orders and its attempt to squeeze the maximum amount of royalties out of what was clearly a relatively minor invention, Judge Rader took a very strict view of the application of the entire market value rule. He held that, to satisfy that rule, a
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plaintiff must prove (1) the infringing components are the basis for customer demand for the entire product, (2) the infringing and noninfringing compo- nents must be sold together so that they are a “functional unit” or are part of a complete machine, and (3) the infringing and noninfringing components must be “analogous to a single functioning unit.” Id . at 286.
Th ese requirements, Judge Rader noted, are additive , not alternative ways to demonstrate the applicability of the entire market value rule, an opinion which is shared with few other courts who have considered the issue.
However, since it was uncontested that the processors at issue worked as a “functional unit” with the rest of the components in the server, this gave Judge Rader the leeway to insist that Cornell also establish that the patented invention drove the sales of CPU bricks. Since, according to Judge Rader, Cornell had not presented any evidence of such demand, he rejected the CPU brick-based royalty base and granted HP’s request for a remittitur.
What Judge Rader did next — in establishing the “real” royalty base to be multiplied by the 0.8 % royalty rate established by the jury — shows, in my opinion, an overly “structural” mindset in dealing with allocation issues that, in the real world, is not understandable and is almost unusable.
Evidently, HP had presented, in its case, “hypothetical” revenues for processors alone. Although the court does not provide many details of how these hypothetical revenues were calculated, it appears as though HP used actual pricing information for three of the eight processors (presumably catalog prices for the processors being sold separately) and “a combination of economic and statistical techniques” to estimate the prices of the other fi ve processors. Rejecting Cornell’s protests that these hypothetical revenues were nothing more than estimates, Judge Rader noted that the Federal Circuit had oft en held that estimates are permitted in the calculation of damages and also that these hypothetical revenues were the “only reliable evidence of adequate compensation for infringement.” Id. at 290.
Judge Rader thus entered judgment for Cornell, using the 0.8 percent royalty rate found by the jury and the HP-generated “hypothetical processor revenue” royalty base.
What Judge Rader did, in trying his best to solve the problem of allocation and to avoid what was clearly looming overcompensation to Cornell, was exactly the wrong way to solve this problem. Judge Rader treated this puzzle like an engineer: breaking the problem into pieces until — instead of an economist — who would take a more “market-based” view of how to deal with the issue.
Where Judge Rader went wrong was to fail to present a solution to the allocation problem that can be applied in other cases and, indeed, by parties hoping to avoid litigation and are trying to determine an equitable royalty rate that is grounded in rigorous legal and economic analysis.
What Judge Rader did was to look at the problem as though the entire market value rule was a trick that greedy plaintiff s used to try to get excessive damages awards (the same view, in fact, which drives much of the damages
New Developments for the Entire Market Value Rule 119 debate in Congress). He was off ended by Cornell’s attempt (in his opinion) to obtain royalties that were not deserved, based on sales of products that were not patented . Th e more the product that formed the proposed royalty base contained unpatented products, the more unfair the process was.
Th e only way to solve this problem, in Judge Rader’s opinion, was to break down the royalty base until only patented products were included. Th us, “real” revenues on products that HP actually sold, which contained the infringing processor, could not be used. Likewise, the next product down — the CPU bricks — could also not be used as a royalty base because they had too many unpatented features. Th e only royalty base that was allowed to be used, according to Judge Rader, were the hypothetical revenues for products that were, for the most part, not sold alone and for which HP did not even have prices.
Apparently no economic analysis or consideration was given to the impor- tance of the processor — or the patented feature — to the sales of the overall server. Indeed, there appears to have been no consideration of the economic relationship between the patented feature and any benefi t that HP may have gained from it or how valuable the feature was to the company. Th e focus was totally on generating the “right” royalty base: one that did not include any unpatented features.
No consideration was given to changing — or even questioning — the 0.8 percent royalty rate. And this is the problem.
Although the procedure employed by Judge Rader may have prevented Cornell from obtaining a windfall verdict, it does not help litigants in future cases that may require allocation. How are litigants, judges and juries supposed to generate “hypothetical revenues” for a tiny component in a larger product? What if that component is never sold separately? Won’t this hypothetical revenue be nothing more than a guess?
Just a few months later, however, Chief Judge Michel came up with an elegant solution to this problem — one that can be applied, in an economically rigorous but understandable way, in nearly every case.
Th e opinion in Lucent v. Gateway , 580 F.3d 1301 (Fed. Cir. 2009) case presented allocation issues even more severe than those in the Cornel l case. Th e patent covered a method for entering information into fi elds without using a keyboard. Th e “date-picker” calendar tool in Microsoft Outlook, and similar features in Microsoft Money and Windows Mobile, was held to infringe this patent.
Th e damages award presented two interconnected issues that cut to the essence of the economic value of this particular feature to users. Th e fi rst was an analysis, already discussed in Chapter 4, of whether the “hypothetical” license that provided the basis for the reasonable royalty award was a lump- sum or running royalty license and the proper royalty base to be used to calculate damages.
More importantly, in terms of the new economic realism of the court, is Judge Michel’s discussion of the entire market value rule. Like Judge Rader in
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Cornell , Judge Michel took particular off ense at the results-oriented testimony of Lucent’s damages expert. Initially, Lucent had taken the position that the proper royalty base for Outlook’s date-picking feature was the entire price of the computer in which it was installed — $1,000 on average — employing a royalty rate of 1 percent.
Once that royalty base was struck down, Lucent’s damages expert changed his focus, testifying that the proper royalty base was, instead, the market value of Outlook, but increased the royalty rate to 8 percent, unsurprisingly, reaching exactly the same total royalty amount he had come up with in the fi rst place. To Judge Michel’s obvious irritation, Lucent’s expert could not provide any economic justifi cation for choosing the larger royalty base, the smaller royalty base, or either royalty rate. He could not explain the importance of the date- picking feature to Microsoft or its customers or even its importance to the functioning of Outlook. Indeed, it was evident to the court that “the infringing feature contained in Microsoft Outlook is but a tiny feature of one part of a much larger soft ware program,” and the “portion of the profi t that can be credited to the infringing use of the date-picker tool is exceedingly small.”
Th e court put the focus of the reasonable royalty analysis where it should be — on the actual value of the patented feature to Microsoft and its customers and how oft en they use that feature. As the court made clear, “the damages award ought to be correlated, in some respect, to the extent the infringing method is used by consumers.” Id . at 1334.
But how is the determination of that value to be translated to the awarding of damages? If Judge Rader’s method were to be used, the jury would be required to determine the “hypothetical revenues” for just the “date-picking” feature of Outlook — something that would be clearly impossible. Even if the court used the smallest operational component of Outlook that uses this feature — the Calendar — any calculation of hypothetical revenues would be purely speculative and nearly useless.
Judge Michel, instead, applied an economically realistic approach that could actually be employed by courts and juries. He noted that, in the real world of licensing, the parties do not lock themselves into preconceived notions of what royalty rates “ought to be” and then construct complicated scenarios to calculate hypothetical revenues for the patented feature to deter- mine the proper royalty vase to apply this royalty rate to.
Instead, they just take the royalty base for which fi gures are most easily obtained and which are easiest to verify — the revenues for the “entire commercial embodiment” — and simply adjust the royalty rate to refl ect the actual value of the patented feature. As the court noted, “sophisticated parties