Responding to increasingly large damages awards based on expert advice grounded more in speculation than fact, the Federal Circuit finally rejected the so-called “25 percent rule,” a rule of thumb used in calculating a reasonable royalty.
The 25 percent rule allowed an expert to opine that the accused infringer would pay a royalty rate equivalent to 25 percent of its profit on the product practicing the patent at issue.
For many years, patent defendants faced an uphill battle against the 25 percent rule because the resulting royalty was often disproportionate to the actual economics of the alleged infringement.
The Federal Circuit changed all that in Uniloc USA, Inc. v. Microsoft Corp., 632 F. 3d 1292, 1315 (Fed. Cir. 2011), when it held “as a matter of Federal Circuit law that the 25 percent rule of thumb is a fundamentally flawed tool…. [and] 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.”
Application of the 25 percent rule during trial in Uniloc highlighted just how speculative the “rule” could be. The patent involved a software registration system to deter copying, which was asserted against Microsoft’s Product Activation feature.
The district court allowed the 25 percent rule to be presented at trial by Uniloc’s expert, who opined that the royalty rate would be $2.50 for each product key sold by Microsoft, which, on average, cost $10 per key and evidently represented nearly 100% profit. The expert then “determined” that the royalty rate should not be adjusted based on other factors because “the factors in favor of Uniloc and Microsoft generally balanced out.”
As a result, the expert said $564 million was the correct damages figure. The jury proceeded to award somewhat less – “only” $388 million – and Microsoft appealed against use of the 25 percent rule.
Rejecting the 25 percent rule, courts returned to requiring the full-fledged “hypothetical modeling” approach outlined in Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970).
A hypothetical royalty negotiation is modeled between the potential licensee and the patent holder on the assumption that the patent is valid and infringed. The model first defines a bargaining range with the upper end of the range set by the largest amount the potential licensee would willingly pay, but the lower end is pegged to the minimum amount the patent holder can accept.
The model then considers multiple factors to determine where the hypothetical negotiators would strike a bargain within that range. If done correctly, the hypothetical negotiation results in a benefit for both sides instead of reaching no deal at all.
By tying the reasonable royalty to the facts of the case and considering a wide array of particular circumstances, it is expected a fairer outcome will result as compared to applying an arbitrary 25 percent rule.