Federal Circuit Damages Decision Emphasizes The Importance Of Sound Economic Models

Messers James E. Malackowski and Robert M. Hess are Chief Executive Officer and Chief Financial Officer, respectively, for Ocean Tomo, LLC, an integrated intellectual capital merchant bank providing finance, asset and risk management, M&A advisory and valuation, diversity and expert services. www.oceantomo.com

On July 31, 2002 the United States Court of Appeals for the Federal Court issued its opinion in the case of William G. Riles v. Shell Exploration and Production Company. In making its ruling, the Federal Circuit described the damage award as being "excessive and unsupported by evidence" and therefore vacated the district court’s award and remanded the case for a re-determination of damages.

While such a situation obviously creates consternation for the client, it also may cause severe hardship for outside counsel and damages experts alike in the form of strained relationships and tarnished reputations. Through a review and analysis of the initial damages award and its subsequent reversal, this article provides additional insight into the determination and calculation of sound damages awards, and highlights the importance of thoroughly supported opinions.

Riles filed suit against Shell for infringement of U.S. Pat. No. 4,669,918 (the `918 patent). With respect to the construction of Shell’s "Spirit" oil drilling platform, the `918 patent relates to a method of construction and installation of fixed offshore drilling platforms. A fixed offshore drilling platform is essentially comprised of foundational pilings imbedded into the sea floor, a tower or "jacket" going to the surface and an above-water "deck." Prior to the `918 patent, "mud mats" were typically used to temporarily level and support the jacket while it was anchored to the sea floor with foundation pilings. According to the invention in the `918 patent, pilings were imbedded first and then the jacket was attached to the pilings. The two main advantages afforded by this method were a cost savings resulting from the exclusion of the mud mats and the use of less jacket material due to improved structural support. At the conclusion of the trial, the jury returned a verdict of infringement and awarded Riles $8.7 million in damages.

Riles’ damages expert prepared three economic models which he used to support his damages position. In ruling on the case, the Federal Circuit could have relied on any of the three models as support for the jury’s award, but found insufficient evidence to support any of the three models.

Economic Model #1

The first model calculated damages by applying a 2 to 5 percent royalty rate to the entire cost of Shell’s platform. The model was based on the assumption that Shell’s construction of a platform utilizing the patented method could result in an injunction on behalf of Riles, thus forcing Shell to either abandon the $84 million platform or pay a percentage of the total cost as a royalty.

Economic Model #2

The second model claimed that Riles deserved a 2 to 5 percent royalty on the gross revenue generated by the platform in its first year of production. Similar to the first economic model, the second model assumed that Riles could enjoin Shell from using the platform. Under such a scenario, Shell would have been willing to pay a percentage of its revenues for use of the patent.

Economic Model #3

The third model simply added the first two models together while providing no actual basis for their combination.

In dismissing the first two models, the Federal Circuit identified two key flaws. First, assuming that an injunction would be granted was legally incorrect. There was insufficient evidence to support an injunction on the use of the Spirit platform, merely because of its method of construction. Second, and more economically important, the Court concluded that the "market" would pay Riles only for his patented product. Therefore, it was incorrect to apply a royalty rate to the entire cost of the platform or the platform’s overall revenues. The Court rightly stated that there was no relationship between the patented method and the total cost of the platform or its revenues. In forming its opinion, the Federal Circuit found that, in a hypothetical negotiation, Shell would have had non-infringing alternative methods for installing the platform. Thus, the negotiation would have been driven by the economic relationship between the patented method and the non-infringing alternative methods. Finally, the Federal Circuit found that the third model compounded the errors in the first two models and therefore found no basis on which it could be supported.

This case is an excellent example of the need and importance of a fully supported and economically sound damages model. In complex cases involving complex business decisions, such as today’s patent infringement cases, it is of utmost importance that damages calculations and their related issues are not looked at in a vacuum. Rather, a well-rounded, defensible opinion must consider all the relevant facts, evidence and circumstances of each particular situation surrounding the alleged infringement. From that perspective, this case contains many examples of critical facts/pieces of evidence that were indeed relevant to properly determine economic damages.

The Federal Circuit emphasized that there must be an economic relationship between the patent-in-suit and the damages model. In today’s patent infringement lawsuits, the plaintiff can no longer propose an exorbitant damages claim in hopes of receiving a windfall from the jury. The Federal Circuit recognizes that the ownership of a valid patent does not necessarily mean that the alleged infringer can be "held up for ransom." The damage figure must be tied to sound economic and accounting principles in assessing what monetary damages are due to the plaintiff.

In this case, it is clear that this economic relationship is based on the cost savings that the patent offers. Clearly, the appropriate damages model should be grounded in an analysis of the cost savings achieved by Shell through its use of the `918 patent. By ruling that Riles could not hold Shell "over a barrel" through the enforcement of its patent, the Court concluded that the value of the benefits provided by the invention must be limited to the invention itself and not the cost and/or benefit of the entire platform.

However, under a different set of facts and circumstances, a patented component may equate to greater economic value. Often discussed as the "entire market value rule," this concept addresses situations where a patent covers only part of a product, but a part that is of such paramount importance that it substantially creates the value of the entire product. In such cases, it may then be appropriate for the patentee to recover damages based on the entire product. Again, the key is to analyze the substantive relationship between the patent-in-suit and the infringing product and to consider all relevant evidence and facts related to each specific case.

The Federal Circuit also identified the critical importance of determining the alternatives available to each of the parties at the time of the hypothetical negotiation. In that regard, it is assumed that both parties would have had knowledge of those alternatives and, as such, would have negotiated a royalty that is consistent economically with those options. Generally, when the value of the invention is limited to the cost savings it produces, the additional cost to the infringer for using its "next best alternative" creates an economic cap to the amount it would pay for use of the patented invention. Although this basic concept is straight forward, the analysis quickly becomes very complex in infringement lawsuits, as the factual evidence must determine the alternatives’ total cost, availability, quality, market acceptance, timing, etc.

Again, the Riles case provides a useful example. Although some evidence was presented at trial that mud mats were an available alternative and would have cost Shell an additional $350,000; there was conflicting evidence that, due to certain geological conditions of the sea floor, mud mats were not an alternative. An appropriate economic model would have pursued this critical information through additional documents, deposition testimony, or market research. At a minimum, there also would be more questions to answer related to the additional material cost savings the patented method may provide in determining the complete value afforded to Shell.

Analyzing the parties’ "next best alternative" is an important step and a simple concept to convey. However, the facts and evidence of each case make this economic principle extremely complex and difficult to model in many patent infringement cases.

Another important piece of economic evidence that the damages models did not incorporate was the historical licensing practices of the plaintiff, Riles. Although evidence was presented to suggest that Riles’ past royalty rate agreements were based on either a percentage of savings that the licensee would have realized or a fee based on platform depth (potentially related to the cost savings associated with the invention), the plaintiff’s damages models calculated a royalty based on the cost/benefit of the entire platform. Every damages model must be thoroughly grounded in the facts of the case. The plaintiff simply cannot belie certain facts and evidence so as to create an inconsistent economic model. In this case the calculation not only ran contrary to the factual evidence, but it also was inconsistent with the first of the 15 factors set forth in Georgia Pacific v. United States Plywood Corp., which is focused on "the royalties received by the patentee for the licensing of the patent-in-suit (proving or tending to prove an established royalty)." From the Federal Circuit’s opinion it is clear that all available evidence must be considered in developing economic and accounting damages models.

• Understand the key assumptions that drive any damages model. Be aware of the source of those assumptions along with their defensibility and potential impact on the damages calculation. Question and critically challenge key assumptions whenever possible.

• Monitor the analysis throughout the entire process to understand the direction and general methodology employed. Also, be prepared to obtain additional discovery if required so that legal schedules and deadlines do not preclude the collection of valuable economic and accounting information.

• Question any alternative theories that may have been considered. Understand why those alternative theories are not applicable. Inquire into and challenge the ultimate conclusions of the damages model.

The Federal Circuit’s decision in this case is an excellent reminder to professionals responsible for working with damages models. As has been addressed in previous decisions, this opinion stresses the importance of creating strategically sound damages models that are not only supported by the specific facts, circumstances and evidence present, but also grounded in economic principles and "real world" analyses.

James E. Malackowski Robert M. Hess Messers James E. Malackowski and Robert M. Hess are Chief Executive Officer and Chief Financial Officer, respectively, for Ocean Tomo, LLC, an integrated intellectual capital merchant bank providing finance, asset and risk management, M&A advisory and valuation, diversity and expert services. www.oceantomo.com