United States: Federal Circuit Takes a Hard Look at the "Entire Market Value Rule"

A patent owner may recover from an infringer "damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use made of the invention by the infringer." 35 U.S.C. § 284. Reasonable royalty damages typically are determined by applying a royalty rate (the royalty percentage) to a royalty base (revenue derived from the infringing activity). For example, a 5% royalty rate applied against $200 million in sales of an infringing product would result in a reasonable royalty damages calculation of $10 million. The calculation is seldom that simple, however, because this example assumes that all of the revenue derived from sale of the infringing product should constitute the royalty base. But what if the infringed patent concerns only one feature of many in the infringing product? Should all of the revenue derived from the sale of the infringing product form the royalty base, or should the royalty rate be applied against only a portion of the infringing revenue, to account only for the contribution that the invention claimed in the infringed patent made to those sales?

Under certain circumstances it may be appropriate to apply a royalty against the entire revenue base of an infringing product even if the claimed invention constitutes only one feature of that product. In particular, the entire market value rule "permits recovery of damages based on the value of the entire apparatus containing several features, where the patent-related feature is the basis for customer demand." State Indus., Inc. v. Mor-Flo Indus., Inc., 883 F.2d 1573, 1580 (Fed. Cir. 1989). In other words, where the patented feature drives customer demand for the entire product, the entire market value rule permits the patent owner to treat all revenue from the infringing product as an appropriate royalty base when calculating reasonable royalty damages.

As part of its patent reform efforts, Congress has been considering a variety of statutory revisions aimed at limiting the ability of patent owners to recover damages considered by some to be excessive, including restrictions on the scope and application of the entire market value rule. Commentators have argued that the rule is misplaced or inconsistent with the Patent Act's damages provisions. For its part, the U.S. Court of Appeals for the Federal Circuit recently confirmed the viability of the rule, but in so doing it made clear that courts must be vigilant when applying the rule to protect against excessive damages awards.

Lucent v. Gateway

In an opinion written by Chief Judge Paul R. Michel, the Federal Circuit vacated a $358 million damages award in favor of Lucent and remanded the case back to the district court for a new trial on damages. Lucent Techs., Inc. v. Gateway, 580 F.3d 1301 (Fed. Cir. 2009). The Federal Circuit found two errors in the district court's application of the entire market value rule. First, the Federal Circuit found a lack of evidence to support the jury's finding that Lucent's patented invention formed the basis for consumer demand for the defendants' infringing products. Second, the court criticized the approach adopted by Lucent's licensing expert. Initially, Lucent sought to apply a 1% royalty rate to a royalty base comprised of sales of computers containing the infringing software; after the district court precluded Lucent from applying its royalty rate to this larger royalty base, Lucent sought to apply an increased royalty rate of 8% to a royalty base comprised of sales of software. The Federal Circuit observed that by increasing the royalty rate, "Lucent's expert tried to reach the damages number he would have obtained had he used the price of the computer as a royalty base."

Lucent accused the defendants of infringing a patent directed to a method of entering information into fields of a computer screen without using a keyboard (i.e., the patented date-picker feature). Lucent accused Microsoft's Outlook, Money and Windows Mobile of using the patented "date picker" feature. Microsoft sold approximately 110 million units of the three accused products, with a total value of sales of approximately $8 billion. At trial, Lucent sought an 8% royalty against sales revenue for the accused products, and asked the jury to award $561.9 million. The jury ultimately awarded a lump-sum royalty payment of approximately $358 million.

In reviewing the jury's damages award, the Federal Circuit noted:

In light of this evidence that the infringing use of the date-picker tool was only a minor aspect of a much larger software program, that the vast majority of other features did not infringe, and the relative importance of these other non-infringing features (e.g., email), the Federal Circuit concluded that "Lucent did not carry its evidentiary burden of proving that anyone purchased Outlook because of the patented method" and that Lucent, therefore, did not satisfy its burden to recover damages under the entire market value rule.

The Federal Circuit also took issue with the approach adopted by Lucent's licensing expert. Initially, Lucent attempted to apply the entire market value rule to the sale of the computers loaded with the accused software and applied a 1% royalty rate to the entire price of the computers loaded with Outlook. The district court excluded testimony applying the entire market value rule to the royalty base of the revenues associated with the sale of the computers, however, so Lucent changed its position at trial. In view of the district court's ruling, Lucent accepted that the royalty base should be the price of the software – not the entire computer – but it argued that the royalty rate should be increased to 8%, rather than the 1% it applied when the royalty base was the higher priced computer. The Federal Circuit observed that:

The Federal Circuit could have concluded its analysis after determining that Lucent's evidence was insufficient to support application of the entire market value rule. That the court went on to criticize Lucent's damages experts' royalty rate shows the court's willingness to reject an arguably results-driven damages analysis that increased the royalty rate to make up for a decreased royalty base.

Cornell University v. Hewlett-Packard Co.

Following an eight-day trial, a jury awarded damages to Cornell of approximately $184 million after finding Hewlett-Packard liable for infringing a Cornell patent concerning the manner in which computer processors process instructions. The jury applied a 0.8% royalty rate against $23 billion in revenue that Hewlett-Packard had derived from sales of a "CPU brick" including the accused component. In an opinion by Judge Randall R. Rader of the Federal Circuit, sitting by designation in the Northern District of New York, the court reduced the damages award to approximately $53.5 million. Cornell University v. Hewlett-Packard Co., 609 F.Supp.2d 279 (N.D.N.Y. 2009). Judge Rader focused his analysis on the revenue base against which the 0.8% royalty rate should be applied, and concluded that the evidence did not support the jury's damages calculation.

Cornell's patent claims a method for instruction issuance within a computer processor. Cornell "did not develop an entire computing system;" rather, the patent was infringed by just one component of the instruction reorder buffer ("IRB"), itself a part of a computer processor. As Judge Rader explained, "[i]n the anatomy of a Hewlett-Packard server, the processor is the smallest salable patent-practicing unit...the claimed invention is a small part of the IRB, which is a part of a processor, which is part of a CPU module, which is part of a 'brick,' which is itself only a part of the larger server."

The jury's damages calculation, however, used as the royalty base the value of the entire CPU brick. Cornell originally sought damages on the revenue from Hewlett-Packard's entire server and workstation systems, which "include vast amounts of technology beyond the infringing part of the processors." But, the district court determined at an evidentiary hearing that Cornell had not offered "credible and sufficient economic proof that the patented invention drove demand for Hewlett-Packard's entire server and workstation market." Thus, the district court excluded at trial "testimony that the entire market value of Hewlett-Packard's servers and workstations should be used as the royalty base." In response, according to the court, "Cornell simply stepped one rung down the Hewlett-Packard revenue ladder from servers and workstations to the next most expensive processor-incorporating product [the CPU brick]."

As Judge Rader's opinion explained, Cornell still failed to offer "any evidence to show a connection between consumer demand for [the CPU brick] and the patented invention." Indeed, "Cornell chose this [CPU brick] royalty base in favor of another alternative more clearly relevant to the value of the patented invention – the revenue Hewlett-Packard would have earned had it sold each infringing processor as just that, a processor, without any additional non-infringing components...[this] logical and readily available alternative was the smallest salable unit with close relation to the claimed invention – namely the processor itself. Cornell nevertheless stuck to its guns, aiming for the highest royalty base still available after the court's exclusion order."

Ultimately, Judge Rader concluded that the record contained "no reasonable basis for finding that Cornell is entitled to the entire market value of Hewlett-Packard's CPU bricks or servers or workstations as a reasonable royalty base." Instead, Judge Rader found that the processor revenue – "the smallest salable patent-practicing unit" – was an appropriate royalty base from which damages could be calculated by multiplying the 0.8% royalty rate.

IP Innovation L.L.C. v. Red Hat, Inc.

More recently, Judge Rader – this time sitting by designation in the Eastern District of Texas – excluded expert testimony because it "improperly inflate[d] both the royalty base and the royalty rate by relying on irrelevant and unreliable evidence and by failing to account for the economic realties of this claimed component as part of a larger system." IP Innovation L.L.C. v. Red Hat, Inc., No. 2:07-cv-447 (RRR). The expert had attempted to rely on the entire market value rule in identifying the royalty base; Judge Rader, however, determined that the expert's "methodology...[did] not show a sound economic connection between the claimed invention and this broad proffered royalty base." In particular, Judge Rader explained that "[t]he claimed invention [a workspace switching feature] is but one relatively small component of the accused operating systems" and that the "relative importance of certain other features such as security, interoperability, and virtualization" confirm the patented invention's "small role in the overall product." In addition, Judge Rader explained that the expert failed to account "for the record evidence that most users of the accused operating systems do not seem to use the workspace switching feature at all." He issued an order excluding the expert report and reminded the parties "that expert testimony on the topic of damages will not be allowed absent a firm basis in accepted economic principles with an eye to the facts of [the] record."

Conclusion

These recent opinions show that, although the entire market value rule remains viable, if a patent owner seeks to recover damages based on revenue from an entire product or system, courts require trustworthy evidence that an infringing component drives consumer demand for the entire system. In the absence of such evidence, courts will limit reasonable royalty damages to a royalty rate applied against only the economic contribution made by the infringing component. And in any case, the royalty rate sought should reflect the economic realities of the infringing component as part of a larger system. Proper patent infringement damage analyses should take into account the contribution that the patented invention has made to the revenue derived from infringing sales.

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