NDIll addresses EMVR, apportionment, unpatented items in royalty base, and price erosion

On March 26, 2014, Judge St. Eve of the Northern District of Illinois issued a lengthy, detailed damages opinion in Sloan Valve Co. v. Zurn Industries, Inc., Case No. 10-cv-00204, in which defendant Zurn moved to exclude testimony of plaintiff's damages expert, Richard Bero. The court addressed several interesting damages issues, including entire market value rule, apportionment, inclusion of unpatented items in the royalty base, and price erosion. The court granted Zurn's motion.

It is important to understand the patented invention and the accused products for the opinion. The patent relates to toilet flush values having a dual mode operation, one for solid waste and the other for liquid. The solid flush would provide a "full flush volume," while the liquid flush would flush with a smaller volume, thus saving water in the liquid mode. The patented dual activation of the handle allowed these two modes.

Bero arrived at a $106 per unit royalty for a total of $7.8 million. He also opined that Sloan had suffered $1.2 million in price erosion damages. Bero applied the entire market value rule (EMVR) because he contended Sloan's patented invention drove demand for the accused products the dual mode flush values. Bero claimed, however, that even though EMVR applied to base the royalty on the entire flush valve, the revenue from the sale of the accused products did not represent the full value of the patented product because it failed to account for the value of sales of collateral goods and of Sloan's pricing considerations (i.e., Sloan's ability to raise its prices in the absence of infringement). Slip op. at 7. Bero opined, then, that the proper royalty base was not just the accused product's revenue, but the entirety of the revenue generated by Zurn's infringing products that included the dual mode valves, plus packages and handles and collateral products (replacement diaphragm kits, urinal valves, and faucets), as well as pricing issues arising from Sloan's inability to raise prices.

Bero also used an approach to reasonable royalty computations that is rarely overtly used in patent cases the "income valuation approach." This approach considers "the amount of profit that is attributable to the invention and/or the increased profits derived from the invention." Slip op. at 8. Bero stated that the "overriding consideration [in this approach] is that Sloan would be directly licensing away its profits on its Patented Products and collateral sales as well as subjecting itself to ongoing pricing pressure on its Patented Products from Zurn that otherwise would not exist." Id. Notably, this sounds a lot like lost profits, without the added burden to prove "but for" causation.

To arrive at the $106 per unit royalty, Bero reasoned that Sloan's floor in a hypothetical negotiation would have been $141 per accused product this included the profits Sloan would have made on the patented dual flush valve packages and handles, the collateral products, and the price erosion (which he called "pricing effect"). He reasoned that Zurn's ceiling would have been $60 per product. He found a "negotiation gap" of $60 between those points, and used the midpoint ($100) as the starting point the hypo negotiation. Applying the Georgia-Pacific factors to the $100 midpoint, he arrived at a per unit rate of $106.

The court found several problems with Bero's methodology: (1) Bero failed to limit his per-unit rate to the value attributable to the patented invention; (2) Bero improperly included profits from the sale of unpatented collateral items in the royalty base; (3) Bero's inclusion of the "pricing effect" in what amounted to the royalty base was improper; (4) Bero's selection of the midpoint of the "negotiation gap" was arbitrary and unreliable; (5) his purported reasonable royalty methodology was in effect a lost profits calculation; and (6) Bero's computation of price erosion damages was flawed.

On item (1), the court broke the analysis down into two components: valves and packages/handles. For the valves, which is where the patented feature existed, Bero concluded that the manual flush valve was the smallest salable patent practicing unit and that, under EMVR, the manual flush vale drove demand for manual dual flush products. Zurn countered that Bero had failed to perform a customer survey, regression analysis, or other fact based analysis of demand sensitivities, and thus that the EMVR could not be satisfied. The court disagreed with Zurn that such analysis was necessary to satisfy EMVR. Zurn next contended that Bero had failed to apportion for the value of the improved dual mode flush over manual single flush vales. The court rejected this argument, finding that the dual mode flush valve was an entirely new product rather than an improvement over an existing product. In sum, regarding the valves, the court found that Bero's analysis was "sufficiently reliable." Slip op. at 14.

However, concerning the packages/handles component of issue (1), the court found to the contrary. Sloan argued that because Bero used a per unit royalty he was not basing the royalty on Zurn's revenues, citing Ericsson v. D-Link, 2013 WL 2242444 (EDTX May 21, 2013). The court distinguished Ericsson because there the expert did not implicate EMVR because he limited his revenue base to the "contribution of the asserted patents to the end products" rather than simply the market value of the end products, finding that Bero had done no such thing. The court also rejected Sloan's argument that the packages/handles only applied to a small amount of Zurn's sales. Finally, the court observed that Sloan had failed to argue that EMVR would allow inclusion of this component in the royalty base, and besides, the patented valves did not constitute a functional unit in combination with toilets, handles, and related accessories evidenced by over 50% of the valve sales of both Sloan and Zurn being separate from these other parts.

Turning to issue (2), the court rejected Bero's inclusion of collateral items into the per unit royalty. Bero based his inclusion on GP factor 6 which allows for consideration of unpatented collateral items in computing a reasonable royalty. Bero opined that the collateral items contributed as much to the $106 per unit rate as the royalty on the accused valves. The court agreed with Zurn that GP factor 6 does not permit a quantitative addition (i.e., the total value of the collateral item) into the royalty base, but rather a qualitative adjustment of the rate determined for the patented product. The court cited Micro Chem, 317 F.3d 1387, 1393 (Fed. Cir. 2003), to support this conclusion. There, the Federal Circuit upheld a trial court's ruling that the patentee could not include sales of unpatented items in the royalty base but would demonstrate those sales were relevant to determining the reasonable royalty, and found that proper application by the expert was to opine that this factor would increase the rate. The court also cited Judge Rader's opinion in Cornell, in which he stated that an "over-inclusive royalty base including revenues from the sale of noninfringing components is not permissible simply because the royalty rate is adjustable." Slip op. at 18 (citing Cornell, 609 F. Supp. 2d 279, 286). (Surprisingly, the court did not address the Federal Circuit's decision in Interactive Pictures Corp. v. Infinite Pictures, Inc., 274 F.3d 1371, 1384-86 (Fed. Cir. 2001), in which the court found no error in the district court's inclusion of convoyed items in the base AND factoring them into the rate. Perhaps Sloan did not cite it.)

On issue (3)—the "pricing effect"—the court noted that more than half the $106 rate was composed of this pricing effect. Here, Bero opined that Sloan would have sold its patented valves at higher prices without Zurn in the market. This, of course, smacks of lost profits. The court found several problems here: (a) Bero lacked foundation to conclude that Sloan would have made every sale that Zurn made (i.e., failure of "but for" proof as in lost profits); (b) Bero based his inclusion of this pricing effect component on GP factor 5, which considers the commercial relationship between the patentee and infringer, and he applied it quantitatively instead of qualitatively (just like the unpatented items in issue (2)); (c) the pricing effect component was twice as large as the value attributed to the patented invention, again smacking of lost profits.

Regarding issue (4)—the—negotiation gap the court found no justification that would satisfy the Daubert standard. The court indicated that Bero's explanation for selecting the midpoint was lacking, citing testimony where Bero was asked to justify the midpoint to which he responded: "why wouldn't you use the midpoint as a reasonable starting point." Slip op. at 23. The court reasoned this was akin to using the 25% rule.

On issue (5)—Bero's—methodology the court was troubled by the per unit rate, and the fact that Bero's base was simply the number of units sold rather than the revenue generated by the infringement. The court concluded that Bero's methodology was an attempt to include lost profits by incorporating them into his reasonable royalty calculation. The court distinguished MPT v. Apple, 2012 WL 5873711 (SDCA Nov. 20, 2012), in which the court permitted a per unit royalty. According to the court here, the plaintiff's expert in MPT testified that the $1.50 per unit rate would be only a small fraction of the revenue from the accused products. The court also once again noted that Bero had included unpatented items and the pricing effect into his per unit rate. The court concluded that Bero's methodology was unreliable.

Finally, the court addressed issue (6) price erosion damages. It cited the same two issues with the pricing effect: the failure to consider price elasticity (i.e., the sensitivity of volume to price increases) and the failure to demonstrate that Sloan would have made all of Zurn's sales had it not been in the market.