Methodologies for Determining Reasonable Royalty Damages

Introduction

Section 284 of the Patent Statute states that a patentee is entitled to damages adequate to compensate for any infringement and that compensation cannot be less than a reasonable royalty for the use made of the invention by the infringer. In other words, the minimum the patentee can recover is the royalty that it and the infringer actually would have agreed upon had there been no infringement suit. In those cases where a patentee cannot prove actual damages (e.g., lost profits) for any or all of the infringing sales, the patentee is still entitled to damages for all the infringing sales. This class of “non lost profits” damages is referred to as “reasonable royalty” damages. Some consider this nomenclature to be misleading because historically the negotiated royalty rate to which the statute refers is frequently not the “reasonable royalty” awarded in court. In fact, reasonable royalty damages awards can be much higher than any actual royalty rate in the particular industry, sometimes exceeding lost profits damages. Further, the Federal Circuit has rejected attacks on such high reasonable royalty damages awards based on an argument that the awarded rate exceeds any actual one. Consequently, while it may be called “reasonable royalty” damages, the actual award may not be a reasonable royalty under the non-litigation meaning of that term.

Over the years, the Federal Circuit has made it clear that there is no one methodology for determining “reasonable royalty” damages. To date, it has specifically approved two different approaches. Here, we identify those two methodologies as well as a few other possible approaches, which, while not explicitly approved by the Federal Circuit, have been used in some cases.

Methodology #1: Georgia-Pacific Hypothetical Negotiation

In the seminal case of Georgia-Pacific Corp. v. United States Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970), mod. and aff’d, 446 F.2d 295 (2d Cir. 1971), cert. denied, 404 U.S. 870 (1971), the district court came up with what it characterized as an approach to this damages question, which has now become the most common way to compute reasonable royalty damages. In general, the district court reasoned that a “hypothetical negotiation,” between a “willing licensor” (the patent owner) and a “willing licensee” (the infringer), at the time the infringement began, may be used to determine reasonable royalty damages, and it listed fifteen factors, which, according to the court, were some of the factors considered in other leading cases. Id. at 1120. In most cases, but not all, this Georgia-Pacific methodology attempts to set a percentage royalty rate, which is then multiplied by the dollar amount of infringing sales to calculate the dollar amount of “reasonable royalty” damages.

While the Federal Circuit considers the “willing licensor-willing licensee” label to be an “absurd” characterization of any attempt to determine reasonable royalty damages, see Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538, 1554 n. 13 (Fed. Cir. 1995) (en banc); Maxwell v. J. Baker, Inc., 86 F.3d 1098, 1109 (Fed. Cir. 1996), it nevertheless looks at the 15 Georgia-Pacific factors as a way to raise a truly negotiated royalty rate (where there was no infringement) to the level where it compensates for the infringement that did actually occur, id. at 1109-1110. As a result, while the Federal Circuit has expressly approved reasonable royalty damages findings based on the Georgia-Pacific approach, its view of this approach is not that it is a “willing licensor-willing licensee” analysis. And it has rejected reasonable royalty damages contentions based too literally on that label.

Key Assumption: Patent Is Valid and Infringed

The Georgia-Pacific approach first requires an assumption that, at the time of the hypothetical negotiation (which is when the actual infringement begins even if damages do not start then), both parties agree that the patent is valid and infringed. Because this assumption almost never exists in any real-world licensing negotiation, this is a further reason that the infringer must be careful in presenting a damages defense based on what the parties might have actually negotiated prior to the infringement and the subsequent lawsuit. Indeed, the Federal Circuit has affirmed “reasonable royalty” rates based on the Georgia-Pacific approach that are in excess of anything the parties would have actually agreed upon as a result of licensing negotiations prior to the infringement. For example, in Deere & Co. v. International Harvester Co., 710 F.2d 1551, 1554-58 (Fed. Cir. 1983), the Federal Circuit affirmed a damages award of a 15% royalty when patent-in-suit had been licensed and offered for license at 1%. Similarly, in other cases, the Federal Circuit has affirmed damages royalty rates of 20%, 33%, and 40% of the infringing sales, as well as other similar high rates that exceeded any actual rate in the particular industry, see e.g., Bio-Rad Laboratories, Inc. v. Nicolet Instrument Corp, 739 F.2d 604 (Fed. Cir. 1984); Biotec Biologische Naturverpackungen GmbH & Co. KG v. Biocorp, Inc., 249 F.3d 1341 (Fed. Circ. 2001); Minco, Inc. v. Combustion Engineering, Inc. 95 F.3d 1109 (Fed. Cir. 1996).

Fifteen Georgia-Pacific Factors

The fifteen Georgia-Pacific factors are as follows. Not all may be applicable in any given case. Further, some may, in certain cases, act to lower the damages royalty rather than increase it. Thus, in any given case, some factors may increase the royalty, while others could be neutral or tend to decrease it. The net result, however, can never be below the statutory minimum, which is really reflected by the last factor.

1. The royalties received by the patent owner for the licensing of the patent-in-suit, proving or tending to prove an established royalty;
2. The rates paid by the licensee for the use of other patents comparable to the patent-in-suit;
3. The nature and scope of the license, as exclusive or non-exclusive, or as restricted or non-restricted in terms of territory or with respect to whom the manufactured product may be sold;
4. The licensor’s established policy and marketing program to maintain its patent monopoly by not licensing others to use the invention or by granting licenses under special conditions designed to preserve that monopoly;
5. The commercial relationship between the licensor and the licensee, such as whether they are competitors in the same territory in the same line of business, or whether they are inventor and promoter;
6. The effect of selling the patented specialty in promoting sales of other products of the licensee; the existing value of the invention to the licensor as a generator of sales of its non-patented items; and the extent of such derivative or convoyed sales;
7. The duration of the patent and the term of the license;
8. The established profitability of the product made under the patent; its commercial success; and its current popularity;
9. The utility and advantages of the patent property over the old modes or devices, if any, that had been used for working out similar results;
10. The nature of the patented invention; the character of the commercial embodiment of it as owned and produced by the licensor; and the benefits to those who have used the invention;
11. The extent to which the infringer has made use of the invention, and any evidence probative of the value of that use;
12. The portion of the profit or of the selling price that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions;
13. The portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer;
14. The opinion testimony of qualified experts; and
15. The amount that a licensor (such as the patent owner) and a licensee (such as the infringer) would have agreed upon (at the time the infringement began) if both had been reasonably and voluntarily trying to reach an agreement; that is, the amount that a prudent licensee – who desired, as a business proposition, to obtain a license to manufacture and sell a particular article embodying the patented invention – would have been willing to pay as a royalty and yet be able to make a reasonable profit, and which amount would have been acceptable by a prudent patent owner who was willing to grant a license.

Variations on the Georgia-Pacific Approach

The starting premise for the Georgia-Pacific approach is a licensing negotiation that occurs at the instant infringement begins. This would seem to mandate that the fifteen Georgia-Pacific factors are evaluated as of that time, and nothing thereafter counts. This is not necessarily the case. In fact, the Federal Circuit has approved consideration of some later events in this analysis. (This look-into-the-future concept is sometimes referred to as the “Book of Wisdom” approach.) For example, in SmithKline Diagnostics, Inc. v. Helena Laboratories, Inc., 926 F.2d 1161 (Fed. Cir. 1991), the Federal Circuit affirmed a 25% damages royalty based on evidence of the commercial success of the invention, not all of which necessarily pre-dated the infringement. In addition, Georgia-Pacific factor 11 specifically relates to the extent the infringer has made use of the invention and the value of that use, all of which must occur after the hypothetical negotiation, which is set at the instant the infringement begins. However, not all future events are considered relevant. In particular, the Federal Circuit has been reluctant to “look into the future” and reduce a damages royalty based on low actual profit margins for the infringer on the infringing product or process. See Hanson v. Alpine Valley Ski Area, Inc., 718 F.2d 1075,1081 (Fed. Cir. 1983).

Methodology #2: Analytical Approach

The “analytical approach” is the second methodology specifically approved by the Federal Circuit for computing reasonable royalty damages. In reality, it has nothing to do with any hypothetical negotiation, but rather, it involves calculating damages based on the infringer’s own internal profit projections for the infringing item at the time the infringement began, and then apportioning the projected profit between the parties as a percentage of sales. The patentee’s percentage is then applied to the sales dollars for the actual infringing sales to determine the reasonable royalty damages.

The Federal Circuit approved this method in TWM Manufacturing Co. v. Dura Corp., 789 F. 2d 895 (Fed. Cir. 1986), cert. denied, 479 U.S. 852 (1986). There, the infringer had an internal memo just before infringement began projecting a gross profit of about 50% for each infringing sale, from which the projected net profit was computed to be about 40% of the anticipated sales price. As the standard industry net profit was about 10% of the sales price, the special master awarded the patentee a reasonable royalty damages rate of the difference – 30%. This rate was then applied to the infringer’s actual sales figures to calculate the reasonable royalty damages. It had nothing to do with any hypothetical negotiation. Instead, it was strictly an apportionment based on the infringer’s projections. The Federal Circuit not only affirmed, but it also expressly rejected the infringer’s contention that the Georgia-Pacific approach was the only possible approach to computing reasonable royalty damages. The Federal Circuit made it clear that other approaches were possible, and this one was proper.

The existence of such a document as found in TWM is not all that unusual, at least in larger companies. Many require some sort of profit projection before the project goes forward or at least before a project is finally approved. Part of the approval process usually involves a comparison between projected profits for the proposed product and the company’s standard profit margins (with projects having projections above the standard margin being the ones that get approved). The amount of the projected excess profit could be the reasonable royalty damages under the analytical approach.

Possible Additional Methodologies: Rule of Thumb

Until recently, some commentators and experts had opined that, as a “rule of thumb,” about 25% (or a bit more) of the profit margin for any infringing products should be attributed to the infringed patent. Generally, when this has been used in cases, it becomes the starting point for a more traditional Georgia-Pacific analysis, which is then used to set the royalty rate that is actually applied to the dollar sales of the infringing products to compute the reasonable royalty damages.

For many years, the Federal Circuit avoided dealing directly with the “rule of thumb” approach. The court suggested that essentially the basic “rule of thumb” approach might, by itself, be enough. For example, in Fromson v. Western Litho Plate & Supply Co., 853 F.2d 1568 (Fed. Cir. 1988), the Federal Circuit rejected the lower court’s reasonable royalty damages calculation. The lower court had concluded (ostensibly in the context of a Georgia-Pacific analysis) that the infringer’s profit margin was 10%, of which (by several steps) about 0.8% constituted the damages royalty rate. In remanding, the Federal Circuit instructed the district court that it could measure reasonable royalty damages as a percentage of the infringer’s net or gross profits on the infringing product.

However, the Federal Circuit squarely rejected the “rule of thumb” approach in Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d 1292 (Fed. Cir. 2011). The court stated: “This court now holds as a matter of Federal circuit law that the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation. Evidence relying on the 25 percent rule of thumb 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.” Id. at 1315.

Possible Additional Methodologies: Established Royalty for the Patent

According to the Federal Circuit (based on 19th-century Supreme Court case law), an established royalty for a patent is the best measure of damages. Theoretically, while this is really the first of the Georgia-Pacific factors, it is essentially the end of the inquiry if it is proven. But the Federal Circuit has interpreted the “established royalty” question in such a way that acceptable proof of such a royalty may be difficult if not impossible in most cases, even if there are a number of licenses for the patent-in-suit. Factors that have been found to undercut an “established royalty” include an insufficient number of licenses to show that the industry as a whole accepted the royalty as reflecting the value of the patent; disregarding licenses in settlement of actual or threatened litigation; and the weakened condition of the licensor when it entered the licenses.

However, with the advent of standard setting and patent pools (which sometimes involve the patentee’s own proposal for a royalty of its patents involved), it is possible that this could change. Such a royalty may be offered and perhaps accepted virtually industry-wide and need not involve threats of litigation. There is no Federal Circuit case, however, holding that such facts create an “established royalty” for the patent. Nevertheless, this “established royalty” methodology may be viable in this context.

Possible Additional Methodologies: Many Licenses in a Small Range of Rates

Many large companies have a very significant number of patent licenses, involving both their own patents and patents licensed from others. It is not unusual for the range of royalty rates for such licenses to fall in a relatively small range. In at least one case, a patentee has tried (ultimately unsuccessfully) to base a damages royalty rate merely on the range of rates in its existing licenses. While this might at first seem like a poor way for the patentee to approach this, it can, in a given case with a very large number of infringing units or an unusually expensive royalty base, result in a windfall not attainable by the more traditional analysis. (While the case did not use this approach, in Hughes Aircraft Co. v. United States, 86 F.3d 1566 (Fed. Cir. 1996), the royalty rate of a mere 1% resulted in $3.5 billion in damages, affirmed by the court.)

Possible Additional Methodologies: Cost Savings

In general, reasonable royalty damages, even determined by the Georgia-Pacific approach, do not necessarily require the setting of a royalty rate that is applied to sales. This is particularly true when dealing with method patents. In one such case, Hanson v. Alpine Valley Ski Area, Inc., 718 F. 2d. 1075 (Fed. Cir. 1983), the invention involved snowmaking machines and a new method of making snow. The magistrate in the lower court case computed “reasonable royalty” damages using the patent method based on a percentage of the cost savings for each gallon of water used. The Federal Circuit affirmed, even though this royalty would exceed the cost of the machine over a few years. Id. at 1081. While the approach in Hanson was theoretically in the context of the Georgia-Pacific methodology, a careful review of the case finds that this cost savings was essentially the only factor involved in setting damages (although the infringer had unsuccessfully argued otherwise).