Reasonable Royalty 25% Rule Is Dead

|||Reasonable Royalty 25% Rule Is Dead

Reasonable Royalty 25% Rule Is Dead

January 2011

The Federal Circuit ruled in Uniloc USA, Inc. v. Microsoft Corp. (January 4, 2011) that the widely used but fatally flawed 25 percent rule can no longer be part of reasonable royalty damages calculations. Generally speaking, the rule pushed patent infringement damages higher. Because a reasonable royalty is the most frequently used measure of damages in patent infringement cases, this is a significant ruling that changes many patent infringement damage presentations.

This ruling affects numerous cases that are in the process of being litigated. Those using the 25 percent rule who have already issued damage reports under FRCP 26(a)(2) should consider how to amend their damage calculation to remove consideration of the now-forbidden rule of thumb.

Section 284 of Title 35 of the United States Code provides that patent infringement damages shall “in no event [be] less than a reasonable royalty for the use made of the invention by the infringer, together with interest and costs as fixed by the court.” In performing these calculations expert testimony is usually offered. The factors to be considered are based on the fifteen so-called Georgia-Pacific factors that come from Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970).

In applying certain of these Georgia Pacific factors, expert witnesses have used the 25 percent rule of thumb for around two decades. The Federal Circuit acknowledged that (i) this 25 percent rule has been widely criticized by many experts, (ii) it had “passively tolerated” the rule of thumb, and (iii) the rule has been widely accepted as evidence. As to its evidentiary merit, the Federal Circuit said:

“Lower courts have invariably admitted evidence based on the 25% rule, largely in reliance on its widespread acceptance or because its admissibility was uncontested.”

Because of its common use, the outright killing of the 25 percent rule of thumb dramatically changes damages calculations in patent infringement cases, as well as in trademark cases where it is sometimes also used. The Federal Circuit ruled:

“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.”

The Federal Circuit described the 25 percent rule and its supposed justification as follows:

“The 25 percent rule of thumb is a tool that has been used to approximate the reasonable royalty rate that the manufacturer of a patented product would be willing to offer to pay to the patentee during a hypothetical negotiation. The Rule suggests that the licensee pay a royalty rate equivalent to 25 per cent of its expected profits for the product that incorporates the IP at issue. As explained by its leading proponent, Robert Goldscheider, the rule takes the following form:

 

‘An estimate is made of the licensee’s expected profits for the product that embodies the IP at issue. Those profits are divided by the expected net sales over that same period to arrive at a profit rate. That resulting profit rate, say 16 per cent, is then multiplied by 25 per cent to arrive at a running royalty rate. …’

The underlying assumption is that the licensee should retain a majority (i.e. 75 percent) of the profits, because it has undertaken substantial development, operational and commercialization risks, contributed other technology/IP and/or brought to bear its own development, operational and commercialization contributions. …”

According to its proponents, the veracity of the 25 percent rule has been ‘confirmed by a careful examination of years of licensing and profit data, across companies and industries.’ Goldscheider published a further empirical study in 2002, concluding that across all industries, the median royalty rate was 22.6 percent, and that the data supported the use of the 25 percent rule ‘as a tool of analysis’. Additionally, in a 1997 study of licensing organizations, 25 percent of the organizations indicated that they use the 25 percent rule as a starting point in negotiations.” [Citations omitted]

With each attempted support of the 25 percent rule, my firm analyzed the underlying data. In each attempted support, the data actually showed that this rule of thumb was unreliable because the data varied considerably. Although the median of the underlying data might have been roughly compared to 25 percent, the data was so variable as to demonstrate that the use of the rule in any particular case was pure unreliable guesswork.

Like any rule of thumb, the 25% percent rule sacrifices accuracy for ease. Because it is so flawed, neither this author nor anyone else in our firm has ever used the 25 percent rule of thumb for any substantial purpose. There is good economic reason why the rule of thumb fails to provide a reliable answer. The 25 percent rule fails to consider:

  1. Differences in the classification of expenses
  2. Expenses in cost of sales that are fixed
  3. Impact of all selling, general and administrative costs that are affected by the product
  4. Consequences to overall revenues and costs
  5. Investment risks
  6. Exclusivity, geographic or other limitations

While not directly analyzing the 25% percent rule, the Federal Circuit did review the results of other cases in which the Federal Circuit concluded that the use of other licenses to determine a reasonable royalty for the patent-in-suit can only be proper if there are substantial similarities to the underlying licensed technology and circumstances. The Federal Circuit then concluded its discussion of these case precedents as follows:

“The meaning of these cases is clear: there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case. The 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement. The rule does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party. Relying on the 25 percent rule of thumb in a reasonable royalty calculation is far more unreliable and irrelevant than [other rejected analyses]. …”

The Federal Circuit Court also addressed the application of the entire market value rule. The entire market value rule allows a patentee to use the entire market value of the accused product as a base against which a royalty is calculated only where the patented feature (i) creates the basis for customer demand, or (ii) substantially creates the value of the component parts. In the Uniloc case, there was no question that the plaintiff’s patent was not the basis for end customer demand, but the District Court nevertheless admitted evidence of the entire market value of Microsoft’s product as a “check” of the reasonableness of the royalty rate. The District Court later granted a new trial on damages based on this improper entire market value evidence. The Federal Circuit agreed that the entire market value evidence was improper, and upheld the District Court’s ruling on the improper application of the entire market value rule.

This decision ends the debate over the blanket applicability of this (or any other) rule of thumb. It further encourages a tight application of the entire market rule.

See our discussion of ResQNet.com vs. Lansa for background of one of the recent Federal Circuit cases that served as the basis of this Uniloc USA, Inc. v. Microsoft decision.

Fulcrum Inquiry performs litigation damage analysis, including in patent infringement cases.

 

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