The 25% Rule is legally inadequate — CAFC

Yesterday, the Court of Appeals for the Federal Circuit (“CAFC”) issued a precedential ruling to the effect that, among other issues in the Uniloc v. Microsoft case, as a matter of Federal Circuit law 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 appeals court was very explicit in stating that Uniloc’s damages expert Joseph Gemini’s starting point of a 25 percent royalty had no relation to the facts of the case, and as such, was arbitrary, unreliable, and irrelevant. The use of such a rule fails to pass muster under Daubert and taints the jury’s damages calculation.

Consequently, as the jury’s damages award was fundamentally tainted by the use of a legally inadequate methodology, the CAFC affirmed the grant of a new trial on damages.

A rule is found

In the late 1950s, Robert Goldscheider performed an empirical study of 18 commercial licenses involving the Swiss subsidiary of a large American company (see e.g.- R. Goldschider, “Litigation Backgrounder for Licensing,”Les Nouvelles, 29 (March 1994), p 20-25). Those licenses referred to the transfer of intellectual property rights to a portfolio of patents, the flow of know-how, trademarks, and copyrights to marketing materials (Goldscheider, Jaroz, and Mulhern, “Use of the 25% Rule in Valuing Intellectual Property”, Chapter 22 in G. Smith & R. Parr, Intellectual Property, Wiley & Sons, 2005). The licensees paid royalties of 5% of sales and typically generated operating profits of 20% of sales. Thus the 5/20 or 25% rule was “discovered.”

The Uniloc damages story

Uniloc’s patent (US5,490,216) covers a system for software registration which Microsoft is allegedly infringing by the way software activation works in Microsoft’s Product Activation feature that acts as a gatekeeper to Microsoft’s Word XP, Word 2003, and Windows XP software programs.

Uniloc’s damages expert arbitrarily picked out an unexplained value attribution of $10, at a minimum, for a Product Key in the context of Microsoft’s business. While it is clear that software piracy prevention measures are valuable, this initial approach completely ignored any specific analysis of the contribution of the software registration algorithm. Dr. Gemini then applied the 25% rule to this $10 amount and posited that $2.50 per activation was the proper royalty due to the patent holder. Multiplying this amount times the number of the accused Microsoft Office and Windows activations, 225,978,721 in all, generates the purported “reasonable royalty” of $564,946,803. The jury found Microsoft willfully infringed the ‘216 patent and awarded $388,000,000 in damages. (The expert then performed a “reality check” of this number by misapplying the Total Market Rule. This is an additional topic we shall touch on in a later post).

Why it is wrong

Over the years, the 25% Rule has been used without much attention being paid to its significance and applicability. From the outset, the “rule” reflected a post-fact measure of the contribution of a complete bundle of intellectual property rights which included all four major categories of IP (trade secrets, patents, copyrights, and trademarks) in a specific industry and economic environment. Based on our collective experience in valuation, licensing, and damages calculations, the specific facts and context of a transaction, license, or case are the arbiters of the value of intellectual property. To adequately reflect the fair market value of a patent, as in this situation, attention must center of what specific contributions are made from an economic perspective, e.g. does it reduce the cost of production, enable new applications, attract market demand? In fact, the determination of a reasonable royalty as the base measure of patent infringement damages has a well-established process that lists the multitude of factors to be considered (the Georgia-Pacific Factors). It is also well established that the 25% Rule of Thumb is not an appropriate guide line for the determination of a reasonable royalty rate under a Georgia-Pacific analysis. A proper patent infringement damages expert analysis must carefully tie the damages amount to the invention’s market significance and this cannot be accomplished with a rule of thumb.

Next

A new trial on the question of damages has been ordered by the CAFC and we shall expect a reconsideration of the economic analysis behind the reasonable royalty attributable to the ‘216 patent. But, more than that, this opinion raises the bar for all future intellectual property damages analyses that must determine a reasonable royalty; no longer can superficial applications of pre-determined percentages be passed-off as “expert testimony.”

(Simultaneously published on the IPmetrics Blog)

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