The 25% Rule Is 100% Out Under Federal Circuit's Uniloc Decision

In a case with practical implications for all patent litigants, the Federal Circuit recently rejected the use of the 25% rule to establish a baseline royalty rate to determine patent infringement damages. Uniloc USA, Inc. v. Microsoft Corp., 2011 U.S. App. LEXIS 11 (Fed. Cir. Jan. 4, 2011). The Federal Circuit also held that the “entire market value” rule cannot be used to determine a royalty base absent a showing that the patented feature provides the basis for customer demand for the allegedly infringing product.

Background

Uniloc USA, Inc. and Uniloc Singapore Private Ltd. (“Uniloc”) sued Microsoft Corp. in the U.S. District Court for the District of Rhode Island on Sept. 26, 2003, for allegedly infringing U.S. Patent No. 5,490,216 (“the '216 patent”) directed to the use of a registration number and remote license ID system to prevent illicit installation of a software program on multiple computers.

Uniloc's Web site touts the '216 patent as Uniloc's “primary patent” and asserts the patent has “held up to exceptional legal scrutiny.” The Web site asserts that 50 other related patents or patent applications cover topics from advertising delivery, anti-tampering, critical infrastructure, code and data protection, and Web authentication, among others. Uniloc has sued dozens of companies for infringement ' a number of which have settled, according to Uniloc.

Here, the accused product was “Microsoft's Product Activation feature that acts as a gatekeeper to Microsoft's Word XP, Word 2003, and Windows XP software programs.” 2011 U.S. App. LEXIS 11 at *5. “Upon receipt of Microsoft's retail software program, the user must enter a 25-character alphanumeric product key,” which permits “Product Activation.” Id. Unless the user initiates “Product Activation,” functionality will be limited and will cease in 30 days. “Product Activation” initiates an algorithm performed at Microsoft. In assessing the merits, the Federal Circuit held that “[t]he functionality of the MD5 and SHA-1 algorithms [was] at the heart of this case.” Id. at *8.

Initially, Uniloc alleged Microsoft infringed claims 1, 12, 17, 19 and 20 of the '216 patent. In 2007, Judge William E. Smith granted summary judgment of non-infringement as to all of these claims. In 2008, the Federal Circuit reversed summary judgment of non-infringement as to claims 12 and 19. On the eve of trial, Uniloc withdrew claim 12 as an asserted claim, moving forward only with claim 19.

The jury returned a verdict of infringement, validity, and willfulness for claim 19, awarding $388 million to Uniloc in damages. At the time, the trial court noted that this was “purportedly the fifth largest patent verdict in history.” The trial court granted judgment as a matter of law (“JMOL”) of non-infringement and no willfulness, granted a new trial on damages, and denied JMOL of invalidity.

Federal Circuit Rulings

The Federal Circuit reversed JMOL of non-infringement because it concluded that the jury's verdict on infringement was supported by substantial evidence, affirmed JMOL of no willfulness, affirmed the grant of a new trial as to damages only, and denied JMOL of invalidity.

Most notably, the Federal Circuit held that the use of the 25% rule ' which “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” (2011 U.S. App. LEXIS at *52-53) ' is a “fundamentally flawed tool” for calculating a reasonable royalty, because it fails to tie the royalty base to the facts of the case at issue. The court squarely held that expert testimony relying on the 25% rule is inadmissible under Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579 (1993).

In so holding, the court rejected the analysis of Uniloc's damages expert, Dr. Joseph Gemini, who opined that Uniloc's damages were $564,946,803. In arriving at this number, Dr. Gemini used a pre-litigation Microsoft document that stated “Product Keys” were “worth anywhere from $10 to $10,000,” and used $10 as the “isolated value of Product Activation.” 2011 U.S. App. LEXIS at *44. Dr. Gemini then applied the so-called “25 percent rule of thumb,” hypothesizing that “75% of the value would remain with Microsoft, resulting in a baseline royalty rate of $2.50 per license issued.”

The Federal Circuit called out Dr. Gemini's own characterization that he “did a kind of check to determine whether [$564,946,803] was reasonable,” quoting him as saying “[i]t's obviously, you know, a significant amount of money.” This “check” was performed against the estimated gross revenues of the accused products, calculated at $19.28 billion, making the calculated royalty “only” 2.9% of this amount.

The court held that Uniloc's use of the entire market value rule as a “check” to its damages calculation was improper because there was no showing that the patented component created the basis for customer demand (i.e., that entire market value of the accused products was derived from the patented contribution).

The court also stated that a new damages trial was appropriate as the entire market value of $19 billion “tainted the jury's damages award” and “the $19 billion cat was never put back in the bag even by Microsoft's cross-examination of Mr.
Gemini. '” 2011 U.S. App. LEXIS 11 at *68.

Conclusion

This case will have broad impact for patent litigants, as trial courts will necessarily increase their focus on the patentees' burden to present a detailed and product-specific damages analysis.

Rebecca Snavely Saelao is a senior associate in the San Francisco office of Morrison & Foerster LLP. She is admitted to practice before the USPTO and represents clients in patent, financial services, and other complex commercial litigation.

In a case with practical implications for all patent litigants, the Federal Circuit recently rejected the use of the 25% rule to establish a baseline royalty rate to determine patent infringement damages. Uniloc USA, Inc. v. Microsoft Corp., 2011 U.S. App. LEXIS 11 (Fed. Cir. Jan. 4, 2011). The Federal Circuit also held that the “entire market value” rule cannot be used to determine a royalty base absent a showing that the patented feature provides the basis for customer demand for the allegedly infringing product.

Background

Uniloc USA, Inc. and Uniloc Singapore Private Ltd. (“Uniloc”) sued Microsoft Corp. in the U.S. District Court for the District of Rhode Island on Sept. 26, 2003, for allegedly infringing U.S. Patent No. 5,490,216 (“the '216 patent”) directed to the use of a registration number and remote license ID system to prevent illicit installation of a software program on multiple computers.

Uniloc's Web site touts the '216 patent as Uniloc's “primary patent” and asserts the patent has “held up to exceptional legal scrutiny.” The Web site asserts that 50 other related patents or patent applications cover topics from advertising delivery, anti-tampering, critical infrastructure, code and data protection, and Web authentication, among others. Uniloc has sued dozens of companies for infringement ' a number of which have settled, according to Uniloc.

Here, the accused product was “Microsoft's Product Activation feature that acts as a gatekeeper to Microsoft's Word XP, Word 2003, and Windows XP software programs.” 2011 U.S. App. LEXIS 11 at *5. “Upon receipt of Microsoft's retail software program, the user must enter a 25-character alphanumeric product key,” which permits “Product Activation.” Id. Unless the user initiates “Product Activation,” functionality will be limited and will cease in 30 days. “Product Activation” initiates an algorithm performed at Microsoft. In assessing the merits, the Federal Circuit held that “[t]he functionality of the MD5 and SHA-1 algorithms [was] at the heart of this case.” Id. at *8.

Initially, Uniloc alleged Microsoft infringed claims 1, 12, 17, 19 and 20 of the '216 patent. In 2007, Judge William E. Smith granted summary judgment of non-infringement as to all of these claims. In 2008, the Federal Circuit reversed summary judgment of non-infringement as to claims 12 and 19. On the eve of trial, Uniloc withdrew claim 12 as an asserted claim, moving forward only with claim 19.

The jury returned a verdict of infringement, validity, and willfulness for claim 19, awarding $388 million to Uniloc in damages. At the time, the trial court noted that this was “purportedly the fifth largest patent verdict in history.” The trial court granted judgment as a matter of law (“JMOL”) of non-infringement and no willfulness, granted a new trial on damages, and denied JMOL of invalidity.

Federal Circuit Rulings

The Federal Circuit reversed JMOL of non-infringement because it concluded that the jury's verdict on infringement was supported by substantial evidence, affirmed JMOL of no willfulness, affirmed the grant of a new trial as to damages only, and denied JMOL of invalidity.

Most notably, the Federal Circuit held that the use of the 25% rule ' which “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” (2011 U.S. App. LEXIS at *52-53) ' is a “fundamentally flawed tool” for calculating a reasonable royalty, because it fails to tie the royalty base to the facts of the case at issue. The court squarely held that expert testimony relying on the 25% rule is inadmissible under Daubert v. Merrell Dow Pharms., Inc. , 509 U.S. 579 (1993).

In so holding, the court rejected the analysis of Uniloc's damages expert, Dr. Joseph Gemini, who opined that Uniloc's damages were $564,946,803. In arriving at this number, Dr. Gemini used a pre-litigation Microsoft document that stated “Product Keys” were “worth anywhere from $10 to $10,000,” and used $10 as the “isolated value of Product Activation.” 2011 U.S. App. LEXIS at *44. Dr. Gemini then applied the so-called “25 percent rule of thumb,” hypothesizing that “75% of the value would remain with Microsoft, resulting in a baseline royalty rate of $2.50 per license issued.”

The Federal Circuit called out Dr. Gemini's own characterization that he “did a kind of check to determine whether [$564,946,803] was reasonable,” quoting him as saying “[i]t's obviously, you know, a significant amount of money.” This “check” was performed against the estimated gross revenues of the accused products, calculated at $19.28 billion, making the calculated royalty “only” 2.9% of this amount.

The court held that Uniloc's use of the entire market value rule as a “check” to its damages calculation was improper because there was no showing that the patented component created the basis for customer demand (i.e., that entire market value of the accused products was derived from the patented contribution).

The court also stated that a new damages trial was appropriate as the entire market value of $19 billion “tainted the jury's damages award” and “the $19 billion cat was never put back in the bag even by Microsoft's cross-examination of Mr.
Gemini. '” 2011 U.S. App. LEXIS 11 at *68.

Conclusion

This case will have broad impact for patent litigants, as trial courts will necessarily increase their focus on the patentees' burden to present a detailed and product-specific damages analysis.

Rebecca Snavely Saelao is a senior associate in the San Francisco office of Morrison & Foerster LLP. She is admitted to practice before the USPTO and represents clients in patent, financial services, and other complex commercial litigation.