By Dennis Crouch
I struggle to understand the mathematical logic in the debate over the recent expansion of the entire market value rule (contemporary EMVR) for calculating damages in patent cases. The entire market value rule is a tool that – in most cases – prevents a patent holder from using entire market value of a product as the starting point (i.e., the “base”) when calculating patent damages. In its newest incarnation, the court has rejected use of the entire market value of an infringing product as the starting point for damage apportionment. In his Patent-Damages blog, Fish & Richardson Partner Justin Barnes provides his bottom line:
[I]f a product is not separable into constituent parts, the plaintiff is not necessarily entitled to a royalty base on that product (e.g., Outlook in the Lucent case), but that if a product is separable into constituent parts, the plaintiff almost certainly is not entitled to a royalty base on the overall product (e.g., [LaserDynamics and] Cornell).
The entire market value rule makes sense when it is being used to stop a patentee from unduly claiming the bulk of the infringer’s profits. However, the absolute rule doesn’t make sense when the entire-product royalty base provides a fine starting point for calculating the value of the incremental benefit provided by the invention in suit.
Patent damages are most often calculated as a percentage royalty rate multiplied by some “base price” of the infringing product and then multiplied again by the total quantity of infringing products. This approach is suggested by the Patent Act requirement that “the court shall award the claimant damages adequate to compensate for the infringement but in no event less than a reasonable royalty for the use made of the invention by the infringer, together with interest and costs.” 35 U.S.C. § 284.
The contemporary entire market value rule debate focuses on what base price to use in a situation involving a patent whose innovation is directed toward a component of a larger product. In particular, the inquiry is whether the base price should be the price of the entire multi-component product or instead some price associated with the component itself. The name for the rule comes into play because the price of the entire product is also known as the “entire market value.” Unfortunately, the name for the rule masks an important element in the royalty calculus – that the percentage royalty rate is shifted downward anytime the base price is shifted from the component price to the price of the larger multi-component product. A patented innovation may have a large impact on the value of a particular component (and thus receive a high royalty rate). Of course, that component will fit within a larger product having many other valuable components. Because so many other factors contribute to the value of the multi-component product, the percentage of value that the patented innovation adds to the multi-component product will be considerably lower. So, as the base price moves toward capturing the entire market value, the percentage royalty rate drops.
In a model with a few assumptions about rational behavior and spillover benefit allocation, the arithmetic works-out so that a small percentage royalty of the entire market value of a multi-component product is equivalent to the appropriate corresponding larger percentage royalty of the component of that product. In one scenario the patentee receives a small percentage of a large sales base and in the other case receives a larger percentage of a smaller sales base. As we drill-down to smaller component pieces, the two variables in question – percent royalty and price-per-unit – vary inversely such that the product of the two stays constant. Since the damage award is based upon the product of those two factors, the choice of whether or not to use the entire market value as a base should not impact the actual damage award. I.e., there is no mathematical sense behind a rule that favors one approach over the other. With a reasonable royalty, we are usually looking to find the infringed invention’s marginal contribution to the infringer’s activities. That marginal contribution will not vary regardless of whether base is the value of the entire product or the relevant component.
Despite this simple analysis above, the courts have begun to severely limit the use of the entire market value in calculating reasonable royalties damages. The entire market value rule stops patentees from calculating damages based upon the entire market value of an infringing product to cases where the patented feature is the basis for customer demand. This is a shift in the law that may have begun with Lucent (2009) and Uniloc (2011). In the most recent case of LaserDynamics v. Quanta Computer, Inc., the Federal Circuit added-on to the rule by confirming that the royalty base used to calculate a reasonable royalty should be the “smallest saleable patent-practicing unit.” Further, the entire market value of a product can only be used when the patented feature is provide to be the “motivating factor” for the customer purchase of the product. Merely being a but-for or “important” cause of the purchase was insufficient. The Laser Dynamics decision is likely the first major patent decision written by Judge Reyna. For his conclusion, Judge Reyna relies heavily on 2009 decision by Judge Rader where he sat by designation as a district court judge in Cornell Univ. v. Hewlett-Packard Co., 609 F. Supp. 2d 279 (N.D.N.Y. 2009). In that case, Judge Rader wrote that “counsel would have wisely abandoned a royalty base claim encompassing a product with significant non-infringing components. The logical and readily available alternative was the smallest salable infringing unit with close relation to the claimed invention—namely the processor itself.”).
Limits on using the entire market value for calculation have been traced back to the 1884 Supreme Court case of Garretson v. Clark, 111 U.S. 120, 121 (1884). In that case, the patentee was awarded only nominal damages because the patentee failed to prove that it had suffered any loss or that the infringer had profited from the patented mop head improvement. In rejecting the appeal, Justice Field wrote:
When a patent is for an improvement, and not for an entirely new machine or contrivance, the patentee must show in what particulars his improvement has added to the usefulness of the machine or contrivance. He must separate its results distinctly from those of the other parts, so that the benefits derived from it may be distinctly seen and appreciated. The rule on this head is aptly stated by Mr. Justice Blatchford in the court below: “The patentee,” he says, “must in every case give evidence tending to separate or apportion the defendant’s profits and the patentee’s damages between the patented feature and the unpatented features, and such evidence must be reliable and tangible, and not conjectural or speculative, or he must show by equally reliable and satisfactory evidence that the profits and damages are to be calculated on the whole machine, for the reason that the entire value of the whole machine, as a marketable article, is properly and legally attributable to the patented feature.”
The plaintiff complied with neither part of this rule. He produced no evidence to apportion the profits or damages between the improvement constituting the patented feature and the other features of the mop. His evidence went only to show the cost of the whole mop and the price at which it was sold. And, of course, it could not be pretended that the entire value of the mop head was attributable to the feature patented. So the whole case ended, the rule was not followed, and the decree is therefore Affirmed.
Garretson. Now, one major difference between now and then is that in 1884 a patentee was still allowed to seek disgorgement of the defendant’s profits – something that is no longer allowed in utility patent law. Setting profits aside, Garretson appears allow use of the entire market value so long as the patentee explains the added value of the particular patented invention and how that added value contributes to the value of the whole product “so that the benefit derived from [the invention] may be distinctly seen and appreciated.” The driving factor in Garretson as in contemporary cases is to prevent overcompensation. However, the contemporary courts have not (and perhaps could not have) explained how the entire market value used as part of an apportionment analysis leads to overcompensation.
We might consider the availability of evidence. In the usual case, the value-added by an invention may be easier to see and understand at the component level because there are fewer issues to consider. On the other hand, base price information tends to be better available when looking at the entire market value of a product because that is what customers purchase – rather than looking at the value (or profit) associated with an integrated component. In situations like these where there are various legal theories available, we usually let the parties decide how to present their case according to what they believe is the best and most convincing evidence. The usual approach to intellectual property valuation is to use a variety of methodologies in the hopes that there will be some convergence on a best estimate and this is one useful methodology. In the larger context of the hypothetical negotiation, it just doesn’t make any sense that neither party would have considered the price of the final product as part of their negotiations.
Cognitive Bias: In many multi-component cases, the correct royalty rate will be <<1% of the market value. Economists would have no problem with that result, but jurors might. In particular, it may be cognitively difficult for a juror to award a royalty rate of <<1% of the base price because that number seems so small. Again, in our adversarial system we normally rely on opposing counsel to help juries through their cognitive difficulties. In the multi-component situation, what’s wrong with allowing the defendant to make the (seemingly easy and intuitive) showing that the accused product is based on thousands of innovations and equally important underlying patents that each deserve (and have received) their share of royalties and that the stacking problem means that royalties for the particular invention in question certainly could not be above say 0.002%. To avoid the small number bias problem, defendants can rescale their calculation to be something like $5 per thousand products sold. This provides a whole number base that we are all comfortable with.
Law Professors Brian Love has a nice pre-2009 article on the entire market value rule and its role in preventing patentee overcompensation. Brian J. Love, Patentee Overcompensation and the Entire Market Value Rule, 60 Stan. L. Rev. 263 (2007). However, the analysis has changed somewhat since then.
To be clear, I’m not arguing that the court should jettison the whole of the entire market value rule – just the post-2009 contemporary conception that applies the rule to prevent use of the entire product value base in an appropriate apportionment analysis.
Although I’m critical here of the damage jurisprudence of the Federal Circuit, at the time it was important for the court to take some steps to control damage calculations. In the background, Congress was a debating patent reform package that included provisions that would have significantly altered patentee’s damages arguments and the FTC had argued forcefully for further restrictions on patent damages. The court’s decisions then relieved the political pressure so that those provisions were eventually removed from the patent reform bill that was passed as the America Invents Act in September 2011.
The LaserDynamics case is also important because of its repudiation of settlement data in the damage calculation – especially when the settlement came at a point where the defendant was in a strategically disadvantageous position.