Guest Post by Prof. Contreras – CSIRO v. Cisco: The Convergence of RAND and non-RAND Royalties for Standards-Essential Patents

Guest Post by Jorge L. Contreras, Associate Professor, University of Utah College of Law. 

In Commonwealth Scientific and Industrial Research Organisation v. Cisco Systems, Inc. (Fed. Cir., Dec. 1, 2015), the Federal Circuit established important new guidelines for the calculation of “reasonable royalty” damages for standards-essential patents (SEPs), even in the absence of the patent holder’s commitment to license on reasonable and nondiscriminatory (RAND) terms. Chief Judge Prost, writing for a panel that also included Judges Dyk and Hughes, found that Chief Judge Leonard Davis of the Eastern District of Texas erred by failing, among other things, to account for the “standard-essential status” of a Commonwealth Scientific (CSIRO) patent infringed by Cisco. The decision signals another important step toward the convergence of “reasonable royalty” damages in RAND and other patent cases.

Background

CSIRO is a leading Australian governmental research organization. In 1996 CSIRO obtained U.S. Patent 5,487,069, claiming techniques for addressing “multipath” problems in wireless signal processing. These techniques were later incorporated into IEEE’s 802.11a (“Wi-Fi”) standard, first published in 1999. In connection with the approval of 802.11a, IEEE requested, and CSIRO provided, a Letter of Assurance under which CSIRO committed to license the ‘069 patent to manufacturers of 802.11a-compliant products on “reasonable and nondiscriminatory” (RAND) terms. When later versions of 802.11 were developed, IEEE again requested that CSIRO commit to license the ‘069 patent on RAND terms. CSIRO, however, refused to issue such additional assurances.

In 2001, Cisco acquired Radiata, Inc., a company founded by a former CSIRO scientist to manufacture wireless chips. Radiata had entered into a Technology License Agreement (TLA) with CSIRO in 1998, under which Radiata paid CSIRO royalties for use of the ‘069 patent based on a percentage of Radiata’s chip sale prices. These royalties ranged from 1% to 5% of the chip price, depending on sales volume. When Cisco acquired Radiata, it inherited the TLA and paid CSIRO approximately $900,000 in royalties over the next several years. Cisco stopped paying royalties under the TLA in 2007, when it discontinued the use of Radiata chips in its products. Cisco and CSIRO negotiated for several years regarding an ongoing license for the ‘069 patent, but could not reach agreement and CSIRO sued Cisco for infringement in 2011.

After a four-day bench trial, the District Court determined that the “reasonable” range for royalties for the ‘069 patent was between $0.90 (based on an “informal suggestion” made by Cisco’s chief patent counsel during negotiations in 2005) and $1.90 (based on the maximum rate that CSIRO offered to potential licensees in 2003). CSIRO v. Cisco, 2014 WL 3805817 (E.D. Tex. 2014). (The Court made a slightly different calculation with respect to products sold by Cisco’s Linksys subsidiary, but we will not consider that here). With these ranges in mind, the District Court developed a volume-based royalty table and assessed damages of approximately $16 million against Cisco. Cisco appealed, arguing that the District Court erred in three major regards: (1) by failing to begin its royalty analysis with the price of a Wi-Fi enabled chip, representing the smallest salable patent-practicing unit (SSPPU) in Cisco’s Wi-Fi enabled products, (2) by failing to adjust its reasonable royalty analysis to account for the essentiality of the ‘069 patent to the 802.11 standard, and (3) by basing its royalty determination on the parties’ negotiation positions rather than the TLA. The Federal Circuit found that the District Court erred as to points (2) and (3), vacating the decision below and remanding for recalculation of the damages award.

Apportionment and the Smallest Saleable Patent-Practicing Unit (SSPPU)

In CSIRO, the Federal Circuit reiterated the century-old rule, now embodied in Section 284 of the Patent Act, that patent infringement damages “must reflect the value attributable to the infringing features of the product, and no more.” Ericsson, Inc. v. D-Link Sys., Inc., 773 F.3d 1201, 1226 (Fed. Cir. 2014). It went on to explain that “[t]his principle—apportionment—is the governing rule where multi-component products are involved” (slip op. at 10, internal quotations omitted). The Court noted, however, that the rule of apportionment may be supplemented by additional tools to help determine the incremental value of the patented invention. One of these tools is the SSPPU model: when “a damages model apportions from a royalty base, the model should use the smallest salable patent-practicing unit as the base” (slip op. at 12).

Cisco argued that the District Court erred by beginning its reasonable royalty analysis using rates derived from inter-party negotiations rather than the SSPPU. The Federal Circuit disagreed, holding that the SSPPU model was inapplicable in the case, as the District Court did not determine a royalty “base” (i.e., the price that is multiplied by a royalty expressed in percentage terms) at all. Instead, the Court used so-called per-unit royalties (i.e., a specific dollar amount per end product). As such, there was no call for use of the SSPPU model, and the District Court did not err by avoiding its use.

Comparable Licenses

As noted above, the District Court determined the applicable range of royalties on the ‘069 patent to be between $0.90 and $1.90 based on figures introduced by the parties at different stages during their licensing negotiations. Cisco argued, however, that the appropriate royalty range should be based on the rates set forth in the TLA entered into by Radiata and CSIRO, as to which Cisco later succeeded. Under the TLA, the royalty rates for Cisco products would have been $0.03 to $0.33 (rates for Linksys products would have been slightly different, but I will disregard these for the sake of simplicity).

The District Court rejected any application of the TLA in its reasonable royalty analysis, reasoning, among other things, that (a) the TLA was a related-party agreement between CSIRO and one of its former scientists, rendering it not comparable to the proposed arm’s length agreement between Cisco and CSIRO, (b) the TLA was entered in 1998, long before any hypothetical negotiation between Cisco and CSIRO, and (c) the TLA royalty rates were based on the price of chips sold by Radiata rather than the value of the invention embodied by the ‘069 patent. To this last point, the District Court reasoned that “[b]asing a royalty solely on chip price is like valuing a copyrighted book based only on the costs of the binding, paper, and ink needed to actually produce the physical product. While such a calculation captures the cost of the physical product, it provides no indication of its actual value” (CSIRO, 2014 WL 3805817 at *11).

The Federal Circuit rejected most of the District Court’s reasoning regarding the TLA, largely because Cisco and CSIRO renegotiated numerous terms of the TLA following Cisco’s acquisition of Radiata. This renegotiation demonstrated both that the TLA did not embody a “special relationship” between CSIRO and the licensee (as Cisco presumably negotiated at arm’s length) and the timing of the amendments coincided with any hypothetical negotiation that would have been conducted between Cisco and CSIRO. As for the District Court’s discomfort with the TLA’s use of chip prices as the base upon which royalties would be calculated, the Federal Circuit quoted its recent decision in Ericsson, 773 F.3d at 1228,

in which it held that a comparable license may not be excluded from the fact finder’s consideration “solely because of its chosen royalty base.” Given this reasoning, the Federal Circuit held that the District Court erred by excluding the TLA from its analysis and directed the Court on remand to “reevaluate the relevance of the as-amended TLA in its damages analysis” (slip op. at 22).

Interestingly, this case represents the second appellate decision this year in which the admissibility of comparable license agreements has been challenged in RAND royalty determinations. In the prior case, Microsoft v. Motorola, 795 F.3d 1024 (9th Cir. 2015), the Ninth Circuit was more deferential to the District Court’s exclusion of potentially comparable license agreements. In Microsoft, the Circuit Court upheld the District Court’s exclusion of three arm’s length license agreements to which Motorola was a party for reasons including the fact that some agreements were entered into to settle or forestall litigation, they included patents other than the patents at issue, they included cross-licenses and they included royalty caps. It will be interesting to see how the Circuits reconcile their interpretations of this key evidentiary standard in future cases.

Impact of Standardization

Perhaps the most far-reaching implication of CSIRO arises from the Federal Circuit’s holding regarding the impact of standardization on a patent. In the case, the District Court determined a “reasonable royalty” using the well-known framework established in Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970). Cisco argued that the District Court erred by failing to modify the Georgia-Pacific factors to account for the fact that the ‘069 patent was essential to the 802.11 standard. In particular, the Court failed to disregard any additional compensation that CSIRO might have been able to extract in a hypothetical negotiation solely as a result of the ‘069 patent’s essentiality to the 802.11 standard. This additional compensation, Cisco argued, is not indicative of the incremental value of the patented technology, but of the significant costs that manufacturers would have to incur if forced to switch to an alternative technology (so-called “switching costs”). For this reason, such adjustments to the Georgia-Pacific factors were made by prior courts determining reasonable royalty rates for standards-essential patents (e.g., Microsoft, Ericsson, and In re Innovatio IP Ventures, LLC, 956 F.Supp.2d 925 (N.D.Ill. 2013)).

But CSIRO pointed to a significant distinction with these prior cases. As noted above, CSIRO agreed to license the ‘069 patent on RAND terms to manufacturers of 802.11a-compliant products. But by the time of CSIRO’s suit, 802.11a was largely obsolete and represented only 0.03% of Cisco’s accused products (slip op. at 8). Thus, CSIRO argued and the District Court agreed that CSIRO had no obligation to offer RAND terms to Cisco with respect to its products implementing later versions of 802.11. And because no RAND obligation was implicated, no adjustment to the Georgia-Pacific factors was warranted.

The Federal Circuit disagreed, holding that the incremental value of a standard-essential patent (SEP) should be determined independently of manufacturer switching costs, whether or not the SEP was RAND-encumbered (slip op. at 17). Citing Ericsson, the Court reasoned that “damages awards for SEPs must be premised on methodologies that attempt to capture the asserted patent’s value resulting not from the value added by the standard’s widespread adoption, but only from the technology’s superiority” (id.) The Federal Circuit thus found that the District Court erred by failing to consider the extent to which the value of standardization may have impacted the calculated compensation range for the ‘069 patent, and remanded for further consideration of this issue.

Implications for RAND and Standards

The Federal Circuit’s analysis of the third factor in CSIRO is sensible, but does raise some interesting questions about standards and SEPs. In rejecting CSIRO’s argument that the royalty damages analysis should not be adjusted because the ‘069 patent was not RAND-encumbered, the Federal Circuit noted first that Ericsson distinguished between RAND-encumbered SEPs and SEPs generally (slip op. at 17). On this basis, the court reasoned that even though the ‘069 patent might not be encumbered by a RAND commitment, the court’s reasonable royalty analysis must take into account the fact that the patent was a SEP (and thus correct for excess compensation that could be extracted based on broad industry adoption of the standard).

If this is the case, then what is the difference in the royalty payable with respect to a RAND-encumbered SEP and the royalty payable with respect to an unencumbered SEP? The result in CSIRO suggests that there is no difference at all. In the case of RAND-encumbered SEPs, the patent holder agrees to charge a “reasonable royalty”, which the courts have calculated using a modified version of the Georgia-Pacific framework. But Section 284 of the Patent Act establishes a “reasonable royalty” as the baseline measure of damages for all patents. Accordingly, a similar reasonable royalty calculation, also using the Georgia-Pacific framework should be used for unencumbered SEPs. And, as held by the Federal Circuit in CSIRO, that calculation must avoid the inclusion of switching costs in the “reasonable” royalty.

In a recent paper, A Unified Framework for RAND and other Reasonable Royalties, 30 Berkeley Tech. L.J. 1447-1499 (2015), Richard Gilbert and I predict this result: namely, the convergence of reasonable royalty damages for RAND-encumbered and unencumbered patents. As we have written, and as the Federal Circuit has repeatedly confirmed, the appropriate measure of damages in patent cases, whether or not involving SEPs, is the incremental value of the patented invention to the product in which it is incorporated.

But if royalty rates for RAND-encumbered SEPs are no lower than royalty rates for unencumbered SEPs, then what is the point of making a RAND commitment? Does it have any effect at all? Professor Gilbert and I argue that RAND commitments are meaningful even without this royalty differential. Most importantly, a SEP holder that makes a RAND commitment severely limits its ability to obtain an injunction to prevent infringement by manufacturers of standardized products. Holders of unencumbered SEPs, on the other hand, have not committed to license their patents, and may not face the same hurdles to obtaining injunctive relief. Then, as predicted by Farrell, Lemley, Shapiro and others, they could use the leverage conferred by the threat of an injunction to extract a higher (unreasonable?) royalty from manufacturers of standardized products without having to resort to a judicial damages determination (which, as we have seen, will be limited to a “reasonable” royalty). This possibility has significant implications, particularly given the increasing acquisition and assertion of SEPs by patent assertion entities that do not make RAND commitments, a complex topic well beyond the scope of this note, but which I have written about here. For these and other reasons, RAND commitments, and the encouragement of RAND commitments by SSOs and market participants, will continue to play an important role in fostering standardization and innovation.