Winning the Patent Damages Case

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Winning the Patent

Damages Case


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Winning the Patent

Damages Case

A Litigators Guide toEconomic Models and OtherDamage Strategies

Second Edition

Richard F. Cauley

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Library o Congress Cataloging-in-Publication Data

Cauley, Richard F.

Winning the patent damages case : a litigators guide to economic models and other damage strategies / Richard F.

Cauley. 2nd ed.

p. cm.

Includes bibliographical reerences and index.

ISBN 978-0-19-976756-4 ((pbk.) : alk. paper)

1. Patent inringementUnited Statesrial practice. 2. Patent suitsUnited Statesrial practice.

3. Lost prots damagesUnited Statesrial practice. I. itle.

KF3155.C38 2011346.7304860269--dc22

2010045375

_____________________________________________

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For Maureen, Elizabeth and Michael


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Contents

INTRODUCTION xiii

SECTION I: Background and Initial Considerations of the

Patent Damages Case 1

CHAPTER 1: Winning the Reasonable Royalty Case 3

CHAPTER 2: Introducing the Combatants 15

CHAPTER 3: Stranger Than Fiction: Imagining the

Hypothetical Negotiation 23

SECTION II: A Strategic Look at the Georgia-PacificFactors 33

CHAPTER 4: Finding the Price of the Patent: Is There

an Established Royalty? 35

CHAPTER 5: Gauging the Infringers Price Range:

Licensing-In Practices 59

CHAPTER 6: Keeping it Exclusive: How Valuable

Is That License? 67

CHAPTER 7: Keeping It to Yourself: The Hypothetical

Negotiation Where the Seller Does NotWant to Sell 75

CHAPTER 8: Selling Your Enemy the Stick to Beat You

with: The Hypothetical Negotiation Where the

Plaintiff and Defendant Compete 83

CHAPTER 9: Boosting the Royalty Rate with Unpatented

Products: Mercy Sakes Alive! Looks LikeWe Got Us a Convoy! 91

CHAPTER 10: How Much Time is Left? The Effect of

an Expiring Patent 97


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Contentsviii

CHAPTER 11: Buy My Product, Buy My Patent! How

the Success of a Patentholders (or Even

an Infringers) Product Can Raisethe Royalty Rate 99

CHAPTER 12: Why New and Improved Costs More

Than the Old Stuff: The Better Your

Invention, the Higher the Royalty Rate 105

CHAPTER 13: The Smaller the Bang, the Smaller the

Bucks: Allocating the Value of the

Patented Component 111

SECTION III: Winning The Lost-Profits Case 123

CHAPTER 14: The Theory of Lost Profits 125

CHAPTER 15: Market Players 137

CHAPTER 16: Working the Hypothetical Work-Around:Alternative Non-Infringing Substitutes 145

CHAPTER 17: Lost Profits on Unpatented Products and

Components: The Entire Market Value Rule 153

CHAPTER 18: Recovering Profits Lost by Price Erosion:

Paying Attention to the Demand Curve 161

TABLE OF CASES 167

INDEX 169


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Detailed Contents

INTRODUCTION xiii

SECTION I: Background and Initial Considerations of the

Patent Damages Case 1

CHAPTER 1: Winning the Reasonable Royalty Case 3

1.01 The Brief Early History of the Reasonable Royalty Remedy 3

[A] The Pre-codified Reasonable Royalty Remedy 3

1.02 The Modern Era of Reasonable Royalty

Begins: Georgia-Pacific 6

[A] List of Factors 9

[B] Consideration of Rigorous Economic Analysis 12

CHAPTER 2: Introducing the Combatants 15

2.01 The Plaintiff: Six Category Types 15

[A] The Dominant Competitor 16

[B] The Minor Competitor 17

[C] Non-Producing Entities 18

[D] Universities 19

[E] Patent Trolls 20

[F] Individuals 20

2.02 The Defendant 21

CHAPTER 3: Stranger Than Fiction: Imagining theHypothetical Negotiation 23

3.01 Applying Game Theory to Hypothetical Negotiation 26

[A] A Zero-Sum Game 26

[B] Perfect Exchange of Information 27

[C] You Cant Walk Away 27

[D] Date of Infringement 27

[E] Assumption of Validity 27

3.02 Determining the Reasonable Royalty Value 28

[A] Game Theory and the Lemney/Shapiro Analysis 29

[B] Injunctions 30

[C] Two More Variables 31


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Detailed Contents xi

6.03 Discovery 72

[A] Use Your Economic Experts 73

[B] If the Plaintiff Is an NPE 73

CHAPTER 7: Keeping It to Yourself: The Hypothetical Negotiation

Where the Seller Does Not Want to Sell 75

7.01 Relevance and Application 75

[A] Sample Scenario: Tiny Motors Corporation 76

[B] Establishing Historical Practices 77

7.02 Analysis 79

7.03 Discovery and Using Your Experts 80

CHAPTER 8: Selling Your Enemy the Stick to Beat You with:

The Hypothetical Negotiation Where the Plaintiff

and Defendant Compete 83


8.02 Analysis 86


CHAPTER 9: Boosting the Royalty Rate with UnpatentedProducts: Mercy Sakes Alive! Looks Like We Got

Us A Convoy! 91


9.02 Analysis 94

[A] Plaintiffs Considerations 94

[B] Defendants Perspective 95


CHAPTER 10: How Much Time is Left? The Effect of an

Expiring Patent 97


10.02 Discovery 98

CHAPTER 11: Buy My Product, Buy My Patent! How the Success

of a Patentholders (or Even an Infringers) Product

Can Raise the Royalty Rate 9911.01 Relevance and Application 99

11.02 Discovery 102

CHAPTER 12: Why New and Improved Costs More Than the

Old Stuff: The Better Your Invention, the Higher

the Royalty Rate 105


12.02 Analysis 10712.03 Discovery 108


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Detailed Contentsxii

CHAPTER 13: The Smaller the Bang, the Smaller the Bucks: Allocating

the Value of the Patented Component 111

13.01 Relevance and Application 11113.02 New Developments for the Entire Market Value Rule 114

13.03 Analysis 121

13.04 Discovery 121

SECTION III: Winning the Lost-Profits Case 123

CHAPTER 14:

The Theory of Lost Profits 12514.01 The PanduitFactors 127

14.02 The Demand Factor 128

14.03 Competition Between the Plaintiff and the Defendant

and the Defining Market: The Battle of the Flying Bikes 129

14.04 Analysis 132

14.05 Discovery 134

CHAPTER 15: Market Players 137

15.01 How Many Players are in the Market?

And Why Does it Matter? 137

15.02 Analysis 142

CHAPTER 16: Working the Hypothetical Work-Around: Alternative

Non-Infringing Substitutes 145

16.01 Analysis 149

16.02 Discovery 150

CHAPTE R 17: Lost Profits on Unpatented Products and

Components: The Entire Market Value Rule 153

17.01 Analysis 157

17.02 Discovery 159

CHAPTER 18: Recovering Profits Lost by Price Erosion: Paying

Attention to the Demand Curve 161

18.01 Analysis 16418.02 Discovery 165

TABLE OF CASES 167

INDEX 169


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xiii

Introduction

Patent litigation is obviously an expensive exercise. For a deendant, beingsued or patent inringement can be deadly. An accused inringer is acedwith the prospect o massive legal ees, the possibility o a crippling injunc-tion, and the spectre o a huge damages award. For a deendant, any patentinringement complaint is a potential death sentence. Indeed, in 2010, thetotal o just the top three damages verdicts totaled over $2 billion.

On the other side o the table, or a patentholder, especially one who relieson its patented technology to compete in the marketplace, the experience o

watching its rival use the technology it developed and patented to take over themarket can be excruciating. For many, bringing a lawsuit to recover or suchinringement may be the only way that company can get back in the game.

Tus, you would think that once the litigation begins the attorneys wouldbend every eort to maximizing the recovery on the plaintis side and mini-mizing the risk o loss or the deendant. No stone would be unturned. Nodetail would be ignored. Te rms top talent would be devoted to wringingthe last penny out o the deendant or slicing and dicing the plainti s claim

or lost prots.You would be wrong.Once a patent case begins, the engineers and scientists take over.

Preparation or Markman hearings and the endless search or the elusivekiller prior art pushes every other concern out o the wayuntil the lastminute. Te damages the plainti may be entitled to and the potentiallydevastating nancial consequences to the deendant are oen given littlepriority. Opportunities to use sophisticated economic analysis and creativediscovery are passed up and the damages case is oen just turned over to theaccountants.

Te result: a massive damages award which the deendant could havereduced or a substantial verdict or the plainti which does not hold up onappeal.

Tis does not have to happen.Properly employed, the tools o economic analysis provided by the courts

can oen make a substantial dierence in the outcome o a lawsuit. Teseeconomic principles are not dif cult to understand, apply, or explain to a

jury. What is critical, however, is that the economic underpinnings o a patent


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Introductionxiv

case be thought through and the principles applied rom the very beginningo the lawsuit. Te collection o documents and economic inormation rom

your own client and rom the other side in discovery must be done early andpursued throughout the case.Tere is one issue, however, which will not be covered here because it is

contrary to the stated purpose o this work, the proper employment o eco-nomic analysis in patent litigation.

It is the so-called Rule o Tumb, which purportedly holds that a rea-sonable royalty or patent inringement is one-quarter o the deendantsprots on the inringing product. Although this model has, in act, been

used by courts and juries to award damages in patent cases, it has so littleworth as an economic tool and so little support in the case law that it simplyhas no place here. In the ace o the Federal Circuits instruction to employrigorous economic analysis in patent damages calculation, this thumb-based model should simply be discarded.

I encourage parties and litigants alike to employ this work as a tool tounderstand the creative use o economic analysis in presenting a winningdamages cases.


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SECTION

I

Background and Initial Considerationsof the Patent Damages Case


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3

CHAPTER

1Winning the Reasonable Royalty Case

1.01 The Brief Early History of the Reasonable Royalty Remedy 3

[A] The Pre-codified Reasonable Royalty Remedy 3

1.02 The Modern Era of Reasonable Royalty Begins:

Georgia-Pacific 6

[A] List of Factors 9

[B] Consideration of Rigorous Economic Analysis 12

1.01 The Brief Early History of the Reasonable

Royalty Remedy

[A] The Pre-codified Reasonable Royalty Remedy

Te reasonable royalty remedy is the most democratic o patent damagesawards. It is available to every patentholder as a minimum, whether or notthe patentholder can prove any actual competitive injury as a result o thedeendants inringement. A plainti can collect a reasonable royalty even iit has never used its patent in its business or even had a business at all.

As the Supreme Court noted in Aro Mg. Co. v. Convertible opReplacement Co., 377 U.S. 476, 507 (1964), in a patent inringement action,a plainti can recover, as damages, the dierence between his pecuniary

condition aer the inringement, and what his condition would have beeni the inringement had not occurred. As the Supreme Court observed, thequestion to be asked in determining damages is how much had the PatentHolder and Licensee suered by the inringement. And that question [is] pri-marily: had the Inringer not inringed, what would Patent Holder-Licenseehave made?

When a plainti cannot show that the deendants inringement causedit to lose prots, either through lost sales or having to lower its prices, the

plainti will at least be able to show that its right to exclude others rom prac-ticing its invention was violated. Te damages, thereore, are measuredby the amount the plainti could have charged the deendant to license the


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Chapter 1 Winning the Reasonable Royalty Case4

patentmoney that was lost because the deendant chose to inringe insteado taking a license.

Since the reasonable royalty remedy came into ull ower in 1970, withthe landmarkGeorgia-Pacifc decision, proper application o this remedy hasoen allen by the wayside. Damages are oen calculated mechanically, withlittle or no economic analysis, and are oen imposed on the basis o rules othumb that have little or no relationship to the parties, to the patent, to thetechnology, or to the marketplace. While oen the most useuland some-times the onlyremedy or patent inringement, it is also the most abusedand neglected remedy.

o win its reasonable royalty caseand to make sure that any awardstands up to posttrial motions and on appealeach party must dig deep intothe economic underpinnings o the reasonable royalty analysis and under-stand how the pieces o this analysis t together. Te hypothetical negotia-tion methodology that orms the basis o modern reasonable royalty analysisprovides myriad opportunities or each side to maximize its leverage inincreasing or decreasing the eventual award.

For a remedy that has virtually universal application, its history is remark-

ably sparse. Indeed, the remedy seems to have initially been virtually an aer-thoughtone that the courts came up with when the plainti was unable toshow more than nominal real damages and was unable, or either evidentiaryor procedural reasons, to show that the deendant had proted rom inringe-ment o the patent. Te courts believed that such a plainti deserved someremedy or the deendants inringement and decided that the patentholderwas at least entitled to a royalty as compensation or the deendants use o its

valuable invention.

Originally, awarding damages in patent cases was complicated by therequirement that the patent plainti decide whether it would pursue theinringement action in law or in equity. I the plainti brought an action inlaw, it would be able to collect damagesthe amount o the injuryromthe deendant. I, on the other hand, the plainti chose to pursue an actionin equity against the deendant, it would be able to obtain an injunction andthe deendants protswhich were deemed to be held in trust or theplainti.

In an action in law, one measure o damages was an established royaltythe amount or which the plainti could have licensed the patent with proothat it had actually licensed the patent and had obtained royalties. However,since, as discussed below, an established royalty is oen dif cult to prove, thecourts were oen stuck as to how to properly compensate a plainti or theinringement o its patent.

Te Supreme Court was presented with this quandary in Suolk Mg.Co. v. Hayden, 70 U.S. 315, 320 (1866), which admitted that the question o

damages is always attended with dif culty and embarrassment both to thecourt and jury. Tere being no established license ee, the court was orced


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Te Brie Early History o the Reasonable Royalty Remedy 5

to resort to general evidence to determine damages, including the utilityand advantage o the invention over the old modes or devices that had been

used or working out similar results, the benets to the persons who haveused the invention, and the extent o the use by the inringer. Te courtdetermined that this inormation would provide enough inormation to the

jury to enable them, in the exercise o a sound judgment, to ascertain thedamages, or, in other words, the loss to the patentee or owner, by the piracy,instead o the purchase o the use o the invention.

Tis decision, however, obviously gave little guidance to the courts as tothe actual procedure a court or jury should ollow in awarding damages to a

plainti that was unable to demonstrate any competitive injury or show thatthere was an already established royalty or its patent.

In 1894, however, the Ninth Circuit lit upon a solution in Hunt Bros.Fruit-Packing Co. v. Cassiday, 64 F. 585, 587 (9th Cir. 1894): Where dam-ages cannot be assessed upon the basis o a royalty, nor on that o lost sales,nor on that o hurtul competition, the proper method o assessing them isto ascertain what would have been a reasonable royalty or the inringer tohave paid. Although the court did not lay out a mechanism or calculating

such a royalty or determining its reasonableness, the court held that, in thatcase, the patentholders estimate o what would be a reasonable royalty wassuf cient to support the jurys verdict, as such opinion was based on guresand estimatesthe cost o manuacture, the selling price, so ar as he hadsold, the prot, and his estimate o the proportion o the prot that should beattributable to the inringed invention.

Tis approach was nally adopted by the Supreme Court in DowagiacMg. Co. v. Minnesota Moline Plow Co., 235 U.S. 641, 648 (1914), the Court

nding that it was permissible to show the value [o the patent] by prov-ing what would have been a reasonable royalty, considering the nature othe invention, its utility and advantages, and the extent o the use involved.Not improbably such proo was more dif cult to produce, but it was quite asadmissible as that o an established royalty.

Aer Dowagiac, the courts continued to award damages in the orm o areasonable royalty where no other remedy was available. Where the courtswere unable to determine an established royalty or the patent, they would

estimate what royalty the plainti and deendant would have agreed to, assum-ing a willing buyer and willing seller. As the Sixth Circuit noted in Horvath v.McCord Radiator & Mg. Co., 100 F.2d 326, 33536 (6th Cir. 1938), In xingdamages on a royalty basis against an inringer, the sum allowed shouldbe reasonable and that which would be accepted by a prudent licensee whowished to obtain a license but was not so compelled and a prudent patentee,who wished to grant a license but was not so compelled. In other words,the sum allowed should be that amount which a person desiring to use a

patented machine and sell its product at a reasonable prot would be willingto pay.


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By 1946, the right to a reasonable royalty was ormally engrained in thePatent Act, with the statute providing that upon nding or the claimant

the court shall award the claimant damages adequate to compensate or theinringement, but in no event less than a reasonable royalty or the use madeo the invention by the inringer, together with interest and costs as xed bythe court.

Te courts continued to wrestle, however, with the procedure to be usedin determining a reasonable royalty and the evidence to be employed. JudgeLindley, inActivated Sludge, Inc. v. Sanitary Dist. o Chicago, 64 F. Supp. 25,36 (N.D. Ill. 1946), set orth the actors he considered: [I]n arriving at my

award I have had in mind the proo as to all actors proper or consideration,including the utility, practicability and advantages o the patents, the popu-lation served, the cost o the inringing plants, the act that substantial sav-ings accrued to deendants rom the inringing use o the patented process,the act that plaintis granted licenses to others at certain gures, that oersto license deendant at certain gures were made, the acts as to settlementsmade with other inringers, the circumstances under which they were made,the testimony as to a reasonable royalty and all other relevant and pertinent

circumstances appearing in the record.Likewise, the special master in Hartord Natl Bank & rust Co. v. E. F.

Drew & Co., 188 F. Supp. 353, 359 (D. Del. 1960), took a number o economicactors into account: Tis Circuit in dening a reasonable royalty to be anestablished royalty, as the amount which an inringing party using anotherspatent must pay, did not exclude, I think, consideration o all other actors,including the tort-easors prots, in arriving at the patent owners dam-ages. For example, the nature o the invention, its utility, its novelty over and

advance in the art, and the extent o its use by the inringer are all entitled tojudicial consideration. Damages may be measured by the deendants gain orthe plainti s loss. Yet, no matter how measured, it can never be less than areasonable royaltyand, there must be the actor o the inringers prots tobe considered as one o the elements o measurement.

However, it was not until 1965, with the decision in Georgia-Pacifc Corp.v. United States Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970), that theactors that should be taken into account in a reasonable royalty analysis were

nally virtually codied in a orm that the courts have used or the past ortyyears.

1.02 The Modern Era of Reasonable Royalty

Begins: Georgia-Pacific

Te modern era o patent damages began in 1955, when the managemento the Georgia-Pacic Plywood Company decided to begin manuacturing


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Te Modern Era o Reasonable Royalty Begins: Georgia-Pacic 7

a highly decorative type o plywood, with a multiplicity o grooves par-allel to the grain o the wood. Management o the United States Plywood

Corporation, who had obtained a patent on just this type o plywood thirteenyears earlier, took exception to these activities and notied Georgia-Pacicthat this product was covered by its patent. Georgia-Pacic led a declaratoryrelie action, U.S. Plywood counterclaimed, and een years later the mostinuential decision in patent damages law was issued.

Te Georgia-Pacic decision is a particularly appropriate place to begin asurvey o the law o patent damages. Not only is it the touchstone o modernreasonable royalty analysis, but it highlights most o the important issues in

patent damages law that continue to be debated almost orty years later.Te litigation arose out o Georgia-Pacics alleged inringement o three

patents held by U.S. Plywood, the only one o relevance being a patent issuedin 1942 to Donald Deskey. Tis patent covered a plywood panel whose suracewas covered with grooves parallel to the grain o the wood. Tis treatment,known as striation, was not only highly decorative but also served to pre-

vent warping o the wood. U.S. Plywood sold products covered by this patentunder the name Weldtex, and these products proved extremely popular.

Even though, or reasons that are not explained, U.S. Plywood did notmake a claim or willul inringement, Georgia-Pacics inringement othe Deskey patent was quite deliberate. Not only was the company aware othe Deskey patent and its scope, it consulted its counsel as to the danger thepatent posed to its prospective product oerings and received an opinion thatthere was a substantial risk that the company would be sued or inringement.Georgia-Pacic, however, was highly motivated to enter the market because,as its lab chie admitted, the manuacture o this product was extremely

advantageous rom a prot standpoint. Georgia-Pacic relied on its coun-sels opinion that, although its product might inringe, the patent was invalid.It started manuacturing its product in February 1955 and delivered a sampleto U.S. Plywood in March.

Almost immediately thereaer, Georgia-Pacics president Owen Cheathamreceived a letter rom U.S. Plywood noting that, although imitation is sup-posed to be the sincerest orm o attery, I must coness to a dierent reactionwhen I learned that you are imitating Weldtex. U.S. Plywood threatened

vigorous action to enorce its patent rights and stated that it would turnthe matter over to its attorneys or appropriate action. Based on this letter,Georgia-Pacic sued or declaratory judgment.

At the time Georgia-Pacic started selling its product, U.S. Plywoods stri-ated plywood product was without substantial competition. Although it hadbeen selling this product since 1946, no other company had posed a com-petitive threat, and U.S. Plywood was able to keep its prices or its Weldtexproducts high.

Given the lucrative opportunities presented, the temptation or Georgia-Pacic to enter the market, even i it were sued, was too hard to resist.


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Litigation ensued almost immediately, with Georgia-Pacic simultaneouslyreaping huge prots rom its sale o its striated plywood products. Indeed, the

company was barely able to keep up with demand.Georgia-Pacics calculated risk initially appeared to have been a goodone; in 1956, Judge Herlands o the Southern District o New York held allthree U.S. Plywood patents invalid. Judge Herlands noted the acquiescenceo virtually the entire plywood industry in respecting U.S. Plywoods monop-oly but discounted it, noting that the resources necessary to challenge even aspurious patent are more than most companies can bear.

Georgia-Pacic, however, was less successul in the Second Circuit. Tat

court held in 1958 that claim 1 o the Deskey patent was valid and inringed.Te case then returned to the district court, where the court expended thenext twelve years in determining the damages U.S. Plywood had suered byGeorgia-Pacics inringing sales rom 1955 through 1958.

Te case was initially reerred to a special master in April 1959. Aera year o discovery, six days o hearing in Portland, Oregon, and a trip toU.S. Plywoods actory in Washington, the special master issued his reportin December 1961, awarding U.S. Plywood the prots earned by Georgia-

Pacic on the inringing product.In January 1962, the parties led objections to this report with Judge

Herlands. Over two years later, in April 1964, Judge Herlands apparently heldthe rst hearing on these objections and, in June 1965, issued his opinion.

Tis opinion, based on the Supreme Courts decision in Aro Mg. Co. v.Convertible op Replacement Co., which placed the ocus in a patent inringe-ment case on what the patentholder lost rather than on what the inringer gained,required, in Judge Herlandss opinion, overturning the special masters opinion

and instituting a new inquiry as to a reasonable royalty or the Deskey patent.Five more years passed.Judge Herlands held thirteen more days o hearing on the issue o reason-

able royalty during 1967, 1968, and 1969, and the parties led ve more setso bries. Finally, aer presiding over the case or thirteen years and aerapparently draing a comprehensive opinion, Judge Herlands died withoutever having ruled on the issue o reasonable royalty.

Judge enney, uture chie judge o the district, was handed the case and,

aer obtaining the stipulation o all parties that he could reely draw uponthe notes, memoranda, and dra opinion o Judge Herlands, nally issuedhis opinion in May 1970, ourteen years aer the suit had been brought.However, it is clear that Judges Herlands and enney did not simply draw ona conspectus o the leading cases to determine the actors that are most rel-evant to determining a reasonable royalty. As they put it, they adapted theseactors, mutatis mutandis, to t the acts beore them.

Indeed, it is clear that the particular circumstances presented in the case

beore themGeorgia-Pacics deliberate inringement and the extremepopularity o both the patentees and the inringers productswas a signicant


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actor in the development o the actors that have dominated reasonable roy-alty analysis ever since. Accordingly, it is highly instructive to examine how

Judges Herlands and enney developed these actors against the backgroundo the unique actual history they had beore them.

[A] List of Factors

Judge enney began his discussion o reasonable royalty with a listing o theamous actors (Georgia-Pacic, 318 F. Supp. at 1120):

1. Te royalties received by the patentee or the licensing o the patent insuit, proving or tending to prove an established royalty.

2. Te rates paid by the licensee or the use o other patents comparable tothe patent in suit.

3. Te nature and scope o the license, as exclusive or non-exclusive; oras restricted or non-restricted in terms o territory or with respect towhom the manuactured product may be sold.

4. Te licensors established policy and marketing program to maintainhis patent monopoly by not licensing others to use the invention orby granting licenses under special conditions designed to preserve thatmonopoly.

5. Te commercial relationship between the licensor and licensee, such as,whether they are competitors in the same territory in the same line obusiness; or whether they are inventor and promoter.

6. Te eect o selling the patented specialty in promoting sales o other

products o the licensee; the existing value o the invention to the licen-sor as a generator o sales o his non-patented items; and the extent osuch derivative or convoyed sales.

7. Te duration o the patent and the term o the license.8. Te established protability o the product made under the patent; its

commercial success; and its current popularity.9. Te utility and advantages o the patent property over the old modes or

devices, i any, that had been used or working out o results.

10. Te nature o the patented invention; the character o the commercialembodiment o it as owned and produced by the licensor; and the ben-ets to those who have used the invention.

11. Te extent to which the inringer has made use o the invention; andany evidence probative o the value o that use.

12. Te portion o the prot or o the selling price that may be customaryin the particular business or in comparable businesses to allow or theuse o the invention or analogous inventions.

13. Te portion o the realizable prot that should be credited to the inven-tion as distinguished rom non-patented elements, the manuacturing


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process, business risks, or signicant eatures or improvements addedby the inringer.

14. Te opinion testimony o qualied experts.15. Te amount that a licensor (such as the patentee) and a licensee (suchas the inringer) would have agreed upon (at the time the inringementbegan) i both had been reasonably and voluntarily trying to reach anagreement; that is, the amount which a prudent licenseewho desired,as a business proposition, to obtain a license to manuacture and sell aparticular article embodying the patented inventionwould have beenwilling to pay as a royalty and yet be able to make a reasonable prot

and which amount would have been acceptable by a prudent patenteewho was willing to grant a license.

Tese actors, apparently draed by Judge Herlands, are, remarkably,without explicit citation. Indeed, the court did not even use all o these actorsin coming up with a reasonable royalty or the inringement o the Deskeypatent. However, how the court used these actors says more about howthe acts o this particular case inuenced Judges Herlandss and enneys

analysis than might generally be appreciated. Teir analysis also gives greaterweight to the hypothetical negotiation mode or constructing a reasonableroyalty than had even been done beore.

Since there was admittedly no established royalty, Judges Herlands andenney were orced to examine a broad spectrum o other evidentiaryacts to determine a reasonable royalty. Teir basic approach was that oa hypothetical negotiation, which they described as more a statement oapproach than a tool o analysis. More economic than legal, this approach

requires consideration not only o the amount that a willing licensee wouldhave paid or the patent license but also o the amount that a willing licensorwould have accepted. Tis analytical tool, also reerred to as the willing buyerand willing seller rule, had been previously used by the Sixth and the NinthCircuits but had never been given the kind o intense analysis and examina-tion employed by Judges Herlands and enney here.

As the court noted, Where a willing licensor and a willing licensee arenegotiating or a royalty, the hypothetical negotiations would not occur in a

vacuum o pure logic, but would involve a market place conrontation othe parties. . . . In applying the ormulation, the Court must take into accountthe realities o the bargaining table and subject the proos to a dissective scru-tiny. Te parties would consider such actors as their relative bargainingstrength; the anticipated amount o prots that the prospective licensor rea-sonably thinks he would lose as a result o licensing the patent as comparedto the anticipated royalty income; the anticipated amount o net prots thatthe prospective licensee reasonably thinks he will make; the commercial past

perormance o the invention in terms o public acceptance and prots; themarket to be tapped; and any other economic actor that normally prudent


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businessmen would, under similar circumstances, take into consideration innegotiating the hypothetical license.

Without any independent analysis, the court held that the hypotheticalnegotiation would be assumed to have taken place on the date that Georgia-Pacic started inringing the Deskey patentFebruary 1955although itstated that it would take into account events subsequent to that date, but onlyas those acts bore on the assumptions that the parties would have had i theyhad actually conducted a negotiation in 1955.

Te most important act or this court was the incredible success o theproductsboth o U.S. Plywood and Georgia-Pacicthat were covered by

the patent and the act that the parties were direct competitors. U.S. Plywoodscommercial success with its Weldtex product would, according to the court,have made it extremely resistant to licensing the patent to a competitor andgiving up its monopoly on the sale o striated plywood. At the time o thehypothetical negotiation, U.S. Plywood legitimately believed that sales o stri-ated plywood would remain high and that, as a monopolist, it would be ableto keep its pricesand its protsextremely high. As the court noted, inthe hypothetical negotiations, USP would have been reasonable in taking the

position that it would not accept a royalty signicantly less than the prot itwas making by its policy o licensing no one to sell striated r plywood in theUnited States.

Likewise, the court put great weight on the act that Georgia-Pacic choseto deliberately duplicate the Weldtex product notwithstanding the caveato GPs own counsel that an expensive inringement suit was inevitable, eventhough there was intense competition in the market or decorative plywoodrom suppliers who did not use the patented process. Obviously, Georgia-

Pacic thought that the U.S. Plywood process was particularly valuable andwould, presumably, have paid dearly or the ability to use it. Indeed, there wassubstantial evidence that Georgia-Pacic had a very good idea o the pro-its U.S. Plywood was actually making on its striated plywood products andtook, as its own guide or the purpose o prot expectations, the prot thatUSP was then making on its Weldtex sales.

Te court also considered two issues that have bedeviled courts having todeal with damages issues ever since: (1) where the deendants inringement

has caused the patentholder to lose sales o both the patented product andnon-patented products sold with the patented product (like a camera and acamera case); and (2) where the patent only covers a particular component oreature o o a larger product.

With regard to the rst issue (so-called collateral and convoyed items),although the court did not award damages based on those sales, it did notethat, in the hypothetical negotiation, U.S. Plywood would have been wellaware that granting a license to Georgia-Pacic would also cost it sales o

these other, non-patented, products and that this would also have been aactor that would have increased the amount o the royalty. Te court noted


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that Georgia-Pacic managed to increase its own sales o these collateralproducts by selling the inringing product.

Te Georgia-Pacic court also tackled the sensitive issue o allocationdetermining how much o the revenue attributable to the inringing productshould be allocated to the patented invention. Te courts analysis, prescientin light o subsequent controversy, applied what has become known as theentire market value rule, which holds that the reasonable royalty shouldbe applied to the entire price o the inringing product where the reason thatthe consumer purchases the item is because o the invention claimed in thepatent i.e., where the entire market value o the inringing product is

attributable to the patented technology. As the court put it, there is a basicdistinction between a patent which is only a part o a machine or structureand which creates only a part o the prots and, on the other hand, a pat-ented article or a patent which gives the entire value to the combination oran article patented as an entirety. Consequently, it is necessary to determinewhether the invention extends to and aects the whole article, giving it itsessential marketability, or whether it is only or an improvement.

In this case, the court ound that it was the value o the striated ace that

created the value o the striated r plywood panel and that the entire marketvalue o Weldtex and GP striated was attributable to the Deskey patent. Tecourt rejected the argument made by many deendants that a portion o thevalue o the inringing product was attributable to other patents simplybecause those inventions may have been used in the product. Te court pre-erred an economic argument: without using the patented invention, theinringing product would have no commercial value at all, thereore theroyalty should be calculated with respect to the entire value o the inringing

product.Te court also reused to deduct any value attributable to the unpatented

decorative appearance o the plywood, which admittedly was a substantialreason or its popularity, because this decorative appearance could not havebeen obtained without using U.S. Plywoods patent. Te actas we nowknow it in retrospect, according to the evidence o the motives o the pur-chasers o striated r plywoodthat the buyers o that product were attractedto it by its decorative appearance is irrelevant to the hypothetical negotiations

o a reasonable royalty where GPs expectations o prots could be lawullyullled only by a license o the Deskey patent and where the rate o protcould be estimated by both USP and GP on the basis o a long and recognizedrecord o past perormance.

[B] Consideration of Rigorous Economic Analysis

Te Georgia-Pacifc decision is noteworthy or many reasons. Tis decisionestablished principles that have been used by virtually every court since in


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determining a reasonable royalty. Although its lessons are oen misappliedand the policy behind its actors is oen distorted or ignored, the decision

provides subsequent decision makers with a rational basis or compensatingplaintis who cannot be awarded lost prots.Even more important, however, Georgia-Pacifc marks one o the rst

real attempts to apply economic principles to the computation o reasonableroyalties in patent cases. In creatively interpreting that or a royalty to bereasonable under the statute it should reect what the parties themselveswould have agreed to, the court gave thoughtul parties the opportunity tobring virtually any economic actor the parties might have considered to the

table. Aer Georgia-Pacifc, the act nder is encouraged to consider suchissues as the nature o the marketplace, the competition between the par-ties (and the competition with third parties), and the relative strengths o theparties, both in terms o their ability to impose their will in the hypotheticalnegotiation and in the marketplace generally. Indeed, under this construct,the act nder can consider both the interest and need o each party to enterinto a license and the ability o each side to walk away rom the table.

By permitting the act nder to take into account every economic actor

that the parties could have considered at the time o inringement, theGeorgia-Pacifc court ully implemented a true economic regime into award-ing damages in a patent case. Although this opportunity is honored muchmore oen in the breach than in the observance, the ability o either party tobring economic rationality to the table in calculating damages is ully avail-able and, more oen than not, acts more to the benet o the party utilizingthis sophisticated analysis over parties that do not.

Attorneys can properly apply these actors to either maximize or minimize

a reasonable royalty award only i they understand both the legal basis andthe economic policy underlying each actor. Only with an understanding othe reasons the Georgia-Pacifc court believed these actors to be importantin determining the basic compensation to be awarded to a prevailing plaintican counsel eectively communicate with his or her expert in constructingthe damages analysis and, later, communicate with the jury in presentingthis analysis in a persuasive manner. Attorneys who understand not only thetheory but also the reasons behind the theory are much more likely to have

their damages position prevail at trial.


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15

CHAPTER

2Introducing the Combatants

2.01 The Plaintiff: Six Category Types 15

[A] The Dominant Competitor 16

[B] The Minor Competitor 17

[C] Non-Producing Entities 18

[D] Universities 19

[E] Patent Trolls 20

[F] Individuals 20

2.02 The Defendant 21

2.01 The Plaintiff: Six Category Types

Te purpose o the reasonable royalty remedy is to provide the patentholder

with a monetary remedy when there is no other way to compensate or itsmissed opportunity to enorce exclusive use o the patent. Sometimes theplainti s entire compensation or the deendants inringement will comerom a reasonable royalty award. On other occasions, the plainti will beable to prove competitive injury in the orm o lost prots or price erosionor some sales or or some inringing products, but not or others. Te pat-entholders compensation or the remaining inringing sales will be coveredby an award o a reasonable royalty.

Although the royalty that would be reasonable or a given patent and or agiven inringing product will depend substantially on the scope o the patentand the way in which the product uses that patented invention, the amounto that royalty is also highly dependant on each partys participation in themarketplace and the parties competitive relationship with each other. Teindividual economic status o each party at the time inringement began ishighly relevant to the determination o a reasonable royalty. Te economicrole o each party in the marketplace is critical to that partys advantage in

litigating the issue o reasonable royalty. A partys ability to maximize thatadvantage depends on its counsels understanding o that economic role.


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Chapter 2 Introducing the Combatants16

In determining a reasonable royalty, the most important player is, o course,the plainti. Whether the plainti uses the patent in a businessand how that

patent is usedmakes a big dierence in the royalty it would have been rea-sonable or that plainti to license the patent in suit to the deendant.A patent plainti seeking a reasonable royalty alls into one o six categories:

(1) a company that sells products covered, in whole or in part, by the patent-in-suit and is dominant in the market; (2) a company that sells products cov-ered by the patent and is a minor player in the market; (3) a non-producingentity that developed the technology at issue and that, at one time, sold aproduct covered by the patent, but no longer does so; (4) a university whose

aculty members develop patented technologyoen with the help o gov-ernment grants; (5) a patent troll, that is, a company that did not developthe technology in the patent and has never sold a product but was ormed orthe purpose o generating revenue rom the licensing o the patents in theirportolio; (6) an individual inventor.

Te strategies a plainti can and should pursue to maximize its return oninvestment in the patent-in-suit depends, to a large extent, on the plainti seconomic status and the use it has made o the patented invention. Although

a particular plainti s economic position may be weak with respect to someactors relevant to the reasonable royalty analysis, the plainti should rec-ognize that weakness and bolster its position in other areas. Te deendantneeds to recognize the obstacles such a plainti has in justiying a substantialreasonable royalty and capitalize on those weaknesses.

[A] The Dominant Competitor

In many instances, a patent plainti dominates its market. Such a plaintihas developed innovative products based on its own advances in technology,which enables it to command a substantial market share and set prices thatare relatively unaected by competitive products. Tink, or example, ApplesiPod.

Tis dominant company has invested millions o dollars in research anddevelopment to create innovative products and has usually careully protected

its advances in technology by obtaining patents or its inventions. Many othis companys patents tend to be pioneer patents and have enabled it toquickly move to the top o the heap. Such a company continues to improveits technology and patent those improvements, oen reinvesting the moneygenerated rom its successul domination o the marketplace to und itsadvancements. Te company then uses the patent laws power to exclude asyet another competitive tool to make it even more dif cult or a rival to get atoehold in the marketplace.

Te products that a dominant company markets are oen unique (or oersome unique eatures) and dierentiate these products rom those oered


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Te Plainti: Six Category ypes 17

by a competitor. A dominant companys patented technology usually iswhat gives it the edge in the marketplace. Te competitor is orced to design

around the dominant companys patents or to develop completely indepen-dent technologies. Tis slows down the other competitor and gives the domi-nant player an opportunity to cement its advantage in the marketplace byeective sales and marketing.

Te dominant companys patents are usually tied closely to its productoeringsthe company tends to actually use the patented technology it oersin the products it sells. Because the company uses the patents exclusionarypower to prevent a smaller competitor rom developing competitive tech-

nologies, it is unlikely to oer its patents or license to anyone. A companythat is presently employing its patented technology in its products is muchmore likely to use patents as a weapon, to prevent the smaller competitorrom gaining a oothold. Such a company will sue its inringing competitorrather than oer a license. Tis patentholder, i it chooses (or is orced) topursue a reasonable royalty remedy, is likely to demand a substantial returnor the inringement o its patents, reecting the very high royalty it wouldhave demanded or licensing its valuable patents to a competitor who would,

in turn, use that technology against the patentholder.

[B] The Minor Competitor

Another type o competitor in the marketplace tends to use its technologi-cal advantage to dierentiate itsel both rom the other minor competitorsand rom the dominant player in the market. Tis company is jealous o its

market niche and tries to use its technological advantage to keep prices high,so as not to be overwhelmed by the lower prices that may be oered by thedominant player and to protect itsel rom other minor competitors and newentrants who are also seeking entry into the market. Because such a companylacks the marketing muscle o a major player in the market and the ability tocut costs through economies o scale, it needs to develop a better mousetrapto compete against a larger rival.

A good example o this type o company is Bose, which has based its tech-

nological and market nicheand the very high prices or its productson theparticular advantages its innovative technology gives the company. Not sur-prisingly, Bose vigorously asserts its patent portolio against its competitors.

Like the dominant player, the minor competitor will also jealously guardits patented innovations because they are the key to its ability to competein the market at all. It is this companys exclusive ability to use its patentedtechnological advantages that allows it to participate eectively in the market.Such a company is unlikely, thereore, to be willing to voluntarily license its

technology to even another minor competitor and would view licensing itsdistinctive technology to a large competitor as akin to slitting its own throat.


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Like the dominant participant in the market, the minor competitor has astrong incentive not to license patents to a rival. Tis company would there-

ore only be satised with a substantial royalty or allowing its patented tech-nology to be used.

[C] Non-Producing Entities

A substantial number o other patent plaintis all into the category o non-producing entities (NPEs)companies that developed the patented technol-

ogy at issue but, or some reason, do not presently market products using thattechnology. Tis type o company may have sold products using this technol-ogy at one time but was not able to compete in the marketplace. Another suchcompany may have had a successul product that used the patent, but mayhave ailed or reasons having nothing to do with that product. Still anothercompany may be successully selling some products but may not have ounda use or the patented technology in those products and is thus willing tolicense that technology to others.

A good example o this type o NPE company is NP, who successullysued RIMthe owner o the Blackberry technologyor patent inringement.At one time, NP had developed a product based on its patented technology,but did not have the resources necessary to compete in the marketplace. Itthus chose to base its business model on its patent portolio.

For the most part, this type o company does not maintain its competitiveadvantage by selling products. Rather, its business is to license its patents toas many companies as possible or the highest possible price. Te only excep-

tion would be where an NPE company presently sells products but does notuse the patented technology or the products it sells. I that NPE companysproducts compete with an inringers products, then the economic consider-ations or that plainti in determining a reasonable royalty would be similarto those or a company that does use its patented technology to compete,whether or not the patentholder uses its patent in its products.

Another important economic consideration or most NPE plaintis is thatthe company will not have any other source o income besides the licenses it

grants and will have a substantial incentive to keep the price o the licenseless than the maximum it could obtain in order to actually sign up licenseesand generate revenue. Tis NPE will also tend to license the patent on a non-exclusive basis so as to expand the customer base or these patents.

A countervailing consideration or an NPE plainti is the act that it mayhave substantial sunk costswhether related to the development o the tech-nology or to its ailed attempts to develop and sell actual products that usethe technologyand may eel the need to recover them by licensing the

patent to others. Tis type o company will seek to recover those costs throughlicensing. Such a strategy may make the NPE more eager to grant a license to


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Te Plainti: Six Category ypes 19

the patents, but may orce it to hold out or a higher royalty amount. Teroyalty demanded by the NPE plainti may also be tied closely to the costs

expended to develop the technology, because these costs will represent, tothis party, how much the patent is worth. Another plainti, without suchsunk costs, is more likely to rely on market considerations in agreeing to alicense.

[D] Universities

Te university, while in a similar position to an NPE plainti, has dierenteconomic considerations. Although it does have an incentive to license thepatent rather than use it to maintain some competitive advantage, it does nothave the same competitive pressures that a plainti in private business wouldhave. Indeed, the universitys patent portolio is more or less a byproduct othe research its aculty members are doing anywayeither under govern-ment grant or not.

Te universitys patent portolio has economic value (as opposed to the

reputational value cutting edge research may give the institution) in twoways. First, the university can enable its aculty members to organizationallyown that technology so that a company can later be spun out o the insti-tution run by the participating aculty member. Tis gives aculty membersa personal incentive to devote themselves to perorming relevant researchbecause they will able to personally benet rom its exclusive use.

Te more likely outcome, however, is that the university will simply licensethe technology to an outside company. Te universitys nancial incentive,

then, is to ensure the patented invention is used by as many companies aspossible, so as to generate the greatest amount o licensing revenue. Te uni-

versity has little incentive to maintain its exclusivity in the technology or todemand a high royalty rate. Indeed, as an institution that has no real needto make money rom the technology it develops, the university has an evenlower incentive than an outside company to demand a high royalty. Whatmight, thereore, be a reasonable royalty or a university might not be reason-able or a prot-making institution in the commercial world.

As a nonprot institution, the university also does not have the sameincentive to license the patent quickly and cheaply as a private business thatwas depending on this licensing income to stay alive. On the other hand, itdoes not have the same incentive to hold out or a higher price in order torecover its sunk costs as a business would. Indeed, i the patent was the resulto a government grant, the university may not have any sunk costs at all.

In act, many universities have a disincentive to be overly aggressive inlicensing their patents or in threatening litigation against recalcitrant targets.

Prominent companies are oen major contributors to such institutions, andtheir executives oen serve on the board o trustees. A university may well


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decide that driving the hardest bargain possible with such targets may not bein its long-term interest.

Accordingly, universities will not, by and large, have an economic incen-tive to hold out or a high reasonable royalty rate.

[E] Patent Trolls

In this work, the term patent troll will be reserved or a patent plainti thatdid not develop the patented technology itsel and has never marketed, or

even sought to market, a product using this technology. Tis type o plaintihas usually purchased or licensed the patents at issue rom the company orindividual that actually developed the technology. In some cases, the troll wasestablished solely or the purpose o licensing one patented technology oreven one patent. Oen such trolls principal place o business is in the EasternDistrict o exas, so as to maximize the chance that a patent case led in thatdistrict will not be transerred.

Te patent troll is solely in the business o licensing the patents it owns

it has no other business other than licensing. Tis plainti has no economicincentive to hold out or the highest royalty and has no incentive to maximizeits competitive inuence or to seek to maximize the power to exclude anothercompany rom using the technology. Te patent troll has little incentive inmaximizing the price obtained rom any one licensee, but, rather, it seeksto sell the patented technology to as many parties as possible. Tere alsois little economic incentive to keep prices high, because this strategy willmake it harder to sell the patent to those who wish to license it.

Tere are no sunk costs that the patent troll needs to recover througha high licensing rate, because, apart rom the amount that may have beenspent to obtain the patent, no money at all was spent in obtaining the rightssought. Since trolls normally operate through attorneys working on contin-gency, they also have ew, i any, sunk legal costs associated with enorcingtheir patents.

Tus, as an economic matter, the patent troll has little economic incentiveto demand a high reasonable royalty, since it makes a prot on every sale

and needs to make as many sales as possible.

[F] Individuals

Te individual inventor, to a certain extent, is similar to the patent troll,in that he or she has little economic incentive to maximize each licensingopportunity but needs to simply maximize the number o licenses closed.

However, the individual is unlike the troll (and like the NPE) in that, at leastpersonally, the individual has substantial sunk costs in developing the


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Te Deendant 21

patented technology that must be recovered, and the patent license may benecessary or nancial support. Oen an individual inventor will have spent

many years developing a patent and have made many personal economicsacrices to do so. Te individual may even have tried to develop an actualproduct but was unsuccessul because o the lack o economic resources ordoing so.

Te individual inventor will, thus, have an incentive to maximize the totalrevenue obtainable rom the licensing o a patent and will not have the incen-tiveor even the abilityto hold out or the best oer. Tis individualmay, like the troll, accept a reasonable royalty ar lower than a company

that uses the technology in its business. However, because o the incentive tomake sure that money is recovered or the time and eort spent developingthe technology in the rst place, the individual will be unlikely to let go o thetechnology as easily or as cheaply as a troll would.

2.02 The Defendant

For the most part, a deendant that would be subject to a damages awardin a patent inringement will be a company that is actually participating inthe marketplace selling inringing products. Te primary market criteria orsuch a deendant that will aect the reasonable royalty award are its domina-tion o the marketplace, the breadth o its product line, its general nancialhealth, and how critical the patented invention is to its ability to compete inthe market.

Te most important o these characteristics o a deendant is how much thedeendant depends on the inringing product to compete in the marketplace.Te more that deendant needs the particular product to compete, especiallyi it is the patented invention that makes the deendants product popular,the more that deendant would pay to license the plainti s patent, and thehigher the reasonable royalty. I the inringing product constitutes virtuallythe entire product line o the deendant, the plainti can justiy a very highreasonable royalty with regard to that deendant, even i a much lower royalty

might result rom a lawsuit against another inringer.Assume, or example, that the patented invention is a glow-in-the-dark

hula hoop that has virtually taken over the previously moribund hula hoopmarket, and there are two inringers. One has chosen to get in on the band-wagon and sells virtually nothing but its Hula Lite product. Te otherdeendant sells a variety o toys and games.

Te rst deendant, whether competing with the plainti or not, is likelyto be hit with a high reasonable royalty because it chose to devote an entire

product line to the inringing product. For this reason, the deendant wouldhave paid a high amount to license the plainti s patent, since the survival o


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the business depends on that product, and it would be dif cult, expensive,and risky to shi ocus to a non-inringing alternative.

Te other deendant, by contrast, might have suered a minor decrease insales i it had been orced to discontinue its sales o the light-up hula hoop,but, since it had a broad-based product line, it would not pay a great deal tolicense the patent so it could keep selling the product. Its reasonable royalty,thereore, would be substantially less than the other deendants.


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23

CHAPTER

3Stranger Than Fiction

Imagining the Hypothetical Negotiation

3.01 Applying Game Theory to Hypothetical Negotiation 26

[A] A Zero-Sum Game 26

[B] Perfect Exchange of Information 27

[C] You Cant Walk Away 27

[D] Date of Infringement 27

[E] Assumption of Validity 27

3.02 Determining the Reasonable Royalty Value 28

[A] Game Theory and the Lemley/Shapiro Analysis 29

[B] Injunctions 30

[C] Two More Variables 31

Te most important Georgia-Pacifc actor is the last: the hypotheticalnegotiation. It is the theoretical underpinning o every other actor and,while easy to understand, is remarkably hard to apply:

Te amount that a licensor (such as the patentee) and a licensee (such as the

inringer) would have agreed upon (at the time the inringement began) i both

had been reasonably and voluntarily trying to reach an agreement; that is, the

amount which a prudent licenseewho desired, as a business proposition, to

obtain a license to manuacture and sell a particular article embodying the

patented inventionwould have been willing to pay as a royalty and yet be able

to make a reasonable prot and which amount would have been acceptable by a

prudent patentee who was willing to grant a license.

As an economic matter, the hypothetical negotiation simply involves divid-ing up the pot o money representing the sum o the patents value to theplainti (either by excluding all others rom using the patent or by licensing


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Chapter 3 Stranger Tan Fiction24

it to others) and the patents value to the deendant (i.e., the economic impacton the deendant o being precluded rom using the patent). Te portion o

this pot o money that would end up in the plainti s hands at the close o thisnegotiation represents the reasonable royalty.Te hypothetical negotiation involves, o course, a completely anciul

situation. It assumes a negotiation between a plainti that is not a willinglicensor and a deendant that, more oen than not, had no idea it was inring-ing the patent and would probably have had no interest in taking a license.It puts these two parties in a room at a time in which they may not have evenknown each other existedat the time the deendant started inringingand

orces them to reach an agreement that they might never have been able toreach. It orces the plainti to lower its price or licensing its patent to a levelat which the deendant could still have made a prot and orces the deendantto agree to pay an amount that would still have been acceptable to the plain-ti. It also orces them to assume a act that the actual parties would neverhave assumedthat the patents are both valid and inringed.

Te court has to be careul not to view this hypothetical negotiation asthough it were a real commercial transaction and acting as though the deen-

dant had not inringed the patent. Such analysis, obviously, simply rewards thedeendant or inringinggiving it the same deal as it would have had absentthe lawsuit, while putting the plainti to the trouble and expense o suing.

With all o these competing considerations, it is remarkable that any expertis able to construct a scenario in which these parties could have agreed toanything or that any act nder could come to any kinds o conclusion as towhat these parties might have agreed to in this ctitious negotiation. However,this theoretical construct has proven to provide the best measure o what

royalty ullls the statutory mandate o being reasonable.Te court in Innogenetics, N.V. v. Abbott Labs., 578 F. Supp. 2d 1079, 1093

(W.D. Wis. 2007), gave a good summary o the hypothetical negotiationmodel: In calculating the amount o a reasonable royalty, the jury has topretend that the parties sat down and negotiated a reasonable royalty beorethe day that deendant began its inringement o the plainti s patent. Unlikea real negotiation, this hypothetical negotiation assumes that the inringermust agree to some amount o royalty payment; it does not have the option

o walking away rom the table. Te jury must put itsel in the shoes o theparties and look at the relevant circumstances as they were at the time thenegotiations would have taken place. Te reasonable royalty calculus assessesthe relevant market as it would have developed beore and absent the inring-ing activity.

Te courts, however, are quite aware o the limitations o this model.As the Sixth Circuit observed in the leading case on lost prots, Panduit Corp.v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152, 1164 (6th Cir. 1978),

[d]etermination o a reasonable royalty aer inringement, like manydevices in the law, rests on a legal ction. Created in an eort to compensate


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25Imaging the Hypothetical Negotiation

when prots are not provable, the reasonable royalty device conjures a will-ing licensor and licensee, who like Ghosts o Christmas Past, are dimly

seen as negotiating a license. Tere is, o course, no actual willingness oneither side, and no license to do anything, the inringer being normallyenjoined, as is Stahlin, rom urther manuacture, use, or sale o the patentedproduct.

Te Federal Circuit concurred in Rite-Hite Corp. v. Kelley Co., 56 F.3d1538, 1576 (Fed. Cir. 1995), noting that while [t]he hypothetical negotiationis oen reerred to as a willing licensor/willing licensee negotiation. . . this isan inaccurate, and even absurd, characterization when, as here, the patentee

does not wish to grant a license. Indeed, the use o a willing licensee-willinglicensor model or determining damages risks creation o the perception thatblatant, blind appropriation o inventions patented by individual, nonmanu-acturing inventors is the protable, cant-lose course.Maxwell v. J. Baker,Inc., 86 F.3d 1098, 110910 (Fed. Cir. 1996).

Te Federal Circuit noted in Fromson v. Western Litho Plate & Supply Co.,853 F.2d 1568, 1576 (Fed. Cir. 1988), that []orced to erect a hypothetical,it is easy to orget a basic realitya license is undamentally an agreement by

the patent owner not to sue the licensee. In a normal negotiation, the poten-tial licensee has three basic choices: orego all use o the invention; pay anagreed royalty; inringe the patent and risk litigation. Te methodology pre-sumes that the licensee has made the second choice, when in act it made thethird. Tus Western must be viewed as negotiating or the right to excludecompetitors or to compete only with licensed competitors, a landscape ardierent rom that created. . . by the inringement o [the deendant] andothers. Whatever royalty may result rom employment o the methodology,

the law is not without means or recognizing that an inringer is unlike atrue willing licensee; nor is the law without means or placing the injuredpatentee in the situation he would have occupied i the wrong had not beencommitted.

In an early case, the Federal Circuit was o the opinion that the hypotheti-cal negotiation should be entirely hypotheticalhaving no relationship tothe real world. [I]n determining a reasonable royalty in hypothetical nego-tiations, a willing hypothetical licensee would not have been a party to any

prior transactions and, thus, would not have had the same psychologi-cal reluctance as Heublein. Stickle v. Heublein, Inc., 716 F.2d 1550, 1563(Fed. Cir. 1983).

However, in more recent cases, the courts have considered the actualmarket and competitive pressures that the parties were under at the time thehypothetical negotiation is deemed to have taken placeat the time theinringement began. For example, in Ball Aerosol & Specialty Container, Inc.v. Limited Brands, Inc., 514 F. Supp. 2d 1051, 1065 (N.D. Ill. 2007), the court

noted that since, at the time o inringement, the commercial relationshipbetween the plainti and deendant made buying the necessary component


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not a viable option, the plainti was in a superior negotiating positionand could have demanded a higher reasonable royalty.

Likewise, inMinco Inc. v. Combustion Engg, 95 F.3d 1109, 1119 (Fed. Cir.1996), the court considered such real-world actors as the act that, at the timeo inringement, the plainti had an inerior product and that the industryenjoyed high rates o prot. Indeed, inAvocent Huntsville Corp. v. ClearCubeech., Inc., 2006 U.S. Dist. LEXIS 55307 (D. Ala. 2006), the court explicitlytook into account the mental state o the respective hypothetical negotia-tors, considering the real economic pressures they would have been under atthe time.

However, the utility o these real-world considerations has its limits, as thecourt cautioned in Cummins-Allison Corp. v. SBM Co., Ltd., 584 F. Supp. 2d916, 918 (E.D. ex. 2008), especially because o the requirement o the hypo-thetical negotiation that the parties assume the validity and inringement othe patent: Te problem with ignoring or overruling Georgia-Pacifc andbasing the royalty rate calculation entirely on a real world view o the hypo-thetical negotiation or uture damages is that the damages expert should then,as real world lawyers and business owners would do, also consider the rela-

tive strength o the inringement and invalidity cases, current trends o patentlaw, the merits o the parties lawyers, their perceived inuence with judges,and even actors such as their willingness to engage in abusive attempts tospend opponents into bankruptcy.

3.01 Applying Game Theory to

Hypothetical Negotiation

Tese articial constraints, however, need not prevent the parties and thecourt rom determining an equitable reasonable royalty using the hypotheti-cal negotiation model. Negotiation modeling drawn rom game theory canoen provide valuable insights into the process by which the parties wouldhave reached a deal in these ctional negotiations. A number o actors spe-cic to the hypothetical negotiation process aect how these negotiationsshould be viewed and modeled.

[A] A Zero-Sum Game

First, the reasonable royalty hypothetical negotiation is what is known as azero-sum gameany advantage gained by one party disadvantages the other.Te hypothetical negotiation model does not allow or the parties workingtogether cooperatively in the uture or orming some kind o joint venturethe parties are just dividing up the spoils.


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Applying Game Teory to Hypothetical Negotiation 27

[B] Perfect Exchange of Information

Second, there is, or the purposes o the patent lawsuit, perect exchange oinormation. Te hypothetical negotiation model presumes that each party isaware o the economic constraints the other is under. Secrecy regarding inor-mation or strategywhich would be a party o any real negotiationis simplynot taken into account. Tese actors, obviously, push the hypothetical nego-tiation arther and arther rom reality. However, it is easy to see that, in thecontext o litigation, trying to account or the secrecy and deception that arepart o any business deal would make the process entirely unworkable.

[C] You Cant Walk Away

Tird, although there is theoretically no ability or either party to walk awayrom the table, even as a negotiating tactic, the courts oen (as covered in moredetail below) impose an outside boundary on the results o the negotiation,holding that one party or the other would never have agreed to a certain

result because it would have been too economically disadvantageous. Tis isusually expressed in terms o the position o the deendant who, in the opiniono the court, would never have agreed to a royalty that did not permit it toretain some prot. Although this actor is inconsistently applied (some courtsexpressing the strong opinion that they did not care whether an inringingdeendant would have ended up with a prot or not), it is a actor that shouldbe taken into account and that a deendant should be sure to emphasize.

[D] Date of Infringement

Fourth, the hypothetical negotiation theoretically takes place on the day thedeendant started inringingeither the day that the deendant startedmaking using or selling the inringing product or, i the patent issued whilethe deendant was already selling the product, the date the patent actuallyissued. As noted elsewhere, the court and jury are supposed to take into

account only the acts the parties knew and the assumptions the parties weremaking as o that date. In certain circumstances, however, the act ndercan take into account acts that occurred aer the date o the hypotheticalnegotiation (usually the actual level o sales o the inringing product)theso-called Book o Wisdom analysis.

[E] Assumption of Validity

Fih, unlike any actual negotiation outside o the conduct o the litigation,the act nder assumes, or the purpose o negotiation modeling, that the


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patent is valid, enorceable, and inringedmaking denite a actor thatthe parties would have considered indenite during the negotiation. Indeed,

the hallmark o any real-world licensing negotiation is the competing analy-ses o the likelihood that the patent may hold up under an invalidity attackand the strength o the inringement case. Although considering that dam-ages are actually awarded at trial only where the patent is valid and inringed,imposing this constraint on the hypothetical negotiation is certainly air, thisactor in particular imposes a particular level o unreality on the negotiationanalysis, because this obviously increases the plainti s bargaining powerdramatically.

3.02 Determining the Reasonable Royalty Value

aking into account all o the actors specic to the reasonable royalty analy-sis, the rst step in splitting up the pot o money between the parties is deter-mining how big the pot is and where the money came rom.

On the plainti s side, this issue depends substantially on whether theplainti uses the patent in its business and, i so, how it uses the patent. Ithe plainti uses the patent in its products, obtains a competitive advantagerom doing so, and would suer a competitive injury rom giving up thisexclusive use o the patent, this competitive advantage has a certain measur-able valuehow much better o would the plainti be with the exclusive useo the patent than without it? Te more important and central the patent is tothe plainti s maintaining this competitive advantage, the greater the amount

o this ascribed value. In the hypothetical negotiation, such a value goesinto the pot.

Where the plainti does not use the patent in its business, the value o thepatent to the plainti is the amount it could obtain by licensing it to thirdparties. Where the plainti has established a royalty (more about this later),the amount it loses i the deendant inringes the patent without compensat-ing the plainti is clearthe market price or licensing the patent. Wherethe plainti, however, has not licensed the patent at all or has licensed it or

inconsistent prices (or where it cannot prove a consistent strategy), or whereall licensing has been conducted as settlements o real or threatened litiga-tion, the value o what this type o a plainti has lost by the inringement isless clear. In act, the amount it puts into the pot may very well depend on theidentity and characteristics o the particular inringer.

Te amount the deendant puts into the pot reects the competitive valuethe use o the patent represents to the deendant and the amount the deen-dant would suer i that use were taken away. Does inringing the patent

enable the deendant to save costs? Increase prices? Increase output? Gainmarket share? Tese amounts can be calculated (or at least estimated) and


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Determining the Reasonable Royalty Value 29

should be added to the pot o money the plainti and deendant are ght-ing over.

One wrinkle that must be taken into account is the extent to which thedeendant needs the patented invention it is inringing in order to gainthese advantages. Could the deendant work around the invention and gainall or part o that competitive advantage in a non-inringing manner? I so,would that process cost the deendant more to implement? Would it take thedeendant more time to implement this other solution? Any non-inringingsubstitute solution will decrease the value o the patent to the deendant andwill thus decrease the amount the deendant needs to put into the pot to

divide with plainti.Now that there is an estimate how much money to put into the pot, how,

then, should it be divided? Is there a better solution than simply guessing atwhat the parties would have done? Game theory may provide a solution, or atleast an approach, to solving this problem.

As noted above, the calculation o a reasonable royalty in a patent case is atwo-person, non-cooperative zero-sum-gamethese parties are not going tocooperate or work together either now or in the uture, and what helps one

player hurts the other. Tere is a limited amount o money in the pot, and theconduct o the parties is not going to create more; the only question is howthe pot is going to be divided up.

[A] Game Theory and the Lemley/Shapiro Analysis

Mark Lemley and Carl Shapiros analysis o real-world royalty negotiation,

described in their article Patent Holdup and Royalty Stacking, 85 EXASL.REV. 1991(2007), which takes into account the plainti s ability to obtainan injunction, is useul and enlightening as to the process that should beollowed in determining a reasonable royalty. Yet in certain respects, theiranalysis is incomplete.

In Lemley and Shapiros analysis, they use the standard economic theoryo Nash Bargaining, in which the negotiated royalty rate depends upon thepayo that each party would obtain i the negotiations break down, i.e., on

each partys threat point in the licensing negotiations. Tey then look at theollowing economic variables:

V: Te value per unit o the patented eature to the deendant, in com-parison with the next best alternative technology. For example, i thepatented eature enhances the value o the product to consumers by $1over the next best alternative, then V = $1.

M: Te margin per unit earned by the deendant on its product. For

example, i the product is sold at a price o $40 and the marginal cost is$30, then M = $40$30 = $10.


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: Te strength o the patent, that is, the probability that litigation willresult in a nding that the patent is valid and inringed by the down-

stream rms product. In the context o a hypothetical negotiation inlitigation, this actor must be given the value o 1, since the patent ispresumed value and inringed.

C: Te costto the downstream rm o redesigning its product to avoidinringing the patent claims, measured as a raction o the total value othe patented eature. For example, i the per-unit value o the patentedeature is V = $1 and the downstream rm expects to sell ten millionunits, then the total value o the patented eature is $10 million. I rede-

signing the product costs $2 million, then C is equal to $2 million/$10million, or 20 percent.

L: Te raction o the downstream rms total unit sales during thelietime o the patent that would be lost i the downstream rm wereorced o the market by an injunction, as reected by the lagin timerequired or the downstream rm to redesign a non-inringing productand introduce it to the market.

B: Te bargainingpower o the patentholder, as measured by the rac-

tion o the combined gains rom settling, rather than litigating, that arecaptured by the patentholder. Tis variable alls between zero and one.Equal bargaining power, B = 0.5, is a common assumption.

Given these variables, Lemley and Shapiro determine a benchmark roy-alty rate, which, assuming equal bargaining power, split[s] equally any gainsrom reaching an agreement. Tey also consider this equal split as theproper benchmark or reasonable royalties.

[B] Injunctions

Lemley and Shapiro go on to evaluate the eect o the prospect o an injunc-tion on such real-world negotiations. Tey note that a plainti may obtain aninjunction that would prevent a deendant rom using the patented eature atall and would, presumably, be able to stop the deendant rom selling the

inringing producteven i the patented eature was a relatively minor com-ponent o the inringing product. Tis, according to the authors, gives theplainti negotiating power in such negotiations that ar outweighs the actualeconomic value o the patent.1

Even taking the injunction actor out o the calculus, under the Lemleyand Shapiro analysis, a reasonable royalty is primarily measured by the

1 Tis article was published beore the Supreme Courts opinion in eBay v. MercExchange,which, contrary to the authors predictions, eliminated the automatic imposition o a perma-nent injunction where patent inringement was ound.


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Determining the Reasonable Royalty Value 31

advantages gained by the deendant rom its inringing use o the patentedinvention and is usually a matter o splitting the dierencethe plainti

charging the deendant about hal o the monetary advantage the deendantgains rom it use o the patent. However, that this analysis is incomplete,because it does not take into account the dierences between (1) patenthold-ers who use the patent-in-suit in their businesses and obtain competitiveadvantage rom being the sole user o its eatures and rom being able toexclude others rom doing so and (2) plaintis whose sole use or the patentis to license it and who have little or no money to put into the pot. For thesecompetitor plaintis (who, or whatever reason, may not be able to utilize

the lost-prots remedy), the competitive value o the patent must also betaken into account.

[C] Two More Variables

Given the need to take the above dierences into account, there should beadded to the Lemley and Shapiro analysis two more variables: VP, the com-

petitive value o the patent to the plainti, representing its increased sales,increased pricing, or decreased costs that result rom being the only player inthe market that oers the patented eature; and DMP, the dierence in theplainti s margins between the plainti s position as a monopoly user o thepatented eature and its margin with the deendant selling the inringingproduct. Tese two actors will represent something similar to what is com-monly called monopoly prots in antitrust analysis.

Where the plainti uses the patented eature in products it sells, this actor

will be signi

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