Federal Circuit Breaks the 25 Percent Rule of Thumb

Last week, in Uniloc USA, Inc. v. Microsoft Corp., Nos. 2010-1035, 2010-1055 (Fed. Cir. Jan. 4, 2010) (hereinafter, "Uniloc"), the Federal Circuit declared that the "25 percent rule of thumb," which has been widely used for calculating damages in patent infringement cases, is "fundamentally flawed."¹ Accordingly, the Federal Circuit held that any evidence relying on the 25 percent rule is inadmissible as a matter of law. This holding represents a significant shift in Federal Circuit precedent. Indeed, the Federal Circuit upheld a jury verdict based on the use of the 25 percent rule as recently as March 10, 2010.² Although the underlying technology that is the subject of Uniloc deals with a software registration system to deter copying of the software, the decision will be felt across all industries.

In calculating damages for patent infringement, a reasonable royalty rate should reflect the anticipated result of a hypothetical negotiation at the time of first infringement. The 25 percent rule suggested that a licensee would pay a royalty rate equivalent to 25 percent of the expected profits from products that incorporate the intellectual property at issue.³ Consequently, when the 25 percent rule was used, an alleged infringer's profit margin (profits divided by net sales) was multiplied by 25 percent to arrive at a reasonable royalty rate. That royalty rate was then multiplied by the royalty base (revenue from the sale of infringing products) to arrive at an alleged reasonable royalty.

The criticism of the 25 percent rule did not begin with Uniloc. Indeed, the rule had previously received criticism as an arbitrary and crude tool.⁴ Specifically, scholars criticized the rule because it did "not take into account specific circumstances that will determine the actual value of the patent at issue[,]"⁵ and because "multiplying by an arbitrary fraction to derive the value of a patent is an exercise in arbitrary business analysis."⁶ Nevertheless, the Federal Circuit had tolerated its use in calculating damages for patent infringement. For example, in i4i Ltd. Partnership v. Microsoft Corp., the Federal Circuit affirmed the district court's admissibility of a damage expert's opinion based on the 25 percent rule because it met the "minimum standards of relevance and reliability."⁷ In support of his opinion's admissibility, the damages expert "testified that the 25-percent rule was 'well recognized' and 'widely used' by people in his field."⁸

Notwithstanding the 25 percent rule's prior use, in Uniloc, the Federal Circuit directly addressed the admissibility of the rule for the first time. The Federal Circuit started its analysis of the 25 percent rule by addressing the rule's previous criticisms, placing them into three general categories: (1) it fails to account for the unique relationship between the patent and the accused product; (2) it fails to account for the unique relationship between the parties, such as the different levels of risk assumed by the licensor and licensee; and (3) it fails to fit within the model of the hypothetical negotiation within which it is based due to its arbitrary characteristics. With these criticisms in mind, this ruling of the Federal Circuit puts a definitive stop to the use of the 25 percent rule in calculating damages for patent infringement:

as a matter of Federal Circuit law[,] the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation. Evidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert⁹ and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.¹⁰

If this was not clear enough, the Federal Circuit further held that even when the 25 percent rule is "offered merely as a starting point[,]" any opinion derived therefrom is still inadmissible because "[b]eginning from a fundamentally flawed premise and adjusting it based on legitimate considerations specific to the facts of the case nevertheless results in a fundamentally flawed conclusion."¹¹  In support of its holding, the Federal Circuit stated that "the 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy" the fundamental requirement that "there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case."¹² In other words, a damages calculation "must be tied to the relevant facts and circumstances of the particular case at issue and the hypothetical negotiations that would have taken place in light of those facts and circumstances at the relevant time."¹³

The Federal Circuit did not leave litigants without a mode for calculating damages in patent infringement cases, however. Indeed, the Federal Circuit reaffirmed the use of the Georgia-Pacific factors for determining a reasonable royalty rate.¹⁴ Specifically, the Federal Circuit pointed to Georgia-Pacific factors one and two, "looking at royalties paid or received by in licenses for the patent in suit or in comparable licenses[,]" and factor twelve, "looking at the portion of profit that may be customarily allowed in the particular business for the use of the invention or similar inventions[,]" as still "valid and important factors for determining a reasonable royalty rate."¹⁵ The Federal Circuit further stated that it requires "evidence purporting to apply to these, and any other factors," to be "tied to the relevant facts and circumstances of the particular case at issue."¹⁶

The total impact of this decision on the "size" of future damage awards may be uncertain, but it is certain that the Federal Circuit is sending a clear message that abstract methodologies for calculating damages are not acceptable. By forcing damage calculations to be tied to the relevant facts and circumstances of the particular case, the Federal Circuit continues its efforts to require damage awards in patent cases to bear a direct relationship between the claims of the patent at issue and the accused products.

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¹ Chief Judge Rader, Circuit Judge Linn and Circuit Judge Moore formed the three judge panel, and Judge Linn wrote for the panel.
² See i4i Ltd. P’ship v. Microsoft Corp., 598 F.3d 831 (Fed. Cir. 2010); see also Uniloc (stating that the "admissibility of the bare 25 percent rule had never been squarely presented" to the Federal Circuit, but it had nonetheless "passively tolerated its use").
³ Robert Goldscheider, John Jarosz and Carla Mulhern, Use Of The 25 Per Cent Rule in Valuing IP, 37 les Nouvelles 123, 123 (Dec. 2002).
⁴ See Goldschreider, 37 les Nouvelles 123, 130-32.
⁵ Goldschreider, 37 les Nouvelles 123, 131 (citing Mark Berkman, Valuing Intellectual Property Assets for Licensing Transactions, 22 The Licensing Journal 16 (April 2002)).
⁶ Goldschreider, 37 les Nouvelles 123, 131 (citing Paul E. Schaafsma, An Economic Overview of Patents, 79 Journal of the Patent Trademark Office Society 251, 251-52 (April 1997)).
⁷ 598 F.3d at 856.
⁸ Id. at 853.
⁹ The U.S. Supreme Court, in Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 589 (1993), provided guidance to district court judges as to how to determine whether expert opinion is relevant and reliable.
¹⁰ Uniloc, at 41.
¹¹ Id. at 46 (emphasis added).
¹² Id. at 45.
¹³ Id. at 46.
¹⁴ Judge Tenney in the Southern District of New York first set out 15 factors to consider when determining the reasonable royalty in a patent infringement case in Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970). These 15 factors are referred to as the Georgia-Pacific factors.
¹⁵ Id. at 46.
¹⁶ Id.