Recent years have seen footing become increasingly precarious for damages experts attempting to determine what constitutes a reasonable royalty in patent infringement matters. Methods that had previously been accepted for calculating both a royalty base and royalty rate have been called into question. The 2014 CAFC decision in the matter of VirnetX, et al. v. Cisco and Apple may offer some degree of clarity around determining a royalty base when the Entire Market Value Rule does not apply and the requirements necessary to employ the Nash Bargaining Solution. This article provides background regarding the case, key arguments made in each party’s motions, and the guidance provided by the Court in the calculation of damages.

Background

The proper application of the Entire Market Value Rule (“EMVR”) in calculating patent infringement damages has been a major focal point of recent case law. In particular, two seminal decisions–Cornell v. Hewlett-Packard (2009) and LaserDynamics v. Quanta Computer (2012)–reshaped perspectives of what constitutes a proper royalty base. In Cornell, a district court decision, Former Chief Judge Rader sitting by designation defined the royalty base as all revenue generated by sales of the smallest salable patent-practicing unit, despite the fact that such a unit often encompasses non-patented features (indeed, this was the case in the Cornell matter itself). In its opinion in the LaserDynamics case, the Court of Appeals for the Federal Circuit (“CAFC”) tightened the standard further, ruling that a further apportionment should be performed upon the smallest saleable unit if that product contains key features that are non-patented.

The two rulings, though similar in much of their language, appear to contradict each other on the fundamental question of whether all the revenue generated by an indivisible multi-feature product was properly included in the royalty base for a patent that protected one or some, but not all, of those features. Further case law seemed necessary to resolve this tension.

Another focal point of the district courts in recent years is not only the need for apportionment, but also the acceptability of various means by which such apportionment can be performed. Since the 25 percent rule was found to be “fundamentally flawed” by the CAFC in the 2011 Uniloc v. Microsoft decision, experts have attempted to split the benefit generated by valid and infringed intellectual property between parties to a hypothetical negotiation in various ways, none of which has emerged as universally accepted industry standard. One methodology that has been employed in several cases involves the application of the Nash Bargaining Solution (“NBS”). Industry participants have looked for signals from the CAFC as to whether this approach would be deemed acceptable, just as they have sought clarity surrounding the EMVR.

The VirnetX Case

The CAFC’s VirnetX decision addressed both issues. Plaintiff VirnetX had initially been successful in its suit against Apple in the Eastern District of Texas, accusing its VPN On Demand feature in certain of Apple’s iPads, iPhones, and iPod Touches of infringing two of its patents and accusing Apple’s FaceTime servers of infringing two other patents. VirnetX’s expert proposed three approaches that indicated damages ranging from $588 million to $708 million. The jury ultimately awarded VirnetX $368 million, however, the CAFC’s 2014 ruling overturned the award.

The CAFC decision was not a rejection of just one methodology, but of all three approaches performed by VirnetX’s expert. Below, we discuss the first approach individually and the latter two (which are similar) together, explaining their mechanics and tracing the related argument from the initial decision granting the $368 million award, through the arguments made by Apple and VirnetX in the briefs that were submitted to the CAFC, and, finally, to the ruling handed down by the CAFC on September 16, 2014, which fully vacated the damages award and remanded the case for further proceedings.

VirnetX’s First Damages Approach

In his first approach, VirnetX’s expert utilized the $29 price of a software upgrade that included FaceTime functionality to determine the royalty base associated with Mac computers. For iOS devices, he determined the royalty base by multiplying the unit sales of the accused products by the lowest price at which each product model had ever been sold. While this base excluded memory upgrades and other features not included in the lowest base price, it obviously included a great number or features that did not relate to FaceTime or VPN On Demand–the two features enabled by the accused technology. The resulting royalty base for iOS devices and Mac computers combined to exceed $70 billion.

VirnetX’s expert applied a 1% royalty rate to this base, relying on produced licenses and VirnetX’s overall licensing policy. His 1% rate resulted in $708 million in damages under this approach. The District Court allowed this approach to be explained before the jury at trial.

Apple’s Brief before the CAFC (10/17/2013)

In its appeal brief, Apple objected to VirnetX’s expert’s first approach as a veiled and improper application of the EMVR. Apple cited LaserDynamics and Lucent v. Gateway (2009) in arguing that the EMVR should be “a ‘narrow exception’ to the general rule for calculating reasonable royalty damages, available ‘only where the patented feature creates the “basis for customer demand” or “substantially creates the value of the [unclaimed] component parts.”’”

Apple contrasted this with the District Court’s jury instruction, which indicated that the EMVR could also be used if “the product in question constitutes the smallest saleable unit containing the patented feature.” Here, Apple illustrated precisely the tension that many felt to exist between the Cornell and LaserDynamics decisions and argued that the standard put forth in LaserDynamics should be governing and the $70 billion royalty base should thus have been excluded.

VirnetX’s Brief before the CAFC (12/9/2013)

VirnetX’s response included a fundamentally different view of the EMVR. Citing the Federal Circuit in Versata v. SAP (2013) and LaserDynamics itself, VirnetX argued that “[i]f the smallest salable unit is used, ‘the award cannot violate the Entire Market Value Rule.’” VirnetX claimed that the “apportionment requirement does not mean the smallest salable unit cannot contain unclaimed features or constitute entire products” and pointed to the specific products sold in both LaserDynamics and Cornell to support its argument. VirnetX accused Apple of arguing “for a new per se rule that an entire product cannot constitute the smallest salable unit” and urged the CAFC to “reject that outright.”

VirnetX positioned the smallest salable unit in a particular case as a question of fact that “the jury was entitled to weigh [as] evidence in determining the award.” Citing LaserDynamics, VirnetX concluded that the EMVR was not abused in the instant matter because its expert had “accurately accounted for the invention’s value through three separate theories and a thorough Georgia-Pacific analysis.”

Apple’s Reply Brief before the CAFC (12/19/2013)

In its reply brief, Apple emphasized the claimed contradiction between the legal standard for applying the EMVR and the jury instruction provided by Judge Davis. Apple, citing Cornell and Rembrandt v. Facebook (2013), argued that the impermissibility of including the entire market value of its royalty base “applies even if the ‘whole machine’ is the ‘smallest salable unit’ incorporating the patented feature; such a ‘unit’ is merely ‘a starting point for the royalty base,’ from which further apportionment is required to reach the claimed feature’s value.’”

Apple rejected the notion that it was attempting to create a “per se” rule, arguing instead that the District Court had erred in instructing the jury of its own “per se” rule “that a patentee could always base a royalty on the entire market value of the ‘smallest salable unit,’ even if it contains numerous other unpatented features and the patented features do not drive customer demand.”

The CAFC’s Decision (9/16/2014)

The CAFC agreed with Apple that the District Court’s jury instruction was improper, saying:

The instruction mistakenly suggests that when the smallest salable unit is used as the royalty base, there is necessarily no further constraint on the selection of the base. That is wrong. For one thing, the fundamental concern about skewing the damages horizon – of using a base that misleadingly suggests an inappropriate range – does not disappear simply because the smallest salable unit is used.

Further, the CAFC, citing Cornell, stated that the purpose of the smallest salable unit approach was “to produce a royalty base much more closely tied to the claimed invention than the entire market value of the accused products.” Rather than providing a de facto completion of the task of establishing a royalty base, “the requirement that a patentee identify damages associated with the smallest salable patent-practicing unit is simply a step toward meeting the requirement of apportionment.” (Emphasis added)

The CAFC’s conclusion was firm on the need for further apportionment, but suggested a certain degree of latitude on the precision of that apportionment:

Where the smallest salable unit is, in fact, a multi-component product containing several non-infringing features with no relation to the patented feature … the patentee must do more to estimate what portion of the value of that product is attributable to the patented technology. To hold otherwise would permit the entire market value exception to swallow the rule of apportionment.

In reaching this conclusion, we are cognizant of the difficulty that patentees may face in assigning value to a feature that may not have ever been individually sold. However, we note that we have never required absolute precision in this task; on the contrary, it is well-understood that this process may involve some degree of approximation and uncertainty.” (Emphasis added)

The CAFC’s rejection of the jury instruction led to its rejection of VirnetX’s first damages approach, as it “relied on the entire market value of Apple’s products without demonstrating that the patented features drove the demand for those products.” The CAFC ruled that “VirnetX should have identified a patent-practicing feature with a sufficiently close relation to the claimed functionality” and that its approach “failed to apportion value between the patented features and the vast number of non-patented features contained in the accused products.”¹

VirnetX’s Second and Third Damages Approaches

VirnetX’s alternative² damages approaches differed from one another in how they calculated the incremental profits attributable to the patented technology:

• In its second approach to damages, VirnetX “calculated the profits that [its expert] believed were attributable to the addition of the front-facing camera”—which was used as a proxy for the FaceTime feature—“to certain Apple products.”
• In its third approach, VirnetX “relied on customer surveys to assert that 18% of iOS device sales would not have occurred but for the inclusion of FaceTime, and determined the profit attributable to those sales.”

Having applied these methods, however, both approaches relied upon an application of the NBS to “split the pie” between VirnetX and Apple. The application involved two steps: a 50/50 allocation of economic value between VirnetX and Apple and then a 10% adjustment of that value from VirnetX to Apple to account for its stronger bargaining position.

The two approaches yielded damage figures of $588 million and $606 million, respectively. The District Court allowed all
aspects of the approaches—from the two methods of isolating economic value, to the 50/50 split, to the 10% adjustment—to be put before the jury.

Apple’s Brief before the CAFC (10/17/2013)

Apple argued, citing Oracle v. Google (2011) and Suffolk Techs. v. AOL (2013), that the Nash bargaining theory should not be admissible because it “idealizes the bargaining problem” rather than relying upon “real-world conditions.” Apple went as far as to declare the theory “indistinguishable from the ’25 percent rule of thumb’” because it made “no effort to ground the 50/50 split in the facts of the case.”

Apple argued against the 10% adjustment, citing Uniloc: “[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.” While this argument would hold even if the 10% adjustment was appropriate, Apple argued further against the adjustment’s legitimacy in itself as VirnetX’s expert “never explained why he chose a 10% variation and not a much greater figure.”

Finally, Apple argued that VirnetX had not properly isolated the incremental profits associated with the use of the patented technology, claiming that the front-facing camera was not a proper proxy for FaceTime and that VirnetX’s patents did not cover all of FaceTime.

VirnetX’s Brief before the CAFC (12/9/2013)

VirnetX replied to Apple’s brief by claiming that the NBS analysis was inherently tied to the facts of the case because it was used only to split the incremental profit generated through the inclusion of the accused technology and has further relevance because the 10% adjustment from 50/50 was “properly supported by evidence and reasoned expert opinion.”

VirnetX went on to characterize Apple’s further arguments about VirnetX’s calculation of the incremental value due to the invention as disagreements over conclusions rather than methodology and argued, citing Daubert, that they should “go to the weight, not admissibility” of VirnetX’s expert’s opinion.

The CAFC’s Decision (9/16/2014)

The CAFC agreed with Apple’s argument that “the invocation of a 50/50 starting point based on the Nash Bargaining Solution is akin to the ’25 percent rule of thumb’ that we rejected in Uniloc as being insufficiently grounded in the specific facts of the case.” This outright rejection of the NBS as an improperly applied rule of thumb rendered the question of whether incremental profits had been properly calculated irrelevant and the CAFC did not rule on it.

The CAFC pointed out that “[t]he Nash theorem arrives at a result that follows a certain set of premises. It itself asserts nothing about what situations in the real world fit those premises. Anyone seeking to invoke the theorem as applicable to a particular situation must establish that fit, because the 50/50 profit-split result is proven by the theorem only on those premises.” (Emphasis added)

As to the adjustment, the CAFC wrote that VirnetX’s expert’s “thin attempts to explain his 10% deviation from the 50/50 baseline in this case demonstrates how this methodology is subject to abuse.” The decision goes on:

His only testimony on the matter was that although he ‘considered other splits,’ he ultimately determined that a 10% deviation – resulting in a 45/55 split – was appropriate ‘to reflect the fact that Apple would have additional bargaining power over VirnetX back in…2009…

The CAFC expressed additional concern about jury bias that seems as relevant to the EMVR as to the NBS:

More importantly, even if an expert could identify all of the factors that would cause negotiating parties to deviate from the 50/50 baseline in a particular case, the use of this methodology would nevertheless run the significant risk of inappropriately skewing the jury’s verdict. This same concern underlies our rule that a patentee may not balance out an unreasonably high royalty base simply by asserting a low enough royalty rate. Although the result of that equation would be mathematically sound if properly applied by the jury, there is concern that the high royalty base would cause the jury to deviate upward from the proper outcome. (Emphasis added)

The CAFC closes its decision by noting that the NBS is superior to the 25% rule in that it is properly applied only to the incremental profits earned by the infringer, rather than the entire profit associated with the allegedly infringing products. Still, however, the CAFC ruled that the 50/50 split was not adequately tied to the facts of the case “and cannot be supported.”

Key Lessons

The CAFC’s opinion in VirnetX clarified certain issues regarding the calculation of damages in patent litigation. First, it explained that when the Entire Market Value Rule is not applicable and when a percentage of revenue royalty rate is to be used, one cannot simply use the value of the smallest saleable unit in determining the royalty base, if that smallest saleable unit still includes non-patented elements. The Court indicated that further apportionment of the royalty base is required to reflect only the value of the patented invention. Second, the CAFC expressed its concerns with the use of the NBS in calculating damages. It explained that if the NBS were to be invoked, one must also establish that the situation being analyzed is consistent with the premises that are the foundation for the Nash theorem.

1. It is worth noting that Apple also objected to VirnetX’s royalty rate determination on the grounds that it relied upon licenses that Apple did not believe to be sufficiently comparable. The CAFC rejected Apple’s argument, ruling that the licenses relied upon by VirnetX–several of which related to the accused technology and all of whose differences from the hypothetical negotiation were presented to the jury – were permissible and that “[n]o more is required in these circumstances.” This did little good for VirnetX, with no royalty base to which it could allow its permitted royalty rate, but offers some clarity for future parties considering the comparability of produced license agreements.
2. Both parties have referred to VirnetX’s second and third damages approaches as “alternatives” to the one discussed above; we will make similar reference to them when discussing them collectively here.