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Federal Circuit Rejects 25 Percent Rule of Thumb for Calculating Damages

10-1035
January 04, 2011

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Last Month at the Federal Circuit - February 2011

Judges: Rader, Linn (author), Moore

[Appealed from: D.R.I., Judge Smith]

In Uniloc USA, Inc. v. Microsoft Corp., Nos. 10-1035, -1055 (Fed. Cir. Jan. 4, 2011), the Federal Circuit rejected the “25 percent rule” for calculating infringement damages as a fundamentally flawed tool for determining a royalty rate in a hypothetical negotiation.  In reaching this conclusion, the Court reversed the district court’s grant of JMOL of noninfringement, affirmed its grant of JMOL of no willfulness, affirmed its grant of a new trial on damages, vacated its grant of an alternative motion for new trial on infringement, and affirmed its denial of JMOL of invalidity of claim 19 of U.S. Patent No. 5,490,216 (“the ’216 patent”).  The Court then remanded the case for proceedings consistent with its opinion. 

Uniloc USA, Inc. and Uniloc Singapore Private Limited (collectively “Uniloc”) asserted the ’216 patent against Microsoft Corporation (“Microsoft”).  Specifically, Uniloc claimed that Microsoft’s Product Activation feature, which acts as a gatekeeper to Microsoft’s Word XP, Word 2003, and Windows XP software programs, infringes the ’216 patent. 

Uniloc’s ’216 patent is directed to a software registration system to deter software copying.  The system allows software to run without restrictions in a “use mode” only if the system determines that the software installation is legitimate.  To do this, the system creates a local licensee unique ID based on information supplied by the user.  The same user information is also sent to a remote vendor’s system, which performs the identical algorithm to create a remote licensee unique ID.  If the local licensee unique ID matches the remote licensee unique ID, the program enables an unrestricted “use mode.”  Otherwise it defaults to a restricted “demo mode.”  Microsoft’s Product Activation feature utilizes a Product ID, Hardware ID, and additional activation information, which are run through either the MD5 message digest algorithm (“MD5”) or SHA-1 secure hash algorithm (“SHA-1”).  This results in a remote “license digest” that is sent back to the user’s computer to create a local “license digest.”  If the local and remote “license digest” match, the software product enters an unrestricted mode; otherwise, it defaults to a restricted mode.

Microsoft’s accused Product Activation feature requires the user to enter a twenty-five-character product key.  If the key is valid, the user is asked to agree to the End User License Agreement (“EULA”), by which the licensor-licensee relationship is initiated.  The user may then either use the software for a limited time without initiating Product Activation or activate the product.  Unless the user activates the product, he is not entitled to the rights granted by the EULA. 

In a first iteration of this case, the district court granted SJ of noninfringement, finding that the algorithms used by Microsoft were not identical at the remote and local sites.  The Federal Circuit reversed and remanded, holding that Uniloc provided extensive evidence that Microsoft’s Product Activation feature used the same algorithm at the local and remote sites, and stating that the issue should have gone to the jury.  On remand, the jury returned a verdict of infringement and no invalidity of claim 19 of the ’216 patent.  Further, the jury found Microsoft’s infringement willful and awarded $388 million in damages.  The district court denied JMOL of invalidity, granted JMOL of noninfringement, granted JMOL of no willfulness, granted a new trial on damages on the improper use of the entire market value rule, rejected Microsoft’s arguments regarding the 25 percent rule as having been previously decided, and granted in the alternative a new trial on infringement and willfulness.  Uniloc appealed all but the denial of JMOL of invalidity, which Microsoft cross-appealed.

In this second appeal, the Federal Circuit first addressed three infringement issues:  (1) whether the accused products contain “licensee unique ID generating means”; (2) whether the accused products contain a “registration system” with a “mode switching means” that precludes full use of the software unless the outputs of the local and remote algorithms match; and (3) whether Microsoft can be liable for direct infringement when it has no control over the user’s computer. 

With regard to the first and second issues, the Federal Circuit found substantial evidence for a jury to conclude that the accused product features performed the claim limitations.  The Court found that a reasonable jury could conclude that the output of the MD5 and SHA1 algorithms in Microsoft’s accused product was a “licensee unique ID” and that the algorithms are “summation algorithms” as those phrases are used in the context of the ’216 patent.  Moreover, the Court concluded that use during the grace period after agreement to the EULA and before Product Activation in the accused product does not constitute full use in accordance with the EULA.  The Court found that once the user activates the software, the registration system switches the software into “full version.”  Accordingly, the Court found substantial evidence that Microsoft’s Product Activation included a “registration system” and “mode switching means.”

Regarding the third infringement issue—whether Microsoft can be liable for direct infringement when it has no control over the user’s computer—the Federal Circuit concluded it could.  The Court found that claim 19 of the ’216 patent focuses entirely on the “remote registration station,” thereby capturing infringement by a single party.

Next, the Court considered the district court’s grant of a new trial on infringement issues.  The Court found that the district court provided no additional analysis apart from its analysis of the JMOL infringement issues in granting the new trial on noninfringement.  Thus, the Court concluded that the district court’s grant of a new trial on infringement had no more merit than the district court’s grant of JMOL on infringement. 

Turning to the issue of willfulness, the Federal Circuit analyzed the grant of JMOL of no willfulness and alternative grant of a new trial on willfulness.  The Court found that Uniloc failed to meet the threshold objective prong set forth in In re Seagate Technology, LLC, 497 F.3d 1360, 1371 (Fed. Cir. 2007), as Uniloc did not present any evidence showing why Microsoft could not reasonably have determined that the features of its product did not meet the claim limitations.  The Court concluded, therefore, that Uniloc failed to show that a reasonable jury could find Microsoft’s conduct objectively reckless on the evidence presented, and thus affirmed the district court’s grant of JMOL of no willfulness.  In light of the affirmation, the Court did address the district court’s alternative grant of a new trial on this issue.

The Federal Circuit next addressed three damages issues:  (1) the propriety of using the 25 percent rule; (2) application of the entire market value rule as a “check”; and (3) excessiveness of damages.  At trial, the jury awarded Uniloc $388 million in damages based on the testimony of Uniloc’s expert, who opined that damages should be $564,946,803.  The expert’s analysis was based on a hypothetical negotiation between Uniloc and Microsoft using the 25 percent rule of thumb and consideration of the Georgia-Pacific factors.  The 25 percent rule suggests that a licensee pay a royalty rate equivalent to 25 percent of its expected profits for the product that incorporates the intellectual property at issue.  Uniloc’s expert applied the 25 percent rule to the lowest value shown in an internal prelitigation Microsoft document describing the value of product keys as $10 to $10,000, obtaining a baseline royalty of $2.50 per license issued.  Multiplying the number of new licenses against the baseline $2.50 royalty rate resulted in a royalty amount of $564,946,803.  Uniloc’s expert then “checked” his analysis using the entire market value rule by comparing the gross revenue value of the licenses against the royalty rate, which amounted to approximately 2.9%.

Addressing first the application of the 25 percent rule, the Federal Circuit held that “the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation.”  Slip op. at 41.  The Court further held that “[e]vidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.”  Id.  Before reaching this conclusion, the Court reviewed the history of the 25 percent rule and the Court’s passive toleration of its use where its acceptability has not been the focus of the case.

In reasoning that the rule is inadmissible, the Court emphasized that expert testimony must pertain to scientific, technical, or other specialized knowledge based on a firm scientific or technical grounding.  Also, the Court reiterated a Daubert principle that “[e]xpert testimony which does not relate to any issue in the case is not relevant and, ergo, non-helpful.”  Id. (quoting Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579, 591 (1993)).  Applying these principles, the Court rejected the application of the 25 percent rule since “[t]he 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy [the] fundamental requirement” of providing “a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case.”  Id. at 45.  Instead of starting with an arbitrary number of 25 percent, the Court stated that evidence of a reasonable royalty must be tied to the relevant facts and circumstances of the particular case at issue, such as the particular technology, industry, or party.  Thus, the Court held that Microsoft was entitled to a new trial on damages because the testimony of Uniloc’s expert was based on the use of the 25 percent rule, was unrelated to the facts of the case, and failed to pass muster under Daubert, thereby tainting the jury’s damages calculation.

Turning to the application of the entire market value rule, the Court concluded that the district court did not abuse its discretion in granting a conditional new trial on damages.  The Court agreed with Microsoft that Uniloc’s use of the entire market value rule was improper because it was undisputed that Product Activation did not create the basis for customer demand or substantially create the value of the component parts.  In the Court’s view, this case provides a good example of the danger of admitting consideration of the entire market value, as the disclosure at trial of the $19 billion revenue figure skewed the damages horizon for the jury, regardless of the contribution of the patented component to this revenue.  The Court rejected Uniloc’s argument that the rule was used only as a “check,” and that the jury must be presumed to have followed the jury instructions and not based its damages calculation on the entire market value rule.  Accordingly, the Court affirmed the district court’s grant of a new trial on damages and expressed no opinion on the excessiveness or reasonableness of the damages awarded by the jury.

Finally, the Federal Circuit addressed the district court’s denial of Microsoft’s motion for JMOL of invalidity.  The Court rejected Microsoft’s argument that if claim 19 reaches far enough to read on Microsoft’s Product Activation, then it necessarily extends far enough to read on the prior art.  The Court reminded that “the proper framework for challenging the validity of a patent is not for the accused to show that it is practicing the prior art, but to show that every element of the patent claims reads on a single prior art reference.”  Id. at 57.  Thus, the Court affirmed the district court’s denial of JMOL of invalidity based on anticipation.  Giving the jury its usual deference on the underlying factual questions, the Court also affirmed the denial of JMOL on the basis of obviousness.

Summary authored by Benjamin H. Huh, Esq.