Intellectual Property Law

CAFC Nixes 25% "Rule of Thumb" Application For Estimating Patent Damages

By Peter Zura

35 U.S.C. §284 provides that on finding infringement, damages shall "in no event [be] less than a reasonable royalty for the use made of the invention by the infringer, together with interest and costs as fixed by the court." In litigation, a reasonable royalty is often determined on the basis of a hypothetical negotiation, occurring between the parties at the time that infringement began.

The 25 percent rule of thumb is a tool that has been widely used to approximate the reasonable royalty rate that the manufacturer of a patented product would be willing to offer to pay to the patentee during a hypothetical negotiation. In a nutshell, the application of the rule works like this:

1. Estimate the infringer's (licensee's) expected profits for the product during the infringing period,
2. divide the expected profits by the expected net sales over that period to arrive at a profit rate (e.g., 16%),
3. multiply the profit rate (16%) by 25% to arrive at a running royalty rate (16% X 25% = 4%), and
4. apply the royalty rate to the infringer's net sales to get the royalty payment.

According to its proponents, the veracity of the 25 percent rule has been "confirmed by a careful examination of years of licensing and profit data, across companies and industries."  Earlier empirical studies concluded that, across all industries, the median royalty rate was 22.6% and that the data supported the use of the 25% rule "as a tool of analysis."  A survey of licensing organizations in 1997 found that 25% of them used "the 25% rule" as a starting point in negotiations.

In the case of Uniloc, Microsoft was found to infringe Uniloc's patent directed to software "product key" technology that helped prevent "casual copying" of software products.  The jury awarded Uniloc $388M in damages.  The damage award was based on the testimony of Uniloc?s expert, Dr. Gemini.  Gemini opined that the damage calculation was based on the value of a product key ($10) multiplied by 25% of the value of the product (Windows XP, Microsoft Word), resulting in a baseline royalty rate of $2.50 per license issued.

During litigation, Microsoft challenged the 25% rule and attempted to exclude Gemini?s testimony. The district court noted that "the concept of a ?rule of thumb? is perplexing in an area of the law where reliability and precision are deemed paramount," but rejected Microsoft?s position because the rule has been widely accepted.

On appeal, the Federal Circuit dismissed the 25% rule outright:

The admissibility of the bare 25 percent rule has never been squarely presented to this court. Nevertheless, this court has passively tolerated its use where its acceptability has not been the focus of the case, or where the parties disputed only the percentage to be applied (i.e. one-quarter to one-third), but agreed as to the rule?s appropriateness.  Lower courts have invariably admitted evidence based on the 25% rule, largely in reliance on its widespread acceptance or because its admissibility was uncontested. 


This court now holds as a matter of Federal Circuit law that 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 Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.

The 25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement. The rule does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party. Relying on the 25 percent rule of thumb in a reasonable royalty calculation is far more unreliable and irrelevant than reliance on parties? unrelated licenses, which we rejected in ResQNet and Lucent Technologies.. . . Lacking even these minimal connections, the 25 percent rule of thumb would predict that the same 25%/75% royalty split would begin royalty discussions between, for example, (a) TinyCo and IBM over a strong patent portfolio of twelve patents covering various aspects of a pioneering hard drive, and (b) Kodak and Fuji over a single patent to a tiny improvement in a specialty film emulsion.

It is of no moment that the 25 percent rule of thumb is offered merely as a starting point to which the Georgia-Pacific factors are then applied to bring the rate up or down. Beginning from a fundamentally flawed premise and adjusting it based on legitimate considerations specific flawed conclusion. 

In addition to challenging the 25% rule, Microsoft challenged the calculation of damages using the entire market value of Office and Windows and caomparing the calculated royalty to the total revenue Microsoft earned through the accused products.  Microsoft argued 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. Microsoft also argued that Gemini?s testimony tainted the jury?s damages deliberations.

The court agreed with Microsoft:

The Supreme Court and this court?s precedents do not allow consideration of the entire market value of accused products for minor patent improvements simply by asserting a low enough royalty rate . . . This case provides a good example of the danger of admitting consideration of the entire market value of the accused where the patented component does not create the basis for customer demand. As the district court aptly noted, "[t]he $19 billion cat was never put back into the bag even by Microsoft?s cross-examination of Mr. Gemini and re-direct of Mr. Napper, and in spite of a final instruction that the jury may not award damages based on Microsoft?s entire revenue from all the accused products in the case." . . . This is unsurprising. The disclosure that a company has made $19 billion dollars in revenue from an infringing product cannot help but skew the damages horizon for the jury, regardless of the contribution of the patented component to this revenue.

Full post as published by Two-Seventy-One Patent Blog on January 05, 2011 (boomark / email).