In March, the Federal Trade Commission (the “FTC”) issued a 300+ page report titled The Evolving IP Marketplace: Aligning Patent Notice and Remedies with Competition (the “Report”) in which it offered a variety of recommendations intended to promote innovation.1 A number of the FTC’s recommendations related to the quantification of compensatory damages in patent cases. Consistent with Section 284 of Title 35 of the United States Code, the FTC stated that compensatory damages should “return the patentee to the financial condition it would have been in but for the infringement”2 and “reflect the economic realities of the market by rendering the patentee no worse off, but also no better off, than it would have been absent the infringement.”3 However, the FTC cited numerous problems that can result if damages either undercompensate patentees (such as reduced incentive to innovate)4 or overcompensate patentees (such as diverting funds from innovation and/or productive activities to litigation).5 Therefore, the FTC made over a dozen specific recommendations that could impact the quantification of compensatory damages. While many of the recommendations were aimed at clarifying or harmonizing past case law, a number of those recommendations were contrary to longstanding case law and would require significant changes in how damages are quantified. It remains to be seen which, if any, of these recommendations will make it into the new patent legislation now pending before Congress. While we do not necessarily endorse the proposed recommendations, we summarize below the FTC’s recommendations related to compensatory damages and highlight, where appropriate, the impact on current practice if those recommendations were adopted.
The FTC’s Recommendations
The FTC issued three recommendations related to the determination of lost profits and 10 recommendations related to the determination of a reasonable royalty.
Lost Profits
FTC Recommendation: Allow a patentee greater flexibility in creating the “but for” world. Refrain from requiring that rigid rules be applied to establish lost profits and refrain from imposing evidentiary requirements beyond what is required by the court to make a reasonable approximation of the patentee’s loss.
The Report criticized the apparent rigidity of the Panduit Test and emphasized that lost profit determination was not an exact science. It proposed that plaintiffs should be permitted to “approximate, if necessary, the amount to which the patent owner is entitled.”6 The Report also contemplated an approach for calculating lost profit damages in which the defendant’s next best alternative to infringing would be identified and then the market outcome in the but-for world would be assessed, presuming it pursued that alternative as opposed to infringing.
FTC Recommendation: Reject the entire market value rule as a basis for awarding lost profit damages based on all infringing sales. Instead, require proof of the degree of consumer preference of the patented invention over alternatives.
The FTC argues that the entire market value rule is not needed to assess lost profits and actually contends that it “distracts fact finders from a careful reconstruction of a market lacking infringement.”7 Furthermore, the Report indicates that the “functional unit” prong of the entire market value rule is irrelevant to the reconstruction of the market in the but-for world.
Instead of using the entire market value rule, the FTC recommends considering the “degree of suitability” that may exist with respect to noninfringing alternatives. By doing so, the infringer’s sales could be apportioned according to the value of the invention – the more valuable the patented feature, the greater the apportionment to the patentee’s but-for sales.
FTC Recommendation: Reject the notion of awarding both lost profits and reasonable royalties in situations when competing alternatives would have prevented the patentee from making all the infringer’s sales in the but-for world.
The FTC argues that in the but-for world, where the patentee would have made a portion of the sales made by the infringer, it should receive lost profits on those sales. The remaining sales in the but-for world would have been made by competitors offering alternatives and, as such, the patentee would have earned nothing related to those sales. According to the FTC, compensating the patentee with a reasonable royalty on those sales would result in the patentee being overcompensated. In making this recommendation, it appears that the FTC was not concerned with overcompensating the infringer by allowing the infringer to retain the full benefit of the portion of infringing sales that, in the but-for world, would have been made by competitors offering alternatives.
Reasonable Royalties
FTC Recommendation: Recognize that the first 14 Georgia-Pacific factors are only a list of evidence categories to be considered and that utilizing the hypothetical negotiation and willing licensor/willing licensee framework is the most critical aspect in determining reasonable royalty damages.
FTC Recommendation: Award reasonable royalty damages consistent with the hypothetical negotiation and willing licensor/willing licensee model.
The FTC argues that while the Georgia-Pacific factors relate to issues that are often considered in actual licensing negotiations, the lack of guidance and framework as to how they should be applied leads to problems. Specifically, their misuse can permit a patentee “to introduce or emphasize information that leads the jury away from an economically grounded analysis based on the facts that would have informed the licensing decision.”8 Additionally, the Report underscores how the lack of guidance can result in “highly unreliable awards that courts may not be able to overturn, given deferential standards for reviewing jury verdicts.”9 Consequently, the FTC concludes that while the Georgia-Pacific factors often do raise relevant issues that must be considered, the hypothetical negotiation and willing licensor/willing licensee framework provides the best construct for determining a reasonable royalty.
FTC Recommendation: The incremental value of the patented invention over the next-best alternative would establish the maximum amount that a willing licensor would pay in a hypothetical negotiation. In cases where the incremental value can be determined, the court should consider that value a cap on reasonable royalty damages.
The Report stresses the importance of properly considering the effect of alternatives to the patented technology in constructing the but-for world and determining the result of the hypothetical negotiation. The FTC agreed with the court’s ruling in Grain Processing Corp. v. American Maize-Products Co.10 in which it held that the cost difference between using the patented technology and an alternative “effectively capped the reasonably royalty award.”11 The FTC appears to disagree with a contrary ruling in Mars, Inc., v. Coin Acceptors, Inc.,12 in which the court found that “an infringer may be liable for damages, including reasonable royalty damages, that exceed the amount that the infringer could have paid to avoid the infringement.”13
FTC Recommendation: Damage awards should not be based on the cost of switching from the infringing technology to a non-infringing alternative. To ensure this, the date of the hypothetical negotiation should be set at an early stage in the product development process when the infringer is making design decisions.
The FTC asserts that in some cases, a hypothetical negotiation contemplated at the time of first infringement can result in a reasonable royalty that reflects the cost of switching to a different design as opposed to the true economic value of the invention. Examples of such switching costs could include costs related to redesigns, retooling, and modifications to ensure the interoperability with related products. The FTC argues that if a hypothetical negotiation is contemplated after the infringer incurred sunk costs related to commercializing the infringing technology, the switching costs would be incremental to the sunk costs and potentially greater than the cost incurred had the alternative been implemented in the first place. As a result, such switching costs might drive a higher royalty than the true economic value of the invention. According to the FTC, this problem can be avoided by setting the hypothetical negotiation at the time the decision to use the infringing technology was made.
FTC Recommendation: The hypothetical negotiation framework should be used in situations in which the technology at issue is part of a standard and subject to a RAND commitment.14 Furthermore, reasonable royalty damages related to such technologies should be capped at the incremental value of the patented technology over alternatives available at the time the standard was set.
“In many IT industries, interoperability among products and their components is critical to developing and introducing innovative products that satisfy a range of consumer needs.”15 Therefore, companies often work with standard setting organizations (“SSOs”) to jointly develop and adopt industry-wide technical standards. Companies owning patented technologies which become part of a standard could potentially demand excessive royalties because once a standard has been implemented: 1) the costs of switching to another technology could be prohibitively high; and 2) products designed without using the standard may suffer from limited demand because of interoperability issues. SSOs commonly attempt to address the problem by requiring participants in the standard to disclose their patents and patent applications and to agree to license such patents on reasonable and nondiscriminatory (RAND) terms.
Considering that “reasonable” is not a clearly defined term, the FTC suggests that a definition of reasonable licensing fees under a RAND commitment would be helpful. Furthermore, capping reasonable royalty damages at the incremental value of the patented technology over alternatives at the time the standard was set would ensure that royalty would not exceed the incremental economic value provided by the patented technology.
FTC Recommendation: The entire market value rule should be eliminated. Likewise, the question as to whether the patented feature is the “basis for customer demand” should be eliminated in that it is irrelevant and risks adding confusion to the determination of a reasonable royalty.
FTC Recommendation: Courts should be charged with identifying the appropriate royalty base that the parties would have chosen in the hypothetical negotiation. Furthermore, it is advised that the royalty base be selected based on the smallest priceable component that incorporates the patented technology.
These recommendations would constitute a drastic change in direction for the courts. In the past few years, the courts have rendered several opinions either striking down damages awards or ruling expert opinions inadmissible because of improper use of the entire market value rule in the determination of a reasonable royalty. For example, in Lucent v. Gateway,16 Cornell v. Hewlett-Packard,17 IP Innovation v. Red Hat,18 and Uniloc v. Microsoft,19 courts ruled that plaintiffs failed to show how the patented technology was the basis for customer demand. In multiple instances, Chief Justice Rader wrote the opinions himself, signaling the Federal Circuit’s agreement with the entire market value rule and the requirement that the patented feature be the basis for customer demand.
The Report points out that in some cases in which a patented technology is a component of a larger product and not the basis for customer demand, the product may still be the best choice for a royalty base. For example, if the component embodying the patented technology is never sold separately, the product containing the component may be the only item that is priced or can be monitored.
FTC Recommendation: Expert testimony related to comparable license agreements should only be admitted into evidence upon reliably showing: 1) the similarities between the licensed patent and infringed patent; and 2) the similarities between the non-price terms of the comparable license and the hypothetical license. Sufficient support must be provided in order to infer that the royalty rate of the comparable license is a reliable indicator of the royalty that would result from the hypothetical negotiation.
The FTC, by this recommendation, is reiterating the opinions expressed by the Federal Circuit in a number of cases in recent years. Since 2009, the Federal Circuit has been increasingly rigorous in reviewing the comparability of license agreements used to support damages awards. In Lucent v. Gateway, ResQnet v. Lansa,20 Wordtech Systems v. Integrated Network Solutions,21 and Uniloc v. Microsoft, the court struck down damage awards based on comparable license agreements, indicating generally that insufficient information was provided for the jury to infer how the royalty rates from the comparable license(s) might indicate the royalty that would result from the hypothetical negotiation.
FTC Recommendation: Courts should only admit the testimony of a damages expert that it deems could reliably assist the trier of fact in determining the amount a willing licensor and willing licensee would have agreed to as compensation for use of the patented invention in the infringing product. Furthermore, just because evidence may relate to one of the Georgia-Pacific factors does not deem it relevant, reliable and admissible.
FTC Recommendation: Courts should require: 1) that a damages expert show the methodology applied is reasonable; 2) that the methodology is reliably applied to the facts of the case; and 3) that the testimony is supported by sufficient data.
With these two recommendations, the FTC is urging the courts to more vigorously exercise their roles as gatekeepers against unreliable or irrelevant expert opinion testimony on damages. The FTC is advocating that the courts be more diligent in analyzing and determining admissibility in a Daubert motion as opposed to a post-trial review after a jury decision has been rendered. In support of their recommendations, the FTC points to the recent Federal Circuit opinion in Uniloc v. Microsoft which “discusses at length the need for courts to consider whether a damages expert reliably applied a common methodology to the facts of the case in assessing the admissibility of expert testimony.”22
Conclusion
While some of the FTC’s recommendations reinforce current practices or represent slight modifications, others reflect significant changes from longstanding approaches to the determination of patent damages. As such, it remains to be seen if and how any of these recommendations will be adopted. Regardless, the Report and the FTC’s recommendations provide food for thought as the issue of patent reform continues to be discussed.
1 Federal Trade Commission, The Evolving IP Marketplace: Aligning Patent Notice and Remedies with Competition (March 2011), (the “Report”) available at http://www.ftc.gov/ os/2011/03/110307patentreport.pdf. Beginning in December 2008, the FTC held eight days of hearings to explore the interplay of patent notice, patent remedies, innovation, and competition. Furthermore, in May 2010 the FTC, in conjunction with the Patent and Trademark Office and Department of Justice, cosponsored a workshop focused on the intersection of patent policy and competition policy. Together, the workshop and hearings involved more than 140 participants including representatives from both small and large firms, start-ups, the independent inventor community, leading patent practitioners, economists, and law scholars. Additionally, more than 50 written submissions were also presented to the FTC. The Report and its recommendations were based on the testimony provided at the workshop and hearings along with the written submissions and independent research.
2 The Report, at 141.
3 Id. at 142.
4 Other problems with undercompensating patentees include: a) incentivizing inventors to utilize trade secrets, undermining the public disclosure benefit of the patent system; and b) impairing investment in innovation).
5 Other problems with overcompensating patentees include: a) increasing prices to consumers; b) depriving consumers of the benefits of competition among technologies; c) when infringers are also innovators, reducing the returns of R&D efforts, which can decrease innovation; d) incentivizing speculation through the purchase and assertion of patents in litigation; e) deterring social beneficial challenges to invalid or narrow patents; and f) disrupting the market’s ability to allocate R&D resources to areas most likely to generate products most valued by consumers.
6 T he Report, at 152 citing Del Mar Avionics, Inc. v. Quinton Instrument Co., 836 F.2d 1320, 1327 (Fed. Cir. 1987).
7 T he Report, at 155.
8 Id. at 182-3.
9 Id. at 183.
10 185 F.3d 1341, 1350-51 (Fed. Cir. 1999). This decision was the last in a series addressing the proper remedy in the case. See Grain Processing Corp. v. American Maize-Products Co., 893 F. Supp. 1386 (N.D. Inc. 1995) (finding infringement, denying lost profits, and awarding a reasonable royalty), aff’d in part, vacated in part, 108 F.3d 1392 (Fed. Cir. 1997) (nonprecedential) (reversing and remanding the denial of lost profits), further decision on remand, 979 F. Supp. 1233 (N.D. Ind. 1997) (again denying lost profits and awarding a reasonable royalty), aff’d, 185 F.3d 1341 (Fed. Cir. 1999) (affirming the denial of lost profits).
11 T he Report. at 188.
12 527 F.3d 1359 (Fed. Cir. 2008).
13 T he Report. at 189.
14 Commitments made by patent holders to license their patents on reasonable and nondiscriminatory terms. RAND commitments are commonly used when patent pools are utilized to implement standards created by a standard setting organization.
15 T he Report, at 191.
16 580 F.3d 1301 (Fed. Cir. 2009).
17 609 F. Supp. 2d. 279 (N.D.N.Y. 2009).
18 705 F. Supp. 2d 687, 691 (E.D. Tex. 2010).
19 Uniloc USA, Inc. v. Microsoft Corp., Nos. 2010-1035, 2010-1055, 2011 WL 9738 (Fed. Cir. Jan. 4, 2011).
20 594 F.3d 860 (Fed. Cir. 2010).
21 609 F.3d 1308, 1320 (Fed. Cir. 2010).
