Fed. Circuit Rejects “25 Percent Rule of Thumb” in Calculating Patent Case Damages in Patent Cases 

On January 4, 2011, the U.S. Court of Appeals for the Federal Circuit found that the so-called “25 percent rule of thumb” analysis long used by damages experts in patent cases to calculate a “reasonable royalty” is “fundamentally flawed.” Uniloc v. Microsoft (Fed. Cir. 2011). The Federal Circuit held that because the 25 percent rule merely applies a general theory that is untethered to the facts of a case, “[e]vidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence.” Slip op. at 41.

Striking down the 25 percent rule has important implications for patent damages in both existing and future patent litigation. As a result, the Uniloc decision is critical for every company that faces any current or potential risk of patent litigation.

Background

The 25 percent rule of thumb has long been a “starting point” of a reasonable royalty analysis. The rule – which the Federal Circuit observed has “met its share of criticism” – is based on the idea that, in a hypothetical negotiation, a licensee generally agrees to pay the patentee a royalty rate equivalent to 25 percent of the licensees’ expected profits on products that incorporate the intellectual property at issue in the case.

In this case, the plaintiff, Uniloc, sued Microsoft, alleging that a certain feature of Microsoft’s Word XP, Word 2003 and Windows XP infringed Uniloc’s patent. The jury agreed and awarded Uniloc $388 million in damages (which was less than the approximately $564 million that Uniloc’s expert opined it was due, based upon the 25 percent rule). These damages represented a “reasonable royalty” that Uniloc and Microsoft would have hypothetically agreed upon at the time the infringement began. Following the jury verdict, the district court granted Microsoft’s motion for a judgment as a matter of law of noninfringement, thereby effectively nullifying the jury’s damage award.

The Appeal

On appeal, the Federal Circuit first observed that the “admissibility of the 25 percent rule has never been squarely presented to this court” but acknowledged that it has “passively tolerated” the rule’s use over the years. After first reviewing the standards for the admissibility of expert opinions, the Federal Circuit concluded that U.S. Supreme Court precedent requires experts to “justify the application of a general theory to the facts of the case.” Slip op. at 43. If an expert cannot do so, then the proffered theory is inadmissible. Id. Given that the 25 percent rule, according to the Federal Circuit, is based on generalized empirical evidence about licenses, the Court concluded that the rule is nothing more than “an abstract and theoretical construct that … does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry or party.” Slip op. at 45. Furthermore, it “is of no moment” that the 25 percent rule is merely a “starting point” for a reasonable royalty analysis; damages experts used the rule as a baseline and then applied other case-specific factors to adjust the rate up or down. According to the Court, “[b]eginning from a fundamentally flawed premise and adjusting it based on legitimate considerations specific to the case nevertheless results in a fundamentally flawed conclusion.” Slip op. at 46. Because Uniloc’s expert’s damages opinion (which was based on the 25 percent rule) was unrelated to the facts of the case, it was “arbitrary, unreliable, and irrelevant.” Slip op. at 47.

Thus, the Federal Circuit held that Microsoft is entitled to a new trial on damages. Because the Federal Circuit also reversed the district court’s post-trial finding of noninfringement, ordering a new trial on damages means that Uniloc may yet obtain a damage award in the case.

Implications of the Decision

The implications of the Uniloc decision on damages analysis for patent cases are tremendous. Because most patentees seek “reasonable royalties” (rather than lost profits, the other general mode of analysis), damages opinions, up until now, often began with the 25 percent rule of thumb and then “adjusted” the royalty rate up or down in light of the facts of the case.

Now that the 25 percent rule has been repudiated, the future promises to bring new and creative modes of analysis to arrive at a “reasonable royalty” in patent cases, which will likely result in new disputes about the admissibility of damages opinions.