25% Rule Dead, But Microsoft Must Face Jury Again on Patent Infringement Damages

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On Jan. 4, the U.S. Court of Appeals for the Federal Circuit overturned a district court's award of judgment as a matter of law that Microsoft Corp. was not liable for infringement of a patent on software copying protection (Uniloc USA v. Microsoft Corp., Fed. Cir., No. 2010-1035, 1/4/11).

However, the court also identified errors in the testimony on damages in the case. Thus, a $388 million jury award was vacated, but Microsoft will now have to face the jury again on the damages issue alone, with new instructions from the Federal Circuit that should reduce that award considerably.

Significantly, the appeals court ruled that the 25 percent “rule of thumb,” that many lower courts have used to determine what percentage of an infringer's profits should go to the patent holder, is “a fundamentally flawed tool.” Since that rule was the basis of the damages calculations heard in the instant case, the court said that the district court erred by not excluding the testimony.

The court further held that testimony as to the entire market value of the Microsoft products that used the alleged infringing component was improper as well. It reaffirmed that for the entire market value rule to apply, the patentee must prove that the patented feature is the basis for customer demand, and that testimony using that value as a “check” on the reasonableness of the 25 percent calculation skewed the jury's calculation.

$388 Million Award Vacated by District Court.

Uniloc USA owns a patent (5,490,216) directed to a method of reducing unlicensed use of software through using the same installation program on multiple machines. The invention requires that, upon software installation on a personal computer, the user enters registration information, the information and a hardware identifier are delivered via the internet to the software supplier, and a “remote licensee unique identifier” is created that ties that user to that copy of the software on that computer.

Microsoft Corp. developed a Product Activation feature that acts as a gatekeeper to Microsoft's Word XP, Word 2003, and Windows XP software programs. Uniloc sued Microsoft for patent infringement in the U.S. District Court for the District of Rhode Island, asserting Claim 19 of the '216 patent only.

Judge William E. Smith construed several contested terms and then granted summary judgment of noninfringement in 2007, but the Federal Circuit reversed in a nonprecedential decision.

On remand, a jury found Claim 19 not invalid and found Microsoft liable for willful infringement. The jury awarded $388 million in compensatory damages.

But Smith found “that the jury 'lacked a grasp of the issues before it' and reached a finding without a legally sufficient basis,” quoting Texas Instruments Inc. v. Cypress Semiconductor Corp., 90 F.3d 1558, 1570, 39 USPQ2d 1492 (Fed. Cir. 1996).

Smith granted Microsoft's motion for JMOL of noninfringement, vacating what was purportedly the fifth largest patent verdict in history. No. 03-cv-440 (D.R.I. Sept. 29, 2009) (78 PTCJ 702, 10/9/09). He left intact the validity judgment as to Claim 19, however.

Uniloc appealed the JMOL grant. Microsoft cross-appealed the denial of JMOL as to patent validity.

Court Distinguishes Standard of Review Choice.

Judge Richard Linn addressed the noninfringement judgment first. He disposed of a standard of review issue summarily.

Because infringement is a factual issue, the normal standard of review of the jury verdict would be substantial evidence, Linn noted. But Microsoft contended that the infringement issue collapsed to one of claim construction, a question of law requiring de novo review.

Linn distinguished the cases on which Microsoft relied, most notably General Mills Inc. v. Hunt-Wesson Inc., 103 F.3d 978, 41 USPQ2d 1440 (Fed. Cir. 1997). “[T]he infringement issue in General Mills collapsed into claim construction because 'the parties agreed with each other and the district court about how each of two competing claim constructions would apply to the undisputed structure of the accused invention,' ” he said. “In other words, the parties conceded that under one claim construction there was infringement and under the other there was none, and were arguing only over which claim construction was appropriate. … [T]his case presents the opposite procedural posture; the claim construction itself is not contested, but the application of that claim construction to the accused device is.”

He thus proceeded to assess the jury verdict of infringement under the substantial evidence standard.

Microsoft's System Performs 'Summation Algorithm.'

One claim construction point at issue was whether Microsoft's Product Activation system included a “summation algorithm” to create the unique identifier, as required by Claim 19.

Though the limitation at issue was written in means-plus-function format--more often than not construed by the appeals court as fatally constrained--the court found ample support in the patent description for Uniloc's broad interpretation. The court determined that the “the importance of the algorithm [in Claim 19] is only that it be 'adapted to generate a registration number which is unique to an intending licensee.' ”

Microsoft further argued that its algorithm had additionally functionality, and so should not be viewed as an equivalent structure for purposes of finding literal infringement under 35 U.S.C. §112, para. 6, on means-plus function claims. But the court considered the context of the invention to be relevant to the determination of equivalent structures in means-plus-function claiming, per IMS Technology Inc. v. Haas Automation Inc., 206 F.3d 1422, 54 USPQ2d 1129 (Fed. Cir. 2000) (59 PTCJ 712, 3/31/00).

“Here, the claimed function is the generation of a licensee unique ID, … and if … [Microsoft's algorithm] uses addition to perform this function, the enhanced functionality of [the algorithm] in making the output more secure should not prevent it from being considered an equivalent structure.”

Finally, the court took issue with the district court's criticism of Uniloc's expert's testimony as “incomplete, oversimplified and frankly inappropriate.” Linn noted that the lower court failed to exercise its Daubert “gatekeeper” role by limiting the expert's testimony, Microsoft failed to object when the expert made an analogy the lower court later found improper, and Microsoft's own expert failed to rebut Uniloc's expert's characterization of the algorithm at issue.

A reasonably jury could conclude that Microsoft used a summation algorithm, Linn said.

Pre-Registration Demo Use Not 'Full.'

The second contested issue that depended on an agreed upon claim construction revolved around a document well known to most software and internet users--the end-user license agreement, or EULA.

Claim 19 required a “mode switching means” that distinguishes between the product functionality prior to registration and “use mode”--“A mode that allows full use of the digital data or software in accordance with the license,” according to the lower court's construction. Microsoft argued that the '216 patent was limited to systems in which legal licensing and registration occur concurrently.

In contrast, the company said, before initiation of Product Activation system, the user agrees to Microsoft's EULA and is then allowed use of the product with certain temporal and functional restrictions. Microsoft described the state of use in the grace period prior to registration--that is, before patent infringement would occur--as “full use” per the terms of the EULA.

But the court determined that a user's rights under the EULA “do not encompass some abstract right to full functionality,” especially since the EULA contains a “mandatory activation” term for use of all the functionality of either Microsoft Office or Microsoft Windows. The court further refused to limit the '216 patent to concurrent activation and licensing based on a preferred embodiment described in the patent specification.

Uniloc Claim Avoids Joint Infringement Requirement.

Microsoft's next argument was that both its website algorithm-generating functionality and the end-user's computer were required for infringement. The company thus relied on the recent line of cases rejecting infringement in joint liability situations, most notably Muniauction Inc. v. Thomson Corp., 532 F.3d 1318, 87 USPQ2d 1350 (Fed. Cir. 2008) (76 PTCJ 410, 7/25/08), and BMC Resources Inc. v. Paymentech LP, 498 F.3d 1373, 84 USPQ2d 1545 (Fed. Cir. 2007) (74 PTCJ 644, 9/28/07).

But, Linn noted, Claim 19 is directed to performance on a “ 'remote registration station,' and defines the environment in which that registration station must function.” In the most recent case on joint liability, in fact, Linn wrote the opinion, in which the court gave advice on “proper claim drafting.” Akamai Technologies Inc. v. Limelight Networks Inc., No. 2009-1372 (Fed. Cir. Dec. 20, 2010) (81 PTCJ 255, 12/24/10).

In the instant case, he said, Uniloc appropriately attempted to capture infringement by a single party. “The claim here is thus distinguishable from those at issue in Muniauction and BMC, because here, only one party, Microsoft, makes or uses the remote registration system,” Linn said.

Having now disposed of Microsoft's arguments related to the jury's infringement finding, the court reversed the district court's JMOL grant. Since the lower court provided no additional analysis in its grant of a new trial on infringement, in the alternative, the Federal Circuit determined that alternative had no more merit than the JMOL, and reversed the new trial decision as well, as to infringement at least.

Willfulness Dismissed Readily.

The court turned next to the jury's willfulness finding and ruled that Uniloc failed to meet the objective threshold prong of showing that “the infringer acted despite an objectively high likelihood that its actions constituted infringement of a valid patent,” per In re Seagate Technology LLC, 497 F.3d 1360, 1371, 83 USPQ2d 1865 (Fed. Cir. 2007) (en banc) (74 PTCJ 491, 8/24/07).

Microsoft's position in the case was “susceptible to a reasonable conclusion of no infringement,” Linn said, affirming the district court's JMOL grant of no willfulness.

No Basis for 25 Percent 'Rule of Thumb.'

The court then devoted 21 pages to the damages question, beginning by recounting Uniloc's expert's arithmetic that led to the $388 million judgment.

In his testimony, the expert effectively made up a value for the Product Activation feature, applied the so-called “25 percent rule of thumb” that has been accepted in some courts, and used the “entire market value” rule--which would take a percentage of Microsoft's revenues from the full value of the products activated using this feature--as a “check” on the reasonableness of his ultimate $565 million calculation. It is not clear why the jury decided on $388 million, though the figure is very close to exactly two percent of the $19.28 million entire market value figure the expert presented.

“The 25 percent rule of thumb is a tool that has been 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,” Linn began. The hypothetical negotiation is assumed to take place between the patent holder and the alleged infringer prior to infringement and typically reflects the application of any combination of 15 factors described in Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116, 166 USPQ 235 (S.D.N.Y. 1970).

After describing the history of the use of the 25 percent rule, Linn identified three categories of criticism:

• “First, it fails to account for the unique relationship between the patent and the accused product.”

• “Second, it fails to account for the unique relationship between the parties.”

• “Finally, the rule is essentially arbitrary and does not fit within the model of the hypothetical negotiation within which it is based.”

As to the Federal Circuit's jurisprudence on the rule, Linn said that the issue had not been squarely presented to the court. “Nevertheless, this court has passively tolerated its use where its acceptability has not been the focus of the case,” he said, “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,” citing most recently to Finjan Inc. v. Secure Computing Corp., No. 2009-1576 (Fed. Cir. Nov. 4, 2010) (81 PTCJ 55, 11/12/10).

The court thus took the instant case as an opportunity to make itself clear:  

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 court cited four recent cases for the proposition that “a patentee could not rely on license agreements that were 'radically different from the hypothetical agreement under consideration' to determine a reasonable royalty,” quoting specifically from Lucent Technologies Inc. v. Gateway Inc., 580 F.3d 1301, 1327, 92 USPQ2d 1555 (Fed. Cir. 2009) (78 PTCJ 583, 9/18/09). The court explained:  

The meaning of these cases is clear: there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case. 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.com Inc. v. Lansa Inc, 594 F.3d 860, 869, 93 USPQ2d 1553 (Fed. Cir. 2010) (79 PTCJ 422, 2/12/10)] and Lucent Technologies. … 

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 to the facts of the case nevertheless results in a fundamentally flawed conclusion. 

 

 

 

In the instant case, as it was clear that Uniloc's expert relied on the 25 percent rule of thumb, the court held that his starting point was arbitrary, unreliable, and irrelevant. The court thus concluded that Microsoft was entitled to a new trial on damages.

Entire Market Value Rule Not a 'Check.'

Nonetheless, the court did not stop there. It further addressed the presentation in court of the $19 billion revenue figure for total sales of Microsoft XP, Word, and Office that took advantage of the Product Activation feature.

“The entire market value rule allows a patentee to assess damages based on the entire market value of the accused product only where the patented feature creates the 'basis for customer demand' or 'substantially create[s] the value of the component parts,' ” Linn said, quoting Lucent.

Though acknowledging that Uniloc never presented customer demand evidence, Microsoft complained that their expert presented the entire market value figure as a “check” on the reasonableness of the reasonable royalty calculation in a way that tainted the jury's damages deliberations.

“This case provides a good example of the danger of admitting consideration of the entire market value of the accused [products] where the patented component does not create the basis for customer demand,” Linn said in agreement. “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.”

The district court thus did not abuse its discretion in granting a new trial on damages based on Uniloc's violation of the entire market value rule, the court concluded.

Validity Judgments Upheld.

Finally, the court affirmed the denial of Microsoft's motion for JMOL as to patent invalidity.

Microsoft argued that its Product Activation feature was a proxy for a prior art patent, such that if Claim 19 is construed to be broad enough to cover the feature, it is broad enough to be anticipated by the prior reference.

The fact-specific issue ultimately involved whether a piece of the information used to create the registration identifier could uniquely identify the user as opposed to only the machine being used. Microsoft's procedure requires the user to input a product key which, though supplied by Microsoft, does create an association with the user, Linn said, relying in part on the court's first appellate decision in the case.

He thus affirmed the lower court's judgment as to anticipation. Since Microsoft offered no further argument as to obviousness, Linn affirmed that judgment as well.

The court therefore remanded the case for a new trial on damages.

Chief Judge Randall R. Rader and Judge Kimberly Ann Moore joined the opinion

Donald R. Dunner of Finnegan, Henderson, Farabow, Garrett and Dunner, Washington, D.C., represented Uniloc. Microsoft was represented by Frank E. Scherkenbach of Fish and Richardson, Boston.

By Tony Dutra

Dunner is a member of this journal's editorial advisory board.

In its damages analysis, the court relied in part on a “BNA Insights” article that appeared in this journal, by William C. Rooklidge and Martha K. Gooding, “When Hypothetical Turns to Fantasy: The Patent Reasonable Royalty Hypothetical Negotiation” (80 PTCJ 700, 9/24/10).