FEDERAL CIRCUIT REJECTS USE OF 25% RULE OF THUMB

August 18, 2011

FEDERAL CIRCUIT REJECTS USE OF 25% RULE OF THUMB by Russell Levine (Partner, Kirkland & Ellis LLP) Note: The views expressed herein are Mr Levine’s personal views and should not be attributed to Kirkland & Ellis LLP nor any of its clients.

On January 4, 2011, the United States Court of Appeals for the Federal Circuit issued its decision in Uniloc USA Inc. and Uniloc Singapore Private Limited v. Microsoft Corporation, Appeal NO. 2010-1035, -1055 and rejected the use of the 25% Rule of Thumb. 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.” “Because the jury’s damages award was fundamentally tainted by the use of [this] legally inadequate methodology,” the court affirmed the grant of a new trial on damages.

The procedural background leading to the Uniloc decision was relatively straight-forward. After a full trial, the jury returned a verdict of infringement and no invalidity, and found Microsoft’s infringement to be willful. The jury awarded Uniloc $388 Million in damages. In post-trial motions, Microsoft, among other things, asked for a new trial on damages based on Uniloc’s alleged improper use of the 25% rule of thumb. The district court denied Microsoft’s request and that issue was appealed to the Federal Circuit. On appeal, the Federal Circuit articulated the issue as “the propriety of using the 25 percent rule.”

In analyzing the issue on appeal, the Federal Circuit defined the rule and reviewed its prior use, both in industry and in the courts. The Federal Circuit explained:

“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.”
“The Rule suggests that the licensee pay a royalty rate equivalent to 25 per cent of its expected profits for the product that incorporates the IP at issue.” citing Robert Goldscheider, John Jarosz and Carla Mulhern, Use of the 25 Per Cent Rule in Valuing IP, 37 les Nouvelles 123, 123 (Dec. 2002).
“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.’” citing John C. Jarosz, Carla S. Mulhern and Michael Wagner, The 25% Rule Lives On, IP Law360, Sept. 8, 2010.
“The 25 percent rule has, however, met its share of criticism that can be broadly separated into three categories.” These three categories are: (1) it “fails to account for the unique relationship between the patent and the accused product,” (2) it “fails to account for the unique relationship between the parties,” and (3) “the rule is essentially arbitrary and does not fit within the model of the hypothetical negotiation within which it is based.”
“The admissibility of the bare 25 percent rule has never been squarely presented to this court” although its use has been “passively tolerated” in situations where its acceptability has not been the focus of the case.”

The Federal Circuit also explained the reasons why it was rejecting the use of the 25 percent rule. The Court stated that “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” and that the “25 percent rule of thumb as an abstract and largely theoretical construct fails to satisfy this fundamental requirement.” The Court went on to criticize the rule because it “does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party.” The Court also rejected the defense of the rule as only being a starting point because “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 light of the Federal Circuit’s decision in Uniloc, amicable and adversarial license negotiations between parties are likely to emphasize even more so the relevant facts and circumstances of the particular case, and the analysis used by experts in litigation also is likely to focus even more so on the hypothetical negotiation that would have taken place in light of those facts and circumstances. Indeed, as the Federal Circuit stated: “To be admissible, expert testimony opining on a reasonable royalty rate must carefully tie proof of damages to the claimed invention’s footprint in the market place.” Georgia-Pacific factors 1 and 2, looking at royalties paid or received in licenses for the patent in suit or in comparable licenses, are likely to take on heightened importance in future actual and hypothetical license negotiations. Similarly, Georgia-Pacific factor 12, looking at the portion of profit that may be customarily allowed in the particular business for the use of the invention or similar inventions, will likely become a significant element in determining a reasonable royalty rate. The key going forward will be to emphasize the facts and circumstances of the particular case, the particular businesses granting and taking the license, the particular products or product lines that will be licensed, and the particular industry in which the parties operate and sell the licensed products.