Federal Circuit Again Scrutinizes Reasonable Royalties in Patent Damages in VirnetX v. Cisco Systems and Apple

Economists Ink: A Brief Analysis of Policy and Litigation

Thomas R. Varner

EI Vice President Thomas R. Varner has experience in complex litigation involving intellectual property and other issues. He has also conducted extensive research in technology licensing across a wide range of industries.

The Federal Circuit’s recent decision in VirnetX, Inc., et al., v. Cisco Systems, Inc. and Apple Inc. (Fed. Cir. Sept. 16, 2014) is one in a series of court decisions addressing reasonable royalties in patent infringement cases. The VirnetX decision addresses the suitability of certain apportionment methodologies and the use of an economic game-theory model, the Nash Bargaining Solution (NBS), to determine a reasonable royalty rate.

In VirnetX, the plaintiff claimed that Apple’s products using its FaceTime and VPN On Demand features infringed four of VirnetX’s patents. VirnetX’s damages expert presented three opinions, one based on VirnetX’s policy of licensing its patents at 1% to 2% of the entire sales price of licensed products, and two using a starting point of a 50/50 profit split derived from the NBS.

VirnetX’s damages expert relied on the entire value of the infringing products as the royalty base in calculating damages. The Federal Circuit stated that even if this value was the “smallest salable patent-practicing unit” the expert still had to determine the value of the patented features as distinct from the unpatented features: “[A] patentee’s obligation to apportion damages only to the patented features does not end with the identification of the smallest salable unit if that unit still contains sufficient unpatented features.”

The Federal Circuit went on to address the use of the NBS. The NBS was developed by John Nash in the 1950s to provide, in Professor Nash’s words, a “theoretical discussion” for evaluating the outcome of a two-person negotiation. The NBS assumes that the parties’ preferences can be defined and follow certain rules, each party has perfect knowledge of the other’s alternatives and preferences, and the parties are equal in “bargaining skill.” Prof. Nash showed that the solution to this idealized bargaining game is one in which the parties equally split the incremental benefit from the bargain.

The Federal Circuit stated that VirnetX’s expert failed to establish “that the premises of the [NBS] theorem actually apply to the facts of the case at hand.” Consequently, use of the NBS was as “inappropriate” as the 25% Rule of Thumb that the Federal Circuit rejected in Uniloc USA, Inc. v. Microsoft Corp.

The VirnetX decision reinforces the importance of carefully analyzing the contribution of patented features to infringing products. Moreover, the VirnetX decision shows that experts who attempt to use the NBS to determine damages will face careful scrutiny from the courts about whether the assumptions underlying the NBS match that of a hypothetical negotiation for the patented technology.