Wednesday 5 January 2011

Adieu 25% rule? At least in US litigation

#alttext#Licensing and litigation experts are well acquainted with the 25% rule for calculating a reasonably royalty which a licensee might be prepared to pay to the patent proprietor when licensing a patent. The rule has had a long genesis and was apparently originally formulated by Robert Goldscheider's analysis of patent licensing rates made by a Swiss subsidiary of a US company to around 18 companies licensees throughout the world ("Use of the 25% rule in valuing IP", 37 les Nouvelles 123, 123 December 2002). A number of other empirical studies have appeared to confirm the general applicability of the rule - and many licensing executives use the rule when establishing their baseline for negotiations.

The underlying assumption is that a licensee should maintain a majority - say 75% - of the profits of a patented product because the licensee has undertaken substantial development, operational and commercialisation risks. The other 25% should go to the patent holder as a licence fee. The 25% rule can be used for calculating a reasonable, running royalty rate by first of all estimating the licensee's profits for the product incorporating the patent and then dividing the total profit by the total cost of sales. This gives a profit rate - of which 25% is the running royalty rate. This rate is then applied going forward for licensing deals - or backwards for calculating damages in litigation

#alttext#The Court of Appeals for the Federal Circuit (CAFC) - the Appeals court in US patent cases - looked into the validity of the rule in a case Uniloc v Microsoft Corp. and concluded that the rule was - for the purposes of the calculation of damages in litigation - fundamentally flawed. The CAFC noted that the court (and lower courts) had accepted the rule in the past because it had never been effectively challenged. The CAFC noted that there had been a number of criticisms of the rule over the years:
  • The rule failed to take into account the unique relationship between a patent and an accused (allegedly infringing) product

  • The rule failed to take into account the unique relationship between the parties in the litigation

  • The rule was essentially arbitrary

The CAFC pointed out that patent proprietor has to prove the level of damages and that any arguments regarding the level of damages must be tied to the facts of the case. Citing a whole raft of case law, the CAFC concluded that the 25% rule of thumb was an abstract and theoretical concept. The 25% rule failed to provide any basis for the hypothetical negotiation between the two parties regarding the level of the royalty or offer any evidence regarding usual royalty rates for a particular technology, industry or party. In other words - the CAFC was not prepared to accept a royalty rate which it considered purely arbitrary and wanted to see comparative figures produced.

The implications for litigation are tremendous. Calculation of damages will rely on the ability to produce comparable figures from other sources - such as stock exchange filings or the annual LES royalty surveys. Licensing executives may not need to be so worried. The concept of the reasonable royalty based on a negotiation between parties is generally one that is practiced in reality. The 25% rule is often used as a starting point for the negotiation and is just one data point. Other data points include similar licensing agreements made with other companies and also publicly available data from sources such as SEC filings. It is unlikely that a court would attempt to change royalty rates in an agreement made entered into freely by two parties, merely because the royalty rate calculation was based on the (unapproved) 25% rule. Only in the unlikely event that one of the parties was put under duress to accept the royalty rate based on the 25% rule would a court be likely to overrule the calculation.

Copy of Goldscheider's article is available here.

Description of Route 25 here

Technorati Tags:
, ,


Anonymous said...

The correct web link for the CAFC's decision is as follows:

Norman said...

This looks to me like a case of bad facts making (possibly) bad law. As Goldscheider explains, the 25% rule is a rule of thumb for apportionment of the benefits “flowing from use of the IP.” The factual basis for application of the rule in this case was an internal Microsoft reports that “a Product Key is worth anywhere between $10 and $10,000 depending on usage.” We don’t what this really means, and the reference to $10,000 should raised some eyebrows. Microsoft argued that it referred to the value of the entire software that Product Keys help protect, and not the value of the Keys themselves – and because damages were assessed by a jury, there is nothing in any of the decisions that helps us assess this argument. Note that the royalty calculated on this basis was almost 3% of the total dollar value of sales for the protected products – so presumably a much higher percentage of the profits. I find it extremely difficult to believe that the patented product activation key could have contributed even as much as 3%, particularly as there is nothing to suggest that Microsoft had no alternative available to it. So my feeling is that problem in this case is not so much the rule, as the valuation that was the basis for its application. But, again because of the jury determination, the Fed Cir had to come up with some error of law in order to reverse, rather than reversing on the facts.

Marco Alexandre Saias said...

Hi Rob,

These kind of rules are absurd in a free market society.

And also are absurd because they don't adapt to reality. Simple.

I hope its really adieu!