PATENT DAMAGES: UPDATED RULES ON THE ROAD TO ECONOMIC RATIONALITY. Richard T. Rapp Phillip A. Beutel

Transcription

1 PATENT DAMAGES: UPDATED RULES ON THE ROAD TO ECONOMIC RATIONALITY Richard T. Rapp Phillip A. Beutel NATIONAL ECONOMIC RESEARCH ASSOCIATES 50 MAIN STREET WHITE PLAINS, NEW YORK TELEPHONE: FACSIMILE: INTERNET:

2 INTELLECTUAL PROPERTY Course Handbook Series Number G-572 Co-Chairs Tom Arnold James L. Ewing, IV Laurence H. Pretty To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI order number G0-0063, Dept. BAV5. Practising Law Institute 810 Seventh Avenue New York, New York 10019

3 PATENTS, COPYRIGHTS, TRADEMARKS, AND LITERARY PROPERTY Course Handbook Series Number G-531 Co-Chairs Tom Arnold James L. Ewing, IV Laurence H. Pretty To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI order number G0-002O, Dept. BAV5. Practising Law Institute 810 Seventh Avenue New York, New York 10019

4 PATENTS, COPYRIGHTS, TRADEMARKS, AND LITERARY PROPERTY Course Handbook Series Number G-493 Volume Two Co-Chairs Laurence H. Pretty James L. Ewing, IV Tom Arnold To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI order number G4-4022, Dept. BAV5. Practising Law Institute 810 Seventh Avenue New York, New York 10019

5 PATENTS, COPYRIGHTS, TRADEMARKS, AND LITERARY PROPERTY Course Handbook Series Number G-457 Volume Two Co-Chairs Tom Arnold Roy E. Hofer Laurence H. Pretty To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI order number G4-3982, Dept. BAV5. Practising Law Institute 810 Seventh Avenue New York, New York 10019

6 PATENT DAMAGES: UPDATED RULES ON THE ROAD TO ECONOMIC RATIONALITY by Richard T. Rapp * Phillip A. Beutel I. INTRODUCTION: GENERAL PRINCIPLES FOR PATENT DAMAGE CALCULATION A. Introduction Since the mid-1960s, the case law on estimating patent infringement damages has made a profound but incomplete move toward recognition that the use of economic principles is fundamental to achieving the statute s make-whole standard. 1 Few would argue that before the Court of Appeals for the Federal Circuit devoted its attention to this subject, a patent holder was unlikely to receive a damage award that would compensate it fully for the theft of its intellectual property. The circuits were divided and, generally speaking, there was a bias toward light-handed enforcement of patent rights. As a result, infringement was a sensible strategy, thus undermining the protection of intellectual property. All else being equal, the courts rarely found patents to be both valid and infringed. Moreover, even if validity and * President and Senior Consultant, respectively, National Economic Research Associates, Inc. (NERA). This paper was originally prepared in 1991 for a Practising Law Institute Handbook on Patent Litigation. We have updated it in August 1996 to reflect important developments in the law. 1 the Court shall award the claimant damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use made of the invention by the infringer. 35 U.S.C. Section 284.

7 - 2 - infringement were found, the likely award of reasonable royalty damages would, in practice, leave the infringer no worse off than if he had chosen to license in the first place. Although there has been great progress since these early days, unresolved problems in both the case law and its interpretation continue to impede the improvement of patent damage calculations. For example, there is no case that correctly handles market expansion and price erosion in lost-profits calculations. Royalty calculations suffer from a lack of any useful analytic framework that would give fact-finders a consistent basis for making awards. The most general problem in the case law and its interpretation is an inadequate understanding of whether or not patents confer power the difference between me too and path-breaking patents and how that should be reflected in damages award to a patent holder. Our paper is intended to enumerate and discuss a set of straightforward principles which, if followed, improve the chances that a damage award will faithfully carry out the statute s mandate to compensate for infringement. In the remainder of this section, we examine some general principles of damage estimation that, when observed, result in awards that are credible, defensible and consistent with microeconomic principles and, therefore, that achieve the make-whole standard. We trace, in Section II, the evolution of patent infringement case law as it has, in fits and starts, embraced an ever-increasing number of these principles. In Section III, we discuss the implications of these principles in patentee lost-profits calculations and provide an illustrative example of such a calculation in Section IV. In Section V, we discuss and provide an example of an economic calculation of reasonable royalties.

8 - 3 - B. Principles For Patent Damage Calculation Commercial damage estimation has rules, whether arising in the context of wrongful injury, antitrust, breach of contract or patent infringement. 2 When these rules are observed, the end result is an economically sound damage calculation that makes the plaintiff whole. When they are ignored, damage estimates will not, except by chance, accurately reflect conditions that would have held absent the illegal action. When estimating patent damages, the fundamental task is to construct a model of the but-for world that simulates, as closely as possible, the marketplace absent infringement. To accomplish this task, there are, at a minimum, four principles that require careful observance. The principles are: 1. A patent s economic and commercial value derives largely from the market power 3 it confers to the patent owner; therefore, in estimating damages from patent infringement, the market power conferred by the patent must be taken into account. 2. When the price of a good increases, consumption of the good declines, and vice versa (law of demand). 3. Only costs caused by extra sales should be charged against extra sales revenues; therefore, incremental costing is the proper approach. Both the technology and the size of the output increment determine which costs are relevant. 4. Royalties are determined in hypothetical negotiations in which both the market power flowing from the patent and the relative bargaining power of the negotiators influence the outcome. 2 We exclude from consideration here damage calculations not subject to a but-for or make-whole standard, such as those that permit capture of ill-gotten gains or punitive damages. From this point forward, the examples given are solely for the case of patent damages. 3 Market power and its meaning are discussed in Section III.A. Suffice it to say here that it refers to the economic (not technical) exclusiveness of a product or process. In the extreme, a valid patent may create a pure monopoly a single seller of a product for which there are no reasonable substitutes in use assuming sufficient demand for the product. On the other hand, a patent for a product which has many close substitutes may confer no market power at all. This latter product is a commodity that will never sell for more than the cost (including a fair return on capital) of making it.

9 - 4 - II. THE CASE LAW: AN EVOLUTION The case law on patent infringement has made only an incomplete transition toward full recognition of the importance of these guiding principles. We find it useful to describe this evolution in two stages. 4 Early patent damage calculation was essentially mechanistic and, for the most part, awarded reasonable royalty damages with little, if any, reference to market-based evidence. Within the first period, however, Georgia-Pacific v. United States Plywood Corp. (Georgia-Pacific) 5 represented a significant advance in that it recognized the importance of economic factors in royalty calculation. Even so, damage calculation in this first period was, from an economic perspective, in its infancy. The second period that we discuss begins with Panduit Corp. v. Stahlin Bros. Fibre Works, Inc. (Panduit). 6 Here, the U.S. Court of Appeals (sixth Circuit) recognized that patent damages may, under certain circumstances, appropriately be awarded as lost profits. Since Panduit, the accepted means of calculating damages has become increasingly consistent with economic principles. A. Pre-Panduit: Early Economic Reasoning In Aro Manufacturing Co. v. Convertible Top Replacement Co. (Aro II), 7 the Supreme Court followed the statute s directive to make the patentee whole by ruling that damages are compensation for a patentee s loss from infringement and should be measured as the difference between the patent owner s profits had the infringer not infringed and its actual profits. That is, this calculation was to be performed regardless of whether the infringer gained or lost as a result of its unlawful acts. The Court, however, did not specify the method to be used to estimate these damages and did not examine the market conditions that would have likely 4 We divide our discussion of the case law into pre- and post-panduit periods only for expositional purposes. We recognize that others may divide this evolution differently F. Supp. 1116, 1120, 166 USPQ 235, 238 S.D.N.Y. (1970); modified 446 F.2d 295, 170 USPQ 369 (2d Cir.: 1971) F.2d 1152, 1164, 197 USPQ 726, 736 (6 th Cir.: 1978) U.S. 476, 507, 141 USPQ 681, 694 (1964).

10 - 5 - prevailed absent infringement. Following the statutory language, the Court awarded reasonable royalty damages as the least that would compensate the patent holder. Georgia-Pacific represented the next important advance. Here, the U.S. District Court (Southern District of New York) provided a list of primarily market-based evidentiary factors to consider when calculating a reasonable royalty sufficient to compensate a patentee. These factors provide a fairly comprehensive catalog of the general empirical factors an analyst ought to consider when estimating a royalty. The Court recognized correctly that it was impossible to assign fixed weights to these various factors that would be applicable to each and every case. In effect, therefore, the Georgia-Pacific Court recognized that patents exist in markets that, in turn, may affect the magnitude of the damages suffered. The Georgia-Pacific factors fall into four basic categories. These are: 1. Directly and indirectly comparable royalty rates. 2. Factors affecting the profits to the potential licensee-infringer if it gains a license. 3. Factors affecting the patent holder s losses resulting from awarding a license. 4. Factors influencing the bargaining power each party brings to the hypothetical negotiation. First, an analyst should consider both directly and indirectly comparable royalty rates. Examples include other agreed-upon royalties for the patent at issue and royalties for patents on similar products or processes. It is unlikely that the conditions that gave rise to any comparable royalty rate perfectly parallel the hypothetical negotiation at issue; e.g., a perfect comparable must involve the same patentee and licensee, with the same relative risk, bargaining power, expected profitability and licensing terms. Comparable royalty rates, therefore, provide a useful benchmark or starting point for an analyst; however, they do not provide a complete assessment of the appropriate royalty for damage calculation. Second, an analyst should consider the factors affecting the profits to the potential licensee-infringer if it gains a license. These must all be considered for an analyst to determine

11 - 6 - accurately the maximum amount that the licensee will pay for the license e.g., the profits it expects to earn from its use of the patented invention. These factors include, among others, the value to the licensee of using the patent, the nature and scope of the license (e.g., exclusive and/or restricted) and the profitability of derivative or convoyed sales. Third, an analyst should consider the factors that affect the losses to the patentee resulting from awarding a license to determine the minimum payment the patentee will accept for the license. These include, for example, whether the potential licensee is a competitor, the duration and term of the license, the commercial success and profitability of the patented invention. Fourth, an analyst should consider the factors that influence the bargaining power each party brings to the hypothetical negotiation. The only guiding principle that the Georgia-Pacific Court gave to this list of empirical factors was a requirement that royalties be determined as the result of a hypothetical voluntary negotiation at the time of infringement between a willing patent owner and licensee. While unexceptionable as stated, this standard, in practice, was used as a basis for royalty damages that would fall below the patentee s smallest acceptable license fees, i.e., royalties were awarded that did not cover the patentee s losses from the licensing agreement. B. Panduit: A Turning Point With Panduit, the U.S. Court of Appeals (sixth Circuit) made two significant breaks from past reasoning: (1) it ruled that the hypothesis of voluntary negotiations between willing parties was intolerable; and (2) it furthered the Georgia-Pacific Court s reliance on marketbased analyses by providing a market-based test with which a patent holder could, for the first time, prove entitlement to lost-profit, as opposed to royalty, damages.

12 - 7 - First, the Court found that the patent owner must be awarded compensation for the unwilling licensure of the invention. 8 Unlike Georgia-Pacific, the willingness of the parties has no place in the Panduit Court s reasonable royalty calculation; rather, the only consideration is that the hypothetical negotiations take place ex ante. The Panduit approach to royalties, therefore, suggests that an analyst should consider patentee and licensee relative bargaining power and profit expectations at the time of infringement. In addition, the patentee must be made whole regardless of whether or not the infringer earned ex post profits. Under this approach, therefore, the infringer could potentially face a very large financial burden one that exceeds its realized profits. In this way, however, the Panduit revision is flawed, since it suggests that royalties may exceed the maximum amount the infringer may have been willing to pay at the time of the hypothetical negotiation. 9 Second, the Court provided a four-point test with which the patent owner could, for the first time, prove entitlement to damages based upon lost profits. 10 To receive lost-profit damages, the patent owner must demonstrate: (1) demand for the patented product; (2) an absence of acceptable noninfringing substitutes; (3) the marketing and manufacturing capability to exploit the demand; and (4) the amount of profit it would have made in the absence of infringement. With this test, damage calculation is an all-or-nothing issue: If all four points are proven, lost-profit damages may be awarded; if any one of the four points is not proven, damages are limited to a reasonable royalty the statutory floor. The all-or-nothing nature of the four-point Panduit test clearly promotes judicial efficiency, but does so at the expense of economic rationality. On the one hand, requiring a 8 The Court interpreted the Georgia-Pacific standard as enabling competitors to use infringement as a means by which to impose a compulsory license policy upon the patent owner. 9 We should note, however, that it is appropriate for a royalty expert to consider the sales and profitability that existed in the market after the royalty negotiation i.e., during the damage period. Unless there are sound reasons for supposing that the past or the present would mislead the negotiators about what the future holds, these data would offer reasonable estimates of what the negotiators might reasonably have anticipated at the time of the hypothetical negotiation. 10 Consistent with economic theory, the Court not only considered lost profits resulting from lost sales, but also considered lost profits resulting from price erosion, i.e., the patent owner s sales during the infringement period may have been made at prices below the level it would have chosen in the absence of infringement.

13 - 8 - demonstration that demand for the product existed (point one) and that the claimant had the capacity to produce and sell the product (point three), prevents workshop inventors from falsely claiming that in the absence of infringement they would, with certainty, have become giant monopoly manufacturers. On the other hand, tests for the absence of noninfringing substitutes (point two), while on its face unexceptionable, as applied by the courts wrongly focus attention on whether or not technical as opposed to economic substitutes exist for the patented product. The patent owner s entitlement to lost-profit damages should depend upon the market power the patent confers, which, in turn, depends in large part upon the availability of economic substitutes for the invention. That is, the presence of technical substitutes does not necessarily imply that the patent owner did not lose sales to infringers and, therefore, should not be entitled to a recovery of lost profits. Likewise, even in the absence of close technical substitutes, the patent owner may have a relatively weak patent with low market value and, therefore, may be compensated with a relatively low royalty. The four-point test misses the essence of patent value; that is, the value of a patent depends upon the market power it confers the ability of the patentee profitably to raise price, to decrease output and/or to exclude competitors. From an economic perspective, the Court s application of the Panduit test is flawed because its focus on an absence of noninfringing technical substitutes leads to an all-or-nothing approach to lost profits. A superior approach, following Aro II s definition of damages as the difference between a patent owner s but-for and actual profits, requires an estimate of the price the patent owner would have charged, and the concomitant impact on its sales, absent infringement. Indeed, it may be possible for damages to consist of both a reasonable royalty for infringers sales that the patentee would not (indeed, could not) have made, plus lost profits on sales that the patentee would have made absent infringement. 11 This approach requires that an analyst assess not only the availability of technical substitutes also known as substitutes in 11 See, for example, State Industries, Inc. v. Mor-Flo Industries, Inc., 883 F.2d 1573, 12 USPQ 2d 1026 CAFC (1989).

14 - 9 - design but also economic substitutes, i.e., substitutes in use. Regardless of the absence or presence of acceptable noninfringing technical substitutes, therefore, economic theory suggests that damages depend upon whether the patent is strong or weak, which, in turn, depends upon the availability and efficacy of economic substitutes. C. From Panduit to the Present Infringement damage decisions after Panduit follow the four-point test and may provide either a nudge toward application of economic principles or, occasionally, evidence of the economic inconsistencies inherent in the test. In Lam, Inc. v. Johns-Manville Corp. (Lam), the Court of Appeals for the Federal Circuit added to the Panduit test the but-for standard for determining entitlement to lost profits. 12 Here, the patent owner must prove causation of lost profits by infringement. The factual basis for causation is that, but-for infringement, the patent owner would have made (all of) the sales that the infringer made, charged higher prices, or incurred lower expenses. The Court s requiring proof of causation implies a need to examine the but-for market and the patent owner s behavior within it. In finding that the patent owner had adequately passed the Panduit test and had proven causation, the Lam Court awarded lost-profit damages arising from both lost sales and price erosion. Among other factors, however, the Court ignored: (1) the cost increases that the patentee may have incurred in making the infringer s sales; and (2) the possibility that the patentee may not have made all of the infringer s sales at the hypothetical but-for price. First, to the extent that patentee production costs rise in pursing additional sales, lost-profit damages should be reduced. Second, the Court s assumption that, absent infringement, the patent owner would capture all infringer s sales is inconsistent with the law of demand. Unless demand is completely unresponsive to changes in price, only by holding price at the infringer s level F.2d 1056, 219 USPQ 670, CAFC (1983). lost profit damages may be in (the) form of diverted sales, eroded prices, or increased expenses, but (the) patent holder must establish causation between his lost profits and infringement; patent owner s burden of proof is not absolute, but is burden of reasonable probability.

15 could the patent owner be expected to capture all of these sales. 13 Even despite these problems, however, Lam indicates the Court s willingness to accept multiple components of lost profits. The next important advance occurred in Bio-Rad Laboratories, Inc. v. Nicolet Instrument Corp. (Bio-Rad). 14 This decision followed both the Georgia-Pacific and Panduit rulings in finding (1) market-based evidence is fundamental to royalty calculations; and (2) the patent owner must be compensated for unwilling licensure. Hence, the Court established that industry royalty rates are not a ceiling for the royalty that may be assessed against an infringer, an important insight that should have received more attention that it has. The unquestioning use of industry-wide royalty rates as benchmarks for royalties in both damage cases and license negotiations is probably one of the leading sources of error in patent valuation. Established industry royalty rates can be useful as comparables only if all patents in the industry are of similar character and strength; however, that is rarely the case. Even so, the Bio-Rad Court further moved toward economically sound damages by using incremental cost accounting to estimate lost profits on sales made by the infringer (Nicolet). 15 Lam and Bio-Rad represent modest adjustments to the Panduit methodology that moved damage calculation further toward achieving the make-whole standard. Not all post-panduit decisions, however, 13 This error remains prevalent in patent damage litigation: In TWM Manufacturing Co., Inc. v. Dura Corp. and Kidde, Inc. (789 F.2d 895, 229 USPQ 525 CAFC: 1986), the Court allowed $100 for each sale made by the infringer, claiming that the patentee would have made all of those sales at a higher price. In Yarway Corp. v. EUR Control USA, Inc., et al. (Yarway; 775 F.2d 268 CAFC: 1985), the Court determined lost profits based upon 100% of lost sales to the infringer, adjusted only for customers that were not known or inaccessible to the patent holder. In Bio Rad Laboratories, Inc. v. Nicolet Instrument Corp. (739 F.2d 604 CAFC: 1984), the Court ruled that merely because there existed a lack of noninfringing substitutes, all of the infringer s sales were assumed lost by the patentee F.2d 604 CAFC (1984). Though established (industry) royalty rates are normally applicable they do not necessarily establish a ceiling for the royalty that may be assessed Further, in Del Mar Avionics v. Quinton Instrument Company (Del Mar Avionics) (CAFC: 1987), the Court ruled that the purpose of reasonable royalty damages is not to provide a simple accounting method but to set a floor below which the courts are not authorized to go. 15 In Paper Converting Machine Co. v. Magna-Graphics Corp. (745 F.2d 11, 22, 223 USPQ 591, 599 CAFC: 1984) (Paper Converting), the Court ruled that the incremental income approach to computing lost profits is well established, recognizing that it does not cost as much to produce unit N+1 if the first N (or fewer) units produced already have paid the fixed costs. Further, the incremental cost approach used in Bio-Rad (incremental costing) takes into account both variable and fixed cost increases associated with the patent holder s recovery of proceeds from infringer s sales.

16 follow this trend. Yarway, for example, illustrates how the misuse of Panduit point two (absence of noninfringing substitutes) may lead to damage awards entirely inconsistent with good economic sense. In ruling that the patent owner was entitled to lost-profit damages, the Court precluded the existence of the noninfringing substitutes test by defining a mini-market consisting only of the patent owner and the infringer even though there were acknowledged economic substitutes in the market. This further illustrates the inherent problems with the Court s use of the Panduit four-point test: the extent of profits lost derives from the loss of the market power inherent in the patent, not from the mere absence or presence of technical substitutes. With Yarway, the Panduit test was circumvented by manipulated or careless market definition. The Court avoided the Panduit all-or-nothing approach to lost-profit damages in State Industries, Inc. v. Mor-Flo Industries, Inc. (Mor-Flo). 16 Rather than debate the existence of technical substitutes for the patented product, the Court accepted a market-based standard State Industries (the patent owner) market share as evidence of its claim to lost profits. Here, Panduit s noninfringing substitutes hurdle was neutralized by crediting all rivals with their market shares. State Industries share of sales was 40 percent of the market; as such, it claimed lost profits on only 40 percent of Mor-Flo s infringing sales and took a royalty on the remaining 60 percent. Therefore, reaffirming their policy that intellectual property theft requires compensation regardless of whether the plaintiff would have made the sale or not, the Court granted both lost profits and royalty damages covering, in total, all of the infringer s sales. Mor-Flo demonstrated the Court s increased willingness to employ market-based evidence in describing the but-for environment. Despite its advances, Mor-Flo, as well as the cases that precede it, inadequately recognizes that the value of a patent is not absolute, regardless of whether or not lost profits or royalty payments are at issue. While, in some settings, it may make sense to award a patent F.2d 1573, 12 USPQ 2D 1026 CAFC (1989).

17 owner only a share of the infringing sales in proportion to its overall market share, it does not follow as in Mor-Flo that this market share accurately reflects the patentee s market power and ability to make these sales. Neither does it follow that the patent owner is necessarily entitled to damages on all sales made by the infringer. Rather, the damage suffered by the patent owner depends upon: (1) the responsiveness of demand to changes in price; and (2) the number and efficacy of economic substitutes. Mor-Flo may be applauded for its attempt to recognize these two factors, albeit using market shares an imperfect and arbitrary standard. The June 1995 En Banc decision in Rite-Hite v. Kelley Company (Rite-Hite) 17 is a twostep-forward-one-step-back decision marred by an internal inconsistency in the application of the make-whole standard. The Rite-Hite court affirmed that the patent holder is entitled to full compensation for commercial damages caused by infringement as long as the injury was reasonably foreseeable by an infringing competitor in the relevant market. Rite-Hite lost sales of its vehicle restraints devices used to secure trucks to loading docks to infringing competition. But the sales it lost in competition with the infringing device did not embody the patented invention, a releasable hook employed on another Rite-Hite vehicle restraint. The decision: 1) Awarded Rite-Hite lost profits on a product that was not covered by the patent at issue but that competed head to head with the product that had been found to infringe; 2) Rejected damages for a second product (so-called dock levelers), that was often sold together with the vehicle restraints, on grounds that the convoyed product was not functionally inseparable from the patented product; 3) Permitted a mixed award of lost profits on lost sales and a reasonable royalty on other infringing sales. As the second point indicates, six judges from the eight-judge majority concluded that unpatented components must function together with the patented component in some manner F.3d 1538, (Fed. Cir. 1995).

18 so as to produce a desired end product or result. All the components together must be analogous to components of a single assembly or the parts of a complex machine, or they must constitute a functional unit. Thus, the majority would not extend liability to include items that have essentially no functional relationship to the patented invention and that may have been sold with an infringing device only as a matter of convenience or business advantage. By this reasoning they rejected Rite-Hite s demand for damages on lost sales of dock levelers which, while often sold together with the vehicle restraints that represented lost sales in the main, were also sometimes sold separately. The court moved both toward and away from economic rationality with these two findings: First, simple causation should determine what damages may be recovered. That is, a patent holder may be entitled to lost profits if infringement caused it to lose sales, even if those lost sales were of an unpatented alternate product. Second, the patent holder may not be entitled to lost profits on ancillary items, even if infringement caused it to lose those sales. The problem is obvious: If the make-whole principal is to dominate, then a patent holder that lost reasonably foreseeable and predictable sales of ancillary goods should be compensated for those losses as long as causality is proven, quite apart from issues of functional relationship. The functional (i.e., technical) relationship between products is ambiguous and unmeasurable. There is no recognizable boundary line between products that are closely related functionally and those that are not. Is toner more functionally related to photocopiers than paper? If so, then functionally related may mean something like incompatible with other brands. As a matter of economics, it is not clear why this should matter and, more important, why the law of damages should create an incentive to reduce compatibility. If the motivation of the functional relationship standard is to prevent the loading up of damage claims with incidental products (the likes of which might be sold only because customers, attracted into a shop by one product purchase a second some of the time), then it is a failure. From our perspective, a sounder standard would be complementarity, defined in economic rather than technical terms. Complementary goods are goods which are sold together for

19 market-determined reasons. The distinguishing characteristic of highly complementary goods is that when the price of one goes up the quantity sold of the other declines. When goods are such strong complements that they are always sold and priced together, then two products become as one e.g., left shoes and right shoes. For the most part, however, complementary goods are priced and sold separately, but sales of one such product can be predicted from the sales of its complement (like service or supplies for durable equipment). Complementarity is determined partly by technological factors such as technical compatibility. For example, televisions and VCRs are probably weak complements in that the price of one going up will only mildly affect sales of the other, since there are so many brands of televisions that can interface with so many brands of VCRs. By contrast, where compatibility among rival brands is lower, the interdependence of demand may be greater. The quantity sold of Nikon 35 mm single lens reflex camera bodies is likely to depend importantly on the price of Nikon s lenses because of the non-interchangeability of lenses among brands. In the end, as a matter of economics, the patent owner should be eligible to receive lost profits on lost sales of complementary convoyed items so long as those lost sales were caused by the infringement; this principle should hold even if the convoyed items are sold with the patent owner s product only as matter of convenience of business advantage. Regrettably, Rite-Hite represented a missed opportunity to set the record straight on convoyed goods. King Instrument Corporation v. Luciano Perego, et al. (King) 18 reinforces Rite-Hite s affirmation of the but-for standard. King was awarded damages for Tapematic s infringement of a patent for competing machines that splice and wind magnetic tape into video cassettes. Tapematic s appeal to the Federal Circuit against the award of lost profits by the District Court was based upon its argument that lost profits can be awarded only to one who makes or sells the patented device, as King itself did not. 19 The Federal Circuit affirmed that Section 284 imposes no limitation of the types of harm resulting from infringement that the statute will F.3d 941, 947, 952 (Fed. Cir.: 1995). 19 In Rite-Hite the patent holder did make and sell a product embodying the patented invention, although that was not the product upon which lost sales were claimed.

20 redress. Thus, the patentee is permitted to earn its reward for investing in innovation by means other than practicing the patent. As long as the patentee receives a proper economic return on its investment in the acquisition of a patent, the Act does not require that return to come from the sale of patented products. Excluding competitors in addition to manufacturing or licensing the patented technology is an approved method of exploiting a patent. Consequently, King apparently reaffirmed Rite-Hite s finding that patent holders may be eligible for lost profits on lost sales of unpatented competing items. Finally, two recent cases which most hearteningly point in the direction of economic rationality and the avoidance of formalistic approaches are BIC v. Windsurfing (BIC) 20 and Mahurkar. 21 The virtue of both cases is their recognition that understanding the nature of demand is crucial to getting damages right. In BIC, the District Court relied on Mor-Flo and divided lost profits on the assumption that the patentee, Windsurfing, would have captured a share of BIC s sales in direct proportion to Windsurfing s share of a so-called sailboard market. Judge Rader s Appellate decision reveals the error in the District Court s formulaic use of Mor-Flo: The Appellate decision wisely describes evidence of a lack of substitution between the higher price Windsurfing sailboards and the less expensive infringing BIC products. The implication is that absent infringement, BIC s customers would not have turned to the patent owner; instead, they would have purchased inexpensive boards sold by other competitors. In effect, the court found that Windsurfing and BIC did not compete in the same market and, therefore, Windsurfing could not have captured a pro rata share of the infringing sales. Relying on indicators of economic substitution represents a mighty improvement over Yarway and its vaguely defined minimarkets. Judge Easterbrook s decision in Mahurkar affirms that calculating patent infringement damages is, in the end, an exercise in economics, requiring careful economic analysis and 20 1 F.3d 1214, 1219 (Fed. Cir.: 1993). 21 In re. Mahurkar Double Lumen Hemodialysis Catheter Patent Litigation, 831 F. Supp (N.D. Ill.: 1993).

21 presentation of evidence. Confronted with a failure of both parties to carry out any meaningful economic analysis of their own, Judge Easterbrook found a few fragments of evidence on which to build an estimate of price erosion damages. In the course of so doing, he explains to the reader the difference between real and nominal price increases, the elasticity of demand and how to tease information about elasticities out of price-cost margins. Underlying the mechanics, Judge Easterbrook affirmed two basic economic principles: First, fewer sales are made at higher prices. Consequently, if there is a price erosion claim, the patent holder is not entitled to lost profits on every sale made by the infringer(s). Rather, economic evidence about the elasticity of demand is vital to explain how quantities will be affected by the higher price that the patent holder would have charged absent infringement. Second, to be made whole, patent holders should be compensated not only for their lost profits but, as well, for the lost earning power of that income. Accordingly, prejudgment interest should consider the risk and uncertainty associated with a patent holder s foregone investment alternatives. The evolution from Panduit to King has been substantial but imperfect. The typical damage calculation still fails to adequately account for demand and supply conditions in the market and, therefore, the market power conferred by the patent. In the next section, we propose remedies that would improve the accuracy of damage calculation. III. THE PRINCIPLES AND CONSISTENT DAMAGE ESTIMATION In this section, we discuss in more detail the four principles enunciated in Section I; in particular, we examine the implications each rule has for a complete and defensible damage theory that follows microeconomic principles. A. Market Power Our first principle of damage calculation is that a patent s value derives largely from the market power it confers to the patentee which, therefore, must explicitly be taken into account

22 in both lost profits and royalty damage calculations. Market power refers to the ability of a firm profitably to raise price above cost (without a large decrease in quantity sold) and/or to exclude competitors. A firm typically expects two distinct advantages from the award of a patent: (1) it can keep its competitors out of the market; and (2) it can have all sales to itself. The first advantage clearly supports the notion of market power as an ability to exclude rivals. The second advantage, the patentee s notion of having all sales to itself, is not equivalent to a claim that it would make, within the confines of the damage period, all of the sales made by the infringer. Rather, the patentee has the right, over the life of the patent, to make as many sales as will maximize its profits. A profit-maximizing patentee will most likely choose, in the short run, a price that exceeds and quantity below those prevailing during infringement. In this situation, because of the law of demand, the patentee surely will not make all of the infringer s sales. 22 In time, the patentee may choose to reduce price and thereby expand the market. 23 This is consistent with long-run profit maximization and with the patentee s right to exclusivity, i.e., to have all sales to itself. Here, the patentee has all sales to itself, yet the timing of those sales depends upon its profit-maximizing strategy. The single most important determinant of market power is the absence of economic substitutes for the patented product or process. For example, a pharmaceutical firm may patent a new chemical entity (NCE) that is distinct from every other molecule in the universe. If, however, that molecule yields a drug that treats a condition for which there are many other similar treatments, the patent is likely to confer little, if any, market power. If, on the other hand, the drug treats a condition that heretofore had no cure, then there are no close economic substitutes and the patent is likely to confer substantial market power. 22 We discuss the inverse relation between price and sales in Section III.C and illustrate this relationship in Exhibit A. 23 This strategy is commonly known as cream-skimming, i.e., the seller charges a higher price earlier in the product s life cycle (those customers willing and able to pay that price purchase the product relatively sooner), and a lower price later in the life cycle.

23 If a patented product has many close economic substitutes, it is natural to ask whether, as a result, the patent has no value. This may not, in fact, be the case. To the extent that the patent allows its owner to produce in the market, albeit at a price that is only marginally above cost, then the patent has minimal value. The power the patent confers on the patentee is limited nonetheless, as reflected in the patent owner s relatively small profits. If, alternatively, the patent allows the patentee to just cover its opportunity costs, i.e., price equal to economic incremental cost, then that patent has no market value; that is, the patent has no commercial value vis-à-vis the next best alternative product or process. As this example illustrates, there is a difference between strong and weak patents. A patent, in and of itself, does not confer monopoly power on its owner; rather, the existence of economic substitutes may limit that power. The case law, to date, does not adequately address this issue. The technical novelty of the product versus others is not determinative of the profits lost by the patent owner. The Mor-Flo decision, by considering the patentee s market share as evidence of its claim to lost profits, represents a significant, but imperfect, step toward full recognition of this rule Market power does not necessarily flow to the patent holder in direct proportion to its market share. That is, market share may, indeed, reflect the exercise of market power; however, it may also reflect, for example, limit pricing to deter market share erosion caused by entry or buying into a market by charging very low prices. Therefore, aside from the patentee s market share, an analyst must, at least conceptually, consider economic substitution and its impact on the patent holder s ability to raise price above cost and/or to exclude rivals. A formal analysis would, for example, estimate the market demand for the product and the responsiveness of demand to changes in price and to change in prices of related products.

24 B. Price-Quantity Relationships Determining lost profit damages requires estimating the patent owner s lost revenues; that is, estimating the sales (quantity) lost and the price at which those sales would have been made, absent infringement. It is important to remember that all such sales are made in markets where the quantity sold depends on the price charged. Hence, price and quantity estimates must be consistent with prevailing demand conditions. While this principle is obvious, the majority of patent damage awards (including all of those discussed in Section II) use price and quantity estimates that do not make economic sense. Because this rule is so often ignored, it is worth repeating: The patent owner is entitled to lost profits only on lost sales. To the extent that the patent confers market power and the but-for price exceeds the market price under infringement, the sales the patent owner would have made absent infringement will not equal the sales made by the infringer. 25 Exhibit A illustrates this point. The price and quantity that prevailed during infringement is labeled point A. Assume the patent owner made no sales during infringement. Further assume that, absent infringement, he profitably would sustain the monopoly price by choosing to produce where his marginal revenue (MR) equals his marginal production cost (MC p ). The law of demand dictates that the but-for price and quantity will be at point M. Hence, the but-for price P M exceeds the infringement price P A. Here, the higher price results in a level of sales below that achieved during infringement. Absent infringement, the patent owner could not have lost sales that it would not have made. Put differently, simple economic theory suggests the patent owner is entitled to damages only on sales of Q M and not on sales Q A -Q M. If the law requires every infringing sale to be compensated, then this requirement contradicts the statutory prescription of damages adequate to compensate the patent holder. 25 We assume that demand is not completely unresponsive to price, i.e., is not perfectly inelastic. If it were, then the patent owner, absent infringement, could raise prices with impunity.

25 The principal source of market expansion infringer increased sales is lower prices that would not have prevailed in the absence of infringement. C. Incremental Cost Thus far, we have focused only on market demand and lost revenues. To estimate damages, we must subtract from lost revenues the (incremental) cost of making lost sales. This principle was accepted, for example, in Bio-Rad and Paper Converting. One way to determine which costs the patent owner will incur when making these extra sales is to review each item on the roster of a firm s costs to ascertain which of them would have been affected by regaining the volume of lost sales. The variable costs associated with each extra unit of output sold ingredients and packaging, for example will always qualify as incremental costs. Fixed costs caused by the extra sales are incremental too, and should be counted, however contradictory that may sound. These costs building a plant, for example are fixed with respect to individual units of output but not necessarily with large increments of output. They are incremental for damage calculation if they would have been necessary to make the infringer s sales. There are two important corollaries to the incremental cost standard. First, accounting conventions, because they do not accurately consider opportunity costs, are inadequate for deciding which costs are incremental and which are not. Cost causation depends upon the volume of extra (lost) sales and the capacity of the firm to produce and market that volume. It will differ from case to case. Second, when dealing with multiproduct firms with joint costs, full cost allocation is always arbitrary and, therefore, can be expected to be wrong. The only standard that directly identifies the costs that should be associated with an additional volume of (lost) sales is the principle of cost causality A test that captures cost causality well is the avoided cost test. Project firm-wide expenses with the additional volume being produced and then cut back output by the amount of the additional volume (lost sales). The costs that disappear are the ones that count for calculating lost profits.

26 D. Royalties and Profits Our fourth rule states that royalties are determined in negotiations in which both market power and bargaining power influence the outcome. While we discuss this negotiation in Section V, suffice it to say here that the availability of substitutes is, as with lost profits, crucial to royalty calculation. Royalty damages are inextricably linked to the patent owner s lost profits from licensing the invention. Assuming a negotiation between the patent owner and a potential licensee, each will consider the relative benefits of awarding/receiving a license. The patent owner will accept no less than the profits it expects to lose if, because of the license, it competes with the licensee. The potential licensee will pay no more than the profits it expects to gain from sales of the invention. While royalties depend, therefore, at least in part on the profits the patentee expects to earn from the invention, there is no rule requiring damages based upon royalties to equal lost profits. In addition, although the statute requires damages must not fall below the royalty floor, there is no rule that estimated lost profits must necessarily exceed royalty damages. Further, there is no rule that prohibits a patent owner from being entitled to both lost profits and reasonable royalty damages from the same infringer. 27 The point is that the differences between royalty and lost-profit damages must be explicit and explainable. IV. LOST PROFITS: AN EXAMPLE For illustration, consider the following hypothetical: PATRIGHT has acquired a patent, and INFRO has subsequently been found guilty during the liability phase of an infringement trial. As the case law illustrates, defendant INFRO may claim that it expanded the market such 27 This may occur, for example, if a fraction of the infringer s sales were made to customers that the patent owner would be unable to reach deriving from, for example, access to foreign markets, a proprietary complementary production process, or having achieved an industry standard in complementary products. This may also occur if the infringer s production costs are less than the patentee s; here, the patentee may maximize its profits from the invention by foregoing production and, instead, choosing to license the product or process.

27 that sales and price exceeded the levels that would have manifested absent infringement. PATRIGHT, on the other hand, is likely to claim that the patent conferred considerable market power and, therefore, that it would have both raised price and increased sales, absent infringement. In the discussion that follows, we illustrate that the general principles of damage calculation prevent the erroneous acceptance of either plaintiff s or defendant s positions. We do not, however, provide a how to manual for lost profit damage calculation. Rather, we illustrate that: (1) adherence to the four general principles facilitates damage calculations that fulfill the make-whole standard; and (2) strong and weak patents, when these principles are followed, command dramatically different damage awards. In Sections IV.A and IV.B, we discuss lost profits and price erosion. We assess, in Section IV.C, the impact on damage estimates of varying degrees of market power. A. Lost Profits The patent owner loses profits if, absent infringement, it would have captured at least some fraction of the infringer s sales. 28 If the patent confers market power sufficient to sustain a price increase for the product, then the profit-maximizing price, absent infringement, will exceed the infringer s price. Consistent with the law of demand, the patent owner can expect to capture a portion of the infringer s sales since higher prices (the but-for price) usually mean lower quantities (relative to the infringer s sales). The patent owner is entitled to lost profits only on the extra sales, above those made in competition with the infringers, that it would have made in the absence of infringement. The lost revenues from making these extra sales must be adjusted to account for the extra costs incurred by the patent owner associated with making those extra sales. Both lost revenues and incremental costs are depicted below.