Federal Circuit Trashes Nash

Well, not the esteemed John Nash himself, but rather the use of the Nash Bargaining Solution for purposes of calculating of patent damages.  The decision at issue is the Federal Circuit's September 16 opinion in VirnetX v. Apple, and although Jason Rantanen and David Long beat me to the punch in blogging about the case on (respectively) Patently-O and Essential Patents, I would be remiss not to add my own observations as well.  What follows is mostly a review of the opinion; if there are any readers who are impatient to hear my conclusions as to its significance, they should scroll down to the bottom paragraph of this somewhat lengthy post.

The case involves four patents, all of which "claim technology for providing security over networks such as the Internet" (p.3). A jury found that none of the claims in suit were invalid, and that Apple's iOS devices (iPhones, iPads, and iPods) infringed.  Specifically, the jury found that Apple's VPN On Demand feature infringed the '135 and '151 Patents, and that Apple's FaceTime feature infringed the '504 and '211 Patents.  On appeal, the Federal Circuit affirmed the findings on validity and some of the findings of infringement with respect to VPN On Demand; reversed Chief Judge Davis's construction of the '504 and '211 Patents and remanded for further proceedings on those patents; and vacated the jury's damages award of $368,160,000.  The opinion is by Judge Prost, joined by Judge Chen; Chief Judge Rader participated in oral argument but retired from the court last June and therefore did not participate in the decision.

Focusing on the damages issues in particular, VirnetX's expert had proposed three different approaches.  The first applied a 1% royalty rate to a base consisting of the "lowest sale price of each model of the accused iOS devices containing the accused features" (p.24).  The 1% rate was based on VirnetX's "policy of seeking to license its patents for at least 1-2% of the entire value of products sold and several comparable licenses" (id.).  This approach would leave VirnetX with "$566 million for products including both FaceTime and VPN On Demand, and $142 million for those including only VPN On Demand" (id.)  Second, the expert proposed using the Nash Bargaining Solution to divide--on a 45%-55% basis, based on VirnetX's weaker bargaining position--the incremental profits Apple derived from the use of the patented technology.  The profits derived from the use of FaceTime were based on "the revenue generated by the addition of a 'front-facing' camera on Apple's mobile devices" (p.25).  This approach yielded $588 million for the infringement by Face Time.  Third, the expert proposed a Nash Bargaining Solution that assumed that FaceTime "'drove sales' for Apple iOS products," based on a survey asserting "that 18% of all iOS device sales would not have occurred without the addition of FaceTime" (id.).  This approach yielded $606 million in damages for FaceTime.

In vacating the award, the court first reaffirmed its holdings in LaserDynamics and Versata Software that basing damages on the entire market value of an end product that incorporates multiple patented features is permissible "only where the patented feature creates the basis for customer demand or substantially creates the value of the component parts” (p.27).  In this case, however, the judge gave the jury the following instruction (p.28):

In determining a royalty base, you should not use the value of the entire apparatus or product unless either: (1) the patented feature creates the basis for the customers’ demand for the product, or the patented feature substantially creates the value of the other component parts of the product; or (2) the product in question constitutes the smallest saleable unit containing the patented feature.     

The court held that the instruction was erroneous (pp. 28-30):

To be sure, we have previously permitted patentees to base royalties on the “smallest salable patent-practicing unit.” LaserDynamics, 694 F.3d at 67. However, the instruction mistakenly suggests that when the smallest salable unit is used as the royalty base, there is necessarily no further constraint on the selection of the base. That is wrong. For one thing, the fundamental concern about skewing the damages horizon—of using a base that misleadingly suggests an inappropriate range—does not disappear simply because the smallest salable unit is used.

. . . [T]he requirement that a patentee identify damages associated with the smallest salable patent-practicing unit is simply a step toward meeting the requirement of apportionment. Where the smallest salable unit is, in fact, a multi-component product containing several non-infringing features with no relation to the patented feature (as VirnetX claims it was here), the patentee must do more to estimate what portion of the value of that product is attributable to the patented technology. To hold otherwise would permit the entire market value exception to swallow the rule of apportionment. . . .

. . . Moreover, that error cannot be considered harmless, as VirnetX’s expert relied on the entire value of the iOS devices as the “smallest salable units,” without attempting to apportion the value attributable to the VPN On Demand and FaceTime features.

In addition, the court concluded that the expert did not justify (under the first approach above) using the entire value of the Apple devices as the smallest salable unit for the royalty base (pp. 30-33).

On the question of the appropriate royalty rate, however, the court rejected Apple's argument that the six licenses VirnetX's expert used for comparison purposes were not comparable, stating that on the record presented comparability was an issue for the trier of fact (pp. 33-34): 

. . . Apple points out that two of the licenses predated the patents-in-suit. Both of those agreements related to technology leading to the claimed invention, and one contained a software license in addition to a license for various patent applications. Apple further complains that three of the other licenses were entered into in 2012, a full three years after the date of the “hypothetical negotiation,” set in June 2009. Apple argues that at the time those licenses were entered into, VirnetX was in a much better financial position (and therefore a better bargaining position) than it was in 2009. Finally, Apple notes that the sixth license covered sixty-eight VirnetX patents, and was therefore much broader than the license to four patents Apple would be seeking in the hypothetical negotiation. It also equated to a 0.24% royalty rate, which is significantly lower than the 1–2% rate Weinstein [the expert] testified VirnetX would accept.

We have held that in attempting to establish a reasonable royalty, the “licenses relied on by the patentee in proving damages [must be] sufficiently comparable to the hypothetical license at issue in suit.” Lucent, 580 F.3d at 1325. “When relying on licenses to prove a reasonable royalty, alleging a loose or vague comparability between different technologies or licenses does not suffice.” LaserDynamics, 694 F.3d at 79. However, we have never required identity of circumstances; on the contrary, we have long acknowledged that “any reasonable royalty analysis ‘necessarily involves an element of approximation and uncertainty.’” Lucent, 580 F.3d at 1325 (quoting Unisplay, 69 F.3d at 517). Thus, we have cautioned that “district courts performing reasonable royalty calculations [must] exercise vigilance when considering past licenses to technologies other than the patent in suit,” ResQNet, 594 F.3d at 869, and “must account for differences in the technologies and economic circumstances of the contracting parties,” Finjan, Inc. v. Secure Computing Corp., 626 F.3d 1197, 1211 (Fed. Cir. 2010).

With those principles in mind, we conclude that the district court here did not abuse its discretion in permitting Weinstein to rely on the six challenged licenses. To begin with, four of those licenses did indeed relate to the actual patents-in-suit, while the others were drawn to related technology. Moreover, all of the other differences that Apple complains of were presented to the jury, allowing the jury to fully evaluate the relevance of the licenses. See J.A. 1600, 1650, 1678–82. No more is required in these circumstances.

The most interesting part of the opinion, though, is the court's skepticism over the expert's use (in relation to his second and third approaches, above) of the Nash Bargaining Solution.  Here's what the court says about it (pp. 36-41):

Apple argues that the invocation of a 50/50 starting point based on the Nash Bargaining Solution is akin to the “25 percent rule of thumb” that we rejected in Uniloc as being insufficiently grounded in the specific facts of the case. . . .  [W]e agree with Apple . . . .

In recent years, numerous district courts have confronted experts’ invocations of the Nash Bargaining Solution as a model for reasonable royalty damages, with varying results. . . . 

For the reasons that follow, we agree with the courts that have rejected invocations of the Nash theorem without sufficiently establishing that the premises of the theorem actually apply to the facts of the case at hand. The use here was just such an inappropriate “rule of thumb.” . . .

. . . The Nash theorem arrives at a result that follows from a certain set of premises. It itself asserts nothing about what situations in the real world fit those premises. Anyone seeking to invoke the theorem as applicable to a particular situation must establish that fit, because the 50/50 profit-split result is proven by the theorem only on those premises. Weinstein did not do so. This was an essential failing in invoking the Solution. Moreover, we do not believe that the reliability of this methodology is saved by Weinstein’s attempts to account for the unique facts of the case in deviating from the 50/50 starting point. . . .

More importantly, even if an expert could identify all of the factors that would cause negotiating parties to deviate from the 50/50 baseline in a particular case, the use of this methodology would nevertheless run the significant risk of inappropriately skewing the jury’s verdict. This same concern underlies our rule that a patentee may not balance out an unreasonably high royalty base simply by asserting a low enough royalty rate. See Uniloc, 632 F.3d at 1320. Although the result of that equation would be mathematically sound if properly applied by the jury, there is concern that the high royalty base would cause the jury to deviate upward from the proper outcome. . . 

We note that the Nash Bargaining Solution does offer at least one noticeable improvement over the 25% rule: where the 25% rule was applied to the entire profits associated with the allegedly infringing product, the Nash theory focuses only on the incremental profits earned by the infringer from the use of the asserted patents. But while we commend parties for using a theory that more appropriately (and narrowly) defines the universe of profits to be split, the suggestion that those profits be split on a 50/50 basis—even when adjusted to account for certain individual circumstances—is insufficiently tied to the facts of the case, and cannot be supported.

It's those last couple of paragraphs, I think, that are the kicker.  I'm having a hard time imagining how the use of the Nash Bargaining Solution could ever be admissible after this, unless the expert somehow was able to substantiate that the parties themselves would have used a 50/50 split of the incremental profit as the starting point of their negotiations over the patented technology.  (How would he or she substantiate that, other than by saying it sounds reasonable?  Is there likely to be any evidence that the parties have expressly used a 50/50 split of incremental profits as their starting point in the past?)  Now, maybe that's as it should be, at least in a jury trial; starting from a 50/50 perspective may well skew the results.  (I wonder if the same result necessarily would follow, though, in nonjury patent cases--which are, of course, the only type of patent cases in the rest of the world.)  Still and all, if you can't start from some premise about how the parties would divide up the incremental profits, it may be pretty hard to use the incremental profits approach at all.  My concern, then, is that the court's effort to prevent jury confusion could actually lead to less accurate damages calculations by channeling most of the analysis to the use of comparable royalties (where, according to this opinion, there remains some leeway to let the jury sort things out), rather than to consideration of the expected profit from the use of the patent in comparison to the next-best available noninfringing alternative.