A Critique of the Federal Circuit's Recent Decision in Aqua Shield v. Inter Pool Cover Team

Today's guest post by Professor Norman Siebrasse of the University of New Brunswick Faculty of Law critiques the Federal Circuit's recent decision in Aqua Shield v. Inter Pool Cover Team, which I blogged about here. 

Professor Cotter and I have a recent paper posted on SSRN arguing that in assessing a reasonable royalty, the hypothetical negotiation should be assumed to take place ex ante, but with the full benefit of all ex post information. We call this the “contingent ex ante” approach to distinguish it from the “pure ex ante” approach, in which only ex ante information (with some exceptions) can be considered in the hypothetical negotiation. It was therefore disappointing to see the Federal Circuit embrace the pure ex ante approach in its recent decision in Aqua Shield v. Inter Pool Cover Team (available here, summary post here). Aqua Shield’s emphasis on the pure ex ante approach is puzzling as well as disappointing. On the facts, the only admissible evidence relevant to the royalty was ex post information, in particular, the infringer’s actual profits. Even under the pure ex ante approach, as was specifically affirmed in Aqua Shield, ex post information may be considered as evidence of what the parties would have believed ex ante. So, in this case, actual profits may be considered as evidence of expected profits. The two approaches only differ when there is conflicting evidence as to both expected and actual profits (or other relevant information). It is therefore unclear why the Federal Circuit emphasized the need to use the pure ex ante approach, given that it explicitly endorsed the use of ex post information. Moreover, even on the pure ex ante approach and even in light of the Federal Court’s decision, it is difficult to understand how the District Court erred.

Aqua Shield’s ‘160 patent relates to enclosures designed to cover pools or create sun rooms. The district court granted summary judgment against Inter Pool Cover Team (IPC) on infringement and validity. These judgments were not appealed (except regarding one of IPC’s models). The district court then conducted a two-day bench trial on remedies. In the original damages opinion, which I was unable to dig up, the district court held that Aqua Shield had failed to prove lost-profit damages. That was not appealed. The district court also refused a reasonable royalty, on the basis that there was not sufficient evidence to establish the reasonable royalty rate; while there was some evidence relevant to the Geogia-Pacific factors that indicated that the royalty should be adjusted upwards, there wasn’t sufficient evidence to determine the initial royalty rate that would then be adjusted. On a motion before the district court to alter the judgment, 2013 WL 6410975, the patentee argued that in determining a reasonable royalty the court should have considered (1) licensing negotiations that the parties conducted in 2009; (2) the inventor’s evidence; and (3) the infringer’s actual profits on infringing sales. The district court rejected the first two, on the basis that settlement negotiations conducted during litigation cannot be used to determine a reasonable royalty and the negotiations were not in any event confined to licensing of the invention at issue, and because the inventor’s evidence was not credible. These holdings were not challenged on appeal (Fed Cir slip op 10). The district court acknowledged that the infringer’s profit was admissible evidence which it wrongly failed to consider. Thus the only evidence on the reasonable royalty was the infringer’s actual profits. The district court went on to award reasonable royalty damages of 8% of the infringer’s net profits on infringing sales.

On appeal, the Federal Circuit emphasized what we have called the pure ex ante approach – “anticipated incremental profits under the hypothesized conditions are conceptually central to constraining the royalty negotiation” (slip op 10, emphasis added) – but it also acknowledged that “[e]vidence of the infringer’s actual profits generally is admissible as probative of his anticipated profits” (ibid). Thus the district court did not err in considering the evidence of actual profits.

The error, according to the Federal Circuit, lay in how that profit evidence was used:

[The district court] did err in treating the profits IPC actually earned during the period of infringement as a royalty cap. That treatment incorrectly replaces the hypothetical inquiry into what the parties would have anticipated, looking forward when negotiating, with a backward-looking inquiry into what turned out to have happened.

Under either the pure or contingent ex ante approach it is permissible to use the infringer’s anticipated incremental profits as a cap on the royalty, because the infringer’s maximum willingness to pay is set by the difference between the maximum profit available from the use of the invention and that available using the best non-infringing alternative: see eg Grain Processing 185 F.3d 1341, 1350-51 (Fed. Cir. 1999). It appears from the available opinions, namely those of the Federal Circuit and the district court’s opinion on reconsideration, there was no direct evidence at all of the anticipated profits; thus the actual profits were the only admissible evidence of the anticipated profits. It is true that the district court used the actual profits as a cap, but it did so expressly on the basis of the pure ex ante approach (slip op 4, 5):

Although a hypothetical license requires the royalty to be determined in light of anticipated profits when the infringement began, courts have held that evidence of subsequent actual profits is relevant to forming a judgment as to anticipated profits.

Considering [the benefits of the invention], while still allowing Defendants a profit on infringing sales, requires the Court to use its best ability to estimate what Defendants would have likely paid for the patented design.

The district court was evidently using the actual profits as evidence of the anticipated profits, and then using the anticipated profits as a cap on the royalty. This is entirely consistent with the pure ex ante approach.

Now, the infringer’s profits should not be used as a cap on the royalty when the infringer is a particularly inefficient producer. As the Federal Circuit explained:

An especially inefficient infringer—e.g., one operating with needlessly high costs, wasteful practices, or poor management—is not entitled to an especially low royalty rate simply because that is all it can afford to pay without forfeiting or unduly limiting its profit if it uses the patented technology rather than alternatives.

As noted, it is the infringer’s anticipated incremental profits – that is, the difference between its profits using the invention and using the best alternative – which sets the cap on the royalty. If the invention is better than the alternatives, the infringer’s incremental profits will be positive regardless of how inefficient the infringer might be, and a reasonable split of those incremental profits might well result in negative accounting profits. But on the facts, the Federal Circuit’s reference to an inefficient infringer is puzzling. There was no indication that the defendant in this case was particularly inefficient, and the district court explicitly considered the incremental value of the invention: “In a hypothetical negotiation, the Court finds Defendants would not have paid more [than 8% of net profits] for the license because they would have likely gone without the benefits of the '160 Patent and designed around it, as they have done now.” Again, it is difficult to see what is wrong with this analysis.

The Federal Circuit also held that “The district court’s analysis also incorrectly replaces the inquiry into the parties’ anticipation of what profits would be earned if a royalty (of amounts being negotiated) were to be paid with an inquiry into what profits were earned when IPC was charging prices without accounting for any royalty” (original emphasis), explaining that “[t]he infringer’s selling price can be raised if necessary to accommodate a higher royalty rate.” Certainly, if an infringer is cutting prices to the bone, in part by avoiding paying a royalty, then positive accounting profits might well turn negative once a reasonable royalty is factored in. It would be wrong to use the infringer’s accounting profits (as opposed to its incremental profits) as a cap in such circumstances. The Federal Circuit stated that “On the record before us, we conclude that the district court committed [this error]” (slip op 11). Again, this is a puzzling statement. It is true, as mentioned above, that the district court allowed the defendants a profit on infringing sales, and this was evidently accounting profits, but the actual royalty was only 8% of net profits. An 8% royalty isn't close enough to the entire profit for the question of whether the district court wrongly thought it was bound to stay under 100% to be at issue. This contrasts with, for example, Golight, Inc. v. Wal-Mart Stores, Inc., 355 F.3d 1327, 1338 (Fed.Cir.2004), in which the Federal Circuit rejected the infringer’s complaint that the reasonable royalty awarded by the district court was unreasonable as a matter of law because it would have resulted in the infringer selling the product below cost. More importantly, the district court never invoked the infringer’s profits as a cap. While it did refer to the need to allow the defendants a profit on infringing sales, which may indeed be an error in some circumstances, as we have seen the court expressly held that if the royalty had been any higher the defendants “would have likely gone without the benefits of the '160 Patent and designed around it, as they have done now.” In other words, the cap is not the infringer’s accounting profits, but rather the incremental profit due to the invention.

Since I am writing without the benefit of the complete record, it may be that there is something else in the record which supports the Federal Circuit’s critique, but as it stands, the Federal Circuit’s decision is more puzzling than enlightening. If there is any error in the district court’s decision, it lay in using accounting profits rather than incremental profits as a cap on the royalty. That would be an error on the contingent ex ante approach just as much as on the pure ex ante approach. Consequently, while Aqua Shield explicitly embraces the pure ex ante approach, it is not particularly strong authority for that approach, as the holding on that point is purely dicta. When the only evidence is ex post evidence, as in this case, the contingent and pure ex ante approaches will come to the same conclusion, whatever other errors the court below might (or might not) have made.