Warsaw Orthopedic, Inc. v. NuVasive, Inc.: Federal Circuit Holds That Royalties Paid by Related Parties Have Little Probative Value as to Patent Value

Yesterday the Federal Circuit published its opinion in Warsaw Orthopedic, Inc. v. NuVasive, Inc. (available here).  Warsaw asserted claims for the infringement of two patents, one for oversized spinal implants and another for methods and devices relating to spinal surgery.  The defendant, NuVasive, asserted counterclaims against Warsaw and three other related companies--Medtronic Sofamor Danek USA, Inc. (referred to as "MSD" in the opinion), Medtronic Puerto Rico Operations Co. (referred to in the opinion as "M Proc"); and Medtronic Sofamor Danek Deggendorf, GmbH (referred to in the opinion as "Deggendorf")--for the infringement of a patent relating to neuromonitoring during surgery.  The jury found the three patents valid and infringed and awarded damages for the infringement of each of them.  The district court entered judgment in accordance with the verdict but denied Warsaw a permanent injunction, awarding ongoing royalties instead.  Warsaw, MSD, and NuVasive appealed the validity and infringement findings.  Warsaw also appealed the court's denial of "supplemental" damages for infringement between the close of discovery and trial, and challenged the amount of the ongoing royalty as too low, while  NuVasive cross-appealed the damages awarded against it.   (Apparently Warsaw did not appeal the damages awarded to NuVasive.)  Writing for the panel, Judge Dyk affirmed all of the determinations as to infringement and validity, before proceeding to NuVasive's challenge to Warsaw's award of compensatory damages.  

To analyze the damages issues, it's important to understand the relationship between Warsaw and three related companies who were joined as counterclaim defendants.  According to the facts, Warsaw licenses the two patents it asserted against NuVasive to M Proc and Deggendorf; M Proc and Deggendorf then make the patented products and sell them to MSD, which resells them.  M Proc and Deggendorf pay royalties to Warsaw on the sales to MSD.  In addition, Warsaw makes "fixations,"  "medical products such as surgical rods and screws that are used in connection with the patented devices during  surgery," and sells these to MSD for profit.  According to the court, "Warsaw asserts it has three sources of income related to the patented technologies," namely "revenue from the sale of fixations to MSD, which it argues should be treated as convoyed sales"; "royalty payments from M Proc and Deggendorf" and "payments from MSD resulting from an inter-company transfer pricing agreement, which are characterized by Warsaw as “true-up” payments" (p.14).  The jury awarded Warsaw $101,196,000 in total, but the verdict form did not make it clear precisely how this amount was derived:

At trial, Warsaw characterized all three sources of income as representing potential lost profits to Warsaw and sought to recover revenue declines allegedly the result of infringement by NuVasive. Warsaw also sought to recover a reasonable royalty. . . .  The verdict form indicated that the $101 million award was for “Lost Profit Damages (with royalty remainder)” and provided royalty rates for each patent. It is impossible to determine from the verdict form what portion of the verdict is attributable to lost profits and what portion is attributable to a reasonable royalty, much less how much of the lost profits portion is attributable to each of the three different revenue streams (id.).

The court vacated the award and remanded for a new trial, for the following reasons.

First, as for the lost profits derived from lost sales of the unpatented fixations (the so-called "convoyed sales,") the court cited Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538 (Fed. Cir. 1995) (en banc) for the proposition that "[t]o be entitled to lost profits for convoyed sales, the related products (e.g., the fixations) must be functionally related to the patented product and losses must be reasonably foreseeable" (p.17).   "Being sold together merely for 'convenience or business advantage' is not enough" (citing Am. Seating Co. v. USSC Group, Inc., 514 F.3d 1262, 1268 (Fed. Cir. 2008)), and "[i]f the convoyed sale has a use independent of the patented device, that suggests a non-functional relationship" (citing DePuy Spine, Inc. v. Medtronic Sofamor Danek, Inc., 567 F.3d 1314, 1333 (Fed. Cir. 2009)).  Concluding that the fixations bear "no functional relationship" to the patented products but rather were sold together more as a matter of "convenience or business strategy," the Court of Appeals held that these sales could not form a part of the damages award.  (This seems correct to me under Rite-Hite, though whether Rite-Hite itself correctly limits damages in this regard is a matter with respect to which I've never been entirely sure.  For discussion, see, e.g., my book pp. 117-18.)

Second, the district court erred in including lost royalty payments from M Proc and Deggendorf in the lost profits award.  As the court noted earlier in the opinion:

Under our case law a patentee may not claim, as its own damages, the lost profits of a related company. See Poly-America, L.P. v. GSE Lining Tech., Inc., 383 F.3d 1303, 1311 (Fed. Cir. 2004) . . . .  Indeed, Warsaw admits it is not entitled to the lost profits of Deggendorf, M Proc, or MSD (p.16).

(Mark Lemley has critiqued this rule here, at p.673.)  On appeal, Warsaw argued that it was not seeking to recover the related companies' lost profits, but rather only money that those companies would have remitted to Warsaw but for the infringement.  In response, however, the court simply stated (a bit abruptly, in my view) that "Here, there is a failure of proof and as a result the revenue stream is not recoverable . . . " (p.19), so this item could not sustain the award either.

Third, the court agreed with NuVasive that the district court erred by including the "true-up" payments from MSD to Warsaw as part of the damages award:

At trial, Warsaw’s accounting witness explained that Warsaw engages in various transactions with related companies throughout the year. But, those initial transactions do not necessarily reflect the fair market value of the product or service exchanged. To comply with relevant tax and accounting laws, a transfer pricing agreement is used to require those related companies to transfer funds back and forth to compensate each other for the fair market value of the property previously exchanged. The “true-up” payments are post hoc transfers to ensure that Warsaw receives fair-market-value. The number is substantial; MSD remits back 95% of the profit it made from the sale of patented technologies, and that accounts for the majority of the total lost profits requested by Warsaw.

It is not immediately clear from Warsaw’s accounting witness’ testimony what the underlying transactions were that made the 95% true-up payments necessary. The true-up payments from MSD to Warsaw appear to result from a variety of transactions. Some are for royalty payments, suggesting an implied licensing agreement between MSD and Warsaw for the sale of various patented technologies. Others, as suggested by spreadsheets in the record, are for other transactions—for example, management fees or implied licenses on other patents. . . . 

Warsaw apparently contends that the true-up payments are recoverable because they contain, in part, royalty payments from MSD to Warsaw for sales of the patented products to surgeons and hospitals. But Warsaw makes no effort to distinguish what percentage of the true-ups was attributable to those payments as opposed to payments on unrelated transactions. Indeed, the transfer pricing policies indicate that the true-ups are established on a company-by-company, not a technology-by-technology or even a product-by-product, basis (p.20).

Turning next to the possibility of a reasonable royalty, the court stated that "[a]lthough the jury verdict did state a reasonable royalty rate, it is not entirely clear the period for which that reasonable royalty was determined or whether the jury impermissibly relied on evidence not probative of the value of the patented technology" (p.21).  A new trial on damages therefore is appropriate.  On remand, however, while  "[e]vidence of a number of existing royalty agreements entered into at arms-length can be evidence of the value of the patent," "royalties paid by related parties have little probative value as to the patent’s value" (id.).  In particular, "the true-up payments have no relevance to the calculation of the reasonable royalty because Warsaw made no effort to determine what percentage of these payments represented royalties for the asserted patents"; and while the court declined to "decide whether royalty payments by Deggendorf and M Proc have any relevance in determining a reasonable royalty," it noted that the district court did not believe that these rates "prove[d] a royalty rate established by an arms-length transaction" and saw "no evidence that Warsaw licensed the patents to unrelated parties" (p.22 & n.6).  On the other hand, "the impact in the United States that granting a license might have on sales of the patented inventions by Warsaw’s related companies can be relevant to the hypothetical negotiation, even if the amounts of intercorporate transfers are not" (id. n.7).

On supplemental damages, the court noted that "[n]either the court’s instructions nor the verdict form specified the period of infringement during which the jury should award damages," and stated that on remand

Warsaw may appropriately assert a claim for supplemental damages limited to a reasonable royalty. But, the time period of the claim must be presented to the jury with clarity so as to avoid the ambiguity that existed at the first trial. The jury instruction and jury verdict forms should make clear the period for which the jury is supposed to determine damages. If that period ends before the date of the jury verdict, the district court may award supplemental damages in light of that gap period (p.23).         

Finally, "[b]ecause the ongoing royalty impermissibly includes a lost profits component," the court also remanded "for the district court to determine an appropriate ongoing royalty rate in light of this opinion and the jury verdict after a new trial" (p.24).