Analyzing the “Analytical Method” of Calculating Reasonable Royalty Patent Damages

The Federal Circuit suggested in Lucent Technologies Inc. v. Gateway Inc. that there are several ways to determine patent infringement damages based on a reasonable royalty. ¹580 F.3d 1301, 1324, 92 USPQ2d 1555 (Fed. Cir. 2009) (78 PTCJ 583, 9/18/09). The court did not mention a third approach to determining royalty-based patent damages, the established royalty, which is used where the evidence shows “the patentee has consistently licensed others to engage in conduct comparable to the defendant’s at a uniform royalty.” See Monsanto Co. v. McFarling, 488 F.3d 973, 978-79, 82 USPQ2d 1942 (Fed. Cir. 2007) (74 PTCJ 143, 6/1/07) (established royalty furnishes best measure of damages (citing Birdsall v. Coolidge, 93 U.S. 64, 70 (1876)); Nickson Industries Inc. v. Rol Manufacturing
Co., 847 F.2d 795, 798, 6 USPQ2d 1878 (Fed. Cir. 1988) (absent proof of unusual circumstances, established royalty is the best measure of damages); Hanson v. Alpine Valley Ski Area Inc., 718 F.2d 1075, 1078, 219 USPQ 679 (Fed. Cir. 1983) (same). The distinction between an established royalty and a reasonable royalty is often blurred, perhaps in part because Georgia-Pacific Factor 1 “requires considering past and present royalties received by the patentee ‘for the licensing of the patent in suit, proving or tending to prove an established royalty.’” ResQNet.com Inc. v. Lansa Inc., 594 F.3d 860, 869, 93 USPQ2d 1553 (Fed. Cir. 2010) (79 PTCJ 422, 2/12/10)(“By its terms, this factor considers only past and present licenses to the actual patent and the actual claims in litigation.”). But see W. Rooklidge, et al., Compensatory Damages Issues in Patent Infringement Cases: A Pocket Guide for Federal District Court Judges at 5 n. 10 (Federal Judicial Center 2011) (“Although sometimes characterized as a reasonable royalty, the established royalty is, strictly speaking, a form of actual damages, and is ‘reasonable’ in the sense that it typically provides the ‘best measure’ of a royalty for the use made of the invention.” (citing Monsanto v. McFarling, 488 F.3d at 978)). One is the familiar hypothetical negotiation construct, in which a reasonable royalty is calculated by determining the royalty the parties would have agreed upon had they negotiated a license just before the infringement began, with both parties presumed to be willing to enter into a license on the shared assumptions that the patent was valid, enforceable, and infringed. ²Lucent v. Gateway, 580 F.3d at 1324. The other approach mentioned by the court—which it called the “analytical method”—“focuses on the infringer’s projections of profit for the infringing product.” ³Id.

The hypothetical negotiation–and the Georgia-Pacific factors that inform it ⁴Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116, 1120-21, 166 USPQ 235 (S.D.N.Y. 1970).–is the most commonly-used methodology for determining patent damages. ⁵See Lucent v. Gateway, 580 F.3d at 1324. But with the Federal Circuit’s insistence on more rigorous damages analysis and proof–reflected, e.g., in limitations on use of the entire market value rule, ⁶See, e.g., id. at 1336 (“For the entire market value rule to apply, the patentee must prove that the patent-related feature is the basis for customer demand.” (quotations and citation omitted)); Uniloc USA Inc. v. Microsoft Corp., 632 F.3d 1292, 1320, 98 USPQ2d 1203 (Fed. Cir. 2011) (81 PTCJ 275, 1/7/11) (“The Supreme Court and this court’s precedents do not allow consideration of the entire market value of accused products for minor patent improvements simply by asserting a low enough royalty rate.”). elimination of the 25 percent rule of thumb, ⁷Uniloc v. Microsoft, 632 F.3d at 1315 (“This court now holds as a matter of Federal Circuit law that the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation. Evidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.”). and insistence on genuine comparability of past licenses used to calculate a royalty rate ⁸Id. at 1317 ( “there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case.”); Lucent v. Gateway, 580 F.3d at 1325-32 (patentee whose damages analysis relies on prior license agreements must establish “some basis for comparison” between them and the hypothetical license at issue); ResQNet v. Lansa, 594 F.3d at 872-73 (Trial court may not “rely on unrelated licenses to increase the reasonable royalty rate above rates more clearly linked to the economic demand for the claimed technology”); Wordtech Systems Inc. v. Integrated Networks Solutions Inc., 609 F.3d 1308, 95 USPQ2d 1619 (Fed. Cir. 2010) (80 PTCJ 264, 6/25/10)(reversing denial of motion for new trial on damages; evidence showed no basis for comparing prior licenses relied on by patentee to the hypothetical license at issue); Finjan Inc. v. Secure Computing Corp., 626 F.3d 1197, 1211, 97 USPQ2d 1161 (Fed. Cir. 2010) (81 PTCJ 55, 11/12/10) (“use of past patent license under [Georgia-Pacific] factors 1 and 2 must account for differences in the technologies and economic circumstances of the contracting parties.” (citations omitted)).–some patentees are turning their attention to the “analytical approach,” presumably with the thought that it may provide a less daunting path to proving damages.

A close reading of the case law, however, shows that the supposed “analytical method” (or “analytical approach”) is not the solution to the challenges of proving a reasonable royalty. Indeed, properly viewed, it is not an independent damages methodology at all. The case cited as the wellspring of the “analytical approach” is the Federal Circuit’s 26-year old opinion in TWM Manufacturing
Co. v. Dura Corp., ⁹789 F.2d 895, 899 (Fed. Cir. 1986). which affirmed a reasonable royalty damages award by a lower court that, in turn, had relied on Georgia-Pacific and Tektronix Inc. v. United States. ¹⁰552 F.2d 343, 193 USPQ 385 (Cl. Ct. 1977) . But none of those three cases purported to create or apply a new damages methodology distinct from the hypothetical negotiation construct. To the contrary, in all three cases, the court determined a reasonable royalty using the hypothetical negotiation analysis and the familiar Georgia-Pacific factors. Thus, TWM v. Dura cannot be read as approving a reasonable royalty shortcut that absolves the patentee of the fundamental requirements that its damages proof rest on “sound economic and factual predicates” ¹¹Riles v. Shell Exploration and Production Co., 298 F.3d 1302, 1311, 63 USPQ2d 1819 (Fed. Cir. 2002) (64 PTCJ 350, 8/9/02). and the reasonable royalty be calculated in a manner that compensates the patentee only “for the use made of the invention by the infringer.” ¹²“Upon finding for the claimant 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, together with interest and costs as fixed by the court.” 35 U.S.C. §284.

I. What Is the Analytical Approach—and Where Did It Come From?

How did the notion of an “analytical approach” to proving reasonable royalty damages—as a method distinct from the hypothetical negotiation (or “willing buyer-willing seller”) approach—find its way into the case law? Based on a careful reading of the cases, it appears to have been an error. To understand how that came about, one must begin with the Federal Circuit’s 1986 opinion in TWM v. Dura.

A. The Federal Circuit’s Opinion in TWM v. Dura

In TWM v. Dura, the court affirmed a damages award that had been crafted by a magistrate sitting as a special master and then adopted in its entirety by the district court. ¹³789 F.2d at 898. The trial court made a minor modification to the magistrate’s report to add a case citation, but otherwise adopted the magistrate’s report in its entirety, concluding that it contained no errors of law and the findings of fact were not clearly erroneous. TWM
Manufacturing
Co. v. Dura Corp., 231 USPQ 525, 526 (E.D. Mich. 1985). The award included amounts for lost profits, a reasonable royalty (for sales where lost profits could not be proven), price erosion, and enhanced damages. ¹⁴TWM v. Dura, 789 F.2d at 898. Then-Chief Judge Howard T. Markey noted that, “[f]or the years TWM could not establish its lost profits, [the parties] agreed that the district court should determine a reasonable royalty based on a ‘hypothetical royalty resulting from arm’s length negotiations between a willing licensor and a willing licensee.’” ¹⁵Id. at 898-99 (citing Hanson v. Alpine Valley, 718 F.2d at 1078; Tektronix, 552 F.2d at 348-49, Georgia-Pacific, 318 F. Supp. 1116). The court cited three cases for the “willing licensor/willing licensee” method—Hanson v. Alpine Valley Ski Areas Inc., Tektroni
x, and Georgia-Pacific
¹⁶Id.—and then summarized how the magistrate had arrived at the 30 percent reasonable royalty award:

The special master, citing Georgia-Pacific and Tektronix, used the so-called “analytical approach,” in which she subtracted the infringer’s usual or acceptable net profit from its anticipated net profit realized from sales of infringing devices. [¶ ] Relying principally on a memorandum written by “[the infringer’s] top management” before the initial infringement, the special master found that [the infringer] projected a gross profit averaging 52.7% from its infringing sales. From that figure, she subtracted overhead expenses to get an anticipated net profit in the range of 37% to 42%. Subtracting the industry standard net profit of 6.56 % to 12.5% from that anticipated net profit range, she arrived at a 30% reasonable royalty. ¹⁷Id. at 899.

The court’s affirmance of that reasonable royalty damages award is significant for three reasons.

First, the court acknowledged that the parties had agreed that the framework to be applied to the reasonable royalty determination was the hypothetical negotiation between a willing licensor and a willing licensee.

Second, the court recognized that, in fashioning the reasonable royalty, the lower court had expressly relied on Georgia
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Pacific and Tektronix—two of the three cases the Federal Circuit itself had just cited for the hypothetical negotiation reasonable royalty framework.

Third, the Federal Circuit rejected the infringer’s arguments that the magistrate “erred as a matter of law in failing to analyze all factors delineated in Georgia-Pacific” and that, had she done so, she would have found the “analytical approach” she used “inapplicable.” ¹⁸Id. The court explained that the special master had correctly focused on the date when infringement began ¹⁹Id. and had credited the testimony of the patentee’s witnesses, “who said their computations were derived from the factors in Georgia-Pacific.” ²⁰Id. at 899-900. The court underscored the trial court’s discretion in selecting the method to assess and compute damages ²¹Id. at 898 (“The methodology of assessing and computing damages under 35 U.S.C. § 284 is within the sound discretion of the district court.” (citations omitted)); id. at 899 (“Section 284 does not mandate how the district court must compute [the royalty] figure, only that the figure compensate for the infringement.”). and noted that the infringer/appellant “cited nothing which would limit the district court’s discretion in choosing the analytical approach to determine a reasonable royalty.” ²²Id. at 899. And after all that, the court affirmed the award, concluding that it was not persuaded “that a 30% royalty does not reflect what a willing licensor and licensee would have agreed to in 1967 … .” ²³Id. at 900 (emphasis added).

In short, a full reading of the TWM v. Dura opinion leaves no doubt that (1) both the appellate court and the trial court analyzed the reasonable royalty in the context of a Georgia-Pacific hypothetical negotiation; (2) the damages evidence was based on–and the lower court considered–the Georgia-Pacific factors; and (3) the resulting damages analysis and calculation was affirmed because it was consistent with what a willing licensor and licensee would have agreed upon before infringement began. All of that belies any intention to create a new “Analytical Approach” methodology for determining a reasonable royalty as an alternative to the willing licensor-willing licensee framework. ²⁴One group of commentators has suggested that the supposed “analytical approach” enunciated in TWM v. Dura “really has nothing at all to do with any hypothetical licensing negotiation.” See J. Skenyon, C. Marchese, J. Land, Patent Damages Law & Practice §3:8 at 3-13 (2012) (“Patent Damages Law & Practice”). As shown above, TWM v. Dura cannot properly be construed as creating a new damages approach, much less one distinct from the hypothetical license negotiation. The same commentators also note that the Federal Circuit’s decision one year later in Hughes Tool Co. v. Dresser Industries Inc., 816 F.2d 1549, 2 USPQ2d 1396 (Fed Cir. 1987), “made no complaint about the validity of the analytical approach,” and they suggest that silence is a clear indication that “the court would have upheld” the damages award under the analytical approach had it not reversed it on different grounds. Patent Damages Law & Practice §3:8 at 3-16. This suggestion, however, is premised on a misreading of the basis for the damages award reviewed in Hughes Tool. The Hughes Tool court explained the basis for the trial court’s damages award, noting that because the trial court had found that the patentee failed to prove lost profits damages, “[t]he court then set out to determine, ‘under the “willing buyer-willing seller” rule, what a reasonable royalty’ would have been.” Hughes Tool, 816 F.2d at 1554. Of course, that willing buyer-willing seller rule is the hypothetical negotiation framework, not a separate “analytical method.” In short, Hughes Tool said nothing about a separate “analytical approach” because it had no occasion to: the trial court had not relied on it, and it was not at issue on appeal.

B. The Lower Court’s Royalty Analysis in TWM v. Dura

What accounts for the Federal Circuit’s suggestion in TWM v. Dura that the district court had “used the so-called ‘analytical approach’” ²⁵TWM v. Dura, 789 F.2d at 899. in calculating the royalty? That’s where the error comes in. To understand how that came about, one has to look at the underlying report by the magistrate/special master in TWM v. Dura that (1) explained the damages methodology she used; (2) was adopted by the district court in full; and (3) ultimately was affirmed by the Federal Circuit.

Remember that the appellate opinion in TWM v. Dura suggested that “[t]he [magistrate,] citing Georgia-Pacific and Tektronix, used the so-called ‘analytical approach,’ in which she subtracted the infringer’s usual or acceptable net profit from its anticipated net profit realized from sales of infringing devices.” ²⁶Id. This suggests that the magistrate had created and applied a methodology—for which she coined the term “analytical approach”–that was in some manner different from the usual Georgia-Pacific hypothetical negotiation approach. But that is not at all how the magistrate described what she did. Here is how she explained the analytical approach she used:

To determine a reasonable royalty in the absence of an established or customary royalty, the parties agree that the court direct its inquiry to the “critical period,” after the patent issues and before the infringement begins, during which a willing buyer and willing seller would have entered into a royalty-bearing license.

* * *

The plaintiff contends that an appropriate analytical approach to determine the reasonable royalty in this case, under the willing buyer/selling technique, is the approach used in two cases: Georgia-Pacific Corp v. U.S. Plywood-Champion Papers, Inc. and Tektronix, Inc. v. United States. The plaintiff contends that the approach used in Tektronix supra, and Georgia-Pacific, supra, provides a realistic basis on which to flush out, in reasonable terms, the fictional willing buyer/willing seller negotiation. It contends that such an approach uses Dura’s own real life projections as well as established industry figures from the critical period. The defendant, however, rejects the Georgia-Pacific and Tektronix analysis as inapplicable to the instant case and wishes to substitute a different analysis resulting in a per unit royalty in this case.

For the reasons stated below this Magistrate agrees that the analytical approach cited in Georgia-Pacific, supra, and Tektronix supra, is appropriate to the case at bar. The Magistrate further agrees that during the critical period, given the record in this case, a willing buyer and willing seller would have entered into a royalty of at least 30% of the invoice price of the infringing device. This analytical approach takes the anticipated net profit realized by the infringer from sales of the infringing device and subtracts the usual or acceptable net profit of the infringer. Then the result is analyzed to be sure it constitutes adequate compensation. This approach is imminently fair to Dura since it awards Dura, the infringer, a normally acceptable profit on the lift suspension, while giving the remainder as a royalty to the patentee. ²⁷TWM v. Dura, 231 USPQ at 527-529 (citations omitted).

Moreover, the magistrate rejected the infringer’s argument that the Tektronix analysis was “inapplicable” to the facts of the case, explaining:

The Tektronix methodology, at least to this Magistrate, should apply to patent infringement cases whenever one must resort to the willing buyer/willing seller methodology. Rather than being ironclad, it is a flexible concept that allows the court to consider all the facts and determine a reasonable royalty based on what the parties would have done had real negotiations occurred. ²⁸Id. at 529.

In short, a close reading of the magistrate’s report–and its explanation of the methodology used to calculate damages—makes clear that the magistrate did not create, apply, or coin the term for a new “Analytical Approach” focused on the infringer’s profits. To the contrary, she applied the same analytical approach described in Georgia-Pacific and Tektronix
–namely, the “fictional willing buyer/willing seller negotiation” ²⁹Id. at 527. for a “royalty-bearing license” ³⁰Id. that takes place “before the infringement begins” ³¹Id. and that “allows the court to consider all the facts and determine a reasonable royalty based on what the parties would have done had real negotiations occurred.” ³²Id. at 529.

C. The TWM v. Dura Courts’ Reliance on Georgia-Pacific and Tektronix

The fact that both the magistrate’s reasonable royalty calculation in TWM v. Dura and the Federal Circuit’s opinion affirming it cite Georgia-Pacific and Tektronix as support for the methodology used further confirms that the analysis applied is the hypothetical negotiation framework. On their face, both opinions make clear that the analysis (or, if one prefers, the analytical approach) applied was to determine the results of a hypothetical negotiation between a willing licensor and a willing licensee.

In Tektronix, the Court of Claims reviewed a trial judge’s award of reasonable compensation for the government’s infringement of eight patents related to oscilloscopes. ³³The patentee’s compensation was based on the statute applicable to determining damages in an infringement action brought against the United States. See 28 U.S.C. § 1498 (where the United States uses or manufactures a patented invention without license, the patentee’s remedy is “reasonable and entire compensation for such use and manufacture”). The infringer argued in favor of a sliding scale established royalty based on the sale price of the scopes, relying on licensing practices of other companies in the “commercial electronics field.” ³⁴Id. at 346. The patentee sought lost profits for some of the infringing sales, and for the remainder it contended that “compensation must be determined by adopting a reasonable royalty based on a willing buyer-willing seller concept as enunciated in Georgia
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Pacific Corp. v. U.S. Plywood-Champion Papers Inc.” ³⁵Id. at 346 (citation omitted).

Noting the parties’ agreement that “plaintiff has no established licensing program or royalty applicable to the patents” ³⁶Id. at 346; id. at 347 (“Where an established royalty rate for the patented inventions is shown to exist, that rate will usually be adopted as the best measure of reasonable and entire compensation.” (citation omitted)). in suit, the Tektronix court rejected both the lost profits and established royalty theories suggested by the parties and concluded that “the best method of computing compensation in this case is to adopt the approach of establishing a reasonable royalty,” as “exemplified by the Georgia-Pacific case, … involv[ing] a willing buyer/willing-seller concept, in which a supposititious meeting between the patent owner and the prospective manufacturer of the infringing item is held to negotiate a license agreement” for the accused products. ³⁷Id. at 349. The court explained:

The negotiation formula which the trial judge borrowed from Georgia-Pacific is, as already mentioned, to start with the infringer’s selling price, deduct its costs in order to find its gross profit, then allocate to the infringer its normal profit, and end up with the residual share of the gross profit which can be assigned to the patentee as its royalty. ³⁸Id.

The Tektronix court accepted the trial court’s general approach but modified the calculation in two respects. First, it concluded that the trial court’s calculation understated the manufacturing costs and therefore inflated what it called the plaintiff’s “residual share.” ³⁹Id. at 350. Second, after correcting the residual share to 7.65 percent of the unit price, the court concluded that, on the facts before it, a reasonable patentee would have insisted upon (and a reasonable licensee would have been willing to pay) a royalty somewhat higher than 7.65 percent. ⁴⁰Id. at 350-51. Accordingly, the court found 10 percent to be the proper royalty rate, noting that it represented the court’s best judgment of “what the parties would have agreed upon, if both were reasonably trying to reach an agreement.” ⁴¹Id. at 352 (citation omitted) (emphasis added). In short, the Tektronix court did not create or apply a new “Analytical Approach”; it simply applied the familiar hypothetical negotiation analysis to determine what the parties would have agreed upon before infringement began.

Likewise, nothing in Georgia-Pacific—the other case cited by the appellate court in TWM v. Dura as the source of the “so-called ‘analytical approach’” ⁴²TWM v. Dura, 789 F.2d at 899.—supports the suggestion that it created a new “Analytical Approach” separate and distinct from the hypothetical negotiation framework. To the contrary, the Georgia-Pacific court noted that the judge originally assigned to the case had earlier (1) affirmed the special master’s conclusion that the patentee failed to prove its own lost profits; (2) rejected the special master’s recommendation to award the patentee infringer’s profits, because the “infringer’s profits” remedy “falls outside the statute’s provision for recovery of damages”; ⁴³Georgia-Pacific, 318 F. Supp. at 1143 (citation omitted). The court clearly was correct on this point. In 1946, Congress eliminated the infringer’s profits as a measure of damages for all but design patents. See Aro Manufacturing Co. v. Convertible Top Replacement Co., 377 U.S. 476, 505, 141 USPQ 681 (1964) (“Prior to 1946, the statutory precursor of the present §284 allowed recovery of both” profits and damages; in 1946, the statute was changed to make only damages recoverable); 35 U.S.C. §289 (infringer of design patent shall, in addition to other statutory remedies, “be liable to the owner to the extent of his total profit”; however, the patentee “shall not twice recover the profit made from the infringement.”). See also n. 73, infra. and (3) concluded that damages should be computed based on a reasonable royalty. ⁴⁴Id. at 1118 (citation omitted). The trial court went on to articulate the now-famous 15 factors “relevant, in general, to the determination of the amount of a reasonable royalty for a patent license,” ⁴⁵Id. at 1120. and then made clear that it was considering those factors within the context of a “willing buyer and willing seller” rule to determine what the parties would have agreed upon had they been trying to reach agreement. ⁴⁶Id. at 1121. The court explained its approach thus:

The rule is more a statement of approach than a tool of analysis. It requires consideration not only of the amount that a willing licensee would have paid for the patent license but also of the amount that a willing licensor would have accepted. What a willing licensor and a willing licensee would have agreed upon in a supposititious negotiation for a reasonable royalty would entail consideration of the specific factors previously mentioned, to the extent of their relevance. Where a willing licensor and a willing licensee are negotiating for a royalty, the hypothetical negotiations would not occur in a vacuum of pure logic. They would involve a market place confrontation of the parties, the outcome of which would depend upon such factors as their relative bargaining strength; the anticipated amount of profits that the prospective licensor reasonably thinks he would lose as a result of licensing the patent as compared to the anticipated royalty income; the anticipated amount of net profits that the prospective licensee reasonably thinks he will make; the commercial past performance of the invention in terms of public acceptance and profits; the market to be tapped; and any other economic factor that normally prudent businessmen would, under similar circumstances, take into consideration in negotiating the hypothetical license.

* * *

In applying the [willing seller and willing buyer] formulation, the Court must take into account the realities of the bargaining table and subject the proofs to a dissective scrutiny. ⁴⁷Id. at 1121-22.

The Georgia-Pacific court proceeded to apply the willing seller-willing buyer analysis, finding that the patentee’s analysis of what it would have demanded and what the infringers would have agreed to pay at the time of the hypothetical negotiation was “rooted in reality,” particularly “with respect to such elements as reasonably anticipated rates of profit, probable volume of sales, normal economic motivations, and the prevailing business outlook, all as of the time of the supposititious negotiations.” ⁴⁸Id. at 1122. The court rejected the infringer’s argument that, because the court could not use its “infringing profits as the legal measure of damages, evidence of [the infringer’s] reasonably anticipated profits as of 1955 is irrelevant to the present inquiry.” Id. at 1123. Likewise, the court rejected the infringer’s argument that because the patentee could not prove lost profits, it could not “use, as one of the primary factors for evaluating a reasonable royalty, the profits that it would have reasonably anticipated it would make at the time when a royalty would have been negotiated hypothetically with [the infringer.]” Id. The court found there was no need to invoke apportionment principles because the entire market value of the accused products was attributable to the patent in suit. Id. at 1134.

In sum, neither Georgia-Pacific, Tektronix, nor the lower court decision in TWM v. Dura can fairly be read to create or approve an “Analytical Approach” to calculating a reasonable royalty that is distinct from the hypothetical negotiation framework. The suggestion in TWM v. Dura that there is such a methodology is, quite simply, an analytical error that has been perpetuated in the ensuing 26 years by citation to TWM v. Dura. The “so-called analytical analysis,” as a stand-alone alternative to the hypothetical negotiation damages calculation, is not properly part of patent damages law.

II. The “Analytical Approach” and Current Patent Damages Law

Now fast forward to 2012 and assume that, despite all indications to the contrary, the TWM v. Dura court intended to articulate a new methodology separate from the hypothetical negotiation. Recognizing that the law of patent damages has been greatly refined in the decades following TWM v. Dura, it is fair to ask whether such a methodology would withstand scrutiny under current patent damages jurisprudence. It would not.

As noted, the most prominent Federal Circuit reference to the analytical method appears to have been in the 2009 Lucent v. Gateway decision. ⁴⁹Lucent v. Gateway, 580 F.3d at 1324. As part of a general, introductory discussion of damages–including citations to the damages statute, the compensatory purpose of the statute, the burden of proof, and the availability of lost profits or royalty damages–the court noted that “[l]itigants routinely adopt several approaches for calculating a reasonable royalty”: the “analytical method” and the “hypothetical negotiation” approach. ⁵⁰Id. at 1324. The court went on to explain:

The first [approach], the analytical method, focuses on the infringer’s projections of profit for the infringing product. See TWM Mfg. Co. v. Dura Corp., 789 F.2d 895, 899 (Fed. Cir. 1986) (describing the analytical method as “subtract[ing] the infringer’s usual or acceptable net profit from its anticipated net profit realized from sales of infringing devices”); see also John Skenyon et al., Patent Damages Law & Practice §3:4, at 3-9 to 3-10 (describing the analytical method as “calculating damages based on the infringer’s own internal profit projections for the infringing item at the time the infringement began, and then apportioning the projected profits between the patent owner and the infringer”). ⁵¹Id.

Because Lucent v.
Gateway did not involve application of the analytical method, the court’s description of the approach is dicta, and it was not the subject of further discussion or analysis in the opinion. ⁵²This Lucent
v. Gateway dicta has found its way, without analysis, into dicta in later opinions. See, e.g., Wordtech Sys
tems, 609 F.3d at 1319 (“A reasonable royalty can be calculated from an established royalty, the infringer’s profit projections for infringing sales, or a hypothetical negotiation between the patentee and infringer based on the [Georgia-Pacific] factors … .”) (citing Lucent v. Gateway, 580 F.3d at 1324); Oracle America Inc. v. Google Inc., No. C-10-03561, ECF No. 352 at 1 (N.D. Cal. Aug. 23, 2011) (analytical method for determining a reasonable royalty calculates damages based on infringer’s internal profit projections for the infringing item at the time infringement began and then apportions projected profits between patentee and infringer (citing Lucent v.
Gateway)). The court’s reference to the analytical method is, nevertheless, noteworthy—and problematic—for several reasons.

First, the court cited Rad
io Steel & Mfg. Co. v. MTD Products
Inc. for the proposition that, in a hypothetical negotiation analysis, a reasonable royalty is based on the royalty to which a willing licensor and willing licensee would have agreed when infringement began, and not on the infringer’s profits. ⁵³580 F.3d at 1324 (citing Radio Steel v. MTD, 788 F.2d 1554, 229 USPQ 431 (Fed. Cir. 1986)). See al
so State Industries Inc. v. Mor-Flo Industries Inc.
, 883 F.2d 1573, 1580, 12 USPQ2d 1026 (Fed. Cir. 1989) (“The determination of a reasonable royalty, however, is based not on the infringer’s profit margin, but on what a willing licensor and licensee would bargain for at hypothetical negotiations on the date infringement started.” (citing Radio Steel v. MTD, 788 F.2d at 1557)). Yet it suggested that the analytical method is based on exactly that–the infringer’s profits. Infringer’s profits, however, is precisely the patent remedy that Congress abolished in 1946. ⁵⁴See n. 43, supra
, and n. 73, infra. The Federal Circuit could not—and surely did not intend to—end-run that legislative policy choice by approving (in dicta, no less) an “analytical approach” to royalty calculations that effectively awards the infringer’s profits under a different label. ⁵⁵Dicta in the 1988 opinion in Fromson v. Western Litho Plate, 853 F.2d 1568, 7 USPQ2d 1606 (Fed. Cir. 1988), also suggested calculating a reasonable royalty based on a percentage of the profits made from use of a patented invention. The Federal Circuit reversed and remanded the trial court’s reasonable royalty damages award, which was premised on findings that (a) the standard profit for lithographic plates was 10 percent; (b) a willing licensee would have paid one-quarter of its profits on the product attributable to the patented invention; (c) one-third of the profits were attributable to the patented invention; and (d) the royalty therefore was 2.5 percent of one-third of the profits attributable to the patented invention. Id. at 1577-1579. Writing for the court, Judge Howard T. Markey found the one-third apportionment erroneous (in part because the accused product was “not formed of separable parts, but is a unitary product”) but declined to affirm 2.5 percent of 10 percent as a reasonable royalty, noting “we cannot fathom either the rationale that led to selection for a ’standard 10% profit’ or the basis for employing a percentage of a percentage.” Id. at 1578. In dicta, the court went on to suggest that “If a district court elects to consider the infringer’s profit, it would appear sufficient to fix a reasonable royalty as a percentage of the dollar amount of profit made by the infringer from its use of the in whatever that dollar amount may have from time to time been.” Id. (citation omitted).

Second, the court’s dicta identified the “analytical method” as a methodology distinct from the hypothetical negotiation framework. As shown above, however, the cases cited for the supposed “analytical method” did not in fact create an “infringer’s profit-based” damages measure divorced from the Georgia
-
Pacific factors and what the parties would have agreed to before infringement began. To the contrary, those cases considered the infringer’s projected and actual profits within the context of a Georgia-Pacific hypothetical negotiation analysis. Such an analysis can properly include consideration of “[t]he portion of the profit or of the selling price that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions” (Georgia-Pacific Factor 12) and “[t]he established profitability of the product made under the patent; its commercial success; and its current popularity” (Factor 8). ⁵⁶Georgia-Pacific, 318 F. Supp. at 1120. See Finjan, 626 F.3d at 1209 (Under Georgia-Pacific Factor 8, “a wide profit margin for accused products supports a higher reasonable royalty.”).

Third, the two definitions of the analytical method cited by the court are not the same: one is simply a mathematical exercise to determine the infringer’s incremental profits on the accused product, and the other requires some kind of apportionment of the infringer’s internal projected profits for the accused products. Examining both formulations in light of current Federal Circuit law reveals flaws in both.

A. The Mathematical Version of the “Analytical Approach”

The first definition suggested in Lucent v Gateway cites TWM v. Dura for the proposition that the analytical approach is a simple mathematical exercise: the reasonable royalty for infringement equals (1) the net profit the infringer expected to realize from the sales of the infringing product minus (2) the infringer’s usual or acceptable net profits. ⁵⁷Lucent v.
Gateway, 580 F.3d at 1324. This formulation is “based on the premise that any rate of return in excess of a normal rate of return can be attributed to the patent.” ⁵⁸Fresenius USA Inc. v. Baxter
International
Inc., No. C03-1431, ECF No. 666 at 10 (N.D. Cal. May 18, 2006) (denying motion to exclude expert damages report based on different methods of calculating reasonable royalty, including the ”analytical method,” and explaining “[t]his method takes the profits of the infringer, subtracts the infringer’s normal profit, and awards some portion of the remainder to the patent owner.” (quoting “Calculating Intellectual Property Infringement Damages” (AICPA)). Interestingly, the AICPA publication cites the appellate decision in TWM v. Dura as the source of the “analytical method.” But computing a royalty simply by subtracting the infringer’s “usual” profits from its “expected” profits from the infringement looks a lot like an unadorned profit allocation with no factual underpinnings. It therefore suffers from the same three overriding flaws that caused the Federal Circuit in Uniloc v. Microsoft to sound the death knell for the 25 percent rule of thumb. ⁵⁹See Uniloc v. Microsoft, 632 F.3d at 1313.

First, mechanically awarding 100 percent of all profits above the “normal” or “expected” profits to the patentee as a reasonable royalty “fails to account for the unique relationship between the patent and the accused product.” ⁶⁰Id. It assumes that every penny of additional profit (above the infringer’s “usual” or “acceptable” profit) is attributable solely to the patented invention. It therefore makes no attempt to account for the importance of the infringed technology in generating those incremental profits and does not reflect “the invention’s contribution to the infringing product or service.” ⁶¹Id. It is easy to imagine an accused product that incorporates a number of valuable features or technologies that were not included in the infringer’s prior product lines, only one of which is the patented feature. In such an instance, assuming that all increases in profit margin for the product are properly attributed to the infringed feature is precisely the kind of unsupported speculation the courts reject. ⁶²See ResQNet v. Lansa, 594 F.3d at 869 (“a reasonable royalty analysis requires a court to hypothesize, not to speculate” (citing Fromson v. Western Litho Plate, 853 F.2d at 1574); Grain Processin
g Corp. v. American Maize-Products
Co., 185 F.3d 1341, 1350, 51 USPQ2d 1556 (Fed. Cir. 1999) (“To prevent the hypothetical from lapsing into pure speculation, this court requires sound economic proof of the nature of the market and likely outcomes with infringement factored out of the economic picture.”). Moreover, in such circumstances, automatically awarding the entire increase in profits to the patentee as a “reasonable royalty” would do far more the make the patentee whole, which is inconsistent with the goal of compensatory patent damages and the statutory mandate that the patentee be compensated only “for the use made of the invention by the infringer … .” ⁶³35 U.S.C. §284. See ResQNet v. Lansa, 594 F.3d at 869 (“Any evidence unrelated to the claimed invention does not support compensation for infringement but punishes beyond the reach of the statute.”); Pall Corp. v. Micron Separations Inc., 66 F.3d 1211, 1223, 36 USPQ2d 1225 (Fed. Cir. 1995) (“[T]he purpose of compensatory damages is not to punish the infringer, but to make the patentee whole.”).

Second, a mechanical calculation (and automatic award) of incremental profits also “fails to account for the unique relationship between the parties.” ⁶⁴Uniloc v. Microsoft, 632 F.3d at 1313. Simply awarding 100 percent of the incremental profits to the patentee ignores the bargaining strengths of the parties, the parties’ competitive positions, the different levels of risk assumed by the licensor and licensee, and all the other facts peculiar to the parties that could affect the outcome of a hypothetical negotiation.

Third, for the same reasons, automatically awarding 100 percent of the incremental profits to the patentee “is essentially arbitrary and does not fit within the model of the hypothetical negotiation within which it is based.” ⁶⁵Id. at 1313. This mathematical version of the analytical methodology makes no effort to tether the royalty to the results of a negotiation that took place just prior to infringement. Mechanically allocating 100 percent of the incremental profits to the patentee appears to be just as arbitrary as allocating 25 percent of the profits from the infringing product to the patentee under a “rule of thumb” or allocating 50 percent of the profits to the patentee under “Nash Bargaining” negotiation theory—both approaches that have been rejected. ⁶⁶Id. at 1315 (rejecting 25 percent rule of thumb); Oracle v. Google, 798 F. Supp.2d 1111, 1119 (N.D. Cal. 2011) (rejecting damages opinion based on presumed 50-50 profit split under “Nash Bargaining” theory because “the Nash solution cannot describe real-world behavior unless the conditions on which it is premised are satisfied in the real world” and “[t]here is no anchor for this fifty-percent assumption in the record of actual transactions.”).

In short, like the rejected 25 percent rule, the mechanical mathematical version of the analytical approach referenced in Lucent v. Gateway “fails to tie a reasonable royalty base to the facts of the case at issue” ⁶⁷Uniloc, 632 F.3d at 1315; id. at 1316 (“If the patentee fails to tie the [damages] theory to the facts of the case, the testimony must be excluded.”). and thus fails to “carefully tie proof of damages to the claimed invention’s footprint in the market place.” ⁶⁸ResQNet v. Lansa, 594 F.3d at 869. It is hard to see how this could survive scrutiny under current patent damages law. ⁶⁹This simple mathematical approach would not be salvaged by subtracting “standard industry profits,” instead of “infringer’s normal profits,” from the infringer’s projected profits. See, e.g., IP Innovation LLC v. Red Hat Inc., 705 F. Supp. 2d 687, 691 (E.D. Tex. 2010) (rejecting use of average “industry” royalty rates as starting point for determining a reasonable royalty because the “software industry” and “computer and electronic products manufacturing industry” encompass far more than the patented feature at issue).

B. The Profit Apportionment Version of the Analytical Approach

The other version of the analytical approach suggested in the Lucent v.
Gateway dicta “calculate[s] damages based on the infringer’s own internal profit projections for the infringing item at the time the infringement began, and then apportion[s] the projected profits between the patent owner and the infringer.” ⁷⁰Lucent v.
Gateway, 580 F.3d at 1324 (citation omitted); see Fresenius v. Baxter, No. C03-1431, ECF No. 666 at 10 (analytical method subtracts the infringer’s normal profit from the infringer’s profits on the accused product “and awards some portion of the remainder to the patent owner.” (quoting “Calculating Intellectual Property Damages” (AICPA)). See also Oracle v. Google, No. 3:10-CV-03561, ECF No. 352 at 1 (analytical method for determining a reasonable royalty calculates damages based on infringer’s internal profit projections for the infringing item at the time infringement began and then apportions projected profits between patentee and infringer (citing Lucent v.
Gateway)). To the extent this approach suggests a rigorous apportionment to ensure that the royalty awarded reflects the actual contribution made by the patented invention to the accused products’ commercial success, it at least acknowledges an important principle of patent damages law. ⁷¹See, e.g., Uniloc v. Microsoft, 632 F.3d at 1318 (the patentee “must in every case give evidence tending to separate or apportion the defendant’s profits and the patentee’s damages between the patented feature and the unpatented features, and such evidence must be reliable and tangible, and not conjectural or speculative” (quoting Garretson v. Clark, 111 U.S. 120 (1884)). Still, it is also subject to criticism.

First, this definition of the “analytical approach” appears to be indistinguishable from the “infringer’s profit” remedy that was abolished by Congress in 1946. The pre-1946 “infringer’s profit” remedy did not simply award 100 percent of the profits to the patentee; it required the profits to be apportioned to reflect the value of the infringer’s use of the patented invention. ⁷²Dowagiac Mfg. Co. v. Minnesota Plow Co., 235 U.S. 641, 646 (1915) (“In so far as the profits from the infringing sales were attributable to the patented improvements they belonged to the [patentee], and in so far as they were due to other parts or features they belonged to the defendants.”); Westinghouse Elec. & Mfg. Co. v. Wagner Elec. & Mfg. Co., 225 U.S. 604, 614-15 (1912) (“if plaintiff’s patent only created a part of the profits, he is only entitled to recover that part of the net gains” and must “give evidence tending to separate or apportion the defendant’s profits and the patentee’s damages between the patented feature and the unpatented features”); Garretson v. Clark, 111 U.S. 120, 121 (1884) (“When a patent is for an improvement, and not for an entirely new machine or contrivance, the patentee must show in what particulars his improvement has added to the usefulness of the machine or contrivance. He must separate its results distinctly from those of the other parts, so that the benefits derived from it may be distinctly seen and appreciated.“). And it is precisely because of the difficulties of performing that apportionment that Congress opted to eliminate the “infringer’s profits” remedy for almost all classes of patents. ⁷³Congress amended the patent statute in 1946 to eliminate the remedy of an accounting for the infringer’s profits. Act of August 1, 1946, Ch. 726, §1, 60 Stat. 778; see also Aro v. Convertible Top, 377 U.S. at 505. Congress eliminated the remedy of infringer’s profits to spare the parties the expense and delay of the detailed accounting procedure and to eliminate the complex apportionment analysis, but stated that infringer’s profits could continue to be considered as an “element” of damages. H.R. Rep. No. 1587, 79th Cong., 2d Sess. 2 (1946); see also Kori Corp. v. Wilco Marsh Buggies & Draglines Inc., 761 F.2d 649, 654-55, 225 USPQ 985 (Fed. Cir. 1985). It is hard to justify reintroducing the same measure of damages through a judicially-created “analytical method.”

Second, even this apportioned approach could be criticized for apparently focusing solely on the profit-based Georgia-Pacific factors, to the exclusion of all the other facts regarding the parties, the market, the product and the technology. The Federal Circuit in Finjan approved reasonable royalty damages under the hypothetical negotiation framework based upon a split of the infringer’s operating profit, but it explicitly held that the split was not arbitrary because the patentee’s damages expert had “considered the custom in the industry, history of prior licenses, competitiveness of the parties, and the importance of the patented technology, among other factors, in concluding that the parties would have agreed that [the patentee] was entitled to 33 percent of the operating profit margin.” ⁷⁴Finjan, 626 F.3d at 1210-11.

Finally, any apportionment would require a sound factual basis to ensure that the ultimate royalty is tied to the facts of the case ⁷⁵See Uniloc v. Microsoft, 632 F.3d at 1318 (apportionment evidence must be “reliable and tangible, and not conjectural or speculative” (citation omitted)). and reflects the “claimed invention’s footprint in the market place.” ⁷⁶ResQNet v. Lansa, 594 F.3d at 869. See
also Riles v. Shell Exploration, 298 F.3d at 1312 (“[T]he market would pay [the patentee] only for his product … . [The patentee’s damages] model [does not support the jury’s damages award because it] does not associate [the] proposed royalty with the value of the patented method at all, but with the unrelated cost of the entire Spirit platform.”). Apportionment based on rules of thumb, negotiation or game theories, or “standard industry” profits would not meet the rigorous standards on which the courts now insist.

III. Conclusion

The so-called “analytical approach” mentioned in the Lucent v. Gateway dicta has no sound basis in the opinions from which it purportedly springs. It appears to have found its way into patent damages jurisprudence based on a misreading, by the appellate court in TWM v. Dura, of the basis for the damages award below—an error that was unwittingly perpetuated when later cases cited TWM v. Dura.

Moreover, the “analytical approach” referenced in Lucent v. Gateway is inconsistent with the 1946 legislation that abolished the infringer’s profits remedy and is out of step with contemporary patent damages law.

The Federal Circuit has made great strides in clarifying patent damages law and reining in some of the more glaring abuses. But there are still important issues that need further clarification and guidance by the Federal Circuit. This is one of them.

If patentees continue to shift their attention to the purported “Analytical Approach,” the court may not have to wait long for a case that presents the opportunity to provide that guidance.