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Getting To The Core: An Alternative Method For Determining A Reasonable Royalty by Michael A. Einhorn, Ph.D.

By: Michael A. Einhorn, Ph.D.

Recent decisions in the Federal Circuit has greatly limited the use of analytic techniques that  experts in patent litigation may use to determine a reasonable royalty due to an infringed patent.  In ResQNet v. Lansa, 594 F. 3d 860 (Fed. Cir. 2010),  the Court disallowed expert testimony that proffered as remedy a royalty rate that was based on benchmark rates drawn from contracts that involved  “similar” patents for technologies that were nonetheless not in suit.  In Uniloc USA, Inc. v. Microsoft Corp., 632 F. 3d 1292 (Fed. Cir. 2011), the Court disallowed expert testimony that based royalty rates upon a 25% partition of defendant profits that was purportedly drawn from general industry results.  A number of expert reports have since been disqualified since the Federal Circuit handed down these decisions.

How now to determine a reasonable royalty? Let’s first consider some economics – beginning with the Edgeworth curve, a time honored concept in professional economic theory first set forth in the 1800s by Francis Ysidro Edgeworth.

The Edgeworth curve (or core) is a series of price points at which a willing buyer and a willing seller may engage in a mutually beneficial exchange. If a car dealer would sell a particular auto  for no less than $20,000 and a car buyer would pay no more than $25,000 for the same vehicle, the spectrum between the maximal and minimal endpoints would be the core.

From an economist’s standpoint, any price in the core could pass the fifteenth standard of Georgia Pacific — i.e., the amount that a licensor and licensee would have agreed upon if both had been trying to reach an agreement. Georgia Pacific Corp. v. United States Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1979). Indeed, some experts have gone so far to attempt to present one point on this spectrum, the Nash equilibrium point, as the unique acceptable outcome. However, the Nash equilibrium is no more than a stylized academic concept that cannot be tested in a real world negotiating situation.  And the Federal Circuit has so recognized this deficiency!

What then should an expert do to derive a reasonable royalty for a hypothetical negotiation?  Let’s consider the outcome in Mitutoyo Corp. v. Central Purchasing, 499 F. 3d 1284 (Fed. Cir. 2007).  Based on the prospective profit margins (i.e., price – cost) of a product bearing a patent-in-suit, the District Court determined that that the most that the Defendant would have paid for a patent license would have been seventy percent of its sales revenues. By the same process, the least that the Plaintiff would have accepted is thirty percent. When the court opted for one point — thirty percent –, the Federal Circuit upheld.  Id. at 1290.

With more analytic elaboration, any point between 30 and 70 is on the Edgeworth curve, and so a potential resultant in a transactional outcome. The case of Georgia Pacific presents fifteen possible influential factors, supra. For example, royalty outcomes would be higher for exclusive uses (Factor 3) and longer license terms (Factor 7).

But there is no plausible weighting of these factors to advance a unique outcome. Rather, an expert may assess the bearing of each factor, as well as any others that come to mind.  The jury must use its own judgment to weight each factor subjectively, and so determine the appropriate remedy.

The expert can legitimately present a breakdown of the curve by weighted deciles; weights for the endpoints may be 90/10, 80/20, …. 50/50, 20/80, 10/90.  The jury may use its judgment to select from the spectrum, perhaps 50/50, perhaps not.  More to the point, engaged lawyers may come to settle the case based on this construction, quite conceivably at 50/50.

This presents to an economist a practical way out of the royalty measurement quandary without stretching him/her beyond professional capability. Consistent with professional practice, the expert finds high points and low points for the royalty range of the core.  But the expert does not go so far to choose any one outcome — Nash equilibrium or otherwise. This modification of Georgia Pacific is preferable to the use of benchmark licenses of technologies not in suit, as these measures may be excluded before trial.

Michael A. Einhorn, Ph.D. is an economic consultant and expert witness in the areas of intellectual property, media, entertainment, technology, cyberspace, , and product design. Dr. Einhorn is the author of Media, Technology, and Copyright:  Integrating Law and Economics  (Edward Elgar Publishers, 2004). He is also a former professor of economics at Rutgers University  a Senior Research Fellow at  the  Columbia Institute for Tele-Information, and the author of seventy professional and academic articles related to intellectual property and economic analysis.  More detail on this topic can be found at his recently published article  Copyright, Causality, and the Courts and “Copyright Settlement Strategies from a Damages Expert”.

Dr. Einhorn may be reached at mae@mediatechcopy.com, 973-618-1212.