Patentee overcompensation and the entire market value rule.

Publication: Stanford Law Review

Publication Date: 01-OCT-07

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COPYRIGHT 2007 Stanford Law School

INTRODUCTION



I. PATENT DAMAGES FOR COMPONENT INVENTIONS A. General Standards for Patent Infringement Damages B. The Apportionment Requirement C. The Evolution of the Entire Market Value Rule II. THE CASE FOR MODIFYING THE ENTIRE MARKET VALUE RULE A. An Economic Model of Patentee Compensation 1. A benchmark royalty level 2. Deriving a benchmark royalty level for an entire complex device 3. Two conditions for benchmark level compensation 4. Measuring patentee overcompensation B. Consequences of Patentee Overcompensation 1. Decreased incentive for investment in beneficial activities 2. Royalty stacking 3. Increased incentive for patent trolling 4. Overvaluation as a patent infringement deterrent C. Predictability and Ease of Administration III. THE ENTIRE MARKET VALUE RULE AND COMPLEX ELECTRONIC DEVICES: A CASE STUDY OF PERSONAL COMPUTER SYSTEMS A. Complex Electronic Devices Under Current Entire Market Value Rule Case Law 1. The functional unit test under Rite-Hite and Juicy Whip 2. Consumer demand and anticipation of sales B. Complex Electronic Devices Under a Modified Entire Market Value Rule IV. POLICY RECOMMENDATIONS A. Evidence of Alternative Technologies B. Evidence of Consumer Demand CONCLUSION

INTRODUCTION

Imagine a computer chip composed of millions of transistors and hundreds or even thousands of individually patented inventions. Could just one of those patented components ever account for the entire economic value of the chip? Could just one such invention ever account for the entire value of a total personal computer system--monitor, keyboard, mouse, printer, software, and all--sold along with the chip? While these questions may seem far-fetched, they may soon be answered in the affirmative under a U.S. patent law doctrine known as the "entire market value rule."

The entire market value rule allows for recovery of patent infringement damages based on the value of an entire product or device containing an infringing component, rather than on the value of the infringing component alone, provided that the entire value of the device as a whole is legally attributable to the patented invention. (1) The doctrine can mean the difference between orders of magnitude in potential patent infringement liability, and yet, surprisingly, the rule has been largely ignored by scholars of the U.S. patent system. This Note asks whether the entire market value rule remains a viable doctrine in a world of increasing technological complexity in which new products are generally not covered by a single patent, but instead incorporate many patentable components. While the U.S. patent system was designed primarily on the premise that new inventions would be covered by a single patent, recent advances in technology have ushered in an era of unprecedented complexity and detail in technological innovation. Gone are the days when inventions were primarily simple mechanical devices. (2) Now, the patent system must adapt to accommodate areas of rapid advancement--such as the computing and biotechnology industries--where products sold to consumers consist of numerous components, each of which may itself be a patented invention.

This Note demonstrates that application of the entire market value rule routinely overcompensates patentees and thereby exacerbates many problems inherent in the current system for awarding patent infringement damages. It concludes that the doctrine's current form should be abandoned so that when calculating infringement damages the infringing device's value must always be apportioned between value added by the patent at issue and value attributable to the infringer's own contributions or to the public domain. In addition, it suggests a number of less drastic patent reform measures that, if adopted, can easily correct much of the doctrine's current overapplication. Part I introduces the current state of entire market value rule case law, emphasizing the expansion of the doctrine over time. It explains that, from its modest origins, the doctrine has been expanded far beyond the rationales behind its creation. Part II presents the case for modifying the entire market value rule by identifying how the doctrine frequently overcompensates patentees compared to their contributions to society. It first introduces and develops an economic model that demonstrates the doctrine's overcompensating effect. It then addresses the negative consequences that result when patents are overvalued. These consequences include a chilling effect on innovation and increased incentives for "patent trolling." (3) The Part concludes by explaining how scaling back the entire market value rule would make the doctrine more predictable and easily administrable. Part III explores how the entire market value rule will likely be applied in future patent litigation involving complex electronic devices. Using a hypothetical infringing personal computer system as a case study, it explains that while complex devices will likely be aggressively targeted under current entire market value rule case law, scaling back the doctrine would largely eliminate its overapplication in this beneficial area. Drawing on the economic model introduced in Part II, Part IV suggests patent reform measures that can help counteract the overapplication of the entire market value rule and the problems caused by the overvaluation of patented inventions.

I. PATENT DAMAGES FOR COMPONENT INVENTIONS

The determination of damages for patent infringement is "not an exact science." (4) Section 284 of the United States Patent Act authorizes a patentee who successfully proves that its patent has been infringed to recover profits lost due to the infringer's unlawful conduct, "but in no event less than a reasonable royalty" for use of the patented invention. (5) An award for infringement under section 284 is intended to provide a patentee with "damages adequate to compensate" for the injury it sustained as a result of the infringement. (6)

A. General Standards for Patent Infringement Damages

A patentee's compensation may be comprised of an award for lost profits, a reasonable royalty, or a combination thereof. (7) Lost profits, however, can be hard to show. To obtain lost profits under Panduit Corp. v. Stahlin Bros. Fibre Works, Inc., a patentee must show: (i) consumer demand for the patented product, (ii) sufficient marketing and manufacturing capacity to exploit that demand, (iii) an absence of noninfringing substitutes, and (iv) the dollar amount of profit that it would have made from additional sales absent infringement. (8)

Patentees who cannot meet the Panduit test or who do not sell products covered by their patents may not recover lost profits. Such patent owners are only entitled to the reasonable royalty for which the infringer could have licensed the patent at issue. Mathematically, a reasonable royalty award requires a court to determine first the proper royalty base--the value of the infringing products or activities for which a royalty is owed--and then multiply that value by a royalty rate to calculate the total amount of damages. In setting a reasonable royalty rate for the license of an infringed patent, courts attempt to reconstruct the hypothetical bargain that the parties would have negotiated at the time when the infringing conduct began. (9) To accomplish this task, courts look to a nonexclusive list of fifteen factors first set out in Georgia-Pacific Corp. v. United States Plywood Corp. (10) In particular, courts rely heavily on evidence pertaining to the rates at which the patent owner previously licensed the patented invention. (11) This fictitious negotiation is notably distorted from reality in a number of respects. For example, in reconstructing this ex ante bargain, courts presume that the patent is valid and covers the in(ringer's product (12)--facts that were likely not at all clear prior to the resolution of the infringement suit. Moreover, the very existence of the infringement suit proves that the parties were in fact not able to strike a bargain prior to infringement or at any time afterwards. While counterfactual, these considerations may be necessary to avoid undercompensation. (13)

B. The Apportionment Requirement

Once the finder of fact has decided to award monetary damages, it must determine what compensation base to use in calculating the patentee's lost profits or the reasonable royalty owed by the infringer. When a patent covers an entire infringing product, the royalty base is simply the total value of the sales or uses of the infringing product. (14) However, when the patent at issue covers only a component of or improvement to the infringing item, the value of the sales or uses of that item must be apportioned between the patented invention and the remaining unpatented (15) components. (16) This requirement ensures that a patentee is normally awarded damages in proportion to the value that its patent contributed to the infringing article, and not based on any value attributable to the infringer's own inventions or the prior art.

Courts have long recognized that damages awards should differ depending on whether the patent at issue covers the entire infringing product or instead covers only a component of or improvement to the infringing product. In Seymour v. McCormick, for example, the U.S. Supreme Court reversed an award for infringement of an improvement patent based on the value of an entire machine including the improvement, stating that "it is a very grave error to instruct a jury that as to the measure of damages the same rule is to govern, whether the patent covers an entire machine or an improvement on a machine." (17) The Court recognized that if patent damages were not calculated after apportioning value between the patented invention and the prior art, "the unfortunate mechanic [who sells a complex device] may be compelled to pay treble his whole profits to each of a dozen or more several inventors of some small improvement in the [device] he has built." (18)

C. The Evolution of the Entire Market Value Rule

Under certain circumstances, however, patent law allows the patentee of an invention comprising only a component of or improvement to a larger article to recover lost profit or reasonable royalty damages based on the value of the entire infringing article. (19) This exception to the requirement of apportionment is known as the "entire market value rule." (20)

As originally conceived, the entire market value rule was not so much an exception to the apportionment requirement as a term of art used to explain away the need for apportionment when a patented component accounted for the entire value of a larger infringing item. (21) In such a scenario, apportionment is not necessary because the entire value of the sales or uses of the infringing article is attributable to the patented invention. The doctrine traces its roots back to Garretson v. Clark, in which the U.S. Supreme Court implicitly suggested that such a rule might exist, while actually emphasizing the need to apportion damages. (22) The Court first stressed the need for apportionment, stating that "[w]hen 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 ... [and] separate its results distinctly from those of the other parts, so that the benefits derived from it may be distinctly seen and appreciated." (23) Only then did the Court go on to favorably quote the opinion below:

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; or he must show, by equally reliable and satisfactory evidence, that the profits and damages are to be calculated on the whole machine, for the reason that the entire value of the whole machine, as a marketable article, is properly and legally attributable to the patented feature. (24)

Thus, in Garretson the Court merely acknowledged that to properly award damages, the value of the patented invention must be dissociated from the value of the unpatented components of the infringing article or the patented invention must be shown to account for the entire market demand for the infringing article. Accordingly, at the time of its formulation, the "entire market value rule" simply allowed a patentee whose patent covered only a component of or improvement to an infringing article to recover damages based on the entire value of that article, provided that the patentee could show that sales of the article were properly attributable to the patented invention alone.

Soon after, however, courts began to expand the entire market value rule from its role as a special case of the rule of apportionment into a full-fledged exception to the apportionment requirement. In Westinghouse Electric & Manufacturing Co. v. Wagner Electric & Manufacturing Co., for example, the Supreme Court incorporated the entire market value rule into a burden-shifting framework for proving damages, ruling that if apportionment was "impossible" the doctrine should be applied to award damages based on the value of the whole infringing article. (25) While this framework for damages calculation was ultimately abandoned after the enactment of section 284, (26) the Court openly displayed a willingness to allow for the compensation of patentees beyond the proven value of their inventions.

Despite attempts to lessen the burden of apportionment, application of the entire market value rule remained firmly tethered to the market demand attributable to the patented invention into the 1980s. In Leesona Corp. v. United States, for example, the Court of Claims reiterated that under the entire market value rule the determining factor in inclusion or exclusion from the compensation base is the "financial and marketing dependence [of the unpatented components] on the patented item." (27) In Leesona, the court awarded damages based on the entire value of a portable, rechargeable battery system, including unpatented anodes, cathodes, and battery covers. (28) The court agreed with the patentee that these unpatented items "derive[d] their utility and value from the patented invention." (29)

In the 1980s and 1990s, however, the Federal Circuit significantly expanded application of the entire market value rule beyond the ambit of consumer demand for a single, discrete device to allow for the recovery of damages based on any functionally related items foreseeably sold along with infringing articles. In Paper Converting Machine Co. v. Magna-Graphics Corp., the Federal Circuit awarded damages based on the entire value of high-speed...

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