Entire Market Value analysis blasted in Red Hat reasonable royalty case

IP Innovation LLC v. Red Hat, Inc., 2010 WL 986620 (E.D. Tex.)(March 2, 2010)

The plaintiffs patented a workspace switching feature and then accused the defendants of using it in their operating systems. The plaintiffs retained an expert to calculate damages based on a reasonable royalty rate. (Because the plaintiff does not manufacture or sell products incorporating its patents, it did not seek lost profits damages.)

The plaintiffs’ expert employed the “entire market value rule” to identify and calculate the reasonable royalty base. Under this rule, damages are recoverable only if the patented features are of “such paramount importance” that they serve as the basis for customer demand of the entire product. Invoking the entire market value rule, the plaintiffs’ expert included 100% of the defendants’ total revenues from sales of subscriptions to their operating systems, which included the workspace switching feature, in calculating his proposed royalty rate base. He relied on an online user forum for a third-party product (not the defendants’) to show that some users touted a desktop switching feature as essential.

The defendants moved to strike the expert and his report under Rule 702 of the Federal Rules of Evidence and the Daubertstandard, claiming his reasonable royalty analysis lacked “sound economic and factual predicates.”

Patented invention but one small feature. In a rather scathing opinion, the U.S. District Court (E.D. Texas) first noted that the plaintiff’s patented workspace switching feature represented “only one of over a thousand components included in the accused products.”  By relying on the data from the online forum, the plaintiff’s expert “selected users’ statements in isolation and without a relationship to the actual claimed technology,” the court said. This did not show an accurate economic measurement of total market demand for the switching feature ”let alone its contribution to the demand for the entire produce asserted as the royalty base.” The expert failed to consider the relative importance of other operating system features, such as security, interoperability, and virtualization, the court added. “Moreover, this proffered evidence has no economic foundation.”

In particular, evidence suggested that users did not buy the accused operating systems for their workspace switching feature. The majority of the defendants’ sales come from their server products, which are not connected to a display and do not use the patented feature; some systems are even sold with a default setting that disables the feature. The plaintiffs’ expert failed to factor out these server products from his reasonable royalty calculations—a “blatant oversight,” the court said.  “In fact, he made no effort to even discern the percentage of users who would never enable or use the claimed feature.”

This “questionable” aspect of his analysis showed “inattention to the economic and factual data necessary for a reliable assessment of a compensatory royalty,” the court held. Overall, the expert never accounted for evidence that most users did not use the workspace switching feature at all. Accordingly, his conclusions that the oft-unused feature drove demand for a royalty base of 100% of the defendants’ operating systems were unfounded. “In sum, this stunning methodological oversight makes it very difficult for this court to give any credibility to [the expert’s] assertion” that the patented feature is the basis for customer demand.

Expert could have used better reasonable royalty data. The plaintiffs tried to shift the blame to the defendants, complaining that they did not provide sufficient information to the expert to determine the separate value of the desktop switching feature—but lack of documentation was no excuse, the court held, and it insisted that the plaintiffs carry their burden of proving reasonably royalty rate damages. The plaintiffs’ expert must show “some plausible economic connection between the invented feature and the accused operating systems before using the market value of the entire product as the royalty base.”

Another problem: Instead of referring to the licensing agreements—which were 10 years old (and thus out of date), the plaintiffs’ expert used a 2004 consultant’s study indicating an average royalty rate for the entire software industry of 11.6% of revenues, with a median of 7.5%. A second consultant’s study examined the computer and electronics manufacturing industry and found royalty rates ranging from 1.0% to 40% of revenues, with a median of 6% and a mean of 10.2%.

However, these studies encompassed much more than the desktop switching feature at issue in this case, the court found. The expert offered no evidence.