The Proper Royalty Base for Patent Damages
How should a court determine the proper royalty base when calculating either reasonable-royalty damages for patent infringement or fair, reasonable, and nondiscriminatory (FRAND) royalties for infringement of, or licensing disputes over, standard-essential patents (SEPs)? This determination is particularly challenging in the context of a multi-component device, such as a smartphone. It is established patent jurisprudence that a reasonable royalty should reflect the terms of a hypothetical license resulting from a voluntary negotiation between a willing licensor and a willing licensee at the moment just before first infringement. In real-world patent negotiations, firms often calculate royalties with reference to the retail price of the downstream product. Therefore, using that downstream retail price as the royalty base is the most authentic assumption about the royalty base that a court could use for a hypothetical negotiation between a willing licensor and a willing licensee. Nonetheless, as a result of a recent series of confusing and contradictory opinions, the Federal Circuit in all but exceptional cases now decidedly favors using, for purposes of the hypothetical negotiation, a royalty base equivalent to the price of the infringing product’s “smallest salable patent-practicing component” instead of the “entire market value” of the product. In cases where the downstream product is the “smallest salable patent-practicing component” and unpatented features constitute a substantial proportion of the product, the Federal Circuit favors subtracting the value of these unpatented elements from the royalty base. This development in the law of the entire market value rule (EMVR) has perverse consequences that the Federal Circuit has yet to recognize. Using the price of the smallest salable patent-practicing component as the royalty base risks undercompensating the patent holder, because it ignores (1) the effects that the patented technology has on the value of the downstream product and (2) the value that synergies between complementary technologies create. A more complete economic approach would account for such complementarity effects by permitting the use of the retail price of the downstream product as the royalty base. The Federal Circuit’s choice of royalty base in its EMVR jurisprudence seems based on a theory that juries tend to overcompensate patent holders due to cognitive bias. However, the Federal Circuit fails to explain the logic and limits of its concern over cognitive bias. It therefore fails to justify its preference for the smallest salable patent-practicing component and risks undercompensating patent holders. Finally, I show that risk-averse firms should prefer structuring damages awards in a manner that reduces errors. This analysis of risk bearing indicates that, if a royalty with a low rate and high base is more accurate than one with a high rate and low base, courts should use the EMVR when awarding damages. The Federal Circuit’s jurisprudence on patent damages currently ignores this concern.