Guidelines and Analysis

Mark A. Glick
Lara A. Reymann
Richard Hoffman

John Wiley & Sons, Inc.

INTELLECTUAL
PROPERTY DAMAGES

INTELLECTUAL
PROPERTY DAMAGES

Guidelines and Analysis

Mark A. Glick
Lara A. Reymann
Richard Hoffman

John Wiley & Sons, Inc.

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Copyright . 2003 by John Wiley & Sons, Inc. All rights reserved.

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Library of Congress Cataloging-in-Publication Data

Glick, Mark A.

Intellectual property damages : guidelines and analysis / Mark A. Glick,
Lara A. Reymann, Richard R. Hoffman.

p. cm.
Includes index.
ISBN 0-471-23719-1 (cloth : acid-free paper)

1. Intellectual property—United States. 2. Actions and
defenses—United States.
II. Hoffman, Richard R.
KF2983 .G58 2003
346.7304′8—dc21
3. Damages—United States.
III. Title.
I. Reymann, Lara A.
2002014438
Printed in the United States of America
109876543 21

ABOUT THE AUTHORS

Mark A. Glick has a Ph.D. in economics and a J.D. in law. He is a professor of
economics at the University of Utah Department of Economics, where he teaches
law and economics and industrial organization. He also serves as Of Counsel with
the law firm Parsons Behle & Latimer, where he practices in the areas of intellectual
property and antitrust. He is a graduate of UCLA, The New School for
Social Research, and Columbia University.

Lara A. Reymann is a member of the Litigation Department at Parsons Behle &
Latimer, where she practices intellectual property law. Ms. Reymann graduated
cum laude from Dartmouth College with a B.A. in government and a minor in
philosophy. She received her J.D. with honors from the University of Chicago
Law School, where she worked in the Mandel Legal Aid Clinic for several
years.

Richard Hoffman is a director at LECG with over 12 years of experience in accounting
and consulting. He is a CPA and is Accredited in Business Valuations. Rick
worked at international accounting firms for approximately 10 years before joining
LECG in 2000. He also has been an adjunct professor at the University of Utah.

Acknowledgments

T
T
he authors acknowledge the contribution of several colleagues, academics,
experts, and lawyers. The IP/Antitrust group at Parsons Behle & Latimer provided
valuable input into the chapters on litigation and the patent and antitrust interface.
In particular, Raymond Etcheverry, David Mangum, and Kevin Speirs have been
mentors and helped the authors appreciate the importance of damages in intellectual
property cases. Also, several patent lawyers and specialists in trademark and copyright
law reviewed and commented on the substantive chapters on IP law, in-cluding
Margaret McGann, Bill Evans, and Vanessa Pierce. Moreover, we are indebted to individuals
outside our respective firms who reviewed chapters within their substantive
specialties and provided vital insights. These individuals include Dr. Duncan Cameron,
economist with LECG’s Los Angeles office; Dr. Mike Lemmon, finance professor at
the University of Utah; and Steve Stauffer of PricewaterhouseCoopers. Ted Tatos,
Dianna Gibson, Roger Smith, and Laura McNichols also assisted in the development
and revision of the book. The authors also express appreciation to Robert
Goldscheider for his valuable help and thoughtful introduction. Any mistakes or errors
are our own.

Finally, the authors thank their respective spouses, without whose extreme tolerance
and support there would be no book.

Contents

Preface xv
Introduction by Robert Goldscheider xvii

PART ONE: LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS
OF INTELLECTUAL PROPERTY DAMAGES 1

CHAPTER 1—THE LITIGATION PROCESS 3

Structure of the Court System 3
The Complaint 6
The Answer 8
Attorneys’ Meeting and Protective Orders 8
Discovery 10
Expert Disclosures 14
Expert Reports 16
Expert Depositions 16
Motion Practice 17
Trial 18
Court Opinions 19
Litigation Versus Alternative Dispute Resolution 19
Summary 22

CHAPTER 2—DAMAGE PRINCIPLES AND DAUBERT 27

Daubert Issues 27
Making Sense of Daubert 29
Damage Analysis in General in Light of the
Substantive Case Law on Damages 34
Summary 40

CHAPTER 3—INTRODUCTION TO THE ECONOMICS OF
INTELLECTUAL PROPERTY DAMAGE CALCULATIONS 43

A Brief Review of Basic Economics 43
The Industrial Organization Foundations of Intellectual Property Damages 46
The Direct Approach: Econometrics 54
The Law and Economics of Bargaining 61
The Economics of Intellectual Property 62
Summary 69

ix

CONTENTS

CHAPTER 4—INTRODUCTION TO ACCOUNTING PRINCIPLES
IN INTELLECTUAL PROPERTY DAMAGES 73

Introduction to Financial Statements 73
Cash Basis 74
The Accrual Method 76
The Financial Statements 77
The Income Statement—Also Called a “Profit/Loss Statement” 77
Balance Sheet 79
Cash Flow Statement 83
The Role of Standards in Financial Statements 83
The Accounting Cycle 85
All Financial Statements Are Not Created Equal 91
Audited Financials 92
Significant Dates Identified in the Report 92
Different Audit Opinions 93
Management Representation Letter 94
Summary of Proposed Adjustments 95
Adjusted Trial Balance 95
Debt Covenant Compliance 95
Financial Statement Trend Analysis 96
Detail of Accounts 97
Summary 99

CHAPTER 5—FINANCIAL PRINCIPLES USED IN
INTELLECTUAL PROPERTY DAMAGES 101

Preliminary Issues 101
Valuation Approaches 104
The Market Approach 113
The Cost Approach 118
Summary 119

PART TWO: PATENT INFRINGEMENT DAMAGES 121

CHAPTER 6—INTRODUCTION TO PATENT LAW 123

A Brief History 123
Description of a Patent 124
The Subject Matter of Utility Patents 125
The Standards of Patentability 127
Patent Infringement 132
Summary 135

CONTENTS

CHAPTER 7—HOW TO CALCULATE PATENT DAMAGES 139

The Patent Statute 139
The Choice Between Lost Profits and Reasonable Royalties 140
Lost Profits 141
The Calculation of Incremental Profits 147
The Damage Period 148
Price Erosion 148
The Entire Market Rule 150
Reasonable Royalty 151
Summary 160

CHAPTER 8—INTRODUCTION TO THE ANTITRUST LAWS 169

The Historical Foundations of the Antitrust Laws 169
The Goals of the Antitrust Laws 175
Antitrust Claims Under Section 1 of the Sherman Act 177
Antitrust Claims Under Section 2 of the Sherman Act 193
Antitrust Claims Under the Clayton Act 195
Summary 195

CHAPTER 9—THE INTELLECTUAL PROPERTY–
ANTITRUST INTERFACE 207

Background 207
Overlap of Patent and Antitrust Principles 209
Antitrust Law and Specific Patent Practices 210
Summary 215

PART THREE: COPYRIGHT, TRADEMARK, AND
TRADE SECRET DAMAGES 219

CHAPTER 10—INTRODUCTION TO COPYRIGHT LAW 221

A Brief History of Copyright Law 221
Standards for Copyright Protection 222
Subject Matter of Copyrights 227
Publication 235
Copyright Formalities 236
Ownership 236
Copyright Holder’s Rights 237
Infringement 238
Copyright in the Digital Age 240
Fair Use Defense 241
Summary 243

CONTENTS

CHAPTER 11—INTRODUCTION TO TRADEMARK LAW
AND TRADE SECRET LAW 253

Brief History of Trademark Protection 253
Types of Marks 254
Primary Classifications of Trademarks 256
Trade Dress 261
Priority 263
Infringement 264
Trademarks and Domain Name Disputes 270
Dilution and Reverse Confusion 275
Summary of Trademark Law 280
Introduction to Trade Secret Law 281
What Is a Trade Secret? 281
Factors Indicative of Trade Secrets 283
Typical Protectable Trade Secrets 286
Information Not Protected as a Trade Secret
and Treatment of Confidential Information 286
Misappropriation of Trade Secrets 287
Summary of Trade Secret Law 288

CHAPTER 12—MISUSE OF COPYRIGHTS, TRADEMARKS,
AND TRADE SECRETS 297

Copyright Misuse 297
Defenses to Copyright Misuse 301
Trademark Misuse 304
Trade Secret Misuse 308
Summary 309

CHAPTER 13—HOW TO CALCULATE COPYRIGHT,
TRADEMARK, AND TRADE SECRET DAMAGES 315

Copyright Damages 315
Trademark Damages 328
Trade Secret Damages 334

CHAPTER 14—THE NUTS AND BOLTS OF INTELLECTUAL
PROPERTY DAMAGE CALCULATION 349

The Process of Determining Whether the Proper Damages Consist
of a Reasonable Royalty, Lost Profits, or a Combination of Both 349
Calculating Lost Profits 353
Calculation of a Reasonable Royalty 361
Summary 367

CONTENTS

PART FOUR: APPENDICES 369
A Sample Requests for Production of Documents and Interrogatories 371
B Sample Expert Report of John Smith 377
C Antitrust Guidelines for the Licensing of Intellectual Property 385
D Sample Patent 417
E United States Code (U.S.C.) Title 35—Patents 427
F Copyright Act of 1976 435
G Trademark Act of 1946 (“Lanham Act”), as Amended 449
H Uniform Trade Secrets Act with 1985 Amendments 459
I Restatement of the Law, 3rd, Unfair Competition 463

Index 469

Preface

T
T
his book arises from the authors’ collective experience acting as damage experts
and managing damage experts in intellectual property (IP) cases. In case after case
we have observed that the damage portion of IP litigation is treated as a neglected
stepchild. This failure to prioritize construction of a damage theory is curious since so
much rides on each side’s evaluation of damages, both for settlement purposes and for
trial preparation. Since it is so typical to allocate insufficient resources and inadequate
attention to damages, lawyers know little about how to effectively use their own experts
and undermine opposing experts, and the experts themselves do not possess the necessary
background in IP to be effective. This uneducated state precludes informed analysis
of IP litigation, including the decision of whether to litigate at all, what possible
outcomes to anticipate, and what terms or financial compensation might constitute a
reasonable settlement.

Over the years the authors have sought to fill this vacuum, first within their (two
authors) own law firm and then more generally. We have taught IP damages classes
for the National Association of Valuation Analysts, given presentations to numerous
law firms, and instructed economists at the University of Utah in the law and economics
program where Mark Glick is a professor. This book represents our attempt to systematize
the general knowledge that experts and lawyers need to have in order to be effective
in evaluating, presenting, and opposing damage claims in IP cases.

There are several implicit themes that run throughout this text. It may be useful to
recognize these themes at the outset to establish a context for the following chapters.
Initially, we are not concerned at all with issues such as how to answer questions in a
deposition. An informed, honest expert will have little problem with learning basic
litigation skills. Of greater moment for any expert is a firm grasp of the necessary substantive
knowledge. The deficiencies experts often display are, in part, a consequence
of the departmentalization of most business schools in the United States. For example,
there is not one question concerning calculating future sales on the CPA exam, and standard
accounting programs do not offer any courses that prepare their majors for litigation
support. However, there is a vast industry of accountants in the litigation support
area, and lawyers typically uncritically rely on these experts for their damages cases.
In contrast, economists are trained in microeconomics and econometrics (statistics
applied to economics), a skill set remarkably compatible with judicial precedent on
damages. Yet nothing in an economics Ph.D. program will prepare an economist to
effectively guide attorneys in the discovery process, or understand the structure of the
books and records of the company, or even how to apply their economic training in
the specific IP context. Financial economists are yet another breed. Finance programs

xv

xvi PREFACE

teach valuation principles, discounting, and risk analysis (i.e., all of the mechanics of
the damage calculation). But none of these skills will have any value in litigation unless
the attorneys provide the right information, effectively relate to the expert the judicial
requirements for the analysis, and manage and combine the right skill sets for each case
situation. In short, our experience is that success in an intellectual property damage
case requires experts with complementary skills, combined with attorney instruction
and management.

In the chapters that follow, we hope to provide experts and lawyers with what they
need to know about intellectual property law and intellectual property litigation in order
to be effective in their roles. Some chapters will be more relevant for some than others.
For example, Chapters 1 and 2 on litigation and Daubert cover material many attorneys
are likely to be familiar with, while nonlawyer experts are less likely to have been
exposed to these topics. Experts, on the other hand, may consider skipping some of
the chapters on economics, finance, and accounting, while lawyers should read those
chapters carefully in order to understand what information and evidence their experts
will require in order to be effective. Attorneys also may be more interested in the factors
that determine potential damages than in the equations necessary for the actual
calculations. In short, the chapters will vary in their direct applicability to the roles
of experts and attorneys in an intellectual property damage case. However, gaining an
increased understanding of the skills and knowledge that each team member will bring
to the table can only benefit the entire litigation enterprise. Finally, because this book
cannot substitute for formal training and experience, we provide suggestions for additional
reading so that any specific topic can be studied in greater depth.

Introduction

I
I
t is a pleasure and an honor for me to write some introductory remarks about this
book, which deals with the fruits of innovation and which is, itself, innovative.
As an active practitioner for over 40 years in the law and business based on intellectual
property, and someone who believes that professionals should make scholarly contributions
to their chosen specialties, I am able to appreciate this excellent collaborative
effort. In my opinion, this is an important new source of insights and information about
this dynamic subject.

This has been an ambitious project with a broader focus than most works in this
area. It contains the most complete and lively analysis about damages from patent
infringements. In addition, it is the only book I know that contains parallel analysis of
the key issues in assessing damages for the misuse of copyrights, trademarks, and trade
secrets. Inasmuch as the majority of technology-related business today involves the
employment of many, if not all, of these intellectual property rights, this multifaceted
commentary is very pertinent.

The authors do not address these core issues in a vacuum. They provide a succinct
and well-written historical background about intellectual property and the arenas in
which disputes are litigated and resolved. They also discuss the antitrust laws and their
interface with intellectual property. Furthermore, their methodology combines theoretical—
sometimes rising to philosophical—discussions of many relevant matters,
together with “nuts and bolts” solutions and vivid examples.

Because of his background as a university professor of economics as well as a litigating
lawyer, Mark Glick has the qualifications to discuss current legal and economic
issues in combination, taking into account his firsthand practical experience. Accounting
skills to help determine lost profits and reasonable royalties are invariably necessary in
these disputes. It was therefore astute that Richard Hoffman, an able CPA who specializes
in these matters, has been included in the team of authors. Mark and Richard frequently
collaborate successfully on matters of this sort. Their integrated inputs are much appreciated.
Lara Reymann, who combines youth, enthusiasm, thoroughness, and high intelligence,
has also played a continually catalytic role in this project.

Since this book covers legal, business, and accounting matters, it should be appreciated
by a wide audience. I believe senior corporate executives, IP litigating attorneys,
whether or not they are patent lawyers, and students should all be able to gain considerable
knowledge from exposure to this work product. Other members of the bar and
bench will also find useful material herein.

xvii

INTRODUCTION

This book is well organized and capable of being read through by someone new to
intellectual property who is motivated to get more than a superficial grasp of IP. The
book can also be effectively employed as a reference and research tool.

Without wanting to sound avuncular, I believe that Mark, Rick and Lara have
succeeded in creating a fine addition to the literature in their chosen field. I therefore
hope that these three ambitious people will not relax their grip on the “controls” of the
“vehicle” they have worked so hard to research, write, and edit. I look forward to regular
updates of their scholarship in the future.

Robert Goldscheider
East Hampton, New York
July 2002

Part One

Legal, Economic,
and Financial
Foundations
of Intellectual
Property Damages

1

The Litigation Process

Although litigators will be familiar with much of the content of this chapter, nonlawyers
often have only a vague understanding of the legal process involved in enforcing intellectual
property (IP) rights. Economists, accountants, and financial economists who
wish to increase their value as members of an IP litigation team should understand the
general structure and chronology of the litigation process to anticipate how they will be
involved at each stage. An expert who understands the overall theory of the case, as well
as the means of developing and presenting that theory at various stages of litigation,
exponentially increases his or her value to the litigation team. A basic knowledge of the
litigation process is therefore integral to an expert’s ability to contribute effectively
throughout litigation.

Intellectual property litigation involves teams of individuals with various areas of
expertise. A typical IP case might require attorneys, economists, accountants, experts in
the relevant field (e.g., computer science), and the necessary support staff. The more
that each participant understands about his or her role and the expected contributions
of the other team members, the more effective each participant will be during litigation.
Commonly, there will be an overlap between the individual roles, and team members
should be ready to question and supplement each others’ theories as the case progresses.

STRUCTURE OF THE COURT SYSTEM

Litigation can take place either in state court or in federal court. Intellectual property
cases (with the exception of trade secret cases) typically occur in federal court, primarily
because patents, copyrights, and, to a large extent, trademarks are governed by federal
statutes. Since there is no federal trade secret statute, trade secret law varies from
state to state and is litigated in both federal court and state court. The litigation process
in federal court is governed by the Federal Rules of Civil Procedure (FRCP). This

3

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

means that the admissibility and form of depositions and live testimony are determined
under the FRCP and the Federal Rules of Evidence (FRE). Each state has its own rules
of civil procedure and evidence that govern actions filed in state court. Typically, these
state rules are similar (but not identical) to their federal counterparts.

Federal litigation begins at the district court level, often referred to as the trial courts.
District courts can hear both criminal and civil cases. There are 93 federal judicial districts
in the United States; each state has at least 1 federal district court, and the states
that tend to have more federal litigation have several districts. For example, New York
has 4 federal districts. Moreover, each district may have multiple judges. The bench
for the Southern District of New York, one of the busiest districts in the country, has
25 judges. In contrast, the bench for the District of Wyoming has 3 judges.

State court structures are less uniform. State trial courts are known by various names,
depending on the particular state. Many states refer to their trial courts as district courts,
while other states have titled their lowest level of courts superior courts (California) or
even supreme courts (New York). Generally, state trial courts are organized along
county lines, with the number of courts varying according to the population and litigation
needs of the relevant geographic area.

If either party decides to appeal a final judgment from the trial court, the litigation proceeds
to the appellate courts. Unlike trial courts, which almost always consist of a single
judge and possibly a jury, appellate courts are made up of a panel of judges and never
involve a jury. The federal appellate courts are divided into 13 circuits, 10 sequentially
numbered circuit courts, plus the circuit court for the District of Columbia; each circuit
handles the appeals for a geographic region of the country. For example, the Court of
Appeals for the Tenth Circuit (referred to simply as the Tenth Circuit) hears appeals
from federal district courts in Utah, Wyoming, Colorado, New Mexico, Kansas, and
Oklahoma. A circuit court typically will have a panel of three judges decide a case,
although the entire court may hear the appeal for particularly significant cases. When all
of the circuit judges hear a case, the resulting decision is referred to as an en banc ruling.

Patent appeals are handled by a specialized federal appeal court known as the United
States Court of Appeals for the Federal Circuit, or simply the Federal Circuit. In 1909,
the Court of Customs and Patent Appeals was created to handle certain customs and
patent matters. The Court of Customs and Patent Appeals was abolished in 1982 and
was completely replaced by the Federal Circuit. According to federal statute, the
Federal Circuit is the exclusive court of appeals for patent decisions from district
courts.1 Federal district court opinions in patent cases are appealed directly to the
Federal Circuit, bypassing the normally assigned circuit court for that region. Opinions
issued by the Federal Circuit are binding on all federal district courts, regardless of
where they are located. Additionally, the Federal Circuit has exclusive jurisdiction
of appeals from decisions of the Patent and Trademark Office (PTO) Board of Patent
Appeals and Interferences relating to patent applications and interferences.2 For example,
the Federal Circuit can hear appeals from the PTO Board’s rejection of certain

THE LITIGATION PROCESS

claims. The Federal Circuit’s decisions can be reviewed only by the United States
Supreme Court.

The Federal Circuit (and the Court of Customs and Patent Appeals before it) was created
because of a perceived need for patent disputes to be heard on appeal by judges
well versed in the technical aspects of patent law. By providing a single forum for
appeals of patent matters, the Federal Circuit strives to achieve uniformity in the exposition
and application of substantive patent law. Although patent appeals are heard only
by the Federal Circuit, the Federal Circuit’s appellate review is not limited to patent
issues. In fact, many nonpatent issues are heard on appeal by the Federal Circuit, primarily
when such issues are present as a separate question within a patent case.3

Like all appellate courts, the Federal Circuit is not bound by the trial court’s reasoning
in evaluating the judgment being appealed.4 A flaw in the trial court’s reasoning is
insufficient grounds for reversal when the court ultimately reached the correct result.5
Generally, appellate courts will not second-guess the trial court’s determinations on
issues exclusively within the trial court’s discretion, such as evaluations of witness credibility.
6 A trial court’s determination that one expert’s testimony and analysis is more
credible than that of the opposing expert is a matter within the discretion of the trial
court.7 The Federal Circuit repeatedly emphasizes in its opinions that it reviews decisions,
not phrases in an opinion, expressions, passing comments, or mere dicta (statements
within an opinion that are not relied on in the court’s findings). A difference in
opinion as to the correct philosophical approach is not critical unless it has resulted
in an improper result. However, if the analysis reflected in an opinion is so hopelessly
flawed that the true basis for the judgment cannot be determined, or if it appears to have
a clearly erroneous factual basis, then the lower court’s opinion may be reversed.8

The Federal Circuit’s review of PTO Board decisions is based on the record testimony
and evidence presented to the PTO. If the PTO Board’s decision affirmed a
patent examiner’s rejection of an application generally, without identifying or reviewing
a particular ground on which the examiner relied, that ground is assumed to be
affirmed. Accordingly, the Federal Circuit will consider such a ground in its review.

All appellate courts have the authority to affirm, modify, or vacate a trial court’s decision.
Moreover, if the appellate court determines that additional action must be taken,
the appellate court may remand the case to the trial court with specific directions or
guidelines as to the necessary findings or calculations that must be done. A remand
returns the case to the lower court’s jurisdiction. Because a remand involves an additional
commitment of judicial resources at the trial court level, it is not a decision that
is taken lightly by appellate courts. Ordinarily, where a trial court errs in applying a
legal standard (such as a stricter burden of proof than is warranted), the appellate court
may remand to permit reconsideration under the proper standard. However, if the record
before the appellate court indicates that there is no question as to what the result would
be on remand, the appellate court can simply correct the error and issue a final decision
itself. In contrast, if the lower court must make additional findings of fact to support the

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

decision, remand is appropriate. For example, if a district court determines that attorneys’
fees are not appropriate, but the appellate court concludes that the prevailing party
should be awarded attorneys’ fees, a remand probably is necessary for the trial court to
determine the proper amount of attorneys’ fees. In general, a remand is required if the
information necessary for the appellate court’s decision is not apparent from or contained
in the record.

Appeals from the state trial courts progress to the appellate courts, or courts of
appeal. Some states only have one level of appellate review—typically the state
supreme court. However, at least one-third of the states now have two levels of appellate
review, that is, an intermediate appellate court that hears appeals from the trial
courts and a higher court that selectively hears appeals from intermediate court decisions.
The initial appeal is called an appeal “as of right,” while an appeal to the higher
court generally is a “discretionary” right to judicial review.

The culmination of the federal and state appeals process is the United States Supreme
Court. The United States Supreme Court has discretion to review certain appeals from
both the highest level of state courts and the federal appellate courts. If the Court
decides to hear an appeal, it is said to have “granted cert.,” a shorthand reference for the
decision to review a lower court’s decision. There are nine justices on the United States
Supreme Court, and all of them hear each appeal (unlike the panels that hear appeals
on the circuit court level). Most cases never reach the United States Supreme Court, due
in part to the low odds of the Court deciding to hear an appeal. The odds of the Court
granting “cert.” on a particular case hover around 1 in 10.9 This does not take into
account the external factors that affect the number of cases submitted to the Court for
review, such as limited resources to fund the expense of protracted litigation, mootness
of particular issues after the length of time it would take to reach the highest court, and
sheer frustration with the litigation process.

THE COMPLAINT

An IP lawsuit, like any other litigation, begins with the filing of a complaint. The party
who files the complaint with the court is known as the plaintiff, while the party against
whom the complaint is filed is the defendant. There may be multiple defendants and/or
multiple plaintiffs in any particular case.

In some instances, multiple plaintiffs may desire to join their claims together in what
is known as a “class action.” A “class” of plaintiffs must satisfy four primary legal
requirements before they can be certified by a trial court to proceed as a single action:

(1) numerosity (there must be a substantial number of class members, too many to deal
with by simply joining them as additional plaintiffs); (2) commonality (common questions
of law or fact must exist and, in some types of class actions, predominate over any

THE LITIGATION PROCESS

questions affecting only individual class members); (3) typicality (the class representative,
i.e., the plaintiff present in the courtroom whose identity is known, must be part of
the class and must possess the same interest and suffer the same injury as the class
members); and (4) representativeness (the parties present must adequately represent the
interests of absent class members who may be bound by the judgment reached therein).
Additionally, the plaintiffs must satisfy the court that the class is adequately defined,
that is, the class must be defined clearly enough that the court and the parties understand
who would fall within the class, even if the exact identities and number of persons
within the class are not yet known. Class actions are more common in tort cases, such
as litigation over a defective product that may have injured a class of persons including
all purchasers of that product, than in IP cases. The reason is simple—seldom will there
be an entire class of individuals, known and unknown, with an ownership interest in a
particular piece of IP.

The complaint must detail the facts of the case sufficient to “plead” every element of
each alleged cause of action. It is not necessary for the complaint to contain every factual
detail known to the plaintiff. The courts require only that the plaintiff provide sufficient
detail to put the defendant on notice as to the basis for the claims against him or
her. The United States Supreme Court, in the seminal case Conley v. Gibson, held that
a complaint only needs to include a short plain statement of the claim, sufficient to show
that the plaintiff is entitled to relief.10 The statement is sufficient if it “give[s] the defendant
fair notice of what the plaintiff’s claim is and the grounds upon which it rests.”11
This standard for pleadings is known as notice pleading. Accordingly, a complaint
may sketch the basis of the wrongful act in fairly broad terms, because the plaintiff
likely has not yet had the opportunity to obtain all of the relevant factual details from
the defendant. For example, a typical complaint alleging patent infringement might
identify the patent being infringed and the defendant’s product or process that is
accused of infringing that patent, but it may refrain from detailing the other particulars
of the infringement. Notice pleading allows a plaintiff the flexibility to develop a
theory of the case as he or she learns more facts about the defendant’s use of the infringing
technology or design.

Generally, a complaint must state the causes of action and then “pray” for some item
of relief from the court. For example, the elements of a negligence tort, like a car accident,
are negligence (not meeting a standard of care), causation, and damages. A complaint
alleging negligence probably would detail what happened in the accident, the facts
allegedly establishing the defendant’s negligence (e.g., the defendant failed a sobriety test
at the scene of the accident), how the defendant’s negligence caused the plaintiff to break
a leg, and what amount of money will be required to compensate the plaintiff for the
damage. Some complaints opt to leave the amount of damages unspecified, simply
asking for an award of damages “in an amount to be determined at trial.” Detailing the
amount of damages sought is not necessary to satisfy the requirements of notice pleading.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

THE ANSWER

After being served with the complaint, the defendant must either answer or move for
dismissal of the case, typically within 20 days. In an answer, the defendant will admit
or deny, in summary fashion, each fact alleged in the complaint. The answer is also
the defendant’s first opportunity to articulate the defenses and counterclaims12 that he
or she wishes to raise in the litigation. Everyone on the litigation team should read the
answer, as the admissions may significantly narrow the issues presented for litigation.
Taken together, the admissions and denials frame the issues that will be fought over in
discovery, in motions, and ultimately at trial.

In lieu of an answer, a defendant may choose to file a motion to dismiss the case.
However, at this stage, motions to dismiss face a very high standard, as the court must
assume that each allegation pled in the complaint is true. However, the defendant may
ask the court to dismiss the complaint for failing to meet certain requirements necessary
for the suit to proceed, such as if the plaintiff has filed the complaint in the wrong court
(resulting in lack of jurisdiction) or failed to state a claim for which relief can be
granted.13 For example, a plaintiff alleging negligence would fail to state a claim if the
plaintiff failed to provide any facts or allegations that he or she was injured by the defendant.
In that case, one of the essential elements of a negligence claim (causation) would
be missing and the trial court could not allow the case to proceed. Like answers, motions
to dismiss are almost exclusively the attorney’s responsibility to draft—expert analysis
is universally unnecessary for judicial evaluation at this point.

ATTORNEYS’ MEETING AND PROTECTIVE ORDERS

Rule 26 of the FRCP requires the parties’ attorneys to meet and develop a discovery
plan.14 This meeting must occur at least 14 days before a scheduling conference is held
with the judge. The discovery plan will set cutoff dates for document requests, expert
reports, interrogatories, and depositions.15 Rule 26 also requires each party to provide
the opposing party with initial disclosures concerning their witnesses, relevant documents,
and damages. Finally, Federal Rule of Civil Procedure 26(a)(2) sets forth what
must be contained in your expert report. This section of the rules should be required
reading for any expert.

The attorneys’ meeting may also be the first time that the parties discuss drafting a
stipulated protective order to govern discovery. Particularly in IP litigation, the documents
likely to be produced during discovery may contain highly sensitive information
concerning research and development, confidential technology, marketing plans, and
customer lists. Given the likelihood that such documents will be relevant to the ongoing
litigation, the parties often agree to produce documents subject to certain restrictions
on their use by the other side. Under Federal Rule of Civil Procedure 26(c)(7), confi

THE LITIGATION PROCESS

dential commercial information warrants special protection. A protective order does not
eliminate the requirement that the information be relevant or that the request for documents
must not be overly broad and burdensome. However, a stipulated protective order
does provide some security for sensitive documents without requiring the parties to seek
judicial rulings on each particular document.

Commonly, a stipulated protective order will permit any producing party to designate
information that is “believed to be subject to protection under Federal Rule of Civil
Procedure 26(c)(7)” as confidential and limit disclosure of all documents so designated.
For example, many protective orders provide that documents stamped “confidential”
may be shown only to counsel and expert witnesses, but not to anyone in-house at the
competing business, possibly including the attorney’s client. Some protective orders
contain degrees of protection, such as “confidential” and “confidential—attorneys’ eyes
only,” where the latter designation may be shown only to an even narrower class of individuals.
Protective orders also may limit the use of the disclosed information to the litigation
at hand and require the destruction or return of such information after the
conclusion of the lawsuit. In order to have a fallback position, attorneys frequently
include in the protective order provisions regarding “inadvertent disclosure” (i.e.,
production of information without the appropriate designation, which nevertheless
should be treated as confidential). Commonly, this provision simply allows an attorney
to remedy the situation if it is addressed within a certain period after the error is
discovered by retrieving the documents or retroactively designating them as confidential.
Because the particulars may vary, attorneys may agree to exchange drafts of
a proposed protective order, tailored to the facts of the case, until they can stipulate
to a mutually agreeable form for the order.

If the parties do not stipulate to a protective order, either party may still ask the court
to grant a protective order at some point in the litigation. The party seeking a protective
order must establish that the information sought is confidential and that the disclosure
of that information has the potential to harm the party or the party’s business.16 The
party opposing the protective order must then show that the disclosure of such information
is neither necessary nor relevant to the case.17 For example, the Federal Circuit
has held that an infringer’s sales information is relevant because it tends to show commercial
success, which may support patentability.18 However, the party opposing such
discovery (or a nonparty objecting to a subpoena) may argue that sales information is
neither relevant nor necessary to the case.19 Alternatively, the resisting party may seek
to delay their disclosure of such information until liability first has been established.20

The Supreme Court has considered and approved the use of protective orders to control
discovery in civil litigation. Early cases have indicated that the restrictions on the
use of information produced subject to protective orders might conflict with the rights
of free speech protected under the First Amendment.21 However, in Seattle Times Co. v.
Rhinehart, the Supreme Court clarified the interaction of those principles and indicated
its support for judicial regulation of the discovery process.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Seattle Times Co. v. Rhinehart22

This United States Supreme Court case addressed whether parties to civil litigation
have a First Amendment right to disseminate, in advance of trial, information
gained through the pretrial discovery process. Rhinehart was the spiritual leader of
the Aquarian Foundation, an organization whose beliefs included the ability to
communicate with the dead through a medium, primarily Rhinehart. The Seattle
Times published a series of articles about the Aquarian Foundation that became the
basis for litigation between the parties. Rhinehart alleged defamation and invasion
of privacy. During the litigation, the Seattle Times sought lists of donors and members
of the foundation and certain financial information about the foundation.

The trial court granted a protective order forbidding the use of the financial and
membership information obtained through discovery for any purpose except
preparation for trial. The Seattle Times appealed, and ultimately the Supreme
Court affirmed the lower court’s decision. The Supreme Court cited the “significant
potential for abuse” of pretrial discovery by litigants as a substantial government
interest unrelated to the suppression of speech, and therefore a legitimate justification
for protective orders issued by trial courts.

In short, when a protective order is entered on a showing of “good cause” as
required by Federal Rule of Civil Procedure 26(c), is limited to the context of pretrial
civil discovery, and “does not restrict the dissemination of the information if
gained from other sources,” it will not be struck down under the First Amendment.

If the parties reach an agreement, the protective order will be submitted to the court
with the signatures of both parties to create an enforceable agreement should the parties
later disagree about the treatment of certain information. One can imagine how important
this would be in a trade secret case. Experts typically are asked to sign the agreement
before obtaining access to confidential information. It is vital that an expert
understand the conditions attached to his or her access, use, and retention of information
that falls under the protective order. Attorneys and experts should take great care to
see that they comply with the terms of the protective order, specifically the process for
designating information “confidential” and the appropriate use of such designated information
received from the other side.

DISCOVERY

The confidentiality agreement is a prelude to discovery. Typically, discovery begins
with document requests and interrogatories (written questions). Document requests
ask the other side to produce copies of relevant information in any form. Interrogatories

THE LITIGATION PROCESS

ask the other side to provide written answers to certain questions about their arguments
in the case, their account of certain events, and the possible witnesses that they may use
at trial. In general, a party has 30 days to respond or object to a discovery request. The
FRCP defines the scope of discovery as follows:

Federal Rule of Civil Procedure 26(b)(1)

Parties may obtain discovery regarding any matter, not privileged, that is relevant
to the claim or defense of any party, including the existence, description, nature,
custody, condition, and location of any books, documents or other tangible things
and the identity and location of persons having knowledge of any discoverable
matter. For good cause, the court may order discovery of any matter relevant to
the subject matter involved in the action. Relevant information need not be admissible
at the trial if the discovery appears reasonably calculated to lead to the discovery
of admissible evidence.

Clearly, the scope of discovery is intended to be broad, with the understanding that not
everything discoverable may ultimately be admissible at trial. Written discovery is an
area where expert input is critical in an IP case. A sample discovery request is included
in Appendix B.

Experts can play a critical role in helping the attorney ask for the right documents
and ask the right questions to establish the damage case. A common mistake made by
attorneys is underutilizing their experts during the discovery process. Not only can
experts assist with framing discovery requests, but the experts also should begin fleshing
out their damages theories as early as possible while there is still time to develop
and revise the theories based on the information that comes to light. Each scheduling
order will contain a deadline for concluding fact discovery; after that cutoff, attorneys
and experts will be unable to request additional information from the other side.

Several objections are available to the party who does not wish to produce responsive
documents. Generally, the responding party will identify several general objections
(such as “vague and ambiguous,” “overly broad,” and “irrelevant”) and then nevertheless
offer to produce the responsive documents “subject to and without waiving the
foregoi,ng objections.” However, there also are grounds on which a party might refuse
to produce anything at all. These objections include:

1.
The discovery request is unreasonably duplicative.
2.
The discovery sought is available from some other source that is more convenient,
less burdensome, or less expensive.
3.
The party seeking the discovery is better situated to obtain the information sought.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

4.
The burden or expense of the proposed discovery outweighs its likely benefit,
taking into account the needs of the case, the amount in controversy, the parties’
resources, the importance of the issues at stake, and the importance of the
proposed discovery in resolving the issues in the litigation.
5.
The material sought is privileged (usually because it consists of communications
between an attorney and a client, or because it represents the “work product”
of the attorney, i.e., part of the attorney’s preparation for litigation).23
If a party claims privilege as the grounds for withholding certain information, it must
produce a “privilege log” describing each document withheld (without revealing the
contents) and identifying the reason for the assertion of privilege.24 Generally, the document
descriptions will include the date of the document, the author of the document,
and sometimes the length of the document.

Privilege generally is claimed most frequently for two types of information: attorney–
client communications and work product. Both of these privileges are the subject of
many treatises, articles, and legal opinions. The following section merely provides a
brief overview of the basis for asserting the privileges.

Attorney–Client Privilege

The attorney–client privilege generally applies to and protects communications between
a client and an attorney made for the purpose of furnishing or obtaining professional
legal advice.25 The purpose of the attorney–client privilege is to encourage full and frank
communication between attorneys and their clients by ensuring that such communications
will be held in confidence.26 Accordingly, the attorney–client privilege belongs to
the client, not the attorney, and only the client may disclose the communications.27

The communication may be oral or written, but it must be made with a reasonable
expectation of privacy. For example, if the client yells something to counsel across a
room full of people, the privilege has been waived as to that communication. Moreover,
the attorney–client privilege attaches only to the contents of the communication itself,
not the underlying facts. This means that a client cannot claim privilege over certain
facts sought to be discovered by the other side simply because the client also communicated
those facts to the attorney.28 The communication itself is protected even if the
information may be discovered through other sources.29 Finally, acts that are simply
observed by the attorney, and not directly conveyed by the client, are not necessarily
privileged. In evaluating that issue, the courts examine whether what the lawyer observed
(e.g., the client’s attitude or actions) could be deemed confidential in nature.30

Work Product Privilege

The work product privilege applies to those documents and tangible things “prepared in
anticipation of litigation or for trial” by a party or that party’s representative, including
the party’s “attorney, consultant, surety, indemnitor, insurer or agent.”31 The party seek

THE LITIGATION PROCESS

ing discovery as to those materials must show that the party has “substantial need of the
materials in the preparation of the party’s case and that the party is unable without
undue hardship to obtain the substantial equivalent of the materials by other means.”32
Even if the court finds that those requirements have been met, the court must still, where
feasible, redact certain information or otherwise “protect against disclosure of the mental
impressions, conclusions, opinions, or legal theories of an attorney or other legal representative
of a party concerning the litigation.”33 Accordingly, in ordering discovery of
work product, the court may redact such information.

The FRCP makes clear that documents indicating a party’s legal strategy, assessment
of the strength of various claims, or other preparation for trial are core work product
and generally will be outside the bounds of discovery.34 The more the materials reflect
the attorney’s mental processes and nature or direction of the investigation, the greater
the burden will be on the requesting party to show good cause for disclosure.35 Just as
with attorney–client privilege, work product protection does not prevent the underlying
information from being discovered; it only precludes production of particular materials
absent a showing of substantial need and inability to obtain that information without
undue hardship. For example, the notes taken by an attorney during or after his interview
of a particular witness may qualify as work product. However, the other party is
entitled to interview that witness and may even be able to require the first attorney to
disclose the identity of that witness.36 Moreover, should that witness become ill and
unable to communicate, the other party could argue that the facts warrant disclosure of
the attorney’s notes to avoid undue hardship on him or her based on the practical
unavailability of the information possessed by that witness. In such case, the court
could require a factual summary, redacted of all mental impressions and legal strategy,
to be turned over to the opposing party.

Electronic Discovery

An important area of discovery that recently is receiving new interest from courts and
attorneys is the discovery of electronically stored information.37 Although the definition
of a “document” under the FRCP has included a reference to electronic data since 1970,
it is only recently that litigators have begun aggressively pursuing the full extent of the
electronic data available in most companies. The volume of data available in electronic
form is staggering. In 1998, 3.4 trillion e-mail messages were sent worldwide, including
approximately 343 billion in the United States.38 Currently, approximately 93 percent
of the world’s information is being generated and stored in digital form, while only
7 percent is stored in other media such as paper and film.39 This means that the attorney
(or expert) who ignores the relevant electronic information that potentially exists in
a case is missing the lion’s share of the evidence.

Moreover, attorneys should not be content with paper versions or “hard copies,” of
the electronic files. Electronic documents have embedded information known as “meta

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

data,” information that is attached to the file and can conclusively resolve conflicting
testimony concerning such issues as the date that a file was created and the author of
that file. For example, a date in a printed document may reflect simply the date that
it was printed rather than the date the document was created. Additionally, electronic
versions of documents may indicate the last date that the document was edited, the
last person to edit it, and possibly even the changes made. None of these factors is
apparent from the printout of the same document.

Not only do electronic documents offer more information, but also they often are
easier to review for relevant information. For instance, a collection of electronic documents
can be combined within a database enabling efficient data analysis. Attorneys,
experts, and their assistants can explore electronic data through text searches rather than
being forced to peruse thousands of pages for a minimal return. Electronic databases,
depending on their particular format, can be searched using key words or phrases,
Boolean requests, fuzzy logic, proximity, and thesaurus-based search methods to extract
relevant information.

Depositions

Discovery also involves taking and defending depositions. Each side will seek to take
the deposition of the witnesses identified by the other party as being their primary witnesses
on certain topics. A deposition involves oral questions asked by an attorney of a
witness who is sworn in as if he or she were giving testimony at trial. The witness’s testimony
will be recorded by a court reporter and will provide valuable insight into the
witness’s likely testimony at trial. In fact, deposition testimony may come back to haunt
the sloppy witness who alters his or her testimony at trial; attorneys will be prepared to
present the earlier testimony as impeachment of the expert’s credibility where it conflicts
or contrasts with the most recent evolution of the expert’s opinion. Expert depositions
are always important, but the expert’s contribution need not be limited to his or
her actual testimony at deposition. Experts can assist in creating a strategy for questioning
the opposing experts and may even attend the depositions to suggest follow-up
questions of which the attorney may not be aware.

EXPERT DISCLOSURES

During discovery, in addition to helping frame the discovery requests made of the
opposing party, expert witnesses must disclose certain information about themselves
and the information that they have reviewed in reaching their opinions. The FRCP
requires all testifying experts to disclose “a complete statement of all opinions to be
expressed and the basis and reasons therefore; [and] the data or other information considered
by the witness in forming the opinions.”40 Some federal courts have interpreted
these requirements quite broadly.

THE LITIGATION PROCESS

In re Pioneer Hi-Bred Int’l, Inc.41

In Pioneer Hi-Bred, the Federal Circuit held that documents and information disclosed
to a testifying expert are subject to mandatory disclosure “whether or not
the expert relies upon the documents and information in preparing his report.”
The court noted that “fundamental fairness requires disclosure of all information
supplied to a testifying expert in connection with his testimony,” including documents
and information that might be classified as privileged. The court emphasized
that the 1993 amendments to the rule were meant to eliminate the argument
that information disclosed to testifying experts could be withheld from discovery
on the basis of work product or attorney–client privilege.

Johnson v. Gmeinder42

In Johnson, the court held that simply reading or reviewing materials before or in
connection with formulating expert opinions would be deemed “consideration” of
the information for purposes of mandatory disclosures. In this case, the expert testified
at the hearing that he had merely read, but not “considered” certain materials
in preparing for his expert report. The court rejected that argument, holding
that mandatory disclosures would even include information that the expert had
evaluated, but then rejected as a basis for his ultimate conclusions.

The requesting party has a right to the contents of a testifying expert’s communications
with counsel, including the attorney’s mental impressions and legal theories,
because such communications could influence the expert’s substantive consideration of
the issues as well as the form of the expert’s opinions. Moreover, a recurring theme in
cases addressing this issue is that the judge has a right “to know who is testifying” (i.e.,
how much of the opinion originated with the expert and how much was spoon-fed by
counsel). Accordingly, attorneys and experts should be aware that all information
reviewed by a testifying expert may be the subject of mandatory disclosures, specific
discovery requests, and lines of questioning at the expert’s deposition.43

Furthermore, mandatory disclosures may require the production of draft versions of
the expert’s report. Draft reports that are exchanged between an expert and an attorney
and contain written comments or notes arguably are additional materials considered
by the expert in reaching his or her opinion.44 Trigon Ins. Co. v. United States took an
extremely strict approach to this requirement and stands as a warning for both counsel
and experts.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Trigon Ins. Co. v. United States45

In Trigon, the documents in question were drafts of expert reports that were not
“solely the product of the expert’s own thoughts and work.” The court found that
parties were required to retain and produce draft reports sent to and from the
experts. The plaintiff had only requested the draft reports informally (apparently at
least once by letter), but the court found that a formal discovery request was not necessary
to trigger the obligation to retain copies of the drafts. Since the defendant had
failed to retain copies of the draft reports, the court found that the plaintiff was entitled
to recover attorneys’ fees and costs related to the issue and an adverse inference
against the expert’s testimony at trial. This adverse inference is an extremely severe
sanction, as it would substantially undermine the expert’s credibility to a jury or the
court. The court considered precluding the expert from testifying at all, but decided
to allow the testimony only because a forensic inspection of the defendant’s computers
had recovered some portion of the missing documents. The defendant also
was required to pay for the cost of the forensic inspection.

The court did not address whether retention and disclosure would be required where
the testifying experts worked alone (which were not the facts presented by the case),
but that distinction may be meaningless in any practical sense given the frequent
occurrence of experts and attorneys working closely together on the expert report.

EXPERT REPORTS

The scheduling order will contain due dates for expert reports. Typically, the plaintiff’s
expert report is due first, followed a month or so later by the defendant’s expert report.
Sometimes initial reports from both sides are due simultaneously, followed by rebuttal
reports. Many different schedules can exist. An expert should have copies of all the
pleadings and the scheduling order prior to preparing and serving his report. Much can
be said about how to structure and write an effective expert report, but that topic is
beyond the scope of this book. A sample expert report is included in Appendix B as an
example of a format and organizational structure that the authors have found particularly
effective in litigation.

EXPERT DEPOSITIONS

Sometime after the expert reports are filed, the experts on both sides usually will be
deposed.46 Testimony given at a deposition is made under oath, subject to the penalties
of perjury. Depositions are always recorded, usually by a stenographer, although videotaping
a deposition is gaining popularity. Support among litigators for videotaping dep

THE LITIGATION PROCESS

ositions has been driven in part by experienced experts who have attempted to evade
clear and honest answers to questions. Videotaping makes evasive tactics in a deposition
difficult.

In a deposition, the person being deposed (the deponent) is asked questions by an
attorney and given an opportunity to answer. At times, the attorneys present may object
either to the form of a question or to the subject matter to which the question pertains.
The deponent should always pause briefly before answering in order to give counsel
the opportunity to object, then listen carefully to the particular objection being made
because the objection may provide a clue as to the goal of the questioning attorney.
After an objection has been made, an expert should resume testifying only after counsel
instructs the expert to continue. Under certain narrow circumstances, an expert may
be instructed by the attorney not to answer. Under the FRCP, an attorney may instruct
the deponent not to answer only: (1) where the question seeks privileged information;
(2) where the question (or probable answer) violates a court-directed limitation on
evidence; or (3) where it becomes apparent that the deposition is being conducted “in bad
faith or in such a manner as unreasonably to annoy, embarrass or oppress.”47

Experts are deposed primarily for three reasons: (1) to gain a more complete understanding
of the expert’s opinions and likely testimony at trial than is possible from the
expert report, (2) to confront the expert with potential oversights and weaknesses in his
opinion or qualifications that may undermine his reliability as an expert, and (3) to test
the expert’s commitment to certain opinions. Experts can be confronted with their deposition
testimony when they are on the witness stand, so it is very important for the deposition
to go well.

As an expert, there is very little real art to being deposed. The expert’s best defense
is to know the case, know the topic of inquiry, and formulate opinions that are defensible
and not exaggerated. Substantive knowledge about IP law and damages theories can
expose the goals of the questioning attorney, as well as the purpose of certain questions
and how an expert’s statements can affect the outcome of the litigation. The Additional
Reading section at the end of this chapter identifies additional materials that provide
more detailed discussions of deposition tactics and procedures.

MOTION PRACTICE

After expert depositions, the parties may file motions to limit the issues for which trial
is necessary and restrict the evidence that will be heard at trial. These motions generally
take the form of either motions for summary judgment or motions in limine.48

In essence, a motion for summary judgment means that the judge can determine the
outcome of the case because discovery has revealed either that the issues in dispute are
purely legal (judges decide law, whereas juries decide facts) or that the evidence is so
one-sided that no reasonable juror could find in favor of a particular party on an essential
element of a claim. A party moving for summary judgment must establish that there

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

are no disputes as to “genuine issues of material fact.”49 Moreover, the court will construe
the pleadings and factual record strictly against the party moving for summary
judgment, essentially giving the opposing party the benefit of the doubt where there is
a basis for such doubt.50 In short, a party seeking summary judgment faces a very high
evidentiary standard. In light of this significant burden, parties often move for partial
summary judgment. A motion for partial summary judgment asks the court to rule on a
limited issue that will further the efficient resolution of the case (sometimes by increasing
pressure to settle), although it does not aim to decide the case completely. For example,
a plaintiff in a patent infringement case might find it strategically wise to file for
partial summary judgment solely on the issue of infringement or validity. Neither one
of those issues resolves the question of damages or ends the case, but it might effectively
limit the amount of time and resources required for trial.

“Motion in limine” simply means a motion “to exclude” certain evidence or testimony.
Since the parties will have deposed each other’s primary witnesses and exchanged
witness and exhibit lists before trial, each side should have a reasonable idea of
what to anticipate hearing at trial. A party may move to exclude evidence that he or she
anticipates the other side will use at trial because that evidence is irrelevant to the
issues that will be tried or because the evidence is more prejudicial than probative of
the issues.51 The FRE broadly defines “relevance” as “evidence having any tendency to
make the existence of any fact that is of consequence to the determination of the action
more probable or less probable than it would be without the evidence.”52 Even if the
court is satisfied that the evidence is relevant, the evidence may still be excluded for a
host of reasons, including “if its probative value is substantially outweighed by the danger
of unfair prejudice, confusion of the issues, or misleading the jury, or by considerations
of undue delay, waste of time, or needless presentation of cumulative evidence.”53
Additionally, a party may object to the admission of testimony that will consist of nothing
more than hearsay evidence.54 Basically, any of the rules of evidence could provide
the basis for a motion in limine, although relevance and lack of adequate probative value
are two of the most common grounds for moving to exclude certain evidence from trial.

Experts often play an important role during motion practice by helping the lawyers
formulate the theories of the case. In the context of motions for summary judgment,
experts often provide affidavits on issues that are submitted as supporting attachments
to the motion for summary judgment or legal memorandum opposing summary judgment.
Additionally, an expert or portions of the expert’s testimony may be the subject
of a motion in limine. Motions in limine regarding experts are commonly referred to as
“Daubert motions” and they are discussed in detail in Chapter 2.

TRIAL

If a plaintiff’s case survives summary judgment, then the dispute will be decided at trial.
The trial is a complicated process in which the expert plays a small but important role.
Although this book does not include a discussion of how to testify at trial, the funda

THE LITIGATION PROCESS

mentals of knowledge, preparation, and accuracy are just as critical at trial as during
deposition. When possible, an expert should be present during the trial to hear the testimonies
of fact witnesses prior to giving his or her own testimony. An expert generally
is not subject to the exclusionary rule that can bar fact witnesses other than the corporate
representative from the courtroom prior to giving their testimony.

COURT OPINIONS

Courts may issue rulings, or opinions, at several points during litigation. Rulings may
address the admissibility of evidence, the propriety of certain discovery tactics, the relevance
of certain issues, and the use of expert testimony. A court may issue various
orders to govern the conduct of the parties in a particular case. Published court opinions
(as opposed to merely oral rulings) also can have weight in unrelated litigation.
An opinion from a higher court (e.g., a circuit court that hears appeals from the particular
district court at issue) is described as “binding precedent.” Binding precedent
must be followed by all lower courts. However, not all circuit court opinions are binding
on all lower courts. For instance, an opinion issued from a higher court that is not
in the same circuit as the district court might be persuasive but is not binding on the
lower court’s decision. The closer the factual parallel between cases, the more likely a
court might be to find another judge’s opinion instructive, even if it comes from a different
jurisdiction. Of course, United States Supreme Court opinions are binding on all
courts.

Commonly, judicial interpretation of statutes and existing law offers better guidance for
lawyers and experts in litigation than the statutes themselves. Different jurisdictions may
interpret the same statute in different and possibly conflicting ways. The outcome of any
particular litigation may depend on the attitude of courts in the relevant jurisdiction, rather
than on some absolute answer that would apply regardless of location. Where certain
issues have not yet been addressed in a specific jurisdiction (as is commonly the case in
less populated areas), the opinions of other courts from around the country can serve both
as predictors of potential outcomes in litigation and as support for particular arguments.

A final judgment in the case can become the basis for an appeal. Until a final judgment
has been entered, other rulings by the court generally cannot be appealed. Some
intermediate decisions may significantly impact the case, but if the litigation were interrupted
for appeals of every ruling, litigation would be even more protracted and resolution
even harder to obtain.

LITIGATION VERSUS ALTERNATIVE DISPUTE RESOLUTION

After the decision to take action, often the first choice that must be made is whether to
litigate in court or pursue one of the alternative means of dispute resolution. Litigation
in court is what people typically think of when they imagine suing or being sued, and
the process has been discussed in detail. However, alternative dispute resolution (or

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

ADR) has been increasing steadily in popularity as an alternative, or sometimes a precursor,
to traditional litigation.

Alternative dispute resolution may be particularly appropriate in the context of IP litigation,
given the typical expenditures of time and resources on the litigation process.
Recent statistics indicate that 76 percent of patent suits settle, but not before each side
has incurred over $1 million in legal fees and indirect legal expenses.55 Moreover, litigating
a patent case through the trial stage costs each side an average of approximately
$2 million in legal fees and related expenses, and the average costs have been increasing
about 15 percent per year over the last five years.56 The theoretical advantages of
ADR include speed, economy, expertise of the decision maker, privacy, greater informality,
convenience related to selecting the time and place of the proceedings, and finality
without recourse to appeal.

However, extremely complex IP cases may benefit from the formal procedures
used in federal court rather than the simplified, potentially less sophisticated approaches
of ADR. Intellectual property cases typically require significant investigation and
exchange of information, perhaps best accomplished through the formal discovery procedures
used in federal courts. Similarly, the parties often will not move toward settlement
until the issues have been narrowed and both parties have been assured that they
have all relevant information. By the time both parties have conducted the necessary
factual investigation, hired and prepared expert witnesses, and identified the linchpin
issues, they may have already invested sufficient resources to void any cost savings
through ADR.

Alternative dispute resolution consists primarily of mediation and arbitration.
Essentially, mediation consists of settlement discussions facilitated by the perspective
of a neutral third party (often someone with experience as a judge or expertise in the
relevant area). Mediation is a meeting of the parties before a mutually selected mediator
who attempts to mediate the differences between the parties and facilitate settlement.
The mediation can last as long as the parties believe that it is serving a useful
purpose, but it generally does not last more than a couple days. The mediator generally
will listen to both sides’ presentations of their arguments, and then may separate
the parties and speak to each side about the perceived strengths and weaknesses in their
arguments. The mediator can present various settlement options to the opposing sides
and discuss the merits of the proposals with each side. A mediator’s goal is to enable
the parties to find a mutually satisfactory resolution to their dispute, given the facts and
the law. Although the mediator’s opinions and findings can sway one or both of the
parties toward a settlement, the parties typically agree that the findings of the mediator
will not be binding, so mediation does not preclude seeking a resolution in court or
through binding arbitration.

Arbitration, on the other hand, is conducted very much like courtroom litigation, and
the arbitrator’s decision, like a judge’s ruling, generally is binding and final for the parties.
57 Generally, the arbitration process moves faster than traditional litigation and can

THE LITIGATION PROCESS

save the parties significant amounts in fees and costs. Moreover, the ability to select
your arbitrator, in effect tailoring him or her to the nature of your case, proffers an
advantage over the random assignment of judges in the federal and state court systems.
Both forms of ADR involve attorneys, witnesses, and rules of evidence. However, the
technical rules governing the admissibility of evidence often are modified, either
through mutual stipulation of the parties beforehand or because the ADR is conducted
under the rules of a particular organization, such as the American Arbitration Association
(AAA). Generally, at a hearing, the arbitrator will receive all relevant evidence
without applying strict rules of evidence. Both parties have the option of being represented
by counsel and to present their cases in a manner possibly very similar to the
organization and structure of a court case. After the hearing, the arbitrator will have a
certain amount of time within which to render his or her final decision. The length of
time that an arbitrator has to issue a decision can be predetermined by the organization’s
rules or by an agreement between the parties. For example, under the AAA rules, the
arbitrator renders a final decision within 30 days of the hearing’s conclusion. This timing
can be in marked contrast to the lengthy time lines of many federal courts.

By law, even “final” or “binding” decisions of an arbitrator may be appealed to a
court in limited circumstances. However, courts have adopted a standard of review (in
other words, the standard to which they will hold the other forum, in this case the arbitrator)
that virtually guarantees that such appeals will be unsuccessful unless the decision
was truly arbitrary or capricious. An arbitration decision, unlike a judicial ruling,
is not subject to reversal by the courts based on the argument that it was legally erroneous.
Under section 10 of the Federal Arbitration Act (FAA),58 the arbitrator’s decision
may be set aside by a court only for such reasons as bias or corruption of the
arbitrator, misconduct by the arbitrator, or action in excess of his or her power.59
Clearly, the courts have an interest in decreasing their own caseload by encouraging
dispute resolution outside the courtroom. If every ADR decision could be essentially
reheard on appeal, the lack of finality would discourage potential litigants from pursuing
that form of dispute resolution. Therefore, the courts will only address the merits of
an arbitrated case where it appears that the arbitrator’s actions were nearly inexcusable.

The courts may, however, at the request of one of the parties, intervene before the
arbitration begins. Courts may stay the arbitration, order that the arbitration proceed, or
stay related judicial proceedings in favor of arbitration. The arbitration process generally
begins with a written “demand for arbitration” or other form of notice sent by one
party to the other alerting them of their intention to arbitrate certain issues. The recipient
of such a demand may ignore the letter and bring suit in court. The party seeking
arbitration may then apply for a stay of the judicial proceedings in favor of arbitration.60
If the party seeking arbitration can satisfy a court that the issue involved in the lawsuit
is covered by a valid and binding arbitration agreement between the parties (frequently
found in the contract at the heart of the dispute), then the court must stay the lawsuit.61
Similarly, the party seeking arbitration may ask a court for an order “directing that such

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

arbitration proceed in the manner provided for” in the parties’ arbitration agreement if
the other party simply refuses to participate in the arbitration, without bringing an independent
suit.62 To issue such an order, the court must determine the existence of a valid
arbitration agreement. Finally, the party who wishes to avoid arbitration may seek a
court order staying the arbitration pending a judicial determination of whether a valid
agreement to arbitrate exists. The federal courts are limited to these forms of injunctive
relief related to arbitration; they will not intervene merely to address evidentiary issues
or other intermediate issues within the arbitration.

SUMMARY

Chapter 1 explained the basic structure of the U.S. court system and generally outlined
the essential chronology of litigation. This background information should provide a
helpful context for participants in the litigation process. By understanding the various
stages of litigation and anticipating your role in those stages, you can be better prepared
and more capable of contributing valuable input to the development of an IP damages
theory. Early involvement and comprehension of the standards that will be applied to
your theory will improve both your work product and the work product of other team
members who could benefit from your perspective.

ENDNOTES

[1]
See 28 U.S.C. § 1295(a)(4)(C).
[2]
See 28 U.S.C. § 1295(a)(4)(A).
[3] In fact, the Federal Circuit’s application of its own law to issues outside the patent area
has sparked some controversy. See Ronald Katz and Adam Safer, Should One Patent
Court Be Making Antitrust Law for the Whole Country, 69 Antitrust L. J. 687 (2002).
[4]
See, e.g., Forsley v. Principi, 284 F.3d 1355 (Fed. Cir. 2002) (stating that appellate courts
must apply the correct law, even if not presented by the parties or considered by the
lower court (citing Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 99 (1991))).
[5]
See, e.g., Glaxo, Inc. v. Torpharm, Inc., 153 F.3d 1366, 1370 (Fed. Cir. 1998) (“We must
reverse a summary judgment if any errors of law were made, unless an independent legal
ground exists in the record upon which we can affirm.” (citations omitted)).
[6]
See, e.g., Molins PLC, v. Textron, Inc., 48 F.3d 1172, 1181 (Fed. Cir. 1995) (“We accord
deference to the fact finder’s assessment of a witness’s credibility and character.”);
DeSarno v. Dep’t of Commerce, 761 F.2d 657, 661 (Fed. Cir. 1985) (“It is not our function
to second-guess the credibility determinations of the presiding official, which were
based on the demeanor of the witnesses during the hearing.”).
[7]
See, e.g., Gould v. Quigg, 822 F.2d 1074, 1077–78 (Fed. Cir. 1987) (affirming trial court’s
resolution of conflicting expert testimony based on credibility assessments).

THE LITIGATION PROCESS

[8]
See, e.g., Smiths Indus. Med. Sys., Inc. v. Vital Signs, Inc., 183 F.3d 1347, 1354–55 (Fed.
Cir. 1999) (reversing trial court’s legal determination of obviousness based on the court’s
erroneous claim construction and flawed analysis of the differences between the claimed
invention and the prior art).
[9] The Supreme Court may review any decision of a court of appeals, including the Federal
Circuit, by granting a discretionary “writ of certiorari.” Unlike the Supreme Court’s jurisdiction
in appeals from state court decisions, which is limited to questions of federal law,
the Court may decide any legal question, whether state or federal, in cases appealed from
lower federal courts. However, the Court generally limits itself to reviewing important
questions of federal law.
[10]
Conley v. Gibson, 355 U.S. 41 (1957).
[11]
Id. at 47.
[12] Counterclaims are simply the affirmative claims that a defendant raises against the plaintiff.
In other words, where the defendant believes that not only is she without blame, but
also that in fact the plaintiff has harmed her, she can raise a counterclaim seeking damages
or some other remedy.
[13]
See Fed. R. Civ. P. 12.
[14]
See Fed R. Civ. P. 26.
[15]
Id.
[16]
See, e.g., American Standard Inc. v. Pfizer, Inc., 828 F.2d 734, 741 (Fed. Cir. 1987).
[17]
Id.
[18]
In re: Huang, 100 F.3d 135, 139–40 (Fed. Cir. 1996) (noting that sales information may
be relevant to commercial success, although such information alone is not dispositive).
[19]
See, e.g., Micro Motion, Inc. v . Kane Steel Co., Inc., 894 F.2d 1313, 1326 (Fed. Cir. 1990)
(holding sales information from a nonparty to be irrelevant).
[20]
Fed. R. Civ. P. 26(d).
[21]
See In re Halkin, 598 F.2d 176 (D.C. Cir. 1979) (overturning a protective order because the
“inherent value of speech in terms of its capacity for informing the public does not turn on
how or where the information was acquired”), overruled by Seattle Times Co. v. Rhinehart,
467 U.S. 20, 32 & n. 18 (1984). At issue in Halkin were copies of documents relating to
Operation Chaos, the CIA’s program with regard to antiwar activities during the Vietnam
War. The plaintiffs intended to release several of them at a press conference. It may be that
the inherent appeal of society’s interest in government information about private citizens
protesting an unpopular war played a role in this decision, where financial documents
about a company offer less intuitive value as a First Amendment argument.
[22]
Seattle Times Co. v. Rhinehart, 467 U.S. 20, 32–37 (1984).
[23]
See Fed. R. Civ. P. 26(b)(2).
[24]
See Fed. R. Civ. P. 26(b)(5).
[25]
See, e.g., American Standard, Inc. v. Pfizer, 828 F.2d 734, 744–45 (Fed. Cir. 1987).
[26]
Id.
[27]
Id.; see also 8 I. Wigmore, Evidence, § 2321 (McNaughton, rev. ed., 1961).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

[28]
See, e.g., In re Grand Jury Subpoena Duces Tecum (Rich), 731 F.2d 1032, 1037 (2d Cir.
1984) (finding that attorney–client privilege protects communications, not underlying
information); J.P. Foley & Co., Inc. v. Vanderbilt, 65 F.R.D. 523, 526 (S.D.N.Y. 1974)
(noting that privilege pertains solely to substance of communications, it does not “preclude
inquiry into the subject matter of communications”).
[29]
See, e.g., United States v. O’Malley, 786 F.2d 786, 794 (7th Cir. 1986) (rejecting argument
that witness’s communications to counsel were not privileged because he had given the
same information to the FBI).
[30]
In re Grand Jury Proceedings, 791 F.2d 663, 665 (8th Cir. 1986) (requiring attorney to
authenticate certain signatures and photographs allegedly of the client who was being
investigated by a grand jury because appearance and handwriting generally are not confidential
communications as others could observe them as well); United States v. Weger, 709
F.2d 1151, 1154–56 (7th Cir. 1983) (affirming lower court’s admission of letter to counsel
purely for the purpose of comparing the typeset with that of another letter typed on the
defendant’s typewriter); In re Walsh, 623 F.2d 489, 494 (7th Cir.), cert. denied, 449 U.S.
994 (1980) (finding that privilege does not apply to attorney’s observations about client’s
physical appearance, demeanor, and dress).
[31]
Fed. R. Civ. P. 26(b)(3).
[32]
Id.
[33]
Id.
[34]
See Hickman v. Taylor, 329 U.S. 495 (1947) (finding that work product includes “interviews,
statements, memoranda, correspondence [and] briefs” of lawyers and indicating a strong
reluctance to force an attorney to become a witness); Ford v. Philips Elec. Instruments Co.,
82 F.R.D. 359, 360 (E.D. Pa. 1979) (lawyer’s discussion with a third-party witness concerning
the lawyer’s evaluation of the case were not discoverable at the witness’s deposition); In
re Grand Jury Proceedings (Duffy), 473 F.2d 840, 848 (8th Cir. 1973) (holding that lawyer’s
recollection of conversations with a witness were privileged as work product); Harper & Row
Publishers, Inc. v. Decker, 423 F.2d 487, 492 (7th Cir. 1970), aff’d 400 U.S. 348 (1971) (holding
that law firm’s memoranda of interviews with witnesses were protected).
[35]
Harper & Row Publishers, Inc. v. Decker, 423 F.2d 487, 492 (7th Cir. 1970), aff’d, 400
U.S. 348 (1971).
[36]
See United States v. Int’l Business Mach. Corp., 79 F.R.D. 378, 380 (S.D.N.Y. 1978) (noting
that Supreme Court has never indicated that opposing counsel “could not subsequently
inquire of the witnesses themselves what they said at the interview); Lauritzen v.
Atlantic Greyhound Corp., 8 F.R.D. 237, 238 (E.D. Tenn. 1948), aff’d, 182 F.2d 540 (6th
Cir. 1950) (requiring defendants to produce lists of witnesses to a bus accident, despite
objection that such lists were work product); United States v. Exxon Corp., 87 F.R.D. 624,
638 (D.D.C. 1980) (finding that work product protection does not preclude answering
questions as to whether protected documents even exist). But see In re Grand Jury
Impanelled Oct. 18, 1979 (Malfitano), 744 F.2d 1464, 1467 (11th Cir. 1984) (holding that
a list of potential witnesses interviewed by the attorney was work product because it
revealed the litigation strategy, although disclosure could be made upon a relatively low
showing of need and hardship).
[37]
See generally Kenneth J. Withers, Computer-Based Discovery in Federal Civil Litigation,
Fed. Cts. L. Rev. (Oct. 2000).

THE LITIGATION PROCESS

[38]
See Kenneth J. Withers, The Real Cost of Virtual Discovery, Federal Discovery News
(February 2001).
[39]
Id.
[40]
Fed. R. Civ. P. 26(a)(2)(B) (emphasis added). These disclosures must be made at least 90
days before the trial date or upon the date directed by the court or stipulated to by the parties.
See Fed. R. Civ. P. 26(a)(2)(C).
[41]
238 F.3d 1370 (Fed. Cir. 2001); see also Aniero Concrete Co. v. New York City School
Constr. Auth., 94 Civ. 9111, 2002 U.S. Dist. LEXIS 2892 (S.D.N.Y. Feb. 22, 2002) (concluding
that the majority of courts agree that reliance by the expert on the information is
not necessary for the information to be subject to mandatory disclosure).
[42]
191 F.R.D. 638, 641 (D. Kan. 2000).
[43] For more judicial treatment of the privilege argument in the context of expert disclosures,
see B.C.F. Oil Ref., Inc. v. Consol. Edison Co., 171 F.R.D. 57, 66 (S.D.N.Y. 1997) (disclosures
must include attorney opinions given to the expert); W.R. Grace & Co. v. Zotos
Int’l, Inc., No. 98-CV-838S(F), 2000 U.S. Dist. LEXIS 18096 (W.D.N.Y. Nov. 2, 2000)
(availability of cross-examination at trial is not an adequate substitute for pretrial disclosures
of information considered).
[44]
See W.R. Grace, 2000 U.S. Dist. LEXIS 18096 (finding that drafts of expert report faxed
to counsel must be disclosed).
[45]
204 F.R.D. 277 (E.D. Va. 2001).
[46]
See Fed. R. Civ. P. 26(b)(4).
[47]
Fed. R. Civ. P. 30(d).
[48]
See Fed. R. Civ. P. 56; Fed. R. Evid. 401–403.
[49]
See Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 250–51 (1986) (mandating summary
judgment if a party fails to establish the existence of an element essential to that party’s
claim and on which it bears the burden of proof).
[50]
See, e.g., Suntinger, Inc. v. Scientific Research Funding Group, 189 F.3d 1327, 1334 (Fed.
Cir. 1999) (viewing evidence in a light most favorable to the nonmovant and drawing all
reasonable inferences in its favor).
[51]
See Fed. R. Civ. P. 401, 402, 403.
[52]
Fed. R. Civ. P. 401.
[53]
Fed. R. Civ. P. 403.
[54]
See generally Fed. R. Evid. 801, 802, 803.
[55]
Robert Goldscheider, ADR Focused on Licensing and Intellectual Property, working
paper; 5 Eckstorm’s Licensing in Foreign and Domestic Operations: The Forms and
Substance of Licensing § 21:2 (April 2002).
[56]
See id.
[57] The binding nature of the arbitration or mediation, like many procedural aspects of ADR,
is subject to the stipulation of the parties, either in a pre-existing contract or through an
agreement reached subsequent to the conflict. However, most parties believe that any efficiency
advantages of arbitration are lost if the parties can simply pursue the case in court
once arbitration has concluded. Therefore, arbitration clauses in contracts typically

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

require the arbitration to take place within a certain time frame and for the parties to
accept the arbitrator’s decision as final.

[58] See 9 U.S.C.A. §§ 1–14 (1999).
[59] See 9 U.S.C.A. § 10(a) (1999).
[60] See FAA, 9 U.S.C.A. § 3 (1999); Uniform Arbitration Act § 2(d).
[61] See FAA, 9 U.S.C.A. § 3.
[62] See FAA, 9 U.S.C.A. § 4; Uniform Arbitration Act § 2(a).
ADDITIONAL READING

Walter D. Alley, Electronic Discovery Tools for Litigators, LJN Legal Tech Newsletter

(Oct. 2001).
Steven Babitsky and James J. Mangraviti, Jr., How to Excel During Depositions: Techniques
for Experts That Work, SEAK, Inc. (1999).

Margaret Berger, Evidentiary Framework, Reference Manual on Scientific Evidence 37
(1994).
Morgan Chu, Discovery of Experts, 8 Litigation 13 (Winter 1982).
Theodore C. Hirt, Expert Reports, 22 Litigation 46 (Summer 1996).

William Iscle, Under Oath: Tips for Testifying, LRP Pub. (1995).
Steven Lubet, Expert Testimony: A Guide for Expert Witnesses and the Lawyers Who
Examine Them, NITA (1998).

Joan A. Lukey and Elizabeth A. Rowe, Electronic Discovery: An Overview, www.abanet.org/
litigation/home.html.

David Malone and Paul Zwier, Effective Expert Testimony, NITA (2000).
Marc Rabinoff and Stephen Holmes, The Forensic Expert’s Guide to Litigation: The Anatomy
of a Lawsuit, LRP Pub. (1996).

Mark D. Robins, Computers and the Discovery of Evidence—A New Dimension to Civil
Procedure, 17 J. Marshall J. Computer Info. L. 411 (Winter 1999).

Michael Sacks, A Guide for Testifying and Consulting Experts, LRP Pub. (1995).
Kenneth J. Withers, The Real Cost of Virtual Discovery, Federal Discovery News (Feb.
2001).

Kenneth J. Withers, Computer-Based Discovery in Federal Civil Litigation, Federal
Courts Law Review (Oct. 2000).

2

Damage Principles and Daubert

The plight of the expert in an intellectual property (IP) case brings to mind the statement
by English author Samuel Butler, “Life is the art of drawing sufficient conclusions
from insufficient premises.” Although Butler’s assessment may not have held up under
the standards applicable to a testifying expert’s opinions, the fact is that a case seldom
presents complete documentation or an opportunity for perfect knowledge of all relevant
facts. Moreover, experts often are privy to only a portion of the evidence and are
instructed to operate under a certain set of factual and/or legal assumptions. In essence,
both attorneys and experts are seeking to draw “sufficient conclusions” from the hand
they are dealt. The manner in which they do so is the subject of great debate, both between
opposing parties in litigation and in the judiciary’s continuing attempt to derive
a single set of standards that would apply equally to all expert testimony and provide a
fail-safe measure of reliability. The authors believe that this attempt has been only partially
successful and that the applicable rules are still evolving. Nonetheless, attorneys
and experts must be aware of and play by the present rules set out by the courts. This
chapter explains the current standards for admissibility of expert opinions.

DAUBERT ISSUES

Federal Rules o,f Evidence 702 and 703 govern expert testimony. The traditional standard
for admissibility of expert testimony under Rule 702 was whether the testimony
would assist the triers of fact, rather than confuse or mislead them. Rule 703 sets forth
the standard for admissibility of the underlying data relied on by the expert in formulating
his or her opinion. Rules 702 and 703 were recently revised and the new text
became effective on December 1, 2000. The revisions are intended to codify and clarify
the standards that have evolved under a line of Supreme Court cases that set forth
guidelines for judging when expert testimony is reliable. This line of cases is known as

27

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

the Daubert trilogy, and the committee notes that accompany the revised rules reaffirm
the trilogy’s continued importance.1 The three cases in the Daubert trilogy are
described in the boxes below.

Daubert v. Merrell Dow Pharmaceuticals, Inc.2

In Daubert, the Supreme Court stated that the judge must act as a gatekeeper to
determine in advance of trial whether expert testimony is reliable. The judge must
exclude unreliable testimony from consideration by the court or the jury. The Court
adopted a four-factor test: (1) is the expert opinion testable, (2) has the methodology
been subject to peer review, (3) is there a known error rate for the method, and

(4) is the method generally accepted in the scientific community? These four
criteria became the foundation for judicial evaluations of expert testimony.
General Electric Co. v. Joiner3

In Joiner, the Supreme Court resolved a disagreement among the circuits concerning
the standard for reviewing a district court’s exclusion of expert testimony. The
Court held that a stringent standard of “abuse of discretion” should be applied, giving
district court judges significant leeway in decisions concerning the admissibility
of expert testimony. Discretionary decisions are extremely difficult to overturn
on appeal. The effect of this decision was to encourage district court judges to perform
their role as a gatekeeper, rather than simply admitting everything and letting
disputes about the evidence go merely to weight rather than admissibility.

Kumho Tire, Ltd. v. Carmichael4

In Kumho Tire, the Supreme Court expressly expanded the Daubert inquiry to all
experts. Before Kumho Tire, it was unclear whether Daubert applied to experts other
than scientists. Kumho Tire applied the gatekeeping analysis to any expert, whether
the expert’s field of expertise was chemistry, accounting, economics, or drywall
repair. The Court also explained that the district court should have flexibility in
the application of the Daubert factors to the facts of the case and the expert at issue. The
flexibility of a case-by-case analysis was a natural extension of Joiner granting the district
courts discretion in the decision to admit or exclude expert testimony.

DAMAGE PRINCIPLES AND DAUBERT

All experts in IP cases must be careful not to run afoul of the Daubert principles, or
they risk having their opinions, reports, and testimony excluded. The Daubert trilogy
anticipates removing an expert from litigation entirely, not merely questioning the
weight or credibility that should be given to the expert’s opinions.

MAKING SENSE OF DAUBERT

The Supreme Court’s concern in Daubert was to establish the trial court judge as a gatekeeper
to keep “junk science” out of the courtroom. The danger of “junk science” is that
an unsophisticated jury could be persuaded by a well-polished expert or a person with
impressive credentials and could base a jury verdict on evidence that is not truly competent.
Essentially, the Supreme Court in Daubert desired to eliminate from the courtroom
“systems of knowledge” that have a fundamental nature different from “scientific knowledge.”
Of course, scientific knowledge is not limited to chemistry, physics, biology, and
the other fields one might consider to be traditional sciences. Scientific knowledge simply
refers to one particular means of establishing knowledge. For example, scientific
knowledge is knowledge that is acquired through the scientific method, whether the
information itself pertains to traditional fields of science, economics, or architecture.

The four Daubert factors that the Supreme Court introduced to differentiate science
from nonscience are (1) testability, (2) peer review, (3) error rates, and (4) acceptance
by the scientific community.5 These guidelines were supposed to aid the trial court
in separating scientific systems of knowledge from other types of knowledge. The
assumption of the Court was that scientific systems of knowledge were inherently more
reliable and thus preferable to other means of establishing knowledge. In our view, the
Daubert factors are not adequate for the task, particularly after the Court’s expansion
of the criteria to cover social science in its opinion in Kumho Tire. Instead, the drafters of
the amendment to Federal Rule of Evidence 702 properly expanded the inquiry by
adding other traditional judicial guidelines relevant to social science and damage
experts in particular. These factors are discussed in subsequent sections.

It is useful to first illustrate the logical underpinnings of several systems of knowledge
and then determine whether the Daubert factors alone are useful in distinguishing
between the systems of knowledge or identifying which types of knowledge are reliable.
One important differentiating characteristic of systems of knowledge pertains to
how each system connects unobservable core concepts to observable or empirical
events. We will refer to the unobservable conceptual theory as the “theoretical” level
and the empirical world (i.e., the phenomena we experience through our physical
senses) as the “observable” level. Exhibit 2-1 depicts two types of knowledge that the
Daubert opinion aimed at filtering out of a case during the pretrial period.6

In religious thought, the power of the analysis resides at the theoretical level alone.
There is no connecting relationship between observable reality and explanatory concepts.
The concepts originate elsewhere (e.g., in sacred texts or proclamations of religious
leaders). The litigation equivalent of religious thought is the expert who bases his

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Theoretical Analysis
x
y
y
x
Observational Knowledge
ReligionMysticism
EXHIBIT 2-1 Theoretical and Observational Knowledge

or her conclusions on theory that cannot be challenged by resorting to observation in the
discovery process or through independent analysis. In contrast, what is labeled mysticism
in Exhibit 2-1 involves pure abstraction from observation without the development
of a system of theoretical concepts that offers an explanation for association of
events and a consistency with other theories. The analogy in litigation is the expert
whose opinion is based purely on his “20 years of experience.”

One can view the Daubert opinion as an effort to eliminate religious and mystical
systems of thought as possible bases for a jury’s verdict in complicated litigation
situations. The weakness of the Daubert four-factor approach is that it is both under-
inclusive and overinclusive. In Daubert, the Court explicitly referred to Carl Hempel, an
extreme advocate of the empiricist view of science. Hempel, along with other logical
empiricists such as Karl Popper and Rudolph Carnap, narrowly defined the scientific
inquiry as encompassing solely a set of what Hempel called “deductive nomological”
explanations. The empiricist approach to accumulating scientific knowledge involves
the use of deductive logic to move from premises based on empirical generalization to
an observational conclusion, such as an explanation of a recurring event that enables a
prediction of its recurrence. Such observational predictions are testable, and testing can
directly verify or falsify the prediction. Using the same illustrative approach as adopted
in Exhibit 2-1, Exhibit 2-2 depicts the “empiricist” approach to science.

The “testability” prong of the Daubert approach is a core feature of the empiricist
critique. Unfortunately, most philosophers of science believe it goes too far and throws
the baby out with the bathwater. As many scientists will admit, there is “no exact way

Empirical Knowledge

Observational Knowledge x y
Theoretical Analysis

EXHIBIT 2-2 The “Empiricist” Approach to Science

DAMAGE PRINCIPLES AND DAUBERT

to define anything outside pure mathematics and logic, and even there some basic terms
have extremely shaggy edges.7 For example, under certain conditions, such as high
speeds, Newton’s laws no longer apply. Yet such observations typically result in modifications
and a theory of broader scope (in Newton’s case the theory of relativity), not
complete rejection of the underlying theory because it failed an empirical test. Results
of experiments inconsistent with atomic theory have led to postulation of new particles,
not rejection of the entire atomic theory. Dark matter is the result of observational
anomalies in astronomy, not theoretical rejection. Causation itself is surprisingly vague;
the modern liability expert defines cause by what courts think they can control, resulting
in something that has “little to do with scientific fact and much to do with society,
culture, and legal will. Much like the law itself, one is told.”8

Although the testability prong of Daubert does appear to accomplish the task of eliminating
religious types of thought from the courtroom, the test still is both overinclusive
and underinclusive. It is overinclusive because the testability prong alone would not
exclude mysticism, the expert whose opinion is based on “experience” but not grounded
in particulars. It is underinclusive because scientific theory, particularly in such social
sciences as economics and finance, cannot strictly meet the empiricist criteria. Exhibit
2-3 illustrates the complicated nature of scientific theory.

In science, a complex interaction exists between the observational and the theoretical.
Theories are modified in response to testing. Testing often cannot reach core concepts
of a theory, but is instead performed on a theory’s implications.

The Daubert line of cases does not provide a philosophical justification for the
assumption that the empiricist approach produces inherently more reliable conclusions
than other theories of knowledge. There seems to be a logical disconnect between testability
and reliability; the mere ability to test a conclusion by reference to observable
phenomena does not necessarily ensure that the resulting opinions will be more reliable
than those opinions based on the more complex (and common) merger of theoretical
and observable knowledge. As set forth in Exhibit 2-3, the scientific approach itself is
a process involving comparison of theory and observable phenomena, with the two
being interdependent elements of the overall scientific conclusion. For example, econometricians
are extremely wary of what they call “data mining.” Data mining involves

Observational Knowledge
a bTheoretical Analysis
x y
EXHIBIT 2-3 Scientific Theory

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

simply discovering the relationships between variables and then telling a story about
these relationships ex post facto. This is an example of empiricism, even though the
results are testable. In contrast, the scientific approach is to conceptually develop theoretical
relationships, test these relationships, and adjust the theory when testing reveals
flawed assumptions.

Damage experts in litigation rely on social science, specifically the fields of accounting,
economics, and finance, for their opinions. Unlike natural science, social science
is based on a body of core nonobservable concepts that are articulated into theories
amenable to empirical verification. The core conceptual aspects of social science are not
falsifiable by empirical testing. Although this is true of the natural sciences as well, it is
true to a lesser extent, a fact that appears to be readily accepted by courts. The conceptual
aspects of many natural sciences can be expressed in sets of equations that make
them more, albeit not completely, subject to refutation. In economics, by contrast, there
is no unifying set of equations, but instead a variety of the basic principles linked to
models. The models themselves are testable, but empirical falsification of a model
does not invalidate basic principles, because these principles are only loosely related
to the models, mediated by layers of specific assumptions. For example, economics
and finance are grounded in assumptions about human preferences that allow for the
existence of a “utility function.” A utility function can then be used to establish other
concepts such as “demand” in economics or “risk aversion” in finance. These latter concepts
are testable, but their utility foundations are not. To the extent that Daubert
requires testability of basic theory, social science cannot clear the hurdle. Yet this certainly
is not the result desired by the Daubert Court, particularly in light of Kumho Tire.

Another ambiguity in Daubert arises over how to apply the testability factor. Is testability
applied to the theory, the expert’s model, or is the expert’s model applied to the
facts of the case? The judicial answers to these questions are not clear or consistent.
Moreover, use of the word methodology is not helpful. All of these levels or any subset
thereof could be included in the term methodology.

Leaving aside the issue of the error rate, which again relates to testability, the Daubert
factors pertaining to peer review and acceptance in the scientific community are helpful
methods of ferreting out scientific thought from nonscientific knowledge within the
natural sciences. Scientists appear to know science when they see it. Thomas Kuhn, in his
book The Structure of Scientific Revolutions, is a dissenter in this regard, but today
his relativist view is held by only a minority. Kuhn contended that acceptance by the
community of scientists was what made a theory survive, not its ability to generate
knowledge. Kuhn himself revised his radical view in a postscript, and few scientists hold
such a skeptical view of science. Nonetheless, academics are well aware that peer review
and professional acceptance are not foolproof criteria for good science, and Kuhn’s criticism
contains a kernel of truth, especially in the social sciences. For example, no one
can argue persuasively that economic theory evolves solely through a series of falsifications.
Instead, social science is closely tied to events outside of its discipline. In the eco

DAMAGE PRINCIPLES AND DAUBERT

nomics profession, the Great Depression gave rise to Keynesianism and the inflation of
the 1970s led to monetarism. Moreover, there are numerous examples of prominent theories
that fail to yield empirically verifiable results yet survive and thrive in the social
sciences. In finance, the capital asset pricing theory (CAPM) is an example. Although
several prominent papers empirically have raised doubts about CAPM, it remains the
leading theory of asset pricing in finance.9 Accordingly, while reliance on peer review in
the social sciences is important, if taken to extreme, it merely delegates issues of admissibility
to a small group of journal referees (with possible political biases).

The Kumho Tire case and the commentary to Rule 702 provide a marked shift away
from the Daubert factors to a much more workable basis for the Court’s gatekeeper
function. In Kumho Tire, the Supreme Court clarified that all expert testimony is admissible
only if it is both relevant and reliable.10 The criteria of reliability and relevance
avoid the pitfalls of the strict four-factor Daubert approach and allow a plaintiff or
defendant to challenge the viability of an opposing theory on scientific grounds in the
specific context of the case in which it is being proffered. By “relevant,” the Court
meant that the expert opinion must “fit” the facts of the case and “aid the trier of fact.”11
An expert cannot simply ferret out facts from the record that are consistent with his or
her opinion and ignore others. Nor will “canned” analysis be acceptable under Rule

702. As an example, in Concord Boat Corp. v. Brunswick,12 the Eighth Circuit overturned
a $44 million verdict on the grounds that the expert opinion should not have been
admitted under Daubert. In part, the court concluded that the expert’s opinion lacked
relevance because the expert did not “segregate any lawful acts and unrelated market
events . . . in order to enable the jury to assign damages only for illegal actions taken
by [the defendant].”13 Disaggregation is connected to relevance because without dis-
aggregating damages, an expert opinion does not “aid the trier of fact.” Following
Concord Boat (which is in accord with a series of Ninth Circuit cases), experts are required
on relevance grounds to segregate damages by each alleged cause. One lump-sum
number for the amount of damages allegedly caused by a variety of conduct (potentially
both legal and illegal acts) likely will not pass the relevance prong of Rule 702.
Rule 702 also requires that an expert opinion be reliable. Reliability is a difficult
concept that combines the four Daubert factors with traditional concerns about speculation,
lack of mitigation, and logical consistency of a damage analysis. The 2000
commentary to Rule 702 is very helpful in elucidating several factors that could be
considered in a reliability analysis. We quote from the commentary at length:

Courts both before and after Daubert have found other factors relevant in determining
whether expert testimony is sufficiently reliable to be considered by the trier of fact. These
factors include:

(1) Whether experts are “proposing to testify about matters growing naturally and directly
out of research they have conducted independent of the litigation, or whether they have
developed their opinions expressly for purposes of testifying.” Daubert v. Merrell Dow
Pharmaceuticals, Inc., 43 F.3d 1311, 1317 (9th Cir. 1995).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

(2) Whether the expert has unjustifiably extrapolated from an accepted premise to an
unfounded conclusion. See General Elec. Co. v. Joiner, 522 U.S. 136, 146 (1997) (noting
that in some cases a trial court “may conclude that there is simply too great an analytical
gap between the data and the opinion proffered).
(3) Whether the expert has adequately accounted for obvious alternative explanations. See
Claar v. Burlington N.R.R., 29 F.3d 499 (9th Cir. 1994) (testimony excluded where the
expert failed to consider other obvious causes for the plaintiff’s condition). Compare
Ambrosini v. Labarraque, 101 F.3d 129 (D.C. Cir. 1996) (the possibility of some uneliminated
causes presents a question of weight, so long as the most obvious causes have been
considered and reasonably ruled out by the expert).
(4) Whether the expert “is being as careful as he would be in his regular professional work
outside his paid litigation consulting.” Sheehan v. Daily Racing Form, Inc., 104 F.3d 940,
942 (7th Cir. 1997). See Kumho Tire Co. v. Carmichael, 119 S. Ct. 1167, 1176 (1999)
(Daubert requires the trial court to assure itself that the expert “employs in the courtroom
the same level of intellectual rigor that characterizes the practice of an expert in the relevant
field”).
(5) Whether the field of expertise claimed by the expert is known to reach reliable results for
the type of opinion the expert would give. See Kumho Tire Co. v. Carmichael, 119 S. Ct.
1167, 1175 (1999) (Daubert’s general acceptance factor does not “help show that an
expert’s testimony is reliable where the discipline itself lacks reliability, as, for example,
do theories grounded in any so-called generally accepted principles of astrology or necromancy.”);
Moore v. Ashland Chemical, Inc., 151 F.3d 269 (5th Cir. 1998) (en banc) (clinical
doctor was properly precluded from testifying to the toxicological cause of the
plaintiff’s respiratory problem, where the opinion was not sufficiently grounded in
scientific methodology); Sterling v. Velsicol Chem., Corp., 855 F.2d 1188 (6th Cir. 1988)
(rejecting testimony based on “clinical ecology” as unfounded and unreliable).
All of these factors remain relevant to the determination of the reliability of expert testimony
under the Rule as amended.14

In sum, the standards for admissibility of expert testimony have become more stringent.
The Supreme Court’s opinions in the Daubert trilogy marked a good first step
toward the development of guidelines for admissibility, but in the long run the current
guidelines will not be workable. However, the revisions to Rule 702 have made the
inquiry more realistic and flexible. Both lawyers and experts must understand and meet
the standards for admissibility as these standards continue to evolve.

DAMAGE ANALYSIS IN GENERAL IN LIGHT
OF THE SUBSTANTIVE CASE LAW ON DAMAGES

An expert can be excluded under a Daubert inquiry or because of a more traditional failure
to satisfy the proper case law standards for computing damages. The core principle
of compensatory damages requires awarding the smallest monetary amount required to
put the plaintiff in the pecuniary position he or she would have been in had the alleged
“bad act” not occurred. In order to comport with this basic standard, the expert must

DAMAGE PRINCIPLES AND DAUBERT

have a good grasp of the plaintiff’s actual economic situation. The expert must then construct
the hypothetical “but for” world, that is, the hypothetical situation that the plaintiff
would have been in had the defendant’s bad conduct not happened.

Compensation

=

“But For” World

–

“Actual” World

The case law puts specific limits on how experts can construct the “but for” world,
and violation of these limitations expose the expert’s analysis to a possible Daubert
challenge on reliability grounds. Being familiar with some of the judicial ground rules
for damages calculations can be as important as having a working knowledge of the
economic or financial basics necessary to reach a reliable conclusion. The most carefully
constructed damage theory may become worthless if it does not comply with the
following judicial principles.

The “But For” World Is Restricted to Constructions Based on
Information Known with “Reasonable Certainty”

Regardless of the expert’s intuition or the plaintiff’s judgment about the “but for” world,
the expert is limited to record evidence, or other evidence conforming to Rule 703, that
is known with “reasonable certainty.” For example, an expert cannot speculate about
future growth rates without a sound basis in past performance, industry growth rates,
or comparable business growth rates. A plaintiff’s confidence that sales were about
to increase ten-fold will not be adequate foundation for projecting lost profits. Absent
use of information known with reasonable certainty, the damage analysis is speculative
and subject to dismissal.

Bigelow v. RKO Productions15

Bigelow involved a suit for treble damages under the Sherman Antitrust Act by an
independent movie theater against distributors of films and their affiliated theaters.
The jury found that there had been an unlawful conspiracy among the distributors
and their affiliated theaters to leave the independent exhibitor with
nothing but second-run films. The jury awarded damages based on the discriminatory
operation of the release system and the resulting decrease in the independent
theaters’ ticket sales. The Supreme Court held that it is proper for a jury
to infer that the plaintiffs had been damaged based on certain circumstantial
facts, including the defendants’ wrongful acts, the tendency of the wrongful
acts to injure plaintiff’s business, and evidence of a decline in profits. The Court

(continues)

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Bigelow v. RKO Productions (continued)

recognized that the bad acts themselves had made it impossible to ascertain precisely
what profits would have been in the but-for world, but found that the jury
could make a “just and reasonable estimate of the damage based on relevant
data . . . [including] probable and inferential as well as . . . direct and positive
proof.”

The Court stated that a jury verdict cannot be based on “speculation or guesswork,”
but that comparison of plaintiff’s receipts before and after the unlawful
acts afforded an adequate basis for the jury’s computation of the damages.

The “But For” World Must Have Been Foreseeable by the Parties

Courts limit the “but for” world to situations that either were foreseen by the parties
in the lawsuit or would have been generally foreseeable at the time of the contract or
the tort. Subsequent exotic or remote circumstances, even if known with reasonable certainty,
cannot be used in constructing the “but for” world.

Hadley v. Baxendale16

Although Hadley v. Baxendale is a case from the English courts in the nineteenth
century, it established a principle of damage calculation, the foreseeability
requirement, that remains extremely important today. In Hadley, the owners of
a flour mill sent a broken shaft to the defendant—a nineteenth century equivalent
of a FedEx office—to be shipped for repairs. Due to some errors on the defendant’s
part, the shipment of the shaft was significantly delayed. The mill owner
sued the shipper, seeking the lost profits that he incurred from shutting down his
mill while waiting for the replacement part. The court held that damages should
be restricted to foreseeable damages, i.e., those damages that the parties might
reasonably anticipate at the time that they made the contract. In this case, the court
found that the shipper could not have reasonably foreseen that a delay in shipping
the part would force the miller to cease all business during the interim.

“[I]t is obvious that, in the great multitude of cases of millers sending off broken
shafts to third persons by a carrier under ordinary circumstances, such consequences
would not, in all probability, have occurred.... It follows, therefore, that
the loss of profits here cannot reasonably be considered such a consequence of the
breach of contract as could have been fairly and reasonably contemplated by both
parties when they made this contact.”

DAMAGE PRINCIPLES AND DAUBERT

The “But For” World Must Be Constructed Using
the “Least Cost Avoidance Principle”

When the expert constructs the “but for” world, he or she must construct it by taking
into account how the plaintiff could have adjusted or did adjust to the changed circumstances.
Optimizing behavior should be assumed on the part of the injured party.
For example, in a case involving the failure to lend money, the “but for” world should
assume that the plaintiff can borrow money at a higher rate from another source. The
expert cannot skip to the assumption of devastating losses unless it can be demonstrated
that no other lender was reasonably available. In short, irrational failures to mitigate and
minimize damages will be held against the injured party when it comes time to calculate
the appropriate remedy.

Only the “Bad Acts” of the Defendant Can Be Subtracted
in Constructing the “But For” World

The defendant is responsible for only his or her bad acts. A bad act is a violation of the
law, such as a breach of a contract or an infringement of a valid patent. The expert must
construct the “but for” world by assuming that the defendant did not behave in the manner
that caused the violation, but that all other factors remained constant. For example,
an expert cannot construct the “but for” world under the assumption that if the defendant
had not breached the contract he or she also would have entered and performed on a
second contract. In addition, the “but for” world must acknowledge shortcomings in the
profit structure of the plaintiff that cannot be attributed to the bad act of the defendant.

Risk and Reward Must be Matched

Because the violation virtually always occurs at a time earlier than the date of the damage
analysis, the difficulty lies in determining how to measure the stream of benefits
that would have occurred in the “but for” world after the date of the violation. This is
an issue of significant controversy. It is clear that when a plaintiff is awarded damages,
he or she is relieved of the risk of the receipt of the benefit stream. Hence, it is inappropriate
to construct a “but for” world in which the plaintiff is compensated for risk
that was reduced by the actions of the defendant. For example, suppose a business contracts
to provide a particular asset (possibly a type of technology) to another business.
The asset is never provided, and as a result, the purchaser loses a potentially valuable
opportunity because of the absence of the asset. Sometime later, when liability issues
are no longer in dispute, the expert is asked to calculate the damages resulting from the
breach of the contractual promise to provide the asset several years earlier. Two important
issues must be addressed. First, what would have been the plaintiff’s position at the
time of the bad act had the bad act not occurred (i.e., what was the value of the opportunity)?
Second, how should the passage of time between when the wrong occurred and

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

the resolution of the case be treated? A large body of economic literature addresses these
issues.17 The answers to both of these questions, in the authors’ view, require the use of
the real option theory.18

Unrealistic Reliance on Market Imperfections Should Be Avoided

To the extent that damages depend on significant market imperfections, such damages
must be factually justified. In the absence of facts to the contrary, courts require that
competitive responses in the “but for” world be taken into account. For example, it cannot
be assumed that a firm in a competitive market would receive substantial economic
rents for long periods without encouraging entry by other participants. Moreover, if the
expert assumes that positive net present value opportunities exist in the “but for” world,
this assumption must be justified in light of the available facts. As a last example, strong
factual justifications must be present before damages can exceed a company’s market
cap or total value.

Courts have excluded from evidence damage analyses that fail to account for competitive
responses. For example, the Ninth Circuit in Murphy Tugboat Co. v. Crowley19
stated as follows:

The expert witness’s testimony as to Murphy’s expected share in the large vessel and flat tow
market segment depended upon an assumption that Red Stack would not cut its prices in reaction,
even to a loss of over one-quarter of its prior share of . . . the market.... A reasonable
jury could not, however, indulge in the assumption that a competitor would follow a course
of behavior other than that which it believed would maximize its profits.... In a hypothetical
economic construction, such as the one underlying Murphy’s theory on lost past profits, economic
rationality must be assumed for all competitors, absent the strongest evidence of
chronic irrationality. Otherwise, it will be impossible to keep chronic speculation in check.

Other cases have reached similar conclusions.20

Where Possible, Damages Must Be Constructed Cause by Cause (Disaggregation)

A failure to disaggregate damages by the various causes at work can be fatal to an expert
opinion. Experts must link, or segregate, their claimed damages according to the identified
causal factors. Where an expert asserts an assortment of separate business practices
or a variety of conduct as the proximate cause of the claimed damages, the expert
also must particularize their damage proof to the fullest extent possible. In other words,
specific damages must be attributed to particular causes.

The impetus for requiring disaggregation wherever possible is the scenario in which
a finder of fact (either the judge or the jury) determines that only some of the challenged
acts were illegal and holds that the remainder of the alleged conduct was lawful.
Without particularized chains of cause and effect, the trier of fact is left with no rational
basis for determining the amount by which to reduce the plaintiff’s damages. Yet, if the

DAMAGE PRINCIPLES AND DAUBERT

damages are not reduced by some amount, they likely are insufficiently tied to the
challenged conduct and fail to account for the effect of legitimate market competition.
Courts want neither to give a windfall to plaintiffs damaged by legal conduct nor to
force a defendant to “compensate” for more than the damages proximately caused by
their illegal acts.

MCI Communications Corp. v. AT&T21

In MCI, the court held that plaintiff’s damage theory failed because it did “not
establish any variation on the outcome depending on which acts of AT&T were
held to be legal and which illegal.” At trial, the jury found that some of AT&T’s
conduct constituted legitimate competition. However, the jury was left without a
means to adjust the amount of damages to reflect lawful competition, other than
purely “guessing” at the appropriate reduction. Leaving the jury in such a position
does not “assist the trier of fact” as required by Federal Rule of Evidence 702, and
therefore the damage theory could not be admissible.

Damages Should Be Discounted to Account for Risk and the Time Value of Money

In some cases, an award of monetary damages should be adjusted to reflect the economic
consequences of the alleged bad act. The actual calculations required to discount
economic damages are discussed in Chapters 5 and 14. However, it is important for the
attorney to understand when such a calculation is necessary or appropriate. Essentially,
damages can be discounted for two reasons: First, where the plaintiff did not bear the
risk related to the profits or opportunity lost as a result of a defendant’s bad act; and
second, where the damages resulting from the bad act are long-lasting.

The theory behind discounting damages in the first scenario is that one component
of lost profits is a return for bearing risk. Where a plaintiff lost the opportunity to earn
profits, he did not bear risk and should not receive a return as if he had borne the risk.
Accordingly, lost profits can be discounted at a rate that includes a risk premium. This
rationale might apply where a defendant is accused of breaching a commercial contract
and that breach prevented the plaintiff from doing business.

The second reason to discount involves the time value of money. In accordance with
well-established economic principles, long-lasting damages should be discounted to
take into account the declining value of money over time. Damages can be long-lasting,
either because they stem from a single wrongful act that had significant consequences
or because they stem from a series of wrongful acts, each of which directly damaged
the plaintiff for a short period. With the first type of bad act, the defendant may have
destroyed an asset that would have yielded a stream of profits for many years. The damages
would last as long as the stream of profits would have lasted, but they would need

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

to be discounted each year back to the time of the wrongful act. Similarly, if the defendant’s
wrongful act resulted in delaying the plaintiff’s opportunity to make profits,
the lost profits attributable to the delay would be discounted for each period of delay.
For example, a stream of lost profits resulting from one year’s delay would be discounted
back to the year when the wrongful act began to inflict damages; a stream of
additional lost profits resulting from an 18-month delay also would be discounted back
to the time of the bad act.

In determining the need to discount the damage award, the duration of the damages
themselves is more important than the duration of the alleged wrongful act or acts. In
essence, courts determine whether a particular set of damages is long-lasting by evaluating
whether and how quickly the plaintiff’s stream of profits could be restored by the
cessation of the bad act.

These basic principles of damages apply in the context of each of the specific areas
of IP law that we discuss in Chapters 6, 7, 10, 11, and 13. It is important to consider the
basic tenets when evaluating your options for damage calculations. Some means of calculating
damages may offer potentially greater recovery than others, but they would be
harder to construct in a manner that coheres with the judicial rules for admissible damage
theories previously discussed. Keep these basic principles of damage calculations
in mind when evaluating the remedies available in particular areas of IP.

SUMMARY

This chapter examined the judicial standards that expert testimony must satisfy to be
admissible for any purpose in court. Specifically, this chapter analyzed the means of
establishing (or attacking) an expert’s opinions as both reliable and relevant under the
Daubert trilogy and the FRE. Additionally, the chapter introduced some general principles
that apply to all damage theories and outlined their particular application in IP litigation.
The information in this chapter provides a basic foundation for discussions of
any potential damage theory and the evidence that will be necessary to support it.

ENDNOTES

[1]
See Fed. R. Evid. 702 Advisory Committee Notes, 2000 Amendments.
[2]
Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579 (1993).
[3]
General Elec. Co. v. Joiner, 522 U.S. 136 (1997).
[4]
Kumho Tire, Ltd. v. Carmichael, 526 U.S. 137 (1999).
[5]
See Daubert, 509 U.S. at 593–94.
[6]
See generally David Willer and Judith Willer, Systematic Empiricism: Critique of a Pseudoscience,
Englewood Cliffs, N.J.: Prentice-Hall (1973).
[7]
Martin Gardner, Science: Good, Bad and Bogus, Buffalo, NY: Prometheus Books
(1989), xii.

DAMAGE PRINCIPLES AND DAUBERT

[8]
Peter W. Huber, Galileo’s Revenge: Junk Science in the Courtroom, New York: Basic
Books (1989), at 215–16.
[9]
See Richard Roll, A Critique of the Asset Pricing Theory’s Tests, J. Fin. Econ. 4 (1977);
Eugene Fama and Kenneth French, The Cross-Section of Expected Stock Returns, J. Fin.
427 (1992).
[10] See Kumho Tire, 526 U.S. at 150–51.
[11] See id.
[12] 207 F.3d 1039 (8th Cir. 2000).
[13] Id. at 1055.
[14] Fed. R. Evid. 702 Advisory Committee Notes, 2000 Amendments.
[15] Bigelow v. RKO Prods., 327 U.S. 251 (1946).
[16] Hadley v. Baxendale, 9 Ex. 341, 354, 156 Eng. Rep. 145, 151 (1854).
[17] Franklin Fisher and R. Craig Romaine, Janis Joplin’s Yearbook and the Theory of Damages,
5 J. Acct., Aud. Fin. 145 (1990). See, e.g., William Tye, Stephen Kabor, and A. Lawrence
Kolbe, How to Value a Lost Opportunity from Market Foreclosure, 12 Res. L. Econ. 83 (1995);
Konrad Bonsack, Damages Assessment, Janis Joplin’s Yearbook, and the Pie-Powder
Court, 13 Geo. Mason U.L. Rev. 1 (1990); Tyler Bowles and W. Chris Lewis, Unsettled
Issues in Measuring Lost Profits, 9 J. Legal Econ. 19 (2000); James Patell, Roman Weil, and
Mark Wolfsen, Accumulating Damages in Litigation: The Roles of Uncertainty and Interest
Rates, 11 J. of Legal Studies 341 (1982); R. F. Lanzillotti and A.K. Esquibel, Measuring
Damages in Commercial Litigation: Present Value of Lost Opportunities, S.J. Acct., Aud.
Fin. 125 (1990); Kenneth Kolaski and Mark Kuga, Measuring Commercial Damages
Via Lost Profits or Loss or Business: Are These Measures Redundant or Distinguishable?
18 J.L. Com. 1 (1998); John D. Taurman and Jeffrey C. Bodington, Measuring Damage to
a Firm’s Profitability: Ex Ante or Ex Post, 37 Antitrust Bull. 57 (1992); Andrew Simmonds,
Indirect Causation: A Reminder from the Biblical Goring Ox Rule for Fraud on the Market
Securities Litigation, 88 Ky. L.J. 641 (1999–2000); Janet Kiholm Smith, Reference Guide
on the Estimation of Economic Losses: The Economic Approach to Evaluating Damage
Awards, 36 Jurimetrics J. 217 (1996); Robert Fuhrman, A Discussion of Technical Problems
with EPA’s Ben Model, 1 Envtl. Law 561 (1995).
[18] This issue is beyond the scope of this book, but the authors plan to address it in some
detail in the first supplement to this book.
[19] 658 F.2d 1256, 1262 (9th Cir. 1981) cert. denied, 455 U.S. 1018 (1982).
[20] See, e.g. Park v. El Paso Bd. of Realtors, 764 F.2d 1053 (5th Cir. 1985), cert. denied, 474
U.S. 1102 (1986); Coleman Motor Co. v. Chrysler Corp., 525 F.2d 1338 (3rd Cir. 1975).
[21] 708 F.2d 1081, 1163 (7th Cir. 1982).
ADDITIONAL READING

Margaret A. Berger, Procedural Paradigms for Applying the Daubert Test, 78 Minnesota
Law Review 1345 (June 1994).

Judge Harvey Brown, Eight Gates for Expert Witnesses, 36 Houston Law Review 743
(Fall 1999).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

David L. Faigman et al., How Good Is Good Enough? Expert Evidence Under Daubert
and Kumho, 50 Case Western Reserve Law Review 645 (2000).

Shubha Ghosh, Fragmenting Knowledge, Misconstruing Rule 702: How Lower Courts
Have Resolved the Problem of Technical and Other Specialized Knowledge in Daubert v.
Merrell Dow Pharmaceuticals, Inc., 1 Journal of Intellectual Property 1 (Spring 1999).

Robert J. Goodwin, The Hidden Significance of Kumho Tire Co. v. Carmichael: A Compass
for Problems of Definition and Procedure Created by Daubert v. Merrell Dow Pharmaceuticals,
Inc., 52 Baylor Law Review 603 (2000).

Michael H. Graham, The Expert Witness Predicament: Determining “Reliable” Under
the Gatekeeping Test of Daubert, Kumho, and Proposed Amended Rule 702 of the Federal
Rules of Evidence, 54 University of Miami Law Review 317 (2000).

D. Bruce Johnsen, Daubert, The Scientific Method, and Economic Expert Testimony,
9 Kansas Journal of Law & Public Policy 149 (1999).
Joseph A. Kuiper, The Courts, Daubert, and Willingness-to-Pay: The Doubtful Future of
Hedonic Damages Testimony Under the Federal Rules of Evidence, University of Illinois
Law Review 1197 (1996).

Mark Lewis and Mark Kitrick, Kumho Tire v. Carmichael: Blowout From the Over-
inflation of Daubert v. Merrell Dow Pharmaceuticals, 31 University of Toledo Law
Review 79 (Fall 1999).

Robert F. Reilly, Implications of Recent Daubert-Related Decisions on Valuation Expert
Testimony, 18 American Bankruptcy Institute Journal 28 (June 1999).

Nicholas Targ and Elise Feldman, Courting Science: Expert Testimony After Daubert and
Carmichael, 13 Natural Resources & Environment 507 (Spring 1999).

Jeanne Wiggins, Kumho Tire Co. v. Carmichael: Daubert’s Gatekeeping Method Expanded
to Apply to All Expert Testimony, 51 Mercer Law Review 1325 (2000).

David Willer and Judith Willer, Systematic Empiricism: Critique of a Pseudoscience,
Englewood Cliffs, N.J.: Prentice-Hall (1973).

3

Introduction to the Economics
of Intellectual Property
Damage Calculations

Intellectual property (IP) damage analysis is significantly informed by the disciplines of
industrial organization economics, law and economics, accounting, and the financial
principles of valuation. Chapters 3, 4, and 5 address these topics. In particular, the legal
framework for calculating damages in IP cases is remarkably amenable to economic
and financial principles. Chapter 3 begins by developing the basic economics used in IP
damage analysis. Chapters 4 and 5 address accounting and valuation principles.

A BRIEF REVIEW OF BASIC ECONOMICS

Assumptions are simply inescapable, in both economic and legal matters. “Economists
make assumptions for the obvious reason that the world, viewed economically, is too
complicated to understand without abstraction. . . . The art of economics is picking
assumptions to better understand certain features of it, without inevitably causing those
features to be unimportant ones.”1 If one were to summarize the foundations of microeconomics
in the tersest fashion, one might focus on three assertions: (1) consumers
maximize utility, (2) firms maximize profit, and (3) the market seeks equilibrium. The
first assumption, that consumers maximize utility, is called consumer rationality, and
it leads to the concept of the demand curve. The demand curve is simply a summary of
the amounts of a product that consumers as a whole will be willing to purchase at different
prices. In contrast, the supply curve describes how much output firms will produce
as their output prices increase. This follows from the second assumption because
firms produce the quantity of output that maximizes profit. Finally, market equilibrium
is the point at which neither producers nor consumers have incentives to change prices
or output. Clearly, microeconomic behavior is more complicated in the real world. The
method used in economics is to first assume perfect markets and in that context model
economic outcomes. Then, after studying perfect markets, assumptions are weakened

43

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

and the impact of market imperfections are studied. The latter process has resulted in
much of the useful economic theory for IP damage analysis.

Demand

Demand is essentially a multivariate relationship that depends not only on the price of
the commodity in question, but also on the prices of other goods that may be substitutes
or complements, the subjective tastes and preference of the individual consumers, their
incomes, and a host of other variables. The demand function relates the quantity that
consumers demand to these determining factors. A sample demand function can be
expressed as:

Q = FP 1,,P2IT

( , )

where
P1 is the price of the commodity concerned
P2 is the price of another commodity (constant)
I is the income of the consumer (constant)
T is the tastes and preferences of the consumer (constant)

When a demand function is plotted, as in Exhibit 3-1, it displays a negative slope
implying that lower quantities are demanded at high prices and vice versa.

Supply

The supply function is also a multivariate function that depends on factors such as the
market price of the commodity at issue; the prices of the labor, capital, and raw materials;
the level of technology; the taxation or subsidy policy of the government; and so

P1

Price

P2

Demand (D)

Q1 Q2

Quantity

EXHIBIT 3-1 Demand Function

ECONOMICS OF IP DAMAGE CALCULATIONS

on. The supply curve illustrates how the quantity produced changes with the prices of
the commodity in question. In general, producers will be willing to produce more when
their ,output prices are higher because it increases their profits. Higher profits from the
sale of one particular product encourage the firm to increase the output of this product,
as opposed to other products or engaging in other activities. The supply curve is positively
sloped, as shown in Exhibit 3-2. A simple supply function can be denoted as:

( KLRG)

Q = GP 1,,, ,

where
P1 is the price of the commodity concerned
K is the amount of capital employed
L is the amount of labor employed
R is the amount of raw materials employed
G represents government taxes or subsidies

Market Equilibrium

Given a supply and a demand function, it becomes relatively simple to determine the
level of output that would be steady state position for producers and consumers alike.
Superimposing the two curves determines the equilibrium level of output and price Q*
and P* (see Exhibit 3-3).

At price P*, the producers are willing to supply Q* amount of the commodity;
likewise; the consumers are willing to pay P* for the same amount of the commodity,
making P* the equilibrium price and Q* the equilibrium quantity. At P* and Q*, there
is no incentive to change position. In contrast, at any P > P*, there will be more supply

Supply (S)

P1

Price

P2

Q2 Q1

Quantity

EXHIBIT 3-2 Supply Curve

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Q*

Supply (S)

Price

P*

Demand (D)

Quantity

EXHIBIT 3-3 Market Equilibrium

than demand. This will cause inventories to build up, and firms will lower prices to
sell their excess stock. Likewise, at P < P*, demand will exceed supply, and firms will
bid up prices to achieve higher profits. As a result, only at P*, Q* is there no incentive
to change price and output. We call this pair the equilibrium price and output. We now
turn (or abruptly jump) from the very basic microeconomic model to more specialized
analyses that are useful in IP damage cases. The reader who is not well versed in economics
should be aware that we now intend to skip several layers of basic concepts to
go directly to the operational economic principles useful for our topics.

THE INDUSTRIAL ORGANIZATION FOUNDATIONS
OF INTELLECTUAL PROPERTY DAMAGES

Competent analysis of damages requires a working knowledge of industrial organization.
Industrial organization is a branch of applied microeconomics that addresses such
issues as the relationship between market structure, prices and output, market power,
defining the relevant market, imperfect competition, and innovation. Numerous economics
textbooks are available that set forth the basic concepts in this area. This chapter
first focuses on a limited number of specific concepts that are critical for conducting
damage analysis in an IP case.

The fundamental question in IP damage analysis is what would the “market” look
like “but for” the infringement of a patent, copyright, trademark, or trade secret. Therefore,
an important issue for analyses of lost profits, reasonable royalties, and the causation
of infringer profits relates to how consumers react to the absence of the infringer’s
product or service in the market. Consumer reaction can be studied directly through
econometric techniques when adequate data are available or more typically through
inferences based on market analysis.

ECONOMICS OF IP DAMAGE CALCULATIONS

In this section, we focus on building the economic apparatus for market analysis.
Economists have developed two exemplifying paradigm market structures used as a
starting point by students of economics: perfect competition and monopoly. Readers
who are unfamiliar with these basic economic tools are referred to the Additional
Reading at the end of the chapter. Exhibit 3-4 illustrates both paradigm types of market
structures.

Under perfect competition, each firm sets prices equal to marginal cost. This is evident
in Exhibit 3-4, where Pc equals MC. This means that the firm achieves average
profitability (sometimes referred to as the opportunity cost of capital because it is
no more than the profits that could be achieved by the next most productive use of the
capital). The conditions that support perfect competition are extreme and exacting.
Formally, these conditions would be: (1) no differences among products; (2) infinitely
many, infinitely small firms; (3) no barriers to entry; and (4) perfect consumer and producer
information.

At the other extreme, in the absence of competition, a firm will set its price at the
monopoly price. The monopoly price is always higher than the competitive price and
occurs where marginal cost equals marginal revenue. Considering the difference between
the monopoly model and the competitive model provides some flavor for how
economics can be useful in calculating differences between an actual world and a “but
for” world in, for example, a patent infringement case. Assume that a market consists
of only two firms, the patent owner and the infringer. In competition, under fairly general
assumptions, the patent owner would set price at Pc and obtain sales of Qc. However,
if the infringer did not exist, the patent owner would set price at PM and sell QM.
The lost profits arising from the difference between the actual world and the “but for”
world in this simple case is the area B. Real-world situations are much more complex
than this simple case. Nonetheless, if the economist has sufficient information, the equilibrium
prices and quantities in the “but for” world can be calculated.

PM

PC

C
B A
DMR
MC
EXHIBIT 3-4 Paradigm Market Structures

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

In most situations, markets in which infringement occur consist of more than two
competitive products. In these more typical situations, economists employ more complex
oligopoly models to study the impact of hypothetical market changes arising from
the removal of an infringing product from the market.

Models of competition and monopoly exhibit an important relationship between market
power and elasticity of demand. Elasticity is the economist’s measure of the responsiveness
of output, or degree of consumer switching, to changes in price. Elasticity is a
ratio of percentage changes, and therefore is unitless, so that its measure is not affected
by the units of measure for prices or quantities. More formally:

ΔQ
Q ΔQP dQP

Elasticity = = ×=×

ΔP ΔPQ dPQ
P

The inverse slope of the demand curve is dQ/dP. The additional term P/Q indicates
that elasticity typically changes at each point on the demand curve. As a firm raises
its price, elasticity generally increases because other competing products appear more
competitive to consumers. As a result, it would be incorrect to simplistically infer a lack
of market power from the observation that consumers freely substitute between a variety
of products.2

A monopolist who maximizes profit will raise its price until it faces sufficient restraints
from substitute products to make further increases unprofitable. The monopolist
maximizes profits by balancing the greater profit margin on all sales that results
from raising its price against the potential lost sales due to consumers defecting to competing
products because of the high price (this is precisely what elasticity measures).
The firm can achieve its optimal profit maximizing price by setting its marginal revenue
(the revenue it receives for an additional unit) equal to its marginal cost (the variable
cost of producing the additional unit of output).

The marginal revenue that a firm receives can be written in terms of elasticity:

dPQ ) dQ

(
dP

MR = =(P) +(Q)

dQ dQdQ

Algebraic manipulation of the right-hand side of the above equation yields:

. Q dP .

= P
1 +

..
P dQ..
1

..

= P
1 .

. e.

ECONOMICS OF IP DAMAGE CALCULATIONS

where “e” is the elasticity measure. When the firm attempts to set price optimally to maximize
its profits, it will set marginal cost equal to marginal revenue:

1

..

MC = MR = P1 .

. e.

Manipulating this equation leads to the following important relationship.3

PMC 1

.

=

Pe

Accordingly, as the equation above demonstrates, there is a very strong general relationship
between the optimal markup over cost (market power) and the inverse of the
elasticity of demand facing the firm.

The economic concept of relevant market attempts to link the concepts of market
power and market share. Market power is defined as the ability to profitably raise price
above competitive levels (i.e., above marginal cost). Courts in antitrust cases have for
several decades equated “monopoly” with large market shares. Indeed, to measure market
share it is necessary to define the relevant market in which market share is measured.
The necessity of defining the relevant market in turn begs the question of the
theoretical basis for equating market share and market power. Two oligopoly models
provide a direct link between market power and market share that does not depend on
the existence of overt collusion. The theoretical establishment of this link provides the
basis for defining the relevant market in a coherent fashion.

The two oligopoly models linking market share and market power are the dominant
firm/fringe model and the Cournot model. For purposes of defining the relevant market,
economists have focused largely on the Cournot model, and the Cournot model can be
justified by its computational simplicity, a strong correspondence with the “Nash” equilibrium
concept for noncooperative strategic interaction, and accepted intuition about
concentrated market structures.4 The Cournot model assumes that several large firms
are involved in competitive rivalry and that little or no new entry exists. Each firm
reacts to the output of its rivals, but under the simplifying assumption that each firm
assumes that its own output change will not impact rivals’ reactions. These assumptions
result in a set of reactions between rivals that culminate in an equilibrium point that is
an example of a “Nash equilibrium.”

To show the relationship between market share and market power in the Cournot
model, assume that n firms in an industry are engaged in Cournot rivalry. Each firm
seeks to maximize its own profits, πi,where profits are defined as the difference between
revenue and costs. Revenue, in turn, is equal to the market price multiplied by
firm i’s output, and the cost also depends on the output of firm i:

= P(Q) q. C(q)

πi iii

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Maximizing profits requires that the first derivative of the profit function is set equal to zero:

dπi . dP .

= O = P + qi .. ..
. MCi

dqi dQ

Manipulating this result leads to the following:

.. qi .. dP .. Q..

MC = P1 .

i ..

. .. Q .. .. dQ.. . P ..

This can be rewritten as:

P

MC = P . Si

E

This expression leads to the result that we seek:

PMC S

.

= i

Pe

where Si is the quantity market share of firm i. The Cournot assumptions therefore lead
to a straightforward relationship between market power and market share parameterized
by the inverse of the market elasticity.

To operationalize this relationship requires a definition of the relevant market that
allows for comparability of market share based on measures of market power across
industries. The 1992 Horizontal Merger Guidelines Definition promulgated by the
Department of Justice and the Federal Trade Commission (the Guidelines) does precisely
this by defining the relevant market in a manner that forces the analyst to select
a market that leads to a common market elasticity among industries5:

e2
e1
P
MC
P
Si

ECONOMICS OF IP DAMAGE CALCULATIONS

Put differently, the market definition test forces the analyst to choose a single market
elasticity, such as e2, for example, to facilitate cross-market comparisons of market power.
With this background in mind, we now turn to the Guidelines’ market test that incorporates
an economically grounded method for selecting competing products for inclusion
or exclusion in the relevant market. This will be a critical decision point in any lost profits
analysis in an infringement case.

Relevant Markets

A rigorous and operational yet accessible approach to market definition appears in
the 1994 Federal Trade Commission and Department of Justice Horizontal Merger
Guidelines.

The stated purpose of the Guidelines is to identify economic dangers posed by mergers
that may “create or enhance ‘market power’ or... facilitate its exercise.”6 “Market
power” is defined as the ability to profitably raise price above competitive levels.7 That
“market power” could result either from an increased unilateral ability to raise price or
from an industry structure more conducive to collusive activities. It has long been recognized
that market power is constrained by the ability of customers to switch away
from a price increase by buying different products, or the same products from more distant
suppliers (demand substitution), or by buying from additional sellers attracted by
the increased price (supply substitution). The Guidelines set out an integrated multistep
procedure designed to analyze these issues.

As the first step in the analytical process designed to determine when market power
may be created or enhanced by a proposed merger, the Guidelines call for defining the
relevant markets. According to the guidelines, a market:

is defined as a product or group of products and a geographic area in which it is sold such that
a hypothetical, profit-maximizing firm, not subject to price regulations, that was the only present
and future seller of those products in that area would impose a small but significant and
nontransitory increase in price above prevailing or likely future levels.8

That is, the relevant market has both a geographic component and a product component.
If, in a given geographic area, a sole provider of a particular product could profitably
raise its price a “small but significant” amount (e.g., 5 percent), then that product is a relevant
market for that geographic area.

The Narrowest Market Concept. The procedure set forth in the Guidelines is as
follows: starting with a particular product of one of the merging firms, the analyst asks
whether a hypothetical monopolist would find it profitable to increase prices of that
product above the current levels by approximately 5 percent.9 If the answer is yes,
that product is deemed a relevant market for further consideration.10 If the answer is
no, the product, in and of itself, is deemed too narrow to constitute a relevant market,

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

and the set of products is broadened to include the next-best set of substitutes and the
process is repeated. The analyst inquires whether a sole provider of both the product
and the next-best set of substitutes could profitably increase price by 5 percent. If
the answer is yes, that set of products is deemed a relevant market. If the answer is no, the
next-best set of substitutes is again added and the process is repeated.11 Thus, a relevant
product market is the smallest set of products for which a hypothetical monopolist
would find it profitable to increase prices by 5 percent. The analysis continues until
markets are delineated around each of the products of each of the merging firms. The
two sets of product markets are then compared to determine whether the two merging
firms are participants in any of the same product markets. If they are, the merger is
deemed “horizontal,” and analysis of any potential anticompetitive effects resulting
from the merger continues.

Geographic markets are defined in an analogous manner. Beginning with the location
of each merging firm, the analyst asks whether a sole provider of the relevant
product could raise its price by 5 percent. If not, the geographic area is expanded to
include the next-best substitute for production and the analysis is repeated.12 This
process continues until the test is satisfied. For any given merger, there can be multiple
relevant product and geographic markets, each addressing a different possible exercise
of market power.

Supply-Side Substitution. The Guidelines’ mechanism for dealing with potential
supply-side responses to an exercise of market power is also noteworthy. In defining the
relevant product market, the Guidelines focus directly on demand-side substitution—
the reaction of the consumer to an increase in price. Supply-side substitution responses
to attempted exercises of market power—supplier reactions to price increases—are considered
in separate sections of the Guidelines dealing with the identification of firms in
the relevant market and the likelihood of new entry.13 This is accomplished by including
among the participants in the defined market not only those firms presently producing
products in the relevant market but also those firms that are “uncommitted
entrants.”14 Uncommitted entrants are firms that, in response to a 5 percent price
increase and without the expenditure of significant sunk costs, would likely supply the
relevant product within one year. The likelihood, timeliness, and sufficiency of longer-
term supply responses (i.e., within two years) are addressed in the entry section of the
Guidelines. This longer-term supply response is also considered because, as recognized
in the Guidelines:

A merger is not likely to create or enhance market power or to facilitate its exercise, if entry
into the marketplace is so easy that market participants, after the merger, either collectively or
unilaterally could not profitably maintain a price increase above premerger levels. Such entry
likely will deter an anticompetitive merger in its incipiency, or deter or counteract the competitive
effects of concern.15

ECONOMICS OF IP DAMAGE CALCULATIONS

Calculation of Market Shares. Once the firms that participate in the relevant markets
have been identified, each firm’s market share is calculated. Market shares typically are
calculated as each firm’s share of total sales or current capacity in the market. Capacity
measures are recommended when goods are homogeneous. Sales are appropriate when
products are subject to some differentiation by product characteristics, brand name, or
other features.

The merger guidelines approach operationalizes results from the industrial organization
literature that allow the economist to make inferences about consumer behavior
where an infringer is to be removed from the market. For example, in such a case, one
plausible assumption is that the infringer’s sales would be distributed according to market
share. It is critical when such an approach is used that the boundaries of the relevant
market and the market shares in the market be determined properly.

Information Used to Implement the Merger Guidelines Market Test. The market test
requires an assessment of consumer reaction to a small but significant increase in price
of one or more products. Indirect information about such reactions typically are available
from the party’s documents and third-party sources. The Merger Guidelines themselves
refer to four categories of information:

1.
evidence that buyers have shifted or have considered shifting purchases between
products in response to relative changes in price or other competitive
variables;
2.
evidence that sellers base business decisions on the prospect of buyer substitution
between products in response to relative changes in price or other competitive
variables;
3.
the influence of downstream competition faced by buyers in their output markets;
and
4.
the timing and costs of switching products.16
In addition, other relevant information would include:

5.
the parties’ pricing documents describing how prices are set;
6.
the parties’ views of their competitors and the market;
7.
third-party views of the market;
8.
vendor’s views of the market;
9.
information concerning how the parties position their products in their advertising.
One important weakness of a market share approach to lost profits is that each
product is treated in a binary “in or out” of the market fashion. Most markets consist of

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

differentiated products, where some products are closer substitutes than others. Such
differentiation can be inferred from the same types of information described above. To
the degree that products are differentiated, close substitutes to the infringer’s product
likely would receive more sales that its market share if the infringer were eliminated;
more distant substitutes would receive fewer sales. It is appropriate to gather as much
information on product differentiation as possible even when adopting the market share
approach to determine whether adjustments to market share are in order.

THE DIRECT APPROACH: ECONOMETRICS

When detailed data are available, market analysis can be performed directly by using
econometrics to estimate a demand function. Empirically, a market demand function is
generally estimated using techniques associated with regression analysis. Regression
analysis, in its most common form, is referred to in the statistical vernacular as ordinary
least squares (OLS), because operationally, regression minimizes the squares of the
differences between the actual value and the “fitted” value of the variable that is being
studied (the dependent variable). Regression analysis is a statistical method used to
relate changes in a dependent variable Y to changes in other variables, known as independent,
or explanatory, variables. Ordinary least squares sometimes can be useful in
extrapolating trends or testing the significance of market structure changes (e.g., the
presence of an infringing product).

In IP damage analysis, we frequently are concerned with estimating demand and
elasticity of demand for market analysis. However, estimating demand functions
requires econometric techniques and considerations that are significantly more sophisticated
than OLS. In the case of a demand function (see preceding), the quantity
demanded is estimated as a function of several variables, usually the following (we now
switch notation slightly to remain consistent with econometrics textbooks):

Qx = f (Px, I, Py )

where
Qx = quantity demanded of good X
P x = price of good X
I = income of consumers
P y = vector of prices of related goods

Once we have a functional form of the model, the particular econometric technique
that is appropriate for the model specified must be chosen. Unfortunately, the expert
often has little or no a priori knowledge of the true functional form of the demand function.
Consequently, the researcher must rely on experience, previous literature on the

ECONOMICS OF IP DAMAGE CALCULATIONS

subject, market analyses, and attempts to use “flexible” specifications. Often, the results
of regression analysis using a particular functional form specification will signal a misspecification
problem. For example, lack of statistical significance in all or a majority
of explanatory variables, poor fit, or incorrect signs (e.g., negative signs on prices of
well-established substitute goods) may indicate a problem with the functional form of
the model. When this happens, the expert should estimate several models with various
functional forms to arrive at a satisfactory solution. A good place to start is to examine
the data using simple descriptive statistics. Although such data sometimes are regarded
by theoreticians as operationally problematic, some data analysis is standard practice,
because theory alone often cannot cull market inconsistencies that may be illuminated
only by analysis of the actual data. Naturally, care must be taken in applying such techniques
to ensure robustness of the results and to avoid violations of the basic assumptions
underlying regression analysis.17

In practice, the simplest demand function to specify and estimate is the linear
demand function. In this case, the term linear refers to linearity in the coefficients. The
variables themselves are free to take any functional form (e.g., quadratic, natural log,
inverse, etc.) specified by the researcher. Such a function would be represented as:

Q= α+βP +γI +Σ λ P +ε

xx yy

where α, β, γ, and λ, are unknown parameters to be estimated and εis a stochastic error
term. Estimating a regression model can be accomplished using any readily available
commercial statistical analysis software such as SAS., Stata, E-Views, and so on, and
even MS Excel. Statistical significance of these coefficient estimates is then performed
using t-tests.18

Determining own-price, income, and cross-price elasticities is one important by-
product of estimating a demand function. Own-price elasticity is defined as the percentage
increase in demand of good X associated with a given percentage increase in
the price of good X. Income elasticity is the percentage increase in the demand for
commodity X associated with a given percentage increase in consumer income. Cross-
price elasticity is the percentage increase in the demand for commodity X associated
with a given percentage increase in the price of a related commodity. Elasticities can be
easily calculated from the demand model specification as:

E= .(ΔQ/ΔP) ×P /Q(own-price elasticity)

x xxxx

=(I/Q) ×γ (income elasticity)

Eix
E =(P/Q) ×λ (cross-price elasticity)19

xyyy y

Obviously, one problem associated with the linear demand model is that the elasticities
are variable. That is, as described earlier, the elasticities are not constant across the
demand curve, but instead vary along the demand curve. A more commonly used and

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

more flexible specification is a nonlinear demand function, which has constant elasticity
along the demand curve:

βIγΠP γ

Q= αP

xx y

Although this model is nonlinear in the coefficients, simple algebraic manipulation
yields a linear model that can be estimated using linear techniques. Taking the natural
log of both sides of the equation, one obtains:

log Q= log α+βlogP+γlogI +λlog(ΣP) +log ε

x xyy

This model yields a constant elasticity estimate along the demand curve.

Unfortunately, the estimation of a market demand function is not resolved once an
appropriate functional form is chosen. The more serious empirical problem of simultaneity
arises with such market demand functions. As in many significant economic
models, a simultaneous relationship exists between the supply and demand variables in
the model. To illustrate the problem, consider the linear model equation previously
shown. We hypothesized that the price of good X influences its demand, but we also
know that the quantity demanded of a good also influences its price. The question that
naturally arises is: Which comes first? Does demand influence price first, or does price
influence demand? The answer to this question is that both variables influence each
other at the same time. That is, they are simultaneously determined, or in the parlance
of econometrics, they are endogenous. Given the simultaneous relationship that
defines them, endogenous variables must be modeled using systems of interdependent
equations. Each endogenous variable is a function of other endogenous variables
and exogenous variables (i.e., variables that are not simultaneously determined). To
examine how feedback loops work within the entire model, the entire system must be
considered together, rather than each equation separately. Consider, for example, the following
system:

Q= α+βP +γI +ΣλP +ε

xx yy 1

P= φ+.Q+δS +ΣηP +ε

x xx yy 2

where the variables are the same as defined previously, and Sx is a vector of supply-side
effects, such as production costs. Note that in the first equation, the dependent variable
is quantity, while price is included as an independent variable. In the second equation,
price is explained as a function of quantity and a series of other exogenous variables.

Two-Stage Least Squares

The above demand system generates additional empirical concerns. The OLS method
discussed previously can no longer be applied to such systems. Ordinary least squares

ECONOMICS OF IP DAMAGE CALCULATIONS

regressions are predicated on the assumptions of the Gauss–Markov theorem, which
states that, if its assumptions are satisfied, the OLS coefficients are the best linear unbiased
estimates (BLUE) of the true population parameters. The above Equations violate
one of these assumptions, that orthogonality must exist between the stochastic error
term and the independent variables cannot be correlated with one another. That is, the
error term and the independent variables must be uncorrelated. The reason for this
assumption is that, if the error term is correlated with any independent variable in the
model, the OLS coefficients will incorrectly attribute some of the effect of the error
term to the independent variable(s) with which it is correlated. As a result, the OLS
coefficients will not be unbiased (centered on the true value) and the BLUE property of
Gauss–Markov will not apply. This phenomenon is commonly known as simultaneity
equation bias. Unfortunately, this is precisely the problem that affects equations that are
simultaneous in nature, such as the demand function. To see how this works, consider
an increase in the error term ε1 in the first equation above. If ε1 increases, it will cause
an increase in Qx. If Qx increases, it will cause an increase in Px in the second equation.
But, if Px increases in the second equation, it will in turn effect an increase in Qx in the
first equation. Thus, the error term in the first equation is correlated with Px in the same
equation, generating biased coefficients and therefore violating the Gauss–Markov
assumptions.

Although OLS is no longer an appropriate tool to estimate such simultaneous equation
models, a variety of statistical tools have been developed that solve this problem.
Most tools can be classified according to two principal methodologies: the generalized
method of moments (GMM) and the method of maximum likelihood (ML). Each of
these methods consists of a series of techniques that can be applied to systems of equations,
and numerous econometrics textbooks describe how to employ the methods.

In practice, the most popular tool for dealing with simultaneous equation systems
falls under the GMM methodology and is an instrumental variable technique known as
two-stage least squares (2SLS or TSLS).20 For the purposes of this discussion, 2SLS is
used as the tool of choice.21

Two-stage least squares attempts to find a variable that is both uncorrelated with the
error term and highly correlated with the dependent variable. Considering Equations
described previously, 2SLS would substitute for Px an instrumental variable that meets
both of these conditions. Although such a variable may seem difficult to find, 2SLS
provides a systematic method to accomplish the task. The steps are as follows:

1.
Identify the demand and supply functions. The parameters of a demand system
can be estimated only if the system is “identified.” Identification refers to the
ability to algebraically recover unique values of the parameters in question. In
practice, identification requires a sufficient number of exogenous variables
in each equation of the system. The reader is referred to the econometrics texts
in the Additional Reading section for the appropriate tests for identification.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

2.
Generate reduced-form equations. Reduced-form equations express each endogenous
variable as a function of the error term, exogenous variables, and possibly
lagged endogenous variables. In this case, separate equations would be
generated for Qx and P x .
3.
Perform OLS on the reduced-form equations. An OLS equation is estimated
for each endogenous variable that was included in the right-hand side of the
system of equations as a function of the exogenous variables in the system. In
our demand function example, a separate reduced-form regression would be
run for Qx and P x .
4.
Substitute predicted values in the model and run OLS. Each equation estimated
in Step 3 will generate predicted values for Qx and P x that are orthogonal to the
error terms. These predicted values now become instrumental variables and
are substituted for the original endogenous variables. In the equations estimated
in Step 4, predicted values would be generated for Qx and P x . These in
turn would be used to reestimate the original system of equations.
Although 2SLS provides a solution for the endogeneity problem, it is by no means a
complete cure. The effects of 2SLS are essentially that the t-tests are more reliable and
the coefficient estimates are consistent and asymptotically unbiased in large samples.
However, 2SLS estimates are still biased, particularly in small samples, and great care
should be taken when drawing any statistical inferences in situations where the sample
size used to estimate the system of equations is small.

The Almost Ideal Demand System (AIDS) Model

As mentioned previously, economic researchers have explored a variety of models to
estimate own-price and cross-price elasticities in order to examine the effects of mergers.
These techniques can be used for market analysis in IP damage cases. Linear, log-
linear (constant-elasticity), and logit models are three useful techniques. Each of these
approaches has a set of idiosyncratic characteristics that differentiate them according
to the criteria sought by the expert: computational tractability, operational flexibility,
ability to explain the data at hand, and intuitive appeal.

The AIDS model, originally proposed by Denton and Muellbauer (1980),22 has
gained a level of acceptance and popularity due to certain desirable characteristics and
is useful in IP cases for its simplicity. The AIDS model specifies the share of a brand in
a given market as a function of the prices of the other competing brands in the market.
For example, the market share of Pepsi-Cola would be modeled as a function of the
price of Coca-Cola, Mountain Dew, and other branded soda products. The model is sensitive
to the market definitions assumed. The expert must be careful because omitting
relevant variables, such as other products, can have a serious impact on the results.

The AIDS model specification for an n-good system is:

ECONOMICS OF IP DAMAGE CALCULATIONS

Si =αi +Σ
n
β ln p +λ ln(XP

ij i / )
j = 1

where
αi = constant term in the ith equation
Si = the market share of the ith brand

= coefficients for the jth brand in the ith equation

βijpj = the price vector for the jth brand
λi = the parameter associated with the aggregate expenditure terms
X = industry (aggregate) expenditure
P = price index

In practice, the aggregate expenditure term can be omitted, leaving the equation as:

n
Si =αi + Σβij ln pj
i = 1

Omitting this term requires the assumption of homotheticity, meaning that changes in
the aggregate expenditure are hypothesized to have no influence on the size of the market
shares themselves. More specifically, a change in industry expenditure is presumed
to filter down to each brand in direct proportion to its market share, such that, while the
quantities purchased of a particular brand may change, its individual market share will
remain unaffected. In merger analysis, the constant terms fall out of the equation as
well, because the metrics of interest are the market share changes created by the merger.
The AIDS model also requires that all market shares sum to 1. This is commonly

n

referred to as the “adding up” property of the AIDS model. Since Σ Si = 1, the N equations

i = 1

can be reduced to N . 1, with prices expressed relative to the “numeraire” product in the
omitted equation, because the last equation can be completely determined by subtracting
the N . 1 market shares from 1. The “adding up” property holds for any set of price
changes, which in turn implies that:

n
Σβij = 0 for any j
i = 1

That is, the own price coefficients βij (where i = j) and cross-price coefficients βij
(where i ≠ j) for any good j equal zero. This is known as the assumption of homogeneity
implied by economic theory. That is, equal proportional changes in the prices of
individual brands have no impact on their market share. Thus, in a market where homogeneity
exists, a marketwide 5 percent price increase would leave the individual market
shares of the brands operating in that market unaffected because relative prices would

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

be unchanged. Another assumption of economic theory that is easily implemented
within the AIDS model is symmetry (i.e., that β= β). That is, the effect of a change

ij ji

in brand j’s price should influence brand i’s market share by the same amount that a
change in brand i’s price will influence brand j’s market share. It is important at this
point not to confuse the βcoefficients with the elasticities. The elasticities are computed
from the βcoefficients, as will be shown subsequently, but for now it is important to
understand that these terms are not synonymous.

An attractive feature of the AIDS model is that the assumptions of homogeneity and
symmetry can be directly tested within the model. Consider a hypothetical market with
four brands. The AIDS model would specify the following equations, based on the
assumptions described:

S1 = βln(p1) +βln(p2) +βln(p3) +βln(p4)

11 121314

S2 = βln(p1) +βln(p2) +βln(p3) +βln(p4)

21 22 23 24

= βln(p1) +βln(p2) +βln(p3) +βln(p4)

S331 32 33 34
= βln(p1) +βln(p2) +βln(p3) +βln(p4)

S441 42 43 44

In this system, the βij (where i = j) indicate the effect of a change in an individuals
brand’s price on its market share. These coefficients are expected to be negative,
because an increase in a brand’s own price would be expected to decrease its market
share, all other things being equal. The cross-price coefficients βij (where i ≠j) indicate
the effects of changes in other brands’ prices on an individual brand’s market share.
Conversely, these signs would be expected to be positive in the case of substitutes,
because an increase in the price of competing brands would make a rival brand more
attractive to consumers, thereby increasing its market share. In the model estimation, it
is relatively straightforward to test the homogeneity and symmetry assumptions using a
likelihood ratio test (LRT). Most statistical software packages, such as SAS., perform
such tests.

The system described reveals a complication of the AIDS model. In the four-brand
market example, the model must estimate 16 parameters. Consider now a market with
100 brands. The model would then be required to estimate 10,000 parameters. That is,
for n goods, the model estimates n2 parameters: n own-price coefficients and n(n .1)
cross-price coefficients. As n is increased, the computational tractability of the approach
becomes an issue of concern, because a very large number of observations would be
needed to ensure that the model retains sufficient degrees of freedom for estimation.23
Furthermore, the more parameters estimated, the greater the probability of obtaining
imprecise measurements of the coefficients or algebraic signs on the coefficients that
are inconsistent with economic theory. Several methods of alleviating this problem can
be used, among them is reducing the number of parameters estimated by specifying a
model produced by a multilevel decision process.24

ECONOMICS OF IP DAMAGE CALCULATIONS

The estimated coefficients of an AIDS model are not elasticities, and we now turn to
converting these coefficients to elasticities. The equation for the elasticities is:

ε = ((βij +λi(Sj .λj ln (X/P)) ÷ Si) . δij

where δij = 1 when i = j and 0 otherwise and the rest of the variables are as defined
previously.

The AIDS model has been used extensively in demand analysis, especially in merger
simulation. Other econometric models exist, as mentioned previously, and often the
choice of the model depends on the issue addressed by the researcher. For example, in
the fields of transportation and environmental economics, the random utility model
(RUM) developed by Daniel McFadden, whose work on the subject earned him the
Nobel Prize in economics, has been widely used to estimate demand for modes of transport
or recreation sites. Operational familiarity with several models is a valuable advantage
to the researcher, as multiple arrows in the quiver can be used to address a wider
array of economic issues.

This section does not contain a full discussion of econometrics. It is meant instead
to alert experts and lawyers dealing with IP damages that economists have developed
powerful statistical tools that can be drawn on in cases in which high-quality data are
available.

THE LAW AND ECONOMICS OF BARGAINING

The economics of bargaining and the principles of game theory are foundational principles
in the analysis of reasonable royalties. This is another topic we do not address,
but again, we alert the expert to the existence of relevant literature. Courts have imposed
the legal fiction that a reasonable royalty is the outcome of a hypothetical negotiation
between the parties at the onset of infringement. The outcomes of negotiations are the
focus of the economics of cooperative game theory.

In a cooperative game, both parties understand that exchange is mutually beneficial;
that is, both parties benefit from cooperating with each other. Suppose Mark owns a car
that he values at $1,000 and Rick values the same car at $2,000. Moving the resource
(in this case the car) from Mark to Rick creates $1,000 of “surplus.” The buyer will
never pay more than the value he places on the resource (typically determined by
the next-best substitute) and the seller will never accept less than his current value of the
resource (typically determined by the next-best employment of the resource). The difference
between these two limits is called the “bargaining range.”

The parties typically will bargain over the transaction price within the bargaining
range. The final price will determine how the surplus is distributed. As long as the game

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

remains cooperative, economics has little to say on how the final negotiation ends,
except that it will remain within the bargaining range. The final transaction price within
the bargaining range depends on the art of bargaining and the parties’ skill and ability
at negotiating.25

THE ECONOMICS OF INTELLECTUAL PROPERTY

Patents

Economists have written extensively about the economics of patents. The originating
assumption for economists is that ideas differ from physical property in several important
respects. First, ideas are what economists call a public good. As Thomas Jefferson
wrote, “He who receives an idea from me, receives instructions himself without lessening
mine; as he who lights his taper at mine, receives light without darkening me.” In
contrast to physical property, where establishing property rights arguably increases the
public welfare by creating incentives to maintain and efficiently use the property, diffusion
of ideas among the members of society produces the greatest public benefit.

Second, it generally is the case that it is less costly to copy an idea than to develop
the idea in the first instance. Think of reverse engineering a product or, more dramatically,
downloading digital music or software files. This means that it frequently will be
remarkably difficult to exclude others from using an idea.

Establishing property rights to IP is a way to provide a reward in exchange for developing
new ideas. By allowing a patent owner to exclude others from using an idea, a
patent owner can earn profits by exclusively selling products that incorporate the idea
or by licensing the use of the idea to others. Thus, IP rights, such as patents, allow a
return to innovation notwithstanding the ease of copying ideas.

There is a basic conflict between the benefits of diffusion of ideas and the incentives
to create new ideas. Although the greatest public benefit would result from making
ideas freely available to the public, this would provide little or no incentive to innovate
because the private returns to innovation would be much less than the public benefit.
Conversely, granting property rights to ideas provides incentives to develop new ideas,
but limits the benefits from diffusion. The important public policy issues regarding
patents involve a balancing of benefits from increased innovation against costs of interfering
with the free use of ideas.

The patent system grants an exclusive right to exclude others from using an idea without
permission for a specified period of time (now 20 years). After the patent has expired,
the idea can be used by anybody. This represents a trade-off between providing incentives
to develop technologies and promoting diffusion of ideas that are developed. In
addition, since it is not necessary to provide rewards for all innovations, patent protection
is limited to ideas that have utility, are previously unknown, and are nonobvious.

ECONOMICS OF IP DAMAGE CALCULATIONS

The fundamental point of IP rights is to create incentives for research and development
(R&D). Studies by economists have established that technological progress is surprisingly
critical to economic welfare. Economic welfare, for economists, thus can be
increased two ways. First, “dynamic efficiency” refers to the increase in consumer welfare
from innovation in new cost-reducing processes and new products. Second, “static
efficiency” refers to the increased benefit that consumers obtain from lower prices
and increased output. Until publication of the seminal papers by Robert Solow and
Edward Dennison,26 economists focused largely on static efficiency concerns. Solow
and Dennison showed that approximately 68 to 81 percent of the growth in U.S. output
has been a result of technological advance as opposed to increased labor and capital.
This was a significant result that caused renewed interest among economists in the issue
of innovation and its causes.

According to economists, the primary problem faced, by potential innovators is that
technical changes, in the form of new products and processes, are largely “public
goods.” This means, unlike with other forms of property, inventors and authors cannot
prevent others from appropriating or using their inventions without the intervention
of the legal system. For example, you can prevent others from using your car by locking
it in your garage. You cannot prevent someone from copying software you have invented
after sale without copyright protection. Mansfield, for example, studied the cost
of imitating or copying inventions compared to the innovator’s original costs. He found
that an imitator’s costs are approximately 65 percent of the innovator’s costs. Moreover,
imitation can occur quickly. Mansfield found that information about most R&D efforts
are in the hands of rivals within 12 to 18 months of their invention, and the imitation of
a new invention can occur within months.27

As a result, absent some legal protection for innovation, the incentives for investment
in new technology would be severely dampened because inventors and authors would
be unable to capture any of the economic benefits of their inventions.

Market Structure and Innovation. Economists have debated whether firms with
market power or competitive firms will engage in more innovating activities. A
number of models have been developed that indicate that the incentive to innovate
is stronger under competition than under monopoly. These results are straightforward
and easy to understand. The incentive for the monopoly firm to innovate is the additional
profit gained from the innovation. The monopolist is already making profits in
the preinnovation stage. Therefore, in the postinnovation stage, the additional profits
are due to the cost savings themselves on the monopoly output. In contrast, the competitive
firm begins from a situation of no economic profits. The innovation potentially
provides the competitive firm with lower costs or greater market power. Thus, the
additional profits from innovation are likely to be higher to the competitive firm than
to the monopolist.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

In contrast, Joseph Schumpeter28 contended that innovation is likely to be larger for
firms with market power than for competitive firms. This is because firms with large
profits will have a greater ability to release free cash flow for use in R&D activities.
Moreover, R&D activities may be subject to significant economies of scale. In this case,
large firms will also be much more efficient at innovating.

The empirical evidence addressing this controversy is mixed. Some studies have
found that spending on R&D and number of patents is positively related to firm size or
concentration. Other studies have found more innovation among competitive firms.
Several empirical studies have found an inverted U-shaped relationship between market
concentration and spending on R&D activities. This result, although criticized by
several other studies, suggests that R&D spending is discouraged by either too much
or too little competition. Still other studies question the relationship between R&D and
innovation and the relationship between R&D and economic growth.

Dynamic Versus Static Efficiency. An issue that lies at the heart of the interplay
between the IP laws and the antitrust laws is the apparent trade-off between incentives
for dynamic efficiency and incentives for static efficiency.

The Trade-Off. Ultimately, the goal of the IP laws can be viewed as maximizing the
difference between the total social benefit from innovation less the total social cost of
innovation. The benefit from innovation consists of lower cost processes and new or
better products. The costs are twofold. First, expenditure on innovation consumes
resources that could be put to other uses. Second, to the extent that the IP laws grant
exclusive rights, static efficiency is reduced because consumers pay higher prices, and
the market has less output. In addition, stringent IP laws can reduce incentives for follow-
on improvement inventions.

Optimal Patent Life. Nordhaus was one of the first economists to formally address
this trade-off.29 Nordhaus considered the issue of the optimal patent life, the one variable
impacting the dynamic efficiency–static efficiency trade-off that Congress can control.
Nordhaus attempted to find the optimal patent life by comparing the size of the lost
consumer surplus due to the monopoly (the deadweight loss), the impact of its deferral
measured by the discount rate, and the increasing R&D costs stimulated by the greater
monopoly profits against the increasing amount of cost reduction (and hence profit and
consumer surplus stimulated by the longer patent life). He found that, as the amount of
induced cost reduction from innovation from longer patent life increases, society must
wait longer to appropriate the full benefits of the innovation. At the same time, monopoly
profits in the future are discounted more heavily, resulting in less innovation. The
optimal length of the patent thus depends on several factors, including: (1) the elasticity
of demand (the greater the demand elasticity, the greater the cost to society from the
patent monopoly); (2) how easy it is to achieve the cost reduction (when bid cost

ECONOMICS OF IP DAMAGE CALCULATIONS

reductions are easily obtained, society is less willing to sacrifice consumer surplus to obtain
them); (3) the impact of the patent length on inventiveness; and (4) the discount rate.

The following equation relates these factors:

NSB(t) = [(CSm +πm) ∫e.rs ds +CSc ∫e.rs ds] P(N) .M(N)

where
CSm is consumer surplus with the patent
πm is the patentor’s profits
CSc is the competitive consumer surplus absent the patent
P(N) is the probability of an invention based on expenditure of N firms
M(N) is the cost of R&D by N firms

Economists believe that it is likely that the optimal patent length will differ by industry.
For example, in less competitive markets, short patents may be best because deadweight
loss can be large, whereas the opposite is true in more competitive markets.
Because of the difficulty of obtaining the required information and the costs of non-
uniformity in the patent system, policy has dictated an across-the-board 20-year patent
length in most of the world.

Optimal Patent Breadth. Unfortunately, little work has addressed the issue of optimal
patent breadth. The breadth of patent protection is a key variable in creating incentives
for the size and type of future innovations. Unlike patent length, the interpretation of
the breadth of a patent claim is a matter of law determined by the federal courts. To understand
the trade-off inherent in determining the breadth of a patent claim, consider two
patents with the following independent claims:

PATENT 1 PATENT 2

Element A Element A
Element B Element B
Element C Element C
Element D

Patent 1 might be considered a basic research patent. Patent 2 is an improvement
patent. Anyone practicing an invention that is covered by claims A, B, C, and D would
be obligated to pay a royalty to the owner of patent 2 for the combination of elements
A, B, C, and D, and to the owner of patent 1 for elements A, B, and C. As a result, the
incentive to produce improvement or second-generation patents is dampened to the extent
that patent 2 “reads on” patent 1. However, if the claims of patent 1 are interpreted
narrowly, patent 2 is less likely to read on its claims and the incentives for follow-on
research is increased, albeit at the expense of the incentive for basic research.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

This problem may be solved privately through joint ventures and patent pools or
cooperative research. However, such collaboration among competitors can raise other
antitrust concerns.

The Economics of Copyrights

The economic literature on copyright protection has essentially focused on two issues.
The first issue is whether copyright protection is really necessary to create sufficient
incentives for authors. The second issue is an attempt to explain how copyright law has
evolved by considering the trade-off between incentives for current increased production
in artistic work and future increases in artistic work plus reductions in static output
from the copyright monopoly.

Supreme Court Justice Stephen Breyer’s article “The Uneasy Case for Copyright: A
Study of Copyright in Books, Photocopies and Computer Programs” is a leading article
that addresses the first issue. Justice Breyer contends that the case for copyright protection
generally may not be as strong as conventional wisdom suggests. This is because
market forces may be sufficient to create the necessary incentives for current investment
by authors. If this is the case, the disincentives copyright protection creates for future
expression and reductions in static efficiency could offset the social gains. Justice
Breyer considers several market mechanisms that create incentives for authors. Among
these incentives are the fact that there is a cost to copying, copying takes time, and the
result may be a poor substitute. In such cases, the author’s profits may not be significantly
diluted by the copier. Moreover, in the case of textbooks, authors receive several
external benefits, such as prestige, tenure, and higher salaries, which may alone create
sufficient incentives for scholarly works. In addition, Justice Breyer suggests that
potential textbook and software buyers could enter into executory contracts that could
ensure an adequate return to the author.

Landes and Posner30 have attempted the more comprehensive exercise of trying to
interpret copyright law as optimally balancing two competing interests. On one side
of the ledger are the incentives for the first generation of authors to create expressive
works. On the other side of the balance are the difficulty copyright protection poses for
future generations of authors who have less public domain art to build on, as well as the
static efficiency costs (proxied by Landes and Posner using an output variable) from
precluding consumers from purchasing less expensive unauthorized copies. After a
formal presentation of the trade-off, Landes and Posner attempt to draw out several
implications of their analysis:

. The rule that independent recreation is not actionable is explained by the fact
that it would be too costly to search the prior art (as done after a patent application)
because the copyrighted literature is too vast.

ECONOMICS OF IP DAMAGE CALCULATIONS

. Ideas are not protected because taking ideas out of the public domain would
increase the costs of future authors (who would have to develop the idea and the
expression) compared to the benefit of the output of first-generation authors.
. The rationale for giving authors a copyright on their derivative work is not to
create more profits on the original work. Landes and Posner contend that derivative
works typically are not close substitutes for original works (like a movie
based on a book). Instead, they argue that the rights in the derivative work (like
a translation) create incentives to create more derivative works. The right should
be given to the original author to prevent delay in original publication until the
derivative work is created. The derivative work’s author (who is not the original
author) also has a known person to go to for a license reducing transactions costs,
and where no copyright exists on the original work, the derivative work’s author
can obtain protection.
. The case for fair use is based on transaction costs. Authors benefit by the publicity
received from reviews, quotations, and parody. Works of art are often
“experience goods” requiring “free samples.” Without fair use rules, each such
quotation would require a costly licensing negotiation that might discourage its
publication.
. Tying the copyright duration to the death of the author makes tracing easier
because all of an author’s works lose protection at the same time.
The Economics of Trademarks

Economists view the analysis of trademarks as a branch of the economics of information.
The development of economic thought concerning information can be traced to Stigler’s
pioneering work on the economics of information.31 Stigler recognized that information
about the price and quality characteristics of goods and services is a scarce resource.
Information is demanded by consumers as an input to market decisions, and real resources
must be expended to obtain such information. The necessary expenditure on such information
is called “search costs.” The purpose of a trademark is to reduce consumer search costs.

To perform this function, a trademark or a brand name must be exclusive. That is, the
consumer must be confident that the name “McDonald’s” applies only to a set of fast-
food restaurants with particular characteristics that the consumer has sampled in the past.

Moreover, exclusive trademarks encourage investment in quality and implicit warranties
by producers. A firm has an important stake in how consumers judge their brand
and will invest resources in ensuring that consumers associate their brand with a high-
quality product. Furthermore, firms recognize that high-quality products can be sold at
higher prices. To the extent that a trademark is not exclusive or is inconsistent or
ambiguous, the return on investment in brand quality is diluted and firms will have a
weaker incentive to invest in quality and consistency.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

There is a growing consensus among economists that strong brands lower search
costs and do not create market power (like a patent or a copyright does). Trademark law
appears to recognize this benefit and has evolved in the direction of protecting trademarks
to the extent that they do not distort consumer information (deceptive marks) or
impede competition by monopolizing the availability of similar marks for competitors
(the ban on generic or descriptive marks without secondary meaning).32

The Economics of Trade Secrets

Very little has been written about the economics of trade secrets. One exception is the
paper by Friedman, Landes, and Posner.33 In that paper, the authors address two questions.
First, why is a choice between patent and trade secret allowed? Second, why does
trade secret law not protect against accidental disclosure or reverse engineering?

The Choice Between Patent Law and Trade Secret Law. The answer to the first quesiton,
according to Friedman, Landes, and Posner, is that inventors choose trade secret
protection when they believe that the secret is worth less than the patent process costs
(typically in the range of $10,000 to for a U.S. patent), the invention might lack the
required novelty for patentability, or the secret is so valuable (like Coca-Cola’s formula)
that patent protection is insufficient in duration. The trade secret alternative may
also have social benefits because it discourages excessive effort in a race to the patent
office.

Why Does Trade Secret Law Only Prevent Improper Misappropriation? There is no
“finders keepers” rule with other types of personal property unless the property is
abandoned. Friedman, Landes, and Posner suggest that the answer is that the level of
protection is reciprocal. Every producer of business information is also a consumer
of its competitors’ information. The law strikes a balance by prohibiting only the most
costly means of information retrieval. If innocent appropriation were illegal, like
reverse engineering or public searches of data, then too much would have to be
expended by companies seeking to conduct business but avoid lawsuits for inadvertent
discoveries of others’ trade secrets. Moreover, a firm would have no way of
knowing whether it came across a trade secret. Refusal to enforce agreements not to
disclose trade secrets, however, would cause the trade secret holders to take unduly expensive
precautions.

The case for reverse engineering is more difficult. Friedman, Landes, and Posner
argue that it would be too difficult to distinguish independent research from reverse
engineering if reverse engineering were illegal.

In sum, economists not only have developed tools in many contexts that can be used
in IP damage analysis, but also, to a more limited extent, they have directly attempted
to explain IP law itself using economic precepts.

ECONOMICS OF IP DAMAGE CALCULATIONS

SUMMARY

This chapter focused on the basic economic tools needed for calculation of IP damages.
One such tool that is critical is an understanding of how to define the relevant product
market. When sufficient data are available, econometrics can be a helpful tool for
obtaining the inputs to an IP damage analysis. This chapter further addressed how economists
think about and understand IP. This latter discussion can help both lawyers and
experts to structure their thinking about an IP case at its initial stages.

ENDNOTES

[1] A. Mitchell Polinsky, An Introduction to Law and Economics, 2nd ed., New York: Aspen
Publishers (1989), 2, 4.
[2] Inferring lack of market power solely from evidence of substitution is known as the “cellophane
trap.”
[3] The algebra is:
MC = P . P ....→ PMC . = P
e e

[4] For a justification of the Cournot output and conjectural variation assumptions, see Carl
Shapiro, “Theories of Oligopoly Behavior,” Handbook of Industrial Organization, Vol. I,
Schalensee and Willig, eds., Amsterdam: North Holland (1990), 329–414.
[5] The Guidelines represent an attempt to bring merger analysis under section 7 of the
Clayton Act more in line with modern economic thinking. The Guidelines were authored
in large part by economists employed at the antitrust enforcement agencies. See Gregory
J. Werden, Market Delineation and the Justice Department’s Merger Guidelines, Duke
L.J. 514 (1983).
[6] See Guidelines § 0.1.
[7] Id.
[8] Id. § 2.0.
[9] In fact, the Guidelines use the term “small but significant and nontransitory” increase in
price. We use 5 percent as a shorthand.
[10] See Guidelines § 1.11.
[11] Id.
[12] Id. § 1.21.
[13] Id. §§ 1.3 and 3.0.
[14] Id. § 1.32.
[15] Id. § 3.0.
[16] Merger Guidelines § 1.11.
[17] For a more rigorous discussion of such methods and their statistical implications,
the expert is referred to W. H. Greene, Econometric Analysis, Englewood Cliffs, N.J.:
Prentice-Hall (1999).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

[18]
T-tests are based on the assumption of asymptotic normality. In small samples, t-tests may
be unreliable and should not be relied on as prima facie evidence of statistical significance.
[19] Cross-price elasticities can thus be estimated for each good in the vector Py .
[20] Although some texts paraphrase two-stage least squares as TSLS, the reader should be
aware of three-stage least squares, whose existence may cause some confusion when
using the TSLS acronym.
[21] An alternative called limited information maximum likelihood (LIML) is not discussed
here, but the reader is referred to W. H. Greene, Econometric Analysis (Upper Saddle
River, N.J.: Prentice-Hall (1999)) for a rigorous discussion of the subject as well as a more
in-depth treatment of 2SLS.
[22]
See A. Deaton and J. Muellbauer, An Almost Ideal Demand System, Am. Econ. Rev. 70 (1981).
[23] Note that imposing constraints on the parameters, such as the homogeneity and symmetry
properties implied by economic theory, and eliminating one equation by virtue of the
“adding up” property, reduces the number of parameters to be estimated. The ease of imposing
these parameter-saving constraints is another desirable feature of the AIDS formulation.
[24]
See Daniel L. Rubinfeld, Market Definition with Differentiated Products: The Post/Nabisco
Cereal Merger, 68 Antitrust Law J. 163, 173–176 (2000), for a discussion of this approach.
[25] Economists can say much more about the outcome of noncooperative negotiation. In
these situations, game theory concepts apply. See Robert Gibbons, Game Theory for
Applied Economists, Princeton, N.J.: Princeton University Press (1992).
[26]
Robert M. Solow, Technical Charge and the Aggregate Production Function, 39 Rev.
Econ Stat. 312 (1957); Edward Dennison, Accounting for United States Economic
Growth: 1929–1969, Washington, D.C.: Brooking Institution (1974).
[27] Edwin Mansfield et al., The Production and Application of New Industrial Technology,
New York: W. W. Norton (1977).
[28] Joseph Schumpeter, The Theory of Economic Development, Cambridge: Harvard University
Press (1934).
[29]
William Nordhaus, An Economic Theory of Technological Change, 59 Am. Econ. Rev. 18
(1969).
[30]
W. Landes and R. Posner, An Economic Analysis of Copyright Law, 18 J. Legal Studies
3LS (1989).
[31]
George S. Stigler, The Economics of Information, 69 J. Pol. Econ. 213 (1961).
[32]
W. Landes and R. Posner, The Economics of Trademark Law, 78 Trademark Rep. 267
(1988), develop the analysis of the various aspects of trademark law based on the economics
of information.
[33] Friedman, W. Landes, and R. Posner, Some Economics of Trade Secret Law, 5 Journal of
Economic Perspectives 61 (1991).
ADDITIONAL READING

Roger L. Beck, The Prospect Theory of the Patent System and Unproductive Competition,
5 Research in Law & Economics 193 (1983).

ECONOMICS OF IP DAMAGE CALCULATIONS

Stanley M. Besen and Leo J. Raskind, An Introduction to the Law and Economics of
Intellectual Property, 5 Journal of Economic Perspectives 3 (Winter 1991).

Richard Gilbert and Carl Shapiro, Optimal Patent Length and Breadth, 21 RAND Journal
of Economics 106 (Spring 1990).

Paul Klemperer, How Broad Should the Scope of Patent Protection Be? 21 RAND Journal
of Economics 113 (Spring 1990).

Janusz A. Ordover, A Patent System for Both Diffusion and Exclusion, 5 Journal of
Economic Perspectives 43 (Winter 1991).

Suzanne Scotchmer, Standing on the Shoulders of Giants: Cumulative Research and the
Patent Law, 5 Journal of Economic Perspectives 29 (Winter 1991).

David L. Kaserman and John W. Mayo, Government and Business: The Economics of
Antitrust and Regulation, The Dryden Press (1995).

Luis M.B. Cabral, Introduction to Industrial Organization, Cambridge: The MIT Press
(2000).

Mark Seidenfeld, Microeconomic Predicates to Law and Economics, Anderson Publishing
Co. (1996).

Stephen Martin, Industrial Economics: Economic Analysis and Public Policy, 2nd ed.,
New York: Macmillan Publishing Company (1994).

Jeffrey L. Harrison, Law and Economics: In a Nutshell, New York: West Publishing Co.
(1995).

Nicholas Mercuro and Steven G. Medema, Economics and the Law: From Posner to Post-
Modernism, Princeton, N.J.: Princeton University Press (1997).

A. Mitchell Polinsky, An Introduction to Law and Economics, 2nd ed., Boston: Little,
Brown (1989).
Eric A. Posner, general editor, Chicago Lectures in Law and Economics, New York:
Foundation Press (2000).

Werner Z. Hirsch, Law and Economics: An Introductory Analysis, 3rd ed., San Diego:

Academic Press (1999).
Robin Paul Malloy, Law and Economics: A Comparative Approach to Theory and
Practice, New York: West Publishing Co. (1990).

Richard A. Posner, Economic Analysis of Law, 4th ed., Boston: Little, Brown (1992).

Robert Cooter and Thomas Ulen, Law and Economics, 3rd ed., Menlo Park: AddisonWesley-
Longman (2000).
Don E. Waldman and Elizabeth J. Jensen, Industrial Organization: Theory and Practice,

2nd ed., Boston: Addison-Wesley-Longman (2001).
William F. Shughart II, The Organization of Industry, Chicago: Richard D. Irwin (1990).
Stephen Martin, Advanced Industrial Economics, Oxford: Blackwell Publishers (1993).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance,
Boston: Houghton Mifflin (1990).
W. Kip Viscusi, John M. Vernon, and Joseph E. Harrington, Jr., Economics of Regulation
and Antitrust, 3rd ed. Cambridge: The MIT Press (2000).
Dennis W. Carlton and Jeffrey M. Perloff, Modern Industrial Organization, 3rd ed., Menlo
Park: Addison-Wesley-Longman (2000).

Lynne Pepall, Daniel J. Richards, and George Norman, Industrial Organization: Contemporary
Theory and Practice, Cincinnati: South-Western College Publishing (1999).

Fred S. McChesney, Economic Inputs, Legal Outputs: The Role of Economists in Modern
Antitrust, New York: John Wiley & Sons (1996, 1998).

Richard Schmalensee and Robert D. Willig, Handbook of Industrial Organization, Vol. I,
Amsterdam: Elsevier Science Publishing Company (1989).

Jan Kmenta, Elements of Econometrics, Ann Arbor: University of Michigan Press (1997).

W. H. Greene, Econometric Analysis, Upper Saddle River, N.J., Prentice-Hall (1999).
G. S. Maddala, Introduction to Econometrics, New York: Macmillan (1992).
George C. Judge, R. Carter Hill, William E. Griffiths, Helmut Lütkepohl, and Tsoung-
Chao Lee, Introduction to the Theory and Practice of Econometrics, New York: John
Wiley & Sons (1988).

A. H. Studenmund, Using Econometrics: A Practical Guide, 4th ed., Boston: AddisonWesley-
Longman (2001).

4

Introduction to
Accounting Principles in
Intellectual Property Damages

In addition to economics, competent intellectual property (IP) analysis requires an
understanding of both the IP owner’s and the infringer’s books and records. A background
in accounting principles is required to accurately identify the financial information
necessary for translating abstract economic theories into factually supported
positions. Moreover, an understanding of the accounting system is needed for efficient
and effective document discovery. While this book does not try to teach a complete
accounting course, this chapter provides an overview that we believe will help the
reader identify the most important records.

INTRODUCTION TO FINANCIAL STATEMENTS

Understanding the financial statements of the relevant companies in a case is critical to
calculating damages. In most cases, the financial records of both parties must be scrutinized.
A lost profits analysis, for example, requires an analysis of the plaintiff’s financial
statements (financials) to determine the profitability of the infringed technology.
Any “unjust enrichment” or “reasonable royalty” calculation also requires an understanding
of the defendant’s financials. The documents sought through discovery will
vary depending on the theory of damages. All too often, attorneys simply will ask the
other side for the same documents that have been requested from their own client.
Such overly simplistic thinking is likely to leave damage experts at a disadvantage.
Furthermore, ineffective discovery can result in additional legal fees as subsequent
requests are necessary to capture the information that should have been included in the
initial set of discovery requests. Finally, because recent trends in the federal rules and
most state rules favor limiting the total number of document requests allowed to each
party, it is increasingly necessary for document requests to be efficient and gather the
necessary information on the first try, where possible.

73

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Accordingly, the purpose of this chapter is to sufficiently educate those with very
little accounting knowledge to enable them to conduct effective discovery requests and
to understand useful accounting techniques generally. Be aware that because the particular
accounting data may vary greatly (even for businesses within the same industry),
the formal assistance of an accountant is likely to be necessary, or at least very
helpful, in completing discovery. The best financial discovery often is performed over
at least two document requests. The first request usually should be relatively small,
focusing on macro-type documents (e.g., tax returns, balance sheets, business plans,
private placement memoranda, etc.). This request most often is made with a relatively
large range of dates in mind, such as tax returns for the last five years. The purpose of
the request is to obtain sufficient information about the opposing party to ensure that
a second request is on point and will result in the best available useful evidence. The
second document request generally is aimed at the most detailed data regarding
the heart of the litigation. For example, a second request might ask for customer lists,
invoices, account details, sales by product number, and so on. Ideally, the second
request will provide the type of information that will allow the damage expert to use
company-related documents rather than industry estimates in performing the analysis.
Again, the actual documents requested will change from case to case, as will the ability
to narrow the requests at an early stage.

Perhaps the biggest factor affecting this two-step discovery process is the method
of accounting used by the company. There are two primary methods of accounting:

(1) cash basis and (2) accrual basis. As discussed in the following section, the practitioner
can make some assumptions about the opponents’ accounting methodology
based on generalizations that empirically function as good indicators. For example,
the tax return of a business contains a box that is checked by the filer to indicate
which method of accounting the taxpayer used. Thus, if you already have your opponent’s
tax return, you can definitively determine the methodology prior to using up
any of your document requests. As a general rule, companies that are either large or
publicly held use the accrual method. Small or private companies tend to operate on
a cash basis.
CASH BASIS

The cash basis of accounting is employed by many small businesses in the United
States. For example, many sole proprietors, multilevel marketers, and businesses
operated as a second job use the cash method of accounting. The cash basis of
accounting is similar to the way most individuals maintain their own checking
account. On the day that a company pays a bill (or cuts a check), they record it. On
the day the company actually deposits revenue, they record it. Cash accounting
ignores checks and bills that have not yet arrived, even if the company knows that they

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

are coming. The cash basis approach even ignores bills that have arrived but have not
been paid, as well as checks that have been received but not deposited. This system of
accounting is regarded as less sophisticated than the accrual method (discussed in the
next section). The cash method is similar to an ostrich with its head in the sand,
because cash basis companies act as if a bill that has not arrived does not exist. Thus,
accounting records maintained on the cash basis of accounting are much less likely to
accurately reflect the entire business situation than if the accrual method had been
used. It is impossible to anticipate whether a cash basis company is in better or worse
financial condition than is indicated by its financial statements than if the company
used the accrual basis of accounting.

A simple example illustrates the difficulties associated in the cash basis methodology.
Imagine that you are evaluating two businesses that are both using the cash basis
of accounting. Assume that the date is December 31 and you are trying to determine
which business is in better condition as of that date. The first company is a construction
firm that has worked since last January 1 on a $5 million construction project. The company
completed construction on December 29. During the last year (over the life of the
project), the company paid out $4.5 million in expenses related to the project. The contract
called for the company to be paid the final 20 percent of the $5 million within
30 days after completion of the project. The company received partial payments of $4
million during the year.

The second business is a construction company that also has worked since last
January 1 on a $5 million construction project. This company is not yet finished with
the project. In fact, the company expects to spend $500,000 in January to complete the
project. This is in addition to the $4.6 million the company has already spent since
it began working on the project. This company did manage to negotiate a better contract
than the first company negotiated, as the second company has already received all of
the $5 million.

Which company is in better financial condition? The first company is more financially
sound. After all, the company spent a total of $4.5 million to complete the work,
netting a $500,000 profit. The second company was paid $5 million on a project that
will ultimately cost $5.1 million ($4.6 million + $500,000), resulting in a net loss of
$100,000. However, the financial statements for the two firms might lead you to the
opposite conclusion. For the year ending December 31, the first company will report
only the $4 million of revenue it received and the $5 million worth of expenses it has
already paid. Thus, the company showed a net loss of $1 million. In contrast, the second
company reported the $5 million of revenue it received and the $4.6 million of
expenses it paid. Thus, the second company showed a net gain of $400,000.

As this example illustrates, the practitioner cannot predict whether a company’s use
of the cash basis method of accounting will overstate or understate the company’s financial
position. Neither can the practitioner assume that the financial condition is in fact
misstated. However, when a firm uses the cash basis of accounting, the practitioner can

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

assume that he or she likely will need to spend time making sure he or she knows about
revenues earned but not yet deposited and expenses incurred but not yet paid. The discovery
requests should take this into account.

THE ACCRUAL METHOD

If the cash method is like an ostrich with its head in the sand, seeing neither approaching
danger nor friends, the accrual method can be compared to Chicken Little’s pessimistic
outlook—“the sky is falling.” The accrual method attempts to include all
conceivable expenses while recognizing only the most conservative estimate of revenues.
The theory behind the accrual method is based largely on the “matching principle.”
Accountants attempt to match revenues with the expenses incurred in generating
those revenues, regardless of when the expenses are actually paid. An example illustrates
the thought process. Imagine that a company engaged in oil and gas development
plans to produce oil over the next five years. At the end of the five years, the company
expects to pay $500,000 to repair the land to make it conform to environmental laws.
Under the accrual method, the company would record $100,000 of environmental remediation
expenses in each of the next five years. This treatment matches the expense with
the revenue, even though the actual remediation payments will not be made until after
the development, some five years from now.

The accrual method is the more commonly used method among large companies. In
practice, many companies use the cash basis throughout the year until the last month of
the reporting cycle. At that point, they make the accounting entries necessary to conform
to the accrual method of accounting. Thus, the expert could receive two statements
for the same company that are not prepared on a consistent basis. An indication of such
a situation is an inventory balance that does not change throughout the year or a balance
sheet that is void of accounts payable. When faced with such a situation, the damage
expert must inquire into the “accounting cycle” to identify information that is fairly
compared to the data in hand. The accounting cycle is discussed in more detail later in
this chapter.

A significant advantage of analyzing a business that uses the accrual method is that
there is a high likelihood that all expenses are identified. However, a disadvantage of
the accrual method is that it is easy to overstate a company’s incremental costs. As
discussed in detail in Chapter 14, “incremental costs” are one of the primary tools
used in preparing a damage analysis. This can be illustrated using the same oil and gas
company described previously. Assume that the company is infringing protected technology
that allows the company to get oil out of the ground for less money than it is
able to without the technology. Further assume that the technology at issue does not
affect the expected remediation costs. The expert must remove the remediation
expense from his or her analysis to avoid overstating incremental expenses. In sum,
when analyzing a cash basis firm, the practitioner must make sure that relevant

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

expenses are not left out of the analysis. Conversely, when analyzing a firm that uses
the accrual method, the expert must be certain not to include expenses that should be
left out of the analysis.

THE FINANCIAL STATEMENTS

The first document request usually is more general in nature and broader in scope than
subsequent document requests. The first request typically asks for the high-level financial
statements for a period of time before the alleged infringement (often 3 to 5 years)
through the date of the request. When accountants use the term financial statements,
they typically are referring to a set of documents consisting of (1) income statement,

(2) balance sheet, and (3) statement of cash flows. Each of the three types of documents
is designed to serve a distinct purpose, and each can be useful for different aspects of
the IP damage analysis.
THE INCOME STATEMENT—ALSO CALLED A
“PROFIT/LOSS STATEMENT”

The income statement is called a “period” document because it relates to a specific
period of time. Most companies prepare monthly, quarterly, and annual income statements.
It is most common for the income statement to have a “Year to Date” column as
well as a column that is for the same period of time during the previous year. Exhibit
4-1 is an example of an income statement for the hypothetical company ABC, Inc.

The income statement is the most useful document for determining the incremental
margin on additional products sold. The incremental margin is the appropriate profit
stream to use when determining a lost profit damage calculation. To obtain the incremental
profit margin, one must begin with the income statement. The income statement
lists the revenues and the expenses of the business. Revenues from the company’s operating
activities are listed at the top. Frequently, the revenues are “net,” meaning net of
returns. For example, in the sample income statement (Exhibit 4-1), “Net product sales”
is listed. This amount is “net” of customer returns. In most cases, the difference between
gross revenues (before returns) and net revenues (after returns) is insignificant.
However, for certain industries, such as in the health care industry, the difference can
be quite large. This is intuitive because hospitals typically charge much more than the
insurance companies pay, which results in the large difference. For companies that are
in an industry that usually does not have such a large difference, the presence of significant
returns can be evidence of poor manufacturing quality.

Next, the cost of goods sold (COGS) is listed on the income statement. The COGS
typically includes direct costs incurred in making the sale. For instance, COGS includes
the material and the labor costs needed to make a widget. Of course, the applicable costs
change from industry to industry. For instance, in a law firm, the COGS is the cost of

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

the attorneys’ labor. In contrast, an automated widget manufacturer may not include any
labor costs in its COGS. The COGS is nearly always incremental and represents the typical
starting point for the determination of the total incremental costs.

Next, the income statement typically lists the company’s operating expenses.
Operating expenses are necessary to conduct the business’s operations. Typically, the
operating expenses include some costs that are incremental and some that are not. By
using a combination of statistical analysis and intuition, the practitioner can estimate the
portion of operating expenses that are incremental. In other words, if the plaintiff had
made the lost sale, they would have incurred the incremental costs.

The operating expenses commonly are followed on the income statement by the business’s
selling general and administrative (SG&A) expenses. Frequently, a portion of the
selling costs are incremental (e.g., commissions, etc.). Conversely, general and administrative
expenses consist of items such as the CEO’s salary and usually are not incremental.

Generally, the remaining listed income or expenses are ignored as irrelevant to a
damage calculation. These recorded but irrelevant items may include gains or losses
from discontinued operations, other income/expense, and extraordinary income and
expenses at the very bottom of the income statement. It is very rare that such amounts
would be applicable to a damage analysis.

Years Ended December 31,
2000 1999
REVENUES
Net product sales
Research grants
Total revenues
$ 5,930
198
$ 6,128
$ 6,292
—
$ 6,292
COST OF GOODS SOLD
Profit from sales
4,530
$ 1,598
5,250
$ 1,042
OPERATING COSTS AND EXPENSES
Selling, general, and administrative
Research and development
Total operating costs and expenses
Loss from operations
$ 4,068
10,398
$14,466
($12,868)
$ 5,320
14,669
$19,989
($18,947)
OTHER INCOME (EXPENSE)
Interest income
Interest expense
Other income
$ 2,941
(762)
—
$ 901
(221)
—
Total other income (expense) $ 2,179 $ 680
Net and other comprehensive loss ($10,689) ($18,267)
Basic and diluted net loss per share ($0.49) ($0.82)
Shares used in calculation of basic
and diluted net loss per share 21,801 15,842
EXHIBIT 4-1 Income Statement for ABC, Inc.

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

BALANCE SHEET

The balance sheet represents a “snapshot” of a company’s assets, liabilities, and equity
as of a particular day. Although the specific items listed on the balance sheet differ from
company to company, certain aspects are always the same; assets are always listed first,
followed by liabilities, and finally equity. Within the assets, those that are most easily
and quickly converted to cash are listed first. The amounts on the balance sheet are
called “book value” and generally represent the amount spent on acquiring the account.
Exhibit 4-2 represents a sample balance sheet for ABC, Inc.

December 31,
2000 1999

ASSETS
Current assets:
Cash and cash equivalents $ 14,153

$ 881
Short-term debt securities held to maturity
and time deposits, partially restricted 109,089

20,630
Receivables 1,526

316
Note receivable from related party 278

278
Other current assets 502

547
Total Current Assets $125,548

$22,652

Property and equipment $ 9,961

$ 9,562
Accumulated depreciation $ (8,938)

$ (8,452)
Net Fixed Assets $ 1,023

$ 1,110

Debt issuance costs 108

127
Long-term debt securities held to maturity $ 12,343

TOTAL ASSETS $139,022

$23,889

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities $ 1,082

$ 993
Accounts Payable 1,663

1,167
Accrued Liabilities 256

214
Total Current Liabilities $ 3,001

$ 2,374

Convertible notes payable $ 10,958

$10,215
Deferred revenue 130

25

Stockholders’ equity

Common stock, .001 par value, 50,000,000 shares

authorized: issued and outstanding 27,352,000

shares in 2000 and 17,503,000 shares in 1999 27

17
Additional paid-in capital 226,465

102,128
Accumulated deficit (101,559)

(90,870)

Total Stockholders’ Equity $124,933

$11,275

TOTAL LIABILITIES AND
STOCKHOLDERS’ EQUITY $139,022

$23,889

EXHIBIT 4-2 Sample Balance Sheet for ABC, Inc.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Assets

The entry titled “Total Current Assets” ($125,548 for ABC) represents the assets that the
company expects to use over the next 12 months. The most common current assets are
cash, accounts receivable, inventory, and prepaid assets. Often, the fair market value of
current assets is very similar to their book value. An asset is considered “current” if it
is likely to be used during the next year.

Fixed assets (here $1,023 for property, plant, and equipment) usually are listed
next. Fixed assets consist of assets that are expected to remain in use for more than
one year. Typical fixed assets include buildings, vehicles, property, and equipment.
Additionally, purchased patents and goodwill are fixed assets. In fact, only purchased
IP is listed. Internally developed IP, whether it be a patented process or copyrighted
software code, is not typically reflected anywhere on the balance sheet. The fixed
assets, including the IP, are recorded at their cost and depreciated over their useful life
during subsequent periods.

Accumulated depreciation is a line item under fixed assets that reduces the book
value of the fixed assets to reflect the wear and tear on the asset. The accumulated
depreciation account is a negative amount within the fixed asset section of the balance
sheet. At the bottom of the fixed asset section is a line item titled “Net Fixed Assets.”
The net fixed assets represent the cost of the assets “net” of depreciation. As each year
passes, the fixed asset balance remains the same, the accumulated depreciation increases,
and the net fixed assets decrease.

For instance, assume that a company buys a building for $600,000. Further assume that
the company expects the building to be used for 30 years. The balance sheet will include
a line item under fixed assets titled “Building” with a corresponding amount of $600,000.
Each year $20,000 ($600,000 ÷ 30 years = $20,000/year) will be added to the accumulated
depreciation account. Thus, in the first year the account balances are as follows:

Building $600,000
Accumulated depreciation ($ 20,000)
Net fixed assets $580,000

The second year would show account balances as follows:

Building $600,000
Accumulated depreciation ($ 40,000)
Net fixed assets $560,000

This process would be repeated until the 30th year when the accounts would be:

Building $600,000
Accumula,ted depreciation ($600,000)
Net fixed assets $ 0

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

Of course, real businesses typically have more than one fixed asset (i.e., buildings,
delivery trucks, equipment, purchased patents, etc.). However, they usually have only
one accumulated depreciation account. Thus, a more typical fixed asset account looks

like the following:
Trucks $ 120,000
Equipment 80,000
Building 600,000
Patents 500,000
Accumulated depreciation ( 300,000)
Net fixed assets $1,000,000

As opposed to current assets, there rarely is a close relationship between the book
value of fixed assets and the fair market value of the fixed assets. The explanation for
this observation is easy to understand. Recall the previous example. Over a 30-year
period, it is likely that the fair market value of the building increases. Yet, after 30 years,
the balance sheet shows net fixed assets of zero. It is precisely for this reason that the
book value of assets is rarely used to value a business.

Liabilities

The liabilities of a company represent debts incurred to partially finance the purchase
of the assets. Like the assets, liabilities are classified as either current (due within one
year) ($3,001 for ABC) or long-term (due on a date later than one year from the balance
sheet date) (for ABC, $10,958 plus $130 ($11,088 total)). Some of the borrowed
amounts are via formal loans, whereas other borrowings are through more “informal”
means. Generally, the formal loans are part of long-term liabilities, whereas the informal
loans are part of the current liabilities. The formal loans typically are made to the
company by banks via a note. The balance sheet typically lists the interest rate of the note
and often the date on which it must be repaid to the bank. Informal loans consist of
accrued expenses, accounts payable, and so on. These types of borrowings usually are
interest-free and for a very short term. As can be surmised from the preceding explanation,
the liabilities section of the balance sheet usually is very straightforward and easy
to understand. There are, however, a couple of relevant exceptions.

Deferred Revenue. Deferred revenue is a liability ($130 for ABC) that indicates that
the company has received cash that it has not yet earned. This is not an uncommon
occurrence. For example, assume that the construction company described previously
had received 25 percent of the contract price as a down payment. The down payment
would be recorded as deferred revenue until the construction company completed 25
percent of the work (at which point it would be revenue or sales). The deferred revenue

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

account may be relevant to IP damage calculations. It is particularly relevant in disputes
involving software companies. Many times, software companies receive cash before
they deliver the software according to their contract. Since the proper accounting for
such revenue is a complex portion of accounting rules, many companies that are not
audited classify the amount as revenue when in fact it is deferred revenue. The result is
that the company looks as if it has higher sales (revenue) than it actually does. It also
appears to have less debt than it actually owes (because the deferred revenue is actually
a debt).

Deferred Tax Liability. Deferred tax liability results from legally deferring taxes.
It arises as a result of a taxpayer taking advantage of the tax laws. Companies legally
may use one method of accounting for tax treatment and another accounting method
for their own financial reporting. The different methods may allow the company to
pay less in taxes, resulting in a tax savings to the company. The tax savings are considered
a liability, as the savings are only temporary and ultimately must be paid to
the taxing authority. For instance, assume that a company depreciates $100,000 of
equipment over a 10-year period ($10,000 per year). Further assume that the tax laws
allow the company to depreciate the equipment over five years ($20,000 per year).
In the first year, the tax return will show $10,000 less profit than the company’s
income statement shows. As a consequence, the taxes paid by the company will be
smaller than if the company had paid taxes on the income in its income statement
(because the profits are less). The savings are booked as a deferred tax liability. The
company ultimately will pay the difference in taxes. Most valuation experts ignore
this “liability.”

Equity

The equity section is perhaps the most confusing portion of the balance sheet. The
equity section is not related to the fair market value of a company. The equity on the balance
sheet is referring to book equity, which is simply the difference between the
total assets and the total liabilities. This amount often is much less than fair value.
Perhaps the easiest way to gain a general understanding of the equity section of a balance
sheet is to describe how it evolves over a company’s lifetime. Imagine that a company
is formed and has 100 shares with a par value of one dollar. Further assume that
the company sells the shares to the original investors for $10 each for a total of $1,000.
The equity section begins with such transactions. The first line item in the example
reflects $100 for common stock. The amount is calculated as the par value times the
number of shares ($1 × 100). The next line item is “paid-in capital.” The paid-in capital
amount is calculated as the difference between the original purchase price and the
par value times the number of shares [(10 . 1) × 100 = 900].

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

Assume next that the company generated $200 of net income during the year and
paid shareholders dividends of $100. The equity section would have increased by a total
of $100. This amount reflects the increase from the net income ($200) less the amount
paid out as dividends ($100). This discussion is intended to provide a very high level
review of the equity section. It usually is not necessary to deal with the equity section
during an IP analysis. Even if it were necessary to determine the true “equity” in a firm,
the practitioner would use valuation techniques to calculate the value rather than use the
equity section of the balance sheet.

CASH FLOW STATEMENT

The primary purpose of the cash flow statement is to provide information about a company’s
inflows and outflows of cash. This information can help project the future net
cash flows of the company. Cash flows are derived through three types of business
activities: cash flows from (used in) operating activities, cash flows from (used in)
investing activities, and cash flows from (used in) financing activities. Additionally, the
cash flow statement reports the effect of foreign exchange rates on the company as well
as the increase or decrease in cash during the period and the noncash investing and
financing activities. There are two formats in which cash flow information may be displayed:
the direct method and the indirect method. Both methods compute and present
the information pertaining to the investing and financing activities, but they differ in the
approach used to calculate net cash flows from operating activities. More important,
both methods result in providing the user with the same valuable information (e.g.,
where the cash went or came from).

An example of the indirect method for ABC, Inc. is shown in Exhibit 4-3.

For more detailed analysis on particular financial statements, it may be necessary to
read accounting literature. As there is an enormous amount of it, the following section
is intended to help the reader determine the best source of information.

THE ROLE OF STANDARDS IN FINANCIAL STATEMENTS

Over the years, the accounting profession has developed a structure of accounting
practice standards to address the comparability of financial statements. The chief body
of practice standards is a set of generally accepted accounting principles (GAAP),
which is intended both to guide and to govern the preparation of financial statements.
“Generally accepted” means either that an authoritative accounting rule-making body
has established a principle of reporting or a principle has achieved general acceptance
through practice and universal application.

Several major organizations are involved in the development of financial accounting
standards in the United States. These organizations are:

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

. Securities and Exchange Commission (SEC)—the government body that regulates
public companies
. American Institute of Certified Public Accountants (AICPA)—the entity that
regulates and licenses accountants
. Financial Accounting Standards Board (FASB)—an organization that creates
accounting policy (referred to as GAAP)
. Governmental Accounting Standards Board (GASB)—the body that governs
governmental accounting
The SEC was created by the federal government in the 1930s as a direct result of the
1929 stock market crash, which was blamed partially on inadequate financial disclosure.
The SEC is an independent regulatory agency of government. Companies issuing
publicly traded stock or listed on stock exchanges are required to file annual audited
reports with the SEC, and the SEC is charged with the responsibility of establishing the
accounting practices and policies that the companies under its jurisdiction must follow.
Initially, the SEC relied on the AICPA to create and enforce accounting standards.
In response, the AICPA created the Committee on Accounting Procedure (CAP) in
the 1930s to set reporting requirements. The CAP was replaced by the Accounting
Principles Board (APB), which was then replaced by the FASB in the early 1970s. The
upshot of all these bureaucratic transitions is that the FASB is the major operating
organization of the standard-setting structure.

Years ended December 31,
2000 1999 1998

CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ($10,689) ($13,017) ($ 8,104)
Adjustments to reconcile net loss to

net cash used in operating activities:
Depreciation and amortization 486 546 604
Amortization of premiums and discounts on investments (15) (725) (819)
Amortization of debt issuance costs 19 — —
Noncash interest expense on convertible notes payable 743 221 —
Stock compensation expense 59 760 124
(Gain)/loss on disposal of property and equipment 74 (128)
Changes in assets and liabilities:
(Increase) decrease in receivables (1,210) (65) 38
(Increase) decrease in other current assets 45 (136) (71)
Increase in accounts payable, accrued — — —
Liabilities and accrued vacation 627 848 413
Increase in deferred rent 105 25
Decrease in deferred revenue

(4,656)

Net cash used in operating activities ($ 9,830) ($11,469) ($12,599)

EXHIBIT 4-3 Indirect Method for ABC, Inc.

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

THE ACCOUNTING CYCLE

As discussed at the beginning of this chapter, the second, more detailed discovery
request aims at obtaining very specific information necessary to make the most objective
damage analysis possible. To make a pointed second request, it is important to
understand the accounting cycle. The accounting cycle consists of the procedures that
firms use to record transactions and ultimately prepare the financial statements. In other
words, the accounting cycle contains the raw information that is summarized by the
financial statements. Exhibit 4-4 illustrates the steps in the accounting cycle.

Each step in the accounting cycle contributes to the ultimate goal—-the generation
of the financial statements. Accordingly, understanding the nature of the steps involved
in the accounting cycle prepares the damage expert or attorney to go beyond the financial
statements and address the underlying data with more precision.

Step 1: Identification and Measurement of
Transactions or Events to Be Recorded

In the first step of the accounting cycle, events that change a firm’s resources or obligations
should be identified and relevant data about those events should be gathered. These

Years ended December 31,
2000 1999 1998

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of investments held to maturity
and time deposits ($238,848) ($30,812) ($39,462)
Proceeds from maturity of investments held

to maturity 127,852 27,903 47,355
Proceeds from sale of investments held to maturity 10,209
Purchase of property and equipment (399) (246) (857)
Proceeds from sale of property and equipment 209
Loan to related party — (125) —

Net cash provided by (used in) investing activities ($101,186)

($ 3,280)

$ 7,245

CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock $121,727

$ 5,146

$ 3,921
Net proceeds from issuance of convertible
notes payable —

9,873

—
Capital contribution 2,561

—

—

Net cash provided by financing activities $124,288 $15,019 $ 3,921
Increase (decrease) in cash and cash equivalents 13,272 270 (1,433)
And cash equivalents at beginning of period 881 611 2,044
And cash equivalents at end of period 14,153 881 611

EXHIBIT 4-3 (continued)

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

types of events fall into two categories: (1) internal events that occur within the entity
and do not involve external parties; and (2) external events that involve either interactions
with a third party or environmental events that are beyond the control of the
enterprise. Examples of internal events include the use of inventory for production and
the recognition of depreciation and amortization of fixed assets. External events include
losses caused by an earthquake or fire and changes in the price of a product bought or
sold by the enterprise. All such events are referred to as transactions and often are accompanied
by a “source document,” which is important to the initial recording of transactions
in a journal. A source document is the most detailed form of accounting record that
exists. For instance, invoices, sales slips, check copies, bank slips, and contracts are all
source documents. Other events, such as the accrual of interest, are not signaled by a new
source document. For example, the source document for the accrual of interest typically
is the original loan document. The objective of a firm’s accountant is to accumulate and
record as many events as possible that affect the financial position of the enterprise.

As an example of when the first step of the accounting cycle may be important to the
discovery process, imagine a case in which the plaintiff alleges that the defendant
misappropriated the plaintiff’s trade secret, a secret formula for making incredibly tasty
barbecue sauce. The source documents (in this case, invoices) could be used to show that
the defendant had never purchased the secret ingredients for the sauce prior to the time
of the alleged theft, but began buying the ingredients shortly thereafter. Accordingly,
the source documents reflecting the external event commonly known as buying supplies
could be used as evidence supporting the plaintiff’s theory of misappropriation.

Step 2: Journalize Transactions and Events

The next step in this process measures and records the economic effect of the transactions.
In other words, it reflects when an accountant actually wrote something down.
The transactions are categorized and collected in “accounts.” The seven major types of

Step 1 Identification and Measurement of Transactions or Events to Be
Recorded
Step 2 Journalize Transactions and Events
Step 3 Posting from Journals to the Ledger
Step 4 Trial Balance Preparation
Step 5 Journalize and Post Adjusting Journal Entries
Step 6 Adjusted Trial Balance
Step 7 Financial Statement Preparation

EXHIBIT 4-4 Accounting Cycle Steps

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

accounts are assets, liabilities, owners’ equity, revenue, expenses, gains, and losses.
Transactions are recorded via “journal entries” that are kept in chronological order.
Journal entries are recorded in “journals,” usually an actual book or a computer file.
Each journal entry includes the date, the account amounts, and a description of the
transaction. A journal entry looks like this:

Cash...100

Accounts Receivable...100

To record the collection of the Smith receivable

Accounting systems usually have two types of journals: general journals and specialized
journals. General journals are used to record all of the journal entries. Specialized
journals are used to summarize transactions with common characteristics. Specialized
journals include cash receipts journals, sales journals, purchases journals, and
cash payments journals.

To see the utility of journal entries, imagine a case in which a patent owner is claiming
that its patent is very valuable. Assume that the patent owner purchased the patented
technology around the time that infringement allegedly began. The defense could
request the journal entry created when the plaintiff purchased the technology. The entry
would reveal the fair market value (per the plaintiff) as of the date of the purchase. It
would be difficult for the plaintiff to argue that the patent had more value at that time
than was recorded in its journal entry.

Step 3: Posting from Journals to the Ledger

The next step in the accounting cycle is to transfer the transaction data from the journal
to the general ledger. This process is called “posting.” Posting reclassifies the data from
the journal’s chronological format to an account classification format in the ledger. This
step creates a single place to find all of the transactions that took place in a similar
account. An account is simply a detailed category of assets, liabilities, equity, revenue,
or expenses. For example, “sales,” “costs of goods sold,” “auto expenses,” “vehicles,”
and “accounts payable” might all be separate accounts in a general ledger.

General ledger information is most useful in situations such as the following scenario.
Imagine a defendant who allegedly has violated a noncompete agreement with his
former employer. The defendant’s sales ledger would give a detail of sales (usually
organized by customer name). The ledger could be used to identify the customers that
were previously customers of his prior employer (the plaintiff).

Step 4: Trial Balance Preparation

Once the transaction entries have been recorded in the journals and posted to the ledger,
an unadjusted trial balance is prepared. Despite its litigious-sounding name, the trial

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

balance is a standard step in the accounting cycle that takes place regardless of whether
the firm’s legal department is particularly busy. The unadjusted trial balance lists all of
the accounts and their totals in one document. Basically, the unadjusted trial balance is
a more detailed version of the income statement and balance sheet.

An unadjusted trial balance could be used in a case in which the defendant is accused
of selling infringing hardware and the defendant is known to sell noninfringing software
as well as the allegedly infringing hardware. The trial balance will show the hardware
sales independent of the software sales. In contrast, the income statement may simply
lump all sales together, which would be less than helpful to the plaintiff’s damage expert.

Step 5: Journalize and Post Adjusting Journal Entries

As discussed at the beginning of this chapter, many privately held firms use the cash
method of accounting during the year but report their financials using the accrual
method. At the end of the year, these firms convert from the cash basis to the accrual
basis. This conversion is done by “adjusting journal entries.” This step comes into play
for a damage expert where it is necessary to compare a firm’s financials in June (calculated
on a cash basis) to its December financial statements (done on an accrual basis).
In that case, the damage expert would want the adjusting entries in order to make a similar
type of adjustment to the June financials. With the adjusting entries, the damage
expert can reasonably compare the financial statements from the two periods. In other
words, the journal entries reflecting the “adjustment” may be necessary to ensure that
your damage calculations are not comparing apples to oranges.

Step 6: Adjusted Trial Balance

Once the adjusting journal entries are made, an adjusted trial balance is prepared.
Thus, the adjusted trial balance is more detailed than the financial statements and represents
accounts that are stated under the accrual method. This document should be
requested whenever litigation requires a detailed summary under the accrual method
of accounting.

Exhibit 4-5 depicts the six steps previously discussed, as laid out in a typical accounting
document.

1.
Under the column “Journal Entries,” you can see the entries made to record six
different sales. The entries are organized in the order in which the sales were
made (Steps 1 and 2).
2.
The next column, “General Ledger,” lists all of the transactions, still in chronological
order. However, all of the sales are in one place and all of the receivables
are in another location (Step 3).
3.
The “Sales Ledger” column sorts the sales by the type of sale. If the accounts
receivable ledger were shown, it would sort the receivables by customer name
(Step 3).

Journal Entries

Account Receivable—Williams 100
Hardware Sale (1) 100
Account Receivable—Mackenzie 100
Software Sale (2) 100
Account Receivable—Smith 200
Maintenance Sale (3) 200
Account Receivable—Kennedy 200
Hardware Sale (4) 200
Account Receivable—McNichols 300
Software Sale (5) 300
Account Receivable—Tatos 300
Maintenance Sale (6) 300
General Ledger Sales Ledger
Sales Sales
1 Hardware Sale 100 1 Hardware Sale 100
2 Software Sale 100 4 Hardware Sale 200
3 Maintenance Sale 200 Total Hardware Sales 300
4 Hardware Sale 200
5 Software Sale 300 3 Maintenance Sale 200
6 Maintenance Sale 300 6 Maintenance Sale 300
Total Sales Total Maintenance Sales 500
Accounts Receivable
1 Account Receivable—Williams 100 2 Software Sale 100
2 Account Receivable—Mackenzie 100 5 Software Sale 300
3 Account Receivable—Smith 200 Total Software Sales 400
4 Account Receivable—Kennedy 200
5 Account Receivable—McNichols 300
6 Account Receivable—Tatos 300
Total Account Receivable 1200

(continues)

EXHIBIT 4-5 Accounting Documentation of Steps

89

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

4.
The “Unadjusted Trial Balance” lists the totals from the Sales Ledger. It also has
the total accounts receivable balance (Step 4).
5.
The “Adjustments” column shows the adjustments necessary to make the
financial statements conform to GAAP. In this case, it has been determined
that the Smith receivable is bad debt. As such, it is necessary to reserve an
amount in the account “Allowance for Doubtful Accounts.” Note that the adjustment
is in a similar form as the journal entry made to create the account receivable
in the first place (Step 5).
6.
The “Adjusted Trial Balance” reflects the trial balance after the adjusting journal
entries have been made. Of course, for a real company, the sales and bad
Unadjusted Trial Balance Adjustments
Hardware Sale 300 Bad Debt Expense 200
Maintenance Sale 500 Allowance for Doubtful Accounts 200
Software Sale 400
Total Sales 1200 To reflect the bad debt of Smith
Account Receivables 1200
Adjusted Trial Balance Financials
Income Statement
Hardware Sale 300 Sales 1200
Maintenance Sale 500 Less: Bad Debt .200
Software Sale 400
Total Sales 1200 Balance Sheet
Accounts Receivable (net) 1000
Account Receivables 1200
Allowance for D.A. .200
1000

EXHIBIT 4-5 (continued)

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

debt would be recorded on the income statement, whereas the accounts receivable
and allowance for doubtful accounts would be recorded on the balance
sheet (Step 6).

After completing the six steps, the financials are complete and need only to be prepared
(Step 7). The “Financials” column reveals the information that became available
via the first document request. Note that the accounts receivable balance is “net” of the
allowance for doubtful accounts and that all sales are lumped together. While this type
of consolidation makes it easier to read the financial statements, it often is too generic
for an expert to use effectively in preparing a sophisticated damages report.

In summary, these seven steps constitute the portions of the accounting cycle that are
most useful to damage experts. The steps typically are performed every fiscal period to
prepare the financial statements.

ALL FINANCIAL STATEMENTS ARE NOT CREATED EQUAL

The problem with a good discovery request is that once made, the practitioner has to
decipher the documents. The following section is intended to assist in that process. As
it is typical to receive more than one document with the same information, one must be
able to determine the best of those documents.

Unreliable financial statements result in a problematic basis for a damage calculation.
Fortunately, accountants make it easy to determine the relative reliability of
financial statements. Accountants include a written explanation of the work they
have done with regard to preparing the financial statements. In that explanation,
accountants indicate whether they have “compiled,” “reviewed,” or “audited” the financial
statements. If there is no explanatory paragraph, it is likely that no independent
accountant has done any work at all on the financials. In other words, if there is no
written explanation, the financial statements are only as good as the ability of the
firm’s management.

Compiled Financial Statements

When a CPA “compiles” financial statements, he or she simply takes the information
from the client and puts it into a conventional format. He or she does not do any work
or opine on the appropriateness of the amounts within the categories.

Reviewed Financials Statements

When a CPA “reviews” financial statements, he or she performs a very limited set of
analytical procedures. While reviewed financial statements are often reliable, they usually
do not contain all of the information that is provided in audited financial statements.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Specifically, they do not contain all of the footnotes to the financials; these footnotes
can be very significant to a damages analysis.

AUDITED FINANCIALS

Audited financial statements are the most reliable financial statements available. You
can tell that an audit has been performed by the existence of an audit opinion. The audit
opinion is in a letter format from the auditor and is attached to the front of the financial
statements. There are two primary reasons an audit opinion is beneficial. First, the existence
of an audit opinion means that the financial statements probably conform to
GAAP. Second, auditors create documents that can be extremely useful in preparing
a damage claim. To most effectively take advantage of audited financial statements,
the practitioner should have a fundamental understanding of: (1) the significance of
the dates identified in the audit report, (2) the different opinions issued by auditors, and

(3) which documents created by auditors are the most useful for damage calculations.
SIGNIFICANT DATES IDENTIFIED IN THE REPORT

There are two dates contained within all audit opinions that are significant to the damage
expert: (1) the report date and (2) the date of the opinion.

Report Date

The report date refers to the last day of the accounting period. After the company name,
the heading of the financial statement says one of two things: either (1) the balance
sheet states “As of December 31, 2002,” indicating the date of the “snapshot”; or (2) the
income statement and statement of cash flows state “For the Period Ending December
31, 2002,” indicating that the document covers a specific period (usually one year).
Thus, when making a discovery request for the income statement, the practitioner
should request the “Income Statement for the Period Ending December 31, 2002.”
Conversely, when making a request for a balance sheet, the practitioner should ask for
the “Balance Sheet as of December 31, 2002.”

Date of the Opinion

The accounting firm that conducted the audit signs and dates the audit opinion. The date
is sometimes useful in a damage case. For example, if the auditors are aware of a significant
event that occurred after the report date but before the date of their opinion, they
will disclose the event in the footnotes. The event is significant if it would reasonably be
expected to affect the financial statements (i.e., a fire at the headquarters, a strike, a loss

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

of financing, etc.). Imagine a situation in which the plaintiff claims that your client stole
their trade secret on January 9. They claim that their business was totally destroyed as a
result. Assume that their expert calculates damages based on the premise that the business
was destroyed the day of the theft. However, the December 31 audit report (issued
January 31) is done without a footnote regarding subsequent events. The lack of a significant
event footnote about the theft is strong evidence that, as of January 31, the plaintiffs
did not have reason to think that their business was destroyed.

DIFFERENT AUDIT OPINIONS

Nearly all audits result in the same type of opinion—an unqualified opinion. However,
since there are various types of opinions, the practitioner should be aware of the different
possible types. The following discussion outlines the main types of audit opinions.

Unqualified Opinion

An unqualified opinion, also called a “clean” opinion, is the most common opinion
issued. A clean opinion generally means that the auditor believes that the financial statements
are materially in compliance with GAAP. In other words, there may be known
problems in the financial statements that are not material. “Material” generally is considered
to be the amount that would influence a reasonable user of the financial statements.
The amount that is considered “material” changes based on the size of the
company. It is easy to appreciate why this is the case. A $500,000 overstatement of revenues
in a company that has $1 billion in revenues is not likely to influence a user.
However, a $500,000 overstatement of revenues in a company with $1 million of revenue
is likely to be very “material” to the user.

Qualified Opinion

A qualified opinion is issued when the auditor does not believe that the financial statements
conform to GAAP. It is rare for an auditor to issue a qualified opinion. While
auditors often find portions of the financial statements that do not conform to GAAP,
they typically bring the problem to management. Management then generally corrects
the problem, allowing the auditor to issue a clean opinion.

Going-Concern Opinion

A going-concern opinion is issued when the auditor believes the company may not survive
for one more year. It is somewhat common among businesses that, in fact, ultimately
fail. Such an opinion often can be very useful to an attorney or an expert. Imagine
that your client is sued for stealing a trade secret. Further assume that the plaintiff claims

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

that the alleged theft caused his business to fail. As proof, the plaintiff points out the fact
that the business failed within three months of the theft. The plaintiff also offers up the
fact that the company had existed for 50 years prior to the theft as another indicator of
the impact of the loss of the trade secret. However, the defense discovers that the trade
secret allegedly was stolen nine months after the plaintiff’s auditors issued a “goingconcern”
opinion. The existence of a “going-concern” opinion is very strong evidence that
the company’s failure was looming long before the alleged theft. The additional documents
that would help demonstrate this defense are described in subsequent sections.

Scope Opinion

A scope opinion is another rare opinion. Generally, this opinion means that after considering
the evidence provided, the auditor believes that the company’s financial statements
comply with GAAP. However, it also indicates that the auditor was not able to
analyze everything it asked the client to provide (i.e., the auditor’s scope was limited).
A common scenario in which a scope opinion is issued involves a company that has
been in existence for many years, but has never before had an audit. Such a client often
has lost track of the documents needed by the auditor. As a result, the auditor must issue
a “scope limitation.”

While an opinion can be helpful on its own, the more likely benefit of audited financial
statements is related to the documents that must be created during the course of the
auditors completing their audit. The following section describes some of the most useful
documents that are kept by the auditors. It should be noted that usually only the auditors
keep a copy of these documents. Thus, it often is necessary to subpoena the auditors
to obtain the desired documentation.

MANAGEMENT REPRESENTATION LETTER

Management often does not want to live with their previously audited financial statements
during litigation. All auditors obtain a management representation letter (MRL)
as part of their steps in completing the audit. In short, the MRL is a letter written by the
management to the auditors telling the auditors that management has disclosed everything
that is material to readers of the financial statements. In the course of conducting
an audit, the company’s management typically represents the following facts:

1.
Management has told the auditors the truth.
2.
Management has told the auditors about all transactions that have occurred.
3.
Management has told the auditors about all existing liabilities (including lawsuits).
4.
There have been no significant events that have happened during the time
period between the report date and the opinion date.

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

5. Management is in compliance with laws, debt covenants, etc.
6. The financial information is the responsibility of the company’s management.
The actual letters include many more representations. However, the significance of
all the representations is that the MRL makes it very difficult for management not to
take responsibility for the accounting and financial statements contained within the
audited statements.

SUMMARY OF PROPOSED ADJUSTMENTS

Although the name of the actual worksheet varies from firm to firm, all audit firms maintain
the same type of information regarding their proposed adjustments. The proposed
adjustments schedule is a list of all adjustments that were proposed by the auditors. In
other words, the schedule discusses all of the problems the auditors found during the
course of conducting the audit. When auditors find such problems, they discuss them
with management. The typical schedule of proposed adjustments also discusses management’s
response to the auditor’s proposed correcting journal entries. Finally, the
schedule details the resolution. The schedule is the fastest mechanism by which to identify
the company’s accounting weak spots. Since the worksheet does not have a standard
name, a subpoena should request something like, “Provide all work papers depicting proposed
journal entries to the financial statements of ABC Company for the period ending
December 31, 2002, including adjustments, reclassifications, and/or eliminating entries.”

ADJUSTED TRIAL BALANCE

An adjusted trial balance is a document that all auditors will keep and most of their
clients will keep as well. As discussed earlier in this chapter, the adjusted trial balance
provides a summary of the accounts that is more detailed than the financial statements.
The adjusted trial balance is to an accountant what the Rosetta stone is to a historian. This
is because the financial statements employ large general categories, whereas the adjusted
trial balance uses detailed summaries. Most auditors use the term adjusted trial balance,
so discovery requests should be able to target the desired documents fairly easily.

DEBT COVENANT COMPLIANCE

One of the steps required to complete an audit relates to the classification of debt. As
discussed previously, a debt that is due within one year is a current liability. A debt that
is due later than one year from the date of the financial statements is classified as a long

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

term liability. Virtually all loans have covenants with which the debtor must comply. If
the debtor does not comply with the covenants, it is typical for the loan to become due
immediately. In other words, failure to comply with certain provisions can transform a
long-term loan into a current obligation. This would devastate most firms. Accordingly,
auditors always check to see if the firm is in compliance with its debt covenants. Since
bankers are concerned with many of the same issues as damage experts (i.e., profitability,
expectations of future earnings, etc.), a request for the auditors’ work papers regarding
compliance with debt covenants is often a fruitful request.

FINANCIAL STATEMENT TREND ANALYSIS

As a standard part of most audits, the auditor performs trend analysis on the company’s
financial statements. The auditor spots material changes and inquires of management
the cause of such changes. The auditor then documents the response from
management in their trend analysis. This schedule has no standard, industry-wide
name. A document request for “ratio analysis performed on any of the financial statements
for the period ending December 31, 2002” or “trend analysis performed on any
of the financial statements for the period ending December 31, 2002” should produce
such schedules.

Imagine that a plaintiff claims that your client’s patent infringement caused the plaintiff
to suffer lost sales. Assume that you obtained a subpoena requiring the plaintiff’s
auditor to produce its trend analysis on the audit conducted one year before the alleged
infringement and one year after the alleged infringement. Further assume that you learn
that the auditors analyzed the decrease in sales. Finally, assume that the auditors’ analysis
indicates that management told the auditors that the sales decrease was related to the
loss of a major customer. The auditors’ schedules facilitate identifying and interviewing
the proper fact witnesses and possibly result in a determination that the loss was unrelated
to the alleged infringement. Obviously, this information would greatly reduce
damages and may even help with establishing liability.

Ratio analysis also can be used to assess the health or performance of a company.
Ratio analysis helps to expose a company’s strengths and weaknesses by creating percentages,
rates, or proportions from a company’s financial statements. These ratios
express the mathematical relationship between one quantity and another and can be
used to chart a company’s performance over time or to compare two competitors.

Four general categories of ratio analysis exist: (1) liquidity ratios, (2) activity ratios,

(3) profitability ratios, and (4) coverage ratios. Each category evaluates a particular area
of performance.
For example, liquidity ratios measure the enterprise’s short-term ability to pay its
maturing obligations. One such ratio, the current ratio, is defined as current assets
divided by current liabilities. Companies with a higher current ratio have better short

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

term debt-paying ability than companies with a lower current ratio. Another type of
ratio analysis, activity ratios, measures how effectively the enterprise is using their
employed assets (e.g., how efficiently assets are used to generate sales). Profitability
ratios measure how successful a company is in a given period; these ratios measure
such things as a company’s profit margin on sales or their rate of return on assets.
Finally, coverage ratios measure the degree of protection and security for long-term
creditors and investors. For instance, debt to total assets measures the percentage of
total assets provided by creditors.

Exhibit 4-6 illustrates ratios often used in ratio analysis.1 Ratio analysis is most useful
in implementing the income approach and the market approach, and in analyzing the
firm’s capacity, which is necessary to recover lost profits, as discussed in Chapter 14.

DETAIL OF ACCOUNTS

In the course of conducting an audit, an auditor details the most significant accounts.
For instance, sales most often are detailed by geography, channel, or customer. Likewise,
the most significant expenses, assets, and liabilities are also analyzed on a very
detailed level. Using the previous example, a request for the “audit work papers related
to the revenue account” would likely have resulted in evidence that the infringement
did not cause the lost sales. Again, there is no term of art for the appropriate
schedules. However, a request for the work papers associated with the desired account(s)
should suffice.

Fortunately, an audit also produces valuable information that does not have to be
obtained from the auditor. The most useful information often is contained in the footnotes
to the financial statements. Footnotes are perhaps the most difficult part of the
financial statements to appreciate, yet they also can provide valuable information. The
footnotes are located just following the financial statements. Some footnotes appear
in all financial statements. However, most footnotes change depending on the type of
business and its particular characteristics. The following footnotes frequently have
been found useful in performing IP damage analysis.

Purchase Price Allocation

When the audited company acquires another company, the purchase price of the
acquired company must be allocated across the various asset categories. All of the
amounts listed in the purchase price allocation are stated at “fair market value.” Patents,
trademarks, trade secrets, goodwill, and other identifiable assets (both tangible and
intangible) are analyzed separately from the other assets. The footnotes to the financial
statements discuss the purchase price allocation. However, for more detailed information,
you may need to obtain the underlying work papers from the company.

RATIO FORMULA PURPOSE
Liquidity
Current ratio Current Assets/ Measures short-term debt-
Current Liabilities paying ability
Quick or acid-test ratio Cash, Marketable Securities, Measures immediate
and Net Receivables/ short-term liquidity
Current Liabilities
Current cash debt Net Cash Provided by Measures a company’s
coverage ratio Operating Activities/ ability to pay off its
Average Current Liabilities current liabilities in a given
year from its operations
Activity
Receivable turnover Net Sales/Average Trade Measures liquidity
Net Receivables of receivables
Inventory turnover Cost of Goods Sold/Average Inventory Measures liquidity
of inventory
Asset turnover Net Sales/Average Total Assets Measures how efficiently
assets are used to generate sales
Profitability
Profit margin on sales Net Income/Net Sales Measures net income generated
by each dollar of sales
Rate of return on assets Net Income/Average Total Assets Measures overall
profitability of assets
Rate of return on Net Income Minus Measures profitability
common stock equity Preferred Dividends/Average of owners’ investment
Common Stockholders Equity
Earnings per share Net Income Minus Preferred Dividends/ Measures net income
Weighted Shares Outstanding earned on each share
of common stock
Price earnings ratio Market Price of Stock/ Measures the ratio of the
Earnings per Share market price per share
to earnings per share
Payout ratio Cash Dividends/Net Income Measures percentage of
earnings distributed in the
form of cash dividends
Coverage
Debt to total assets Total Debt/Total Assets or Equity Measures the percentage
of total assets
provided by creditors
Times interest earned Income Before Interest and Taxes/ Measures the ability to meet
Interest interest payments as they come
due
Cash debt coverage Net Cash Provided by Operating Measures a company’s ability
Activities/Average Total Liabilities to repay total liabilities in a
given year from its operations
Book value per share Common Stockholders’ Equity/ Measures the amount each share
Outstanding Shares would receive if the company
were liquidated at the amounts
reported on the balance sheet
EXHIBIT 4-6 Ratios
98

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

Goodwill Valuation

Accounting rules recently have changed to require companies to make an annual determination
of whether their goodwill is “impaired.” Goodwill is considered to be
“impaired” if the fair market value of the goodwill is less than its book value (amount on
the balance sheet). However, the reverse is not true. If the fair market value is expected to
be greater than the book value, the goodwill is left on the books at its cost, as accountants
are loath to risk overstating assets. The footnotes to the financial statements typically will
provide significant details regarding the impairment analysis. Again, the footnotes will be
supported by more detailed analyses that may be obtained via subpoena.

Related Party Transactions

Another frequently used footnote relates to disclosing any transactions between the
company and related parties. Related parties generally are described as owners, directors,
officers, spouses of the preceding, and so on. It is common for privately held companies
to have several related party transactions. Furthermore, the related transactions
frequently are not being conducted at their fair market value. To properly analyze the
company, it is common for practitioners to adjust the financial statements to account for
the related party transactions. Such adjustments are made by adjusting the affected
accounts to make them reflect the amount that would be reported if the expense had
been done at fair market value.

SUMMARY

This chapter addressed the basic accounting principles that attorneys and experts
must understand to conduct effective discovery. Moreover, the a,ccounting principles
discussed herein enable the analysis of the relevant financial information. In most IP
damages cases, the financial information of both parties should be analyzed to determine
the existence and extent of damages. Therefore, the effective utilization of
accounting skills facilitates understanding the financial information retrieved and reaching
a proper value for IP.

ENDNOTE

[1]
D.E. Kieso and J.J. Weygandt, Intermediate Accounting, New York: John Wiley & Sons
(1998).
ADDITIONAL READING

Thomas R. Dyckman, Roland E. Dukes, and Charles J. Davis, Intermediate Accounting,
Chicago: Irwin (1995).

100 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Ernst & Young, Understanding and Using Financial Data, New York: John Wiley & Sons
(1996).

Andrew A. Haried, Leroy F. Imdieke, and Ralph E. Smith, Advanced Accounting, New
York: John Wiley & Sons (1994).

Donald Kieso and Jerry Weygandt, Intermediate Accounting, New York: John Wiley &
Sons (1998).

George Mundstock, A Finance Approach to Accounting for Lawyers, New York:
Foundation Press (1999).

K. Fred Skousen, Harold Q. Landerderfer, and W. Steve Albrecht, Accounting Principles
and Applications, Cincinnati: South-Western Publishing (1993).
Clyde P. Stickney, Roman L. Weil, and Sidney Davidson, Financial Accounting: An
Introduction to Concepts, Methods, and Uses, Englewood Cliffs, N.J.: Academic Press
(1991).

Ciaran Walsh, Key Management Ratios, Englewood Cliffs, N.J.: Prentice-Hall99 (1996).

Gerald White, Ashwinpaul Sondhi, and Dov Fried, The Analysis and Use of Financial
Statements, New York: John Wiley & Sons (1998).

5

Financial Principles Used in
Intellectual Property Damages

A third scientific discipline useful in intellectual property (IP) damage analysis is financial
economics. The field of financial economics has a very broad scope, similar to but
distinct from the related fields of accounting and microeconomics. Financial economists
study primarily three topics: investments, option theory, and corporate finance.
The area of financial economics that is most useful to constructing a sophisticated damage
analysis in an IP case is the portion that addresses business valuation. The tools
used in business valuation are required to properly perform the mechanics of the IP
damage calculation. We use these tools in Chapter 14 on the mechanics of damage
analysis. This chapter discusses the general principles of valuation, a critical topic for
understanding a damage analysis because of the many ways in which general valuation
principles overlap damage calculations and theories.

PRELIMINARY ISSUES

Standard of Value

It is essential for both the attorney and the damage expert to have a clear understanding
of the appropriate standard of value in a business valuation. In the United States, the most
common standard of value used is fair market value. Fair market value is defined by the
American Society of Appraisers as “the amount at which property would change hands
between a willing seller and a willing buyer when neither is acting under compulsion and
when both have reasonable knowledge of the relevant facts.”1 This standard of value commonly
is applied in valuations for mergers and acquisitions, estate and gift tax purposes,
charitable contributions, buy–sell agreements, property taxes, as well as in litigation.

Another concept of value, investment value (also called strategic value), represents
the value ascribed to an asset from a specific investor’s point of view. For example, if
a potential buyer views a purchase as a synergistic purchase, the buyer may offer a pre

101

102 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

mium over and above the price that another independent investor would offer for the
same company. Consider the following scenario. An office building with inadequate
parking is located next to a vacant lot. The owner of the office building is likely to pay
more than fair market value for the lot because the lot has a specific utility to him
(providing the necessary parking space) that is worth paying a premium. In other words,
the investment value of the lot from the building manager’s perspective is higher than
the amount that might be accorded the lot under a more objective fair market value. In
the litigation context, investment value generally is closer to the concept captured by a
reasonable royalty damage calculation.

Finally, fair value usually is a statutorily defined standard of value that varies from
state to state. An example of fair value is a value that does not consider discounts for
lack of marketability and/or control. Fair value is a common standard of value for dissenting
stockholder actions and for divorce settings, but it is less useful in IP litigation.

Law of One Price

The law of one price is a basic concept in financial economics that provides a basis for
performing valuations. The law of one price states that assets that have identical future
payoffs must trade at the same price. This is the case because different prices for identical
assets create arbitrage opportunities. While initially this seems obvious, the law
of one price goes on to state that two different assets must be valued equally after
adjusting for all relevant differences. In other words, a stock that is slightly more risky
than its counterpart stock must have a slightly lower price than the counterpart stock
to compensate for the additional risk. A much riskier stock must have a much lower
price. By making this type of adjustment, the two stocks are valued equally, while
accounting for differences in risk. This is helpful only if the practitioner knows the
value of the counterpart stock. Yet, by applying this thought process to the investments
whose value is known and agreed upon, the expert can effectively use a variation of
the law of one price (because the payoffs on each side of the equation are not identical)
to perform a reasonableness check on a valuation. The variation can be algebraically
performed as:

(RFR)(RFI)t = (VU)(PU)t + (VD)(PD)t

where

RFI = risk-free investment

RFR = risk-free return

t = time periods over which the investment is measured

VU = investment’s value in the up stage

PU = probability of the investment going to the up stage

VD = investment’s value in the down stage

PD = probability of the investment going to the down stage

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 103

The following example illustrates the principle. Assume that the valuation is related
to the value of a biotechnology firm. The firm is performing clinical tests that have a
2 percent chance of great success, a 38 percent chance of mediocre results, and a 60
percent chance of failure. Accordingly, based on the results of clinical tests, the firm
has a 2 percent chance of being worth $20 million. It is determined that if the product
fails or gets very poor clinical results, it has a 60 percent chance of being valueless.
Finally, if the results are mediocre, the product has a 38 percent chance of being worth
$5 million. In other words, an investor can choose to take the following risk:
(.02)(20,000,000) + (.60)(0) + (.38)(5,000,000) = $2,300,000 (in one year), or the
investor can buy a risk-free bond from the government. If we assume that the risk-free
rate of return currently is 5 percent, the investor would need to buy $2,196,476 worth
of bonds to be certain of having $2.3 million one year from today. Thus, the value of
the business is $2,196,476.

This exercise is still useful when there is insufficient evidence about the probability
of an event. For instance, assume that you are valuing the aforementioned biotech firm.
However, this time there is no information regarding the probability of the firm’s succeeding
in its clinical trials. The opposing expert prepares a valuation that results in
a value of $15 million. You determine that the most successful project is likely to lead
to a value of $20 million, whereas a failure leads to a worthless project. Next, you perform
the following calculation as a reasonableness check of their conclusion2:

$15,000,000 = (x)(20,000,000) + (1 . x)(0) =
$15,000,000 = (x)(20,000,000) + (0) =
$15,000,000 / $20,000,000 = x
75% = x

In other words, the opposing expert’s valuation implies that there is a 75 percent
chance of the project’s being successful. Even though you were unable to determine the
probability of successful clinical trials, it is likely that you can gather information that
proves the true probability is much less than a 75 percent chance. If there is less than a
75 percent chance, the opposing expert’s value is overstated because it does not comply
with the law of one price. Although the law of one price is often a useful reasonableness
check, more rigorous analyses are needed to actually determine a proper estimate
of value.

Valuation theory includes three conventional approaches for determining the value of
a company’s stock: the income approach, the market approach, and the cost approach
(asset-based approach). If performed properly, all three approaches will indicate a similar
range of value. It is precisely for that reason that the expert must consider undertaking
all three approaches where possible. Since each of the three approaches includes
subjective steps, an expert can use the various methods of valuation to act as “sanity”
checks for the other calculations (see Exhibit 5-1).

104 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

VALUATION APPROACHES

There are three conventional approaches to valuation that may apply in estimating
damages for an IP case. These approaches are (1) the income approach, (2) the market
approach, and (3) the cost approach.

Income Approach

The income approach estimates the value of a business or IP based on future cash-
generating ability. This approach quantifies the expected value of the future economic
benefits that accrue to the owners of the IP. These benefits, or future cash flows, are discounted
to the present or (if constant over time or growing at a constant rate) capitalized
at a rate of return that is commensurate with the risk associated with the future cash
flow and the time value of money.

The four steps typically conducted in performing the income approach are:

1.
Estimate the expected future cash flows for a certain discrete projection
period.
2.
Discount these future cash flows to present-value dollars at a rate of return that
considers the relative risk of achieving the future cash flows and the time value
of money.
Let n = years, r = interest rate, F = future value, P = present value, A = annuity payment,
g = growth rate

n

1 Future value:
F = P (

() 1 + r)
F

2 Present value: P() = n

(1 + r)
..

.
1 . n

.1 ..

.1 + r.

(3) Present value of an annuity: P = A..
. r .

..

A

(4) Present value of a perpetual annuity: P =
R

(5) Present value of F growing at
F
P =

rate g indefinitely:

r . g

EXHIBIT 5-1 Some Useful Financial Formulas

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 105

3.
Estimate the residual value of cash flows (if any) subsequent to the discrete
projection period.
4.
Combine the present value of the residual cash flows (if any) with the present
value of the discrete projection period cash flows.
The methodology for each of these steps is discussed in the following sections.

Step 1: Project the Expected Future Cash Flows of the Subject Intellectual Property.

The first step in the income approach is to create a projection of the expected future
benefit stream of the asset. Whenever possible, cash flow should be used as the appropriate
benefit stream. Investors are concerned with the actual cash that they will receive
from an investment and the timing and risk associated with those cash flows. Not only
is this principle accepted in theory, but also the proposition has growing empirical support.
Most studies of accounting changes that impact cash and earnings differently find
that security prices are determined by the change in cash flows.3 Earnings, or the net
income on a firm’s income statement, is not the most appropriate measure of the benefit
stream if cash flows are known or can be reasonably predicted and are significantly
different from net income.4 As discussed earlier, net income is defined according to
the accounting principles of matching and conservatism, which can be independent of the
true time of payment. Moreover, empirical work on investor perceptions of value tend
to confirm that investors see through accounting conventions and react to underlying
changes in cash flow.5 However, when informational problems exist, earnings can be a
better measure of future cash than current cash flows. For example, if information concerning
cash flow is known only for two years and during those two years the firm has
significant capital investments that are not expected to yield returns until more than two
years in the future, the matching principle that is used to construct earnings may provide
a better measure of future cash flow than present cash flows. When earnings are
used to proxy cash flows, an appropriate earnings model (which has an equivalence to
the dividend discount model or discounted cash flow model) should be adopted.6

Once a benefit stream is selected, it is important to determine whether the valuation
should relate to total invested capital (i.e., interest-bearing debt holders and equity holders)
or just equity holders. Assuming that cash flow is used, the net cash flow to total
invested capital is computed using the following formula:

Earnings Before Interest and Taxes (EBIT)
. Estimated federal and state tax expense

+ Noncash expenses (e.g., depreciation, deferred taxes, etc.)
± Requirements to fund working capital
. Capital expenditures
+ Preferred dividends, if any
= Net cash flow to invested capital

106 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Net cash flow to equity is computed using the following formula:

Net income
+ Noncash expenses (e.g., depreciation, deferred taxes, etc.)
± Requirements to fund working capital
. Capital expenditures
± Changes in long-term debt
= Net cash flow to equity holders

After the appropriate future cash flow benefit stream is identified, it is appropriate to
begin the projection analyses. The projection should approximate the expected value of
the future cash flows. The expected value is not the expert’s subjective intuition about
the future. Rather, it represents the weighted value of all future possible cash flow scenarios
weighted by their probabilities. This expected future cash flow must take account
of both the probability of a project’s utter failure and the probability of miraculous success.
To be consistent, the expected value of the future cash flows is the place in the valuation
procedure where the unsystematic or the unique risk faced by the company
should be taken into account. The benefit stream should be an expected value of several
possible future scenarios.

Projections are estimated most easily in situations where the subject IP has established
a long track record. The historical results often are very useful in predicting the
future performance of the property. However, the historical results should not be the
sole basis for establishing the projections. The projections also must consider the asset’s
situation at the date of the valuation, the outlook for the relevant industry, and any relevant
expected changes in the law, new competition, and so on.

Projections usually are best determined by starting with the revenues. Ideally, a relationship
between sales and an identifiable independent variable can be established. For
example, it is possible that there will be a relationship between new home sales in a particular
city and the revenue for furniture companies in the same city. Other factors that
must be considered include new competitors moving into the city, interest rates, new
technology, price changes, and so on. Although a certain portion of the revenue projection
is subjective, reasonable projections must conform to considerations of the particular
subject property. For instance, the revenue must be based on manufacturing, sales,
and financial limitations specific to the firm at issue as well as market developments
outside the firm.

Once the revenue has been projected, all of the expenses that must be incurred to generate
this specific revenue should be calculated. Many practitioners use econometric
analysis to assist in this calculation. Additionally, the expenses should include amounts
that may not historically have changed with sales but would be necessary to produce the
projected revenue. For example, if the projected revenues are based on adding a third
shift, the required expenditures for the additional supervisors, management, and so on
required for adding a third shift must be determined.

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 107

Finally, any required costs for capital expenditures and working capital must be considered.
Although neither capital expenditures nor working capital is an expenditure in
the true sense of the word, both categories reduce cash flows and therefore must be
considered.

Working capital typically reduces the cash flows in periods of growth. Working capital
represents the value of the current assets less current liabilities. Current assets
include items such as cash, receivables, and inventory that are partially used to finance
the short-term liabilities. The short-term liabilities generally include the accounts
payable, accrued expenses, and so on. The necessity of accounting for the investment
in working capital can be illustrated by the following example. Assume that a firm
begins business on January 1. Although the company makes sales on the first business
day, it offers credit to its customers and does not begin to collect on its receivables for
30 days. The employees must be paid before the 30 days have elapsed. Thus, the firm
must have capital (either from borrowing it or from an additional investment by the
owners) to pay the employees. This capital is called working capital. Just as a new firm
needs working capital funds, nearly all firms that are growing their revenues require
working capital investment. If a firm’s revenues are decreasing, the change in working
capital may actually contribute to cash flows.

Capital expenditures are also an investment that typically reduce cash flows. The relevant
capital expenditures represent the cost of buying buildings, office space, computers,
trucks, and so on that are required to make the projected sales. Capital expenditures
are usually required for firm growth. However, some firms can experience enormous
growth with very little investment in capital expenditures. For instance, many Internet-
based firms require very little additional capital expenditure beyond what is needed to
make the first sale. In contrast, even firms that are experiencing stabilized revenues may
have significant required capital expenditures. For instance, airlines must continually
invest in new airplanes or airplane maintenance, even if sales are low.

Finally, some reasonable economic theory must guide the benefit projection process.
Experts should not assume that a firm will receive returns above the competitive average
for an extended period unless there is a very good explanation for that assumption.
This caution is empirically justified because high returns induce entry and, in the case
of IP, significant design-around efforts by competitors. These consequences in turn
should reduce the original firm’s returns until the market stabilizes.

Step 2: Determine the Discount Rate Applicable for the Projected Cash Flows. The
discount rate is a mechanism for reflecting the systematic risk and the time value of
the future estimated cash flow streams. Once an expert determines the expected future
cash flow from the asset being valued, he or she must construct the proper discount rate.

The Time Value of Money. The adjustment for time value of money results from the
fact that investors value a dollar received today more than they value a dollar received

108 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

in the future. Thus, to value future cash flows from a business, a security, or an asset
such as IP, the expected future cash flow must be converted to an equivalent value
today, or into its “present value.” The present value represents what investors are willing
to pay today for each dollar received in the future, abstracting from any risk. This
present value represents the opportunity cost of funds invested today at a risk-free rate
of return for the number of periods involved. To determine the opportunity cost of funds
at a risk-free rate, it is necessary to find the spot rate or interest rate on a risk-free asset.
The set of spot rates for each period can change, and the term structure of interest rates
represents the entire set of spot rates on risk-free assets for different holding periods.
The term structure of interest rates generally (but not always) is upward-sloping.
Because the term structure of interest rates can change and there is no consensus on the
factors determining the term structure, it often is appropriate to assume a flat term structure
and use a single interest rate, such as the interest rate on a 20-year government note,
as a proxy for the risk-free rate of return in all periods.

Adjusting for Risk. Risk simply refers to variability in expected returns. For example,
asset A may be certain to generate $10 in cash flow in one year, whereas asset B may
generate a 50 percent chance of receiving $20 in one year and a 50 percent chance of
receiving $0 in one year. The expected returns on both assets are the same (10 percent),
yet asset B is more risky. To understand why asset B is less desirable, financial economists
have constructed a theory of investor preferences over uncertain outcomes. The
basic assumption of the theory is that investors are “risk-averse,” meaning that where
possible, investors like to avoid risks. This assumed aversion implies that investors have
a utility function7 with the following characteristic:

.UW(

″)

UW( )> 0

′

U″ is the second derivative of the utility function with respect to W, or wealth, and
U′ is the first derivative with respect to W. A utility function with risk aversion can be
depicted as:

Utility
U
Wealth

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 109

As an investor’s wealth increases, his utility increases, albeit at a decreasing rate. The
impact of such a utility function is that reductions in wealth result in a greater loss
of utility than increases in wealth yield increases in utility. Therefore, investors lose utility
overall by variation in returns. As a result, all other factors being equal, investors dislike
variation in returns.

Investment theory assumes that the risk-averse utility function is described by the
mean and variance, σ,2 of the asset’s return. The typical assumption is that asset returns
are multivariate normally distributed, so even if investors cared about other aspects of
the asset’s return, such concerns would not impact investment behavior because normally
distributed returns are fully defined by the mean and variance alone.

If μis the mean return, then the variance is:

2

σ =Σ
n (Xi .μ)2

i =1

That is, the variance is simply the sum of the squared deviations of the asset’s returns
from the mean return. One important characteristic of the variance is that the sum of
several variances will yield a lower variance to the extent that the returns of the assets
being summed are not perfectly positively correlated. This observation has led modern
portfolio theory to theorize about how investors will select an optimal portfolio. For
example, the capital asset pricing model (CAPM) uses this observation to develop
appropriate risk premiums. Under CAPM, investors are interested in minimizing risk
per unit of expected return. Because of the characteristic of the variance described
previously, investors optimize by holding diversified portfolios. The result is that the
total risk of an asset can then be divided into two components: (1) the unsystematic or
unique risk that can be diversified away, and (2) the systematic or market risk, which
is related to the economy as a whole and cannot be reduced by diversification. In the
CAPM model, only systematic risk or market risk is the risk for which investors are
compensated in the form of a risk premium. This systematic risk can be measured by
the variable beta. Beta, βi, measures the contribution of an asset to the total risk of a
well-diversified portfolio; stated differently, beta is the variability in the price of the
asset in relation to the total market variability.

ri =rf +βi [E(rm) .rf]

where ri is the risk-adjusted discount rate, rf is the risk-free rate of return, and the last
term represents the systematic risk premium, E(rm) .rf. In the income method, the
unique risk is captured by the expected value of future cash flows in the numerator, and
only systematic risk is considered in determining the discount rate.

110 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

It should be noted that discount rates developed in the CAPM model are based on
data derived from publicly traded securities. Consequently, the resultant value derived
from using this discount rate represents value attributable to a noncontrolling investor
of a marketable investment. As such, the analyst should consider, based on the interest
being valued, whether a control premium and/or a discount for lack of marketability are
applicable.

The Build-Up Approach. An alternative approach to determining the risk premium
that strays from financial theory and instead relies on empirical findings is called the
“build-up” method. The build-up approach estimates the cost of equity by “building up”
the required rate of return on equity. The build-up method is performed by estimating
each of the risks. The components most often considered are:

Risk-free rate

+ Equity premium
+ Size premium
+ Specific company premium
= Total cost of equity
A comparison of the CAPM approach and the build-up approach reveals that both
calculations consider similar risks. One difference is that in the CAPM the only
source of risk is completely captured by beta, whereas the build-up method relies on
the expert’s judgment. The build-up method deviates from the CAPM assumption in
that the CAPM assumes that only systematic risk is priced by diversified investors. A
frame of reference regarding required rates of return can be found in the next section.
Historically, small firms have had higher rates of return than large firms. This belief
is widely held among the valuation community. There have been several studies
demonstrating that this relationship holds true empirically, although there is no
consensus regarding the theoretical explanation for this effect, or whether it is true
at present.8 Thus, if the business is a very small firm, the cost of its equity probably
should be high.

The Weighted Average Cost of Capital. In certain situations, it is appropriate to value
more than the portion of the business owned by the equity holders. For example, if one
is valuing a controlling interest of a company where the owner has to incur debt, it
may be appropriate to value the business on a total invested capital basis (i.e., interest-
bearing debt and equity), assuming the industry’s capital structure, to properly reflect
value. In that type of situation, it may be appropriate to value the company based on its
weighted average cost of capital (WACC).

The discount rate for a firm or asset that is not all equity financed is the WACC. The
WACC is calculated by weighting the required returns on interest-bearing debt and

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 111

common equity capital in proportion to their estimated percentages in an expected capital
structure.

Several possible methods are used in the determination of the appropriate WACC
rate. The general formula for calculating the WACC rate is:

WACC = Kd × (d%) + Ke × (e%)

where
WACC = weighted average cost of capital
Kd = after-tax rate of return on debt capital
d% = debt capital as a percentage of the sum of the debt, preferred and
common equity capital (total invested capital) measured in
market terms
Ke = required rate of return equity capital
e% = common equity capital as a percentage of the total invested
capital, measured in market terms

We have discussed two alternative methods of determining the required return on
equity, CAPM and the build-up approach. In contrast, the rate of return on debt capital
is the rate a prudent debt investor would require on interest-bearing debt. Since
the interest on debt capital is deductible for income tax purposes at the corporate level, the
after-tax interest rate is most often used in the WACC calculation. The effective income
tax rate is the federal income tax rate plus the effective state income tax rate (adjusted
for federal income tax deductibility).9

The after-tax rate of return on debt capital is typically calculated using the formula:

Kd = K × (1 × t)
where
Kd = after-tax rate of return on debt capital
K = pretax rate of return on debt capital
t = effective federal and state income tax rate

Combining the discount rates for debt and equity with the WACC identity provides a
discount rate for valuing the total assets of a firm, thus removing any specific financing
decisions from the valuation.

Step 3: Estimate the Residual Value of Cash Flows (If Any) Subsequent to the
Discrete Projection Period. Since businesses, and occasionally IP, are unlike humans
in that they do not have to die (but they do pay taxes), the expert faces a problem with
establishing the number of years to project revenues. Experts project the cash flows to
the point that a reliable terminal value can be determined. The terminal value is the
nomenclature used for the valuation of the firm for all of the years that are beyond

112 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

the last year of the projections. It is reflected in a lump-sum amount that usually is
calculated via the Gordon growth model or via application of a market-based multiple
of earnings or sales.

The Gordon growth formula is:

CF0 (1 + g)

PV =

Kg

.

where
PV = present value at time 0
CF0 = prior periods projected cash flow (or other economic benefit stream)
g = projected growth, compounded annually into infinite future
K = required rate of return

Thus, the projections are made for the number of years necessary to do one of the
following:

1.
The revenue growth levels off to a point at which it will remain relatively
steady for the future.
2.
The firm grows to the point of having public firms/private transactions that are
suitable comparisons.
Once the revenue growth rate subsides to a long-term sustainable rate, the Gordon
Growth Model can effectively be applied. Even if the firm is still growing at a rate that
is too fast to sustain on a long-term basis, it is appropriate to end the projections if a
reliable comparative firm or transaction can be used to value the firm.

Regardless of the method used to calculate the terminal value, the value must be discounted
back to the present from the date at which the terminal value is calculated.

Step 4: Other Adjustments. Several other adjustments may be necessary when valuing
an asset. The first potential adjustment concerns inflation. The valuation equation
must be consistent. Both the numerator and the denominator should be measured consistently
in either real terms or nominal terms. When a conversion from nominal terms
to real terms is required, an approximation to the Fisher equation is often used. The
approximation formula is:

r (nominal) = r (real) + i

where i represents the inflation rate. Quoted interest rates are nominal interest rates. The
key is ensuring that cash flow projections are also in nominal terms when using nominal
discount rates.

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 113

Step 5: Combine the Present Value of the Residual Cash Flows (If Any) with the
Discrete Projection Period Cash Flows. Next, the present value of the projected cash
flows is added to the present value of the terminal value to arrive at the total value,
incorporating all adjustments. A further adjustment may concern marketability (liquidity)
and control. For example, shares in a closely held corporation are more difficult to
sell than publicly traded assets. To adjust for these differences, a marketability discount
often is applied to the underlying asset value.

THE MARKET APPROACH

The market approach is a conventionally accepted valuation method that leads to a
value estimate based on the transactions of other purchasers and sellers in the marketplace.
This approach is based on the principle of substitution. The principle of substitution
states that the limit of prices, rents, and rates tends to be set by prevailing prices,
rents, and rates for equally desirable substitutes. Use of the market approach results in
an indication of value based on an estimate of the price one may reasonably expect to
realize on the sale of the subject asset.

This concept is largely intuitive. Many people have employed the same technique
during the process of buying a house. For example, assume that a person wanted to buy
a house in an exclusive neighborhood (“subject” home). The person would obtain the
recent actual sales prices of similar homes. Ideally, the similar homes would be located
in the same neighborhood (“comparative” homes). The person would also consider the
physical differences between the “subject” home and the “comparative” homes. For
instance, if a “comparative” home had a swimming pool and the “subject” home did not,
an adjustment would be made to reflect the anticipated difference in the value of each
home. Similarly, the person may make price adjustments for other significant features,
such as size, style, and so forth.

The market approach is performed in the same manner when valuing a business. The
approach generally is accomplished through the following steps:

Establish Criteria for Identifying Comparative Transactions

As with the preceding example, the starting point for this method is identifying “comparative”
firms. The advent of the Internet has provided many web sites that are dedicated
to providing financial data to the valuation community. Nearly all of the web sites
have a search function that facilitates the identification of companies that can be used
as comparative firms. Depending on the nature of the engagement, it may be more beneficial
to use a database of privately held firms.

Regardless of the database searched, the most common way of locating suitable comparative
firms is by searching based on industry (standard industrial classification

114 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

code) and/or size, usually revenue, total assets, or market capitalization (number of
shares multiplied by the share price). Factors that should be considered include company
size, growth, liquidity, leverage, and profitability, among others.

The most useful data are gathered from the same period as the date of the damage
date. Additionally, as the comparative firms become more similar to the subject
business, fewer comparative companies are needed. Conversely, a larger sample of
firms can “smooth” differences between the comparative firms and the subject firm.
Revisiting the example regarding the price of a home discussed previously illustrates
this point. Imagine that the comparative home sales took place three years earlier. Such
comparative sales may yield a poor analysis depending on how the market changed
during the period between the date of the comparative sale and the valuation date of
the subject home. Next, imagine that the comparative home sales involved homes
of the same size, sold on the same date, and of the same style as the subject home. However,
the comparative homes were in a neighborhood with a view of the ocean, whereas
the subject home had no such view. Again, without adjustment, the expert is likely to
come to a poor conclusion of value.

If Necessary, Refine the Search by Adding More Criteria and Thus Reduce the
List to Those That Are the Most Comparative

Because of the importance of identifying the best comparative firms, it is most common
to make initial searches that are rather broad and then refine the search. When
the search criteria produce too many comparative companies, it is necessary to refine
the search. Shannon Pratt’s book on performing business valuations discusses the process
under a section called “How Many Guideline Companies.” The book suggests that
“the answer depends on a number of factors:

. Similarity to the subject—the more similar, the fewer needed.
. Trading activity—again, the more actively traded, the fewer needed.
. Dispersion of value measure data points—the wider the range of relevant measure
data points, the more companies it takes to identify a pattern relevant to the
subject company.”
Further insight is found in Corporate Finance: A Valuation Approach, which also
discusses the refining step:

Since we scale prices of other firms to value the firm being analyzed, we would like to use
data of firms that are as similar as possible to the firm we value. The flip side of this argument,
however, is that by specifying too stringent criteria for similarity, we end up with too
few firms to which we can compare. With a small sample of comparable firms, the idiosyncrasies
of individual firms affect the average multiples too much so that the average multiple

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 115

is no longer a representative multiple. In selecting the sample of comparable firms, you have
to balance these two conflicting considerations. The idea is to obtain as large a sample as possible
so that the idiosyncrasies of a single firm don’t affect the valuation by much, yet not to
choose so large a sample that the “comparable firms” are not comparable to the one that you
value.10

Additional rigor can be added to this step by using econometric analysis. For instance,
a large initial search can be refined using cluster analysis, factor analysis, or other statistical
techniques.

Rather than relying on intuition, these techniques can identify how close comparable
companies are based on predetermined factors. This will be a fruitful area of future
analysis by financial analysts. Sometimes it is useful to identify two or more groups of
comparative firms. Revisiting the home price example, imagine that the subject home
is unusually small and has a view of the ocean. Assume that you are unable to find
homes of a similar size that have a view of the ocean. Instead, you find a group of home
sales that are very similar in the date of the sale, their style, and size; however, this
group of comparative sales does not have a view of the ocean. You also identify a second
group of home sales that are similar to each other in size, have an ocean view,
yet are different from the subject home’s size. Finally, you find a third group of sales
that are similar to the size of the homes in the second group and similar to the location
of the first group of smaller homes. You can use the difference between the second
group and the third group to estimate the value of the view, then add that to the value
established by the first group for homes of the same size as the subject home. Such a
process is not uncommon when valuing a business. Many firms have segments or components
of the business that are more easily valued individually rather than based on the
entire business.

Obtain Appropriate Financial Data for the Comparative Companies

Once the comparative firms have been identified, their financial data must be obtained.
This typically is an easy step to perform because the same web sites that perform the
searches typically provide the financial statements. The most common data obtained are
the income statement, balance sheet, and statement of cash flows. Additionally, it is
useful to obtain any projections or analysts’ reports. Finally, the number of shares and
the respective share price must be obtained. It is important that all of these data be the
financial information as of the date of the valuation.

A valuation generally occurs as of a specific date. The value of a company changes
daily. In fact, it is not uncommon for the value of a company to change dramatically in
a very short period. Experts and attorneys must always keep the valuation date in mind
in the course of gathering discovery and conducting their analyses. Generally, valuation
experts believe that the only information that should be considered is the information
that is known or knowable as of the date of the valuation. This is particularly important

116 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

when valuing IP. For example, there can be a great deal of uncertainty as to the rate of
a technology’s adoption. Frequently, after a claim is filed, both parties gain a much
better understanding as to the actual rate of adoption. Generally, it is inappropriate to
value the technology based on the information that has been learned subsequent to the
date of valuation. This convention can be segregated into two situations:

1.
Event-Specific—The practitioner should ignore event-specific information
that has become known after the date of valuation. For instance, a fire that
burned down a manufacturing plant or terrorist acts that changed the industry
generally should not be relied on when performing a valuation if they occurred
after the valuation date.
2.
Information Regarding the Parties’ Expectations—Since value is ultimately
based on the expectations of a business at a particular point in time,
it is important to base value on projections that would have been made at
the time of the valuation. Practitioners typically begin their analysis with the
parties’ projections (created at or around the valuation date) rather than actual
results. However, it would be careless to ignore the actual results because projections
may be found to consistently be very optimistic (or pessimistic). The
actual results sometimes can be used to indicate a proxy that represents reasonable
expectations the parties’ would have had at the valuation date.
Once the data have been gathered, it is typical to perform ratio analysis on the financial
statements. The purpose of the ratio analysis is twofold. First, the analyst is trying
to identify similarities between firms. As more similarities are found, the practitioner
gains confidence that the comparative firms are suitable. Second, the analysts are looking
for differences. Differences indicate either that the firm may not be a suitable comparison
on which to base a valuation or that there are accounting differences between
the firms. As unsuitable companies are identified, they should no longer be considered
(or at least they should be given less weight). To the extent that there are significant accounting
differences, the financial statements must be adjusted so that the ratio analysis
(and the financial statements) is comparable. This process is discussed in the next step.

Consider Adjusting or Normalizing Financial Data of the
Comparative Companies

In certain instances, generally accepted accounting procedures (GAAP) allow two firms
to use different methods of accounting for the same type of transaction. If the transaction
is prevalent in the firm’s financial statements, the different accounting methods could
cause material differences between the financial results of the two firms. Furthermore,
two firms may also make operational decisions that affect the financial statements but
really do not affect the firm’s value. Examples of such differences are the following:

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 117

Accounting for Inventory. Firms typically choose between one of two methods—
LIFO (last in first out) and FIFO (first in first out). For example, assume that there are two
businesses that are the same in all respects except their inventory accounting. The firm
using the LIFO method will look less profitable than the other business. Additionally,
the LIFO firm will appear to have less valuable inventory. Of course, the firms have the
same value. However, failing to adjust for such differences in accounting methods will
yield an analysis that indicates deceptively different values for the two firms.

Owning a Building Versus Renting a Building. Again, assume that the two businesses
differ only with respect to their property interest in the building. The building
owner is likely to have a lower level of profitability (due to depreciation, debt, insurance,
etc.) than the identical business that rents its space. Thus, the financial statements
must be adjusted.

Even more common, it is necessary to make such adjustments when comparing a private
firm with a public company. For instance, owners of privately held firms frequently
have the business pay for many items that may otherwise be considered personal (car
allowance, gym fees, etc.). Similarly, owners of private firms often pay family members
something other than the fair market rate as a wage.

Select the Valuation Multiples That Are the Most Appropriate to
Measure the Comparative Companies and Calculate the
Multiples for the Comparative Companies

The valuation multiples that have been used by practitioners are nearly limitless. Some
of the most commonly used valuation multiples include price to earnings, price to sales,
price to EBIT, price to earnings before interest, taxes, depreciation, and amortization
(EBITDA), and so on. Most analysts tend to select several multiples. Next, they look at
the variance of the multiples. Ideally, a multiple that is consistent across several firms
gives an indication that it is a good proxy for establishing value. For example, if the following
multiples were calculated, it is likely that the analyst would conclude that price
to sales is an appropriate proxy.

COMPANY A COMPANY B COMPANY C
Price to sales
Price to EBIDTA
Price to earnings
1.9
12
16
1.7
7
1,0
1.7
18
31

Econometrics also can be helpful in performing this step because techniques are available
that can identify the most significant multiples among firms.

When making the necessary subjective portion of this assessment, the most important
point to keep in mind is ensuring that investors actually trade on the multiple. This
point is highlighted by the main drawback of this approach, which is that a multiple of

118 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

anything can be calculated. For instance, a multiple of price to numbers of letters in the
company’s name can be calculated. Obviously, such a multiple has nothing to do with
the value of a firm. Accordingly, evidence of the proper multiple is the multiple’s applicability
across different firms that have been determined to be suitable comparisons.

Select and Adjust Multiples to Make Them Appropriate
to Apply to the Subject Company

Often the multiples will be further adjusted to account for remaining differences between
the comparison companies and the subject firm. The most common type of adjustment is
based on size. There is significant evidence that investors pay less for smaller companies
than they pay for larger companies. Many times the comparison firms are much larger
than the subject firm and the multiple must be adjusted accordingly.

Apply the Multiples to the Subject Company

The last step in the market approach is the application of the multiple(s) to the subject
company. The primary thing to keep in mind while implementing this step is to apply
the multiple to the subject company in the same way that it was calculated. Upon application
of the multiple, the expert has completed the market approach (before consideration
of any applicable discounts and/or premiums).

THE COST APPROACH

The cost approach estimates the fair market value of an asset using the concept of
replacement cost as an indicator of fair market value. The premise of the cost approach
is that a prudent investor would pay no more for an asset than the amount for which
the asset could be replaced. Replacement cost new, which refers to the cost to replace
the property with like utility using current material and labor rates, establishes the
highest amount a prudent investor would pay. To the extent that an existing asset will
provide less utility than a new one, the value of that asset is less. Accordingly, replacement
cost is adjusted for loss in value due to physical deterioration, functional obsolescence,
and economic obsolescence.

Physical deterioration is the loss in value brought about by wear and tear, action of
the elements, disintegration, use in service, and all physical factors that reduce the life
of an asset. Functional obsolescence is the loss in value due to changes in technology,
discovery of new materials, and improved manufacturing processes. Economic obsolescence
is the loss in value caused by external forces such as legislative enactments,
overcapacity in the industry, changes in supply and demand relationships in the market,
and so on. Obsolescence typically is measured by identifying excess operating costs,
overcapacities, or the inadequacies of an asset.

FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 119

Although the cost approach should yield the same valuation conclusion that the other
two approaches yield, the underlying data needed to perform the cost approach often are
more subjective and more difficult to find than the supporting evidence for the other
two methods. Accordingly, the market approach and the income approach are used more
frequently than the cost approach. However, the cost approach can be the best approach
when valuing certain intangible assets such as research libraries, partially completed
software code, and so on.

SUMMARY

Calculation of IP damages requires the successful implementation of valuation principles.
Such calculations often require the effective utilization of finance, economic, and
accounting skills to properly consider the various factors surrounding the subject property.
As a result of the significant disagreement regarding IP damages, experts often are
employed to value and explain the damages to the judge and jury.

To properly estimate IP damages, it is essential to determine what is being valued and
to specify the valuation date. Then it is appropriate to consider the three common valuation
approaches: the income approach, the market approach, and the cost approach.
Each of these approaches, if determined to be applicable, not only will indicate the
value of the property in dispute, but also will act as a sanity check on the conclusions
derived under any of the other approaches.

This chapter set forth the basic financial concepts involved in the valuation of an
asset. Valuation concepts are often present in expert damage analysis in IP cases, and
in trade secret cases in particular. We use many of the concepts developed in this chapter
in our discussion of the mechanics of IP damage analysis.

ENDNOTES

[1] American Society of Appraisers, Business Valuation Standards, Definitions.
[2] In practice, one should also include an intermediate state.
[3]
See review in Tom Copeland, Tim Koller, and Jack Murrin, Valuation Measuring the
Value of Companies at 62–87.
[4] Accountants have developed a model of “abnormal earnings” which is mathematically
equivalent to a cash flow model but uses accounting earnings as an input. We plan to
address such models in the first supplement to this text.
[5]
See, e.g., Gary C. Biddle and Fredrick W. Lindahl, Stock Price Reactions to UFO
Adoptions: The Association Between Excess Returns and UFO Tax Savings, 20 J. Acctng.
Res., 551 (1982); E. Lindberg and M. Russ, To Purchase or to Pool: Does It Matter? 12
J. Applied Corp. 23 (1999); Bradford Cornell, Corporation Valuation, at 104–108 (1993).

120 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

[6]
See discussion in Gerald White, Ashwinpaul Sondi, and Dov Fried, The Analysis and Use
of Financial Statements, at 1062 et seq. (1998).
[7]
A utility function is merely a function in which preferences are converted to real numbers.
[8] For a discussion of this point, see Zvi Bodie, Alex Kane, and Alan Marcus, Investments,
New York: McGraw-Hill (1999) at Chapter 13.
[9] Personal taxes can also have an impact on rates of return required by debt and equity
investors. We will discuss this in more depth in the first supplement.
[10] Simon Benninga and Oded Sarig, Corporate Finance: A Valuation Approach, New York:
McGraw-Hill (1977).
ADDITIONAL READING

Bradford Cornell, Corporate Valuation, New York: McGraw-Hill (1993).

Krisha Palepu, Paul Healy, and Victor Bernard, Business Analysis & Valuation, Cincinnati:
South-Western College Publishing (2000).

Simon Benninga and Oded Sarig, Corporate Finance: A Valuation Approach, New York:
McGraw-Hill (1997).

Tom Copeland, Tim Kuller, and Jack Murrin, Valuation: Measuring and Managing the
Value of Companies, New York: John Wiley & Sons (2000).

Shannon Pratt, Robert Reilly, and Robert Schweihs, Valuing Small Business &
Professional Practices, New York: McGraw-Hill (1998).

F. Peter Boer, The Valuation of Technology: Business and Financial Issues in R&D, New
York: John Wiley & Sons (1999).
Richard Razgaitis, Early Stage Technologies: Valuation and Pricing, New York: John
Wiley & Sons (1999).

Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The
Analysis and Appraisal of Closely Held Companies, 3rd ed., New York: McGraw-Hill
(1996).

Robert F. Reilly and Robert P. Schweihs, Valuing Intangible Assets, New York: McGraw-
Hill (1998).

Part Two

Patent Infringement
Damages

6

Introduction to Patent Law

A BRIEF HISTORY

The American patent tradition derives from the “letters patent” issued by England’s
monarchs, which granted 14 years of exclusive use to the “first and true inventor” of
new manufactures. The Statute of Monopolies of 1623 required letters patent only to
issue with respect to new devices that were “not contrary to law, nor mischievous
to the State, by raising prices of commodities at home, or hurt of trade, or generally
inconvenient.”1 Interestingly, the American patent system never adopted standards
that so explicitly referenced the potential economic disadvantages to these limited-
term monopolies.

The U.S. Constitution, art. I, sec. 8, gives Congress the power “to promote the
Progress of Science and useful Arts, by securing for Limited Times to Authors and
Inventors the exclusive Right to their respective Writings and Discoveries.” Although
the term patent is not used in the Constitution, the Constitutional Convention’s records
make clear that the clause was intended to authorize the granting of patents.

The first U.S. patent statute was passed in 1790 (authored by Thomas Jefferson). It
called for patent applications and a 14-year term of exclusive use by the inventor if the
invention was deemed “sufficiently useful and important.” The statute granted a 14-year
monopoly on the invention in exchange for disclosure sufficient to enable someone
skilled in the art to construct or use the invention.

The U.S. patent law has been revised several times. In 1836, the U.S. Patent Office
was established to review patent applications. In 1861, the patent term was extended
to 17 years, and three criteria were established for patentability: “novelty,” “usefulness,”
and “priority.” In other words, the invention must be a new and useful improvement
over existing devices or processes, while “priority” requires that the inventor be
the first and true inventor. These requirements are discussed in more detail in the following
sections.

123

PATENT INFRINGEMENT DAMAGES

The current patent law was passed in 1952 (the Patent Act) and is located in Title 35
of the United States Code (U.S.C.). The Patent Act was partially revised in 1995,
extending the patent term to 20 years from the date of filing2 and classifying “offers to
sell” as infringement.3 The legal standards applied in patent cases are rooted in the
statutory language, as interpreted by federal courts. It is important to understand how
courts have developed the requirements for patentability because many vital principles
cannot be found in the Patent Act alone.

Charles Duell, the American Commissioner of Patents, is widely credited with the
statement, “Everything that can be invented has been invented.” Duell supposedly made
this statement in 1899.4 Regardless of the accuracy of the quotation, no one could have
forecast the spectacular increases in the number of patent applications. On December
10, 1999, the U.S. Patent and Trademark Office (PTO) granted its six millionth patent.5
In fiscal year 2001, the PTO expected to receive 335,000 patent applications—a 12 percent
increase in applications over the filings received in fiscal year 2000.

DESCRIPTION OF A PATENT

Patents may be identified by their titles or by patent number. All patents are assigned
numerical identifications. Patent numbers are sequential, so a higher number indicates
a more recently issued patent. Because the titles can be cumbersome, a patent often is
reduced to three numbers for quick reference, especially in litigation. Those three numbers
are the last three digits of a patent number. For example, U.S. Patent No. 1,234,567
would be referred to as “the ′567 patent.”

The body of a patent has two main parts: the “specification” and the “claims.” The
specification follows the cover page; it contains a description of the invention, including
drawings when necessary. The specification should also describe related art and the
relevant prior art (i.e., similar inventions or techniques that precede the patent). The specification
further must describe how to make and use the invention (“enabling” the invention)
and the “best mode” of carrying out the invention known to the inventor at the time
of filing the patent application.6

The claims are the most important part of a patent. The claims identify the scope of
what is “claimed” for the inventor’s exclusive use during the term of the patent.
Generally, claims are broader than what is described in the specification in order to
include obvious alterations within the scope of the invention. Claims are either “independent”
or “dependent”; an “independent claim” refers to a relatively broad claim that
is not a subset of another claim. Narrower, “dependent claims” typically follow and
incorporate material from an independent claim. The aim of the patent’s drafter is to
ensure that if the broader independent claim is held invalid, the narrow dependent
claims may survive. Dependent claims generally are also attempts by the drafter to preclude
small variations on the invention from being patentable.

INTRODUCTION TO PATENT LAW

Each claim usually has three parts: a preamble, a transition, and the body. The preamble
generically defines an invention, for example, “an apparatus for writing.” A
process patent typically begins with “a method for.” The transition uses language like
“comprising” or “consisting of.”7 The body limits the invention to certain elements (e.g.,
“an apparatus for writing comprising a wood shaft and a graphite core”).

THE SUBJECT MATTER OF UTILITY PATENTS

There are three types of patents: design, plant, and utility patents. We consider only utility
patents—the category of patents one is most likely to encounter as a damage expert.8

To be patentable, an invention must come within one of the four categories set forth
in section 101 of the Patent Act:

Whoever invents or discovers any new and useful process, machine, manufacture, or composition
of matter, or any new and useful improvement thereof, may obtain a patent therefore,
subject to the conditions and requirements of this title.9

Thus, only four types of inventions can be patented: (1) a process, (2) a machine, (3) a
manufacture, and (4) a composition of matter.10 A process is a new means of achieving
a goal or product. Categories (2), (3), and (4) cover types of products made from
patentable subject matter. A composition of matter consists of a combination of known
things, where the combination itself is the invention. For example, a new combination
of known chemicals is patentable as a “composition of matter.” A manufacture is an
object made by human labor, such as a chair. It does not include products that exist in
nature. A machine is an invention that embodies a process. The machine itself is the
invention under this category, not the process.

Courts also have excluded certain categories of things or discoveries from patentable
subject matter. These excluded categories include printed matter, laws of nature, mathematical
algorithms, natural forces, natural principles, methods of calculation, and
abstract ideas. As the following cases illustrate, inventions that include elements from
some of these categories are not absolutely precluded from constituting patentable subject
matter (e.g., mathematical algorithms may be used in patentable applications).

The accepted justification for the categorical exclusions is that patenting such fundamental
categories would impede rather than advance innovation and technological
progress. Theoretically, awarding exclusive rights to a very broad concept or fundamental
principle precludes varied approaches to development, improvements, and
applications. However, without the incentive of at least a limited-term monopoly, the
inventor lacks the motivation to invest significant time and resources in research and
development at all. Moreover, a process or thing that is present in nature supposedly
does not require as significant an investment of resources by the inventor, and therefore

PATENT INFRINGEMENT DAMAGES

less reward is necessary to compensate the inventor and preserve his incentive to invent.
Patent law is a perpetual attempt to balance the competing interests of diversity of
development and inventor incentives. This delicate balancing test is a recurring theme
that guides, either explicitly or implicitly, judicial decisions in many areas of patent law,
including the scope of patentable subject matter, the breadth of the patent, and the relationship
between prior art and the allegedly new invention.

To understand patent law (or any area of intellectual property), it is necessary to gain
a familiarity with some judicial opinions. Because reading entire cases can be tedious,
difficult, and time-consuming, throughout this book we present the highlights of certain
cases. The selected cases were included either because they establish precedent on a
particular issue or because they offer a particularly helpful explanation of a legal principle.
On certain topics, courts have reached apparently conflicting results; being aware
of the potential for varying outcomes and the factors that influence those decisions can
be as valuable as learning a straightforward answer.

Several cases epitomize the current analysis of patentable subject matter. Diamond v.
Chakrabarty is well known for its description of the breadth of the standard for patentable
subject matter and its application to modern inventions. State Street Bank & Trust Co. v.
Signature Financial marks a relatively recent shift in the law that permits the patenting
of business methods and transformative applications of mathematical algorithms.

Diamond v. Chakrabarty11

Diamond v. Chakrabarty should help you understand how courts analyze the question
of patentable subject matter. The Chakrabarty court famously described the
scope of patentable subject matter as “anything under the sun that is made by
man.” Chakrabarty held that the inventor must change the product’s naturally
occurring physical properties, not merely take advantage of inherent qualities.
Chakrabarty developed a bacterium that broke down crude oil; the genetically
altered bacteria were useful for cleaning up oil spills. In upholding the patent, the
court emphasized that, although a natural biological phenomenon would not be
patentable, a man-made biological product, even a living creature, can be patented.

State Street Bank & Trust Co. v. Signature Financial Group, Inc.12

The patented invention in this case was a data processing system that allowed a
user to record financial information and make calculations necessary for maintaining
a particular financial service called a “partner fund” for mutual funds. The

INTRODUCTION TO PATENT LAW

State Street Bank & Trust Co. v. Signature Financial Group, Inc.
(continued)

district court found that the claimed invention fell into one of two judicially created
exceptions to statutory subject matter: the mathematical algorithm exception or the
business method exception. However, the Federal Circuit held that neither of those
categories is necessarily unpatentable subject matter. First, the transformation of
data by a machine using algorithms is patentable where it produces a “useful, concrete
and tangible result.” The court cited to earlier cases such as Diamond v. Diehr
and In re Alappat for the rule that computer software code alone is not patentable,
but a machine or manufacture that embodies both hardware and software elements
can be patented. This results-oriented analysis means that practical applications of
purely mathematical algorithms merit patent protection. Second, the court found
that “business methods” are statutory subject matter for patents.

In short, the court held that patentable subject matter should be evaluated not
by which of the four statutory categories it most closely matches, but by its
“essential character,” particularly the inventor’s “practical utility.” This holding
opens the door to a wide range of business methods and activities as patentable
subject matter.

These two cases represent a pragmatic and expansive approach to patentability. This
approach is particularly relevant for Internet companies today. Internet companies
have been awarded patents for fairly traditional business methods, simply because they
are “new” and original in the context of e-commerce. These patents are controversial and
often are the subject of current litigation.

THE STANDARDS OF PATENTABILITY

Qualifying as patentable subject matter is necessary, but not sufficient, for patentability;
the invention must also possess certain specific characteristics. In addition to falling
within the scope of patentable subject matter, an invention must meet three statutory
criteria. A patentable invention must be novel, have utility, and be nonobvious. Section
101 requires novelty and utility.13 Section 103 requires an invention to be a nonobvious
development compared to prior art.14

Utility

Section 101 of the Patent Act provides that a patentable invention must be “useful.” The
courts require an invention to have a specific beneficial use. It need not be a successful
commercial product, but the value of the invention cannot be purely hypothetical. In the

PATENT INFRINGEMENT DAMAGES

vast majority of cases, courts require only a very low threshold of proof of utility.
Typically, usefulness is only an issue for chemical combinations, as illustrated by
Brenner v. Manson.

Brenner v. Manson15

Brenner emphasizes that patents are related to the world of commerce, not philosophy
or pure science. The invention at issue was a new chemical process for
making a known steroid. There was presently no use for the steroid, but the inventor
asserted that potential future uses existed. The Court held that vague potential
utility is insufficient to satisfy section 101. The Court stated, “a patent is not a
hunting license. It is not a reward for the search, but compensation for its successful
conclusion.” The patent system grants a monopoly in exchange for disclosure
of a specific useful invention that benefits the public. If there is no present
use, then the monopoly not only does not benefit the public, but it can discourage
subsequent discovery of additional uses.

Clearly, the Brenner court’s opinion relies heavily on the balancing test described
above. Awarding the Brenner inventor a patent would have been equivalent to granting
a monopoly on knowledge for which the inventor had not yet figured out a useful application,
and would have excessively preempted other inventors from developing a
method and a beneficial use for the method.

Novelty

Sections 101 and 102(a), (b), (e), and (g) require that an invention be “new” or novel
before it can be patented. These sections work together to ensure that the first person to
invent the product, not necessarily the first person to file for a patent, receives the
patent. Under section 102, an invention cannot be novel if there was “anticipation” of
the invention. In the United States, any of the following events, for example, could constitute
anticipation of the claimed invention: (1) each and every element of the invention
was described in a prior patent or printed publication, (2) all claimed elements
existed in an unabandoned and unconcealed invention by others, or (3) the claimed
invention was used by others in the United States before the person applying for the
patent invented it. In other countries, each and every element must be described in a
prior patent or printed publication in order to anticipate a claimed invention. A product
or process that would infringe the applicant’s invention if it came later in time anticipates
the invention if it came before.

When discussing “anticipation” and other issues relating to inventions preceding the
allegedly patentable invention, we often use the term prior art. Prior art simply refers

INTRODUCTION TO PATENT LAW

to the state of knowledge and known discoveries that existed in the relevant field of art
before the invention in question. Prior art can encompass published articles, theses,
machines, models, other products, and so on. Experts commonly are called on to distinguish
the supposedly new invention from the prior art or to discuss the scope of the
prior art.

Scripps Clinic & Research Found., Inc. v. Genentech, Inc.16

Scripps analyzes the extent to which a prior disclosure may put the invention in
the hands of the public. The invention in this case involved a method for making
a protein related to the clotting of blood. One issue in the case was whether the
claims under which infringement was alleged were anticipated by a Ph.D. dissertation
that was published before the invention. The dissertation was cited in
the application as prior art. The court stated that “invalidity for anticipation
requires that all of the elements and limitations of the claim are found within a
single prior art reference.” If multiple references are necessary to cover all the
elements of the claimed invention, then the invention cannot be anticipated and
therefore is “novel,” but nevertheless may still fail to qualify as nonobvious
under section 103.

The justification for novelty requirements is that there is no need to encourage innovation
if the invention is already known by people in the relevant field. Patent law
should not punish prior users of a product or method by creating a monopoly where
there previously was free access and open availability.

To avoid rejection of patent claims on the basis of novelty, an inventor may “swear
behind” the date of the use or publication that allegedly anticipates his or her invention.
The effective date of a reference is the date on which an ordinary person in the relevant
field of art has effective access to the disclosure. Clearly, this may vary from the date
of publication to the date of indexing by a library (in the case of a publication that does
not circulate widely). The critical date for the inventor is the date on which he or she
completed the invention; this date is assumed by the PTO to be the date on which the
applicant filed a complete application disclosing the invention. However, if the examiner
produces anticipating prior art dated before the inventor’s date of filing, the inventor
is permitted to establish that she invented the invention before the date of filing. The
usual procedure for establishing this invention date is to “swear behind” by filing an
affidavit under Patent Office Rule 131 claiming “completion of the invention in this
country” before the date of the anticipatory reference.17 An invention is “completed”
when the invention has been “reduced to practice” or the inventor establishes “conception
coupled with due diligence” from the date of the reference to reduction to practice.

PATENT INFRINGEMENT DAMAGES

Statutory Bar—“Loss of Right”

The purpose of the statutory bar or “loss of right” is to encourage inventors to seek
patent protection for their inventions diligently.18 The statutory bar focuses on the activities
of the applicant and the public more than one year before the date of filing of the
patent application (not the issuance of the patent). Section 102(b) invalidates a patent if
the invention was on sale in the United Sates more than one year before the application
(the “on-sale bar”). In addition, a patent can be invalidated if the invention is patented
or described in a printed publication in the United States or a foreign country one year
before the date of the application. Finally, if the invention is in public use by anyone in
the United Sates one year before the application, the patent will be invalid (“public use
bar”). In general terms, if the inventor or patent owner is responsible for any of these
activities, the patent statutes bar the patent even though the invention is novel, and
thus the result is a “loss of right.” If someone other than the inventor or patent owner
is responsible for these activities, then the patent is barred because the invention is
not “novel.”

Pfaff v. Wells Electronics, Inc.19

Pfaff filed a patent application on a computer chip socket invention on April 19,
1982. The statutory bar therefore concerns events occurring prior to April 19, 1981.
On March 17, 1981, Pfaff showed the invention to Texas Instruments. On April
8, 1981, Pfaff received written confirmation of a previous oral purchase order.
The order was filled in July 1981. The court found that the patent was invalid.
The court found that an offer for sale was enough for the product to be considered
“on sale” under section 102(b), because an “attempt to commercialize”
may be sufficient if the invention was “ready for patenting” at the time of the offer
for sale.

Pfaff’s two-pronged test governs application of the on-sale bar, although the courts have
had some difficulty applying the two tests to the facts of particular cases.

Crystal Semiconductor Corp. v. TriTech Microelectronics Int’l, Inc.20

In this case, the Federal Circuit clarified the on-sale bar doctrine. Crystal filed a
patent application for its analog-to-digital converter technology on October 2,
1987, thus creating a “critical date” of October 2, 1986, for purposes of the
statutory bar. Crystal received a purchase order confirmation for five of its converter
chips on September 11, 1986. The court found that the purchase order could

INTRODUCTION TO PATENT LAW

Crystal Semiconductor Corp. v. TriTech Microelectronics Int’l, Inc.
(continued)

qualify as a “commercial exploitation” of the patented technology even though
Crystal placed the order “on hold” and did not accept the offer until after the critical
date. Apparently the fact that the order was capable of being accepted was
sufficient to satisfy the commercialization prong of Pfaff.

Linear Tech. Corp. v. Micrel, Inc.21

Linear Technology filed a complaint against Micrel alleging infringement of
Linear Technology’s patent pertaining to adaptive transistor drive circuitry used
in telecommunications, cell phones, and computers. The District Court held the
patent invalid due to the on-sale bar.

The Federal Circuit reversed, holding that none of the activities in question constituted
an “offer” to sell. In order to interpret “offer,” the court looked to the common
law definitions of the term and concluded that an offer must (1) communicate
with potential customers, and (2) must indicate that assent by the customer will
constitute an agreement (i.e., that Linear Technology intends to be bound by its
offer, if accepted). Mere advertising, such as promotional materials sent to distributors,
may simply qualify as “an invitation for offers,” but not an actual offer.

Finally, Monon examines not whether an offer or sale was made, but whether that transaction
was commercial in nature.

Monon Corp. v. Stroughton Trailers, Inc.22

A sale prior to the critical date does not necessarily establish invalidity; if the sale
or public use of the patented device was primarily experimental (as opposed to
primarily commercial), the patent may survive the statutory bar. In Monon, the
patentee manufactured trailers. Since the patentee did not also operate its trailers,
it completed a sale in order to subject the patented device to conditions of actual
use. Specifically, the court heard testimony that the sale was necessary to determine
whether the trailer could withstand the stress of heavy loading and long
hauls. The Federal Circuit held that this evidence was sufficient to withstand summary
judgment because it raised a genuine issue of material fact as to whether the
sale was primarily for “commercial” or “experimental” purposes.

PATENT INFRINGEMENT DAMAGES

Nonobviousness

Section 103 of the Patent Act requires that a patentable invention must not be obvious
at the time of the invention to a person of ordinary skill in the relevant art. Prior art must
be in the same field, or an “analogous art” (i.e., a field of expertise that would be logical
to search if confronted with the particular problem facing the inventor). Where
the prior art “teaches away” (i.e., discourages the inventor’s approach to the problem, the
prior art can be good evidence of nonobviousness). To render an invention obvious,
the prior art must provide both an enabling suggestion, teaching, or motivation to combine
the prior art in the manner that the invention is claimed in the patent, and must
contain a reasonable expectation of success.

Graham v. John Deere Co.23

This case sets out the factors to be considered in determining nonobviousness:

(1) determine the scope and content of the prior art; (2) determine the differences
between the prior art and the patent claims at issue; (3) determine the level of
ordinary skill in the art; and (4) determine secondary considerations, such as commercial
success, long-felt need, failure of others, and the acquiescence of others
to the validity of the patent as demonstrated in licensing or development agreements.
The Court first recounts the history leading up to the 1952 Patent Act. The
1952 Act added section 103, requiring nonobviousness (and replaced the earlier
“new and useful” tests). The invention at issue in Graham was a spring clamp that
allowed a plow to be pushed upward if it hits obstructions, thus preventing the
plow from breaking as frequently. The defendant who was alleged to infringe
Graham’s patent claimed the patent would have been obvious. Under the four-
pronged test, the Court found that the Graham patent would have been obvious to
one skilled in the art at the time of the invention. The difference in structure
between the Graham clamp and the prior art was the only other possible effective
structure, as the simple inversion of the shank and hinge plate was the only way
to increase the flex. Thus, the product would have been obvious and not worthy
of patent protection.
PATENT INFRINGEMENT

Section 271 of the Patent Act governs infringement. There are two types of infringement.
The first type of infringement is “direct” infringement, which occurs when a
person makes, uses, sells, or offers to sell in the United States an apparatus or process
encompassed by any claim of a patent. Intent or knowledge of infringement is irrele

INTRODUCTION TO PATENT LAW

vant. The second type of infringement is “indirect” infringement, which occurs when
the defendant causes another to directly infringe and the defendant actively and knowingly
aids in the direct infringement. Indirect infringement also includes “contributory”
infringement. Contributory infringement is a subset of indirect infringement; under
section 271(c), offers to sell, sale, or import a component that is a “material part” of the
patented invention, made with the knowledge that the component will likely result in
infringement by the purchaser, constitute contributory infringement. However, if the
allegedly infringing component is a “staple article or commodity of commerce suitable
for substantial noninfringing use,” then the offer to sell, sale, or import the component
cannot be the basis for contributory infringement. In other words, if the product incorporating
the component could be used in a substantial manner that would not infringe
the patent, the courts will not protect the patent owner from its sale.

Infringement is determined by comparing the allegedly infringing, or “accused,”
product or process with the claims of the “patent in suit.” Infringement is “literal” if
the product or process falls within the literal meaning of the words of each element of
a claim. Section 112, paragraph 6, allows patents to include claims in which some or
all of the claimed elements or steps are stated in “means plus function” format, and
such claims that may be the basis for literal infringement. A “means plus function”
format describes elements in broad terms of what function the element accomplishes
rather than reciting the structure of the element. For example, a claim might include “a
means of linking A to B,” instead of specifying “a nail.” However, “means plus function”
elements are limited to the specific structures disclosed in the patent specification
and “equivalents” thereof. This proviso acts as a check on potentially broad claim
elements.

Infringement can also be shown by the “doctrine of equivalents.” Proof of infringement
under the doctrine of equivalents requires proof of “substantial equivalency” of all
the limitations of a claim that are not “literally” satisfied. A patent owner may sue for
infringement under the doctrine of equivalents if the accused device performs “substantially
the same function in substantially the same way to obtain the same result.”24
Equivalency considers the type of patent (pioneer invention or improvement), the prior
art, the prosecution history, the content of the specification, and other factors. Individual
elements, not the invention as a whole, must be considered for application of the doctrine
of equivalents.

Graver Tank & Mfg. Co. v. Linde Air Prods. Co.25

Graver Tank analyzes infringement under the doctrine of equivalents, examining

what constitutes “equivalence.” The Court held that equivalency must be deter

mined in the context of the patent, the prior art, and the particular circumstance of

(continues)

PATENT INFRINGEMENT DAMAGES

Graver Tank & Mfg. Co. v. Linde Air Prods. Co. (continued)

the case. In this case, the Court found that the substitution of manganese for the
particular alkaline earth metal used in the patent’s welding process was a substitution
taught by prior art, and thus still infringed. The purpose for an ingredient,
the way in which it serves its function, and the result are all factors that enter an
analysis of equivalence. Thus, a patent’s protection cannot be circumvented by
unimportant or insubstantial alterations to a patented device.

Hilton Davis Chemical Co. v. Warner-Jenkinson Co., Inc.26

Hilton Davis presented a slightly different way of analyzing the doctrine of equivalents
to establish infringement as compared to the function/way/result test outlined
in Graver Tank. In Hilton Davis, the Federal Circuit emphasized that the
doctrine of equivalents applies “if and only if the differences between the claimed
and accused products or processes are insubstantial.”

The factors to be determined in evaluating the “substantiality” of the differences
between the products or processes include: (1) whether persons with skill
in the relevant art actually knew of the equivalence of the claimed and accused
inventions; (2) whether a person with skill in the relevant art could have known
of the equivalence; and (3) how the defendant invented or designed her product.
This last factor examines whether the defendant intended to copy the patented
invention (which could indicate that the differences were only trivial), had
intended to design around the patented invention (which might imply that the
defendant had attempted to make substantial changes), or had inadvertently
arrived at the same invention through independent research (which may neutralize
this factor for purposes of the evaluation).

Despite these limitations on applying the doctrine of equivalents, the doctrine is commonly
asserted in patent litigation, at least as an alternative grounds for establishing
infringement. Many plaintiffs will argue that the defendant infringes both literally and
under the doctrine of equivalents, and possibly narrow their theory as discovery progresses.
However, a recent Federal Circuit decision appears to place extensive new limits
on the use of the doctrine of equivalents to establish infringement.

INTRODUCTION TO PATENT LAW

Festo Corp. v. Shoketsu Kinoki Kogyo Kabushiki27

Festo marks a shift in the Federal Circuit’s approach to the doctrine of equivalents
by limiting the potential applications of the doctrine and thus confirming the
court’s narrower approach to claim construction. The Federal Circuit held that
when a party amended a claim during prosecution of the patent for any reason
related to the statutory requirements for a patent, no range of equivalents is available
for the amended claimed element. In other words, the patentee must prove
that the accused product or process literally satisfies the language of the amended
element. The court also found that “voluntary” claim amendments—i.e., those not
required by the examiner or made in response to a specific rejection by an exam-
iner—must be treated the same as any other claim amendments if the result of the
amendment was to narrow the scope of the claim. Since the patent owner, Festo,
had not established explanations unrelated to patentability for its claim amendments,
the Federal Circuit found that the doctrine of equivalents was not available
to Festo as a theory of infringement.

Since many patent applications go through several amendments, and arguably all
amendments are related to meeting the patentability requirements, Festo casts a daunting
shadow on the scope of the doctrine of equivalents. Many commentators think that
the Federal Circuit went too far and essentially eliminated the doctrine of equivalents in
all but a few, unusual cases where the patent application did not go through the typical
revision and amendment process. Upon appeal of the Federal Circuit’s decision, the
United States Supreme Court granted cert. and heard oral arguments in early 2002. At
the time of drafting and submission of this manuscript to publisher, the authors were
awaiting the Supreme Court’s decision. The Supreme Court decision issued on May 28,
2002, effectively reaffirmed the importance of the doctrine of equivalents while recognizing
its limited application where claims were amended for patentability reasons.
However, the Supreme Court rejected a complete bar on infringement by equivalents in
those cases in favor of a rebuttable presumption. The first supplement to this book will
discuss the Supreme Court decision and its aftershocks in detail.

SUMMARY

This chapter addressed the basic law of patents. It is critical that both attorneys and
experts working in the area of patent damages understand the foundation elements of
patent law. This chapter described what a patent is, how to read a patent, the requirements
of validity, the requirements to demonstrate infringement, and the defenses to

PATENT INFRINGEMENT DAMAGES

infringement. Only after a patent is found to be valid and infringed will damages be
awarded. Yet damage experts must undertake their analysis before the resolution of
these issues. As a result, damage experts must understand how their arguments impact
the liability arguments, and they must be able to make intelligent decisions concerning
the breadth of the patent claims. This chapter attempted to lay the foundation for these
skills.

ENDNOTES

[1] Great Britain, Statutes at Large, 21 Jam. 1, ch. 3, § 6 (1623).
[2] 35 U.S.C. § 154.
[3] 35 U.S.C. § 271.
[4] Some sources dispute the accuracy of this quotation, especially in light of Duell’s 1899
report, which documents an increase of about 3,000 patents over the previous year and
nearly 60 times the number granted in 1837. See Samuel Sass, A Patently False Patent
Myth, Skeptical Inquirer 13 (1989), at 310–312. However, the quotation still is popularly
attributed to Duell and frequently used as an example of predictions that do not come to
pass.
[5]
USPTO Performance and Accountability Report: Fiscal Year 2000, at 13. The patent was
awarded to 3Com Corporation for the HotSync Technology, which allows Palm users to
synchronize their information with a computer at a single touch of a button.
[6] 35 U.S.C. § 112.
[7] The particular language used in a claim indicates precise limitations on the scope of the
patent. It is important to be aware that words or phrases commonly understood to be synonymous
may have distinctly different meanings in the context of a patent. For example,
“comprising” indicates that the following terms are a nonexclusive list (“comprising A”
thus means “including at least A, and possibly other elements”), while “consisting of ” is
an exclusive phrase that implies “A and only A.” Accordingly, “comprising” is generally
appropriate in descriptions of new areas, where the obvious substitutes for certain elements
are not yet clear. Patent drafting is a highly particular process, and the lesson for
most experts simply is not to make assumptions about the meanings of claim language.
[8] Design and plant patents have slightly different requirements, which are not discussed in
detail here. Designs must be new, original, nonobvious, and ornamental in order to receive
patent protection. Plant patents are awarded only to distinct, new, asexually reproduced
varieties of plants. (Sexually reproduced plants receive protection under the agricultural
statutes. See Plant Variety Protection Act, 7 U.S.C. § 2402.)
[9] 35 U.S.C. § 101.
[10] Improvements on inventions within any of the four categories are also patentable if they
are new, useful, and nonobvious.
[11]
Diamond v. Chakrabarty, 447 U.S. 303 (1980).
[12]
State Street Bank & Trust Co. v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir.
1998).

INTRODUCTION TO PATENT LAW

[13] 35 U.S.C. § 101.

[14] 35 U.S.C. § 103.

[15]
Brenner v. Manson, 383 U.S. 519 (1966).

[16]
Scripps Clinic & Research Found., Inc. v. Genentech, Inc., 927 F.2d 1565 (Fed. Cir.
1991).

[17]
See 37 C.F.R. § 1.131.

[18] 35 U.S.C. § 102(b), (c), and (d).

[19]
Pfaff v. Wells Electronics, Inc., 525 U.S. 55 (1998).

[20]
Crystal Semiconductor Corp. v. TriTech Microelectronics Int’l, Inc., 246 F.3d 1336 (Fed.
Cir. 2001).

[21]
Linear Tech. Corp. v. Micrel, Inc. 275 F.3d 1040 (Fed. Cir. 2001).

[22]
Monon Corp. v. Stoughton Trailers, Inc., 239 F.3d 1253 (Fed. Cir. 2001).

[23]
Graham v. John Deere Co., 383 U.S. 1 (1966).

[24]
Graver Tank & Mfg. Co. v. Linde Air Prods. Co., 399 U.S. 605 (1950).

[25]
Id.

[26]
Hilton Davis Chemical Co. v. Warner-Jenkinson Co., 62 F.3d 1512 (Fed. Cir. 1995).

[27]
Festo Corp. v. Shoketsu Kinoki Kogyo Kabushiki, 187 F.3d 1381 (Fed. Cir. 1999).

ADDITIONAL READING

Suzanne Scotchmer, Standing on the Shoulders of Giants: Cumulative Research and the
Patent Law, 5 Journal of Economic Perspectives 29 (Winter 1991).

Kimberly Moore, Paul Michel, and Raphael Lupo, Patent Litigation and Strategy, New
York: West Publishing (1999).

Margreth Barrett, Intellectual Property: Cases and Materials, New York: West Publishing
(1995).

Arthur Miller and Michael Davis, Intellectual Property in a Nutshell, New York: West
Publishing (1990).

Robert Harmon, Patents and the Federal Circuit, Washington, D.C.: BNA (2001).

7

How to Calculate Patent Damages

In this chapter, we describe how experts and lawyers should approach the calculation
of patent infringement damages. The chapter combines skills in law, econom,ics, and
accounting.

THE PATENT STATUTE

The starting point for any analysis of patent damages is Title 35 of the United States
Code (U.S.C.), section 284 (the Patent Statute), which provides that:

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 use made of
the invention by the infringer.

Before 1946, the precursor to section 284 went beyond “compensation,” allowing for
both recovery of compensation and the infringer’s profits. The 1946 Amendment Act of
August 1, 1946, Ch. 726, § 1, eliminated the language regarding the infringer’s profits
and added the reference to compensation.1

This revision is important. Before 1946, patent owners were awarded damages that
included both the lost profits to the patent owner and the infringer’s profits.2 Essentially,
a successful plaintiff was placed in a better position than had the infringement not
occurred because profits on some sales were counted twice—once as lost profits to the
patent owner and again as the actual profits the infringer received. The Supreme Court
interpreted the 1946 revision as correcting this situation, holding that the intent of the
revised statute was to limit a plaintiff’s damages to “compensation for the pecuniary
loss [the patent owner] has suffered from the infringement, without regard to the question
whether the defendant has gained or lost by his unlawful acts.”3 According to the
Court, the statutory reference to compensatory damages means that damages are limited

139

PATENT INFRINGEMENT DAMAGES

to “the difference between [the patent owner’s] pecuniary condition after the infringement,
and what his condition would have been if the infringement had not occurred.”4
In other words, “[h]ad the infringer not infringed, what would [the] Patent Holder...
have made?”5

King Instruments, Inc. v. Perego6

In King Instruments, a manufacturer of machines for loading magnetic tape into
cassettes claimed that a competitor was infringing his patent. The Federal Circuit
found that the competitor’s reel changer infringed the patent and held that the
manufacturer was entitled to both lost profits and a reasonable royalty. The Court
maintained that the only limitation on the types of harm for which damages may
be awarded is that the plaintiff must prove that the injury was caused by the
alleged infringement. The Court also upheld the patent owner’s right to withhold
the subject of the patent where it led to higher profits from manufacturing and
marketing nonpatented products that would otherwise compete with the patented
product. To compensate for infringement of the right to exclude, damages may include
lost profits on competing products not covered by the infringed patent claims.

THE CHOICE BETWEEN LOST PROFITS AND REASONABLE ROYALTIES

The first decision the lawyer or expert must make is to decide which method to use
in calculating damages in a particular case: “lost profits,” a “reasonable royalty,” or a
combination of both. The courts view lost profits as the preferred method when it is
appropriate for the facts of the case. As stated in Hansen v. Alpine Valley Ski Area,
Inc., “If the record permits the determination of actual damages, namely, the profits
the patentee lost from the infringement, that determination accurately measures the
patentee’s loss. If actual damages cannot be ascertained, then a reasonable royalty
must be determined.”7

There are situations in which the patent owner would be better off licensing to others
the right to use the patent in exchange for royalties. A classic example is the garage
inventor, who has a great idea but lacks the necessary manufacturing, marketing, distribution,
or other assets necessary to fully exploit the value of the patent. The best use of
the patent is to license the technology to a firm with the requisite manufacturing and
marketing assets to develop the product into a commercially successful product.
Another example of licensing is when a product requires the use of multiple patents
owned by different firms. In this case, since each patent owner can prevent the other

HOW TO CALCULATE PATENT DAMAGES

from producing the product, it frequently will make sense to break the deadlock by
cross-licensing each other.

In each of these licensing examples, the crucial feature is that the patent owner cannot
make optimal use of the patent by himself. As discussed subsequently, licensing
requires some sharing of the profitability gained from the invention between licensor
and licensee. Therefore, when the patent owner can use the patent without licensing, it
generally will be more profitable to do so.

The lost profits damages scenario—embodied in the four-part Panduit test discussed
in the next section—essentially identifies a clear case in which a patent owner can profitably
go it alone, producing and selling the patented product without having to recruit
the assistance of others. Although subsequent cases have recognized that while the
Panduit test identifies a clear case where lost profits are appropriate, the criteria may be
too narrow and exclude other cases in which lost profits would also be appropriate.
Consider the first part of the test, whether there is a market for the patented product. In
Rite-Hite the court recognized that the real issue is what sales the patent owner has
lost, whether those sales are of the patented product.8 This is because the patent owner’s
right is to exclude others from using the patent and does not require that the patent
owner use the patent. Therefore, Rite-Hite established the principle that the patent
owner’s lost sales need not necessarily be of the patented products, but would
include any lost sales that are attributable to the infringement. As discussed below, the
practical effect of Rite-Hite is to allow a patent owner to claim lost profits on products,
including functionally related “convoyed” products, by showing that infringement displaced
sales of such products.

LOST PROFITS

Proof of lost profits requires the patent owner to demonstrate that, absent infringement,
he would have made the sales that the infringer actually made. The standards for such
proof have changed measurably in the last 15 years. Before the establishment of the
Federal Circuit, the burden of proof to establish lost profits was substantial. Any possibility
that someone other than the patent owner could have made any sales of the
infringer completely negated a recovery of lost profits.9 In contrast, the Federal Circuit
has adopted a lower standard of “reasonable probability.” Under that standard, the
patent owner must show only that it is more probable than not that he would have made
the infringer’s sales but for the infringement.

Although the Federal Circuit has made it clear that there is no single method by
which the patent owner must carry its burden of proving lost profits, by far the most
common approach is the four-part test outlined in Panduit Corp. v. Stahlin Brothers
Fibre Works, Inc.10 (mentioned previously). The Panduit test requires that the plaintiff

PATENT INFRINGEMENT DAMAGES

establish (1) the existence of demand for the patented product; (2) the absence of
acceptable noninfringing substitutes; (3) the patent owner’s ability to meet demand; and

(4) some proof of the amount of profit lost per lost sale.11 Satisfying these four factors
results in the establishment of the fact that, absent infringement, the patent owner would
have made the infringer’s sales.
The first prong of the Panduit test rarely is difficult for the plaintiff to meet. Likewise,
the fourth factor may require little more than the production of the plaintiff’s
income statement. It is not surprising, then, that the key inquiries involved in proving
lost profits are the absence of acceptable noninfringing substitutes and the patent
owner’s ability to produce, market, and sell to the infringer’s customers. Both of these
questions are well suited for economic analysis, and the Federal Circuit has increasingly
incorporated economic analysis when addressing these issues.

Pall Corp. v. Micron Separations, Inc.12

In Pall Corp., the court held that, in order to be acceptable, a noninfringing alternative
must be free of any pending litigation. The proposed noninfringing alternatives
(certain membranes used in microfiltration) were themselves the subject of infringement
litigation during the time of Micron’s infringement, until they were licensed.
The Federal Circuit held that the trial court should have recognized “the distinction
between the legal and market situation before and after the licensing,” and held that
during the period that the proposed design-arounds were not licensed, their presence
in the market did not provide an acceptable noninfringing alternative such that
would defeat Pall’s entitlement to lost profits for all of Micron’s infringing sales.

Zygo Corp. v. Wyko Corp.13

Zygo, the patent owner, manufactured and sold a patented interferometer. Wyko
produced the Wyko 6000 interferometer, which was found to infringe Zygo’s
patent. As a defense to awarding lost profits, Wyko argued that it could have sold
SIRIS instead, a similar product that Wyko had sold before launching the infringing
Wyko 6000. Zygo did not contend that SIRIS was infringing. However, the
court rejected Wyko’s argument, holding that in order to be an acceptable noninfringing
alternative, the product must be available in the market. Since Wyko had
discontinued production of SIRIS, the court found that SIRIS was only “available
on the market” during the period that it was still being marketed by Wyko.

HOW TO CALCULATE PATENT DAMAGES

Fiskars, Inc. v. Hunt Manufacturing Co.14

Fiskars involved evaluation of a potential noninfringing alternative not disclosed
until several years after the conclusion of the trial. The procedural posture of
Fiskars therefore is somewhat unusual, but it offers informative guidance on the
nature of noninfringing alternatives for the purposes of calculating patent damages.
The manufacturer Hunt claimed, subsequent to the trial, that he was entitled
to relief from the trial court’s damages award because of his new, noninfringing
alternative to Fiskars’s patented paper trimmer. The Federal Circuit rejected the
manufacturer’s claim, holding that he was not entitled to a second opportunity to
present his case.

The manufacturer argued that he could not have introduced evidence of the
new product at trial because he lacked sales data at the time to demonstrate
the acceptability of the noninfringing product. However, the Court rejected this
argument, finding that although sales data could provide significant evidence of
an alternative’s acceptability, such data “is not the sole means for demonstrating
acceptability.” The Court held that accused infringers could rely on witness testimony
to show that the alternative was acceptable because customers did not
require the patented features that were (necessarily to avoid infringement) absent
from the substitute product. Although parties must support their positions with
“sound economic proof,” absolute certainty is not required in constructing the
hypothetical but for market.

Accordingly, Hunt was denied relief from the trial verdict because it could
have argued the existence of the noninfringing alternative at the time of the damages
award.

Initially, the Federal Circuit required proof that noninfringing substitutes did
not possess all of the attributes of the patented product.15 Such a test cannot withstand
even cursory scrutiny, however, because substitutes that possess literally all
of the attributes of the patented product would be infringing, not “noninfringing.”
Accordingly, the effect of this early Federal Circuit doctrine was to ensure that
patent owners virtually automatically met the critical second prong of the Panduit
test.

The logical defect in this first approach led the Federal Circuit to focus on the attitudes
of consumers toward the patented product and any substitutes rather than on their
physical attributes.

PATENT INFRINGEMENT DAMAGES

Slimfold Mfg. Co. v. Kinkead Indus.16

In Slimfold, the court denied awarding lost profits to the patent holder because

Slimfold was unable to attribute demand for the infringing product to the patented

feature. The patent covered a part for a metal door; however, Slimfold could not

establish that the defendant’s inclusion of the patented part resulted in a change in

demand or market share for either Slimfold or the defendant’s door. Moreover,

Slimfold failed to prove the absence of noninfringing substitutes that would have

been equally acceptable to the customers. Accordingly, the defendant could sim

ply have shifted to marketing one of the acceptable substitutes.

The court also affirmed the court’s award of a relatively small royalty—

0.75 percent—because the advantage of the patented invention primarily was a
manufacturing advantage (for which the court awarded damages separately) and
did not significantly increase the value of the entire door.
Although this change of focus marked an improvement, the Federal Circuit also held
that acceptable noninfringing substitutes are legally absent when some set of customers
can be shown to prefer the patented product.17 The difficulty with this approach is that,
if consumer tastes are not uniform, some subset of consumers will always prefer the
patented product. As a consequence, this second approach also negated any serious
analysis and ensured that the patent owner could satisfy the second Panduit prong.

Federal Circuit case law has now advanced significantly. In State Industries, Inc. v.
Mor-Flo Industries, Inc., the Federal Circuit held that lost profits are available to the
patent owner only for the share of the infringing sales that would have gone to the patent
owner absent the infringement.18 Thus, the Federal Circuit dispensed with the rigid “all
or nothing” approach of Panduit. Under this new procedure, a court can award lost profits
to the patent owner on the portion of the infringer’s sales that are equal to the patent
owner’s market share. For example, assume that there are three competitors in a market:
the patent owner, the infringer, and another firm that sells a noninfringing substitute.
Each competitor sells 100 units, so the market shares are one-third each. If the
infringer were removed from the market and the customers of the infringer were redistributed
to the remaining firms (the patent owner and the noninfringing substitute producer),
the result would be that the patent owner’s “but for” infringement sales would
be increased by half the infringer’s sales. The resulting damages in such a circumstance
would be a “hybrid” of lost profits and a reasonable royalty. A lost profits analysis
applies to half of the infringer’s sales based on the reasoning in Mor-Flo, and a reasonable
royalty applies to the remaining sales.

To establish the applicability of a Mor-Flo–type analysis, the expert must establish
that the customers of the infringer are reasonably likely to redistribute themselves

HOW TO CALCULATE PATENT DAMAGES

among the other sellers according to market share “but for” the infringement. Examination
of marketing, advertising, and historical changes in market share can be useful
in this analysis. This approach, although a substantial improvement, is still not without
problems. One is likely to find that the Mor-Flo approach is accurate only for cases in
which the products at issue are “homogeneous,” that is, where the products lack significant
brand-name recognition or significant physical or quality differences. However, in
cases in which products are heterogeneous, the Mor-Flo market share approach may
still lead to erroneous conclusions.

In applying the Mor-Flo approach, consider the following example of infringement in
the carbonated soda industry where products theoretically are heterogeneous. Suppose it
were found that Pepsi had been infringing the patented formula used by Coca-Cola (in
reality the formula is a trade secret). Further assume that the relevant market is defined
as branded soda in the United States and includes the sales of 7-Up, Dr. Pepper, several
root beer brands, and a few other products sold nationally.19 Moreover, for purposes of
illustration, assume that in this market, Coca-Cola’s market share is 30 percent and
Pepsi’s share is 20 percent. We would now have the situation depicted in Exhibit 7-1.

In this example we assume, following Mor-Flo, that once the infringer is removed
from the market, consumers will choose products in the same proportions as they did
prior to the infringer being removed. This approach makes the calculation of lost sales
easy. Lost sales are the difference between Coke’s sales in the “but for” world absent
the infringer and its sales in the actual world. In this case, lost sales are 37.5 percent of
the market less 30 percent of the market, or 7.5 percent of the sales of branded soda.

However, it is evident that consumers of Pepsi may have chosen Coke as a closer
substitute than other sodas. If this is true, the Mor-Flo approach underestimates Coke’s
lost sales. In BIC Leisure Products, Inc. v. Windsurfing Int’l, Inc., the Federal Circuit
recognized the importance of product differentiation to the lost profits analysis.20 In that
case, the patent owner sold a high-end, high-priced windsurfing board, while the alleged
infringer sold a similar, but lower-priced, low-end board. The Federal Circuit reached
beyond the standard market share approach to lost profits and held that the two products
at issue, while arguably part of the same product market, were sufficiently differentiated
that the patent owner probably would have sold to very few of the infringer’s

ACTUAL “BUT FOR”
MARKET SHARES MARKET SHARES

Coke 30% Coke (30/8020) 37.5%
Pepsi 20% Pepsi 0
Dr Pepper 10% Dr Pepper 12.5%
7-Up 10% 7-Up 12.5%
Private label 0% Private label 0
Others 30% Others 37.5%

EXHIBIT 7-1 Market Shares in Soda Brands

PATENT INFRINGEMENT DAMAGES

customers. This was the court’s conclusion despite the fact that the patent owner had a
significant overall market share. BIC Leisure thus represents a clear advance in economic
thinking for the Federal Circuit. Finally, in a recent case, Grain Processing Corp.

v. American Maize-Products Co., the Federal Circuit held that a noninfringing substitute
need not be “on the market” or “for sale.”21 All that is required is that the substitute
be “available” to be included in the market.22
In order to be entitled to lost profits damages, the patent owner also must demonstrate
that he possesses the marketing, manufacturing, and financing capability to make
the infringer’s sales. The reason for this requirement is that, even if it could be shown
that demand for the patent owner’s product would have increased absent the infringement,
the patent owner must show that he had the ability to meet the additional demand
and actually increase his sales.23

Hebert v. Lisle Corp.24

In Hebert, the patentee admitted that he had never sold one of his patented exhaust
manifold spreaders. The court noted that where the patentee does not seek to make
and sell the invention, lost profits are not an appropriate measure of damages.
However, Hebert presented evidence of his activities that allegedly established his
intent to manufacture the tool. Hebert also claimed that Lisle’s action in flooding
the market with its infringing version of the tool deprived him of the opportunity
to market and sell the patented invention. The court found that it would be incorrect
to bar a patentee who is not yet manufacturing the product from proving that
his actual damages were larger than a reasonable royalty, but that the burden on
such a patentee was “commensurately heavy” to prove what he would have
earned but for the infringement. “Damage awards cannot be based upon speculation
or optimism, but must be established by evidence,” concluded the court, and
remanded the issue to the trial court for evaluation of the evidence that Hebert
would have and could have captured Lisle’s profits but for the infringement.

Although in the past, the ability to make the infringer’s sales was considered solely
from the point of view of manufacturing capacity, courts today also inquire whether
the patent owner has the ability to market and service the infringer’s customers.25 This
is important because, as any business people know, the ability to procure sales requires
much more than merely producing the product. The ability to distribute, market, and
service a product is equally as important as the manufacturing capacity to produce it.
Other factors that an expert should consider include:

. Is there distribution capacity?
. Are the infringer’s sales made to longtime customers?

HOW TO CALCULATE PATENT DAMAGES

. Does the patent owner have the required marketing, full line of products, services,
or other attributes required to make the infringer’s sales?
. Do the cash flow statements indicate any capital constraints?
. Is there sufficient inventory of the product available?
THE CALCULATION OF INCREMENTAL PROFITS

Once the amount of lost sales has been established, all that remains is to determine the
amount of profits that would have been earned on those lost sales. Since we are attempting
to determine how much better off the patent owner would have been had there
been no infringement, an appropriate method is to measure the “incremental” profits or
income that would have resulted from the lost sales. As stated in Paper Converting:

[t]he incremental income approach to the computation of lost profits is well established
in the law relating to patent damages. The approach recognizes that it does not cost as
much to produce unit N + 1 if the first N (or fewer) units produced already have paid the
fixed costs. Thus fixed costs—those costs which do not vary with increases in production,
such as management salaries, property taxes, and insurance—are excluded when determining
profits.26

Thus, the patent damages expert is directed to determine how much additional cost is
incurred to make the additional sales that would have been made “but for” the infringement.
Elements of cost that would have been incurred in either case obviously do not
enter into this calculation; only costs that vary with the changes in the sales volume at
issue should be deducted from the sales at issue to determine incremental profits.

The determination of incremental costs can be an area of significant contention in a
patent damages case. For example, the patent owner may claim that it could produce the
additional volume of sales in question without adding any additional plant, equipment,
overhead, or infrastructure, so that only the variable cost of goods sold need be subtracted
to calculate incremental profitability. The patent owner would argue that the
“gross margin” line on his income statements is the appropriate benchmark for calculating
incremental profitability. The infringer, however, may claim that in order to produce
the incremental output, the patent owner would have to increase all his costs
proportionately (i.e., adding to plant, equipment, overhead, and infrastructure as output
increases). The infringer would argue that the “net profits” line on the patent owner’s
income statement more accurately represents the patent owner’s incremental profitability.
Depending on the facts, the truth could lie anywhere in the range bounded by these
two positions.

The expert must carefully examine how costs change with sales of the products
in question over the range of output claimed as incremental sales. The most direct
approach usually entails a detailed examination of each discrete line item of costs, bro

PATENT INFRINGEMENT DAMAGES

ken down as finely as possible. For each cost line item, the patent damages expert
should determine whether such costs are variable or fixed over the range of the incremental
output.27

Alternatively, or as a check on the detailed cost item calculation, the expert can examine
the historical behavior of total costs at different ranges of output. Changes in the
patent owner’s output comparable to the claimed incremental sales can yield important
information relevant to the amount of incremental costs that would have to be incurred
to make those incremental sales. Of course, the patent damages expert should be careful
to remove any extraordinary or nonrecurring cost items that would not be expected.

In addition, it may be possible to apply econometric methods to cost and input data
to estimate the effect on cost of incremental sales volume. Over the past several
decades, the use of the ordinary least squares to estimate cost functions has grown
widely. Although this method is a powerful tool for the analysis of data, it is important
that the expert have a thorough understanding of when and how the method is appropriately
used and of the limitations of the methodology (see Chapter 3).28

THE DAMAGE PERIOD

The damage period over which lost profits are available begins at the onset of infringement
of an issued patent if the patent owner’s products are marked as patented (if such
marking is possible).29 In no case can damages be awarded for infringement committed
more than six years prior to the filing of the complaint.30 If the patent owner’s patented
products are not marked, the damage period begins when the infringer receives actual
notice of infringement. The damage period ends on the date of trial because presumably,
if the infringer loses its case on liability, an injunction will be imposed. An interesting
issue, however, concerns whether a patent owner can be compensated for an infringer’s
future impact on the patent owner’s sales that results from the market effect of the
infringer’s past infringement.

PRICE EROSION

Lost profits include not only the loss of sales due to infringement but also the price
reduction that results from the unlawful competition from the infringer. This reduction
in price, or “price erosion,” is now a recognized part of the lost profits damage measure.
According to the Federal Circuit:

lost profits may be in the form of diverted sales, eroded prices, or increased expenses. The
patent owner must establish causation between his lost profits and the infringement. A factual
basis for causation is that, “but for” the infringement, the patent owner would have made the
sales that the infringer made, charged higher prices, or incurred lower expenses.31

HOW TO CALCULATE PATENT DAMAGES

The earliest case to establish a price erosion element of lost profits was Yale Lock
Manufacturing Co. v. Sargent.32 In Yale Lock, the Supreme Court found that the
infringer was selling locks that included the infringing device at a lower price than
the patent owner was. As a result, the patent owner was forced to lower his price by one
dollar on some types of locks and by two dollars on other types of locks. The Court
awarded, as part of the patent owner’s lost profits, the erosion of the patent owner’s lock
price multiplied by the sales on which the lower price had been applied. But Yale Lock
failed to consider the impact that the hypothetical price increase might have had on output
or sales. As some later courts have recognized, it is not consistent for the patent
owner to claim that “but for” the infringement, prices would have been higher, while
simultaneously contending that total sales would have remained unchanged.33

Economic principles teach that there is a direct relationship between the price level
and the level of output or sales.34 Some courts have recognized this connection. For
example, in the seminal case of Panduit Corp. v. Stahlin Bros. Fibre Works, Judge Markey
held for the purposes of calculating lost profits that demand was sufficiently elastic that
“any loss in Panduit’s profits due to the price reduction was more than compensated
by the gain in profits due to the increase in plaintiff’s sales volume because of the
price reduction.”35 Similarly, in Polaroid Corp. v. Eastman Kodak Co., the Massachusetts
District Court concluded that no lost profits from price erosion were justified because
“the higher prices Polaroid says it would have charged would have depressed demand
so substantially that the strategy they historically pursued is actually the more profitable
one.”36 In other words, the court found that price elasticity was already too high to justify
an award based on price erosion.

Despite the apparent simplicity of this principle, the majority of courts that have
awarded damages for price erosion have done so without adjusting the level of output
on which lost profits are calculated. The case of Micro Motion, Inc. v. Exac Corp. is
illustrative.37 The case involved Exac’s infringement of Micro Motion’s patent for flow
meters. Before Exac entered the market, Micro Motion was the only supplier of the
flow meters at issue. Micro Motion claimed patent damages in the form of lost profits
on Exac’s sales for which Micro Motion had the capacity to produce and a reasonable
royalty on the remainder of Exac’s sales. But Micro Motion also claimed that, but for
the infringement, its prices on its sales would have been higher. Micro Motion called
Professor Daniel Rubinfeld, a nationally recognized economist, who testified that
absent infringement, Micro Motion’s prices would have been 4 percent higher, and as a
result, total output would have been 1 percent lower (thus, elasticity was 0.25). Citing
this testimony, the court awarded the plaintiff an additional 4 percent of sales on the lost
profits portion of Exac’s sales, but surprisingly did not reduce the size of the total output
base consistent with Rubinfeld’s analysis.

The court was clearly in error. Either output should have been reduced based on the
theorized price increase, as plaintiffs’ expert conceded, or the court should have refused
to grant damages for price erosion altogether. The theory would be that if Micro Motion

PATENT INFRINGEMENT DAMAGES

had licensed Exac (the basis for the reasonable royalty award), Exac would have competed
with Micro Motion for all sales (since it had a license), thus eliminating any ability
of Micro Motion to raise its prices.

To illustrate the problem with awarding price erosion damages without also adjusting
for resulting decreases in the quantity demanded, consider Exhibit 7-2. The original “but
for” price and quantity combination, representing total sales of both infringer and patent
owner, is denoted Pc, Qc. A damage award that does not take into account price erosion
would award the patent owner profits equal to the area corresponding to Pc, Qc, less the
profits actually earned by the patent owner. However, absent infringement, Micro Motion
would have been able to attain even greater profits with the price and quantity combination
of Pm, Qm. Doing so would gain a higher margin on sales that remained despite the
higher price, denoted by area a, while losing the margin on sales that are lost due to the
higher price, denoted by the area b.38 Whenever area a is larger than area b, it is profitable
to charge the higher price and sell fewer units. Therefore, the typical damage award, not
accounting for price erosion, undercompensates the patent owner by the amount of area
(a . b). However, in the Micro Motion case, in attempting to account for price erosion, the
court appears to have awarded profits based on a price and quantity combination of Pm,
Qc. The result is to overcompensate the patent owner by the sum of areas b and c.

THE ENTIRE MARKET RULE

Another issue often raised in patent infringement cases is what product sales are eligible
for compensation to the patent owner—that is, can the sale of products not covered
by the patent in suit be a basis for lost profits? The contours of the proper legal and economic
limitations to recovery on the sales of nonpatented items raises serious legal and

a
Qm Qc

b
c
Pm

Pc

EXHIBIT 7-2 Price Erosion Damages

HOW TO CALCULATE PATENT DAMAGES

constitutional issues. Only a brief outline of the pertinent rules is provided here.39 The
Federal Circuit recently addressed this issue in Rite-Hite Corp. v. Kelley Co., Inc.40
There, the Federal Circuit held that lost profits on nonpatented components or complementary
products sold with the patented product must satisfy the so-called entire market
rule to be compensable. The entire market rule requires that, to be recoverable, the
“unpatented components must function together with the patented components in some
manner so as to produce a desired end product or result. All the components together
must be analogous to components of a single assembly or be parts of a complete machine,
or they must constitute a functional unit.”41 Thus, the sale of products that are complements
to a patented product (i.e., convoyed sales) but not functionally integrated are
not compensable.42 The court reasoned that the Patent Statute sought to compensate
only competitive injury, and products sold with the patented product do not necessarily
compete directly with the infringer.

Although this reasoning narrows the lost profits recovery by eliminating awards for
convoyed sales, it also expands potential recoveries for lost sales on products that are
not covered by the patent in suit, but nonetheless compete with the infringer’s products.
To illustrate such a situation, suppose that the patent owner sells two products, A and B.
Further assume that the infringer infringes the patent covering product A, but sells its
product in competition with product B. According to Rite-Hite, the patent owner can
recover for lost profits on its lost sales of product B, even though product B does not
use the patented technology.

The Rite-Hite holding is likely to raise future controversy.43 The foundation of the
Rite-Hite rule lies in the court’s definitions of “competition” and “functional integration.”
Both concepts are defined narrowly by the Federal Circuit. Functional integration
is defined in physical terms rather than economic terms, focusing on how products
physically relate to each other in use, rather than the efficiencies or inefficiencies from
their complementary features. Likewise, competition is limited to a direct product by
product confrontation and does not consider broader strategic rivalry among firms.
Economic analysis can be useful in unpacking the logic of the Rite-Hite holding as these
issues are revisited in the future.

REASONABLE ROYALTY

As an alternative to the lost profits method of calculating damages, the patent owner can
claim reasonable royalties for use of the patented technology. This analysis can be used
to determine damages for any portion of the infringing sales for which the patent owner
cannot establish lost profits. A reasonable royalty analysis seeks to determine the royalty
the patent owner would have obtained in a voluntary “hypothetical negotiation”
between the patent owner (as a willing licensor) and the infringer (as a willing licensee)
just prior to the onset of infringement, assuming that both parties agreed that the patent

PATENT INFRINGEMENT DAMAGES

is valid and that the infringers’ products infringe the patent.44 This analysis is guided by
economic principles bearing on the costs and benefits of a license to each participant
and the relative bargaining leverage of the parties.

The Georgia-Pacific Factors

The case law on reasonable royalties contains valuable guidelines for conducting such
an analysis. Georgia-Pacific Corp. v. U.S. Plywood Corp.45 provided a list of 14 factors
that should be considered in the analysis. These factors are:

1. The royalties received by the patentee for the licensing of the patent in suit,
proving or tending to prove an established royalty.
2. The rates paid by the licensee for the use of other patents comparable to the
patent in suit.
3.
The nature and scope of the license, as exclusive or nonexclusive; or as
restricted or nonrestricted in terms of territory or with respect to whom the
manufactured product may be sold.
4.
The licensor’s established policy and marketing program to maintain his
patent monopoly by not licensing others to use the invention or by granting
licenses under special circumstances designed to preserve that monopoly.
5.
The commercial relationship between the licensor and licensee, such as
whether they are competitors in the same territory in the same line of business
or whether they are inventor and promoter.
6. The effect of selling the patented specialty in promoting sales of other products
of the licensee; the existing value of the invention to the licensor as a
generator of sales of his nonpatented item; and the extent of such derivative
or convoyed sales.
7. The duration of the patent and the term of the license.
8. The established profitability of the product made under the patent, its commercial
success, and its current popularity.
9. The utility and advantages of the patent property over alternative products or
methods, if any, that had or could have been used to obtain similar results.
10. The nature of the patented invention, the character of the commercial embodiment
of it as owned and produced by the licensor, and the benefits to those
who have used the invention.
11. The extent to which the infringer has made use of the invention, and any evidence
probative of the value of the use.
12. The 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.
13. The portion of the realizable profits that should be credited to the invention as
distinguished from nonpatented elements, services provided in conjunction

HOW TO CALCULATE PATENT DAMAGES

with the product, the manufacturing process, business risks, or significant features
or improvements added by the infringer.

14. The opinion testimony of qualified experts.
The Georgia-Pacific factors identify economically important areas of inquiry and
types of evidence that should be considered in an analysis of reasonable royalties sufficient
to compensate for alleged infringement. However, as the Georgia-Pacific
court recognized, the 14 factors necessarily fall short of providing a formula for
weighing and quantifying the factors to arrive at a solution to the royalty rate question.
Rather, the factors provide an important framework for the analysis and a checklist
of information that should be examined in a rigorous economic analysis of
reasonable royalty rates.

A Useful Classification of the Georgia-Pacific Factors. For purposes of this discussion,
it is convenient to parse the Georgia-Pacific factors into five groups corresponding
to the major economic considerations they address. Factors 3 and 7 ask us
to identify the major parameters of the license at issue. Although we are, by necessity,
required to construct a license agreement resulting from “hypothetical negotiations
between the patentee and the infringer (both hypothetically willing) at the time infringement
began,”46 this hypothetical construction must nonetheless comport with the
market realities and opportunities available at the time of the hypothetical negotiation.
For example, the hypothetical license should reflect the number of years remaining in
the life of the patent. Chapter 14 discusses the Georgia-Pacific factors again in a more
practical context.

The Georgia-Pacific factors 1, 2, and 4 direct us to examine whether other licenses
provide useful information. This is discussed in the subsequent section covering comparable
licenses.

Factors 4 and 5 direct us to consider costs to the licensor of granting a license.
Considerations such as alternatives to licensing or the potential creation of a competitor
through licensing affect the royalty rate that would be acceptable to a patent owner.
In particular, a patent owner would not be willing to accept a royalty rate that does not
cover his costs of licensing. These “opportunity costs” to the licensor play an important
role in defining one of the boundaries of a mutually acceptable license in the hypothetical
negotiation.

Factors 6 and 8 to 13 require examination of benefits to the licensee of obtaining a
license. Generally, the more profitable the resulting products, the more important the
technology is in allowing the production of profitable products and the less the alternatives
available to the licensee, the higher the royalty rate. The important point is that a
licensee will not willingly pay more than the expected benefits from licensing. This
consideration determines the other boundary of a mutually acceptable license agreement
in the hypothetical license negotiation.

PATENT INFRINGEMENT DAMAGES

Finally, the issue of relative bargaining power between licensee and licensor must be
addressed. A number of rules of thumb or methods of identifying a likely royalty rate
from among mutually acceptable rates have been employed. Having identified the general
type of license at issue, the maximum acceptable price to a licensee and the minimum
acceptable price to a licensor, and the outcome of bargaining in similar situations,
we can draw better inferences about the likely outcome in this particular situation.
Considerations such as the risks borne by the licensee in developing a salable product
and the importance of other resources that the licensee brings to the process can help to
narrow the area of mutually beneficial royalty rates.

Comparable Licenses. When there is an established industry price for the technology
at issue or similar technology, this “prevailing” royalty rate may be a good indicator of
the result of a hypothetical royalty negotiation for the subject patent. For example, other
licenses for the same patent can be highly instructive. However, it often is the case that
there are no established or prevailing royalty rates and that other licenses are not comparable
for a variety of reasons.

First, patents are by definition unique. The technology covered by one patent is sufficiently
different from the technology covered by another patent; otherwise it would
not be patentable.

Second, experience with licensing and examination of publicly available data indicates
that license fees for patents exhibit impressive range; most licensed patents
are worth little or nothing, while a few command very high fees. Moreover, the terms
of actual license agreements are typically complex and do not lend themselves to easy
extrapolation to other situations. For example, licenses can contain provisions that
require subsequent performance by the parties, contingencies that affect the ultimate
payments such as caps, and either lump-sum and running royalties or a combination of
royalties. Many licenses border on joint venture agreements to develop future products
rather than simple payments for the right to use a technology. Similarly, cross-licenses
and licenses for portfolios of patents present difficulties in assigning values to individual
patents in the portfolio.

Third, in the typical nonlitigation negotiation between a willing licensee and licensor,
there is uncertainty regarding whether the patent is valid or whether it is infringed.
Thus, in real-world licenses, there is some discounting of the value of the patent
owner’s right to prevent infringing use of a valid patent. For example, suppose each
party believes there is a 50 percent chance of invalidity. If the royalty agreed upon is
3 percent, then the reasonable royalty at trial arguably must be 6 percent. As the example
shows, most nonlitigated patent royalty rate agreements reflect a discount for uncertainty
with respect to validity and infringement. In contrast, in the litigation context, the
patent damages expert is asked to determine a reasonable royalty for a patent assuming
that it is both valid and infringed. Thus, there should be no discounting for uncertainty
regarding the infringement in a royalty rate established through litigation, because the

HOW TO CALCULATE PATENT DAMAGES

facts of validity and infringement are known and the parties have borne the risk of finding
out. A “reasonable royalty” for the purposes of assessing damages for past patent
infringement may often be significantly different from (i.e., higher than) royalty rates
negotiated outside the litigation context for otherwise comparable patents. The case
law recognizes that royalty rates established through litigation are fundamentally not
comparable to royalty rates agreed to in nonlitigation negotiation. As stated in Panduit,

The setting of a reasonable royalty after infringement cannot be treated, as it was here, as the
equivalent of ordinary royalty negotiations among truly “willing” patent owners and
licensees. That view would constitute a pretense that the infringement never happened. It
would also make and election to infringe a handy means for competitors to impose a “compulsory
license” policy on every patent owner. Except for the limited risk that the patent
owner, over years of litigation, might meet the heavy burden of proving the four elements
required for recovery of lost profits, the infringer would have nothing to lose, and everything
to gain, if he could count on paying only the normal, routine royalty noninfringers might have
paid. As said by this court in another context, the infringer would be in a “heads I win, tails
you lose” position.47

Finally, there is a sample bias in comparing licensed patents to the patent in question.
Most patents are not licensed, probably because they have little or no market value.
Comparing a litigated patent only to licensed patents is comparing the subject patent
only to the patents that turn out to be market successes.

Empirical Surveys of Royalty Rates. Sometimes industry data on royalty rates can
serve as a useful sanity check. Several surveys of the membership of the Licensing
Executives Society (LES) have been conducted and published in the LES journal, Les
Nouvelle. The first survey, which was conducted by McGavock, Haas, and Patin and
published in the March–April 1991 issue,48 was based on a sample of 118 respondents
who filled out questionnaires on a variety of licensing topics. The respondents came
from a variety of industries, so the survey allows for a cross-tabulation of industry type
and average royalty rate, as well as royalty type, relation to profit, and other information.
Degnan and Horton conducted a second survey of LES members, which involved
428 respondents and was published in the June 1997 issue of Les Nouvelle.49 Finally,
McGavock and Lasinski performed a third survey of LES members (186 of whom
responded), which was published in the September 1998 issue of Les Nouvelle.50 This
last survey focused on intellectual property (IP) policy and, strategy employed by LES
members. Although far from determinative of the applicable royalty in a particular
case, these surveys can provide helpful estimates of a range of reasonable royalties and
proffer a good check on outrageously high or low figures.

To qualify as admissible evidence rather than merely internal sanity checks, surveys
must meet several judicial criteria. Survey evidence must be “material, more probative
on the issue than any other evidence and... [have] guarantees of trustworthiness.”51

PATENT INFRINGEMENT DAMAGES

The trustworthiness of a survey depends on its conformity to generally accepted survey
principles, including sampling “an adequate or proper universe of respondents.”52 To
some extent, technical or methodological deficiencies affect the weight accorded a survey,
not its admissibility, so long as the survey complies with generally accepted survey
principles to establish a proper foundation for admissibility.53 However, surveys may
be excluded where the flaws are so substantial that any probative value of the survey is
outweighed by the inaccuracies.54 Precisely what constitutes a “generally accepted survey
principle” is subject to some debate, but the courts have identified certain primary
standards as follows:

The trustworthiness of surveys depends on foundation evidence that (1) the “universe” was
properly defined, (2) a representative sample of that universe was selected, (3) the questions
to be asked of interviewees were framed in a clear, precise and non-leading manner, (4) sound
interview procedures were followed by competent interviewers who had no knowledge of the
litigation or the purpose for which the survey was conducted, (5) the data gathered was accurately
reported, (6) the data was analyzed in accordance with accepted statistical principles
and (7) objectivity of the entire process was assured. Failure to satisfy one or more of these
criteria may lead to exclusion of the survey.55

Courts have criticized unreliable means of selecting the interviewees and found that a
sample that is not properly representative warrants exclusion of the survey at trial.56
Moreover, leading and suggestive questions undermine the legitimacy of the results.57
The Les Nouvelle surveys do not appear to meet these criteria for admissibility other
than as a sanity check.

Generally, the proponent of the survey will establish these criteria by using the testimony
of the individuals responsible for various parts of the survey.58 Where the proponent
cannot proffer this type of testimony, the survey itself may lack sufficient
foundation for admissibility. For example, in Toys “R” Us, Inc. v. Canarsie Kiddie Shop,
Inc., the expert witness relying on the survey for evidence of trademark confusion conceded
that he had no knowledge of what the interviewers actually did in conducting the
interviews, no personal knowledge of whether they followed their instructions, and
no knowledge of the accuracy of the content analysis because that work, too, was subcontracted
to another company.59 Based on the expert’s lack of the necessary knowledge
of the survey’s methodology and calculations, the court excluded the survey and the
opinions of the experts based on that survey.60 In concluding that the survey could not
be used as evidence at trial, the court noted that the “absence of any testimony by others
who were responsible” for the survey raised doubts as to the survey’s trustworthiness.61

Hypothetical Negotiation: The Boundaries. A basic economic principle is that a
rational economic agent will not willingly enter into an agreement that makes him
worse off. As discussed previously, the Georgia-Pacific factors include consideration of
the cost to the hypothetical licensor (the patent owner) of granting a license to the patent

HOW TO CALCULATE PATENT DAMAGES

$
Mutually
acceptable
range
Licensor Licensee

EXHIBIT 7-3 Range of Acceptable Royalty Rates

and the benefits to the hypothetical licensee from taking a license to the patent. These
considerations determine the boundaries of a mutually beneficial license; the patent
owner will not accept less than his cost of granting the license, while a potential licensee
will not pay more than his gain from licensing.

In the willing licensor–willing licensee hypothetical situation, it must be assumed
that there are mutual gains from voluntary trade, that is, that both the licensor and the
licensee will be better off if a license is granted. If this were not the case, no trade
between the parties would occur.

Exhibit 7-3 represents the range of acceptable royalty rates for both licensor and
licensee. The area of overlap, the “mutually acceptable range,” defines the set of royalty
rates that make each party better off by licensing.62

Thus, the expert must determine the boundaries of the set of mutually agreeable royalty
rates. Typically, the opportunity cost of the patent owner is the amount of profit that
could be earned by not licensing (i.e., producing the product himself) or by licensing to
somebody else.

On the other side of the hypothetical bargaining table, the potential licensee’s benefit
from licensing typically is the profit that could be gained by producing and selling
products that use the patented technology.63 In calculating the licensee’s profit from
using the technology, it is important to consider the licensee’s opportunity costs. Opportunity
cost means the benefits that could have been derived from the licensee’s next
best opportunity. Therefore, the appropriate maximum that a licensee would be willing
to pay is equal to the profit that the licensee expects to receive from using the new
technology net of the profit that it could obtain by utilizing the next-best alternative
technology available.

It would be a fundamental error to consider the licensee’s potential gains to be the
actual accounting profits. Yet some courts have made this error in calculating patent

PATENT INFRINGEMENT DAMAGES

damages.64 An example will illustrate the problem. Suppose that a licensee can make
$5,000 using technology A, but using this technology will infringe a patent covering
technology A. In the alternative, the licensee can make $4,000 using a noninfringing
technology. Therefore, the licensee will be unwilling to pay more than $1,000 to license
the patent to technology A, even though his income statement would show a profit of
$5,000 using technology A. Quite simply, paying more than $1,000 for a license to technology
A would not be as profitable as simply using technology B. Thus, one must know
what the opportunity cost of the infringer is to correctly identify the maximum royalty
that the infringer would pay. Most courts have recognized that taking account of opportunity
cost is the only correct method.65

One open issue is when the expert should consider the bargaining situation as taking
place. Although the case law tells us that the bargaining should occur at the “onset” of
infringement, an expert must be careful to consider whether the situation is prior to the
infringer incurring significant sunk costs. Once sunk costs are incurred, the infringer’s
opportunity costs will be higher than prior to such commitments. For example, once
a company has undertaken a massive investment in a project only to discover on the eve
of the product launch that its product infringes, obtaining a license could be a “bet the
company” issue. Conversely, had the potential infringement been discovered earlier,
the company’s willingness to pay would be determined by the value of undertaking the
infringing project compared to undertaking the next-best net present value project.

Experts often rely on forecast documents to attempt to understand how the infringer
would value a license. Forecast documents can be useful, but they also reflect the hidden
assumptions and institutional motives of their author. Such documents cannot be
taken at face value. Instead, interviews or discovery should be used to understand their
contextual meaning before relying on them.

In any event, there typically will be a range of royalty rates that satisfy the requirements
of the mutually acceptable range. A particularly difficult issue in calculating reasonable
royalties involves determining where within the mutually acceptable range the
negotiating parties would end up. Which amount is the most reasonable royalty? Of
course, this also determines the split between the licensor and licensee of the benefits
of the patented technology. In the following sections, we discuss several approaches
that have been used to address this indeterminacy.

The Rule of Thumb. One rule of thumb, sometimes used as a starting point in license
negotiations, is to set a royalty rate such that 0.25 to 0.33 of the licensee’s profits from
using the patent go to the patent owner as a license fee. The rationale for leaving 0.75
to 0.66 of the profits to the licensee is because the licensee is expected to assume greater
financial risk in commercializing the technology. This is appropriate in situations in
which the patent owner is unable to commercialize the technology without significant
assistance from a licensee with complementary assets, such as manufacturing, marketing,
distribution, or product development skills. Recently, Jarosz, Mulhern, and Vigil of

HOW TO CALCULATE PATENT DAMAGES

Analysis Group conducted an empirical survey of royalty rates and concluded that,
despite the fact that royalty rates varied significantly, royalty rates tended to range
between 21 and 40 percent of successful licensee profits.66

Analytical Method. Another approach is called the “analytical method.” The analytical
method is based on the premise that any rate of return in excess of normal can be
attributed to the patent and constitutes the profits to be divided between the negotiation
parties. The analytical method takes the profits of the infringer, subtracts the infringer’s
“normal” profit, and awards some portion of the remainder to the patent owner. The approach
in Tektronix67 is typical. In that case, the court calculated the reasonable royalty
as follows. First, the court determined the infringer’s sales and subtracted both
variable and fixed costs to arrive at gross profits and a gross profit rate. Next, the court
subtracted the infringer’s rate of profit on his other products from this gross profit rate.
Finally, the court divided the remainder among the infringer and the patent owner to
provide some return to the infringer for the risks of manufacturing the patented product.

Design-Around Costs. The “design-around costs” method is based on the observation
that a willing licensee will not be willing to pay more for the right to use the patent than
it would cost him to “design around” the patent. If the patent owner demands more than
the design-around costs, the potential licensee is better off using his own resources to
avoid the patent. Of course, there may be some risks associated with attempting to
design around a patent, and such risks should be considered when assessing design-
around costs. This method pegs the maximum value of a patent as the advantage of the
patent over the next-best alternative, consistent with Georgia-Pacific’s factor requiring
the examination of acceptable noninfringing substitutes.

Other Patent Damages. In addition to lost profits and reasonable royalties, the patent
statute allows for an injunction preventing future sales of the infringing product. When
there is a finding of willful infringement, a court can increase damages up to three times
the amount and assess attorney fees. “Willfulness” requires that the infringer (1) was
aware of the patent, and (2) failed to investigate the patent’s scope and form a good-
faith belief that the patent was invalid or not infringed by the product or process in question.
Finally, the statute makes clear that an infringer will be assessed interest and costs.

Stryker Corp. v. Intermedics Orthopedics, Inc.68

Stryker, the patent owner, sued Intermedics for infringement of its patent for a

hip implant prosthesis. The court affirmed a finding of willful infringement, not

ing that “slavish copying” is not required to establish “deliberate” infringement.

(continues)

PATENT INFRINGEMENT DAMAGES

Stryker Corp. v. Intermedics Orthopedics, Inc. (continued)

Copying is relevant, but not a necessary element of willful infringement, although
it could be evidence of a lack of good faith. Moreover, the infringing product need
not be “virtually an exact copy of the patentee’s product.” The court found that
Intermedics had failed to investigate the scope of the patent at issue once it knew
of its existence and had no good-faith belief that the patent was invalid or not
infringed by its prosthesis. Intermedics had an affirmative duty of due care to avoid
infringement of the known patent rights of others, including seeking and obtaining
competent legal advice before engaging in potentially infringing activity.

Minco provides an example of the available remedies and possible damages enhancements
once a court determines that a defendant willfully infringed the patent at issue.

Minco, Inc. v. Combustion Engineering, Inc.69

In Minco, the district court found willful infringement on the part of Combustion
Engineering. Since courts have the discretionary power to increase a damage
award up to three times the original amount where willfulness is proven, the court
doubled the sum of the lost profits and reasonable royalty that it had awarded,
then added attorneys fees and prejudgment interest. Moreover, the royalty was
already a “relatively high royalty” of 20 percent based on the fact that the parties
were close rivals in the same market, the absence of noninfringing alternatives,
the inferiority of Combustion Engineering’s product before infringement, and the
high rate of profitability enjoyed in the industry.

SUMMARY

This chapter is a core chapter presenting the basic principles that must be employed in
the calculation of patent damages. The chapter began where every lawyer and expert
must, with the applicable statute. The patent statute sets out a scheme for damage calculation
from which courts have developed a methodology that is very compatible with
economic theory. This chapter explained how economic principles can be used to satisfy
the statutory and judicial aims in devising appropriate remedies for patent infringement.
In Chapter 13 we build on and contrast with the principles discussed in this chapter,
while discussing the means of calculating damages for other types of IP infringement.

HOW TO CALCULATE PATENT DAMAGES

ENDNOTES

[1] The legislative history of the Patent Statute is discussed in Kori Corp. v. Wilco Marsh
Buggies & Draglines, Inc., 761 F.2d 649, 654 (Fed. Cir. 1985).
[2]
See Kori Corp., 761 F.2d at 655.
[3]
Aro Manufacturing Co. v. Convertible Top Replacement Co., 377 U.S. 476, 507 (1964).
[4]
Id.
[5]
Id.
[6]
King Instruments, Inc. v. Perego, 65 F.3d 941 (Fed Cir. 1995).
[7]
Hansen v. Alpine Valley Ski Area, Inc., 718 F. 2d 1075, 1078 (Fed. Cir. 1983).
[8]
Rite-Hite Corp. v. Kelley Co., Inc., 56 F.3d 1538 (Fed. Cir. 1995).
[9]
See Tektronix, Inc. v. United States, 552 F.2d 343, 349 (Ct. Cl. 1977) (“if lost profits are
ever to be awarded . . . it should be only after the strictest proof that the patentee would
actually have earned and retained those sums in its sales”).
[10]
Panduit Corp. v. Stahlin Brothers Fibre Works, Inc., 575 F.2d 1152 (6th Cir. 1978).
[11]
Id. at 1156.
[12]
Pall Corp. v. Micron Separations, Inc., 66 F.3d 1211 (Fed. Cir. 1995).
[13]
Zygo Corp. v. Wyko Corp., 79 F.3d 1563 (Fed. Cir. 1996).
[14]
Fiskars, Inc. v Hunt Manufacturing, Co., 279 F.3d 1378 (Fed. Cir. 2002).
[15]
See, e.g., TWM Manufacturing Co., Inc. v. Dura Corp., 789 F.2d 895, 901 (Fed. Cir. 1986)
(“a product lacking the advantages of the patented [product] can hardly be termed a substitute
acceptable to the consumer who wants those advantages”).
[16]
Slimfold Mfg. Co. v. Kinkead Indus., 932 F.2d 1453 (Fed. Cir. 1991).
[17]
See Standard Havens Products, Inc. v. Gencor Industries, Inc., 953 F.2d 1360, 1373 (Fed.
Cir. 1991) (“if purchasers are motivated to purchase because of particular features available
only from the patented product, products without such features—even if otherwise
competing in the marketplace—would not be acceptable noninfringing substitutes”).
[18]
State Industries, Inc. v. Mor-Flo Industries, Inc., 883 F.2d 1573 (Fed. Cir. 1989)
[19]
This is how the Federal Trade Commission has defined the relevant market in this industry.
[20]
BIC Leisure Products, Inc. v. Windsurfing Int’l, Inc., 1 F.3d 1214, 1218 (Fed. Cir. 1993).
[21]
Grain Processing Corp. v. American Maize-Products Co., 185 F.3d 1341 (Fed. Cir. 1999).
[22]
See also Riles v. Shell Exploration and Prod. Co., No. 01-1553 (Fed. Cir. July 31, 2002)
(holding that a reasonable royalty rate must consider potential noninfringing alternatives
as limit on hypothetical negotiations).
[23]
This third Panduit prong is connected to the second prong because the size of the patent
owner’s capacity impacts the number of noninfringing substitutes in the market. If the
patent owner cannot meet demand, then the class of acceptable noninfringing substitutes
must expand as consumers turn to other products to satisfy their needs. Despite their connection,
the two issues can be treated separately.
[24]
Hebert v. Lisle Corp., 99 F.3d 1109 (Fed. Cir. 1996).

PATENT INFRINGEMENT DAMAGES

[25]
See Polaroid Corp. v. Eastman Kodak Co., 16 U.S.P.Q. 2d 1481 (D. Mass. 1990).
[26]
Paper Converting Machine Company v. Magna-Graphics Corporation, 745 F.2d 11, 22
(Fed. Cir. 1984).
[27] Preexisting classifications of costs among “variable,” “fixed,” and “semivariable” may
not be reliable because such classifications may not have been assigned according to the
scale of output that is relevant in a particular case.
[28] This topic is too large and technically involved to be adequately discussed here. The
reader is advised to consult some of the many texts available on the topic. We list several
texts at the end of Chapter 3. See, e.g., Rubinfeld Reference Guide on Multiple
Regression, in Reference Manual on Scientific Evidence; Fisher, Multiple Regression in
Legal Proceedings, 80 Columbia Law Review 702 (1980); Rubinfeld, Econometrics in
the Courtroom, 85 Columbia Law Review 1048 (1985).
[29] 35 U.S.C. § 287.
[30] 35 U.S.C. § 286.
[31]
See LAM, Inc. v. Johns-Manville Corp., 718 F.2d 1056, 1065 (Fed. Cir. 1983) (emphasis
added); see also General American Transp. Corp. v. Cryo-Trans, Inc., 893 F. Supp. 774,
796 (N.D. Ill. 1995) (“price erosion occurs when a plaintiff is forced to lower prices due
to the presence in the market of the defendant’s infringing product”); Saf-Gard Products,
Inc. v. Service Parts, Inc., 491 F. Supp. 996, 1002 (D. Ariz. 1980) (“Computation of the
plaintiff’s lost profits also requires determination as to the plaintiff’s effective selling
price. If the plaintiff’s reduced selling prices are used in the computation of lost profits,
the defendant would receive a substantial benefit as a result of its infringing competition
with the plaintiff.”)
[32]
Yale Lock Mfg. Co. v. Sargent, 117 U.S. 536, 548 (1886).
[33] Courts have granted damages based on a price erosion theory on the basis of a variety of
types of evidence. For example, in TWM Mfg. Co., Inc. v. Dura Corp., 789 F.2d 895, 902
(Fed. Cir. 1986), the Federal Circuit upheld an award of damages based on price erosion
because of proffered evidence that TWM “had to give special discounts to compete with
Dura’s pricing practices.” Id. at 902. The court further dismissed defendant Dura’s argument
“that there was no correlation between the special discounts and its infringing activity.”
Id. Similarly, in Brooktree Corp. v. Advanced Micro Devices, Inc., 977 F.2d 1555,
1579 (Fed. Cir. 1992), the Federal Circuit upheld an award of lost profits based on price
erosion because of evidence presented by Brooktree that “it was forced to reduce its prices
when AMD announced its chips at lower prices, and that but for the infringement,
Brooktree would have continued to sell its chips at the prices that had already been established.”
Id. at 1579.
[34] As discussed in Chapter 3, this relationship is measured by the concept of “elasticity.”
Demand for a product is said to be very elastic when consumers are willing to switch to
a different good that is only slightly less expensive. In contrast, demand for a product is
said to be inelastic when significant increases in price fail to cause equally significant
reductions in the quantity purchased.
[35]
Panduit Corp. v. Stahlin Bros. Fibre Works, 575 F.2d 1152, 1157 (6th Cir. 1978).
[36]
Polaroid Corp. v. Eastman Kodak Co., 16 U.S.P.Q. 2d 1481, 1506 (D. Mass. 1990).

HOW TO CALCULATE PATENT DAMAGES

[37]
Micro Motion, Inc. v. Exac Corp., 761 F. Supp. 1420 (N.D. Cal. 1991).
[38] For simplicity in exposition, this example assumes that costs are zero. However, the conclusion
does not depend on assumptions about costs.
[39] Those readers interested in the deeper issues raised by the entire market rule should consult
the complete set of opinions cited in Rite-Hite Corp v. Kelley Co., Inc., 56 F.3d 1538
(Fed. Cir. 1995).
[40]
Rite-Hite Corp. v. Kelley Co., Inc., 56 F.3d 1538, 35 U.S.P.Q. 2d 1065, 1071 (Fed. Cir.
1995).
[41]
Id. at 1071.
[42]
Prior to Rite-Hite, convoyed sales were compensable if they were normally sold with the
patented product.
[43] For a discussion, see Lisa C. Childs, Rite Hite Corp. v. Kelly Co., The Federal Circuit
Awards Damages for Harm Done to a Patent Not in Suit, 1996 Loy. U. Chi. L. Rev. 665.
[44]
See, e.g., Mahurkar v. C.R. Bard Inc., 79 F.3d 1572, 1579 (Fed. Cir. 1996) (“Hypothetical
results of hypothetical negotiations between the patentee and the infringer (both hypothetically
willing) at the time infringement began.”); Georgia-Pacific Corp. v. U.S.
Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1970), modified on other grounds, 446
F. 2d 295 (2d Cir. 1971), cert. denied, 404 U.S. 870 (1971).
[45]
Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1970),
modified on other grounds, 446 F. 2d 295 (2d Cir. 1971), cert. denied, 404 U.S. 870
(1971).
[46]
Mahurkar v. C.R. Bard, Inc., 79 F.3d 1572, 1579 (Fed. Cir. 1996).
[47]
Panduit Corp., 575 F.2d at 1158.
[48] Daniel McGavock, David Haas, and Michael Patin, Factors Affecting Royalty Rates, Les
Nouvelles, March–April 1991 at 205.
[49] Stephen Degnan and Corwin Horton, A Survey of Licensed Royalties, Les Nouvelles, June
1997 at 91.
[50] Daniel McGavock and Michael Lasinski,
IP Survey Finds Gap in Information, Les
Nouvelles, September 1998 at 107.
[51]
Harolds Stores, Inc. v. Dillard Dep’t Stores, Inc., 82 F.3d 1533, 1544 (10th Cir. 1996); see
also Starter Corp. v. Converse, Inc., 170 F.3d. 286 (2d Cir. 1999) (affirming exclusion of
trademark survey where the survey did not effectively test consumer confusion of the two
marks and thus was irrelevant); C.A. May Marine Supply Co. v. Brunswick Corp., 649
F.2d 1049 (5th Cir. 1981); Simon Prop. Group L.P. v. mySimon, Inc., 104 F. Supp. 2d 1033,
1041 (S.D. Ind. 2000) (excluding surveys where flaws are “so fundamental that the court
does not believe it would be fair to treat them as matters going only to the weight of the
evidence”); Fed. R. Evid. 402; 4 McCarthy on Trademarks § 32:170.
[52]
Id.
[53]
Id.; Indianapolis Colts, Inc. v. Metropolitan Baltimore Football Club, L.P., 34 F.3d 410,
416 (7th Cir. 1994) (finding that imperfect survey may still be admissible); AHP
Subsidiary Holding Co. v. Stuart Hale Co., 1 F.3d 611, 618 (7th Cir. 1993) (holding that
flawed survey is admissible except in “rare” occasions); McGraw-Edison Co. v. Walt Disney
Prods., 787 F.2d 1163, 1172 (7th Cir. 1986) (same).

PATENT INFRINGEMENT DAMAGES

[54]
Simon Property Group, L.P. v. mySimon, Inc., 104 F. Supp. 2d 1033, 1039 (S.D. Ind. 2000)
(excluding survey regarding Internet home pages because the survey so grossly distorted
the marketplace conditions as to strip the survey of any significant probative value);
Starter Corp. v. Converse, Inc., 170 F.3d 286, 297 (2d Cir. 1999); A.H.P. Subsidiary
Holding Co. v. Stuart Hale Co., 1 F.3d 611, 618 (7th Cir. 1993) (finding that flawed surveys
may be completely unhelpful to the trier of fact and therefore inadmissible);
Spraying Systems Co. v. Delavan, 975 F.2d 387, 394 (7th Cir. 1992) (affirming summary
judgment where survey of consumer opinion was too flawed to create a genuine issue of
material fact).
[55]
Toys “R” Us, Inc. v. Canarsie Kiddie Shop, Inc., 559 F. Supp. 1189, 1205 (E.D.N.Y. 1983)
(emphasis added); see also Ramdass v. Angelone, 530 U.S. 156, 172 (2000) (excluding
death penalty poll and citing Toys “R” Us, Inc. for factors to consider in determining survey
reliability).
[56]
See Harolds Stores, Inc., 82 F.3d at 1544, citing Bank of Utah v. Commercial Sec. Bank,
369 F.2d 19, 27 (10th Cir. 1966); Toys “R” Us, Inc., 559 F. Supp. at 1204 (random intercept
survey method and inaccuracies in recording the responses might yield unreliable
results); Amstar Corp. v. Domino’s Pizza, Inc., 615 F.2d 252, 264 (5th Cir. 1980) (noting
inadequate universe of survey recipients); Dreyfus Fund, Inc. v. Royal Bank of Canada,
525 F. Supp. 1108, 1116 (S.D.N.Y. 1981) (unreliable survey technique); Kingsford
Products Co. v. Kingsfords, Inc., 715 F. Supp. 1013, 1016 (Kan. 1989).
[57]
Simon Property Group, L.P. v. mySimon, Inc., 104 F. Supp. 2d 1033 (S.D. Ind. 2000);
Sterling Drug, Inc. v. Bayer AG, 792 F. Supp. 1357, 1373 (S.D.N.Y. 1992) (disapproving
of improperly drafted survey questions); Conagra, Inc. v. Geo. A. Hormel & Co., 784 F.
Supp. 700, 726 (Neb. 1992) (survey flawed in that failed to inquire regarding reasons certain
answers were selected).
[58]
Id.
[59]
Toys “R” Us, Inc. v. Canarsie Kiddie Shop, Inc., 559 F. Supp. 1189, 1203 (E.D.N.Y.
1983).
[60]
Id. at 1205.
[61]
Id.
[62] If the analysis determines that there is no royalty rate that makes both parties better off,
this probably is a signal that a “lost profits” rather than a “reasonable royalty” is appropriate.
[63] One vexing problem is that the boundaries of the mutually acceptable range are sensitive
to when the negotiation takes place. For example, if the negotiation takes place before
the potential licensee invests in production facilities to make the product, his potential
benefit from taking a license is different than it would be if the licensee had already made
“sunk” investments specific to the patented product. The cases simply state that the hypothetical
negotiation takes place at the onset of infringement.
[64]
See, e.g., Polaroid Corp. v. Eastman Kodak Co., 16 U.S.P.Q. 2d 1481 (D. Mass. 1990);
Fromson v. Western Litho Plate & Supply Co., 853 F.2d 1568, 1575 (Fed. Cir. 1988).
[65]
See, e.g., Columbia Wire Co. v. Kokomo Steel & Wire Co., 194 F.108, 110, 114 C.C.A. 186
(C.C.A. 1911); Union Carbide Corp. v. Graver Tank & Mfg. Co., 345 F.2d 409, 411, 145
U.S.P.Q. 240 (7th Cir. 1965); Hanson v. Alpine Valley Ski Area, Inc., 718 F.2d 1075, 1078,

HOW TO CALCULATE PATENT DAMAGES

219 U.S.P.Q. 679 (Fed. Cir. 1983); Smith International, Inc. v. Hughes Tool Co., 1986 WL
4795, 299 U.S.P.Q. 81, 83 (C.D. Cal. 1986); Ellipse Corp. v. Ford Motor Co., 461 F. Supp.
1354, 1369, 201 U.S.P.Q. 455 (N.D. Ill. 1978); and Slimfold Mfg. Co., Inc. v. Kinkead
Industries, Inc., 932 F.2d 1453, 1458, 18 U.S.P.Q. 2d 1842 (Fed. Cir. 1991).

[66] John Jarosz, Carla Mulhern, and Robert Vigil, “Industry Royalty Rates and Profitability:
An Empirical Test of the 25% Rule,” Presentation to LES Annual Meeting, October 30,
2001.
[67] Tektronix, Inc. v. United States, 552 F.2d 343 (Ct. Cl. 1977).
[68] Stryker Corp. v. Intermedics Orthopedics, Inc., 96 F.3d 1409 (Fed. Cir. 1996).
[69] Minco, Inc. v. Combustion Eng’g, Inc., 95 F.3d 1109 (Fed. Cir. 1996).
ADDITIONAL READING

Russell L. Parr, Intellectual Property Infringement Damages: A Litigation Support
Handbook, New York: John Wiley & Sons (1993).
Everett M. Rogers, Diffusion of Innovations, 3rd ed., New York: The Free Press (1995).

Jay B. Abrams, Quantitative Business Valuation, New York: McGraw-Hill (2001).
Geoffery A. Moore, Paul Johnson, and Tom Kippola, The Gorilla Game, New York:
Harper Business (1999).

Clayton M. Christensen, The Innovator’s Dilemma, New York: Harper Business (2000).

Frederick P. Brooks, Jr., The Mythical Man-Month, 20th Anniversary Edition, AddisonWesley-
Longman (1995).
Geoffery A. Moore, Inside the Tornado, New York: Harper Perennial (1999).
Damages: Lost Profits on Lost Sales of Unpatented Items, 5 Federal Circuit Bar Journal

242 (Summer 1995).

Dorsey Baker, Patent Damages—Quantifying the Award, Journal of the Patent & Trademark
Office Society 121 (March 1987).
Jonathan Bloom et al., Federal Circuit Addresses Patent Infringement Damages Issues,

7 Journal of Proprietary Rights 21 (Aug. 1995).

Patricia N. Brantley, Patent Law Handbook 1993–94 ed., § 604, Clark Boardman
Callaghan, Ltd.
Alex Chartove, Patent Law Developments in the United States Court of Appeals for the

Federal Circuit During 1991, 9 Computer & High Technology Law Journal 109 (1993).

Alex Chartove, Patent Law Developments in the United States Court of Appeals for the
Federal Circuit During 1989, 39 The American University Law Review 1142 (1990).
Lisa C. Childs, Rite-Hite Corp. v. Kelley Co.: The Federal Circuit Awards Damages for

Harm Done to a Patent Not in Suit, 27 Loyola University of Chicago Law Journal 665
(Spring 1996).

PATENT INFRINGEMENT DAMAGES

Ned L. Conley, An Economic Approach to Patent Damages, 15 AIPLA Q.J. 354 (1987).

Ronald B. Coolley, Overview and Statistical Study of the Law on Patent Damages, Journal
of the Patent & Trademark Office Society 515 (July 1993).

Robert J. Cox, Recent Development: But How Far?: Rite-Hite Corp. v. Kelley Co.’s
Expansion of the Scope of Patent Damages, 3 Journal of Intellectual Property Law 327
(Spring 1996).

John D. Culbertson and Roy Weinstein, Product Substitutes and the Calculation of Patent
Damages, Journal of the Patent & Trademark Office Society 749 (Nov. 1988).

Robert Goldscheider, Companion to Licensing Negotiations, Licensing Law Handbook
(1993–1994).

Robert Goldscheider, Measuring Damages in U.S. Patent Litigation, 5 Journal of
Proprietary Rights 2 (1993).

Robert Goldscheider, Value of Patents from a Damages Expert’s Point of View, 12 Licensing
Law & Business Report 109 (Nov.–Dec. 1989).

Robert L. Harmon, Damages, Interest, and Costs, Patents and the Federal Circuit 478
(3rd ed., 1994).

Robert L. Harmon, Patents and the Federal Circuit, § 12.2 (2d ed., 1991).

Robert L. Harmon, Seven New Rules of Thumb: How the Federal Circuit Has Changed the
Way Patent Lawyers Advise Clients, 14:3 George Mason Law Review 573 (1992).

Paul M. Janicke, Contemporary Issues in Patent Damages, 42 The American University
Law Review 691 (1993).

Wm. Marshall Lee, Determining Reasonable Royalty, Les Nouvelles 124 (Sept. 1992).

Nancy J. Linck and Barry P. Golob, Patent Damages: The Basics, 34 IDEA: The Journal
of Law & Technology 13 (1993).

Frederick A. Lorig and David J. Meyer, Maximizing Patent Damages, 321 Practicing Law
Institute 367 (1991).

Timothy J. Malloy and Melissa M. McCaulley, Rite-Hite: Has the Federal Circuit
Expanded the Legal Limits on Damages Awarded in Patent Infringement Actions? 424
Practicing Law Institute 515 (1995).

Timothy J. Malloy and Robert P. Renke, Patent Damages Revisited: Recent Issues Before
the Federal Court, 397 Practicing Law Institute 277 (1994).

Daniel M. McGavock and Rochelle Kopp, Emerging Topics in the Calculation of
Economic Damages in Patent Litigation, 5 Journal of Proprietary Rights 17 (March 1993).

William E. McGowan, Patent Law—Limiting Infringement Protection for Product-by-
Product Claims, 27 Suffolk University Law Review 300 (1993).

Joel Meyer, State Industries v. Mor-Flo and the Market Share Approach to Patent
Damages: What Is Happening to the Panduit Test? Wisconsin Law Review 1369 (1991).

HOW TO CALCULATE PATENT DAMAGES

George F. Pappas and April J. Sands, Law of Patent Damages, CA42 ALI-ABA 1 (Sept.
28, 1995).

Laura B. Pincus, The Computation of Damages in Patent Infringement Actions, 5 Harvard
Journal of Law & Technology 95 (Fall 1991); reprinted in Journal Business Law (U.K.)
(March 1992), 213.

N. Richard Powers, At the End of the Second Rainbow—Calculation of Damages in Patent
Cases, Delaware Lawyer 18 (March 1989).
Richard T. Rapp and Philip A. Beutel, Patent Damages: Rules on the Road to Economic
Rationality, 321 Practicing Law Institute 337 (1991).

Charles Shifley, Upfront and Benchmark Payments as Part of Reasonable Royalty Patent,
4 Federal Circuit Bar Journal 33 (Spring 1994).

Charles W. Shifley, Alternatives to Patent Licenses: Real-World Considerations of
Potential Licensees Are—and Should Be—a Part of the Courts’Determinations of Reasonable
Royalty Patent Damages, 34 The Journal of Law & Technology 1 (1993).

John M. Skenyon and Frank P. Porcelli, Patent Damages, Journal of the Patent & Trademark
Office Society 762 (Nov. 1988).

Gerald Sobel, Damages for Patent Infringement, 416 Practicing Law Institute 197 (1995).

Stephen I. Willis, Economic Modeling of Patent Infringement Damages, 321 Practicing Law
Institute 331 (1991).

Harold E. Wurst and Anne Wang, The Law of Patent Damages, 376 Practicing Law
Institute 7 (1993).

8

Introduction to the Antitrust Laws

This chapter provides a basic overview of the antitrust laws. A working knowledge of
antitrust principles is important to the analysis of intellectual property (IP) damages
because there are significant areas of overlap between the IP laws and the antitrust laws.
In addition, many of the tools developed by the courts in antitrust cases, such as the concept
of a relevant market, have been imported into the IP arena. This chapter provides
a historical background concerning the two principal antitrust statutes, the Sherman Act
and the Clayton Act; describes the evolving goals of the antitrust laws; and discusses
the essential components of the major antitrust claims.

THE HISTORICAL FOUNDATIONS OF THE ANTITRUST LAWS

In contrast to the IP laws that find their roots in the U.S. Constitution, the antitrust laws
were born in the upheaval of the Industrial Revolution at the end of the nineteenth century.
Contemporary descriptions of the time describe it as a period of “excess competition.”
The increased intensity of competition after the Civil War occurred in part as a
result of advances in transportation that brought formerly isolated geographic markets
into rivalry with each other. The rising competitive pressure impacted unevenly on large
and small firms, and the years following the Civil War coincided with an accelerated
process of mechanization, which widened the gap between large and small enterprises.1
Mechanization had significant consequences for competition. Thorelli states that as a
result of “heavy fixed investments” by the new industrial firms:

Many old enterprises [were] unable or unwilling to expand fast enough and raise the capital
necessary to keep abreast in their fields [and] were gradually, or in the recurrent slumps suddenly,
forced to the wall. To this extent at least a certain concentration of production to fewer
firms became concomitant with the increase in optimum size. . . .2

169

PATENT INFRINGEMENT DAMAGES

It was under these circumstances that the most dynamic large firms in the economy
attempted to avoid the detrimental effects on accelerated competition by organizing
profit pools, cartels, and trusts. As a result of these successful efforts to control inter-
firm rivalry, major tensions were created between big business and their smaller competitors,
farmers, and urban workers.

Before to the Industrial Revolution, traditional firms were insulated from competitive
pressure by their small size and the distance from their competitors. As the
Industrial Revolution took hold, new technologies led to larger firms with increased
capacity and new forms of communication and transportation that broke down old barriers
to competition. The result was severe price competition as large firms selling
homogeneous commodities clashed in the market. The response to the downward pricing
pressure was to form new corporate forms that reduced competition by collective
price-setting.

Not surprisingly, other groups in the economy—particularly farmers organized by
the granger movement, small businesses that formed the backbone of the progressive
movement, and urban workers—vehemently opposed the large trusts. The trusts
became an object of ridicule and hatred, and the political pressure mounted to heightened
levels prompting action by Congress. Few people deny that Congress passed the
Sherman Act because public condemnation of trusts was becoming increasingly violent.
In introducing his antitrust bill, Senator John Sherman explained:

The popular mind is agitated with problems that may disturb social order, and among them all
none is more threatening than the inequality of condition, of wealth, and opportunity that has
grown within a single generation out of the concentration of capital into vast combinations to
control production and trade and to break down competition . . . They had monopolies and
mort mains of old, but never before such giants as in our day. You must heed their (the voters’)
appeal or be ready for the socialist, the communist and the nihilist.3

Congressional debate and revision of the antitrust bill represented a condensation of
many conflicting political forces caused by the economic upheaval of the Industrial
Revolution.

The Origins of the Sherman Act

The original purpose of Sherman’s antitrust bill was to protect the small traditional
firms.4 Although Sherman tried to keep the bill in the Finance Committee, which he
controlled, the Judiciary Committee, after much debate, obtained jurisdiction and
within a week had produced a different bill that employed the language of the old common
law of restraints of trade. Many historians contend that the final legislative language
was essentially a political compromise between the interests of both large firms
and small firms. It was the compromise nature of the Sherman Act and the difficulty of
its interpretation that may have fostered its overwhelming support (it was passed with

INTRODUCTION TO THE ANTITRUST LAWS

only one dissenting vote in the Senate) and may account for the initial weak enforcement
efforts in the first decade following its enactment.

The final draft of the Sherman Act5 stated:

An Act To Protest Trade and Commerce Against Unlawful Restraints and Monopolies.

Section 1. Every contract, combination in the form of trust or otherwise, or conspiracy, in

restraint of trade or commerce among the several States, or with foreign nations, is declared

to be illegal. Every person who shall make any contract or engage in any combination or con

spiracy hereby declared to be illegal shall be deemed guilty of a felony. . . .

Section 2. Every person who shall monopolize, or attempt to monopolize, or combine or

conspire with any other person or persons, to monopolize any part of the trade or commerce

among the several States, or with foreign nations, shall be deemed guilty of a felony. . . .

The final draft that became the Sherman Act replaced Sherman’s original words
requiring “free competition” with a more ambiguous prohibition on “restraints of
trade” and “monopolization.” By returning to these older and more malleable common
law concepts, a measure of protection for smaller businesses was accomplished, but
essentially without sacrificing or stemming the corporate revolution that was transforming
the economy. In addition, because of the ambiguous language, the meaning
of the Sherman Act at the time was not obvious to lawyers who needed to advise their
corporate clients and also was unclear to enforcement officials. Congress had left
the arduous task of interpreting and applying the terms of the Sherman Act to the
Supreme Court.

It was not until 1897 that the Supreme Court first heard a series of restraint of trade
cases and first interpreted the ambiguous language of section 1, which literally stated
that “[e]very contract, combination in the form of trust or otherwise, or conspiracy, in
restraint of trade . . . is declared to be illegal.” The issue first arose in United States v.
Trans-Missouri Freight Association,6 in which the government filed a lawsuit, under
section 1 of the Sherman Act, against 18 railroads that controlled most of the commerce
west of the Mississippi River and that regularly fixed prices. The railroads defended on
the grounds that, absent the cartel, the railroads would be destroyed because of “ruinous
competition.” The railroads contended that the Sherman Act should outlaw only “unreasonable”
restraints, and a restraint that prevents ruinous competition must be “reasonable.”
The majority decision of the Supreme Court rejected the railroad’s argument,
reasoning that the plain language of the statute makes illegal “every” contract, combination,
or conspiracy that is in restraint of trade, not just unreasonable agreements.7
Therefore, the ruinous competition defense was without merit. The Court further made
clear its concern that such restraints of trade as the railroads proposed would “drive out
of business all the small dealers in the commodity.”8 Justice White wrote a forceful dissent,
to which four members of the Court concurred, supporting the view (which is now
prevailing law) that when Congress used the term restraint of trade it meant only
“unreasonable” restraints of trade, as the term was used in the common law.9

PATENT INFRINGEMENT DAMAGES

The majority’s interpretation of the Sherman Act not surprisingly was supported by
small business and its political allies in the progressive movement. In contrast, organizations
such as the National Civic Federation, which represented big business, lobbied
Congress to reject the majority’s interpretation and to overturn the Trans-Missouri opinion.
At the same time, Justice Peckham authored several more opinions holding fast to a
narrow interpretation of the Sherman Act and to the interpretation offered in the dissenting
opinion in Trans-Missouri Freight Association. Specifically, in 1898, Justice
Peckham authored United States v. Joint Traffic Assoc.10 and Hopkins v. United States.11

Between Judge Peckham’s opinions in Trans-Missouri Freight Association and Joint
Traffic, Judge Taft rendered his famous and highly lauded opinion in United States v.
Addyston Pipe & Steel Co.,12 in which he offered an alternative interpretation of the
Sherman Act. The Addyston Pipe case involved a challenge by the government to a cartel
of six pipe makers that had allocated customers through a bid-rigging arrangement.
Under the arrangement, one cartel member was designated as the real bidder and others
would submit (phony) high bids. The pipe makers claimed that stricter law applied to
the railroad industry than to other industries, and under the common law the pipe makers’
agreement should be judged reasonable. Judge Taft disagreed. Judge Taft distinguished
between “naked restraints,” those not ancillary to any larger legitimate contract,
and “ancillary restraints,” those reasonably necessary to fulfill the “main and lawful
purpose” of a contract. For an ancillary restraint to be legal, it must make the main
transaction more effective in accomplishing its legitimate purpose.13 Taft provided a
nonexhaustive list of transactions to which a restraint could be ancillary. The first example
Taft recited was “agreements by the seller of property or business not to compete
with the buyer in such a way as to derogate from the value of the property or business
sold.”14 In Judge Taft’s opinion, ancillary restraints are illegal only if they are part of a
transaction that involves a general scheme to control a market. The Supreme Court did
not adopt Judge Taft’s approach.

The Supreme Court also did not reevaluate how the Sherman Act should be applied
to horizontal restraints until 1911, when it issued its opinion in Standard Oil Co. of New
Jersey v. United States.15 In Standard Oil, the United States filed suit against John D.
Rockefeller’s Standard Oil, contending that Standard Oil had engaged in a series of
predatory pricing and cartel activities. Justice White, writing for the new majority on
the Court, overturned the earlier broad interpretation of the Sherman Act,16 stating
instead that “it follows that it was intended that the standard of reason which had been
applied at the common law and in this country in dealing with subjects of the character
embraced by the statute was intended to be the measure used for the purpose of determining
whether, in a given case, a particular act had or had not brought about the wrong
against which the statute provided.”17 In other words, the Court held for the first time
that only “unreasonable” restraints of trade, not “every” restraint of trade, are illegal.

Contrary to Justice Harlan’s dissent, Justice White’s opinion did not set forth an
open-ended rule of reason. Instead, Justice White clearly reasoned that the statute does

INTRODUCTION TO THE ANTITRUST LAWS

not mean “all” restraints of trade are illegal, but that Congress intended “to leave it to
be determined by the light of reason, guided by the principles of law,” which restraints
were to be prohibited.18 White’s rule of reason also contained structure. For instance, a
restraint on trade that by its inherent nature is anticompetitive should be condemned.19
This suggests a per se concept, even though little guidance is provided for which types
of conduct come within this category. If a restraint is not judged by its “inherent nature,”
the Court was then to examine its “inherent effect” (or market power) and its “evident
purpose” (or intent).20

The Standard Oil decision caused an immediate reaction in Congress. Progressive
movement forces feared that a conservative Supreme Court would take the teeth out of
the Sherman Act by determining much of the conduct of the trusts and monopolies to
be “reasonable.” Immediate work began on a new bill in Congress to specifically define
what acts would be unreasonable and would violate the law. This new bill eventually
would be the Clayton Act in 1914.

The Clayton Act and the Federal Trade Commission

The Clayton Act21 and the Federal Trade Commission Act22 were enacted simultaneously <,BR>in 1914. The Clayton Act aimed at defining specific practices that were anticompetitive
and to reach these anticompetitive practices in their incipiency.23 The Federal
Trade Commission (FTC) proscribed “unfair methods of competition” and established
an administrative enforcement procedure.24

The simultaneous enactment of these acts established a new framework, which some
believed to be an additional congressional step toward curbing the power of big business.
Other historians disagree. For example, Weinstein advanced the following view:

The Federal Trade Commission Act of 1914 is most often thought of as a Wilsonian reform
embodying a bias against “big business.” In fact, the principles underlying the FTC were
enunciated by corporation leaders and their lawyers consistently through the Progressive
Era in response to a series of legislative and judicial actions stretching over some seventeen
years.25

As in the case of the Sherman Act, the impact of the Clayton Act depends in part on
how it is enforced. According to Wise, with respect to the FTC:

doing something about the trusts was no longer the central issue of the day. Rather, it was a
consensus whose details were being worked out. But the devil is in the details; the form the
compromise package took foreshadowed the Commission’s almost immediate troubles.26

Specifically, the Clayton Act originally contained several loopholes that favored big
business. Section 7 of the Clayton Act covered acquisitions of “the whole or any part of
the stock or other share capital of another corporation.” Use of the term stock originally

PATENT INFRINGEMENT DAMAGES

excluded asset acquisitions from regulation. Likewise, the section 8 prohibition on
interlocking directors was easily circumvented by indirect interlocks.

Like the Sherman Act, the Clayton Act can be viewed as a political compromise.
Representatives of small business supported a law that specified that certain practices
were anticompetitive. In contrast, big business was particularly supportive of the FTC,
because it satisfied a long-standing desire for an administrative approach to antitrust
that would provide some certainty and consistency in enforcement.

The Clayton Act addresses the following practices:

a.
Section 3 prohibits tie-in sales, exclusive dealing and requirements contracts
where the effect “may be substantially to lessen competition or tend to create
a monopoly” in a relevant market.27
b.
Section 4 allows private plaintiffs to bring treble damages actions under the
Sherman Act and Clayton Act.28
c.
Section 6 exempts labor unions and agricultural cooperatives from the antitrust
laws.29
d.
Section 7 prohibits mergers and acquisitions where the effect “may be substantially
to lessen competition or tend to create a monopoly” in any relevant
market.30
e.
Section 8 prohibits interlocking directors of competing companies.31
Subsequent to 1914, the Clayton Act was amended several times. For example, the
Robinson-Patman Act32 of 1936 substantially amended section 2 to prohibit price discrimination
except in certain defined situations.33 The Celler-Kefauver34 Act of 1950
amended section 7 to close the loophole for “stock acquisitions” and generally tightened
the antimerger provisions.35 In 1976, a premerger reporting requirement was added
as section 7A.36 Finally, in 1990, section 8 was amended to prohibit both interlocking
directors and officers.37

The Federal Trade Commission Act created the FTC and gave it broad powers to
enforce the Sherman Act and the Clayton Act concurrent with the Department of Justice
(DOJ) and private parties. Section 5 of the Federal Trade Commission Act gave the
FTC exclusive authority to prosecute “unfair methods of competition” and “unfair or
deceptive acts or practices.”38 Section 5 has been subsequently interpreted to give the
FTC wide-ranging enforcement powers.

Antitrust Enforcement from World War I to World War II

Despite passage of the Clayton Act, prosecution of antitrust claims during the 1920s
was minimal. In the 1920s, business was encouraged to adopt “scientific management”
and to participate in trade associations that could provide industry data. The Supreme
Court curbed some abuses, but collaboration and mergers went largely unchecked.

INTRODUCTION TO THE ANTITRUST LAWS

During the Depression, the prominent theory of the collapse was excess competition. As
a result, during the first half of the New Deal, the National Recovery Administration
(NRA) organized business into industrial groups and suspended antitrust enforcement.
The views of Leon Henderson, the chief economist for the NRA, were typical of the
1920s. Henderson stated:

The Anti-Trust Acts are a throw-back to the Neolithic Age of statesmanship, and their blind
sponsorship is a sort of jittering caveman ignorance.39

By 1935, however, the NRA was under heavy criticism and was considered by many
to be unmanageable. That same year, the NRA was declared unconstitutional. Although
the economy certainly was not out of the Depression in 1935, the immediate emergency
situation was over, and the time was ripe for more conventional approaches. At the end
of the first New Deal, Franklin Roosevelt was tempted to reorganize industries using a
scheme similar to that of the NRA, but under private control in the tradition of trade
associations of the 1920s. However, he ultimately decided to return to vigorous antitrust
enforcement as a method to resolve price flexibility problems. The historian Herbert
Stein summarizes Roosevelt’s dramatic change in attitude as follows40:

At the same time many of the President’s advisors, even the “planners” among them, were
afraid of giving so much control to the businessmen [within new “private” codes]. The prevailing
view of this subject within the administration ran in the opposite direction—to take
steps to curb the “concentration of economic power.” Roosevelt went along with this to the
extent of sending Congress a special message on the subject in April, 1938. Congress
responded by setting up the Temporary National Economic Committee. . . .41

The Depression itself had a devastating effect on the traditional sector of industry.
The collapse of obsolete firms was a major factor in the long duration of the Depression,
but it also is important to stress the other side of the coin: that the Depression also was
an important event in the transition to a new economy dominated by large efficient
enterprises, both politically and institutionally. Without the rivalry of the traditional
small firms, the post–World War II period became an era of reevaluation and revamping
of the goals and objectives of the antitrust laws, and an increase in importance of
intellectual property.

THE GOALS OF THE ANTITRUST LAWS

In the post–World War II period, four competing goals of the antitrust laws emerged.
These goals include the need to protect simple businesses, to encourage allocative efficiency,
to prevent wealth transfers from buyers to sellers, and to encourage dynamic or
innovative efficiency.

PATENT INFRINGEMENT DAMAGES

Protection of Small Business

Many earlier antitrust opinions held that the antitrust laws should protect the independence
of small, often locally owned, businesses. In attempts to protect small businesses,
the courts and commentators alike have relied on various democratic rationales. For
example, in United States v. Trans-Missouri Freight Ass’n,42 the Supreme Court’s decision,
authored by Justice Peckham, stated that large firms and concentrated industries
were not in the substantial interest of the country or its citizens. The Court reasoned:

[I]t is not for the real prosperity of any country that such changes should occur which result
in transferring an independent business man, the head of his establishment, small though it
might be, into a mere servant or agent of a corporation for selling the commodities which he
once manufactured or dealt in, having no voice in shaping the business policy for the company
and bound to obey orders issued by others.43

In addition, many commentators have suggested that the concentration of wealth would
lead to the concentration of political power. Therefore, the argument goes, preservation
of small business protects the vitality of democracy.

Allocative Efficiency

The ascendant view of the goals of antitrust laws in the post–World War II period is that
antitrust laws are aimed at protecting consumers, not small business. It is conceivable
that this change may have been made possible by the destruction of the political power
of small business during the Depression. Nonetheless, once the interests of consumers
take center stage, microeconomics provides an elegant and powerful tool to analyze the
impact of corporate practices on consumer welfare. According to economists, consumer
welfare is maximized at the competitive price and output. Any price and output pair
other than the competitive price and output generates some “deadweight loss” to society.
This means that resources are not deployed to their highest valued use. Some
judges, including Judge Robert Bork and Judge Richard Posner, have prominently
advocated the view that the only viable goal of the antitrust laws is to maximize consumer
surplus.44

Wealth Transfers

The result of reducing prices from monopoly pricing to competitive pricing is twofold:
it increases consumer surplus and reduces monopoly profits. Lande has argued in
response to a pure consumer welfare goal that Congress, in passing various antitrust
laws, was more interested in preventing transfers of wealth from consumers to monopolies
than in increasing consumer surplus.45 The DOJ recognizes the need to protect
against the transfer of wealth from buyers to sellers and the misallocation of resources
as goals in its enforcement statements.46

INTRODUCTION TO THE ANTITRUST LAWS

Dynamic Efficiency or Innovation Efficiency

More recently, the antitrust agencies and the courts have recognized that innovation is
an important source of consumer welfare. Dynamic efficiency was discussed at length
in Chapter 3. As a result of new research on technological change, preventing conduct
that reduces competition for future innovation has become an object of antitrust
enforcement. The Intellectual Property Guidelines address concerns about innovation
efficiency by considering the impact of IP acquisitions and licensing on three types
of markets: (1) traditional “goods” markets, (2) “technology” markets that consist of IP
and their substitutes, and (3) “innovation” markets that consider the impact of conduct
on research and development activities.

ANTITRUST CLAIMS UNDER SECTION 1 OF THE SHERMAN ACT

This section summarizes the primary recognized violations of the antitrust laws. It is not
exhaustive, but instead is meant only as an introduction to be used by lawyers and
experts in IP cases to identify possible issues for further research.

Section 1 of the Sherman Act47 prohibits any “contract, combination...or conspiracy”
that creates an unreasonable restraint of trade.48 Intellectual property license often
involves horizontal restraints. These restraints can take the form of territorial divisions,
covenants not to compete, or other restrictions on competition between licensors and
licensees. Attorneys and experts must be careful not to allow such restraints, whether in
the form of a settlement to infringement litigation or a licensing arrangement to be
structured in a manner that violates section 1 of the Sherman Act.

A section 1 claim requires that two elements be proven. First, an agreement between
two or more persons must exist (“contract, combination, or conspiracy”). Second, the
agreement must involve an “unreasonable” restraint of trade.

An Agreement

An agreement requires either a meeting of the minds to accomplish some goal or the
coerced cooperation of several parties under the leadership of a ringleader. An agreement
can be demonstrated from either direct evidence or circumstantial evidence.
Circumstantial evidence requires such evidence “that tends to exclude the possibility
that the alleged conspirators acted independently.”49 In other words, circumstantial evidence
consistent with unilateral action is not sufficient to establish an illegal agreement.

Unilateral conduct cannot be a basis for a section 1 claim. This was made clear in
1987 by the Supreme Court in Copperweld Corp. v. Independence Tube Corp.50 There,
the Court stated that “Section 1 of the Sherman Act . . . reaches unreasonable restraints
of trade effected by a ‘contract, combination...or conspiracy’ between separate
entities, and does not reach conduct that is ‘wholly unilateral.’”51 The Court went on to

PATENT INFRINGEMENT DAMAGES

hold that wholly owned subsidiaries of a corporation cannot conspire for section 1 purposes.
52

Rule of Reason, Per Se, and Quick-Look Approaches to
Conduct Under Section 1 of the Sherman Act

Once an agreement has been demonstrated, it also must be shown that the restraint at
issue is unreasonable. An unreasonable restraint of trade can be established under the
per se test, the rule of reason test, or more recently the quick-look test. This is one of
the most difficult and controversial areas of antitrust jurisprudence, yet it is a critical
area for IP licensing and joint development.

Rule of Reason. It is arguable that the full-blown rule of reason approach was established
in 1918 by Justice Brandeis in Board of Trade of Chicago v. United States,53 as
opposed to being established in Standard Oil. Board of Trade of Chicago involved a
challenge to the Chicago Board of Trade’s call rule in which dealers agreed that grain
purchased after the trading session ended (in transit to Chicago) would be purchased at
the closing price. The case, however, is important not for its facts but for its method.
According to the majority decision authored by Justice Brandeis, a restraint on trade
violates section 1 of the Sherman Act when it suppresses or destroys competition as
opposed to merely regulating and perhaps promoting competition.54 To determine the
effect of a restraint, the Court mandated a full inquiry into the:

[F]acts peculiar to the business to which the restraint is applied, its condition before and after
the restraint was imposed; the nature of the restraint and its effect, actual or probable. The history
of the restraint, the evil believed to exist, the reason for adopting the particular remedy,
the purpose or end sought to be attained, are all relevant facts.55

The Court concluded that these factors were important because intent was relevant to
the analysis. Specifically, the Court stated that knowledge of intent may help the Court
to interpret facts and predict consequences.56 There is a simple efficiency explanation
for this rule. Large dealers had much better information about grain in transit and could
obtain better deals from small dealers after the trading session closed than they could
during the day when information was revealed during the bidding process. Justice
Brandeis came to the right conclusion, but he never clearly stated why.

Following the Board of Trade of Chicago opinion, the prevailing legal opinion was
that the rule of reason applied to all or most restraints of trade.57 The extent of the penetration
of the rule of reason analysis can be judged from the Supreme Court’s subsequent
1933 opinion in Appalachian Coals, Inc. v. United States.58 In Appalachian Coals,
the government challenged a classic cartel of coal producers that set prices for the sale
of coal through a single selling agency. This “selling agency” was formed in response
to the depressed conditions in the coal market due to oversupply and the eroding

INTRODUCTION TO THE ANTITRUST LAWS

demand resulting from the Depression. The plan was enjoined by the district court, but
the Supreme Court reversed, holding that the serious decline in the industry justified “an
honest effort to remove abuses, to make competition fairer, and thus to promote the
essential interests of commerce.”59 Thus, the Court applied the rule of reason and
upheld a restraint that was nothing more than a price-fixing scheme. The Court did this
on the grounds of preventing ruinous competition,60 an argument that had been consistently
rejected since the Supreme Court’s 1897 decision in the Trans-Missouri case. The
Appalachian Coals decision shows how strong the prevailing view—that the rule of
reason should be widely applied to horizontal restraints—was at that time.

The Rise of the Per Se Rule. The Supreme Court first articulated a per se rule for
price-fixing in 1927 in United States v. Trenton Potteries Co.61 Trenton Potteries upheld
a trial court opinion that a price-fixing scheme involving 82 percent of the market for
pottery fixtures for bathrooms and lavatories was conclusively unreasonable without a
rule of reason analysis and therefore illegal under the Sherman Act.62 In upholding the
lower court, the Supreme Court held that even if a cartel set a reasonable price today, it
is dangerous for the cartel to possess pricing power because that same reasonable price
may prove unreasonable in the future.63 Moreover, the Court reasoned that relying on a
judicial determination of what is reasonable independent of the competitive process is
a useless endeavor. The Court could have obtained the same result by contending that
the agreement was not ancillary to a contract with a lawful purpose. Instead, the Court
essentially held that price-fixing was per se illegal, ancillary or not.64

The tension between Trenton Potteries and Appalachian Coal was resolved by Justice
Douglas’s opinion in United States v. Socony-Vacuum Oil Co. Inc.65 Socony-Vacuum represents
the apex of per se condemnation. Socony-Vacuum involved a buying scheme that
impacted the spot price of gasoline. There was no direct price-fixing as in Trenton
Potteries. The spot price of gasoline impacted numerous contracts and had a dramatic
impact on overall prices. Under the NRA, which repealed the Sherman Act for approved
industry coordination, the petroleum industry had attempted to control the spot price of
gasoline. However, even after the repeal of the NRA, the petroleum industry continued
to try to prevent the decline of spot prices by establishing “dancing partners” between the
major oil producers and the independents. Under the plan, the majors would purchase
“distress” gas from independents, which provided a floor for the spot price. In now-
famous language, the Supreme Court struck down the scheme as per se illegal holding:

Under the Sherman Act a combination formed for the purpose and with the effect of raising,
depressing, fixing, pegging, or stabilizing the price of a commodity in interstate or foreign
commerce is illegal per se.66

The language of Socony-Vacuum is very broad. The Socony-Vacuum Court essentially
held that any horizontal constraint that impacts prices is presumed to be unreasonable

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per se.67 This abbreviated approach stands in stark contrast to the broad application of
the rule of reason approach announced in Board of Trade of Chicago.

Finally, the Supreme Court returned to articulating the per se rule in Northern Pacific
Railway Co. v. United States.68 Although the case was a tying case, the Court took the
opportunity to explain the rationale behind the per se approach:

However, there are certain agreements or practices which because of their pernicious effect
on competition and lack of any redeeming virtue are conclusively presumed to be unreasonable
and therefore illegal without elaborate inquiry as to the precise harm they have caused or
the business excuse for their use. This principle of per se unreasonableness not only makes
the type of restraints which are proscribed by the Sherman Act more certain to the benefit of
everyone concerned, but it also avoids the necessity for an incredibly complicated and prolonged
economic investigation. . . .69

To date, Socony-Vacuum and Northern Pacific are the most widely cited cases advocating
a broad application of the per se rule.

Recent Erosion of the Per Se Rule. The Supreme Court revisited the per se rule in
National Society of Professional Engineers v. United States.70 In National Society, the
association of engineers required as a condition of membership that its members not
discuss the question of fees until a client had selected an engineer. The United States
challenged the restriction as an agreement to suppress price competition. The engineers
disagreed, arguing that bidding to the lowest price could threaten public health and
safety. The district court rejected the defense, and the Court of Appeals affirmed. The
Supreme Court also affirmed, but indicated that, under some conditions, restrictions on
certain practices that impact competition might be reasonable.71 The Court went on to
state that only two categories of antitrust analysis exist. The first category involves
“agreements whose nature and necessary effect are so plainly anticompetitive that no
elaborate study of the industry is needed to establish their illegality—they are ‘illegal
per se.’”72 The Court identified these agreements as the proper province of the per se
rule. The second category includes “agreements whose competitive effect can only be
evaluated by analyzing the facts peculiar to the business, the history of the restraint, and
the reasons why it was imposed.”73 These agreements require treatment under the rule
of reason. The Court concluded, however, that a ban on competitive bidding fell within
the per se category.74

A year earlier, the Supreme Court had overturned the rule, announced in United
States v. Arnold Schwinn & Co.,75 that all vertical territorial restrains were per se illegal.
In Continental T.V., Inc. v. GTE Sylvania, Inc., the Court held that such restraints
would in the future be governed by the rule of reason.76 In the opinion, the Court recognized
that the rule of reason is the prevailing standard, and thus retreated from
Socony-Vacuum, stating:

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Since the early years of this century a judicial gloss on [Section I] has established the “rule of
reason” as the prevailing standard of analysis. Under this rule, the fact finder weighs all of the
circumstances of a case in deciding whether a restrictive practice should be prohibited as
imposing an unreasonable restraint on competition. Per se rules of illegality are appropriate
only when they relate to conduct that is manifestly anticompetitive.77

The Court went on to claim that the market impact of vertical restrictions “is complex
because of their potential for a simultaneous reduction of intrabrand competition and
stimulation of interbrand competition.”78 The Court further described the per se rule as
a “demanding standard” and made clear that any “departure from the rule of reason
standard must be based upon demonstratable economic effect rather than . . . upon formalistic
line drawing.”79 As a result, the court concluded that vertical nonprice
restraints are not an appropriate candidate for per se treatment.80

The Supreme Court further retreated from Socony-Vacuum in three cases involving
claims of horizontal price-fixing: Broadcast Music, Inc. v. Columbia Broadcasting
System, Inc. (BMI)81; Arizona v. Maricopa County Medical Society (Maricopa)82; and
NCAA v. Board of Regents of University of Oklahoma (NCAA)83. BMI followed
Sylvania’s assertion that the per se rule should be limited to restraints that are clearly or
manifestly anticompetitive. For years, BMI and its codefendant (ASCAP) represented
composers and holders of copyrights to musical works. Broadcast Music, Inc. offered
buyers a blanket license to all of its copyrighted works or a program license for a use
of all of its works for a specific program. Columbia Broadcasting System challenged
the license as per se price-fixing. Under Socony-Vacuum, there is no doubt that CBS
should have prevailed. Instead, however, the Court upheld BMI’s licensing plan. The
BMI Court introduced a two-step approach to analyzing horizontal restraints in the following
passage:

As generally used in the antitrust field, “price-fixing” is a shorthand way of describing certain
categories of business behavior to which the per se rule has been held applicable. The
Court of Appeals’ literal approach does not alone establish that this particular practice is one
of those types or that it is “plainly anticompetitive” and very likely without “redeeming
virtue.” Literalness is over simplistic and often over broad. When two partners set the price
of their goods or services they are literally “price-fixing,” but they are not per se in violation
of the Sherman Act.... Thus, it is necessary to characterize the challenged conduct as falling
within or without the category of behavior to which we apply the label “per se price-fixing.”
That will often, but not always be a simple matter....84

The BMI Court went on to hold that the horizontal price-fixing rule should not be
applied to the blanket copyright license at issue, because it “is not a naked restrain[t] of
trade with no purpose except stifling of competition, but rather accompanies the integration
of sales, monitoring, and enforcement against unauthorized copyright use.”85
The BMI opinion linked the concept of ancillary restraint to the effect of an agreement
that increased productive efficiency through integration. The Court deemed as signifi

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cant the fact that without the pricing limitation, it would not be possible to offer the
product itself.86

The Supreme Court’s decision in Maricopa is consistent with BMI, despite the fact
that it reached a different result. In Maricopa, the Court dealt with an arrangement in
which doctors in Arizona fixed maximum prices. The Court held that these maximum
price schedules were simply an invitation to set minimum prices and declared the agreement
per se illegal.87 The Court contrasted the arrangement among the independent
doctors with the efficiencies that would result from an integration such as a merger or
a joint venture:

If a clinic offers complete medical coverage for a flat fee, the cooperating doctors would have
the type of partnership arrangement in which a price-fixing agreement among the doctors
would be perfectly proper. But the fee agreements disclosed by the record in this case are
among independent competing entrepreneurs. They fit squarely into the horizontal price-fixing
mold.88

Accordingly, because no production efficiencies were created and because no new product
was developed, the Court held that the scheme was a naked constraint that was per
se illegal.89

The Supreme Court’s opinion in NCAA is also consistent with BMI and Maricopa. The
litigation involved a challenge to the NCAA plan that allocated rights to televise college
football games. The NCAA Court found that the plan prevented schools from conducting
separate price negotiations and artificially limited output.90 Nevertheless, the Court
rejected the per se approach because the “case involves an industry in which horizontal
restraints on competition are essential if the product is to be available at all.”91 The NCAA
Court then concluded that the restraint violated the Sherman Act because it was not truly
necessary for the production of the product, “college football.”92 Put differently, the Court
found potential production efficiencies from the NCAA joint venture, but the output
restriction at issue was not be shown to be linked to the attainment of these efficiencies.
Had this link been demonstrated, the Court likely would have approved the restraint.

In 1986, the Supreme Court again addressed the issue of per se treatment of a group
boycott in FTC v. Indiana Federation of Dentists.93 Briefly, the facts involved a joint
effort by Indiana dentists to resist insurance company requests for dental X rays as part
of the paperwork required for reimbursement. The Court stated as follows:

[W]e decline to resolve this case by forcing the Federation’s policy into the “boycott” pigeonhole
and invoking the per se rule. As we observed last term in Northwest Wholesale
Stationers, Inc. v. Pacific Stationary Printing Co., 472 U.S. 284, 105 S. Ct. 2613, 86 L.Ed.2d
202 (1985), the category of restraints clauses as group boycotts is not to be expanded indiscriminately,
and the per se approach has generally been limited to cases in which firms with
market power boycott suppliers or customers.... [W]e have been slow to . . . extend per se
analysis to restraints imposed in the context of business relationships where the economic
impact of certain practices is not immediately obvious....94

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The Court went on to condemn the dentists’ practice under the rule of reason.95

The Quick Look. The trend toward erosion of the per se rule has continued in the
Supreme Court. The NCAA, in particular, ushered in an approach to horizontal restraints
called the “structured rule of reason” or “quick look.”96 The quick-look approach is
applied when the Court is not sufficiently familiar with the specific fact pattern, yet the
conduct is suspicious enough that it could fall within a suspect per se category.97 Under
the quick look, the plaintiff need prove only that a restraint is a type of agreement that
is likely to have anticompetitive effects. After such a showing is made, the burden of
proof shifts to the defendant to demonstrate any procompetitive justification for the
restraint. If the defendant can make such a showing, then the analysis reverts to a full-
scale rule of reason analysis.

In California Dental Ass’n v. FTC,98 the Ninth Circuit used a quick-look analysis to
address a restraint by California dentists that limited advertising. The dentists’ argument
that the restraint prevented false advertising was rejected by the Ninth Circuit.99 On
appeal, the Supreme Court reversed, holding that “the Court of Appeals erred when it
held as a matter of law that quick look analysis was appropriate.”100 The Court
remanded the case, not for per se treatment, but for a full rule of reason analysis.101 In
addition, the Court concluded that there is “no categorical line to be drawn between
restraints that give rise to an intuitively obvious inference of anticompetitive effect and
those that call for more detailed treatment. What is required, rather, is an enquiry meant
for the case, looking to the circumstances, details, and logic of a restraint.”102 “The truth
is that our categories of analysis of anticompetitive effect are less fixed than terms like
per se, quick look, and rule of reason tend to make them appear.”103 The Court, therefore,
pushed even farther away from perfunctory per se condemnation toward the
approach used in Chicago Board of Trade.

In the dissent, Justice Breyer agreed with the majority that a rule of reason approach
was appropriate but sought to provide guidance and structure to the analysis. To this
end, he set forth an approach to horizontal restraints that many commentators believe
probably will be adopted by courts in the future:

I would break that question down into four classical, subsidiary antitrust questions: (1) What
is the specific restraint at issue? (2) What are its likely anticompetitive effects? (3) Are there
offsetting competitive justifications? (4) Do the parties have sufficient market power to make
a difference?104

The Views of the Federal Antitrust Enforcement Agencies. Both the FTC and the
DOJ (collectively, the Agencies) have specifically rejected a strict per se approach in all
but the most narrow of circumstances.

In the Department of Justice Antitrust Enforcement Guidelines for International
Operations, the DOJ adopted an approach where the per se rule was restricted to

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“restraint[s] that [are] inherently likely to restrict output or raise price and [are] not
plausibly related to some form of economic integration (by contract or otherwise) of the
parties’ operations that in general may generate procompetitive efficiencies.”105 More
recently, in 1996, then Assistant Attorney General Joel Klein unveiled the DOJ’s “stepwise”
approach for review of horizontal restraints.106 Under the stepwise approach, the
DOJ first determines whether the restraint clearly falls within a per se category. When
determining whether an agreement should be subject to per se treatment, the DOJ looks
to see whether the agreement is ancillary and necessary for accomplishing a lawful
agreement. If the agreement is not ancillary, the inquiry ends. If the restraint is ancillary,
then the DOJ further inquires into whether there is a procompetitive justification.
If there is, then the DOJ will determine whether such procompetitive benefits outweigh
any anticompetitive effects. Interestingly, Klein specifically criticized the Topco decision
for ignoring the clear procompetitive effects that resulted from the private label
program. Such efficiencies would have removed the restraint from per se scrutiny by
the DOJ. William Kolasky, the deputy to the current Assistant Attorney General Charles
James, responded to the DOJ’s stepwise approach in an article, published in Antitrust
Magazine, contending that it misplaces the burden on defendants to show efficiencies
in the second step.107 Kolasky’s article may or may not be indicative of the current DOJ
position after Klein’s departure.

The recent United States Department of Justice and Federal Trade Commission
Antitrust Guidelines for Collaborations Among Competitors (Joint Venture Guidelines)
also counsel that the Agencies will consider efficiencies prior to condemning a restraint
as per se:

If, however, participants in an efficiency-enhancing integration of economic activity enter into
an agreement that is reasonably related to the integration and reasonably necessary to achieve
its procompetitive benefits, the Agencies analyze the agreement under the rule of reason, even
if it is of a type that might be considered per se illegal.108

In the FTC’s 1988 decision, In re Massachusetts Board of Registration in Optometry,
the FTC rejected the per se rule of reason dichotomy and replaced it with a three-step
decision analysis. The FTC stated:

First, we ask whether the restraint is “inherently suspect.” In other words, is the practice the
kind that appears likely, absent an efficiency justification, to “restraint competition and reduce
output?”. . . If the restraint is not inherently suspect, then the traditional rule of reason, with
attendant issues of definition and power, must be employed. But if it is inherently suspect, we
must pose a second question: Is there a plausible efficiency justification for the practice? That
is, does the practice seem capable of creating or enhancing competition (e.g., by reducing the
costs of producing or marketing the product, creating a new product, or improving the operation
of the market)? Such an efficiency defense is plausible if it cannot be rejected without
extensive factual inquiry. If it is not plausible, then the restraint can be quickly condemned.
But if the efficiency justification is plausible, further inquiry—a third inquiry—is needed to

INTRODUCTION TO THE ANTITRUST LAWS

determine whether the justification is really valid. If it is, it must be assessed under the full
balancing test of the rule of reason. But if the justification is, on examination, not valid, then
the practice is unreasonable and unlawful under the rule of reason without further inquiry—
there are no likely benefits to offset the threat to competition.109

Former chairman Pitofsky has contended that the per se approach still exists, but
only for restraints that both are “naked” and have no efficiency justification.110
Nonetheless, the FTC’s Massachusetts Board decision still provides insight into how
the FTC approaches the characterization of horizontal restraints.

Types of Conduct That Can Be Per Se Illegal
Under Section 1 of the Sherman Act

The potential per se categories of conduct include price-fixing (and bid-rigging), market
allocation, group boycotts, minimum resale price maintenance, and tying. Because
price-fixing has been discussed in the context of the development of the per se rule, we
begin our discussion with market allocation.

Market Allocation. Intellectual property licenses have sometimes been viewed as a
vehicle to divide territories or customers. As a result, it is important to understand the
characterization problem in connection with market allocation. In an early case,
National Ass’n of Window Glass Manufacturers v. United States, Justice Holmes actually
upheld an agreement among makers of handblown glass to operate only during half
the year.111 The purpose of the agreement was to allocate scarce labor between the factories.
112 Justice Holmes applied the full-blown rule of reason approach of Chicago
Board of Trade to uphold the agreement on the grounds that the industry could not survive
without it, and massive unemployment would result.113

Subsequent to Window Glass Manufacturers, the Supreme Court decided the Socony-
Vacuum case. In 1951, the Court had an opportunity to clarify its view on how to treat
horizontal market allocation in Timken Roller Bearing Co. v. United States.114 In
Timken, the government charged that Timken, British Timken, and French Timken
restrained trade in the sale of antifriction bearings. The parties had allocated territories
among themselves and attempted to fix prices on the products whenever one firm sold
in the territory of another firm. Timken defended its restraints as reasonable, arguing
that they were ancillary to a joint venture between the parties that was organized to
exploit the Timken trademark. The Supreme Court rejected this argument, holding that
the “dominant purpose for the restrictive agreements . . . was to avoid all competition.”
115 With respect to the trademark defense, the Court found that the parties had
gone far beyond what was necessary for trademark protection.116 Nevertheless, the
Court did not explicitly condemn the market allocation as per se illegal.

In 1966, the Supreme Court again addressed the post–Socony-Vacuum characterization
of market allocation in United States v. General Motors Corp.117 This case

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involved General Motors’ “location clauses” contained in their dealer agreements that
prohibited a dealer from moving to or establishing “a new or different location.” Dealer
associations policed the agreements to prevent discounters. The Court struck down the
agreements as per se illegal on the grounds that the dealers were openly cooperating to
prevent discounters.118

Similarly, United States v. Sealy, Inc.119 involved an agreement among mattress manufacturers
that created mutually exclusive territories. Sealy retailers themselves monitored
and enforced agreements that set exclusive territories, retail prices, advertised
prices, and other terms of sale. The Court found concerning these practices that “[t]heir
anticompetitive nature and effect are so apparent and so serious that the courts will not
pause to assess them in light of the rule of reason.”120 As in Timken Roller, the Court
rejected Sealy’s defense that the territorial allocation was ancillary to the use of the
Sealy trademark.121

United States v. Topco Associates, Inc.122 was the first case before the Court in which
horizontal market division was presented in its pure form. The facts of the case were
that 25 small regional supermarkets (with market shares all below 10 percent) formed
Topco, a cooperative, to distribute to its members “private label” brand-name products.
Topco argued that this was required if its members were to compete successfully with
large chain stores, such as A&P, that had their own brands. The agreement between the
members contained an ancillary restraint that Topco private label products could only
be sold in the geographic area assigned to it by Topco. Citing Northern Pacific, Justice
Marshall wrote that “[o]ne of the classic examples of a per se violation of § 1 is an
agreement between competitors at the same level of the market structure to allocate territories
in order to minimize competition....We think that it is clear that the restraint
in this case is a horizontal one, and, therefore, a per se violation of § 1.123 As discussed
below, Topco is inconsistent with subsequent Supreme Court precedent and has been
widely criticized, although it has not been overruled.124

Since Topco, and following the precedent in BMI, Maricopa, Sylvania, and NCAA,
lower courts that have addressed horizontal market allocation have advocated a flexible,
non–per se approach.125 The three most important cases from the appellate courts
addressing division of territories are: (1) General Leaseways, Inc. v. National Truck
Leasing Ass’n (General Leaseways)126; (2) Polk Bros., Inc. v. Forest City Enterprises,
Inc. (Polk)127; and (3) Rothery Storage & Van Co. v. Atlas Van Lines, Inc. (Rothery
Storage)128. Each of these cases suggests that the application of the per se rule must
take into account possible efficiencies that may result from, and justify, any transaction
at issue.

In General Leaseways, Judge Posner recognized the per se rule expressed by Topco,
Sealy, and Timken, but indicated that the rule should not apply where the defendants
establish that their agreement facilitates market efficiencies. The defendants in General
Leaseways consisted of 130 competing trucking companies that had agreed not to operate
their leasing or repair businesses within certain designated territories. The agree

INTRODUCTION TO THE ANTITRUST LAWS

ment also contained a provision that required that participants perform emergency
repairs on each others’ trucks if the trucks happened to break down in their territories,
such repairs being subject to reimbursement from the other party. The Seventh Circuit
examined the possibility that the agreement contributed to certain economic efficiencies,
but it concluded that the territorial division was broader than necessary (i.e., not
the least restrictive means) to achieve the legitimate purpose of creating a nationwide
system of truck repairs, and therefore was per se illegal.129 However, by analyzing the
relationship between the per se rule and the alleged efficiencies of horizontal restraints,
the court indicated that the per se rule could not be applied without examining potential
economic efficiencies.130

Judge Posner even suggested that a division of geographic markets might have been
justified in Topco if Topco had established that its program would have prevented a market
inefficiency such as a free-rider problem (i.e., one grocer benefiting unfairly from
the promotional investment made by another grocer in a particular market).131
Regardless of whether the facts of Topco support that analysis, Judge Posner’s introduction
of efficiency considerations into the per se characterization problem undercuts
the simplified approach of merely classifying a type of transaction as a horizontal market
allocation once it is “alleged” and then declaring it per se illegal. Accordingly, Judge
Posner artfully constructed his analysis to be consistent with BMI, Maricopa, and
NCAA, indicating that those cases might best be explained by the “enormous efficiency”
of the arrangements involved therein and the need for those arrangements in order to
attain the efficiencies.132

In Polk, the Seventh Circuit addressed how to characterize market allocation after
BMI, Maricopa, and NCAA. The case involved two stores that agreed to share a single
building for the sale of their complementary products (lumber/hardware and home
appliances). The two companies also contracted not to sell competing products at that
store location. Although the arrangement was construed as a horizontal allocation of
market and customers, the Polk court examined the market effects of the agreement
rather than characterizing it as per se illegal.133 It held that if an agreement arguably
“promoted enterprise and productivity at the time it was adopted,” then the rule of reason
must be applied to distinguish legitimate competition from anticompetitive
effects.”134 Moreover, the Polk court noted that per se characterization is an unusual
step that should apply only to classic naked restraints, not ancillary restraints contributing
to “productivity through integration of efforts.”135 The court concluded that the
noncompetition provisions between the parties were necessary for “productive cooperation,”
or production efficiencies, and that consumers would benefit from the arrangement.
136 Accordingly, the court held that the per se rule did not apply to the agreement
at issue and ruled in favor of the defendants.137

The last important post-Topco market decision case (prior to Palmer, which is discussed
next) is Rothery Storage. In that case, Judge Bork (of the District of Columbia
Circuit Court) emphasized the inconsistency between Topco and subsequent Supreme

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Court decisions, stating: “[R]ecent Supreme Court decisions... demonstrate[] . . . that,
to the extent Topco and Sealy stand for the proposition that all horizontal restraints are
illegal per se, they must be regarded as effectively overruled.”138 Rothery Storage concerned
a challenge to the Atlas network’s policy of terminating its agents (independent
moving companies throughout the country) that persisted in handling interstate carriage
on its own account as well as for Atlas as a group boycott. The Rothery Storage court
held that the restraints at issue were ancillary to the joint venture that constituted the
Atlas van line.139 In rejecting application of the per se rule, the court stated that “[t]he
restraints preserve the efficiencies of the nationwide van line by eliminating the problem
of the free ride.”140 The free-rider argument referred to the market efficiencies that
result from preventing these agents from benefiting from Atlas’s training, services, and
equipment without paying Atlas anything.

The court also rejected the per se rule because, after evaluating the specific facts, it
appeared that there was no possibility that the restraints could suppress market competition
or decrease output.141 The facts showed that Atlas had less than 6 percent of the
relevant market and therefore lacked the market power to impact market prices through
decreasing output.142 In addition, the Rothery Storage court ruled that a joint venture
made more efficient through ancillary restraints was equivalent to a corporate merger
and therefore should be evaluated under the rule of reason used in section 2 cases.143

Despite the opportunity to do so in its 1990 decision Palmer v. BRG of Georgia,
Inc.,144 the Supreme Court did not validate the erosion of Topco and the per se rule. In
Palmer, two competing companies offering bar review courses and related materials
entered into a noncompetition agreement for certain territorie,s. Part of the agreement
provided for one company to license its material and well-known name to the other
company for use in Georgia in exchange for a share of the resulting revenue. The two
companies argued that the noncompetition provisions were reasonable and were merely
ancillary to the IP license. Notwithstanding this argument, the Court found that the
revenue-sharing formula, particularly viewed in light of the price increase that took
place immediately after the licensor withdrew (as per the agreement) from Georgia,
established that the agreement was formed for the illegal purpose of raising prices and
thus constituted a per se violation.145

Group Boycotts. Another area in which antitrust law is applied to IP is concerted
refusals to deal or group boycotts. Boycotts can arise from certain patent pools and
cross-licensing agreements. Some types of group boycott and concerted refusals to deal
have been held to be per se illegal.146 For instance, in Klor’s, Inc. v. Broadway-Hale
Stores, Inc. (Klor’s), a large San Francisco department store, Broadway-Hale, secured
the agreement of several appliance manufacturers to boycott Klor’s, a small competitor
next door. Broadway defended on the grounds that even if Klor’s closed, it would not
impact competitors. The Supreme Court held that because the boycott was horizontal
and concerted, no analysis of competition was required.147 Earlier, in Fashion

INTRODUCTION TO THE ANTITRUST LAWS

Originators’ Guild of America v. FTC (Fashion Originators), the Supreme Court struck
down an effort by the Fashion Originators’ Guild to boycott retailers who sold copies of
the guild members’ “original creations.” The Court noted that the guild had market
power and engaged in activities beyond what could be justified by the control of copying.
148 The Court therefore held the boycott to be illegal.149 Radiant Burners, Inc. v.
Peoples Gas Light and Coke Co. involved a boycott in a standard-setting situation. In
that case, the Supreme Court determined that an agreement among gas companies to sell
natural gas only to customers using equipment approved by an industry organization
comprised of manufacturers of such equipment to be per se illegal.150

Not all boycott cases are per se cases. Generally, the cases in which the Supreme
Court has applied the per se rule to group boycotts typically have involved two types of
situations. In the first type of situation, a group of sellers or buyers refuses to allow a
competitor to participate in a trade association or other type of cooperative. In such
cases, the Court generally has held that per se treatment is reserved for cases where “the
cooperative possesses market power, or exclusive access to an element essential to
effective competition.”151 The second type of situation in which the Supreme Court typically
applies the per se rule involves a group of sellers boycotting customers to enforce
a price-fixing cartel. For example, in Federal Trade Commission v. Superior Court Trial
Lawyers Association,152 the Court held that an agreement by members of the Superior
Court Trial Lawyers Association to refuse representation to indigent criminal defendants
until the District of Columbia increased their compensation was subject to analysis
under the per se rules.153 The Court stated that the conduct involved “not only a
boycott but was also a horizontal price-fixing agreement—a type of conspiracy that
has been consistently analyzed as a per se violation for many decades.”154 In contrast,
in situations in which market power is not present or where important efficiencies can
be claimed as a result of the boycott, the Supreme Court has applied a rule of reason
approach.155