VirnetX's Royalty Triumph Is Excellent News

Mar.10.14 | About: VirnetX Holding (VHC)

Summary

Judge Davis’ 2/25/14 Court Order regarding the .98% ongoing royalty rate is nothing but positive for VirnetX.

Recent articles from investors short VHC have obfuscated the upside.

Key points in these developments require clarity that I will try to deliver in this article.

Opening:

There have been varying opinions with regard to VirnetX's recent developments. An article regarding Apple's (NASDAQ:AAPL) appeal with regard to VirnetX (NYSEMKT:VHC) has ignited confusion as to what is really going on. I believe there is a disconnect in the marketplace - positive news being smothered by timely "coincidental" articles published by investors short VHC. The public needn't misunderstand the Judge Davis' recent Order - which is nearly the last step towards finality of a positive outcome for VirnetX and its shareholders.

The Judge's Ordered Rate Doubles the Jury's Award:

Judge Davis assigned a 0.98% ongoing royalty rate "to adjudicated products and products not colorably different from those adjudicated at trial, including but not limited to the iPhone 5, iPod Touch 5th Generation, iPad 4th Generation, and the iPad Mini." Estimates for 2013 alone equal a very healthy $341.3 Million for VirnetX. This Order is major news for investors in VirnetX and is a serious victory for the company. 2014 estimates by J.P. Moreno ring in at $800 Million pre-tax for offending iOS products.

Here is the conclusion to the Judge's order:

Accordingly, for the foregoing reasons, VirnetX's Motion to Set an Ongoing Royalty Rate is GRANTED IN PART and DENIED IN PART. Apple shall pay VirnetX an ongoing royalty of 0.98% on adjudicated products and products not colorably different from those adjudicated at trial that incorporate any of the FaceTime or VPN On Demand features found to infringe at trial. The Clerk is directed to close Cause No. 6:13-cv-211.

VirnetX Filed An 8K With No Legal Document. Here's why

There was some confusion as to why VirnetX filed an 8-K with no physical order attached from the judge. This was due to the fact that VirnetX has to disclose material events to shareholders within a set number of business days. As the case ended on 2/25/14, VirnetX had to disclose this event to shareholders within 4 business days (Monday, March 3, 2014 and they did so. PACER (Public Access to Court Electronic Records) only allowed public access to the Judge's order several days later.

(Source)

The parties petitioned the court to unseal and redact the order before making it available to the public. Judge Davis swiftly accepted the redacted order request, with the addition of keeping an un-redacted version on file with the court. With that, the order came online and is available for the viewing pleasure of all.

(Source)

Why Apple Hasn't Implemented A Workaround:

Why hasn't Apple implemented a viable workaround? The proposed relay server workaround proposed by Apple has been very time consuming in implementation, much more expensive than was first represented in court, and created a firestorm of negative comments with customer service during testing.

Many investors in VirnetX knew that Apple was misrepresenting their workaround claims back on the 8/15 hearing. Those that bet that the Judge would not catch on were very wrong.

"Apple grossly misrepresented its ability to implement a non-infringing alternative to the jury. The huge disparity between Apple's position at trial and Apple's position post-judgment also warrants increasing the implied royalty rate." (Order Except)

Judge Davis' order is worth a very close read, as it is abundantly clear that he not only knows Apple's technology infringes - he slammed them for their tactics as well. He is also well aware that Apple's proposed workaround is not the answer, and does not relieve them of infringement.

Intelligent investors in VirnetX have done a huge amount of due diligence on the company, and this is the end result they were hoping for. This order removes a considerable amount of risk from the investment as appeals are ordinary in nature, while achieving a triumphant victory is proof positive for VirnetX.

When looking back to one of my more comprehensive reports covering VirnetX, this order is a cornerstone that investors were waiting for. Keep in mind that we are still awaiting the Cisco (NASDAQ:CSCO) judgment on a retrial or JMOL on the '759 - although that is a high mark to reach.

Nash Bargaining Solution and Entire Market Rule:

It is not my intention to argue with other authors, just to point out when information is not as clear as it should be. Shares of VirnetX fell yesterday in the face of the good news available - news that will hopefully be cleared up with this update article. First off, there was some confusion surrounding the use of the Nash Bargaining Solution or NBS at the CAFC oral hearing. In the recent article on VirnetX, the below quote is not as accurate as it should be.

"Judge Randall Rader has been publicly stating, at conferences, and in interviews, that he intends to end abusive misuse of Nash Bargaining Solution (NBS) and the Entire Market Value "Rule." (Article excerpt)

There is nothing definitive that Judge Rader has stated that says anything along these lines. The linked interview makes no mention of the Nash Bargaining Solution and the discussion surrounding the entire market simply states what evidence he likes to see when that theory is presented. The author of the article puts Judge Rader in the position that the judge said that he intends to end the use of NBS. Although any attorney would tell you that the Judge taking a position prior to the CAFC trial would signify an advanced bias in the case - and as such Judge Rader could be impeached or removed from the bench from having such a strong bias prior to the appeal.

CAFC Oral Hearing: March 3, 2014:

The article that I am referring to includes questions which I feel are taken out of context and do not reveal VirnetX's attorney's responses. Mr. Farmwald does not include the quote directly related to the discussion regarding the "alleged bad jury instruction" and how VHC rebutted this stating the jury was not provided with the entire market royalty base. Even if the entire market analysis is bad and the judge doesn't like it, VirnetX's expert did not use this theory in his calculations, he used the smallest saleable unit approach. Apple's lawyers have been polluting the waters on this issue since their first Daubert motion on damages. Judge Davis has seen through this pollution and I have every confidence that the CAFC panel will realize this is the case once they review the documents.

"Given all of this questioning, as well as the other legal errors not discussed in the oral hearing, but described in the written filing, I would estimate the probability of at least a 90% chance that the Fed Circuit will reverse on damages. There is also a high likelihood of significant reversals on the Markman, and related issues. My best guess here is greater than 50%." (Article)

The Markman issues were not a major concern at the hearing. Coming to a conclusion of 50% odds is a stretch. The 90% estimate is arbitrary. Historically, the rate of overturning a jury verdict on appeal is roughly 10%. It appears that Mr. Farmwald's numbers are speculative and not based upon fact. Also, with regard to Judge Davis' past, in researching Judge Davis' past work, one could undoubtedly find that he is fair and accurate with an impeccable reputation in the legal community. Given that the author has a PhD in Computer Science, I'm not sure why he feels comfortable in opining on legal errors. Also, Judge Davis' record on Markman terms surviving CAFC appeals is stellar.

"Any reversals would most likely result in a remand for new trial, with the district judge deciding on possible summary judgments or a new trial." (Article)

In the case of a reversal, the CAFC would remand the case to the EDTX with instructions on how to conduct the case differently. There would not be a retrial, with a new judge, in random vicinity that is implied above.

The Discussion In Inter Partes Reviews:

The discussion surrounding IPRs is one of the largest problems with the recently published article on VirnetX and Apple . After following RPX's, New Bay's and Apple's IPR's against VirnetX's patents quite closely, this section of his article was a major red flag.

"RPX has filed petitions for Inter Partes Reviews (IPRs) against the patents asserted in this case (VirnetX, Inc. v. Cisco Systems, Inc.)" (Article)

I would like to point out that these petitions, by RPX, were filed only a few days after New Bay's IPRs were dismissed. Many assumed Apple needed a party to file IPRs which they could join as there IPR's were over the year limit. This was just my opinion, although Apple's were thrown out for being over the one year time limit.

"VirnetX is doing everything possible to stop or delay this process, including filing subpoenas in the Eastern District of Texas." (Article)

A subpoena in EDTX does not delay the IPR process. VirnetX solely asked for documents to be produced, this does not in any way impede the IPR process. Moreover, it was RPX which is fighting to quash the subpoena order to delay the discovery process.

"Given that there is a process for such discovery at the patent office, I find it interesting that VirnetX is trying to get around the patent office process and instead wants to use subpoenas issued from an unrelated court case against an unrelated party - the Magistrate in the request to quash the subpoena made this exact observation during the hearing in San Francisco on February 26, 2014." (Article)

New Bay Capital offered the same argument and lost in late 2013. Secondly, the EDTX subpoena is relevant because if RPX has any privity with Apple of Microsoft then it is game over since collateral estoppel applies. Also, the discovery process at the USTPO is very narrow and strict. In federal district court it is very broad, VHC is pursuing it there to be able to get as much information as possible in order to narrow in on whether RPX is connected to Microsoft or Apple. At the end of the day, the EDTX subpoenas do not delay or hinder the IPRs in anyway. In closing, VirnetX is not afraid of the IPR process as they have a strong position.

"As a practical matter VirnetX will probably not sue any additional large companies prior to resolving its dispute with Apple - any new lawsuit would likely lead to the immediate filing of IPRs to invalidate the asserted patents, with (almost certainly) a two year stay of any new litigation while the IPRs are in process, and a very high probability of the patents being invalidated." (Article)

Incorrect statements can spread misinformation surrounding a company. In the above except, taken from the recent article, there are two incorrect statements. First in line is that a two year stay of litigation is just an arbitrary number. Microsoft (NASDAQ:MSFT), Cisco and Apple all tried to stay their litigation with VirnetX pending the IPR process and they all failed.

Secondly, VirnetX's patents have never been invalidated at trial. Let us not forget the numerous settlements VirnetX has under their belt with Siemens (SI), NEC, Aastra (OTC:AATSF), Avaya (AVYA), Mitel (NASDAQ:MITL) and Microsoft. Also the company's major win against Apple two Novembers ago to the tune of $368M that has grown to north of $440M.

"This is why VirnetX has sued Apple and Microsoft repeatedly instead of suing new companies." (Article)

The only reason VirnetX sued Apple a second time was due to the fact that Apple put out newer products that were not covered in the first trial. VirnetX sued Microsoft a second time because Microsoft purchased Skype and this application was not covered by VirnetX's original settlement with Microsoft. VirnetX has real reasons for initiating these steps and taking them out of context does not tell the entire story.

Confusion That Needs Clarity:

There are numerous confusing opinions circulating on Twitter. Some are of the opinion that Judge Rader is against Judge Davis. Although this is not true, if you listen to the end of the Fractus v. Samsung (OTC:SSNLF) oral argument, Judge Rader boasts that the parties are lucky to have Judge Davis as he is one of the finest patent judges in the U.S. Keep in mind his reversal percentage is in the low single digits.

Some have brought out Apple's August 15th hearing when Apple's attorney stated that:

"Apple continues to look at other designs (FOR) FaceTime and VPN on Demand".

Let's keep in mind that Apple has still failed to implement and viable workarounds. Data at this hearing demonstrated that the FaceTime workaround was not feasible due to the long term costs, not being as reliable and over 500,000 complaints filed.

Some investors have also stated that the iPhone 5 could have a design around that could make it colorably different and not subject to any royalty rate at all. Although, the workaround is not in the device design, it would have to be in the software, in the iOS. Apple has stated that they have been attempting a work around for several years and they have never implemented one. As per the Judge's order, the royalty rate applies to any devices that use FaceTime or Secure VPN on Demand, what version does not matter.

Lastly, some investors have brought up that the CAFC will lower the "base" of the royalty rate. In reality, the CAFC does not have the authority to do so. They can either reverse the verdict or remand the case with instructions to revise the jury instructions in a new damages trial. They cannot instruct a rule on what the amount should be. This is a question of fact and the CAFC is not the trier of facts. If they were, then there would never be a point to a trial because you could get a new second shot on an appeal.

Further, the base is based off of the base that was argued at the 8/15 conference. This base is roughly $600 per iPhone - being the cost of the devices. The "base" that the judges were discussing at the CAFC was the "entire market base" which the jury was never told about anyway - so no problem here.

Judge Davis' Take On Some CAFC Hot Topics:

There are a few topics at play at the CAFC between Apple and VirnetX that can be given more perspective if we look at Judge Davis' final order in VirnetX's first legal victory over Apple.

Apple has argued that VirnetX's alternative damages theories are not supported by the evidence. A quick look to the final judgment in VirnetX's first legal victory over Apple demonstrates a much different picture. Judge Davis states that there is ample evidence to support VirnetX's alternative damages theory.

Mr. Weinstein adequately supported his alternative damages theory. First, he calculated the contribution of the "FaceTime" feature to Apple's total profits by estimating the price differential between the accused product and the last previous version of the product not capable of supporting the feature. 11/01/12 p.m. TT at 143:13-144:17; 219:1-6. Mr. Weinstein then reduced this revenue by the percentage of the revenue associated with the addition of the "FaceTime" feature. In this analysis, Mr. Weinstein relied on the price of the camera, because the addition of the camera enabled the feature. See 11/01/12 p.m. TT at 215:18-22. Additionally, Mr. Weinstein accounted for the 45%-55% profit split in his analysis, explaining that VirnetX would have been in a weaker bargaining position at the time of the negotiation because of its financial situation.9 benefitted from this inequity in bargaining positions, and Mr. Weinstein modified the profit split to reflect this. Contrary to Apple's assertions, VirnetX did provide substantial evidence to supports its alternative damages theory. (Bold For Emphasis, Source)

This alternative theory is the Nash Bargaining Solution. NBS has resurfaced due to the recent CAFC appeal between the two parties as a hot topic, but even Judge Davis backed the use of NBS in his courtroom.

Another issue raised is at the CAFC is that the court made a mistake regarding instructions to the jury about the royalty base it could consider when awarding damages. Some point to the royalty base as an area of weakness, but they could be wrong.

At trial, the Judge gave the following instructions to the jury:

In determining a royalty base, you should not use the value of an entire apparatus or product unless either: (1) the patented feature creates the basis for customers' demand for the product, or the patented feature substantially creates the value of the other component parts of the product; or (2) the product in question constitutes the smallest saleable unit containing the patented feature.

Apple's main argument at trial was that this instruction allowed the jury to consider the entire value of the accused devices without complying with the entire market value. Judge Davis explains why the court did not error in its jury instructions regarding the royalty base

In this instance, the Court's instruction was not erroneous. While Apple is correct that the entire market value rule when applied requires a showing by plaintiff that the patented feature either drove demand for the entire product or substantially created the value of the component parts, the Court's instruction explained another alternative when the jury could consider the entire value of a product. There are instances when the smallest saleable patent-practicing unit is the entire product. Depending on the claim language of a patent, it is foreseeable that an entire product is required to practice the invention. See Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538, 1550 ("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. Our precedent has not extended liability to include items that have essentially no functional relationship to the patented invention and that may have been sold with an infringing device only as a matter of convenience or business advantage."). Accordingly, the Court's instruction to the jury was proper. (Bold for emphasis, Source)

Conclusion

Everyone should do his or her due diligence and research facts before making any changes when it comes to investing. The risk/reward ratio has never been more favorable for VirnetX. Investors are always reminded to understand the risks involved with these forms of complex investments. Once the market receives a clear understanding of the favorable ruling that has just occurred the share price of VHC stock should rebound and then trend higher.

Disclosure: I am long VHC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. This article is informational and in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades.