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Summary

  • No error regarding Entire Market Value Rule.
  • No error regarding Nash Bargaining System.
  • No error in jury instructions.

Apple (NASDAQ:AAPL) vs. VirnetX (NYSEMKT:VHC) Appeal

I have reviewed both the appellant and appellee briefs and have conducted my own legal research regarding the issues under review in the Apple v. VirnetX appeal pending before Federal Circuit. At trial, VirnetX was awarded slightly more than $368 million of money damages plus interest as compensation for Apple infringing Patent Nos. 135, 151, 211, and 504. (Hereinafter, I will refer to all four of the aforementioned patents as the "Patents.") There are five broad issues on appeal:

(1) Are the Patents valid?

(2) Is there substantial evidence that Apple infringed the Patents?

(3) Did Judge Davis abuse his discretion in excluding evidence of the Patent and Trademark Office's ("PTO") interim administrative action rejecting the Patents, and did such abuse of discretion substantially prejudice Apple's ability to present its case?

(4) Did Judge Davis abuse his discretion by allowing VirnetX's expert witness testimony?

(5) Did Judge Davis improperly instruct the jury on how to calculate damages payable by Apple?

The first two issues are highly technical and I will leave their analysis to another commentator. Here are my thoughts regarding the final three issues on appeal:

(3) Exclusion of Evidence of Interim Administrative Action. Apple claims Judge Davis abused his discretion in excluding evidence that the PTO administratively rejected the Patents on an interim basis. A federal trial judge may exclude evidence if its probative value is substantially outweighed by a danger of unfair prejudice, confusing the issues, misleading the jury, undue delay, wasting time, or needlessly presenting cumulative evidence. Federal Rule of Evidence 403. The Federal Circuit will reverse and remand for a new trial regarding this issue if Judge Davis abused his discretion in excluding this evidence, and such exclusion substantially prejudiced Apple's ability to present its case. Bose v. JBL, 274 F.3d 1354, 1360 (Fed. Cir. 2001); Wellogix v. Accenture, 716 F.3d 867, 882 (5th Cir. 2013).

Apple fails on both points here. First, there is clear Federal Circuit authority that excluding non-final administrative action regarding a patent is not an abuse of a trial judge's discretion. SynQor v. Artesyn Techs., 709 F.3d 1365, 1380 (Fed. Cir. 2013). Second, Apple cannot show any prejudice to presenting its case because it was not prevented from presenting any of the evidence it presented to the PTO that supported the interim action by the PTO. Consequently, the Federal Circuit will affirm Judge Davis on this point.

(4) Expert Witness Testimony and Other Evidence Supporting Damages. Apple claims Judge Davis abused his discretion in permitting VirnetX to present Roy Weinstein's expert testimony as to the amount of damages payable by Apple. A trial judge may allow an expert witness to testify in the form of an opinion if: ... "(NYSE:C) the testimony is the product of reliable principles and methods; and (NYSE:D) the expert reliably applies such principals and methods to the facts of the case. Federal Rules of Evidence 702. The trial court must ensure that any scientific testimony is relevant and reliable." Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 589-90 (1993); see also Kumho Tire Co. v. Carmichael, 526 U.S. 137, 141-42 (1999).

Judge Davis' ruling on the relevance and reliability of expert testimony is reviewed for an abuse of discretion, and the Federal Circuit will reverse if such abuse substantially prejudiced Apple. Sulzer Textil v. Picanol, 358 F.3d 1356, 1363 (Fed. Cir. 2004); Moore v. Ashland Chem. Inc., 151 F.3d 269, 276 (5th Cir. 1998) (en banc). Whereas, when the methodology is sound, and the evidence relied upon sufficiently related to the case at hand, disputes about the degree of relevance or accuracy (above this minimum threshold) may go to the testimony's weight, but not its admissibility. Knight v. Kirby Inland Marine Inc., 482 F.3d 347, 351 (5th Cir. 2007).

Royalties are typically calculated by multiplying (NYSE:I) a royalty base by (ii) a royalty rate. 2 At trial, Mr. Weinstein testified as to the following three methods for calculating a reasonable royalty for past infringement through the trial date:

(4.1) Smallest Salable Unit Methodology. The first methodology involved multiplying a royalty base calculated using (NYSE:A) the lowest gross sales price for each iOS device ever sold, excluding revenue from extra memory and accessories, plus (ii) the $29.00 software upgrade price for every Mac computer to create FaceTime computer program functionality, by (NYSE:B) a 1% royalty rate. Weinstein's calculation of royalties payable by Apple to VirnetX using this method resulted in $708 Million.

(4.2) Nash Bargaining System Methodology. The second methodology involved multiplying a royalty base using an aggregate of Weinstein's estimates of the FaceTime program's incremental value for each Apple product as the royalty base, by a 45% royalty rate. Weinstein's calculation of royalties payable by Apple to VirnetX using this method resulted in $730 Million.

(4.3) Per Unit Royalty Method. The third methodology involved multiplying a royalty base calculated using the percentage of iPod Touch customers who purchased their units to use the FaceTime program, which was 18% in a consumer survey, by (ii) Apple's profits generated by sales of iPod Touch units, by (NASDAQ:III) the number of infringing iPod Touch and other infringing models sold by Apple, by a 45% royalty rate. Weinstein's royalties calculation using this method resulted in $749 Million.

Apple challenges Mr. Weinstein's testimony regarding all three calculations as unreliable within the meaning of Federal Rules of Evidence 702, and also challenges supporting evidence for these calculations as unfairly prejudicial within the meaning of Federal Rules of Evidence 403.

(4.1) First Measure of Damages - Smallest Salable Unit Method of Calculating Damages. Apple attacks the first measure of damages in two ways:

(1) Apple argues using the lowest gross sales price for each iOS device as a base for determining royalties is a disguised use of the entire market value of an infringing product to measure VirnetX's damages without satisfying the requirements of the Entire Market Value Rule; and

(2) a 1% royalty rate based upon the royalties agreements between VirnetX and other users of VirnetX is not reliable within the meaning of Federal Rules of Evidence 702.

Calculation of Royalty Base - Entire Market Value Argument. Apple argues that testimony and other evidence supporting the royalty base in Weinstein's first damages calculation violates the Entire Market Value Rule. Generally, the base for determining damages is the value of the smallest salable patent-practicing unit, but the base can be the entire market value of a single machine that has both infringing and non-infringing components if the patent-related feature is the basis for customer demand or substantially creates the value of its component parts. Versata Software v. SAP, 717 F.3d 1255, 1268 (Fed. Cir. 2013); Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538, 1549, (Fed. Cir. 1995) (en banc). Under this rule, a plaintiff may recover damages calculated by a royalty imposed on the value of patented and unpatented components of a single machine when all of the components together are a single assembly or parts of a complete machine. Rite-Hite Corp. v. Kelley Co., 56 F.3d at pp. 1549-1550. This rule even allows "inclusion of physically separate unpatented components normally sold with the patented components" if "the unpatented and patented components together" are "parts of a complete machine." Id, at p. 1550. Whereas, damages cannot be based on the entire value of a machine if it includes 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. Id. For example, a manufacturer of loudspeakers is liable for royalties based upon the entire market value of loudspeakers sold when it included patented technology in the design of the loudspeakers, the patented technology was integral to the performance of the loudspeakers, and the patented technology improved the performance of the loudspeakers which substantially contributed to increased consumer demand for the loudspeakers. Bose v. JBL, 274 F.3d at p. 1361. As another example, a manufacturer who distributed marketing materials that emphasized an infringing feature in an imaging device that included both infringing and non-infringing features was liable for damages based upon the cost of the entire device. Fonar Corp v. General Electric, 107 F.3d 1543, 1552-1553 (Fed. Cir. 1997).

In our case, Mr. Weinstein used the lowest gross sales price for each iOS device in determining the base for calculating royalties and iOS devices clearly use features that are not patented by VirnetX. Apple is arguing that an iOS device is not the smallest salable patent-practicing unit and that there is no evidence to support the proposition that VirnetX's patented technology substantially increased customer demand for iOS products. Assuming arguendo that the lowest gross sales price for an iOS device is not the smallest salable patent-practicing unit, Weinstein cited Apple's own survey that showed 18% of purchasers bought iOS products because they viewed the FaceTime program, which incorporates VirnetX's technology and provides security for its transmissions. Additionally, Apple's own marketing materials stressed the security of its FaceTime feature on its iOS devices. This is more than sufficient to pass the initial threshold of reliability for the purposes of Federal Rules of evidence 702 because a reasonable jury could conclude that VirnetX's technology was the basis for consumer demand and that the lowest gross sales price of an iOS device is the smallest salable patent-practicing unit for the purposes of calculating money damages.

Calculation of Royalty Rate - Benchmark Royalties. Apple argues that testimony and other evidence supporting the 1% royalty rate in Weinstein's first damages calculation is not reliable for the purposes of Federal Rules of 702, or was irrelevant or unfairly prejudicial within the meaning of Federal Rules of Evidence 403. This argument appears to have been rejected by the Federal Circuit when it cited the trial court's opinion in this case on this point as an example of using benchmark royalties that are reliable for the purposes of Federal Rules of Evidence 702. Apple v. Motorola, ___ F.3d ___, 94 Fed. Rul. Evid. Serv. 301, 310 (Fed. Cir. 2014).

Therefore, the Federal Circuit is likely to rule that Judge Davis did not abuse his discretion when he admitted Weinstein's testimony regarding the first method calculating the base and royalty rate in determining VirnetX's damages and other associated evidence.

(4.2) Second Measure of Damages - Nash Bargaining System Methodology. Apple attacks Weinstein's expert testimony regarding the second method for calculating damages as unreliable within the meaning of Federal Rules of Evidence 702. Apple analogizes Weinstein's second method for calculating damages to the 25% Rule of Thumb that the Federal Circuit determined was an unreliable method for calculating damages within the meaning of Federal Rules of Evidence 702. Uniloc v. Microsoft, 632 F.3d 1292 (Fed. Cir. 2011). The 25% Rule of Thumb calculated damages for infringement of a patent by multiplying a base equal to the entire profits generated by an infringing device by a flat 25% royalty rate. E.g. i4i Limited Partnership v. Microsoft, 598 F.3d 831, 849 (Fed. Cir. 2010). The Federal Circuit ruled this method of calculating damages is not reliable because it is an arbitrary calculation that does not distinguish between important and unimportant patented technology, the availability of non-infringing substitutes, and levels of risk assumed by licensors and licensees. Uniloc, at p. 1312-15. Consequently, it fails to tie the facts of a particular case to a reasonable royalty base. Uniloc, at p. 1315. Mr. Weinstein's testimony did tie the facts of this case to his calculation of a reasonable royalty using the Nash Bargaining System. He calculated the incremental profit to Apple generated by Apple from using VirnetX's technology, there was significant evidence that VirnetX's technology was very important to Apple's products that used this technology, and there was significant evidence Apple had no commercially reasonable substitutes to using VirnetX's technology. These facts justified Apple and VirnetX splitting equally the incremental profit from Apple's use of VirnetX technology. Weinstein discounted VirnetX's share of the incremental profits from 50% to 45% because Apple had stronger bargaining power than VirnetX at the time of the hypothetical royalty negotiation. Therefore, Weinstein's expert testimony on the second method of calculating a reasonable royalty is tied to the facts of this case and Judge Davis did not abuse his discretion by allowing this testimony pursuant to Federal Rules of Evidence 702.

(4.3) Third Measure of Damages - Per Unit Royalty Method. Apple attacks the third measure of damages in two ways:

(1) Apple argues that calculating a royalty base by multiplying the percentage of iPod Touch customers who purchased their units to use the FaceTime program, which was 18% in a consumer survey, by (ii) Apple's profits generated by sales of iPod Touch units, by the number of infringing iPod Touch and other infringing models sold by Apple, is a disguised use of the entire market value of an iPod to calculate a royalty without satisfying without satisfying the requirements of the Entire Market Value Rule; and

(2) Apple argues Weinstein's expert testimony regarding the 45% royalty rate used in the third method for calculating damages is unreliable within the meaning of Federal Rules of Evidence 702 by analogy to the 25% Rule of Thumb that the Federal Circuit determined was an unreliable method for calculating damages within the meaning of Federal Rules of Evidence 702.

Calculation of Royalty Base - Entire Market Value Argument. Apple's first argument fails because Weinstein's third measure of damages is based upon the net profits generated by the iPod not its gross sales price which is its entire market value. Also, VirnetX satisfies the predicates for using the entire market value of the iPod in calculating a reasonable royalty. The base for determining damages can be the entire market value of a single machine that has both infringing and non-infringing components if the patent-related feature is the basis for customer demand or substantially creates the value of its component parts. Versata Software, 717 F.3d at p. 1268; Rite-Hite Corp., 56 F.3d at p. 1549. An Apple survey admitted into evidence shows 18% of purchasers of Apple mobile devices viewed Apple's FaceTime program as the most desirable feature, and testimony that VirnetX's security technology makes FaceTime's use possible. Consequently, this third measure of damages does not use the entire market value of an iPod as the measure of damages, and even if it did, there is sufficient evidence showing that VirnetX's technology substantially creates demand for Apple's iOS products or substantially creates the value of these products.

Calculation of Royalty Rate - Nash Bargaining System Methodology. Apple's argument regarding calculation of the royalty rate in the third measure of damages fails for the same reason it fails in the second measure of damages.

Therefore, the Federal Circuit is likely to rule that Judge Davis did not abuse his discretion when he admitted Weinstein's testimony regarding the third method calculating the base and royalty rate in determining VirnetX's damages and other associated evidence.

Conclusion. Apple claims that the Federal Circuit must reverse if any one of Mr. Weinstein's three damages calculations is inadmissible pursuant to Federal Rules of Evidence 703. In the Federal Circuit, admission of evidence that supports an erroneous measure of damages is harmless error if there was a correct measure of damages in evidence. Energy Transportation Group v. William Demant Holding, 697 F.3d 1342, 1356-1357 (2012) (admission of 25% Rule of Thumb evidence is harmless error because another measure of damages admitted into evidence). The Federal Circuit should affirm on expert testimony regarding all three methods of calculating damages, but it is almost certain to affirm on at least one method. Consequently, the Federal Circuit will not reverse the trial court's money damages judgment based upon an abuse of discretion regarding admission of Mr. Weinstein's expert testimony, and other evidence supporting this testimony.

(5) Improper Jury Instruction on Calculating Damages. Apple claims Judge Davis improperly instructed the jury how to calculate damages payable by Apple to VirnetX. The Federal Circuit will reverse a general verdict if: the trial judge instructed the jury that it could rely on any single legal theory of two or more legal theories, one of those legal theories is defective, and the defective theory is prejudicial to the complaining party. i4i Limited Partnership, 598 F.3d at p. 849; Advanced Display Sys., Inc. v. Kent State Univ., 212 F.3d 1272, 1281 (Fed.Cir.2000). There is prejudice when the error is inconsistent with substantial justice. Advanced Display Sys., Inc., at p. 1283. Whether a legal theory is defective is a question of law. Brooktree Corp. v. Advanced Micro Devices, Inc., 977 F.2d 1555, 1570 (Fed. Cir. 1992). When reviewing an instruction for legal error, the Federal Circuit reads the instructions as a whole and considers them in light of the entire charge to the jury. See United States Surgical Corp. v. Ethicon, Inc., 103 F.3d 1554, 1564 (Fed. Cir.1997). When there is an error in a jury instruction that could not have changed the result, the erroneous instruction is harmless. Environ Prods., Inc. v. Furon Co., 215 F.3d 1261, 1266-67 (Fed.Cir.2000); Weinar v. Rollform Inc., 744 F.2d 797, 808 (Fed.Cir.1984) ("[A] reversal ... is not available to an appellant who merely establishes error in instructions ... where the procedural error was `harmless,' i.e., where the evidence in support of the verdict was so overwhelming that the same verdict would necessarily be reached absent the error, or the error was cured by an instruction, a new trial would be mere waste and affirmance of the judgment is required."). In this case, Judge Davis gave the following jury instructions:

"In determining the royalty base, you should not use the value of the entire apparatus or product unless either: (1) the patented feature creates the basis for the customer's 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 salable unit containing the patented feature."

Apple challenges the second alternative as legally improper. Generally, damages are calculated by multiplying a royalty rate by the value of the smallest salable patent-practicing unit that infringes the patent. Laser Dynamics v. Quantana Computer, 694 F.3d 51, 67 (Fed. Cir. 2013). However, damages may be calculated by multiplying a royalty rate by the entire market value of a product that contains multiple features if the patented feature creates the basis for customer demand or substantially creates the value of the component parts. Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d 1292, 1318 (Fed. Cir. 2011). Judge Davis' jury instruction is consistent with applicable law and is not erroneous as the law currently exists. Also, as explained above in the expert testimony section of this memo, there is sufficient evidence to justify damages based upon the entire value of Apple's iOS products because of Apple's survey that shows 18% of its consumers view FaceTime as the most desirable feature and VirnetX's technology is what makes communications using FaceTime secure. Consequently, the Federal Circuit should not reverse on the jury instruction issue.

Summary. For the reasons stated above, the Federal Circuit will probably not reverse the trial court's $368 Million judgment against Apple on evidentiary or jury instructions grounds.

Disclaimer. I wrote this article to educate myself on these issues and I am sharing it with Seeking Alpha's readers for informational purposes only. No one has retained me to advise any person regarding this matter and I encourage every reader to conduct his or her own due diligence when deciding whether to invest in VirnetX or Apple. In fact, I advise you to retain your own lawyer to explain this article to you and I also advise you to read the cases cited herein yourself to conclude whether I fairly describe them and have properly applied their principles to the facts in Apple v. VirnetX. I expressly state that you may not rely upon this article in making any investment decisions.

2 The base and royalty rate are determined by the following factors: (1) royalties the patentee has received for licensing the patent to others; (2) rates paid by the licensee for the use of comparable patents; (3) the nature and scope of the license (exclusive or nonexclusive, restricted or non-restricted by territory or product type); (4) any established policies or marketing programs by the licensor to maintain its patent monopoly by not licensing others to use the invention or granting licenses under special conditions to maintain the monopoly; (5) the commercial relationship between the licensor and licensee, such as whether they are competitors; (6) the effect of selling the patented specialty in promoting sales of other products of the licensee; (7) the duration of the patent and license term; (8) the established profitability of the product made under the patent, including its commercial success and current popularity; (9) the utility and advantages of the patent property over old modes or devices; (10) the nature of the patented invention and the benefits to those who have used the invention; (11) the extent to which the infringer has used the invention and the value of that use; (12) the portion of profit or of the selling price that may be customary in that particular business to allow for use of the invention or analogous inventions; (13) the portion of the realizable profit that should be credited to the invention as opposed to its non-patented elements; (14) the opinion testimony of qualified experts; and (15) the results of a hypothetical negotiation between the licensor and licensee. Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1970).

Source: Apple Vs. VirnetX: The Federal Circuit Will Affirm Judge Davis