(This content was originally issued as a Ravicher Report on July 29, 2012. It is now being made available for free to the public for the first time here.)
At the end of last week VirnetX (VHC) dropped roughly 20% after the publication of an article titled, VirnetX: Do You Believe In Fairytales? Part 1, in which an anonymous author discussed the company's prospects for asserting its patents relating to securing real-time communications over the Internet against Apple (AAPL), Cisco (CSCO) and other tech firms. Without debating the legitimacy and reliability of anonymous sources, here I provide my comments on some of the substantive points made in the article, including the probative value of VirnetX's past settlement with Microsoft and more recent settlements with Aastra and Mitel to future expectations, as well as the arguments that, regarding VirnetX's current patent actions, "VirnetX may lose," "VirnetX may win, but be awarded a comparatively small amount of damages," and "VirnetX may win a substantial award, but it will be subject to appeal."
VHC currently has three lawsuits in Federal Court (all in Texas) and one action at the International Trade Commission asserting its patents. ITC cases are different from Federal Court cases in that the ITC can only offer a patent holder the remedy of forbidding the importation of infringing articles, not any monetary compensation for past infringement. Federal Courts, on the other hand, offer patent holders the ability to recover monetary damages for past infringement and receive an injunction against any future infringement.
Amongst its four current patent infringement actions, VirnetX is asserting seven different patents, as summarized in the table below. In the first current Federal Court case filed in August 2010, VirnetX is asserting six patents against Aastra, Apple, Cisco and NEC. In the second current Federal Court case filed in January 2011, VirnetX is asserting three of those same patents against Mitel Networks, Siemens Enterprise Communications, and Avaya. In the third current Federal Court case and the ITC action, both of which were initiated in November 2011, VirnetX is asserting one additional patent against just Apple.
Federal Court Texas
August 11, 2010
Aastra, Apple, Cisco, NEC
Federal Court Texas
January 12, 2011
Mitel, Siemens Enterprise Comm., Avaya
Federal Court Texas
November 1, 2011
November 4, 2011
Figure 1: Current VirnetX Patent Actions
VirnetX in the past had two other Federal Court cases, both against Microsoft. The first of those cases was filed in February 2007 and asserted the 6,502,135, 6,839,759 and 7,188,180 patents. The second case against Microsoft was filed in March 2010 and reasserted the 6,502,135 and 7,188,180 patents. Both of those cases were dismissed in May 2010 after the parties reached a settlement under which Microsoft paid VirnetX $200M as a one time fully paid up license. The settlement came after a jury verdict in the first case against Microsoft found that two of VirnetX's patents were valid and infringed and awarded roughly $100M is damages, $71.75M for the '135 patent and $34M for the '180 patent (the '759 patent had been voluntarily dismissed from the case by VirnetX prior to the jury verdict).
With that overview, here are my responses to various portions of last week's article.
INCOMPLETE ANALYSIS OF RECENT SETTLEMENTS
Before identifying what it believes are "several serious risks" to VirnetX's ability to succeed in its current patent actions, last week's article makes an assertion about settlements reached between VirnetX and two of the defendants involved in the current actions. Namely, VirnetX reached a settlement with Aastra in May 2012 and with Mitel earlier this month. Regarding those two settlements, the anonymous author says they were for, "undisclosed sums which I believe to be trivial." To support that belief, last week's article asserts, "the first defendant to settle (Aastra) appears from its Q2 2012 financials to have paid VHC an immaterial amount."
However, the anonymous author fails to address the fact that the Aastra settlement was not for just a one-time payment, but instead also included "an ongoing reasonable royalty for all future sales through the expiration of the licensed patents." So too did the Mitel settlement. For the article to fail to mention this material aspect of the settlements before concluding that they must be "trivial" in amount seems incomplete.
It would be reasonable for the agreements to set forth a standard royalty rate to apply to all covered products made by the licensee, applying that rate retrospectively to past sales to calculate the one time payment amount and prospectively to future sales for the ongoing royalty amount. Thus, the majority of licensing revenues from the agreements may not be represented in the one time payment amount, but instead may come from the rest of the life of the agreements through the ongoing royalty payments. The insinuation from the article that reviewing VirnetX's next 10-Q in order to infer the size of the agreements seems similarly indefensible.
Further, it would not be in VirnetX's interests to settle for trivial royalty rates, because Section 284 of the Patent Act states that a patentee is to be awarded "damages adequate to compensate for the infringement but in no event less than a reasonable royalty," meaning that the royalty rates included in the settlements with Aastra and Mitel could be used to establish evidence of what would be a "reasonable royalty" minimum to award VirnetX as damages against the remaining defendants in the current cases. Thus, it would be in VirnetX's interest to ensure any royalty rates in any settlements agreements it enters are sufficiently high to support its damages demands in the ongoing litigation. The article makes no argument as to why VirnetX would be willing to accept a royalty rate in the Aastra and Mitel agreements that isn't at least as much as it seeks from the remaining defendants.
"VIRNETX MAY LOSE"
Regarding the assertion that "VirnetX may lose," of course that is technically correct, but in reality for VirnetX to "lose" means that every single patent claim it is asserting must be found to either be invalid, unenforceable or not infringed. So long as one claim from one of VirnetX's seven currently asserted patents is found to be valid, enforceable and infringed by defendants' products, VirnetX wins, and is entitled to seek both monetary damages for past infringement and an injunction to prohibit future infringement.
Generally, a patentee has a spectrum of patent claims, ranging from broad to narrow. Broad claims are easier for a patent holder to prove are infringed, as they cover more subject matter. However, they are also more easily proven to be invalid by a defendant, because there is, for example, a greater pool of prior art from which to challenge the broad claim. Narrow claims, on the other hand, are more difficult for a patent holder to prove are infringed, but at the same time are more difficult for a defendant to prove are invalid. Thus, what frequently occurs in patent cases is that a patent holder focuses in on certain patent claims that are barely broad enough to cover the accused infringing product, because these claims are the least susceptible to an invalidity challenge. With seven patents being asserted by VirnetX in the current matters, they have a large group of claims from which to find at least one that is valid, enforceable and infringed. This seems especially more likely than normal due to the fact that two of the seven patents being asserted by VirnetX in the current cases were asserted previously against Microsoft and the jury in that case found those two patents to be valid, enforceable and infringed.
To be clear, I have not performed my own independent analysis of VirnetX's patents and the various accused products in the current actions. Thus, I cannot conclude, and I do not conclude here, that VirnetX does indeed have at least one claim that is valid, enforceable and infringed by the defendants. Nor can I opine that the anonymous author of last week's article is incorrect to say that "VirnetX may lose." Indeed they "may." I merely point out here the size of VirnetX's portfolio, the past success in asserting two of the patents against Microsoft, and the difficulty the defendants face in overcoming every single asserted patent claim.
"VIRNETX MAY WIN, BUT BE AWARDED A COMPARATIVELY SMALL AMOUNT OF DAMAGES"
In addition to the recent settlements with two of the defendants from the current actions, which I discuss above, the article from last week asserts the Microsoft settlement from May 2010 is a rational basis on which to measure the possible outcomes for VirnetX in the current cases. However, there are several factors that distinguish the Microsoft settlement from the current actions, and the anonymous author's numerical comparison between the Microsoft settlement and the current actions seems flawed regardless.
First, the Microsoft settlement was a significant event in VirnetX's history, as Microsoft was the first defendant sued by VirnetX for patent infringement. VirnetX's experience and risk tolerance were likely much different then than they are now. For one, VirnetX's current cash position, having been buttressed by the Microsoft settlement, may make it more comfortable proceeding with the current actions without feeling desperate to settle. Further, it is often the case that parties like Microsoft require as part of any settlement a most-favored-nations clause, that punishes the patent licensor if they later enter into a license agreement for the same patents with another party on more favorable terms. Thus, I do not see VirnetX settling on terms worse than those in the Microsoft agreement.
In fact, I doubt VirnetX would even be willing to settle on relatively the same terms today. First, the Microsoft cases only involved three of VirnetX's seven currently asserted patents. While the Microsoft agreement most assuredly covers VirnetX's entire portfolio, including later issued patents, the strength of VirnetX's patent portfolio has grown in the more than two years since that agreement was reached. For example, the additional patent being asserted by VirnetX against Apple in the November 2011 Federal Court case and ITC action (U.S. Patent 8,051,181) was not issued until November 2011. Thus, that patent was not part of VirnetX's portfolio as of the date of the Microsoft settlement, as it was only a pending application at that time. There is much more strength in an issued patent, which VirnetX has now, than merely a pending application, which VirnetX had then. For one, you cannot bring suit for infringement of a patent application. You can only sue for infringing an issued patent. And, in fact, the '181 patent is so strong in VirnetX's opinion, that it sued Apple for infringing it on the very day it was granted by the Patent Office. Similarly, the 7,921,211 patent being asserted in the current actions was also not yet issued at the time of the Microsoft settlement. The subsequent issuance of more patents to VirnetX has, in my opinion, greatly increased its strength, making the Microsoft settlement terms no longer acceptable to the company.
Regarding the range of damages that could be awarded to VirnetX if it is successful in the current Federal Court cases, as discussed above, the jury in the Microsoft case awarded $71M for the '135 patent and $34M for the '180 patent. Taken as a wildly rough approximation of $50M per patent and multiplying that by the number of patents asserted in the current matters (seven), one gets $350M for a single defendant. With seven current defendants, the total amount could reach nearly $2.5B. And that would only be for past infringement. It would not take into account the amount of future royalties that VirnetX could seek.
Having said that, the amount awarded by the jury in the Microsoft case was most likely influenced by a number of factors, including Microsoft's size, the number of infringing articles sold by Microsoft, the relative importance of VirnetX's patented technology to Microsoft's infringing products, the revenues Microsoft garnered from sales of infringing products, etc. We really don't know for sure what the jury based its award on, as juries don't have to tell us how they reached their number in the jury verdict form. Thus, the amount a jury would award against a current defendant could be much lower than that awarded against Microsoft. It could also be higher. The facts of particular cases and the jurors sitting in judgment can differ dramatically.
My point here is not to assert that VirnetX will be awarded billions of dollars in damages if it is successful in its litigation. That amount may, as last week's article suggest, be a fairytale. However, I do disagree with the anonymous author's assertion that the Microsoft settlement somehow is a relative cap on how much VirnetX could recover in the current actions.
"VIRNETX MAY WIN A SUBSTANTIAL AWARD, BUT IT WILL BE SUBJECT TO APPEAL"
Again, there is nothing technically incorrect with this statement, as of course all Federal Cases are eligible for review. It is impossible to know what issues the defendants in the current actions would raise on appeal if they were to lose at the trial court to VirnetX. However, the main issue the article says could be appealed would be a large damages award. Indeed, the article cites several damages awards from other cases that supposedly were reversed on appeal. However, three of the four cited cases were not Court of Appeals decisions reversing large jury awards due to their size, and the fourth case has an inconclusive result. Therefore, the anonymous author's reliance on these cases to argue that large jury verdicts are destined to be reversed on appeal is flawed. Specifically:
- MirrorWorlds was not "tossed on appeal" as the article states. Rather, after the jury returned a verdict for the patent holder, the trial judge himself found that there was no possible way the patent was infringed, and thus he overruled the jury's finding on that issue. He did continue to find that the jury's award of $625M was not supportable by the facts either, but this was a quite radical step by a trial judge, as he should not have let the case even go to the jury if he felt there was no way for the patent holder to prove infringement. Regardless, the case has been appealed by the patent holder and was argued at the Court of Appeals in March with David Boies, the attorney who represented Al Gore in Bush v. Gore, arguing for the patent holder. Thus, the case is not over and the implication in the article from last week that this case is a clear example of a high damages award being overturned on appeal is just simply not correct.
- Uniloc did indeed have its damages award reversed on appeal, but the case was later settled, and the article does not cite any evidence to support its claim that the settlement was "apparently far smaller than the original award." That statement appears to be pure speculation.
- The Lucent verdict against Microsoft awarding $1.5B in damages for infringing two patents was reversed because, like in the MirrorWorlds case, the judge held the jury's verdict of infringement on one patent was against the clear weight of the evidence and that Lucent did not even have standing to sue Microsoft for infringing the second patent. The court did continue to find that one aspect of the jury's royalty calculation was flawed, but it ordered a new trial on that issue. The Court of Appeals upheld the findings of non-infringement and lack of standing, and expressly did not decide the damages issues. Thus, again, this was not a Court of Appeals case reversing a large jury verdict for a patentee.
- In the JNJ case, the Court of Appeals reversed the jury verdict for the patent holder because it found the underlying patent was invalid. The issue of the amount of the damages awarded, $1.67B, was not addressed by the Court of Appeals at all. Thus, the article's assertion that this case supports a conclusion that large jury verdicts won't stand on appeal is, like the above cases, not legitimate.
In closing, I reiterate that I have not performed my own analysis of the merits of VirnetX's current patent assertion actions. However, I do believe last week's article casting doubt on the viability of their claims was substantially flawed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I was not compensated to write this report. After publishing it on ravicher.com, I was contacted by an independent third party that asked me to release it publicly, which I have now done here. I was compensated by that third party for releasing it publicly.