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On Wednesday, a court order was handed down which may have severely damaged Apple's (NASDAQ:AAPL) defense in its patent infringement case with VirnetX (NYSEMKT:VHC). The judge in the case largely adopted and granted VirnetX's proposed sanctions against the Cupertino-based tech firm. Sanctions are penalties used by courts to reprimand or correct the damage done by an attorney for violating rules or abusing the judicial process. The sanction in this case came about in light of Apple's actions in interfering with a witness deposition.

Much is at stake for both companies in the litigation. The order for sanctions may significantly better VirnetX's position in its legal wrangling with Apple, helping it to secure a license for potentially billions of dollars in future sales. For Apple, the sanctions put it at an increased risk of paying damages, future royalties, and facing potential injunction of sales of its top products.

Earlier this year, VirnetX interviewed an Apple software engineer in preparation for the upcoming trial. During the deposition, the court order shows the engineer testified that he worked extensively to help develop Apple's "VPN On Demand". VPN On Demand is in many ways at the heart of Apple's alleged infringement in this case.

According to Apple's documentation, VPN On Demand is used to "…establish a connection automatically when accessing predefined domains, providing a seamless VPN connectivity experience for iPad users." VPN On Demand is critical for Apple for several reasons. Without this feature, VPNs on the iPhone must be manually established, with many apps unable to connect without this access. Furthermore, this functionality found throughout Apple devices.

VPN On Demand is very relevant to the current patent case as VirnetX is alleging that any Apple product with VPN On Demand functionality infringes on its patents, which claim the methods to trigger secure communication links and VPNs (virtual private networks) based on DNS lookups. These alleged infringing products include the Apple iPhone, iPhone 3G, iPhone 3GS, iPhone 4, iPod Touch, and iPad. VirnetX will likely seek an injunction to halt sales of this wide range of products, which would completely cripple the company and directly impact Apple's bottom line. Furthermore, a license to VirnetX's patent portfolio will easy cost the company hundreds of millions, if not billions, in royalties in the long run.

During deposition, the software engineer claimed to have invented the method of "determining whether to establish a VPN based on a domain name" for Apple's VPN On Demand. The witness continued to explain how he and his team had attempted to patent this very idea via patent application 10/940,225.

VirnetX is asserting its 6,502,135 patent (the '135 patent) in this case, which details a similar method of establishing a VPN based on a DNS request. This idea, VirnetX argues, was patented by its inventors years before Apple's engineers attempted to do so.

The engineer had never previously heard of VirnetX's '135 patent. However, during the deposition, he was read claim 1 of this patent. Afterwards, he was asked if he still thought he and his Apple colleagues were the first to invent a DNS-triggered VPN. At this point, Apple's counsel began to intervene and disrupt the deposition. VirnetX again pressed the engineer to compare the claims of Apple's patent to VirnetX's. Apple counsel then instructed the engineer to "zip it" and eventually shut down the deposition, packed up, and fled the deposition with the engineer.

In response, VirnetX subsequently requested sanctions be put in place against Apple for their disruption of the deposition, which violates Rule30(d)(3)(NYSE:A).

In the court order released yesterday, the judge concluded the engineer was indeed willing to answer questions, but he was "not allowed" by Apple's attorney, which is a clear violation of Rule30(d)(3). He further stated that Apple's counsel had acted in "bad faith" and "bad contact", citing their apparent intention to create "…disruption of the deposition and an opportunity to visit with the witness regarding his testimony".

The court handed down a particularly clever and creative set of tailored sanctions, giving Apple the choice between two options:

Option 1: In addition to paying VirnetX the costs associated with this particular issue, Apple must also produce the engineer again for further deposition by VirnetX. Apple is banned from communicating with witness regarding the patents. If Apple attorneys have had conversations with the engineer since the deposition was interrupted, they are deemed to have waived any confidentiality of those conversations. Meaning, VirnetX is free to ask questions regarding those discussions and the witness must truthfully answer all questions about any communication. Apple, on the other hand, will not be able to ask the witness questions about the comparison of the two patents.

Option 2: Apple is not allowed to call the engineer to the stand at trial or provide ANY rebuttal or counter arguments of the engineer's testimony regarding the comparison of the two patents. In addition, (and here is the kicker) the jury will receive instruction at trial that Apple's interference was improper and that "…Apple's counsel's reason for terminating the deposition was to prevent such unfavorable testimony from being presented to you in this case."

Ouch.

Apple is now forced to either admit it deliberately interfered (Option 2) or that it did not (Option 1), but that option allows VirnetX to continue deposition, ask about the otherwise more privileged conversations attorneys had with the engineer, all while Apple is blocked from questioning him about the patents in re-direct (to which he already admitted much about on record).

However, having Apple on record admitting it tried to patent the same idea four and a half years later completely undermines the argument that VirnetX inventors' ideas were unpatentable, obvious, and not valuable. This development is reminiscent to the similarly damning evidence VirnetX used against Microsoft when it took down the tech giant in the same court for a $200 million settlement. Apple now appears to be following a similar path.

On its face, the sanctions do not directly benefit VirnetX investors. But the development has the ability to significantly alter the direction and landscape of the litigation in VirnetX's favor. Furthermore, this makes Apple quite vulnerable walking into a courtroom with several million dollars likely on the line for damages. VirnetX already accuses Apple of infringing on product sales nearing $100 billion. On top of this, VirnetX has settled and secured three licenses from other companies in this same litigation, all within the company's publicly disclosed 1%-2% running royalty on future sales. For investors, this could mean billions in future Apple royalties.

To a jury, it could not be more obvious. This testimony by Apple's own engineer demonstrates that the VPN On Demand functionality actually does include using domain names to determine whether to establish a VPN, the technology VirnetX owns.

But here is where the curtain gets lifted: the engineer's "DNS-triggering VPN" patent idea stemmed from the work that was being done on VPN On Demand, the very system Apple denies infringes VirnetX's "DNS triggering VPN" patents.

And Apple's defense begins to quickly unravel.

Source: Apple Sanctioned In VirnetX Patent Case For Obstructing 'Unfavorable Testimony'