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IP Alert: Nash Bargaining Solution Is No Bargain: VirnetX v. Cisco and Apple

September 18, 2014

Vacating an award of $368 million in the Eastern District of Texas, the Federal Circuit, in VirnetX, Inc. and Science Applications International Corp. v. Cisco Systems, Inc. and Apple, Inc., rejected the use of the Nash bargaining solution in determining reasonable royalty damages. The court reasoned that, like the “25 percent rule of thumb,” the use of the Nash bargaining solution in determining reasonable royalty when based on a set of premises that are not tied to the facts of the particular case is improper. It further appears that the court rejected most use of the Nash theorem in the determination of reasonable royalty damages. 

The Nash bargaining solution is a complex stratagem in game theory for analyzing a set of conditions applicable to a negotiation between multiple parties. In patent cases, a few patent litigants have attempted to estimate “reasonable royalty” damages predicated on the Nash theorem. Under this approach, one begins by calculating an incremental profit that the infringer enjoyed by its use of the patented invention. Next, one assumes that a hypothetical negotiation would have begun with the rule of thumb that these incremental profits would be split equally between the parties. From this point, the apportionment of this incremental profit is adjusted by the bargaining power of each of the parties, and damages are calculated accordingly.

Plaintiffs VirnetX and Science Applications International Corp. own four patents relating to computer technologies. The plaintiffs brought suit against Apple based on FaceTime and VPN technologies found in certain Apple products. After a five-day trial, the jury found all the asserted claims valid and infringed and awarded plaintiffs $368 million in reasonable royalty damages. 

At trial, plaintiffs’ expert provided three reasonable royalty theories, two of which were predicated on the Nash bargaining solution. The expert began by determining the “incremental or additional profits that are associated with the use of the patented technology.” After determining this profit figure, the expert invoked Nash bargaining to begin with the assumption that in a hypothetical negotiation, the parties would have started by splitting the incremental profits on a 50/50 basis. The expert then applied several factors to adjust that split based on the “relative bargaining power of the two entities.”

Apple objected to the expert’s use of the Nash bargaining solution. It argued that the invocation of a 50/50 split of incremental profits as a starting point was akin to the “25 percent rule of thumb,” a theory that the Federal Circuit rejected in the Uniloc USA, Inc. v. Microsoft Corp. decision. The district court overruled the objection and allowed the expert’s testimony. Eventually, the court determined that the plaintiff’s patents were valid and infringed, and awarded the plaintiffs a judgment of $368 million. Apple appealed.

On appeal, the Federal Circuit first addressed the merits of the judgment. The court affirmed the judgment that none of the asserted claims had been proved invalid, and upheld a portion of the infringement verdict. Turning next to damages, the court vacated the jury’s damages award. In this portion of its opinion, the court commented in detail on the Nash bargaining approach. 

Recalling its earlier Uniloc decision, the court reasoned that it had rejected the “25 percent rule of thumb” theory “because it fails to tie a reasonable royalty base to the facts of the case at issue.” The court noted that the 25 percent rule “did not differentiate between different industries, technologies, or parties. . . . The problem was that the 25% rule made too crude a generalization about a vastly more complicated world.”

The court then opined that, like the 25 percent rule, “[t]he Nash theorem arrives at a result that follows from a certain set of premises. It itself asserts nothing about what situations in the real world fit those premises.” The court rejected the application of the Nash bargaining solution in the case at bar, holding that someone seeking to invoke the theorem “must establish that fit, because the 50/50 profit-split result is proven by the theorem only on those premises.” The court held that, on the facts before it, there had been an “essential failing” in invoking the Nash bargaining solution.

The opinion contains language that further seems to repudiate the Nash bargaining solution in its entirety in the reasonable royalty analysis. The court stated:

[E]ven if an expert could identify all of the factors that would cause negotiating parties to deviate from the 50/50 baseline in a particular case, the use of this methodology would nevertheless run the significant risk of inappropriately skewing the jury’s verdict. This same concern underlies our rule that that a patentee may not balance out an unreasonably high royalty base simply by asserting a low enough royalty rate.

The Federal Circuit then reiterated its insistence that the expert testimony on damages be “tied to the particular facts.” 

The court did not expressly repudiate all uses of the Nash theorem, but portions of its opinion call into question the continued viability of the Nash bargaining approach in determining reasonable royalty damages. If the approach retains any viability, a party wishing to invoke the Nash bargaining solution in a reasonable royalty analysis must tie the hypothetical split of incremental profits to the particular facts of the case, and may not adopt a 50/50 split as a rule of thumb.

For more information on this matter, please contact Fitch Even partner Eric L. Broxterman, the author of this alert.

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