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September 12, 2012 Articles

Use-Based Damage Theory Garners an Unreasonable Royalty

Use-based theories can not only assess royalties, but they can lead to significantly higher dollar awards than sales-based theories or lost profits.

By Konrad Sherinian

A reasonable royalty for the use of an invention by an infringer sets the floor for damages that a patent holder can recover, but the recent case of Michael S. Powell v. The Home Depot USA, Inc., 663 F.3d 1221 (Fed. Cir. 2011), conclusively demonstrates that a reasonable royalty is not always less than what would be recovered by way of lost profits. Powell also demonstrates the power of use-based theories in assessing a reasonable royalty, and how in certain circumstances, it can lead to significantly higher dollar awards than sales-based theories or lost profits.

In Powell, the patentee had a long-standing business relationship with Home Depot. He was the company's point of contact for the installation and maintenance of radial saws in each of its stores. Home Depot used the radial saws—as did many of their competitors—to cut lumber to customer-specified dimensions. Cut lumber was, in many ways, integral to Home Depot's strategy to be a "one-stop shop" for contractors.

But the company had a very serious problem. The radial saws at its stores resulted in numerous injuries to employees—with lacerations and finger amputations being most common. In addition to harm caused to employees, the number of lawsuits filed and the subsequent compensation employees were paid had grown significantly.

Lowes's, one of Home Depot's competitors, decided that despite the utility that cut lumber offered its customers, the radial saws were simply too dangerous and stopped offering cut lumber. Home Depot CEO Robert Nardelli became aware of the issue and told his management team to find a solution or the radial saws would be removed. The team that Home Depot assigned to examine the issue, however, concluded that while injury claims were costing the company more than $1 million a year, the extra sales generated by cut lumber outweighed the cost of the injuries to employees. Home Depot, therefore, set out to find a way to make the radial saws safe.

Independent contractor Michael Powell realized that his business of installing and maintaining radial saws depended on Home Depot continuing to provide cut lumber. He created a saw guard that would protect employees from injury while using the saws and demonstrated his invention to Home Depot in July 2004. The company ordered eight prototypes, which were installed in Home Depot stores the following month, and Powell applied for a patent for his saw guard. Unbeknownst to Powell, however, Home Depot was not satisfied in paying approximately $2,000 per saw guard.

In an effort to obtain a better price, Home Depot showed Powell's saw guards to Georgia-based manufacturer Industriaplex and asked the company if it could produce saw guards for less than $2,000 per unit. Industriaplex agreed, and eventually sold Home Depot nearly 2,000 saw guards at a price of $1,295 each.

Powell continued discussions with Home Depot but could not come to an agreement to produce saw guards at the price the company was willing to pay—$1,200 per saw guard, including installation.

Powell's patent was issued in May 2006, and he sued Home Depot a year later. He was awarded $15 million in damages (later increased by $3 million in enhanced damages and $2.8 million due to willful infringement by Home Depot), or approximately $7,736 per infringing radial saw, following a jury trial. This award was approximately $11,122,000 more than the total revenue Powell would have received—using the $2,000/unit he charged Home Depot in 2004—if Home Depot had initially purchased the radial saws from him. The award was also approximately $12,488,995 more than Home Depot paid Industriaplex to build and install the infringing saw guards.

On appeal, the Federal Circuit ruled—apparently for the first time in history—that lost profits are not a cap on the value of a reasonable royalty in a patent case. While the previous cases of Golight v. Wal-Mart Stores, 355 F.3d 1327 (Fed. Cir. 2004), and State Industries v. Mor-Flo Industries, 883 F.2d 1573 (Fed. Cir. 1989), established that a reasonable royalty could exceed an infringer's net profit margin, Home Depot argued that the upper bounds of Powell's damages was the amount that he had agreed to take in exchange for providing the radial saw guards during their 2004 negotiations. This amount was a number that Home Depot conservatively estimated at $2,180 per radial saw guard, but the Federal Circuit rejected this argument for two reasons.

First, while the court acknowledged that Powell would have supplied Home Depot with radial saw guards for $2,180 per radial saw guard in 2004, the correct point of reference was when the infringement began with the issuance of Powell's patent in May 2006. Home Depot by then had nearly two years to observe the effectiveness of Powell's radial saw guards—as manufactured and installed by Industriaplex—in preventing the types of laceration and amputation injuries that its employees had been suffering. This additional objective evidence of effectiveness could have persuaded Home Depot to pay a higher price than when Powell first demonstrated the saw guards two years prior.

Second, while the court acknowledged that both an infringer's net profit margin and a patentee's profit expectation could be used as factors in determining a reasonable royalty, neither set a ceiling on what a reasonable royalty can be. In particular, the court stated that "damages to the patent holder cannot simply be calculated in all cases by determining the difference between his pecuniary condition after the infringement, and what his condition would have been if the infringement had not occurred" (quoting Yale Lock Manufacturing v. Sargent, 117 U.S. 536, 552 (1886)).

In addressing the question of whether substantial evidence supported the jury's verdict, the court found that Powell presented extensive evidence of the benefit that Home Depot received from the radial saw guards. This evidence included the directive of CEO Robert Nardelli that the rate of employee injuries was not acceptable and the radial saws must be fixed or removed; the cost of employee injuries resulting from radial saws was in excess of $1 million per year; one of Home Depot's chief competitors—Lowe's—made the decision to remove radial saws from its stores and no longer offered cut lumber; continuing to offer cut lumber gave Home Depot a significant competitive advantage over Lowe's and others due not only to the sale of cut lumber, but also from add-on purchases of nails, hinges, and other goods that are often purchased with cut lumber; and not one injury occurred in stores where infringing saw guards were installed. Based on this evidence, Powell's damages expert submitted a range for the reasonable royalty bounded on the lower end by the $2,180 that Powell had agreed to supply Home Depot for in 2004, to an upper range of $8,500—or less than 8.5 percent of the savings that Home Depot enjoyed from the use of the saw guard.

Home Depot attempted to counter this use-based evidence by arguing that a reasonable royalty would be three to five percent of the $1,295 it paid Industriaplex (in other words, $38–$65 per saw). As an upper range, Home Depot argued that Powell was willing to deliver the saw guards for $2,180 in 2004, and therefore a reasonable licensee would never pay more than that. The Federal Circuit largely rejected these arguments as "nothing more than what it might have preferred to pay," citing its en banc decision in Rite-Hite v. Kelley, 56 F.3d 1538, 1554–55 (Fed. Cir. 1995).

It should be noted that Powell presents a relatively rare set of facts that make what nominally appears as a poor damages case into a superior damages case. In particular, Powell likely would not have recovered his cost of litigation if he had pursued a standard percent-of-sales theory in determining a reasonable royalty. In addition, he would have had to overcome additional evidentiary hurdles, such as those imposed by Uniloc USA v. Microsoft, 632 F.3d 1292 (Fed. Cir. 2011), regarding the application of the entire-market-value rule.

By marshaling use-based evidence, however, Powell was able to impose a much higher royalty on Home Depot. His attorneys recognized that his saw guards had a measurable benefit to the company far beyond the amount that he set for Home Depot prior to the issuance of his patent. Accordingly, plaintiffs in patent cases should at least consider a use-based damage theory for trial.

Defendants, however, can counter a use-based damage theory by presenting a noninfringing alternative to the infringing product. By presenting a noninfringing alternative, a defendant can cap damages to a quantity approximated by the cost of the noninfringing alternative, accounting for any improvement in performance of the infringing product. See Riles v. Shell Exploration and Production, 298 F.3d 1302, 1312 (Fed. Cir. 2002) (the market does not award a royalty divorced of all relation to a potential noninfringing alternative method); Grain Processing v. American Maiz, 185 F.3d 1341, 1347 (Fed. Cir. 1999) (the difference in production cost between an infringing and a noninfringing product capped the reasonable royalty award.

If Home Depot produced a noninfringing alternative saw guard that worked as well as Powell's and cost $2,800 per saw guard, damages would have been capped at $2,800 per unit, which is far closer to the value that a sales-based theory would have produced. Therefore, while Powell and use-based damage theories provide another tactic for patent plaintiffs to generate higher damages, it is likely to be a little-used tool, given that use-based damage theories have relatively narrow applicability, and they are susceptible to being diffused by the presentation of a noninfringing alternative. This noninfringing alternative effectively caps the reasonable royalty to the difference in cost of the noninfringing and infringing products accounting for any improvement in performance of the infringing product.

Keywords: litigation, intellectual property, use-based damage theory, sales-based damage theory

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