3.01 Applying Game Theory to Hypothetical Negotiation 26 [A] A Zero-Sum Game 26 [B] Perfect Exchange of Information 27 [C] You Can’t Walk Away 27 [D] Date of Infringement 27 [E] Assumption of Validity 27 3.02 Determining the Reasonable Royalty Value 28 [A] Game Theory and the Lemley/Shapiro Analysis 29 [B] Injunctions 30 [C] Two More Variables 31
Th e most important Georgia-Pacifi c factor is the last: the hypothetical negotiation. It is the theoretical underpinning of every other factor and, while easy to understand, is remarkably hard to apply:
Th e amount that a licensor (such as the patentee) and a licensee (such as the infringer) would have agreed upon (at the time the infringement began) if both had been reasonably and voluntarily trying to reach an agreement; that is, the amount which a prudent licensee — who desired, as a business proposition, to obtain a license to manufacture and sell a particular article embodying the patented invention — would have been willing to pay as a royalty and yet be able to make a reasonable profi t and which amount would have been acceptable by a prudent patentee who was willing to grant a license.
As an economic matter, the hypothetical negotiation simply involves divid- ing up the “pot” of money representing the sum of the patent’s value to the plaintiff (either by excluding all others from using the patent or by licensing
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it to others) and the patent’s value to the defendant (i.e., the economic impact on the defendant of being precluded from using the patent). Th e portion of this pot of money that would end up in the plaintiff ’s hands at the close of this negotiation represents the reasonable royalty.
Th e hypothetical negotiation involves, of course, a completely fanciful situation. It assumes a negotiation between a plaintiff that is not a willing licensor and a defendant that, more oft en than not, had no idea it was infring- ing the patent and would probably have had no interest in taking a license. It puts these two parties in a room at a time in which they may not have even known each other existed — at the time the defendant started infringing — and forces them to reach an agreement that they might never have been able to reach. It forces the plaintiff to lower its price for licensing its patent to a level at which the defendant could still have made a profi t and forces the defendant to agree to pay an amount that would still have been “acceptable” to the plain- tiff . It also forces them to assume a fact that the actual parties would never have assumed — that the patents are both valid and infringed.
Th e court has to be careful not to view this hypothetical negotiation as though it were a real commercial transaction and acting as though the defen- dant had not infringed the patent. Such analysis, obviously, simply rewards the defendant for infringing — giving it the same deal as it would have had absent the lawsuit, while putting the plaintiff to the trouble and expense of suing.
With all of these competing considerations, it is remarkable that any expert is able to construct a scenario in which these parties could have “agreed” to anything or that any fact fi nder could come to any kinds of conclusion as to what these parties might have agreed to in this fi ctitious negotiation. However, this theoretical construct has proven to provide the best measure of what royalty fulfi lls the statutory mandate of being “reasonable.”
Th e court in Innogenetics, N.V. v. Abbott Labs. , 578 F. Supp. 2d 1079, 1093 (W.D. Wis. 2007), gave a good summary of the hypothetical negotiation model: “In calculating the amount of a reasonable royalty, the jury has to pretend that the parties sat down and negotiated a reasonable royalty before the day that defendant began its infringement of the plaintiff ’s patent. Unlike a real negotiation, this hypothetical negotiation assumes that the infringer must agree to some amount of royalty payment; it does not have the option of walking away from the table. Th e jury must put itself in the shoes of the parties and look at the relevant circumstances as they were at the time the negotiations would have taken place. Th e reasonable royalty calculus assesses the relevant market as it would have developed before and absent the infring- ing activity.”
Th e courts, however, are quite aware of the limitations of this model. As the Sixth Circuit observed in the leading case on lost profi ts, Panduit Corp. v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152, 1164 (6th Cir. 1978), “[d]etermination of a ‘reasonable royalty’ aft er infringement, like many devices in the law, rests on a legal fi ction. Created in an eff ort to ‘compensate’
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Imaging the Hypothetical Negotiation
when profi ts are not provable, the ‘reasonable royalty’ device conjures a ‘will- ing’ licensor and licensee, who like Ghosts of Christmas Past, are dimly seen as ‘negotiating” a “license.’ Th ere is, of course, no actual willingness on either side, and no license to do anything, the infringer being normally enjoined, as is Stahlin, from further manufacture, use, or sale of the patented product.”
Th e Federal Circuit concurred in Rite-Hite Corp. v. Kelley Co. , 56 F.3d 1538, 1576 (Fed. Cir. 1995), noting that while “[t]he hypothetical negotiation is oft en referred to as a ‘willing licensor/willing licensee’ negotiation . . . this is an inaccurate, and even absurd, characterization when, as here, the patentee does not wish to grant a license.” Indeed, “the use of a willing licensee-willing licensor model for determining damages risks creation of the perception that blatant, blind appropriation of inventions patented by individual, nonmanu- facturing inventors is the profi table, can’t-lose course.” Maxwell v. J. Baker, Inc. , 86 F.3d 1098, 1109–10 (Fed. Cir. 1996).
Th e Federal Circuit noted in Fromson v. Western Litho Plate & Supply Co. , 853 F.2d 1568, 1576 (Fed. Cir. 1988), that “[f]orced to erect a hypothetical, it is easy to forget a basic reality — a license is fundamentally an agreement by the patent owner not to sue the licensee. In a normal negotiation, the poten- tial licensee has three basic choices: forego all use of the invention; pay an agreed royalty; infringe the patent and risk litigation. Th e methodology pre- sumes that the licensee has made the second choice, when in fact it made the third. Th us Western must be viewed as negotiating for the right to exclude competitors or to compete only with licensed competitors, a landscape far diff erent from that created . . . by the infringement of [the defendant] and others. Whatever royalty may result from employment of the methodology, the law is not without means for recognizing that an infringer is unlike a true “willing” licensee; nor is the law without means for placing the injured patentee in the situation he would have occupied if the wrong had not been committed.”
In an early case, the Federal Circuit was of the opinion that the hypotheti- cal negotiation should be entirely hypothetical — having no relationship to the real world. “[I]n determining a reasonable royalty in hypothetical nego- tiations, a willing ‘hypothetical’ licensee would not have been a party to any prior transactions and, thus, would not have had the same psychologi- cal reluctance as Heublein.” Stickle v. Heublein, Inc. , 716 F.2d 1550, 1563 (Fed. Cir. 1983).
However, in more recent cases, the courts have considered the actual market and competitive pressures that the parties were under at the time the hypothetical negotiation is deemed to have taken place — at the time the infringement began. For example, in Ball Aerosol & Specialty Container, Inc. v. Limited Brands, Inc. , 514 F. Supp. 2d 1051, 1065 (N.D. Ill. 2007), the court noted that since, at the time of infringement, the commercial relationship between the plaintiff and defendant made buying the necessary component
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“not a viable option,” the plaintiff was “in a superior negotiating position” and could have demanded a higher reasonable royalty.
Likewise, in Minco Inc. v. Combustion Eng’g , 95 F.3d 1109, 1119 (Fed. Cir. 1996), the court considered such real-world factors as the fact that, at the time of infringement, the plaintiff had an “inferior product” and that the industry “enjoyed high rates of profi t.” Indeed, in Avocent Huntsville Corp. v. ClearCube Tech., Inc. , 2006 U.S. Dist. LEXIS 55307 (D. Ala. 2006), the court explicitly took into account the “mental state” of the respective “hypothetical negotia- tors,” considering the real economic pressures they would have been under at the time.
However, the utility of these real-world considerations has its limits, as the court cautioned in Cummins-Allison Corp. v. SBM Co., Ltd. , 584 F. Supp. 2d 916, 918 (E.D. Tex. 2008), especially because of the requirement of the hypo- thetical negotiation that the parties assume the validity and infringement of the patent: “Th e problem with ignoring or overruling Georgia-Pacifi c and basing the royalty rate calculation entirely on a ‘real world’ view of the hypo- thetical negotiation or future damages is that the damages expert should then, as real world lawyers and business owners would do, also consider the rela- tive strength of the infringement and invalidity cases, current trends of patent law, the merits of the parties’ lawyers, their perceived infl uence with judges, and even factors such as their willingness to engage in abusive attempts to spend opponents into bankruptcy.”