Aqua Shield v. Inter Pool Cover Team – Evidence of Actual Profits Does Not Hold Water in Reasonable Royalty Analysis

By: Clifford S. Chang

The Federal Circuit, in Aqua Shield v. Inter Pool Cover Team, 774 F.3d 766 (Fed. Cir. 2014), recently provided further guidance on the traditional method for assessing the market value of a patent: the hypothetical negotiation. The court considered evidence of an infringer's actual profits and clarified that such evidence is of limited value in the determination of a reasonable royalty award for patent infringement.

Aqua Shield sued Inter Pool Cover Team (IPC) and others for infringement of U.S. Patent No. 6,637,160. A bench trial in the District of Utah ultimately led to an award of reasonable royalty damages of $10,800 and a finding of no willful infringement. In calculating damages, the lower court relied on evidence of Defendant IPC's net profits of $135,000 on past infringing sales as the foundation for a royalty calculation. The court then "[c]onsider[ed] the[]benefits [of the patented invention], while still allowing Defendant a profit on infringing sales," and awarded a damages figure based on an 8 percent royalty, reflecting several Georgia-Pacific considerations. Aqua Shield at 769. Aqua Shield took issue with the methodology underlying the district court's damages computation, and the Federal Circuit agreed.

A Hypothetical Negotiation Analysis Considers Evidence of Anticipated Profits

In determining the a reasonable royalty damages figure for an infringed patent, courts typically conduct a hypothetical negotiation analysis, in which the core economic question is "what the infringer, in a hypothetical pre-infringement negotiation under hypothetical conditions, would have anticipated the profit-making potential of use of the patented technology to be, compared to using non-infringing alternatives." Aqua Shield at 770 (emphasis in original). A critical assumption is that the infringer would expect to realize a profit from the use of the patented technology.

While there is no one methodology for determining "reasonable royalty" damages, the Federal Circuit to date has approved two different approaches, both of which include considerations of an infringer's anticipated profits. The Georgia-Pacific approach analyzes a non-exhaustive list of fifteen factors which include profit-related considerations such as: “(8) The established profitability of the product made under the patent; its commercial success; and its current popularity; . . . [and] (13) The portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer.” Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1970) mod. and aff’d, 446 F.2d 295 (2d Cir. 1971), cert. denied,404 U.S. 870 (1971). The second methodology for computing reasonable royalty damages is the "analytical approach" which was specifically approved by the Federal Circuit in TWM Mfg. Co. v. Dura Corp., 789 F. 2d 895 (Fed. Cir. 1986), cert. denied, 479 U.S. 852 (1986). The analytical approach involves calculating damages based on the infringer's own internal profit projections for the infringing item at the time the infringement began, and then apportioning the projected profit between the parties as a percentage of sales.

Evidence of Actual Profits is Only Indirectly Relevant

The Federal Circuit in Aqua Shield explained that while an infringer's actual profits during the infringement period may be relevant to a hypothetical negotiation analysis, it is only relevant in an "indirect and limited way - as some evidence on a directly relevant inquiry into anticipated profits." Aqua Shield at 770 (emphasis added). The court found that although the district court acted properly in considering IPC's actual profits earned during the period of infringement, the district court erred in treating the profits actually earned as a royalty cap. The district court's treatment was improper hindsight analysis, which as the appellate court explained, had “incorrectly replaced the hypothetical inquiry into what the parties would have anticipated, looking forward when negotiating, with a backward-looking inquiry into what turned out to have happened.” Id. at 772.

The district court's “backward-looking” analysis also "incorrectly replace[d] the inquiry into the parties' anticipation of what profits would be earned if a royalty (of amounts being negotiated) were to be paid with an inquiry into what profits were earned when IPC was charging prices without accounting for any royalty." Id. (emphasis in original). According to the Federal Circuit, the district court erroneously assumed that “any royalty that was paid by IPC would have directly reduced its profits, dollar for dollar.” Id. Citing to an earlier holding in Douglas Dynamics, LLC v. Buyers Prod. Co., 717 F.3d 1336 (Fed. Cir. 2013), the court explained that it was error to assume that an awarded royalty rate would "leave some room for profit" at an infringer's current prices because an infringer like IPC could have raised its prices to account for a royalty payment. Here, the district court did not find, and IPC did not argue, that IPC was selling its products in a perfectly competitive market that forced the company to act as a pure price-taker. In fact, there was no evidence suggesting that the case at bar was any different from the typical case in which pricing could have been adjusted to account for a royalty based on sales price; nor was their evidence to support the district court's finding that a reasonable royalty should be based on a percentage of profits rather than of sales revenues.

For those reasons, the Federal Circuit vacated the district court’s royalty calculation and remanded the case for a redetermination of a reasonable royalty in a manner that was consistent with the appellate court’s opinion. The Federal Circuit instructed the district court to consider “all relevant record evidence,” including several Georgia-Pacific related factors such as the advantages of the patented product, the ease and cost of designing around the claimed invention, and the relevance of IPC’s actual profits to what IPC’s expectations would have been in a hypothetical negotiation. The order further suggested reconsideration of other aspects of the district court's analysis, not specifically discussed, that relied on the erroneous focus of IPC's actual profits, such as rejection of certain testimony and other proffered evidence.

Infringers May Be Liable For More Than Their Profits

This ruling makes clear that there is no assumption that a reasonable royalty rate based on an actual sales price would leave room for actual profits. Infringers, therefore, can no longer rely on actual sales prices and profits to help establish a reasonable royalty. Instead, a liable defendant may now be penalized for inefficiently operating a business and his low sale price may possibly be adjusted up in a damages calculation. Furthermore, defendants may need to show that pricing practices accounted for possible licenses. However, care should be taken to evaluate issues relating to willfulness. A defendant may also argue that it could not, or would not, have raised prices to adjust for royalties, but would likely need to cite to supporting evidence. Ultimately, this holding gives additional guidance concerning calculating royalties and may open the door to additional discovery.