A district court strikes testimony in a patent case
Recently, a district court judge noted that the overall percentage of successful Daubert challenges to damages in patent cases is “exceedingly small.” Yet, he went on to say that, “every once in a great while, a Daubert challenge to a patent damages expert is justified.” This judge found that to be the case in Dynetix Design Solutions, Inc. v. Synopsys, Inc., where the patent expert’s reasonable royalty testimony was neither tied to the facts nor reliable.
The ins and outs of the expert’s testimony
As you know, calculating a reasonable royalty is a two-step process. In the first step, an expert determines the revenue pool that’s implicated by the infringement (that is, the royalty base). Next, the expert determines the percentage of that pool adequate to compensate the plaintiff for that infringement (that is, the royalty rate).
In the Dynetix case, the plaintiff’s expert started by determining the royalty base. The patented feature was just one of numerous features in the defendant’s product. Nonetheless, the expert determined that the royalty base would be the entire sales of the product simply because the defendant hadn’t separately sold any smaller unit with the patented component. And he also didn’t further apportion the royalty base to account for nonpatented features.
As to the royalty rate, the expert divided the gross margin of the infringing product equally between the two parties. And then he applied the Georgia-Pacific factors for determining reasonable royalties in order to alter the rate. When focusing on the third and fourth factors (the nature and scope of the hypothetical license in terms of exclusivity and the licensor’s policy for maintaining its patent monopoly by limiting licensing), he then reduced the royalty rate to 19%.
After he made a couple more adjustments, the expert arrived at a royalty rate of 14.25%. He then applied that rate to the royalty base for the relevant time period, thus concluding that the reasonable royalty would be around $156 million. Because only one of the two components originally accused of infringement remained in the case, he then apportioned 75% of the royalty to the remaining component, which resulted in a royalty of some $117 million.
The court weighs in
The district court ultimately rejected the royalty base, finding that the expert had failed to apportion profits between the numerous noninfringing features in the defendant’s product and the patented feature. So, even though he was correct that the smallest salable infringing unit was the defendant’s entire product, he should not have ended his analysis there. Moreover, he needed to determine the infringing component’s value relative to the entire product’s other components. This failure to apportion justified the exclusion of his opinion.
But the court also rejected the royalty rate. It found that the expert’s analysis only compounded the problems with his opinion. Although half of the gross margin for the infringing profits may indeed have been “one reasonable starting point,” the law required the expert to customize the royalty rate to the specific facts of the case — including the particular industry, technology or party. And, as the court explained, “an arbitrary starting point is impermissible under Uniloc.”
The Federal Circuit in Uniloc rejected a “25% rule of thumb” profit margin for starting the royalty rate calculation. And the 50% starting place, the district court said, was even more arbitrary because the expert based it solely on his own judgment and experience, without even considering analogous licenses offered in the industry or the nature of the patented component as an optional and small feature in the product.
The court’s striking of the expert testimony wasn’t the end of the matter. The court then granted the plaintiff five days to submit a new expert report on the damages.
The bottom line
Many have questioned the “gatekeeper” role of courts in evaluating and admitting the reliability of expert testimony. But many courts still exclude testimony based on Daubert objections. It’s critical that attorneys keep on top of developments in this area and work with qualified experts who’re unlikely to face Daubert challenges.
Sidebar: Limits to the gatekeeper role
The Supreme Court’s decision in Daubert assigned district courts a type of “gatekeeper” role in admitting expert testimony and evaluating its reliability. A recent case, Manpower, Inc. v. Insurance Co. of the State of Pennsylvania, demonstrates that this role has limits.
The “Manpower” case involved a dispute over reimbursement for business interruption losses under an insurance policy. The insured’s forensic accounting expert expressed an opinion on the total loss, and the insurance company moved to exclude the testimony, saying it wasn’t the product of reliable methodology.
The district court found that the expert had, indeed, followed the insurance policy’s prescribed methodology for calculating losses. But the reliability of the expert’s calculations turned on whether he’d used reliable methods when he selected numbers for the projected total expenses and revenues. The court held that the method for projecting revenues was unreliable due to his estimated growth rate, so it excluded his testimony. The insured party then appealed.
The court of appeals acknowledged that district court judges have a lot of leeway when determining whether particular expert testimony is reliable. It pointed out, however, that a district court “usurps the role of the jury … if it unduly scrutinizes the quality of the expert’s data and conclusions rather than the reliability of the methodology.”
The appellate court determined that the district court’s concerns weren’t due to the reliability of the expert’s methodology, but the resulting conclusions. The district court then took issue with his selection of particular data. But the selection of data inputs to apply in a model is a question that’s separate from the reliability of the methodology reflected in the model itself.
The appellate court warned that it wasn’t saying that an expert can rely on data with no quantitative or qualitative connection to the methodology. Experts should use the type of data on which specialists in the field would reasonably rely.
IRS Undermines a Family Limited Partnership
Author: Joe Aquino
Recently, the IRS celebrated another victory in its long-running campaign to challenge family limited partnerships (FLPs). In Estate of Lockett v. Commissioner, the agency attacked an FLP for being an invalid partnership under state law. Ultimately, however, it was the decedent’s estate planning that undermined the FLP, thus handing the IRS another win.
Widow takes ownership
Lois Lockett was predeceased by her husband, whose will established a trust for her benefit (Trust A). In 2000, as part of her estate planning, Lockett formed Mariposa Monarch, LLP under Arizona law. The partnership’s formal agreement, signed in 2002, named her sons Joseph and Robert as general partners. Lockett, the sons and Trust A were named as limited partners. At that point the parties hadn’t yet agreed on initial capital contributions or their percentage interests in Mariposa.
Shortly after the agreement was signed, Lockett and Trust A began funding Mariposa. Joseph and Robert never made any contributions. In 2003, Trust A was terminated, and Lockett became the owner of her limited partnership interest in the partnership. An amended agreement was executed to reflect this. The agreement continued to list the sons as Mariposa’s general partners, but an exhibit listed their mother as holding 100% of the partnership and each of the sons holding 0%.
When Lois Lockett died in 2004, Mariposa held assets worth more than $1 million. On its tax return, the estate valued Lockett’s 100% ownership interest in Mariposa at $667,000 after applying control and marketability discounts.
IRS raises state law
Initially, the IRS argued that Mariposa wasn’t a valid partnership under Arizona law. In that state, partnerships are defined as an association of two or more persons and are formed to operate a business for profit. The IRS contended that only Lockett contributed assets to Mariposa and that Mariposa wasn’t operated for profit.
Nevertheless, the court found that Mariposa was a valid partnership. Although the sons didn’t hold interests in it, Trust A contributed assets and was therefore a limited partner, satisfying the requirement of an association of two or more persons.
The court also found no requirement that an Arizona business engage in a certain level of economic activity. Moreover, it determined that Mariposa was operated to derive a profit. The partnership hired a financial advisor to manage its stock portfolio, purchased real estate that it leased and made loans requiring annual interest payments. It thus operated as a business for profit.
Trust termination found faulty
Unfortunately for the estate, the IRS had an alternative argument. Even though a valid partnership was formed, it had terminated at the time of Lockett’s death because she had acquired 100% of the interest in it. This occurred when Trust A was terminated in May 2003 (effective Dec. 31, 2002). At that point, Lockett had become the owner of Trust A’s limited partnership interest in Mariposa as well as being its sole partner.
Arizona law provides that a partnership is dissolved when a dissolution event previously agreed upon in the partnership agreement occurs. The Mariposa agreement established that the FLP would be dissolved when one partner acquired all of the other partners’ interests. So on Dec. 31, 2002, Mariposa dissolved and Lockett became the legal owner of its assets.
Many potential errors
Because the FLP had dissolved by the time of Lockett’s death, its assets were included in her gross taxable estate. If her sons had made contributions to fund their general partnership interests or she had gifted them with small interests in Mariposa, the FLP may well have withstood scrutiny and removed the assets from the estate.
Lockett’s mistakes were only a few of the many errors that can sabotage an FLP. To protect your clients from IRS attack, work with financial experts when drafting partnership agreements and making estate plans.
If you have any questions about FLPs or any other issue, give us a call at 716.847.2651, or you may contact us here.