The Federal Circuit made news this month when it reversed a jury’s $358 million dollar award to Lucent and against Microsoft. Court decisions involving that kind of money—even when they don’t involve Microsoft–generally attract attention.

More importantly, Chief Judge Michel’s decision in Lucent v. Gateway et al. also sent a strong message to patent litigants about acceptable methods for proving patent damages, from both a policy and procedural standpoint. Not only does the decision provide specific guidance regarding the nature of the evidence that must be presented to support patent damages awards, but it also tackles issues raised in the recent debates over the best course for Congressional “patent reform.”

In Lucent, the Federal Circuit held that the jury’s award, which would have required Microsoft to pay Lucent $358 million for infringement arising from use of a “date picker” feature in Outlook and other Microsoft software, “lacked sufficient evidentiary support,” and sent the damages portion of the case back to the district court. In rejecting the award, the Federal Circuit panel (Judges Michel, Newman and Lourie) took the opportunity to make some powerful points about how damages must be proven at trial.

The decision signals unwavering approval for the continued use of a “hypothetical negotiation” or “willing licensor/willing licensee” approach to determining a reasonable royalty as a basis for patent damages award, and embraces the venerable Georgia Pacific factors as a framework for calculating such damages. (Reasonable royalties is the standard measure of patent damages, when lost profits are not quantifiable or available.)

While approval of this entrenched analytical method might seem unremarkable, it is worth noting given the criticisms of the Georgia Pacific factors made in the patent reform debate. Critics have claimed that the factors are overly complex, malleable to a fault, and do not provide juries sufficient guidance. Lucent makes clear that the court believes the problem lies not with the analytical framework, but with the litigants, or, more precisely, their attorneys and experts, who have responsibility for guiding the jury’s analysis of the factors.

Lucent claimed an 8% running royalty rate on Microsoft’s total sales revenues for the infringing software, for a total of $561.9 million. Microsoft countered with a lump-sum payment theory which would have resulted in a damages award of $6.5 million. The Federal Circuit admonished both parties for failing to provide the jury with sufficient evidence and analysis to support their damages theories.

For example, the court noted that when a party asserts a damages theory which is based on a running royalty theory, and past license agreements are presented at trial as a basis for a proposed royalty rate, enough information about the past licenses must be in evidence to support the jury’s award.

This may seem self-evident, but in Lucent, the court explained that the evidence presented must allow the jury to appreciate that significant differences exist between a running royalty license and a lump-sum license. For example, a running royalty structure shifts many risks to the licensor since it does not receive an immediate and guaranteed payment as it would with a lump-sum license. The court concluded that Lucent had failed to provide a sufficiently clear explanation.

As a result, when the jury made a lump sum award, it did so based on evidence presented by Lucent relating to running royalty licenses. Thus, the jury did not have sufficient evidence on which to base its calculation.

Similarly, the court faulted Lucent for failing to supply any explanation to the jury about the subject matter or patents covered by past “lump sum” royalty agreements which were introduced into evidence, which precluded the jury from properly understanding and relying on those past agreements as evidence supporting its award.

The decision also insists that, for the jury to evaluate what a “willing licensor” and “willing licensee” would have agreed on in any hypothetical negotiation, the litigants must provide it with the same sort of information that parties to a license would normally consider in real-world negotiations. Again, this seems like common sense, but given the disproportionate amount of trial time that parties often feel they must devote to complex issues of liability, their damages presentation is often perfunctory.

Lucent warns litigants that they give short shrift to the proof of damages at their own peril. The court criticized Lucent for not showing how the patented method is used by consumers, e.g., whether it is a frequently or minimally used feature of the software, a consideration that parties in a true negotiation would view as important.

Specifically, Lucent presented no evidence to support the jury’s award, which the court held required it to conclude that parties in the hypothetical negotiation would have estimated “that the patented date picker feature would have been so frequently used or valued as to command a lump sum payment that amounts to approximately 8% of the sale price of Outlook.”

The Lucent decision also addresses head-on recent criticisms of the “entire market value rule,” a controversial analytical tool often used by plaintiffs seeking to maximize patent damages.

Under prevailing case law, the rule may be applied where a patented component provides the primary basis for consumer demand for the overall product, and all the components together are analogous to components of a single-assembly machine or otherwise constitute a single functional unit. See e.g., Rite-Hite Corp. v. Kelley Co . (Fed. Cir. 1995). In such a circumstance, revenues earned on the sale of the entire product of which an infringing component is a part may be considered as the royalty base.

The Federal Circuit restated that, for the entire market value rule to apply, a patentee must prove that “the patent-related feature is the ‘basis for customer demand.’” Further, in calculating a damages award, the rule allows a party to include the sales revenues of the product which contains a patented feature in the royalty base, but only if the royalty rate that is applied to that revenue base reflects, at least approximately, the value of the patented feature to the overall product.

The court faulted Lucent for failure to prove that anyone purchased Outlook because of the patented date-picker method, and for the testimony of its expert who inflated the royalty rate in view of the date-picker’s actual value relative to that of Outlook as a whole.

The court was careful to balance its criticisms by acknowledging that, although substantial evidence must be provided to support the jury’s award, “[c]reating a license agreement for patented technology is, at best, an inexact science.” Further “[i]n actual licensing negotiations, willing parties negotiating at arms-length do not necessarily generate and analyze precise economic data concerning the perceived value of a patented invention.”

When considering jury awards in post-trial procedures, “district court judges must scrutinize the evidence carefully to ensure that the ‘substantial evidence’ standard is satisfied, while keeping in mind that a reasonable royalty analysis ‘necessarily involves an element of approximation and uncertainty.’”

The Federal Circuit took pains to make clear that the evidentiary failings at trial were due to the actions of the parties, not of the district court judge. The decision pointedly notes that while “[a]t times Microsoft’s briefs seem to suggest that the district court judge ‘abdicated’ her role as a gatekeeper … the responsibility for objecting to evidence, however, remains firmly with the parties.”

The Lucent decision provides important guidance regarding the nature of the evidence that must be presented to support patent damages awards. It also provides a welcome response, directly from the court, to critiques of damages-calculation methods raised in the recent debates surrounding patent reform.