Reconsidering the Hypothetical Negotiation: Is the Tail Wagging the Dog?

Reasonable royalty damages are the predominant form of relief awarded in patent infringement cases and, of late, have been a lightning rod for assertions that the patent protection system is out of control.

The primary tool used to assess reasonable royalty damages is the hypothetical negotiation construct, which emanated from the seminal Georgia-Pacific Corp. v. United States Plywood Corp. decision in 1970. The construct provides that a reasonable royalty should be determined by hypothesizing an imaginary negotiation between a patent holder and an infringer over the use of a patented invention at the time of first infringement.

In our article, "The Hypothetical Negotiation and Reasonable Royalty Damages: The Tail Wagging the Dog" (Stanford Technology Law Review, September 2013), we examine the wisdom and efficacy of the historically heavy reliance on the construct. In particular, we question whether it is likely to achieve the ultimate goal of reasonable royalty damages, which is to provide the patent holder with fair and adequate compensation for the unauthorized use of a patented invention. In our analysis of this topic, we considered the origins of and initial motivations for the measurement of reasonable royalty damages and found that the logic for using the hypothetical negotiation construct is tenuous. Its use actually introduces unnecessary and unproductive questions and conflict into the determination of reasonable royalty damages.

In the paper, we explain that prevailing concerns about the "proper" application and implementation of the construct – regarding the timing of the negotiation, for example, or the relative bargaining positions and power of the negotiating parties – often overshadow a more fundamental question: Do the proposed damages adequately compensate the patent holder? We conclude that reliance on the hypothetical negotiation often does not provide a sound or reliable basis for properly determining reasonable royalty damages. As an alternative, we propose that the determination of reasonable royalty damages be based on a direct and objective assessment of a patent’s incremental benefits, licensing comparables, and design-around costs.

An incremental benefits analysis examines the gains the infringer enjoys that can be attributed to use of the patent. It focuses on the difference between the benefits the infringer gains from using the patent and the benefits it would gain from using a non-infringing, next-best alternative. A licensing-comparables analysis examines actual licensing agreements that involve patents similar to the ones at issue to determine whether, and the extent to which, arms-length negotiations can provide useful insights into the amount of compensation that is appropriate. And a design-around cost analysis examines the costs the infringer would have incurred by adopting the non-infringing, next-best alternative in order to determine whether there is a limit to the amount an infringer might have been willing to pay to use the patented technology.

Experts can balance and weight the results of these different assessments to determine the amount of compensation that should be paid to the patent holder in light of the specific unauthorized use of the patented technology – without introducing artificial bargaining drama or modeling complications into the analysis. ■

By Managing Principal John Jarosz in the Washington, DC office of Analysis Group.