VirnetX v. Cisco: Apportionment Does Not Stop at the Smallest Salable Unit

VirnetX, Inc. v. Cisco Systems, Inc., 767 F.3d 1308 (Fed. Cir. 2014), Appeal No. 2013-1489, decided September 16, 2014, closed two loopholes that had opened in the wake of the court’s earlier apportionment decisions. Writing for the panel, Judge Prost held that identifying the smallest salable unit is the beginning of apportionment, not the end of it, and that the Nash Bargaining Solution — a game-theoretic 50/50 profit split — is no more admissible than the 25 percent rule it resembles. The court vacated a $368,160,000 jury award against Apple and remanded for a damages retrial, while leaving the infringement findings intact.

At a glance

• Case: VirnetX, Inc. v. Cisco Systems, Inc., 767 F.3d 1308 (Fed. Cir. 2014), Appeal No. 2013-1489
• Court and date: U.S. Court of Appeals for the Federal Circuit; decided September 16, 2014; opinion by Judge Prost
• Patents: U.S. Patent Nos. 6,502,135; 7,418,504; 7,490,151; and 7,921,211, directed to secure communications and on-demand virtual private network technology (accused features included VPN On Demand and FaceTime)
• Holdings: A patentee must apportion to the patented features even when it uses the smallest salable unit as the royalty base, if that unit still contains significant unpatented features; the entire-market-value jury instruction was erroneous; and the Nash Bargaining Solution is an inadmissible rule of thumb absent proof its premises fit the case. The $368 million award was vacated and remanded.

The instruction that swallowed apportionment

The trial in the Eastern District of Texas produced a jury award against Apple of $368,160,000. The damages presentation relied on a jury instruction telling the jury that when the smallest salable unit is used as the royalty base, the law imposes no further constraint on the base. That instruction, the Federal Circuit held, was legally erroneous.

The smallest-salable-unit concept, inherited from LaserDynamics and its predecessors, was designed as a tool of apportionment — a way to keep juries from anchoring on the revenue of an entire multi-component product. But the court recognized that the tool could be turned against its own purpose. A smartphone’s lowest-priced configuration is “salable,” yet it bundles a camera, a processor, a display, an operating system, and countless features unrelated to VirnetX’s secure-communications inventions. Treating that whole device price as a license-free royalty base simply relocates the entire-market-value problem one level down.

The court therefore held that a patentee’s obligation to apportion damages to the patented features does not end with identifying the smallest salable unit when that unit “still contains significant unpatented features.” The instruction was wrong because it suggested otherwise — that once the base is the smallest salable unit, no further apportionment is required. Apportionment is a substantive requirement that follows the patented contribution all the way down, regardless of how the royalty base is labeled.

Two damages theories, both rejected

VirnetX’s damages expert offered the jury alternative paths to a large number, and the court found problems with each.

The first theory used a device price as the royalty base and applied a royalty rate to it without genuinely apportioning out the value of the device’s many unpatented features. Under the corrected legal standard, that approach failed for the same reason the instruction did: it captured value the patents did not contribute.

The second theory invoked the Nash Bargaining Solution, an economic bargaining model that, under stated assumptions, predicts parties will split the surplus from a deal evenly. The expert began from a 50/50 division of incremental profit and then adjusted it modestly in Apple’s favor. The Federal Circuit rejected the maneuver. The Nash model rests on a specific set of premises, and a party invoking it “must establish that fit” — must show that the assumptions actually describe the negotiation at issue. Absent that showing, a 50/50 starting point is just another arbitrary anchor. The court drew the analogy explicitly: the Nash Bargaining Solution, applied as a default, is a rule of thumb “akin to the 25 percent rule” condemned in Uniloc. Dressing an unsupported split in the language of game theory does not make it reliable; if anything, the mathematical veneer heightens the danger of misleading the jury.

A pattern of distrust toward shortcuts

Read alongside Uniloc and LaserDynamics, VirnetX completes a coherent project. The Federal Circuit has steadily dismantled the convenient defaults that once let experts reach large numbers without doing the case-specific work: the 25 percent rule, the casual use of whole-product revenue, the assumption that the smallest salable unit needs no further apportionment, and now the unexamined Nash split. The throughline is a demand that damages testimony connect, at every step, to evidence about this invention’s incremental contribution in this market.

What makes VirnetX distinctive is its target. The earlier cases policed obviously crude heuristics. The Nash Bargaining Solution is a respected result in cooperative game theory, and its appearance in a courtroom carries an aura of rigor. By subjecting it to the same fit requirement as the 25 percent rule, the court signaled that sophistication is no substitute for foundation. The question is never whether a model is elegant; it is whether its assumptions are shown to describe the real-world bargain the parties would have struck.

Open questions

VirnetX sharpened the apportionment requirement but left the execution contested. How does an expert prove the incremental value of a feature like on-demand VPN within a device of hundreds of features — through consumer surveys, feature-level pricing, technical usage data, or some combination? When, if ever, can the Nash framework be admitted on a sufficient showing that its premises fit, and what would that showing look like? And how do trial courts craft jury instructions that convey the full apportionment duty without overwhelming jurors? The opinion identifies the duty more clearly than the method of discharging it.

Implications

• Apportion below the smallest salable unit. Using a small component or low-end device as the base is not a safe harbor; if it bundles unpatented features, the patentee must apportion further.
• Beware the labeled-base shortcut. Calling something the smallest salable unit does not relieve the duty to isolate the patented contribution.
• Game-theory models need foundation. The Nash Bargaining Solution and similar frameworks are inadmissible as defaults; the proponent must prove the model’s assumptions fit the facts.
• Sophistication is not reliability. An elegant mathematical method can mislead a jury more effectively than a crude one; courts will scrutinize the premises, not the polish.
• Liability and damages are severable. A correct infringement verdict can survive while a damages award is vacated for methodological error — the cost of a flawed theory is a retrial, not a defense win.

Frequently asked questions

What is the core holding on apportionment? Even when a patentee uses the smallest salable unit as the royalty base, it must still apportion the royalty to the patented features if that unit contains significant unpatented features. Apportionment does not stop at the smallest salable unit.

Why did the court reject the Nash Bargaining Solution? Because applying a 50/50 profit split as a starting point, without proving that the model’s premises actually describe the parties’ negotiation, makes it an arbitrary rule of thumb akin to the discredited 25 percent rule.

Did VirnetX lose? Not on liability. The court left the infringement findings standing and vacated only the $368,160,000 damages award, remanding for a new damages determination under the corrected standards.

Authorities and sources

• VirnetX, Inc. v. Cisco Systems, Inc., 767 F.3d 1308 (Fed. Cir. 2014), Appeal No. 2013-1489 (Sept. 16, 2014). Citation, patents, and holdings: Wiley Federal Circuit Patent Bulletin.
• Smallest-salable-unit apportionment and the erroneous EMVR instruction: Practical Law summary and Mondaq report on the vacated $368 million award.
• Rejection of the Nash Bargaining Solution as a rule of thumb: Essential Patent Blog.