The U.S. Patent and Trademark Office grants three types of patents: design patents, plant patents, and utility patents. The patent most commonly issued, and the one most likely to be involved in infringement damages claims, is the utility patent.

Damages in patent infringement cases are awarded under Section 284 of the Patent Act, which provides the following:

Upon finding for the claimant, the court shall award the claimant damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use made by the infringer, together with interest and costs as fixed by the court.¹

Through interpretation, “damages adequate to compensate for the infringement” has come to represent lost profits. Accordingly, the damages awarded to claimants in patent infringement cases may be a measure of lost profits, reasonable royalties, or both.

Forensic accounting experts must exercise caution in determining which damages measurement is applicable to a particular case. Further guidance regarding the appropriate measurement of damages in patent infringement cases is provided by the Court in Hansen v. Alpine Valley Ski Area, Inc.:

If the record permits the determination of actual damages, namely, the profits the patentee lost from the infringement, that determination accurately measures the patentee’s loss. If actual damages cannot be ascertained, then a reasonable royalty must be determined.²

The Panduit Test

In order to recover lost profits from patent infringement, the patent owner must satisfy a four-part test that was put forth in Panduit Corp. v. Stahlin Bros. Fibre Works, Inc. and adopted by the Federal Circuit. The four-part assessment, known as the Panduit test, requires that the patent owner prove all of the following factors:³

1. Demand existed for the patented product.
2. Acceptable non-infringing substitute products were not available to satisfy demand.
3. The patent owner possessed the manufacturing and marketing capability to exploit demand.
4. Lost profits can be quantified.

First Panduit test:
Demand existed for the patented product

The most logical sources of information used to determine whether demand existed for the patented product are sales records belonging to both the patent owner and the infringer. Business plans and marketing materials belonging to the infringer may also be used.

It is particularly important for damages experts to consider whether the “demand” existed for the actual patented product as a whole or for another product that included the patented product as a component. If it is shown that the specific patented component did not contribute to the customer’s decision to purchase the product, and that the customer demanded the infringer’s product as a whole, then the patent holder has failed to demonstrate that demand existed for the patented product.

Second Panduit test:
Acceptable non-infringing substitute products were not available to satisfy demand

Findings related to the second Panduit test are often challenged because the terms “acceptable, non-infringing, and substitutes” are loosely defined.

Prior to 1989, case law suggested that if any acceptable non-infringing substitutes were sold in a market, the second Panduit test failed and the patent holder should receive damages in the form of a reasonable royalty. However, the Federal Court has since relaxed their interpretation, as demonstrated in State Industries, Inc. v. Mor-Flo Industries, Inc.:

In a three-or-more market, the patent owner can receive lost profits in accordance with the patent owner’s pro rata share of the “but for” market and a reasonable royalty on the remaining infringing sales.⁴

Based on this decision, patent holders may still receive damages for lost profits, along with a reasonable royalty, even if a market contains acceptable non-infringing substitutes.

To illustrate how damages may be assessed under these circumstances, consider a scenario in which a patent holder held a market share of 75% before an infringer entered the market (i.e., the “but for” market share). Upon entry, the infringer takes a 20% share of the market. The patent owner’s lost profits would then represent 15% (75% x 20% = 15%) of the infringer’s market share. Additionally, the patent owner would be entitled to a reasonable royalty on the other 5% of the infringer’s share of the market.

It’s important to consider whether a patent holder’s product and a non-infringing substitute sold in the market are different in terms of relative pricing, customer base, and marketing channels. If differences exist, one could conclude that the two products are actually different. Therefore, a patent holder may be denied lost profits damages based on market share. However, the claimant may still be awarded a reasonable royalty.

Third Panduit test:
The patent owner possessed the manufacturing and marketing capability to exploit demand

The patent owner must be able to show that he had the manufacturing and marketing capabilities to fill the infringer’s sales “but for” the infringement. Production managers can provide relevant information on manufacturing capabilities regarding excess production capacity, existing fixed asset base, use of employee overtime, increased number of production shifts, physical expansion, and additional costs necessary to exploit the increased demand.

Increased manufacturing capabilities would require more working capital and additional investments in facilities and equipment. Therefore, damages experts must evaluate the patent holder’s financing capabilities with respect to the expansion needed to exploit demand and understand the required level of investment. Observing relationships between sales and working capital levels for the patent owner and peer companies is one way to estimate financing requirements. If long-term financing would be used to exploit demand, then the damages expert would need to gain insight into the patent owner’s ability to secure financing. This may be accomplished by analyzing the leverage ratios for the patent holder and peer companies.

One way to review the marketing capabilities of the patent holder is to review both his and the infringer’s customer lists. If infringing sales were made to common customers, it is clear that the patent owner possesses the marketing capabilities to exploit demand. If the list doesn’t indicate that infringing sales were made to common customers, then the damages expert should consider the costs required by the infringer to develop these customer relationships.

Fourth Panduit test:
Lost profits can be quantified

It is easy to establish that lost profits can be quantified because evidence is readily available through the income statements and sales records of the patent owner and the infringer. The damages expert can also use the income statement to infer the incremental cost of sales that were lost to the infringer.

Final Thoughts

Once the patent holder is able to demonstrate proof for all four factors of the Panduit test, the damages expert must calculate the underlying lost profits. If the patent holder fails any of the tests, then it must be determined whether a reasonable royalty rate can be applied and awarded to the patent holder.

¹ 35 U.S.C. § 284 (1952)
² Hansen v. Alpine Valley Ski Area, Inc., 718 F.2d 1075 (Fed. Cir. 1983).
³ Panduit Corp v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152 (Sixth Ciircuit 1978).
⁴ State Industries, Inc. v. Mor-Flo Industries, Inc., 883 F.2d 1573 (Fed. Cir. 1989).

This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.