Prof. Doug Lichtman, UCLA School of Law
August 9, 2010

Patent law intentionally and explicitly exaggerates damages.  That is, when a court decides that a valid patent has been infringed, it typically imposes a remedy, the net value of which clearly exceeds the value of any deal the parties would have made had they negotiated a license prior to the infringement.  There are many reasons for this exaggeration, including, quite frankly, the simple fact that juries and judges are often hoodwinked by outlandish expert testimony as to the value of a patented component.

But, in this blog post, I want to survey three public policy justifications that to some degree support the practice.  My goal is not to defend the current damages regime; quite the opposite, I am enormously skeptical of the rules as they stand today, and I fear that the patent system as currently constituted does more harm than good.  That said, the only way to engage in a meaningful discussion of patent reform is to first understand the best points in favor of the current approach.  To that end, I here want to sketch the case in favor of what might otherwise seem to be excessive damages numbers.

One reason why patent law intentionally exaggerates is that exaggeration encourages private parties to negotiate rather than litigate.  The mechanism here is obvious: An infringer who knows that litigation will yield exaggerated liability has strong incentives to avoid litigation.  This is good public policy primarily because judges and juries are not well equipped to value patented inventions.  True, they might be able to make educated guesses based on the evidence presented; they might even be as likely to overestimate as they are to underestimate.  But, in any specific dispute, there is little reason to believe that judges and juries will come up with even a remotely accurate estimate for the value of the patent at issue.

Private negotiation, by contrast, can be reliable.  There are a number of caveats and conditions to consider here, but, at a high level, private negotiation is attractive in instances where it can take place before the would-be infringer has made any investments that are specifically tied to the patented technology.  Negotiation after investment does not work.  If the infringer has already built its factories or made commitments to its customers, a patent holder at that point can demand a royalty that reflects not only the value of the patented technology as compared to next-best alternatives, but also the value that this infringer would place on avoiding disruption to its existing business.

Negotiation prior to investment, however, is a different story.  Prior to investment, negotiation between a patent holder and a potential infringer will typically resemble a competitive interaction.  The patent holder will ask for a high starting price; the potential infringer will counter by pointing to potential substitute technologies.  Ultimately, the process should yield a price that accurately reflects the marginal advantages of the patented technology.

Exaggeration thus can serve a useful purpose.  If infringers are able to negotiate prior to making any patent-specific investments, exaggeration can helpfully increase their desire to do so.  The net result is a patent system where patents are more likely to be priced in the private market, and courts are therefore more often able to avoid the difficult task of valuing patented inventions themselves.

The second justification for patent law exaggeration derives from the concern that, without exaggeration, infringers would have a strong incentive to hide their illegal activity instead of addressing it.  My remarks thus far already speak to this concern in part.  My first justification for exaggeration was that it creates an incentive for an infringer to negotiate prior to making patent-specific investments.  Obviously, to negotiate, an infringer will have to identify himself to the patent holder, and thus an incentive to negotiate is simultaneously a disincentive to hide.

But hiding is a bigger issue than just that.  Consider, for instance, an infringer who neither knew nor could have known about a patent prior to making patent-specific investments.  If this infringer later discovers the patent, he will be reluctant at that point to contact the patent holder and negotiate, because then the patent holder will hold hostage the infringer’s already-made investments.

Worse, this infringer will have an affirmative incentive to keep quiet.  After all, the patent holder might never even notice the infringement and hence, if the infringer keeps his head down, he might never have to pay.  The patent system on these facts faces a real challenge: The system needs to create an incentive for the infringer to identify himself, but at the same time it needs to protect him from an undesirable hostage situation.

Exaggerated damages can solve this problem.  Where there is evidence that the licensee reasonably could have stepped forward but chose not to, patent law can punish that choice by exaggerating.  The infringer would suffer because of his decision to hide, and in the long run that would encourage infringers in similar situations to step forward.

By contrast, in cases where the licensee does step forward, patent law can promise to take its thumb off the scale, calculating royalties with an eye toward the royalty the parties would have struck had they been able to strike a deal back before the infringer first invested.  The parties would then hopefully foresee that even-handed result and negotiate in its shadow.  But the key point is that the backstop to their negotiation would be the threat of a truly reasonable royalty, and not the threat of either a hostage-taking situation or exaggerated court remedies.

The third justification for patent law exaggeration is simply this: Exaggeration is the way the patent system accounts for changes in patent uncertainty.  Prior to litigation, there is almost always some uncertainty as to whether the patent at issue is valid and/or whether the patent at issue actually has been infringed.  That is, the accused infringer might plausibly argue that the patent should never have been issued, and the accused infringer might similarly argue that its technology is not covered by the patent’s claims.  Litigation resolves the uncertainty.  Thus, when a patent holder prevails, the damages awarded naturally are higher than the royalties the parties would have negotiated prior to verdict.  Negotiated royalties reflect uncertainty; court-determined royalties do not.

Think of it this way: If prior to litigation a patent holder and a would-be licensee both agree that there is a 50-percent chance that the asserted patent is invalid, their private deal would reflect those doubts.  The licensee would demand a discount as compared to a sure-thing royalty, and the patent holder would accept that discount in order to avoid the risk of a bad outcome.  If that patent holder ends up successfully litigating the issue, however, the resulting court-ordered royalty should no longer reflect that 50-percent discount.  Had the patent holder lost the case, he would have earned nothing.  Given that he won, he should correspondingly earn the undiscounted award.  Intuitively, that’s what it means to take the risk of actually litigating the issues.

Reasonable minds can disagree over whether damages exaggeration is an effective way to address the above three policy concerns.  And reasonable minds can also worry that patent law exaggeration goes far beyond these bounds, increasing damages even when none of the above stories remotely apply.  For now, though, I want to only point out that we should not expect damages after litigation to necessarily match the royalties that the parties would have negotiated prior to infringement.  Patent damages must accomplish much more, namely: encouraging private parties to negotiate, encouraging infringers to step forward, and ensuring that uncertainty with respect to validity and infringement are properly accounted for in the ultimate legal outcome.