Winter 2011

Greetings!

Invotex® Group is pleased to share insights about current trends and issues of interest to litigators and counsel, particularly those with which we have recent experience. We hope you find this information informative, and we welcome your feedback.

In this Issue

1. Patent
   Questions Stemming from Recent Uniloc v. Microsoft Opinion
2. Valuation
   Is it Enough to Distinguish between Personal Goodwill and Enterprise Goodwill when Dividing Marital Assets?
3. IP Transactions
   How to Avoid Licensing Disputes
4. Financial Investigations
   How Madoff Used Options to Defraud Investors
5. The Year in Review
   It’s a Wrap - A Look at Invotex’s Litigation Group in 2010
6. Continuing Professional Education
   Upcoming Events

Patent

Questions Stemming from Recent Uniloc v. Microsoft Opinion
by Edward A. Gold

On January 4, 2011, a Federal Circuit panel of three judges, including Chief Judge Rader, issued an opinion in Uniloc USA, Inc. and Uniloc Singapore Private Limited v. Microsoft Corporation holding, in part,

“This court now holds as a matter of Federal Circuit law that the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation. Evidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.”(1)

The Court’s broad condemnation of the “25% rule” itself rather than the application of the rule by the Plaintiff’s expert raises important questions.

Quoting from an article by Robert Goldscheider, John Jarosz and Carla Mulhern,(2) the Court states, “The Rule suggests that the licensee pay a royalty rate equivalent to 25 percent of its expected profits for the product that incorporates the IP at issue.”(3) The Court later explains that, “The rule does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party.”(4) In other words, the Court is demanding the damages expert draw a tighter connection between the specific facts and circumstances facing the hypothetical negotiators and the conclusion reached by the expert.

Applying the rule as defined in the aforementioned Goldscheider article to the Uniloc case facts would result in a royalty computed as 25% multiplied by the profits(5) associated with the sale of an $85 per unit software product. However, as described by the Court, Uniloc’s expert did not actually compute damages in this manner. Instead, “Gemini took the lowest value, $10, and testified that this is “the isolated value of Product Activation.” Gemini then applied the so-called “25 percent rule of thumb,” hypothesizing that 25% of the value of the product would go to the patent owner and the other 75% would remain with Microsoft, resulting in a baseline royalty rate of $2.50 per license issued.”(6) One can argue over whether $10 represents the isolated value of Product Activation and thus “tie[s] a reasonable royalty base to the facts of the case,”(7) but the Court is silent on this point. Instead the Court focuses solely on the 25% component of the calculation.(8)

The Court’s focus raises a couple of questions:

1. Is the Court insisting that when any rule of thumb is used for one component of a calculation of damages, its use should be tied to case-specific facts? If yes, then what happens if in a future matter one sees evidence of actual use of the 25% rule by the parties and / or other industry participants?
2. Is the Court accepting of the generalized profit split approach(9) as long as the split of profits is connected to case-specific facts? If yes, then will District Court judges be able to distinguish the nuance between an expert’s application of the profit split approach and the 25% rule?

In the Uniloc opinion, the Court also retraces the CAFC’s reasoning and conclusions in each of three recent decisions related to damages: ResQNet, Lucent and Wordtech.(10) The Uniloc Court then concludes, “The meaning of these cases is clear: there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case.”(11) Throughout the individual case summaries and, therefore, the overall conclusion, the Uniloc Court focuses attention on the need to connect prior licenses to the hypothetical negotiation at hand. Generally, prior licenses provide market-based data for valuation purposes while the 25% Rule falls with the category of income-based approaches. This market-based theme is further reinforced when, after reiterating its support for using the Georgia-Pacific factors to frame a damages analysis, the Court states, “In particular, factors 1 and 2—looking at royalties paid or received in licenses for the patent in suit or in comparable licenses—and factor 12—looking at the portion of profit that may be customarily allowed in the particular business for the use of the invention or similar inventions—remain valid and important factors in the determination of a reasonable royalty rate.”(12) There is only a passing reference in the next sentence to the use of “any other factors.”

The Court’s emphasis on market-based factors leads to further questions:

3. Why didn’t the Court call attention to other factors connected to profit and profit apportionment, in particular, factor 13 (the portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks or significant features or improvements added by the infringer)?
4. Will the Court be accepting of greater weight being applied to a profit split approach than to evidence from arguably comparable licenses? What if, in the ResQNet matter, the Plaintiff’s expert rejected all the comparable licenses that the CAFC later ruled should have been rejected and found himself left with the choice of using one settlement-related license (which might have required adjustment to be sufficiently comparable to the hypothetical negotiation) versus using a profit split approach? Would the expert have been free to conclude that a profit split approach under factor 13 requires less judgment and thus warranted receiving greater weight than the prior license under factor 1?
5. Finally, what about factor 14 (the opinion testimony of qualified experts)? What should happen if an expert has made her or his own significant use of the 25% rule in non-litigation licensing contexts? What if based on that experience, the expert believes that the hypothetical negotiation is similar?
   

It is too soon to predict how these questions will be resolved in future matters. However, in light of this decision, experts and attorneys will need to use carefully selected, case-specific evidence to develop reliable estimates of damages.

For more information, contact Edward A. Gold.
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(1) Uniloc v. Microsoft, (Fed. Cir. January 4, 2011), page 41.
(2) Use Of The 25 Per Cent Rule in Valuing IP, 37 les Nouvelles 123, 123 (Dec. 2002).
(3) Uniloc v. Microsoft, (Fed. Cir. January 4, 2011), page 36.
(4) Uniloc v. Microsoft, (Fed. Cir. January 4, 2011), page 45.
(5) Generally defined as operating profits elsewhere in the Goldscheider, et al. article.
(6) Uniloc v. Microsoft, (Fed. Cir. January 4, 2011), page 34.
(7) Uniloc v. Microsoft, (Fed. Cir. January 4, 2011), page 41.
(8) This question arises at two other points in the opinion. In the first instance the Court states, “To be admissible, expert testimony opining on a reasonable royalty rate must “carefully tie proof of damages to the claimed invention’s footprint in the market place.” ResQNet, 594 F.3d at 869.” (Uniloc, page 46.) In the second, the Court states, “He did not testify … that the contribution of Product Activation to Office and Word justified such a split.” (page 47.) In both instances, the Court appears to focus on the split component of the calculation and does not address the adequacy (or inadequacy) of selecting $10 as a means to tie the damages to the claimed inventions’ footprint. This article does not express any opinion on whether Plaintiff’s expert did successfully tie the damages to the claimed inventions’ footprint. However, it might have been helpful had the Court articulated more fully its reasoning.
(9) The profit split (or apportionment or allocation) approach is a commonly accepted methodology for the valuation of intellectual property in a wide variety of non-litigation contexts. (See for example Valuing Intangible Assets, Robert F. Reilly and Robert P. Schweihs, McGraw Hill, 1999 and Valuation of Intellectual Property and Intangible Assets, Gordon V. Smith and Russell L. Parr, John Wiley & Sons, Inc., 2000.) It likewise is applicable to intellectual property damages calculations. (See for example Litigation Services Handbook, Third Edition, Roman L. Weil, Michael J. Wagner, and Peter B. Frank editors, chapter 24, pages 25 to 27 and “Avoiding the Patent Storm”, Bryan Benoit and Kimberly Cauthorn, Intellectual Asset Management, October / November 2006.) Like all valuation methodologies, the profit split approach must be applied with care. The 25% Rule is a specific subset of the generalized profit split approach.
(10) ResQNet.com, Inc. v. Lansa, Inc., 594 F.3d 860 (Fed. Cir. 2010); Lucent Techs., Inc. v. Gateway, Inc., 580 F.3d 1301 Fed. Cir. 2009); and Wordtech Systems, Inc. v. Integrated Networks Solutions, Inc., 609 F.3d 1308 (Fed. Cir. 2010).
(11) Uniloc v. Microsoft, (Fed. Cir. January 4, 2011), page 45.
(12) Uniloc v. Microsoft, (Fed. Cir. January 4, 2011), page 46.

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Valuation

Is it Enough to Distinguish between Personal Goodwill and Enterprise Goodwill when Dividing Marital Assets?
by William J. Bavis

Family courts for most jurisdictions in the United States find the distinction between personal goodwill and enterprise goodwill a troublesome matter. The current majority rule is that the corporate component of goodwill (referred to as “enterprise”) is a divisible marital asset, but the component of goodwill attributable to the skills and efforts of the subject individual (referred to as “personal” or “professional”) is not.

Both attorneys and valuation analysts struggle with the distinction between enterprise and personal goodwill. This struggle has become murkier as recent cases have further designated personal goodwill as “transferable” or “nontransferable” goodwill. In McReath v. McReath, WL 2943198 (Wis. App) (July 29, 2010), the court determined that all salable goodwill is a marital asset subject to division, whether it is personal or enterprise. In McReath the court looked at a prior purchase transaction as evidence that the “lion’s share” of the value of the professional practice, as evidenced by a non-compete, was personal goodwill. Accordingly, “there is no serious dispute that a significant, but unspecified, portion of [the $1 million practice value] is attributable to saleable professional goodwill.”

Consideration of the terms of a potential sale seems to be consistent with the concept of “fair market value,” in that a “willing seller” is an assumed component of the definition of “fair market value.” Using a “willing seller” concept makes it more likely that goodwill will be transferable, both personal and enterprise, as it assumes that the seller is willing to assist in the transfer to maximize the value of the sale. Typical to transactions, the covenant assists in the transfer of the “personal” goodwill.

Attorneys and valuation analysts may need to further refine their evaluation of goodwill in light of recent cases such as McReath. This analysis might include:

• Enterprise goodwill, which is transferable by definition in that it belongs to the enterprise;
• “Transferable” personal goodwill, which may be evidenced by patient lists, covenant not to compete, etc.; and
• “Nontransferable” goodwill consisting of unique personal relationships, exclusive skills or talents of the individual, etc.

In McReath, the husband claimed that allocating transferable personal goodwill to the wife with an award of maintenance constituted an unfair double dip, which is consistent with the rulings in many jurisdictions that have concluded that personal goodwill cannot be included both for division and for support as it is double counting of revenues. The Wisconsin court acknowledged a problem if the husband continued in practice. Alternatively, if the husband retired or died after the divorce, excluding the value of the transferable goodwill from the marital settlement would cause the wife to lose her full share of the practice’s value and then lose maintenance also.

For more information, contact William J. Bavis.

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IP Transactions

How to Avoid Licensing Disputes
by Michele M. Riley and Debora R. Stewart

The reasons behind entering into an intellectual property (IP) license are numerous and include dissemination of knowledge and technology for the greater good as well as expansion of market share for the IP holder. Much time is spent by the parties to the license in the negotiation stages discussing minute details regarding fields of use and indemnity clauses. Arguably, the license would never be consummated if it was not for the consideration paid for the license. However, IP holders often do not receive the full amount of monies they are due under license agreements. In fact, the most recent statistics from Invotex’s royalty audit practice show alarming results. Invotex has found that in 86% of the licenses it audits, there are instances of misreporting. The most common causes of misreporting are issues of license interpretation, followed by oversights relating to the launch of new products or sales made in new territories. Chart 1 summarizes Invotex’s most recent findings (April 2010) relating to the dollar impact of royalty reporting errors.

As shown in Chart 1, 47% of the dollars associated with the total amount of understated royalties Invotex has uncovered during its royalty audits are related to questionable license interpretation.

IP holders can employ one of several tactics to avoid disputes over consideration—particularly the implementation of a robust and consistent monitoring program that is designed to deter such complications as questionable license interpretation. In addition, IP holders can employ strategies for dealing with licensees when underpayments are suspected.

Prevention of underpayments / avoidance of disputes
An important preemptive strategy for avoiding disputes over consideration is for the licensor to implement a robust and consistent monitoring program for licenses. A license agreement that is monitored consistently is generally less likely to result in significant underpayment of royalties. A compliance program should include desk audits and full royalty audits.

A desk audit is a monitoring activity that can be performed without visiting a licensee location. Within the context of a desk audit, licensors should analyze royalty payments for accuracy. For example,

• If royalty payments suddenly decrease, is there a valid explanation?
• If there are cost deductions from the royalty base, are those cost deductions appropriate? 
• Are any of the calculations unsupported or lacking in sufficient detail? 
• Do the calculations include sales by sublicensees? 
• Does the calculation include sales from all relevant geographies?

A desk audit also should compare data from various sources to identify anomalies. For example,

• If a product catalog or other marketing materials of the licensee are accessible, are all relevant product names/codes included on the royalty report?
• Do public statements about sales growth (e.g., press releases) agree with the royalty report?
• How does the performance of licensed products compare to the performance of other products sold by the licensee?
• How do the royalty payments made by one licensee compare to the royalty payments made by other licensees?

A royalty audit is designed to determine whether or not a licensor is receiving royalty payments in accordance with the license agreement. A royalty audit typically involves three phases: (1) pre-site research, (2) site investigation, and (3) post-site analysis and report. Each of these phases is discussed in turn below.

• The first phase typically includes an analysis of all relevant information available from both public sources and the licensee prior to the site visit.
• The second phase involves investigative interviews—typically in the accounting, finance, technical, marketing, business development and royalty reporting areas. A facility tour may also be deemed appropriate. The focus for this phase is to gain a thorough understanding of the accounting and reporting systems the licensee uses for royalty reporting.
• The third phase involves continued analysis and development of the audit report.

A license monitoring program will not succeed without active and meaningful communication between the licensor and the licensee. As such, another preemptive strategy is for a licensor to develop and foster a healthy and productive relationship with its licensees. To that end, licensors should:

• Contact licensees regularly. Know who is submitting royalty and other reports and when those reports should be submitted. Make sure the individual responsible for preparing the royalty report has detailed knowledge of the license agreement. Request to be notified of changes in royalty reporting staff.
• Follow up immediately in cases of delayed, insufficient or incorrect data.
• Call licensees to acknowledge receipt of reports, thank them for their timeliness and discuss any relevant developments.
• Perform audits early in the licensing relationship so that potential misunderstandings regarding the terms of the license agreement can be addressed as soon as possible.
• Make audits routine rather than reactive. Make it clear that all licenses that meet a certain threshold or are of a certain type will be audited. If a formal monitoring program is implemented, advise each licensee of the program so that no licensee feels targeted.

Dealing with licensees when underpayments are suspected
It is not uncommon for individuals who did not participate in the original negotiation of a license agreement to be in charge of preparing the royalty report. Therefore, misreporting is almost de rigueur. Although all licenses should be part of a comprehensive monitoring program, certain red flags will indicate that there is an increased potential for misreporting of royalties and that immediate follow-up is required. Red flags can be identified through an analysis of a royalty report or by scrutinizing the licensee’s performance in the marketplace. These red flags, some of which have been touched on above, include the following:

• There are unsupported calculations, or there is an insufficient level of detail surrounding the calculations.
• The licensor is not able to respond to questions about its royalty calculation.
• Royalty payments are late.
• Minimum payments are not in complete compliance with the license agreement.
• Royalty payments are not as high as anticipated or are not in line with current market expectations.
• The royalty report demonstrates inconsistent sales in relation to market performance.
• The royalty report shows poor performance of a licensed product compared to other licensee products.
• The royalty report indicates a poor or failing financial condition for the licensee.
• The royalty reports continuously contain miscalculations of amounts owed.
• The licensee operates with poor internal controls.
• The royalty report contains evidence of product combinations.
• The licensee uses complex distribution channels for the licensed product.
• The licensee’s contact person, who possesses comprehensive knowledge of the license agreement, is inconsistent or nonexistent.

What happens when a licensor receives a royalty report and suspects that royalties are underpaid? What tactics can be used to remedy the situation? The first step is to communicate with the licensee in an effort to resolve any questions or concerns that have arisen. There may be a straightforward and acceptable answer that can assuage the licensor’s suspicions of misreporting. Or, there may be a difference in language interpretation within the license agreement that can be amicably and quickly resolved.

If communication efforts do not resolve suspicions of misreporting, the next step is to confirm the underpayment via a royalty audit, such as that described above. This should be done promptly, before any additional loss is incurred or the business relationship is further compromised, to enable the licensor to negotiate with full information rather than negotiating in the dark.

License agreements typically state that a third party auditor will perform the audit. A licensee will likely feel more comfortable being audited by a third party because of the unbiased and non-adversarial nature of the relationship. The selected auditor must have significant royalty audit experience and expertise to communicate effectively with licensee personnel, analyze complex contract provisions and uncover sales that can be masked by product combinations or complex distribution channels. A royalty audit is a different animal than a financial statement audit. The required expertise is very distinct.

If a royalty audit uncovers an understatement of royalties, the auditor can provide (1) a quantification of the unreported sales dollars or units and (2) a quantification of the amount of royalties owed. The next step is for the auditor and /or licensor to work alongside the licensee to identify any flaws in the royalty tracking system and develop measures that can be taken to prevent future misreporting.
A licensor that suspects an understatement of royalties may be inclined to immediately pursue legal action against the licensee. Nonetheless, even if an alleged understatement is confirmed via preliminary audit results from an independent auditor, the licensor should complete all of his due diligence before commencing legal action. The licensor should consider the following:

• Is the audit final?
• How much money is at issue?
• How valuable is the overall business relationship with the licensee?

Is the audit final? Whether or not the audit is final is critical. Obtaining information through the audit process is less costly than obtaining information through the discovery process. It may achieve the same result in terms of the collection of relevant documents without the onus of the myriad of legal requirements surrounding the discovery process. In addition, the licensee will likely be more forthcoming with information than he would be through interrogatories and depositions. As such, if the audit is not yet final, care should be taken to ensure that all documents associated with the underpayment are collected.

How much money is at issue? The key here is to consider whether the anticipated cost of litigation outweighs the potential for recovery. Perhaps a negotiated settlement, even if reduced from the amount of the underpayment, will still outweigh any recovery via the legal system once attorney costs and court fees are taken into consideration.

How valuable is the overall business relationship with the licensor? A litigation proceeding can be an efficient and effective way to terminate a business relationship. If commencing litigation against the licensee will serve as a lethal dose of poison to the business relationship, the licensee will need to think long and hard about whether the recovery of any underpayment via the legal process (after attorney, court and other possible fees) outweighs the anticipated value stemming from a profitable business relationship into the future.

But, if the licensee refuses to acknowledge the underpayment or takes an unacceptable position vis-à-vis the interpretation of language within the agreement, the next step may be legal action if it is deemed necessary to recoup losses. Taking legal action may also be warranted if the IP is licensed out to many parties and the licensor, along with legal counsel, deems it necessary (and value-added) to send a message to all licensees that underpayments will not be tolerated and will be dealt with through the legal process.

Final words
Invotex Group’s most recent statistics show that there are instances of misreporting in 86% of the licenses it audits. Whether those instances of misreporting relate to intentional omissions of product sales, to pure human error, to some ambiguity within the license agreement or to something else, the frequency of misreporting suggests that licensors need to take more proactive measures to prevent misreporting.

Implementing a robust and consistent monitoring program can help prevent instances of misreporting, as will developing and fostering a healthy and productive relationship with licensees.
When misreporting is uncovered, a licensor needs to determine the most effective and appropriate method for the collection of underpayments, whether that is a negotiated settlement or legal action.

For more information, contact Michele M. Riley or Debora R. Stewart.

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Financial Investigations

How Madoff Used Options to Defraud Investors
by Stephanie G. Kelly

In the Fall 2010 edition of Litigation Perspectives, we discussed how Lehman Brothers allegedly used repurchase agreements to move debt off its books to mislead investors. In this article, we will illustrate how Bernie Madoff used option theory to mislead and defraud investors of more than $85 billion. Option theory, not option trading, is an appropriate description since it is alleged that Madoff never actually traded.

Option trading has four basic trades: long a call option, short a call option, long a put option and short a put option.  When depicted in a payoff diagram, the option trades resemble a hockey stick: the payoff line begins as a straight horizontal line to depict a zero payoff until the underlying price is equal to the option’s strike price.  An inflection point occurs at the time the strike price equals the underlying price. The payoff line rises at a 45 degree angle.

Madoff was able to attract investors with above market returns achieved on a consistent basis.  As time passed, his returns remained constant and positive even when the market declined significantly.
 
When questioned about his performance, Madoff responded that he purchased put options to protect the portfolio (long the underlying and long a put, referred to as a protective put) and would sell call options to generate additional returns (long the underlying and short a call, referred to as a covered call).  In theory, his answers would be logical. However, in reality, the market only had $1 billion in options outstanding, and Madoff would have to have traded $7 - $65 billion in options to achieve his results; making his strategy impossible.(1)

Additionally, Madoff’s performance, which could be illustrated with an extraordinarily long, 45 degree payoff line, did not make sense when combined with the option trading that he alleged he was implementing.  When the options trades are combined with the Madoff’s long-only portfolio, the combined strategy’s return does not resemble the 45 degree line.(2) Using this strategy, the cost alone would have negatively affected his returns.

Option traders, upon hearing of Madoff’s strategy, told inquirers that Madoff was not participating in the option market. While there are numerous lawsuits against those who helped facilitate the fraud, the underlying question is what should be done about those who suspected that he was a fraud and did nothing about it?  The CFA Institute ethical guidelines state that “although a failure to report is less likely to be construed as a violation than a failure to dissociate from unethical conduct, the impact of inactivity on the integrity of capital markets can be significant.”(3)   The Dodd-Frank bill contains a whistleblower component that will compensate persons for turning in suspected fraudsters.  Only the future can tell if market participants have learned that the do-nothing approach has the greatest consequences and impact on all of us.

For more information, contact Stephanie G. Kelly.
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(1) No One Would Listen:  A True Financial Thriller by Harry Markopolos
(2) http://www.cboe.com
(3) CFA Institute Code of Ethics, Guidance for Standards, Standard I – Professionalism.

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The Year in Review

It's a Wrap - A Look at Invotex’s Litigation Group in 2010

Invotex’s litigation practice expanded in both size and expertise over the course of 2010. Two additional senior level professionals joined the practice, and we expanded our fraud investigation capabilities as well as our economic and complex litigation credentials.

Edward A. Gold, Ph.D., ASA joined the firm as a managing director. With nearly 20 years of economic consulting experience, Dr. Gold’s experience includes analyzing liability and damages related to intellectual property, antitrust, and other complex commercial litigation; valuing intellectual property assets; and applying economic and financial analysis in non-litigation settings.

In addition, Stephanie G. Kelly, CPA/CFF, CVA, joined the firm as a Director. With more than 14 years of financial and accounting experience, Ms. Kelly works on behalf of clients involved in accounting malpractice, fraud investigations, management conflicts, stockholder disputes, damage claims and bankruptcies. Her experience includes providing business valuation, bankruptcy consulting and litigation support to various clients.

Overall, the firm initiated work on nearly 50 new litigation matters involving Intellectual Property, antitrust, fraud, breach of contract, marital dissolution and other commercial claims for clients comprising public and private companies, institutions of higher education and government entities.

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Upcoming Events

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Disclaimer: The opinions expressed in this newsletter are the opinions of the individual author(s) and may not reflect the opinions of the firm or any other individual associated with the firm.