Patent Damages and Real Options: How Judicial Characterization of Non-Infringing Alternatives Reduces Incentives to Innovate

The legal framework under which patent damages are calculated changed substantially after the Federal Circuit decided Grain Processing Corp. v. American Maize-Products Co. in 1999. Perhaps the most important question in the typical lost profits analysis is determining the fraction of the infringing sales that constitute lost sales to the patent holder. The answer to this question usually depends on the set of non-infringing substitute products to which the customers of the infringing product could have turned in the but-for world where the infringing product was not available to them. Before Grain Processing, the case law as a legal matter generally restricted the set of non-infringing substitute products to include only products that were actually sold in the marketplace.

For example, an infringer could claim that it would have continued to sell a non-infringing product that it had actually been selling and that this product would have captured some of the infringing sales, which would tend to limit the patent holder’s lost sales. However, the infringer could not claim that it would have developed and introduced some new non-infringing product in the but-for world and that this product would have captured some of the infringing sales. Grain Processing eased this restriction on the set of non-infringing substitutes available in the but-for world by allowing an infringer to claim that it would have offered a non-infringing product that, although not actually sold in the marketplace, was technically feasible at the time and could have been made commercially available relatively quickly. The Grain Processing decision then went further and concluded that, in the particular case at issue, the plaintiff was not entitled to lost profits because the infringer’s non-infringing product would have been identical from the point of view of customers (though more costly to the infringer). Damages were therefore calculated on a reasonable royalty basis only.

Although Grain Processing has generated much scholarly commentary, we are unaware of any article considering the factor that we see as the decision’s most important economic ramification: the grant of a free option to the infringer. Although it is widely appreciated how Grain Processing has made it more difficult for patent holders to claim lost profits damages, it is less well understood how Grain Processing has affected the incentives of companies to risk litigation by using patented technology (without a license) rather than to avoid infringement by using an economically inferior non-infringing technology.

Whether the patent is valid and infringed is not known until the litigation takes place. A patent only provides the patent holder with the right to sue for infringement. A court decides whether the patent is valid and infringed. We find that the grant of a free option is contrary to the basic framework of the patent system in the United States. If a firm chooses to risk litigation and use the patented technology, it retains the option to switch to the non-infringing technology if the patent is later found to be valid and infringed. Of course, it will be liable for damages for the period of infringement.

If, on the other hand, the firm chooses to use the non-infringing technology, it will not have the opportunity to learn whether the patent is valid and infringed. Thus, by choosing the patented technology, the firm keeps its options open, although at the risk of having to pay damages once the uncertainty regarding validity and infringement is resolved. Grain Processing has the effect of substantially decreasing this risk by decreasing the size of the damages award. If the patent is found to be valid and infringed, the firm can argue under Grain Processing that it would have switched to the non-infringing technology in the but-for world, thereby effectively making the switch retroactively.

Grain Processing thereby makes the option essentially free. By providing potential infringers with increased option value if they use the patented technology, Grain Processing reduces the deterrent effect of litigation and therefore encourages infringement. Consequently, it reduces the returns to research and development, and so also the incentives to innovate.

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