CPIP Research Scholar Jonathan Putnam and co-author Tim Williams’ paper “The Smallest Salable Patent-Practicing Unit (SSPPU): Theory and Evidence,” shows how poorly patent law measures the value of litigated patents. Using theory and empirical evidence, they show that the economic contribution of patented technology is better measured by the output, such as the commercial product, rather than the smallest input, or component, that embodies the invention. Unfortunately, the theoretically and empirically supported conclusions they reach stand in stark contrast to the state of the law as it currently exists.
The paper begins by surveying how the courts have arrived at the current method for determining patent damages, called the smallest salable patent-practicing unit (SSPPU) rule. In a nutshell, patent damages are often assessed as a “reasonable royalty” paid by the infringer for his use of the patented technology. This is calculated by determining a rate (e.g. 3%) and multiplying it by a base (either the product or some portion of it that has an identifiable price). As the name suggests, the SSPPU rule requires that the base be the smallest salable patent-practicing unit rather than the final product as actually commercialized.
Putnam and Williams trace this rule to an idiosyncratic and quixotic case where there was a need to guard against a patent owner’s overreaching because of particular litigation behavior and unusual procedural issues. However, what was initially an ad hoc solution developed in a lower court for unique circumstances was later generalized to become the default rule in many patent cases.
Proceeding next to mathematically rigorous economic theory, Putnam and Williams show why the generalization of the SSPPU rule conflicts with basic economic theory. Because different components of a product interact to generate the product’s value, they conclude that properly determining the value added by an invention on a component requires looking at the incremental value added to the final product. In other words, the SSPPU rule fails to account for how the invention may improve the product of the whole beyond just the smallest component.
As a prosaic example, Putnam and Williams use smartphone battery life. The battery is a clearly identifiable component to which the SSPPU rule could apply for a patent improving battery life. But the value of the invention is not just in the battery, but also in how the invention affects the design and tradeoffs in the rest of the phone. The improved battery life may permit a larger screen or result in other changes in smartphone design. Attributing the value of the improved battery life only to the price of the battery will not capture the effect of the invention on all the other components that go into the final product. Using the value of the smartphone—i.e. the final product—is the only royalty base that captures all of the interacting effects that determine the value of the battery improvement invention.
Of course, all of this theoretical modeling would be for naught if real world actors behaved differently. After surveying previous studies and publicly available license terms in the telecommunications sector, Putnam and Williams were able to confirm for the vast majority of cases that the royalty base was not a component or combination of components. Furthermore, they were not able to identify a single instance where a mere component, salable or not, was used as the royalty base. This confirms in practice what they showed in theory, that the final product is the economically proper method for measuring royalties.
The paper addresses one final flaw with the SSPPU rule. As the SSPPU rule has become entrenched in court opinions, there have been efforts to expand its use to entire patent portfolios rather than individual patents. Putnam and Williams use a sample patent portfolio to show that this would be misguided for an additional reason: the smallest salable unit would not be “patent practicing” in relation to the entire portfolio.
Despite demonstrating that using the final product rather than the SSPPU would be the economically pure way to determine the royalty base, Putnam and Williams propose a more nuanced solution. Courts should use economic theory to scrutinize the royalty bases proposed in litigation. For example, it would be useful to permit the patent owner to show the normal practice in the industry or which product in the supply chain captures the incremental value of the patented technology. As their paper shows, this will typically be the final product.
Importantly, the proposed reform is not the unfaltering use of the final product’s price as the royalty base. If the royalty rate approaches zero because the royalty base is too large, using a smaller base may be helpful. In other words, if the final product is too distant in the supply chain from the invention, it may be hard to properly align the rate with the base. This was one of the exigent circumstances that led to the SSPPU rule in the first place, where the patent was on a system related to how computer CPUs make calculations, but the patent owner claimed damages on entire servers and workstations. Rather than make the error at the other extreme, Putnam and Williams’ recommendations simply allow the parties to make arguments and develop evidence that is consistent with basic economics, rather than apply inappropriately rigid judge made rules.