How Patent Damages Skew Licensing Markets

If a litigated patent has previously been licensed to a third party, the courts generally adopt the terms of the prior agreement as the best measure of damages. However, while administratively convenient, this “licensing-based damages” standard creates problematic incentives and undermines the efficient commercialization of patented inventions. It rests on the trivialized (and generally false) presumption that a patent license is like a commodity, with the patentee charging a common price to all comers. As a consequence, patentees distort their future recovery prospects – and by extension the outcomes of future licensing negotiations – whenever they license their patents, whether or not today’s agreement will be a good proxy for tomorrow’s dealings or disputes. Knowing this, patentees are discouraged from licensing at anything less than a high royalty rate, even if they could reach many additional mutually-beneficial agreements on more modest terms. The result is that patent holders rationally cut off the bottom segment of the licensing market, creating substantial deadweight loss. This injures not only patentees, but also prospective licensees and their consumers. The standard creates additional problems by encouraging secrecy and “gamesmanship” in patent licensing. We propose that the licensing-based damages standard be abandoned, and that damages should generally be awarded ad hoc. This does not mean that private parties should ignore comparable licenses in their private dealings; it simply means that courts should not use them as a measure of damages. That this necessitates some speculation does not suggest it is the less desirable approach, for it is better that damages be somewhat random than systematically harmful. Further, while the licensing-based damages standard is clearly easy to apply, there is little reason to believe it is accurate in a typical case. As such, its apparent lack of randomness does not suggest that it is producing good results.