State Industries, Inc., Plaintiff/cross-Appellant v. Mor-Flo Industries, Inc. And American Appliance Mfg. Corp.

Citation: 883 F.2d 1573Docket: 89-1032

Court: Court of Appeals for the Federal Circuit; November 8, 1989; Federal Appellate Court

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Mor-Flo Industries, Inc. and its subsidiary, American Appliance Manufacturing Corporation, were found to have infringed State Industries, Inc.'s Patent No. 4,447,377, which details a method for insulating water heaters using polyurethane foam. The district court awarded State lost profits on about 40% of Mor-Flo's infringing sales and a 3% royalty on the remaining sales, determining that Mor-Flo's infringement was not willful, thus denying enhanced damages and attorney's fees.

The '377 patent describes a method involving wrapping the water heater tank with a plastic sheet, installing a jacket and cover, pouring foam through an opening, and sealing the opening to contain the foam. Mor-Flo's infringing method involved using a cylindrical plastic sleeve over the tank, which was taped below the top of fiberglass insulation. In the liability trial, Mor-Flo argued that its sleeve did not qualify as an 'envelope' as required by the patent. However, the court found the sleeve identical to a partial envelope embodiment in the patent, and noted that Mor-Flo developed its method only after examining a State water heater. The court concluded that Mor-Flo's method literally infringed the patent and also held that it infringed under the doctrine of equivalents. The appellate court upheld the lost profits and royalty award but vacated the finding of non-willfulness, remanding for further determination on that issue.

The water heater industry is characterized by intense competition and low profit margins. The patent in question pertains specifically to residential gas water heaters recognized as 'energy efficient' by the American Society of Heating, Refrigeration and Air Conditioning Engineers. Foam insulation offers superior insulating properties compared to fiberglass, leading to cost advantages in materials, packaging, and shipping. Foam-insulated heaters can meet energy code requirements while occupying less space, and the foam's density enhances the strength of the heater's outer jacket, making it more dent-resistant.

In addressing the damages, the district court examined three primary issues: lost profits, reasonable royalty, and willful infringement. Infringement was identified between May 8, 1984, when the patent was issued, and June 9, 1986, when Mor-Flo adopted a non-infringing method. State provided evidence of lost sales and sought recovery for its market share of Mor-Flo’s infringing sales, along with a reasonable royalty for the remainder and increased damages due to willful infringement.

The court ruled in favor of State, awarding lost profits for part of the damages and a royalty for the remainder. It recognized a growing demand for foam-insulated water heaters, with State's patent being the first method to address this demand, and noted that during the infringement period, most of State's competitors were utilizing either State’s patented method or a similar one. A Canadian competitor also employed these methods. A.O. Smith Corporation was identified as the only non-infringing competitor, using fiberglass insulation, which the court deemed an inferior substitute due to its disadvantages.

The court determined that State could produce and sell enough foam-insulated water heaters to capture its 40% market share of Mor-Flo’s sales, awarding State lost profits on 40% of the sales of 754,181 infringing Mor-Flo water heaters. For the remaining 60% of sales, State sought a royalty of 8-10%, while Mor-Flo argued it should not exceed its net profit margin of 2.1%. The court ultimately set the royalty at 3%. Additionally, it ruled that Mor-Flo’s infringement was not willful, as it acted on the advice of outside counsel. Mor-Flo is appealing the actual damages and royalty reasonableness, while State cross-appeals regarding the royalty's reasonableness and the determination of willfulness and increased damages.

Determining damage awards is inherently discretionary for district courts, which must base their decisions on factual findings, avoiding clear errors or legal mistakes. The damages aim to compensate patent owners for losses due to infringement, as outlined in 35 U.S.C. Sec. 284. The minimum damage award is a reasonable royalty, while actual damages can include lost profits if proven. To establish lost profits, the patent owner must show a reasonable probability of making the infringer's sales without the infringement, though they need not eliminate all alternative purchaser behaviors. A recognized method for demonstrating lost profits involves proving demand for the patented product, lack of acceptable substitutes, the capacity to exploit demand, and the expected profit. The district court's reliance on this method supports its judgment. Additionally, the court acknowledges the lack of prior rulings on whether lost profits can derive from market share but maintains that its discretion in remedy selection is bound only by the need for adequate compensation. Any uncertainties regarding the award favor the patent owner.

In cases where the patent owner and infringer are the sole suppliers in a market, the patent owner aims to recover profits lost from infringer sales. If the patent owner possesses the necessary manufacturing and marketing capabilities, it is reasonable to assume they could have captured the infringer's sales. The Panduit test, often applied in such scenarios, supports claims of lost sales when the patent owner asserts that its sales are equivalent to the infringer's. However, this case involves multiple competitors, with the patent owner alleging that these competitors either infringed or provided inferior alternatives, such as fiberglass.

The district court treated the lack of acceptable substitutes as a neutral factor while assigning market shares to competitors, which could allow the patent owner to claim a greater market share, including sales attributed to infringing competitors. Regardless of the accuracy of this assumption, the patent owner’s market share was affirmed, and it would receive at least what it sought. The court noted that Mor-Flo, the infringer, had benefitted from this approach, as the allocation of credit to infringing competitors reduced the market share against which Mor-Flo's damages could be evaluated. Thus, the existence of acceptable non-infringing alternatives was deemed irrelevant in this context.

Regarding demand, the district court highlighted a significant need for foam-insulated heaters in the late 1970s, stating that State's patented method effectively addressed industry challenges. Evidence of this demand was reflected in State's sales growth, from fewer than 200,000 to over 400,000 heaters between 1984 and 1986, yielding $155.2 million in net revenue. Mor-Flo also reported substantial sales from foam heaters, indicating a strong market demand. Despite Mor-Flo's marketing efforts, it did not provide evidence of any unique value from its water heaters' other components. Ultimately, the district court concluded that during the infringement period, there were no viable non-infringing methods for foaming gas water heaters, indicating that the demand centered on the patented method itself.

Mor-Flo argues against the district court's findings that certain alternative methods could have infringed on State's patents, specifically disputing the availability of the 'top-off' method and fiberglass foam stop during the infringement period. The testimony from Bradford-White's president regarding the 'top-off' method's use was uncertain and lacked corroborating evidence prior to 1987. Mor-Flo's claims about the fiberglass foam stop being on the market were unsupported, as evidence indicated it was only introduced by Mor-Flo in June 1986. The court emphasized that for a method to be a substitute, it must be commercially available, and Mor-Flo's patent application for the foam stop was filed in December 1986.

The court also questioned whether the Rheem foam belt method likely infringed, given that it was prior art to State's '377 patent. However, it noted that customer demand was for foam insulation, and both State and Rheem were the only patented methods available, suggesting that they would have captured a share of Mor-Flo's infringing sales due to this demand.

Regarding market share, the court found that State had a 40% national market share, which Mor-Flo did not contest, but Mor-Flo claimed the majority of infringing sales occurred in California, where State shared a smaller market percentage. The district court dismissed Mor-Flo's argument about the 'Western Region' being unrealistic, affirming that State had the capacity to meet its market share and had lost sales to Mor-Flo's infringing products, evidenced by testimonies from retailers in California and Connecticut. Therefore, the district court reasonably inferred that State could have met the demand for its products in the market.

The district court awarded State damages for patent infringement based on the incremental profit from foam-insulated gas water heaters, acknowledging that this method is established for such cases. The court found fixed cost variations to be minimal and deemed the award of incremental profits appropriate without requiring greater precision. The profit margin was aligned with the entire market value rule, allowing recovery based on the value of the entire apparatus when the patented feature drives customer demand. Mor-Flo's argument that foam insulation was not a key driver of consumer demand was dismissed, as they did not provide evidence for the value of nonpatented components, which cannot be sold separately except as repair parts.

The court affirmed that it acted within its discretion in basing damages on State's market share. Mor-Flo's attempts to introduce new evidence on appeal were deemed irrelevant, as the trial record supported the damage award. The only direct evidence regarding a reasonable royalty came from State's president and an expert, suggesting a rate of 8% on infringing sales. Mor-Flo's actual profit margin was only 2.1%, leading them to argue for a lower royalty, but the court clarified that the reasonable royalty is determined by hypothetical negotiations at the time of infringement, not based on the infringer's profit margin. The established success of State's process and Mor-Flo's choice of foam over alternatives reinforced the value of the patented feature.

Collateral sales values may influence the royalty rate, as seen in Deere Co. v. International Harvester Co. The district court appropriately considered gross profits in determining royalty rates, with Mor-Flo’s gross profit at 19.6% and net incremental profit at 17.48%. During infringement, Mor-Flo's net profits ranged from 5.9% to 7.3%, leading the court to conclude a 3% royalty on net sales was reasonable.

Mor-Flo argued the availability of alternative methods, such as the Rheem patented plastic foam belt and others, to mitigate damages. However, the court noted the lack of evidence that these alternatives were accessible or that Mor-Flo could have licensed them. The district court's decision to disregard third-party patents in mitigating damages was deemed appropriate.

Regarding State's cross-appeal, the court recognized the competitiveness of the water heater industry with small profit margins, and found that while fiberglass was a lesser alternative, it remained a direct competitor to foam insulation. Thus, the district court reasonably concluded that potential licensees would avoid high licensing fees, favoring more profitable alternatives.

On the issue of willful infringement, the court found that the determination is fact-based and must meet a clear and convincing standard. Mor-Flo/American's knowledge of potential infringement was insufficiently proven, as they relied on erroneous legal advice without evidence of awareness of its inaccuracy. Consequently, the court ruled that their actions did not constitute willful infringement, and punitive damages were not awarded.

The standard for establishing willfulness in patent infringement cases is based on whether a reasonable person would have confidence that a court might find the patent invalid or not infringed. Actual knowledge of infringement is not necessary. The court determined that Mor-Flo should have been aware of the infringement, which contradicts the finding of nonwillfulness. However, Mor-Flo's reliance on incorrect legal advice, asserting that their method did not infringe, was also noted. Despite this, the court indicated that Mor-Flo's method was intentionally designed to resemble that of State's, which is indicative of willful infringement. Due to conflicting evidence on these issues, the judgment regarding increased damages under 35 U.S.C. § 284 is vacated and remanded for further consideration of willful infringement and enhanced damages. This uncertainty may also impact the conclusion on attorney's fees. The judgment is partially affirmed, partially vacated, and remanded, with Mor-Flo responsible for the costs of the appeal.