Principles of FRAND Royalties

1. Principles of FRAND Royalties Norman Siebrasse University of Toronto Patent Colloquium 2014

2. FRAND Royalty Determinations Microsoft Corp v Motorola, Inc, Robart, J In re Innovatio, Holderman J CSIRO v Cisco, Davis J Samsung v Apple, Japan Huawei v InterDigital, China Ericsson v Micromax, India (interim)

3. Microsoft v Motorola“ECONOMIC GUIDEPOSTS FOR ASSESSING RAND TERMS”

4. Economic Guideposts • Avoid patent hold-up • Avoid royalty stacking • Ensure reasonable return to patentee • Reflect value of the technology, not value of the standard • Reflect relative importance of individual patent to the standard

5. Economic Guideposts • Avoid patent hold-up • Two issues, one important, one not important • Avoid royalty stacking • Ensure reasonable return to patentee • Reflect value of the technology, not value of the standard • Reflect relative importance of individual patent to the standard

6. Economic Guideposts • Avoid patent hold-up • Two issues, one important, one not important • Avoid royalty stacking • Important • Ensure reasonable return to patentee • Reflect value of the technology, not value of the standard • Reflect relative importance of individual patent to the standard

7. Economic Guideposts • Avoid patent hold-up • Two issues, one important, one not important • Avoid royalty stacking • Important • Ensure reasonable return to patentee • Two issues • Reflect value of the technology, not value of the standard • Reflect relative importance of individual patent to the standard

8. Economic Guideposts • Avoid patent hold-up • Two issues, one important, one not important • Avoid royalty stacking • Important • Ensure reasonable return to patentee • Two issues, one important, one not important • Reflect value of the technology, not value of the standard • Not important • Reflect relative importance of individual patent to the standard

9. Economic Guideposts • Avoid patent hold-up • Two issues, one important, one not important • Avoid royalty stacking • Important • Ensure reasonable return to patentee • Two issues, one important, one not important • Reflect value of the technology, not value of the standard • Not important • Reflect relative importance of individual patent to the standard • Desirable, but difficult

10. hold-up

11. Two Kinds of Hold-Up 55 The ability of a holder of an SEP to demand more than the value of its patented technology and to attempt to capture the value of the standard itself is referred to as patent “hold-up.” Standard value hold-up

12. Two Kinds of Hold-Up • The threat of hold-up increases as the standard becomes more widely implemented and firms make sunk cost investments that cannot be recovered if they are forced to forego implementation of the standard or the standard is changed. • Sunk cost hold-up

13. Standard Value Hold-Up ([see alsoSchmalensee Testimony] (explaining that the “essence of hold-up” is that while ex ante competition constrains what a patent holder can obtain for access to its patent, ex post, the technology in the standard does not face that competition).)

14. Standard Value Hold-Up: Example 1 • 100 firms that have developed and patented WiFi technology, A, B, C . . . • All equally good. • Very cheap to implement • Each adopted by 10 users in isolated networks • Each user pays royalty = $10 • Total value of the technology = $10k • Each of the 1000 users would be willing to pay $100 each if all users were using the same technology

15. Standard Value Hold-Up • SSO chooses A as the standard • A is adopted by all users • Total value of the technology = $100k • Recall, each user willing to pay $100 for standardized tech • Difference between ex ante and ex post value = value of standardization = $90k • If A can get injunction, it can charge $100 each • A can get full value of the market

16. Standard Value Hold-Up • Imagine ex ante auction for privilege of being chosen being chosen as standard • Patentees make royalty bid to users • Users choose patentee with lowest bid • What would be the winning royalty bid? • $0 • Swanson & Baumol; Layne-Farrar, Padilla & Schmalensee • Royalty constrained by ex ante competition • All of the value of standardization is captured by users

17. Standard Value Hold-Up • Winning patentee should not be able to charge more ex post than it would have been able to charge ex ante • The . . . attempt to capture the value of the standard itself is referred to as patent “hold-up.” • while ex ante competition constrains what a patent holder can obtain for access to its patent, ex post, the technology in the standard does not face that competition. • Why not?

18. Standard Value Hold-Up: Example 2 • No firm has developed WiFi technology • Value of the market = $0 • Firm A develops and patents WiFi technology • No other firm does the same • A is adopted by all users • Each user pays $100 to A • Total value of the technology = $100k • A captures the entire value of the market = $100k

19. Standard Value Hold-Up • Why should A be able to capture entire value of standardization in Example 2, but not in Example 1? • When the standard becomes widely used, the holders of SEPs obtain substantial leverage to demand more than the value of their specific patented technology. This is so even if there were equally good alternatives to that technology available when the original standard was adopted. • What is wrong with that?

20. Fairness Objection • Not fair that A should be able to demand more ex post than it could have ex ante • But also not fair that patentees should get $0 in Example 1, but everything in Example 2 • Cf Shapley value pricing, in which patentees capture entire value of standardization, regardless of the amount of competition ex ante: Layne-Farrar et al • Why should users capture 100% of the value of standardization, when they have contributed nothing?

21. Efficiency Objection • From user perspective, no difference between Example 1 with hold-up and Example 2 • Hold-up has no adverse effect on user behaviour

22. Incentive Problem • Two firms develop and patent different technologies for use in valuable standard • Each technology is equally good • Under auction pricing model, each will get $0 royalty • Insufficient to induce creation of technology • Auction model considers pure static efficiency • Does not consider incentive to innovate

23. Legal Counter-Argument Swanson-Baumol is an auction model An auction is not a negotiation Auction drives patentee down to minimum willing to accept Negotiationsplits difference between minimum willingness to accept and maximum willingness to pay

24. Standard Value Hold-UpSummary • Allowing standard value “hold-up” • Has no adverse effect on user behaviour • May have positive effect on incentive to innovate • Conclusion • Standard value hold-up is not an important problem

25. Sunk Cost Hold-up • A holds patent for piling for offshore oil platform • $100k to license ex ante • User builds $10m platform using patented method • Anticipates $11m revenue for $1m profit • A sues ex post • User will pay $10m to avoid injunction ex post • Net profit = Negative $9m

26. Sunk Cost Hold-up • Threat of ex post injunction with sunk costs increases risk • User will invest in less risky projects • Social loss from sunk cost hold-up is avoidance of positive value investments • Cf standard value hold-up • Users will not avoid WiFi even if they have to pay $100 ex post

27. Sunk Cost Hold-Up • The threat of hold-up increases as the standard becomes more widely implemented and firms make sunk cost investments that cannot be recovered if they are forced to forego implementation of the standard or the standard is changed. • Same in principle as non-SEP sunk cost hold-up • Though more of a problem in practice • Ex ante licensing may be impractical

28. Distinguish Sunk Cost and Standard Value Hold-up • Sunk cost hold-up • Does not require a standard • Requires sunk costs • Makes user less likely to adopt • Standard value hold-up • Requires a standard • Does not require sunk costs • Does not affect ex ante user decision to adopt

29. Hold-Up Summary • Standard value hold-up unique to SEPs • But not an important problem • Sunk cost hold-up a serious problem • But not unique to SEPs • Though very important in SEP context

30. Royalty Stacking

31. Royalty Stacking The payment of excessive royalties to many different holders of SEPs is referred to as “royalty stacking.” The RAND commitment also addresses royalty stacking and the need to ensure that the aggregate royalties associated with a given standard are reasonable.

32. Royalty Stacking • Technical problem • Cournot complements • Many patentees with complementary patents negotiating independently with user will charge more than single patentee holding all of the patents • Practical problem • Excessive demands • Motorola asked 2.25% of product price • Implies $150 royalty on $300 Xbox, for video standard alone

33. Royalty Stacking • Royalty stacking only occurs when there is more than one SEP • Often 100s of US SEPs, thousands worldwide • Cf hold-up (both kinds) which can occur when there is only one SEP

34. Patent Pools

35. Patent Pools • Group of patentees pool patents and offer single licence to users • Solves • Royalty stacking • Sunk cost hold-up • Does not solve • Standard value hold-up

36. Patent Pools Robart J used a patent pool comparator to set FRAND rate As discussed with relation to SSO policy, RAND is informed by two prevailing concerns: preventing stacking and eliminating hold-up. The court finds that, among these two goals, the anti-stacking principle is the primary constraint on the upper bound of RAND.

37. Ensure reasonable return to patentee

38. Reasonable Return to Patentee To induce the creation of valuable standards, the RAND commitment must guarantee that holders of valuable intellectual property will receive reasonable royalties on that property. Encourage standards Requires that return to patentee must be higher than return to outside option

39. Reasonable Return to Patentee Moreover, since licensing through SSOs under the RAND commitment is, at least for some entities, an important component of profitability, reducing that component would reduce the incentive to innovate and thereby slow the pace of innovation in the economy Preserve incentive to innovate Requires that return to patentee is sufficient to cover costs of innovation

40. Reasonable Return to Patentee • These are distinct concerns • Preserving the incentive to innovate is NOT generally a concern • If a patentee spends $100m to develop a worthless product, it should not be rewarded • Encouraging creation of standards is a basic goal of the FRAND commitment • A return sufficient to induce patentee to join standard may not cover the cost of innovation • This concern emphasized by Robart J

41. Reasonable Return to Patentee • Lower bound of FRAND rate should be value of outside option • Patent pool comparator addresses this problem • Patent pools need to attract patentees as well as licensees

42. Reflect value of the technology, not value of the standard

43. Reflect Value of the Technology See above re Standard Value Hold-Up

44. Reflect relative importance of individual patent to the standard

45. Relative Importance of Patent [A] patent that is extremely important and central to the standard would reasonably command a higher royalty rate than a less important patent. What does “important” mean?

46. Relative Importance of Patent • 1) Function is important to the value of the standard • WiFi transmission technology is important • Power management functions less important • 2) Many other options for achieving the same function • WiFi transmission has several good technologies which compete ex ante

47. Relative Importance of Patent Both may be assessed by incremental value Microsoft contends that the economic value of patented technology isolated from the value derived from incorporation into the standard would be determined by calculating the incremental value of the technology compared to the alternatives that could have been written into the standard.

48. Relative Importance of Patent If function is important, but many competing technologies, incremental value of the patent is small If only one technology, but function is relatively unimportant, increase in incremental value of the standard is small

49. Relative Importance of Patent In practice, approaches linking the value of a patent to its incremental contribution to a standard are hard to implement. SSOs do not use incremental value Patent pools do not use incremental value Courts do not use incremental value

50. Relative Importance of Patent • Pure incremental value approach is difficult to implement • But importance of patent in question may be assessed in relation to comparator • Robart J considered patent pool comparator • Assessed patents in question as not being of more than average importance • Did not adjust pool rate upwards