Standard-Essential Patents: The Question of FRAND Licensing and Its Impact on Standard-Setting, Competition and Innovation

The complexity of modern information and communications technology (ICT) has put almost every firm in the sector in the awkward position of not only competing with its rivals but also providing them with intellectual property (IP). Licensing the use of patents covering technologies that have been incorporated in a technical standard on ‘fair, reasonable and non-discriminatory’ (FRAND) terms has become a core issue for the industry. In recent years, there have been a growing number of high-stakes legal disputes over the meaning of FRAND – and in recent months, there have also been some potentially landmark court decisions.

The nature of ‘standard-essential patents’ (SEPs) and FRAND licensing - and their implications for standard-setting, competition and innovation - were the focus of a major TSE conference earlier this year. The high-level discussion brought together academic experts, corporate representatives, consultants and policy-makers from patent offices and competition agencies in Europe and the United States.

Among researchers and regulators, there have been some concerns that ambiguities and omissions in the FRAND system used by most standard-setting organizations (SSOs) might undermine innovation - so it was valuable to hear the perspectives of a diverse range of technology companies.

At the same time, many academics act as expert witnesses, informing courts on potential resolutions of conflicts: their formalized ways of thinking offered insights into the problems that firms face ‘in the trenches’.

The Value of Interoperability

When competing firms within an industry get together to agree on something, economists typically expect that it will be harmful to consumers. But in the case of standard-setting in technology industries, the opposite is very often the case: consumers can benefit a great deal. For example, widely disseminated standards like Wi-Fi can be of great value to consumers, assuring them that when they take their laptop computer to the coffee shop, they will be able to connect to the internet.

Voluntary standard-setting organizations (SSOs) enable industry participants to meet and establish technical standards. For example, the Institute of Electrical and Electronics Engineers established the standard for Wi-Fi. Such standards allow ‘interoperability’ across different platforms.

In general, standards can facilitate competition and innovation, but it is important to ensure that SSOs do not provide opportunities for anti-competitive behavior by firms. Competition economists tend to keep Adam SMITH’s famous warning in the back of their minds: ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.’

Once a standard like Wi-Fi has been established, it will naturally rely on IP that is owned by some of the firms – what are known as ‘standard-essential patents’ (SEPs). So most SSOs will say to their members, if you want your technology included in a standard, you have to promise to license it to users on ‘fair, reasonable and non-discriminatory’ (FRAND) terms - which is usually interpreted to mean at a very low price. This is intended to ensure that the market power that is generated by ownership of SEPs cannot be exercised.

ICT products like routers and smart phones typically embody a great many patents, some of which are necessary for the implementation of a standard that allows interoperability across platforms. In such cases, the technologies cannot be implemented without using SEPs and hence it becomes important to think about how to make them as widely available as possible, how SSOs should ask their members to make FRAND commitments and how to resolve conflicts over the meaning of FRAND.

FRAND commitments serve to promote the standard by assuring firms that use it that they will not be blocked from bringing their products to market as long as they are willing to pay reasonable royalties for any SEPs. The commitments are also intended to provide reasonable rewards to firms that have invested in research and development (R&D) to develop the technology used by the standard.

The reason that a FRAND promise is needed upfront is that once the standard becomes successful and popular (everybody adopts it, coffee shops invest in routers, firms invest in factories to make the chips and so on), then the owner of the IP could try to charge a very high price for it - a problem known as ‘hold-up’. With everybody locked in, the costs of switching to an alternative technology could be very high, so they would just have to pay the high price.

But foreseeing that outcome, firms and consumers would be hesitant to make use of the standard. To forestall that outcome and to ensure that the standard is successful, owners of SEPs are asked to make FRAND commitments. The problem then comes when there are ex post disagreements about what FRAND actually means - and in practice, there has been a great deal of costly litigation as a result.

For example, disagreements can arise over the exact definition of a FRAND commitment and the validity of the patent. Potential licensees may claim that a licensing demand made by a SEP owner is not a FRAND offer or that the patent is not valid or essential in the first place. But even when the potential licensee is likely to be correct in such an assessment, the SEP owner can still make it very costly to resolve such disputes.

A SEP owner’s threat to engage in expensive litigation (or to pursue an injunction or exclusion order, which would forbid the defendant from using the technology, if the licensee does not pay the requested royalties) creates a powerful incentive for a licensee to settle, even on poor terms. Thus, SEP owners can obtain payment far in excess of the value of their technology and appropriate the profits due to the later investments of others. Such behavior potentially raises licensing costs in the industry, distorts the market for innovation and discourages adoption of standards.

The recent surge of litigation in the smart phone and other technology sectors, much of which concerns the interpretation and enforcement of FRAND commitments, has brought these issues to the attention of regulators. Many feel that a better approach to FRAND is needed.

The View from the Trenches

Ostensibly, there is a great deal of disagreement and polarization between parties involved in the debate over FRAND, in part perhaps because it is a manifestation of a global battle between rival platforms. But discussions at the corporate roundtable of the TSE conference suggested that there is much more on which industry participants agree than might be expected.

By and large, the ‘view from the trenches’ seems to be that the system of FRAND in SSOs is working and that, despite all the litigation, the problems may be somewhat overstated. While there is a desire by many market participants to avoid the growing legal costs and uncertainty associated with existing rules, some corporate representatives see litigation as a natural part of the patent system and the appropriate way to resolve disputes.

But while there is a general level of consensus as to what are the chief issues, there is less consensus about how to reach solutions - and what should be the respective roles of the SSOs, the courts and the competition agencies. Certainly, there is increasing involvement by the competition agencies, particularly on issues related to the definition of the FRAND commitment; whether FRAND commitments go with a patent when it is transferred; and whether and to what extent FRAND commitments preclude the availability of injunctions or exclusion orders in the international trade arena.

Nevertheless, the general consensus from the corporations is that the process of developing standards through the SSOs and the FRAND system of licensing that supports the deployment of IP into standards are an engine of innovation. In general, economists and the competition agencies agree with the view that this engine is working at least adequately.

But research by Justus Baron and colleagues finds a beneficial effect of the proliferation of SEPs on the progress of standards only when ownership of the SEPs on a given standard is concentrated. And a study by Jorge Contreras notes that FRAND commitments have proved ineffective in addressing the problem of ‘royalty stacking’, which occurs when multiple patent holders assert rights in - and demand royalties on - the same standard (both papers are summarized in the accompanying post, “Summaries of Recent Studies of SEPs/FRAND by Leading Economists”).

Furthermore, as some economists pointed out at the conference, what is not observed is the counterfactual: how much innovation there would have been in a world where the FRAND system worked more effectively. As one said, ‘the problem is that we don’t know what we don’t know’.

The Assessment of the Courts

While there has been a great deal of litigation surrounding FRAND commitments, it is important to note that most of the firms have been on both sides of the table – as both defendants and claimants in disputes about intellectual property rights (IPR). This suggests that, ultimately, they should all have an interest in finding the solution that is best for society, given that they are not always on the same side of the issue.

Of course, litigation is very expensive, but by involving both economic expertise and legal expertise, the process does try to evolve legal rules that embody economic good sense and it has procedurally rich ways of doing that. As several participants noted, it is hard to see how resolution of some of these FRAND disputes could happen without litigation. If the opinions are written well by courts, then eventually the issues should be resolved and litigation should abate.

Indeed, there have been several significant SEP-related court cases that are beginning to suggest some guidelines. One is the very first court estimate of a FRAND royalty, which was made in April 2013 when Judge James Robart put a figure on what Microsoft should reasonably pay for two SEPs relating to video and Wi-Fi that are owned by Motorola Mobility (which is now part of Google).

Motorola had originally demanded a royalty as a percentage of the final price that Microsoft charged for any product using the SEPs - for example, an Xbox games console. Instead, the judge recommended a royalty measured in cents rather than dollars, on the basis of which Microsoft would owe Motorola $1.8 million a year as opposed to the original demand of $4 billion. A jury subsequently found that Motorola had breached its FRAND commitments over the two SEPs, and the judge has rejected Motorola’s motion to overturn the verdict.

In a separate case relating to Wi-Fi, another judge has applied a modified version of Judge Robart’s methodology to determine the FRAND rate to be paid by manufacturers of Wi-Fi equipment for 19 SEPs owned by Innovatio. Exhaustive details of the decisions on these cases and many others can be found on the blogs that discuss SEPs and FRAND (see “Summaries of Recent Studies of SEPs/FRAND by Leading Economists”). A paper by Gregory Sidak presented at the conference aims to provide courts with a practical approach to determining FRAND royalties (see the summaries of studies in the accompanying post, “Summaries of Recent Studies of SEPs/FRAND by Leading Economists”).

The Role of the Standard-Setting Organizations

The issues surrounding standards and the licensing of IP are really global problems. Most of firms are operating globally and many of the SSOs are global organizations: consumers naturally want their coffee shop connection to Wi-Fi to be guaranteed to work wherever they are in the world.

But the strategies of firms in their litigation over what constitutes FRAND commitments are often local: they might bring a case in Germany or different places in the United States. This phenomenon of ‘forum shopping’ arises because there are rules that are more favorable to one party or the other in different jurisdictions.

There are also considerable differences in terms of the tools available to competition agencies in different parts of the world. The European Commission, for example, has a tool called Article 102 that is designed to deal with monopoly and market power and which makes it possible to pursue companies on the grounds of ‘abuse of dominance’; in the United States, the antitrust tools are less flexible and so the competition agencies cannot pursue companies in the same way as in Europe. There is also an issue of whether the policies, competition rules and court decisions in the two continents are actually consistent with one another.

It is also important to look beyond the West, especially at what China is doing in this area. The Chinese have a very aggressive standard-setting policy driven by central government, whereas in the Western economies, standard setting is much more market-driven, which is one reason why there is so much ambiguity in the system. China seems to be much more focused on how the government thinks these policies ought to work, which has the potential to generate conflict with the Western SSOs.

The processes of the SSOs on the use and licensing of IP in ICT have recently been examined by a committee commissioned by the National Academy of Sciences to look at ‘Patent challenges for standard-setting in the global economy’. Among the many recommendations in the report, which was published in late 2013, the committee ‘urges SSOs to become more explicit in their IPR policies regarding their understanding of and expectations about FRAND licensing commitments’.

The Way Forward

In both Europe and the United States, competition agencies are increasingly signaling their willingness to intervene in the SEPs licensing problem because they fear that industry bodies are not delivering. For example, there are policy initiatives to regulate the use of SEPs to prevent adverse effects of so-called ‘patent thickets’ on the development and use of new technology. The high number of SEPs is in particular perceived to be responsible for the legal battles characterizing the telecoms industry.

While the TSE conference understandably did not reach an agreed position among the diverse range of participants on the way forward, a common theme was that since it is the actions of SSOs that create market power for SEP owners, they have the responsibility to ensure that this market power is constrained so that consumers can benefit as much as possible from standard-setting activity.

There was no great debate on economic principles: what needs to be done is to make FRAND work better. Papers by Jorge Contreras, by Kai-Uwe Kühn and colleagues, by Mark Lemley and Carl Shapiro, and by Josh Lerner and Jean Tirole suggest ways in which the SSOs can act (see the summaries of studies in the accompanying post, “Summaries of Recent Studies of SEPs/FRAND by Leading Economists”).

One participant concluded: ‘a big message is that there is a need for organizations such as the industry bodies to provide that improvement in the processes that is necessary. We cannot rely necessarily on the courts; we cannot rely on other antitrust agencies to do the jobs of the court. If the solution needs to come from within, then it needs to come from within. But it needs to be fast because the antitrust agencies are pursuing this.’

The preceding was written by Romesh Vaitilingam, and is re-published on TAP with permission by the Toulouse Network for Information Technology (TNIT). “Standard-Essential Patents: The Question of FRAND Licensing and Its Impact on Standard-Setting, Competition and Innovation” was originally published in TNIT’s December 2013 newsletter.