Hold-up and standard essential patents: leading economists weigh in

Do you own a mobile phone? Have you recently bought a printer? Are you thinking about replacing your DVD player with a new Blu-Ray system? If you answered yes to any of these questions, be careful when you handle your hi-tech devices. They are full of dangerous standard essential patents (SEPs), which are commonly believed to be a potential cause of hold-ups and patent ambushes in the information and communication technology sector. To ensure that these risks are promptly dealt with, three high-profile personalities in the US and EU joined forces to publish a short paper on how 'Standard Setting Organizations Can Help Solve the Standard Essential Patents Licensing Problem'.

Don't touch my SEP!

To recap in brief, firms may create a standard setting organization (SSO) to define a set of technical specifications that provides a common design for a product or process. The standard includes the interoperability information and technology needed to allow industry participants to create compatible products (mobile phones that use the UMTS or 3G network, networks that implement the TCP and IP protocols, etc.). If the implementation of a standard necessarily requires the use of a patented innovation, commonly referred to as a standard essential patent (SEP), its owner is usually required to commit to licensing it on (fair), reasonable and non discriminatory terms (F/RAND).

The adoption of standards brings about several beneficial effects, allowing a more efficient resource allocation, increasing consumer choice, reducing research and development costs, promoting the cross-licensing of intellectual property rights. However, it also creates potential negative effects, which the European Commission, in its 'Guidelines on the applicability of Article 101 of the TFEU to horizontal co-operation agreements', summarized as follows:

(1) if companies were to engage in anti-competitive discussions in the context of standard-setting, this could reduce or eliminate price competition in the markets concerned, thereby facilitating a collusive outcome on the market;

(2) standards that set detailed technical specifications for a product or service may limit technical development and innovation ... Once one technology has been chosen and the standard has been set, competing technologies and companies may face a barrier to entry and may potentially be excluded from the market ... In addition, standards requiring that a particular technology is used exclusively for a standard or preventing the development of other technologies by obliging the members of the standard-setting organisation to exclusively use a particular standard, may lead to the same effect; 

(3) standardisation may lead to anti-competitive results by preventing certain companies from obtaining effective access to the results of the standard-setting process ... If a company is either completely prevented from obtaining access to the result of the standard, or is only granted access on prohibitive or discriminatory terms, there is a risk of an anti-competitive effect.

In their short paper [shall we call it a manifesto?, wonders Merpel], Professors Kai-Uwe Kühn (Chief Economist at the DG Competition of the European Commission), Fiona Scott Morton (former Chief Economist at the Antitrust Division of the US Department of Justice), and Howard Shelanski (Director of the Federal Trade Commission's Bureau of Economics) focused on the risk that the owner of a SEP could use its market power to engage in hold-up practices. 'Hold-up occurs', the authors explain, 'when the SEP owner approaches firms practicing the standard—after those firms have invested in developing their products that depend on the standard - with an onerous licensing demand [which places] the firm in a poor bargaining position'.

Howard Shelanski

The key issue is identified with the uncertainties surrounding F/RAND terms and the validity of the patents, which allow the SEP owner to ‘obtain payment far in excess of the ex ante value of the technology, and [to] appropriate the profits due to the later investments of others’, by threatening to engage in expensive litigation or by pursuing an injunction, if the licensee does not pay the requested royalties. This situation, according to the paper, ‘raises licensing costs in the industry, distorts markets for innovation and investment, and discourages adoption of standards’.

The proposed solution focuses on the role of SSOs. The authors suggest four improvements that organisations should implement through their IPR policies [headings added by the IPKat]:

Transfer of F/RAND obligations in case of sale.

IPR policies should create as strong a commitment as possible to bind future owners of the IPR to any F/RAND commitments made to the SSO. Clearly a F/RAND commitment that becomes weaker or more vague upon the sale of a patent (or undermines a commitment to effective dispute resolution) will not to be as effective in protecting consumers as one in which all F/RAND obligations must be transferred in a sale.

A fast and low cost process to adjudicate F/RAND disputes.

Fiona Scott Morton

A F/RAND commitment should include a process that is faster and lower cost for determining a F/RAND rate, or adjudicating disputes over F/RAND, than litigation. The expensive nature of litigation creates frictions in the market for ideas, is a high transaction cost for licensees, and renders this market less accessible for smaller firms. Each SSO can consider alternatives (even if leaving litigation as one possible option) that it thinks will work well for its members and technologies, [...including] arbitration and alternative dispute resolution within the SSO. These procedures could be made more efficient by the SSO defining, for example, the specification of the base to which a royalty should apply or other factors that would simplify the assessment as to whether a particular licensing offer is F/RAND. 

An obligation to specify acceptable cash price.

The F/RAND dispute resolution process should require that the licensor specify a cash price for its SEPs as an alternative to other pricing arrangements to aid in evaluation of the proposed license terms by the third party. Determining if a complex package of crosslicenses satisfies F/RAND is difficult for a third party. If the licensee has the option to choose a F/RAND cash price, but instead chooses to cross-license, then clearly it is better off.

Restrictions to the use of injunctions and exclusion orders.

The F/RAND commitment should include a process that SEP owners must follow before they can seek an injunction or exclusion order by the licensor. This process would include specifying what steps must be taken by parties to resolve disputes over a F/RAND’s rate, validity, essentiality, or infringement before an injunction or an exclusion order may be sought against the licensee. Reducing the ability of licensors to threaten to exclude a product from the market will reduce the ability of the licensor to extract royalties above the F/RAND rate and other significant licensing conditions from willing licensees. The essence of the F/RAND commitment is that the firm has voluntarily chosen to accept royalties rather than pursue a business model based on exclusion. This suggests that there can be no irreparable harm from the use of the SEP. 

Kai-Uwe Kühn

While reading the influential paper, this Kat had a distinct sense of déjà-vu. The proposed improvements could indeed contribute to limit the SEP owners' leverage on their market power, allowing potential licensees to gain access to standards on fairer terms. However, the proposal mainly focuses on the adoption of procedures aimed at resolving [rather than preventing] conflicts between the SEP owner and the licensee. This indirect approach is certainly strengthened by the temporary suspension of the SEP owner's right to seek injunctive relief in case of disagreement (and the USPTO agrees), which creates a stronger incentive to settle and levels the field between the parties, but is it enough to cope with the potential anti-competitive risks embedded in F/RAND licensing?

Several studies (one of the most famous is here, another here) highlighted the necessity of directly addressing other substantial issues, ranging from the definition of 'essentiality' to the disclosure of patents and licensing terms. In 2011, a 'Study on the Interplay between Standards and Intellectual Property Rights (IPRs)' provided a more comprehensive list of improvements to be implemented by SSOs. These included:

• clear and binding IPR policies including irrevocable and worldwide licensing commitments;
• legal certainty in case of the transfer of essential patents to third parties; 
• reasonable incentives for good faith IPR inquiries and disclosure;
• transparent, complete and accessible IPR databases;
• cooperation with patent offices on identifying prior art.

It appears that the approach suggested by the paper may provide a good answer to some of these aspects. Other issues, however, remain unresolved and are likely to jeopardise the efficiency of the proposed improvements. What follows is a short, incomplete recap of potential improvements that would warrant a more in-depth discussion:

1. the specific and early disclosure of standard essential patents and of the rights thereby claimed (in particular, avoiding generic or 'blanket' assertions, which shift search costs on potential licensees);
2. the publication of disclosure information in a searchable database available to the public;
3. the expressed inclusion of patent applications, alongside issued patents;
4. the definition of the requisite of 'essentiality' and the exclusion of useful or equivalent patents;
5. the ex-ante disclosure of licensing terms (the EU Commission, in its 'White paper - Modernising ICT Standardisation in the EU : the Way Forward', suggested that a '[d]eclaration ex-ante of the most restrictive licensing terms, possibly including the (maximum) royalty rates before adoption of a standard, may be a means of improving the effectiveness of (F)RAND licensing since this can allow for competition on both technology and price' - however, it has been noted that this could cause negative effects);
6. the definition of an economic approach (possibly standardised) to calculate F/RAND terms (here is an interesting take on approaches based on the cooperative game theory, the Swanson-Baumol model and other theories);
7. the evaluation of ancillary licensing terms proposed by the SEP owner (most notably, grant backs), when establishing whether an agreement contains F/RAND terms;
8. the predisposition of rules aimed at ensuring that the licensor does not apply discriminatory licensing terms, which could lead to de facto exclusivity or substantial competitive advantage for a privileged licensee;
9. the analysis of risks related to patent staking and the amendment of IPR policies to take this factor into account;
10. the implementation of a mechanism devoted to the assessment of compliance with IPR policies.

Now it is time for the IPKat to step back and let readers share their view. Are the improvements proposed by the paper sufficient to address potential hold-up? Which aspects of F/RAND licensing could be improved through IPR policies? How to achieve a fair balance between the interests of SEP owners and licensees? Which would be the best way to give concrete content to the notions of fair, reasonable and non discriminatory licensing?