2. FRAND Commitments and Royalties for Standard Essential Patents

This chapter addresses the conceptual and practical effect of Fair, Reasonable, and Non-Discriminatory (henceforth “FRAND”) commitments to standard setting organizations (henceforth “SSOs”) on royalties for standard essential patents (henceforth “SEPs”). While SSO activities are recognized as potential sources of economic efficiency, the nature of the SSO process facilitates and requires communication and agreement among parties that may otherwise compete in the marketplace, thus leading to antitrust agencies and private counsel to require caution in the standard setting process. The industry-wide, international scope of technological agreement in SSO activities is a potential source of market power for intellectual property owners. The risk of such market power has led technology adopters to seek assurances from technology contributing SSO participants that technologies adopted in the standard are made available on FRAND terms. In addition, it has become increasingly common for technology contributors to provide FRAND commitments in conjunction with their SSO participation. Recent decisions by U.S. courts and regulatory agencies have clarified that FRAND commitments can be binding on technology contributors, and that determination of FRAND royalty rates on standard essential technology can be meaningfully different from that applicable to technology unencumbered by FRAND commitments. More specifically, determination of FRAND royalty rates likely requires inquiry into the apportionment of inherent technology value from value that resulted from the SSO process and standard itself. This chapter addresses various methods to evaluate the sources of economic value of SEPs, to apportion inherent technology value from that resulting from a standard, and the implications of such apportionment on the royalties for FRAND encumbered SEPs.

Technical or industry standards (henceforth “standards”) have become an integral part of technological development as well as everyday use of common devices. Cellular phone calls, wireless internet connection, broadcast television and radio, video and audio content streaming, connection of computer and media equipment peripherals (e.g. keyboard, mouse, speakers, set-top box), transfer of data between devices, storage and viewership of media on optical discs (e.g. DVDs) collectively make up just a sample of common uses of standards. More specifically, 3G, 4G, and LTE mobile telecommunication technology, 802.11 Wi-Fi wireless internet protocols, ATSC and DVB-T digital television transmission, H.264 video compression, USB and HDMI connectivity, Bluetooth wireless data exchange, and Blue-ray technologies are all examples of standards. Formally, standards are defined as product technology and/or manufacturing processes including consistent use of product, process, or production rules, conditions, characteristics, and guidelines, together with defined design and specification, performance, testing methods, and quality control.¹ As evidenced by the plethora of standards incorporated into today’s products, standards are a major contributor to product development in the modern economy.

The establishment of standards and the incorporation of them into products and manufacturing processes provide benefits for consumers and manufacturers of goods. Standards can make products more valuable for consumers and product manufacturers, as well as the production of products more efficient for the manufacturers. For example, a manufacturer of a wireless phone earpiece will benefit if its device operates with a wide range of phone models, as that would expand its potential customer base and demand for its products. In addition, broad functionality would prevent the need to manufacture a variety of models to fulfill the demands of various phone purchasers. Similarly, a consumer benefits from an earpiece working with a wide range of phone models that would prevent the need to purchase a new earpiece after obtaining a new phone. In other words, both the value of the earpiece to the consumer and the value to the product manufacturer increase due to the interoperability of products as the number of phone manufacturers implementing the same technological method of communication between the phone and an earpiece expands. Economists refer to this phenomenon as a networking effect. In economics, a network effect, or network externality, occurs when the value of a good to a user increases as others use the same type of product.² Standardizing the method of wireless communication between mobile phones and earpieces ensures that consumers and product manufacturers can experience the benefits associated with the network effect. For example, the existence and industry adoption of the Bluetooth wireless standard prevents a scenario where, only a Samsung earpiece works with a Samsung phone, only a Motorola earpiece works with a Motorola phone, and so on. Thus, network effects from standards typically increase the value of standard practicing products. In addition, this increase in value from the network effects typically corresponds to market expansion of the unit volume in terms of the products practicing the standards.³

At the heart of the network effect associated with standards is the interoperability of various products due to the incorporation of standard technology. Interoperability through standardization can be crucial for satisfying various consumer needs, particularly in the information technology industry.⁴ Through the standardized interoperability, consumers are less likely to be “locked in” to a single product model or manufacturer. In addition, more manufacturers can develop new and/or enhanced products to replace or work in conjunction with other manufacturers’ products.

The networking effect benefits experienced by both consumers and product manufacturers are a substantial driving force behind the motivation for standard setting. Not only can standards make products more valuable for consumers, they also increase production efficiency and incentivize increased innovation.⁵ In addition, the interoperability network effects can facilitate and sustain international trade. It is for such reasons that the U.S. Department of Justice (henceforth “DOJ”) and U.S. Federal Trade Commission (henceforth “FTC”) (henceforth collectively, “U.S. agencies”) recognize standards as a driving force for the modern economy.⁶

The development of a standard typically involves a SSO.⁷ SSOs serve an important role by providing a platform for businesses, universities, and individuals from across the world working in corresponding industries to collaborate and participate in the development and establishment of standards.⁸ Typically SSOs engage in evaluating various alternative technologies and determining which technologies to incorporate into a standard. Given the benefits of standards, SSOs play an important role in product and technology development. Ultimately, SSOs choose which technology solutions will most likely be embedded in products with widespread development.

Just as economists like to say there is no such thing as a free lunch, the saying holds for the SSOs and standards. The rationale is that the benefits of the SSOs establishing standards come with a potential competitive cost. This is because the SSO standard establishment process outlined above involves coordination among entities that would typically otherwise compete but-for their involvement in the SSO process. As a result, SSO activities can be the cause of potential anticompetitive effects. One cost of SSO member collaboration is the exclusion of rivals’ alternative technology. However, typically SSO membership and participation is open to all industry participants thereby limiting the exclusion of any technology option as a candidate for the standard evaluation and selection process. In addition, the ultimate selection of a standard enables the beneficial network effects through product interoperability.

Another anticompetitive concern with the SSO process relates to enforcement of patent rights covering technology required to practice a standard—often referred to as standard essential patents. Upon an SSO’s adoption of a standard, SEP owners gain the position of control of access to rights to the standard, positioning them to capture licensing fees reflecting the resulting value of the standard.⁹ That is, after adoption of a standard as the industry is locked into the technology selection, implementers may have no choice but to license the rights to the SEPs in exchange for royalties reflecting a lack of technology alternatives and/or the expanded market value created by the standard adoption, thereby increasing SEP holders’ licensing fees.

This effectively non-competitive licensing position for implementers can be of particular concern given the common widespread reach of a chosen standard, nationally or globally. It is the widespread adoption that enables SEP patent holders to extract whatever the market will bear (potentially including value of the standard) given the standard-enhanced market value and the lack of substitutability from otherwise alternative technologies. After all, it is not only past, un-adopted technology that is locked out once a standard is set; it is also new technology that arises after standard adoption that may not reasonably be turned due to the lock-in effect. In addition, in anticipation, and as a result, of widespread adoption of a standard, manufacturers of products implementing the standard technology may expend significant resources on production processes based on the selection of the standard, resulting in significant sunk costs which together with widespread standard adoption inhibit the pursuit of any alternative product designs due to increased switching costs.¹⁰ High switching costs may further enable SEP holders to obtain licensing fees, for example, based on royalty rates higher than they would have absent the establishment of the standard. Thus, patent holders can benefit from the inclusion of their SEP-protected technology into a standard from both increased royalty rates after an industry is locked into a standard, plus an expansion of licensed sales due to widespread standard adoption.

SEPs owners’ ability to capture relatively higher licensing fees as a result of industry participants being locked into an industry standard and/or facing high switching costs is commonly referred to as patent “hold-up.” Typically, the more widespread the standard and/or higher the switching costs the higher a patent holder can charge in licensing fees.¹¹ An SEP holder obtaining such increased licensing fees essentially reflects the patentee’s ability to extract the network effects value from the standard for itself. In doing so, SEPs owners may prevent product manufacturers and consumers from experiencing the full realization of the benefit of network effects. If patent holders successfully demand and obtain elevated licensing fees, this raises product manufacturers’ costs, which at least partially offsets some of the potential gains for manufacturers from the adoption of a standard.¹² In addition, the high licensing fees may delay or hinder further investment by manufacturers in products implementing the standard. Furthermore, higher production costs can ultimately result in decreased profits to product manufacturers, increased prices for consumers, and delayed further investment by manufacturers in products using the standard.¹³

As part of efforts to influence the licensing of SEPs, SSOs have developed certain licensing policies for patent holders in an attempt to mitigate the risk of excessive licensing fees from SEP owners, particularly where technology contributors participate in the SSO process. These policies typically address the risk of patent hold-up through disclosure requirements and licensing rules.¹⁵ Disclosure rules generally require SSO participants to make known any patents or applications for patents owned by participants that read on the (proposed) standard. The objective with the disclosure rule is to identify the various intellectual property rights associated with the technologies considered for the standard ex ante, thus allowing SSO participants to make informed decisions during the standard selection process and minimizing the number of surprise licensing obligations once the standard is selected (ex post).¹⁶

It has become increasingly common for SSOs to require their participants to commit to identifying any potential SEPs, and to licensing them on FRAND terms. Generally speaking, FRAND terms categorically have two components: first, the requirement to license to any potential licensee without discrimination; and second, to offer reasonable royalty terms for SEP licensure. However, SSOs typically do not explicitly define what exact licensing royalty terms qualify as FRAND, and not all SSOs’ licensing rules are identical. In fact, an SSO policy may explicitly prohibit any discussion, among members and participants, of license rates.¹⁷ The inclusion of often vague language in SSO licensing policies leaves room for interpretations over the licensing fee terms that would be consistent with an SSO’s FRAND requirements, which thus can ultimately be up for debate.¹⁸ Yet, the general goal of FRAND term licensing rules is to make sure holders of SEPs do not (i) use the threat of patent hold-up or refusal to license to extract excessive and unreasonable licensing fees (i.e., the licensing rate must be Reasonable); (ii) lock out a competitor from the industry by refusing to licensing (i.e., licensing must be Non-Discriminatory)¹⁹; or (iii) use the essential nature of the SEPs to extort fees for other non-SEPs or require cross-licenses (i.e., the licensing terms must be Fair). In other words, as a practical matter, given the market power SEP owners may obtain with the adoption of a standard, the extra requirements for FRAND licensing include, but are not necessarily limited to, determining a reasonable royalty with the following extra conditions: (i) no exclusive licensing terms that would restrict technology adopters’ access to standard essential technology; (ii) no cross-license requirement with regards to non-SEPs; and (iii) no bundling of the SEPs with non-SEP technologies to extend the SEP owners’ market share reach into other non-essential technology areas.²⁰

It has not been historically clear whether or how FRAND commitments are binding, or how the “reasonable” condition of FRAND terms can be determined. Taking the definitional components of FRAND—Fair, Reasonable, and Non-Discriminatory—at face value, it may intuitively appear that determining a SEP royalty rate that is “reasonable” is no different than a “reasonable” royalty rate resulting from royalty analyses for non-essential patents. As will be shown in the next part, this is not necessarily the case, as there are distinct and meaningful differences between royalty rate analyses for SEPs compared to analyses for patents that are unencumbered by FRAND commitments. These differences are motivated by the goals of FRAND term licensing outlined above, namely preventing patent holdup while also promoting widespread adoption.²¹ It will also be shown in the next part that SEP owners should account for such differences when making licensing offers given the apparent current view from U.S. courts regarding the binding nature of commitments to SSO licensing policies.

Committing to an SSO’s FRAND licensing term policy is often times mandatory for technology contributors participating in the SSO standard process. On the other hand, typically there is no SSO policy requirement for SEP owners that do not participate in the standard development and selection process. However, there are incentives for holders of SEPs to participate in the SSO activities, thereby ultimately committing to the FRAND terms for any licensing activity. For example, SSO’s typically aggregate assurances regarding which patents are claimed essential to the standard, which may be perceived as an endorsement of the relevance of SEPs for technology contributors. In addition, SSO participation provides patent holders the opportunity to influence the standard that is adopted. Ultimately, participation in an SSO process is voluntary and holders of SEPs that do not participate in the SSO process are not necessarily bound by all the SSO disclosure and FRAND licensing rules.²²

The U.S. agencies have recognized licensing SEPs based on FRAND terms as a method for mitigating the potential for patent hold-up. At the same time, the agencies further recognize that certain aspects of SSO licensing policies may hinder the impact of any FRAND commitment to an SSO by holders of SEPs. For example, as previously noted, SSO licensing policies generally do not incorporate any well-defined criteria for what licensing fees actually qualify as FRAND. In addition, patent holders may simply fail to comply with an SSO’s licensing policy. Failing to comply with an SSO’s FRAND policy may be the result of a patent holder taking advantage of a negotiation position and engaging in patent hold-up. On the other hand, negotiating parties may legitimately disagree as to what terms qualify as FRAND.

There is no universal authority or method for identifying FRAND licensing terms. Again, thus far, SSO’s licensing policies generally fall short of explicitly defining FRAND terms. Nevertheless, recent decisions from U.S. courts, together with guidance from U.S. agencies provide clarity for identifying licensing terms for SEPs. A few takeaways from these recent decisions which will be discussed below relate to when FRAND terms apply, and certain conditions for obtaining FRAND terms.

The FRAND royalty analysis requirement of apportioning to the value of the actual technology in isolation from any value of the adoption of the standard including the patented technology can certainly have an impact on the royalty determination. The goal is to limit the value captured by the royalty to the technology itself without capturing hold-up value due to, for example, switching costs and/or the industry locked into a standard. Since switching costs can be very large, licensees may be willing to pay royalties based on a value amount well above that for the patented technology alone for access to technology covered by SEPs, to avoid these costs. This potential premium, which can be attributed to patent hold-up, can be eliminated under a proper FRAND analysis, thereby potentially lowering the royalties patentees may expect to earn from licensing fees.

The main competitive/market concern surrounding SSO collaboration is that patent holders may gain market power through standardization and lead to exclusion of alternative competitive technology. Whether or not this occurs, there is no claim that implementers (i.e. potential licensees) have somehow inappropriately attained market power or any other inappropriate economic rent in their commercial efforts. Ultimately, if not allowing SEP holders to capture the value of the standard means implementers capture the value, this does not suggest there is any loss in economic efficiency. There is no theoretical claim that FRAND commitments are a means by which implementers gain market power or otherwise achieve an unfair advantage. As such, any value captured by implementers is only that dictated by a competitive and efficient market system. That is, implementers should be able to keep whatever gains or rents the competitive market allows them to keep.

On the other hand, if the value of the standardization cannot be captured by SEP holders, this does not necessarily translate into the value transferred to implementers. If the standardization itself has value, the objective of FRAND is to prevent SEP holders from capturing that value, and the idea that implementers capture it, suggests the downstream implementer market is somehow concentrated or monopolized. This is contrary to implementer markets generally, where substantial and ever increasing competition usually exists. In other words, it should not be expected that implementers will not compete-away (pass through) any standard-based value. Such a claim would require evidence of the lack of competition, entry barriers, etc. Furthermore, a concentrated downstream standard implementer market is contrary to an intended goal of standardization and FRAND terms, namely widespread adoption.⁴¹ The combination of FRAND terms and increasing competition between implementers of standard technology can effectively yield a transfer of the value of standardization to the public domain (e.g. consumers).

Given that proper FRAND analysis accounts for alternative technologies, for example at the time of the adoption of the standard technology, the nature of the alternative technologies would likely have an impact on the patent value. The lesser the improvement of the technology covered by the SEP over the alternatively available technology, the smaller the royalty rate that is warranted. Therefore, if an SEP really had no viable alternative technology, then a FRAND rate may not be materially different than a rate reflecting all the value the SEP owner could extract (absent any FRAND requirement). It is when there were alternatives to an SEP, but the standard adoption rendered them irrelevant, or their use not reasonably feasible due to switching costs, that it would be expected that the FRAND rate will differ from that which the market will bear. In other words, application of the above FRAND requirements does not necessarily guarantee a “low” rate, nor should it. What should happen is that certain items are factored in, and others factored out of the royalty rate. Proper FRAND determination can still yield royalty fees that result in material impact on implementers’ costs, and potentially consumer prices. For example, if there is a lack of alternatives and the improvement of the technology covered by the SEP is highly valued by consumers, market-based economics may justify increased implementer costs, supported by higher product prices.

In the December 2015 ruling by the Federal Circuit regarding CSIRO, the appellate court apparently provided further clarification regarding the additional apportionment required for valuing all SEPs, as opposed to only those encumbered by FRAND obligations. The Federal Circuit seemingly eliminated previous ambiguity by stating “royalties for SEPs generally—and not only those subject to a [F]RAND commitment—must not include any value flowing to the patent from the standard’s adoption”.⁴²

The answer to the question of what impact, if any, a FRAND requirement has on patent royalties may depend on who you ask. What is clear, however, is that recent decisions from U.S. courts and guidelines established by U.S. agencies emphasize that a proper FRAND analysis for SEPs must be based on the value of the patented technology and not the value of the standard adoption. Proper reliance upon established market transactions and adjustments to a hypothetical negotiation analysis can provide realistic effective means for determining appropriate FRAND royalty terms. The guidance from the U.S. agencies can be helpful in providing some consistency in FRAND analyses given the oftentimes vague language of SSO licensing policies. Despite the vague language, practitioners should consider SSO licensing policies to be binding. Between the binding nature of the SSO commitments and the focus of eliminating standard adoption value from FRAND royalty terms, the cost for access to standard essential intellectual property rights should be kept within reasonable reach. Additional clarity from U.S. courts and/or U.S. agencies may or may not increase the consistency of FRAND determinations. However, keeping these requirements and guidelines in place should remain beneficial given the collusive nature of SSOs. This is not to say that the coordination amongst competitors through SSO activities is necessarily a bad thing. Networks effects made possible through product interoperability based on standards published by SSOs can increase consumer product value, promote manufacturing efficiencies, and stimulate international trade.

The common justification for intellectual property law is that inventions must be properly protected to allow inventors to be rewarded for inventions, thereby stimulating innovation. However, promoting inventions and innovation does not justify, nor does it require, rewarding patent owners beyond the value of the technology the intellectual property is meant to protect. Allowing patent holders to extract the value of the network effect created from a standard rewards the patentees based on value beyond the patented technology. Without FRAND terms the network effects value will flow to SEP holders. Proper FRAND terms that keep SEP holders from extracting the value of network effects can still leave the efficient level of return for innovators—that based on the technology itself. In other words, extracting the value of network effects by SEP holders is not necessary to appropriately motivate innovation. Any value of the standardization resulting from collaborative efforts during the SSO process may ultimately be available in the public domain.