China and Qualcomm - a new reference

On Feb 9, US chip maker and wireless SEP-holder Qualcomm reached a concluding settlement with the National Development Reform Commission (NDRC) of China, under the Anti-Monopoly Law investigation it has been subject to.

In practice, the settlement results in Qualcomm's cellular SEP portfolio royalty rate being 3.25% of the net selling price of 3G- or 3G/4G-compliant devices sold in China. Clearly the Chinese authorities deemed Qualcomm's original rate to be unreasonably high, since the imposed discount is almost 35%.

But besides that specific message to Qualcomm, a broader message can also be detected here. China tells the world that it does not embrace market disruptiveness with respect to the cellular SEP FRAND licensing model per se. It confirms the applicability of long-standing basic SEP-portfolio licensing principles, with the end-product price as the royalty-base and royalty rates in the order of lower single-digit percentages for strong SEP-portfolios.

This message from China is actually a powerful endorsement of the importance of basic wireless R&D to the ecosystem. Hopefully regulators and policy makers worldwide will consider this input when confronted with various SEP-devaluing proposals popping up in recent times.

Portfolio licensing and patent hold-out

In the early days of the patent system, there was typically one company - one invention - one patent - one product - one jurisdiction. Today however, all these aspects have become de-coupled. Virtually any product can be covered by a number of patents in different jursidictions, originating from a number of inventions and owned by multiple companies.

For wireless Standards-Essential Patents (SEP) in particular, it's not about individual patents, it's all about portfolios of patents. Any standards-compliant product - your smartphone for example - will be covered by a number of patent portfolios, owned by different companies. By portfolio I mean one or more "patent families", where one patent family in turn consists of all patents worldwide originating from one invention. So one patent family consists of one or more patents in each of one or more jurisdictions, sometimes totalling dozens of patents. And remember, a patent portfolio can consist of many patent families, perhaps tens or even hundreds of them!

Of course, this is not strange in itself. First of all, as I described in a previous post on royalty stacking, a wireless standard is normally built through a multitude of inventions. An active contrubutor to a Standards Setting Organization (SSO) will typically contribute several inventions to the standard, quite possibly in different technology areas. Secondly, the world is highly globalized today, and virtually all manufactureres/sellers of standards-compliant devices (Original Equipment Manufacturers, "OEMs") sell their products in more than one country, and in most cases in a large number of countries. So obviously, innovators have the legal right to protect their IPR from being infringed in whichever countries support such protection.

But how about the licensing aspects of patent portfolios? Well, generally speaking patent portfolio licensing is more efficient than individual patent licensing, due to e.g. significant savings in transaction costs and time. So-called "patent pools" are often cited as examples of an extreme form of patent portfolio licensing that can bring greater efficiency to the market. Wireless SEP portfolio licensing (whether pool-based or not) also carries an additional aspect of efficiency. SEP holders normally generate new SEPs over time, and so license agreements are often designed to cover new additions of SEPs without the need of amendments or further transactions. Indeed, wireless SEP licensing has allowed the wireless device market to prosper tremendously in the last two decades. But in recent years, a worrying aspect of SEP portfolio licensing has emerged. It's connected to enforcement, and seriously threatens this efficiency. It's called "patent hold-out".

Since OEMs as well as SEP portfolios are typically global, it's perfectly natural and efficient for the SEP holder and OEM to agree on Fair, Reasonable and Non-Discriminatory (FRAND) licence terms for the entire global SEP portfolio. So there's a need to assess the value of a global SEP portfolio, in order to determine FRAND terms for it. While this is generally a reasonable requirement, there are also some important observations to make with this in mind, related to courts:

1) A given court has, at most, jurisdiction over it's own geographical territory (a region or a country), and can thus by definition only process a particular local sub-set of a given global SEP portfolio for infringement litigation.

2) Even a local sub-set of a global SEP portfolio may be very large, and consist of tens or even hundreds of patents. It's not always feasible for a given court to process even such a local sub-set in its entirety within a reasonable time.

3) Even with (hypothetically) super-high-capacity courts, the cost for an SEP holder to enforce an entire global SEP portfolio through litigation patent-by-patent would be extremely high.

Demonstrating the value of a global SEP portfolio in each jurisdiction to the fullest extent possible through patent-by-patent litigation is therefore difficult to do in practice. Only subsets of subsets of global portfolios, sometimes only a handful patents, can feasibly (from a time- and cost perspective) be processed per jurisdiction.

Because of this, an infringing OEM can adopt a "patent hold-out" strategy (also called "reverse patent hold-up") when confronted with an SEP portfolio licensing offer. The OEM can claim that the SEP-holder's offer - whatever it is - is non-FRAND, and then simply wait for the SEP holder to file infringment proceedings, knowing that proving the entire SEP portfolio's worth using that route can be very inefficient for the SEP-holder. So the strategy can allow a lot of time to pass, usually several years, during which virtually no royalty payments would have to be paid on a global basis. The OEM can continue and even increase its sales of infringing products, possibly even taking market share from licensed competitors (as I mentioned in a previous post on royalty stacking). Using the patent hold-out strategy, the absolutely worst thing that can happen from the OEM's viewpoint is that it will have to pay the royalties actually requested by the SEP holder in the first place, but many years later and even then possibly only sequentially per jurisdiction. It's true that in some jurisdictions, lawyers' and courts' fees may sum up to significant amounts over time, but in many cases the patent hold-out strategy is still very attractive for the infringing OEM, especially if sales revenue is large. As a result, the SEP holder may find itself effectively forced by the OEM to agree to a SEP license agreement on sub-FRAND terms.

But since wireless SEP licensing has always been about portfolio licensing, didn't patent hold-out happen in the past? Actually not. The emergence of patent hold-out is related to a tremendeus change to the mobile device marketplace in the recent decade or so. In the past, virtually all OEMs were also strong innovators, SSO contributors and SEP holders, and so there was a widespread acknowledgment of the actual value of R&D investment in standardization and hence SEP licenses. License negotiations for SEP portfolios were seen by all parties on the market as part of the normal business. Today, due to e.g. globalization and specialization, the situation is precisely the opposite - extremely few OEMs invest heavily enough in basic R&D to contribute to SSOs and become SEP-holders. Instead it has become possible for OEMs to use technology developed by others more or less off-the-shelf. This is generally a good market development, but unfortunately, it has also become an attractive proposition for many to ignore or avoid SEP licenses (and even other forms of IPR licenses) for such technologies to the greatest extent possible.  I've personally witnessed many cases of patent hold-out, and even received more or less explicit informal confessions from infringing OEMs on the clear benefits of the strategy.  It's certainly not just a theoretical concern.

The availablity and actual use of patent hold-out in the SEP portfolio licensing context constitute a devaluation of innovation. In effect this means - counter-intuitively - that it's more difficult to fairly enforce a large SEP portfolio than a small one. This is actually very serious and could be an important reason behind the trend of SEP divestments seen in recent years. Since it is difficult to realize the potential efficiency of portfolio licensing in practice due to patent hold-out, there can be a resulting tendency of portfolio break-up. Entities, including Non Practicing Entities (NPEs), procuring sub-portfolios for their own licensing programmes could thus ultimately be seen as a perfectly natural response to infringing OEMs engaging in patent hold-out against large SEP portfolios.

Some courts and agencies have finally begun to recognise and discuss patent hold-out as a serious problem. For example in its Samsung vs. Apple investigation July 5, 2013, the US International Trade Commission found that “Apple's position illustrates the potential problem of so called reverse patent holdup …..". And in relation to the Apple vs. Motorola US Court of Appeals for the Federal Circuit decision of April 25, 2014, Chief Judge Rader commented that hold out "is equally as likely and as disruptive as a hold up". Moreover, the Korean Fair Trade Commission in its decision on Feb 26, 2014 apparently also found that there had been patent hold-out in Apple vs. Samsung. These are clearly good calls, but considering the seriousness and widespread nature of patent hold-out, more courts and agencies worldwide need to become aware of it and disincentivize it as much as possible.

For sure, patent hold-out is real and is happening as we speak. But so far there's actually been more talk about something called "patent hold-up", which is the notion that an SEP holder is able to procure licenses on super-FRAND terms based on excessive power achieved by the SEP nature of the patent portfolio. However, the idea of an SEP holder as an armed robber (as in "patent hold-up") is hardly a fitting analogy if you think about it. To begin with, the FRAND regime exists precisely to combat such potential abuse of power. And at the end of the day only a state, i.e. a court or agency, can possess any "weaponry" and can decide whether to use it or not. In the context of SEP infringement where FRAND licensing commitments are in place, the court or agency will ultimately decide what form of relief would be appropriate.  From my experience of licensing in the wireless industry, patent hold-up is rather an allegation made by an infringing OEM while executing a patent hold-out strategy. This observation is in line with e.g. a recent finding by the US International Trade Commission in InterDigital vs. Nokia et. al., June 13, 2014: "While there may be a hypothetical risk of holdup, we have evidence that this is not a real threat in this case, or in this industry."

To counteract a patent hold-out situation by an infringing OEM, SEP holders would naturally be inclined to seek injunctive relief (or an exclusion order) for SEP infringment. Having frequently observed patent hold-out in real life, I believe that the availability of injunctive relief is crucial when an infringing OEM refuses an SEP portfolio FRAND license and engages in patent hold-out. A real threat of injunctive relief even only in a single jurisdiction weakens the attractiveness of the one-sided patent hold-out strategy for the OEM and instead allows the parties to conduct a balanced negotiation in good faith. Hence, in such a scenario injunctive relief - remarkably - works as a pro-competitive tool and helps maintain the value of innovation.

However, some voices in the industry appear to be against any kind of injunctive relief for SEP infringement, no matter what. For example, in 2011 Apple made the statement in a published letter to ETSI that "Seeking an injunction would be a violation of the party's commitment to FRAND licensing.". And in 2012, this stance appeared to be more or less endorsed by Microsoft. But taking such a position is clearly unfounded and unreasonable, as e.g. recently observed by the US Court of Appeals for the Federal Circuit decision in the aforementioned Apple vs. Motorola case of April 25, 2014: "To the extent that the district court applied a per se rule that injunctions are unavailable for SEPs, it erred.". It went on to say that "an injunction may be justified where an infringer unilaterally refuses a FRAND royalty or unreasonably delays negotiations to the same effect."

Granted, a perfectly reasonable question is of course: who decides whether an infringer is clearly engaging in patent hold-out? In response, there have been proposals put forward that address this question. For example, the parties could first be mandated to go through some form of binding arbitration or judicial process to ultimately determine FRAND terms for the portfolio. Such a scheme was used e.g. in the US Federal Trade Commission's Consent Order in the Google/Motorola case. This kind of process intends to strike some kind of balance between efficiency and rigorousness on a portfolio basis. The general idea is that if the infringing OEM refuses to be bound by the outcome of such process (or refuses the process per se), then seeking injunctive relief would be permissible. Unfortunately though, even creative proposals of controlled injunctive relief for SEP infringement are being challenged. The discussion about injunctive relief in SEP infringement cases is complex, but in absence of other ideas to combat patent hold-out, simply banning injunctive relief altogether would be totally unreasonable and would heavily tilt the playing field in favour of infringers and away from innovators.

On a policy level, it's really about whether we want to fairly credit innovation in a world where it's difficult to value global patent portfolios perfectly. How can we maintain efficiency in SEP portfolio licensing given that valuing a significant SEP portfolio through global litigation on a patent-by-patent basis is inefficient in practice? One could of course simply accept that the nature of global SEP portfolios means that one has to go through a very long and expensive process to arrive at a fair global FRAND SEP license. However, due to significant time and cost aspects, this disincentivizes innovation, promotes portfolio breakup and reduces the overall efficiency of SEP FRAND licensing. In my opinion, these negative aspects are overwhelming and bad for society as a whole. The question is; is it justified to find some solution for more efficient and fair SEP portfolio valuation other than forcing the SEP holder into global patent-by-patent litigation? I would say that it is. Consider that SEP portfolio licensing has historically worked very well indeed, and has struck a good balance between innovators and users that has led to an explosive growth in the wireless industry. This balance should be preserved rather than disrupted. Ideas such as the one used by the US Federal Trade Commission in the abovementioned case at least represent creative steps towards such preservation.
 
To summarize, in recent years it's become increasingly challenging for SEP holders to enforce their SEP portfolios to obtain FRAND royalties from infringers. By using a "patent hold-out" strategy, SEP infringers tend to avoid SEP portfolio license fees for years with limited risk, based on the notion that the SEP holder needs to demonstrate the value of the entire SEP portfolio to the fullest extent possible through litigation. The limited risk to the infringer is due to the limited feasibility for the SEP holder to timely and cost-efficiently litigate its entire global SEP portfolio. Ultimately all of this leads to devaluation of innovation and inefficient SEP licensing, since it - remarkably - makes it more difficult to fairly enforce a large SEP portfolio than a small one. This contributes to innovation disincentivization, patent portfolio fragmentation, NPE proliferation and ultimately decreased market efficiency. Furthermore, lobbying efforts against any kind of injunctive relief or exclusion orders for SEP infringement certainly do not help the situation at all. I believe there's a strong need for courts and agencies world-wide to acknowledge the problem of patent hold-out, and to disincentivize it in order to make SEP portfolio licensing more fair and efficient. Creative policy proposals need to be encouraged in the space of SEP portfolio licensing, which can strike a reasonable balance between the market participants and society as a whole. In the absence of any other potent balancing factor against clear and present patent hold-out in cases of SEP portfolio infringement, injunctive relief and exclusion orders continue to be necessary - and in fact pro-competitive - remedies.

Royalty stacking

I'll begin by sharing some thoughts around the concept of “royalty stacking”. This term is generally “buzzing around” in patent licensing circles, and is sometimes brought up as being a problem for Standards Essential Patent (SEP) licensing in the mobile wireless communications sector. In this context, "royalty stacking" basically means that manufacturers/sellers of standards-compliant products (whom I will call “OEMs”, Original Equipment Manufacturers) need to obtain licenses from several SEP holders, and the aggregate royalty then becomes the sum of the individual royalties paid to the different SEP holders.

So why does an OEM need several licenses in the first place? Well, it's a consequence of how the wireless standards are created. Different entities from the industry come together to research and create a standard in a way that's simultaneously collaborative and competitive. By competing on technical merit for the various solutions within the standard, this quite ingenious process promotes the overall creation of a widely accepted, state-of-the-art and future-proof standard. As a result of this, SEPs will also be generated, and each individual SEP covers a specific part of the standard. In other words, all SEPs are complementary and an OEM must therefore by necessity obtain licenses to all SEP portfolios in order to be fully licensed.

So the first thing to note is that royalty stacking is not a problem in itself. Royalty stacking naturally occurs as a logical consequence of the wireless standardization process.

I guess that those who talk about royalty stacking as a “problem” actually refer to a potential consequence of royalty stacking; namely the cumulative SEP license royalty fee becoming too high for an OEM to bear while maintaining a reasonable profit margin. In these circumstances, references are sometimes made to royalty rates published by various (alleged) wireless SEP holders. And if those “published rates” are added up, the cumulative figure can indeed look rather unappealing. In a recent working paper by Intel and law firm Wilmer Hale, precisely this approach was taken, leading them to conclude a theoretical wireless SEP stack of more than US$100 for a smartphone (!). For sure, I for one do expect the authors to be aware that such a figure has very little to do with reality.

Potential negative consequences of royalty stacking are surely valid concerns, but as is often the case, it's advisable to also consider actualities before drawing conclusions based on theoretical analysis.

So how to assess whether royalty stacking has led to problems or not in the mobile wireless business? To begin with, I'd suggest looking at some aspects of the actual wireless device market and the SEP licensing situation.

During the last 25 years of 2G to 5G wireless cellular standardization, the SEP licensing technology sharing process has been governed by the well-known FRAND (Fair, Reasonable And Non-Discriminatory) regime. Also during this time, there's been an exponential increase of wireless device sales, to the extent that there are now close to a mind-boggling two billion new devices sold annually. So from a consumer point of view, it's not easy to detect any actual prohibitive pricing effects resulting from “too high” cumulative SEP royalties. Looking at the mobile device businesses too, evidence of problems from SEP royalty stacking is not exactly abundant. Consider that the vast majority of the top OEMs today were hardly even in the business only a decade or so earlier (e.g. Samsung, Apple, HTC). And conversely, many of those that were highly successful back then - also traditionally strong SEP holders - are all but gone from the device business today (e.g. Ericsson, Siemens, Alcatel1). Regarding WiFi, considering that it's a more recent wireless standard, the market has similarly exploded and perhaps even more spectacularly than cellular. There's now WiFi connectivity in virtually every device around us, including game consoles, cameras, TVs and vehicles. At the very least, these market developments suggest a low entry-barrier, and for sure I see no suggestion of the wireless SEP royalty stack being too high; this reality might even support the notion of a too low royalty stack (!).

From my own experience of wireless SEP patent licensing, I'd say that serious OEMs with few or no own SEPs are typically well aware - through their own license negotiations with various SEP holders - that the cumulative wireless SEP royalty rates are in general reasonable. And for sure that they're nowhere near e.g. the sum of all “published rates”. 

It's also somewhat interesting to look at e.g. the Apple vs. Motorola case, where Apple apparently refused to be bound by a potential judicial order of FRAND royalty payment, when such order presumably would have considered e.g. the actual payable cumulative royalty. It seems to me that Apple might have had the opportunity to demonstrate any real royalty stacking problems, but chose not to do so. This could perhaps suggest that any such problems may not have been that overwhelming.
 
It's true that some significant OEMs are said to operate on much lower profit margins than Apple, and sometimes royalty stacking problems are blamed for OEM's profit margins even being "too low". However, this is far from obvious, as there can be many different reasons for low profit margins. In fact, low profit margins may - ironically - be at least partly due to some competing OEMs not obtaining necessary IPR licenses in the first place. By being unlicensed for prolonged periods of time, such OEMs may in effect compete unfairly in the market, potentially forcing legitimate OEMs to reduce their profit margins. The truth of the matter is that some OEMs enter the market without including necessary SEP license costs as part of their original business case. It might be initially tempting to see this as being “good” for consumers due to potentially lower prices, but it's actually detrimental in the longer term. It skews the market in favour of infringers and globally undermines incentives for investments into technological innovation. 

So while evidence of problems from royalty stacking do need to be taken seriously, it's not clear that we've actually seen any in reality. However, if courts, agencies and lawmakers would simply assume that there are such problems where there are in fact none, there could actually be a potential risk of royalties being set unfairly low (!). This could unjustifiably harm the market and cause R&D “disincentivization”, which in the longer term can lead to limitations on consumer choice. Because of this risk, allegations of royalty stacking problems should in my view always be properly scrutinized, wherever they may turn up. So how good are courts and agencies at scrutinizing? Well, it's a mixed bag it seems.

In the Ericsson vs. D-Link et. al. case, defendants brought up royalty stacking as being a problem and at one point argued that the stack could amount up to “$23.30”. There was a lot of argumentation on this, but the defendants ultimately failed to convince the court of any real evidence of harmful stacking. As a result the court dismissed their arguments. In this particular case, sound skepticism to alleged stacking problems was apparently clearly expressed by the court. I understand that this case is currently on appeal, but this particular observation from the court has not been challenged.

Looking at the case of Motorola vs. Microsoft, the court in that case did appear less critical of allegations of royalty stacking problems, and made assumptions in view of that. Consequently, it e.g. essentially capped the cumulative rate at the selected rate of the Via Licensing WiFi patent pool, even though the patent holder's and others' patents were not part of the pool, and inspite of concluding that patent pools tend to produce lower rates and that a rate higher than a pool rate could still be FRAND. In the Innovatio case, again in apparent consideration of alleged royalty stacking problems but without real evidence of such, the court chose to determine the FRAND rate ultimately based on the profit margin of a chip manufacturer. Although this touches on another topic - the question of a relevant royalty base - this choice of reference is in my opinion actually quite arbitrary. In these two cases courts appear to have presumed cumulative rates being "too high" without any convincing evidence to that effect, while still ultimately determining royalty rates based on such presumtions.

While SEP royalty stacking can potentially cause market disruption, claims of such problems should be thoroughly scrutinized to determine if they are genuine. After all, in the last 25 years, the wireless device market has seen a virtually astronomical development in terms of cutting-edge technology and standards development, consumer choice and successful new businesses. Some companies complain about negative effects of royalty stacking, but have been unable or unwilling to demonstrate any actual problems. Others may blame royalty stacking for low profit margins while reasons may rather be found elsewhere, including unlicensed price-cutting competitors. One may in fact wonder if "royalty stacking problems” is sometimes used as an argument to avoid paying what would in fact be perfectly fair and reasonable royalties for wireless SEP licenses.

For sure, SEP FRAND determination cases are often complex, and courts, agencies and lawmakers mostly do a formidable job in trying to bring clarity and fairness to the situation at hand. Even with good intentions though, less well-founded assumptions and theoretical models ought to be minimized in favour of looking at real facts and requiring entities to substantiate claims of problems resulting from royalty stacking. Otherwise, SEPs and ultimately R&D investments actually run the risk of being devalued without addressing any real problem.


 1 “Alcatel”-branded phones seen on the market today are by Chinese company TCL under trademark license from Alcatel-Lucent.