Clarifications from the Federal Circuit

On December 4, a much anticipated opinion was delivered by the US Court of Appeals for the Federal Circuit ("Federal Circuit") in the Ericsson vs. D-Link et. al. case, concerning a WiFi (IEEE 802.11) SEP portfolio license. I'm pleased to note that the Federal Circuit in several aspects aligned itself with what I've myself been expressing in recent posts under this blog.

Firstly, on the issue of "royalty stacking", the Federal Circuit rejected jury instructions on royalty stacking because the defendants failed to present evidence that there was a royalty stacking problem: “A jury, moreover, need not be instructed regarding royalty stacking unless there is actual evidence of stacking. The mere fact that thousands of patents are declared to be essential to a standard does not mean that a standard-compliant company will necessarily have to pay a royalty to each SEP holder. In this case, D-Link’s expert "never even attempted to determine the actual amount of royalties Defendants are currently paying for 802.11 patents."” This is what I opined in my earlier post on royalty stacking, i.e. damaging royalty stacking shouldn't be assumed to exist per se, but instead clear evidence to that effect needs to be presented in each case. Once again we need to remember that royalty stacking occurs per definition in wireless SEP portfolio licensing. That doesn't mean that it's automatically harmful to the market nor to any given OEM.

Secondly, on "Patent hold-up", again no evidence of such was presented: “Absent evidence that Ericsson used its SEPs to demand higher royalties from standard-compliant companies, we see no error in the district court’s refusal to instruct the jury on patent hold-up or to adjust the instructions expressly to take patent hold-up into account.” As I wrote in my post on portfolio licensing and patent hold-out, evidence of "patent hold-up" is hard to find in reality. But the key point from the Federal Circuit again being that clear evidence must be presented in each case, it should not simply be presumed to exist just because it's a theoretical possibility.

Thirdly, on the topic of "Royalty base", which I touched upon in my post on cellular FRAND royalty levels, the Federal Circuit made another good clarification. On apportionment and the "Entire Market Value Rule", it stated that according to the “substantive legal rule”, the “ultimate reasonable royalty award” – that is, the result of e.g. multiplying a royalty rate with a royalty base – ”must be based on the incremental value that the patented invention adds to the end product”. The Federal Circuit confirmed that to determine a (F)RAND royalty in the wireless industry, you are definitely not mandated to use the smallest salable component such as a chipset as a royalty base. There's nothing wrong with using the entire end-user product as royalty base, as long as reasonable apportionment of value of the patented invention to the end-user product is done.

The Federal Circuit's practical approach to SEP licensing and damages is encouraging. Hopefully other courts and agencies, including those in other jurisdictions, will follow suit and move away from theoretical calculations towards a focus on real world practices and evidence.

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.