What does it mean for a patent holder to commit to a standard-setting organization (SSO) to license its standard-essential patents (SEPs) on fair, reasonable, and nondiscriminatory (FRAND) terms? When is a royalty FRAND? Drawing from both legal theory and economic theory, I propose an interpretation of FRAND that distinguishes and reconciles the conflicting definitions of FRANDand provides courts a practical approach to identifying FRAND royalties. A proper understanding of a FRAND royalty requires recognizing the combinatorial value of standard-essential patents. That recognition reveals the fallacy in attempting to apply the "ex ante incremental value" rule to the determination of a FRAND royalty. FRAND royalties divide the aggregate royalties generated by the standard among the holders of patents essential to the standard. Such a division should maximize the surplus resulting from the standard's creation. It must also satisfy an individual-rationality constraint for the patent holder and the licensee, thereby encouraging continued participation in the setting and implementation of open standards, as opposed to greater reliance on proprietary standards.
What does it mean for a patent holder to commit to a standard-setting organization (SSO) to license its standard-essential patents (SEPs) on fair, reasonable, and nondiscriminatory (FRAND) terms? When is a royalty FRAND? Drawing from both legal theory and economic theory, I propose an interpretation of FRAND that would be acceptable-owing to its fairness and efficiency-to someone in the original position, cloaked in a Rawlsian veil of ignorance that prevents him from knowing whether he will ultimately be a net infringer or net licensor of SEPs.1 Courts and other tribunals could feasibly administer this interpretation of FRAND in the many disputes concerning smartphones and other technologically complex products that read upon hundreds or thousands of patents.
In Part II of this article, I explain how an economist measures, in the simplest case, a reasonable royalty for infringement of a patent that is not essential to any standard. This simple case uses a model of bilateral bargaining-the hypothetical negotiation between a willing licensor and a willing licensee at the time of first infringement of the patent in suit. The size of the bargaining range depends in part on the incremental value that the patent in suit creates for the infringer relative to the value created by the next-best noninfringing substitute available to the infringer. Importantly, I clarify that the incremental value of a patent must include the infringer's cost of acquiring the next-best alternative.
In Part III, I explain the FRAND requirements in the intellectual property rights (IPR) policies of the SSOs most involved in setting standards for mobile devices and networks. I next explain why it is erroneous to apply the simple bilateral bargaining model to the complex, multilateral case of FRAND licensing of SEPs. Understanding a FRAND obligation requires understanding the economic significance of the combinatorial value of standard-essential patents. This understanding in turn reveals the fallacy in attempting to apply the "incremental value" rule to determine a FRAND royalty for the infringement of an SEP. If a patent is indeed essential to making downstream products that read on a standard, then it logically follows that the patent does not have a substitute, including the notional noninfringing substitute that courts attempt under existing law to identify for purposes of determining a reasonable royalty for infringement. All standardessential patents must be used in fixed proportion. By definition, therefore, they are nonsubstitutable. So it makes no sense to engage in an exercise that requires hypothesizing that there exists for a nonsubstitutable patent a noninfringing substitute. It is therefore necessary to confine the incremental value method for calculating damages to infringement of standard-inessential patents, known among patent law practitioners as implementation patents.
In Part IV, I explain the problems with applying the incremental value approach to measuring a FRAND royalty for SEPs, which bases the FRAND royalty on the incremental value of the patent above the value of substitute patents, which competed with the patent in suit for adoption into the standard. First, I question whether it is intellectually rigorous or even practical to apply the Georgia-Pacific factors2 to the FRAND context. Second, a main judgment in Judge Robart's April 2013 ruling in Microsoft v. Motorola3 was that the FRAND royalty should not include any value accreting to the patent from its adoption into the standard. Thus, Judge Robart adopts the ex ante incremental value approach. I explain why the ex ante incremental value approach for calculating FRAND royalties is inconsistent with Judge Robart's other premise, that FRAND royalties should encourage participation into the standard, because it fails to compensate patent holders for additional risk associated with participating in the setting of open standards. Third, I explain how Judge Holderman's October 2013 decision in Innovatio IP Ventures4 addresses some of the flaws of Judge Robart's opinion.
In Part V, I provide an economic framework for calculating FRAND royalties that reconciles the many disparate views on the meaning of FRAND. A FRAND royalty satisfies the individual-rationality constraint, under which both the SEP holder and the implementer are better off with the license than without it. A royalty is FRAND if it (1) ensures the SEP holder's continued participation in standard setting, (2) does not deny the implementer access to the standard, (3) is consistent with a reasonable aggregate royalty burden for all SEPs on the implementer's standard-compliant product, and (4) approximates the royalty rates of similarly situated licenses. The SEP holder and the implementer each must expect to profit more by participating in the SSO than by forgoing such participation. The individual-rationality constraint provides a bargaining range for a FRAND royalty. The lower bound is the SEP holder's minimum willingness to accept, equal to the SEP holder's opportunity cost of choosing to monetize its inventions by participating in the setting of an open standard and licensing its SEPs to all comers on FRAND terms. The upper bound is the licensee's maximum willingness to pay for the patents as SEPs. I also explain why setting a FRAND royalty as the ex ante incremental value of the SEP is unworkable in practice.
In Part VI, I explain how the FRAND commitment resembles an ancillary restraint in antitrust law, without which joint venturers could not bring a new product into being. The challenge lies in dividing the producer surplus among SEP owners. The law of fiduciary duty and the principles of equity can guide courts in preventing opportunistic behavior that would jeopardize the value created by the production of downstream products resulting from the aggregation and exploitation of the SEPs. Put differently, the existence of fiduciary duties and the availability of equitable remedies reduce the likelihood that royalty stacking will occur.
In Part VII, I adapt the FRAND model to the considerably more complex case in which bargaining takes place with respect to portfolios of SEPs, and one must determine the FRAND royalty for a single SEP. I examine five alternative methods for dividing the joint surplus among SEP holders based on (1) heuristic use of the Lorenz curve, a tool that economists have used for measuring the distribution of income inequality of nations, (2) the Shapley value from game theory, (3) bargaining theory and the ultimatum game, (4) patent counting, and (5) patent pools. These methods will require further refinement before they are implementable.
A sequel to this article will examine the meaning of FRAND as it pertains to the patent holder's right to seek an injunction against infringers and to the duty of members of an SSO to negotiate a FRAND royalty in good faith.5
J. Gregory Sidak is an Expert Economist in the fields of Antitrust, Telecommunications Regulation, Commercial and Investment Arbitration, and Intellectual Property Law. Prof. Sidak is the Ronald Coase Professor of Law & Economics at Tilburg University and the Chief Economic Expert at Criterion Economics in Washington, DC. The focus of his research has been regulation of network industries, antitrust policy, the Internet and electronic commerce, intellectual property, and constitutional law issues concerning economic regulation.
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