Standard-essential patents (SEPs) have been critical to the ICT revolution. SEPs have allowed for the fast rates of innovation diffusion that the world has witnessed in the past 25 years. Yet the SEP system is under pressure. It suffers from a smoldering crisis of confidence as costly legal disputes across several international jurisdictions have caused unpredictable frictions in the markets for standardized technologies. Regulators in several parts of the world are now considering actions that seek to overcome obscurities in the SEP system. Asymmetric information is at the very heart of current problems in the market for SEPs, and all too often resembles a market dominated by a “confusopoly” with little transparency about products, quality and prices. In this paper, we will discuss ideas and concepts for what could be done to maintain a balanced and trusted system that supports technological innovation and at the same time conforms to economic efficiency.
Research assistance by Nicolas Botton and Julie Richert is gratefully acknowledged.
Observers of the debate about standard essential patents (SEPs) will have noticed that passions run high and that there are radically different views about how these patents are supposed to work, and how they work in practice. It is almost like the Tale of Two Cities, Charles Dickens’s classic novel about social justice and the French revolution. While the technologies that are covered by SEPs – most frequently used in ICT goods and the provision of digital services – are very far away from the world of Dickens, many (but far from all) participants in this debate have opposing views about the strengths and weaknesses of the current SEP “regime”. Just like one of Dickens’ key characters, some companies have been enveloped in costly legal disputes across several jurisdictions, leading to unpredictable frictions in the market for patented and standardized technologies.
It is admittedly a generalization, but one view in this debate is that current practices in the SEP system – especially how so-called FRAND rules are interpreted and used – drain the market of financial incentives to develop new upstream technologies. At the same time, opposing observers claim that SEPs are increasingly subject to high transaction costs, not least high potential legal costs, which clog the arteries of downstream innovation. To stylize the positions a little more: some IP holders claim they are effectively blackmailed over the patented technologies they offer to declare as essential to a technological standard under FRAND rules, while some SEP users argue that there are SEP suppliers that behave in ways that resemble extortion.
Although the debate about the functioning of SEP markets is subtler in matters of detail, current developments and major strands in the debate give reason to ask whether the system of FRAND-encumbered SEPs is moving towards a breaking point.
It is easy to take a pessimistic view about whether the system will break. If the current trend continues, the system is likely to break at some point for the simple reason that companies will not trust it anymore. The series of legal disputes witnessed over the past years – sometimes referred to as the “smartphone patent wars” – has been fodder for a pessimistic reading of “the two tales of SEPs”. While it is common in the business world that disputes over patents and licenses are settled in courts, various SEP disputes have revealed problematic aspects of the SEP market that are different from those disputes that follow the normal stream of business and contracts. Often, the SEP disputes are less concerned about the rights and boundaries of patents, and more about antitrust limits to market behavior: they concern market abusive practices and restrictions to competition as much as they are about intellectual property.
If the SEP system actually does break at some point, the consequences would be felt throughout the economy. SEPs have been a critical part of the ICT revolution. SEPs have allowed for the fast rates of innovation diffusion that the world has witnessed over the past quarter of a century. All the computer and Internet related products and services that people are now dependent upon for their private and professional lives are intricate webs of intellectual property. As many as 250,000 patents can be used to claim ownership of some technical specification or design element in a single smartphone (NYT 2012). A laptop, suggests one calculation, implements more than 250 interoperability standards (Biddle et al. 2010), and the number of SEP holders for 3G and 4G standards grew from 2 in 1994 to 130 in 2013 while the number of SEPs rose from fewer than 150 in 1994 to more than 150,000 in 2013 (Galetovic and Gupta 2016). The standardization-body ETSI has registered more than 150,000 declarations of SEPs from companies, and ETSI is just one of many bodies in the world of ICT standardization. For the 3G standard, the same body has about 24,000 patents that have been declared essential. Now, with the economy yet again on the threshold of big technological change, a trusted and credible system for creators and users of technology to standardize proprietary technology would be a boon for innovation, interoperability and – ultimately – the consumers.
And there are reasons for optimism. Although many of the problems in the SEP regimes need to be addressed, the numbers above indicate that the SEP system is in fact attractive to patent holders and SEP implementers. It is easy to see why: neither holders nor implementers are presented with alternative options that on the face of it would be far more profitable for them. In other words, there simply would not be as many patents declared as essential if both creators and users of technology believed the SEP system worked to their disadvantage or was grossly unfair. While the reality for some companies may be that legal disputes and unpredictability prompt them to find other ways than SEPs to get access to key technologies for their products, it remains the case that most stakeholders have strong economic incentives to maintain a balanced SEP system that is trusted.
First, standard essential patents are an asset for creators of technology because, by becoming essential to a standard, their volumes of sales for technologies that users value rise significantly. As many holders want to raise more revenues for their SEPs and – ideally – have the freedom to contract with buyers on their terms, they can expand their customer base when they agree to sell patented technology in accordance with a set of rules that are designed to prevent SEP holders exploiting the weakness of a customer that has grown dependent on having access to their technology.
Second, SEPs are hugely beneficial also to those that buy the licenses – the implementers or users. Through the SEP system, they can access technologies that are interoperable and work with different products and functionalities – and they can do it under conditions that, if history is a guide, in most cases give them stable and predictable terms of contract. As a consequence, both creators and users can focus on their competitive advantages and profit on the economies of scale and specialization. Downstream firms do not need to develop their own upstream technology and upstream firms do not need to package their technologies in end-customer products in order to make their products valuable.
Third, standard-setting organisations (SSOs) also have a big stake in an SEP system that works well – and, like creators and users of technology, they would stand to lose significantly if the SEP system were to collapse.
Lastly, the biggest beneficiaries are individual consumers – those who buy the end products using FRAND-conditioned SEPs. The advent of SEPs and the rules represented by FRAND have enabled a development of fast technology creation and contributed to the rapid diffusion in ICT goods and ICT-based services. The SEP system has also allowed for new competition, both between existing technologies and brands, and from new ones that have stepped into the market with the ambition to disrupt it, again to the benefit of the consumer. It is difficult to imagine that the ICT and digital development would have been as fast as it has been if SEPs had not been a central feature of the market.
The changing fortunes of companies operating in the cellular and smartphone market would not have been possible if there had not been an SEP system that supported competition. Now that the world economy is on the doorstep of new innovations that are dependent on a great number of input technologies – e.g. the Internet-of-Things, transport connectivity and intelligent vehicles – it is crucially important for the consumer that a balanced and functioning SEP system is maintained and that actors in the system converge towards it – which would ultimately meet their economic interests.
Improving the SEP System
How does a balanced and functioning SEP market differ from the current system – and how could changes towards a more balanced market design be achieved? In this paper, we will discuss ideas and concepts for what could be done to maintain a balanced and trusted system that supports technological innovation and at the same time conforms to economic efficiency. Unlike many other papers and contributions in this debate, our approach is not based on technical legal arguments, but rather seeks to anchor the purpose of the SEP system, and improvements of it, in economic analysis or what in academic jargon is called political economy.
Consequently, we are less occupied with exclusive legal interpretations of various court decisions that have begun to set norms for what FRAND rules should mean in practice, even if they naturally come into play. Nor do we intend to make a contribution based on the same degree of legalese that characterizes many other papers in this field. We put greater emphasis on basic economic analysis and, arguably, the two chief economic challenges of the SEP system, which currently give plenty of reasons for concern from an economics perspective:
- Allowing for a market-led discovery process of new technologies, leading to market-based pricing of technologies, in a SEP system that is currently anchored in a price commitment by those who offer licenses on FRAND terms.
- Ensuring that markets are transparent and that there is an incentive or, in other words, a premium for reducing – rather than expanding – non-transparent and directly obscure market and contract practices, which have led to confusion, legal risks, litigation and high transaction costs for involved stakeholders.
Therefore, the connaisseur of standards and patents would immediately spot that our focus is the market – and how it works. An alternative way of describing these two economic aspects of the SEP system is that they directly relate to the use of a standard that is based on proprietary technology, which is a somewhat odd creature in a market-based economy that otherwise seeks to foster or maintain competition. The protection of intellectual property is important to support innovation, but in the current SEP system, the market power given to a patent holder through the original exclusivity rights is reinforced by the standard. In other words, the standard is multiplying the economic value of the original patent. Therefore, there is an element of political economy involved, especially behavior of rent seeking and the hierarchy of firms on the markets (affecting the market distribution of income).
The first challenge that we outline concerns the actual standardization process, the SEP declaration and the time when prices are formed. Decisions about prices happen at different occasions, but a common approach – underpinned by several legal and competition-policy interpretations of FRAND rules – is that the relevant benchmark for a FRAND price is the price of the license before it is known whether a patent is essential to a standard, let alone the SEP declaration itself. The nature of incentives and market power between different companies changes once a standard has been established and it is clear which technologies are essential to the standard and deemed valuable by the market. In the process before a standard has been established, the creators of technology have an interest to signal commitment to low prices and to patent as much as possible around the likely standard. Importantly, all that happens before there is any real market valuation of the technology – before there has been a discovery of what utility market participants will have for the technology.
The second challenge concerns how market behavior evolves after the decision of standardization and whether parties to a contract have incentives to clarify or obscure information in the market for SEP licenses. Obviously, many SEP cases that have been litigated over the last decade reveal an astonishing degree of obscurity between contracting parties, let alone practices that are directly intended to confuse the buyer and other market participants. Most of these problems can be attributed to asymmetric information about product quality and prices, which is created by state-of-the-art SEP standardization processes. Figure 1 provides an overview of the problems of asymmetric information and market characteristics along the process of SEP standardization.
Source: own diagram.
There are reasons to suspect, however, that the two features are partly complementary as far as market practices are concerned: some problems of market transparency and obscurity are a reflection of a price mechanism for FRAND-encumbered SEPs that is in fact artificial. The argument we will pursue throughout the paper is that the flaws and frictions that have emerged in the SEP system in the past are direct reflections of these two challenges, and that the SEP system is in need of clarification of the commitments and flexibilities that come under FRAND rules. Furthermore, we argue that the only two bodies that can provide such clarification are courts and standard-setting organisations. Other actors can aid that development, but they cannot compensate for a situation where courts and standardization bodies cannot or will not provide clarification. Competition authorities, for example, have recently helped to shape a clearer limitation of market practices by applying standard antitrust economics through guidelines and case decisions. However, there are limits to what they can do because they operate ex-post and ideally should not be a price regulator.
Regulators in several parts of the world are now also considering actions that seek to overcome obscurity and asymmetric information in the SEP system. It is easy to understand why, but there are clear dangers that uncoordinated regulatory action, soft or hard, would create substantially more uncertainty and legal frictions rather than less. The technologies concerned are usually used, licensed and sourced globally – and distinct deviations between countries would risk causing clear incentives to localize contracts and production in some jurisdictions rather than others. Such “forum shopping” most likely takes place already, at least as far as litigation is concerned, and improvements of the system should effectively reduce the possible arbitrage between jurisdictions, rather than expanding it.
Why are we Here?
Before consideration is given to possible changes of the current SEP system, it is first necessary to understand why we have come to a point where they are deemed necessary. After all, for many outside observers the practices around SEPs are a bit obscure and often seen as part of a standardization system that has worked remarkably well in the past. Furthermore, if it is now relevant for government authorities to provide guidance or (self-) regulation about how the SEP system is due to evolve, it is important to understand current problems and how they are actually manifested in reality. Let us consider some of the events and developments that have shaped the current system and led to frictions.
First, markets, technology and business models have changed.
Developments over the past decade have had a significant impact on how companies compete and where revenues are generated. Some businesses have been forced to change because the high-tech or ICT market has changed, and they may not be producing today what they produced when the SEP system emerged. New businesses have entered the SEP system, and there is generally a much higher degree of variation between companies that have a stake in it. With the rise of new companies on both sides of the SEP market, cross-licensing between a relatively small number of companies like Apple, Samsung, Microsoft and Google may take a much smaller share in overall SEP licensing in the future. Market and technological change over the years has led to a greater degree of corporate specialization – and that change has gradually delineated the economic interests in the SEP system. There are now many more stakeholders in the system and, even if many of them still both contribute to and implement SEPs, there is today much less of a balance inside and between companies in how they perceive the importance of revenues generated from either using or contributing SEPs.
Second, there has been a marked rise in SEP litigation cases over the years (see Annex 1).
Increasing legal costs for managing SEPs are a distinct aspect of that development – and one that has led to expectations of potentially high transaction costs for participating as a contributor to, or user of, SEPs. Still, a more noxious aspect is the uncertainty that litigation has caused over the marketability of designated SEP-technology and SEP-based products. If companies are at risk of either having licenses being used unfairly or being exposed to injunctions that prevent them to compete, at least temporarily, that in fact constitutes a significant deterrent against using the SEP system in the future. Increased litigation is also a reflection of market practices that partly have become obscure and somewhat impenetrable for those that do not have long experience of SEPs or significant legal resources allowing them to safely navigate the system of standards and patents (e.g. emerging Internet-of-Things companies). In many respects, the evolution of standards and markets has led to less transparency. It has worked against some market participants’ ambition to gradually reduce problems of asymmetric information and the potential for market abusive practices, and can be regarded as an implicit competitive advantage (or subsidy) to incumbent businesses that understand the rules of the game.
Third, courts have increasingly defined market conditions for SEPs.
As a consequence of litigation, courts in key markets in the world have increasingly become the theatre for defining the practices for FRAND-encumbered SEPs: how they are negotiated and what terms of contract that are considered fair and reasonable. While it is only natural that courts are the final instance for resolving legal or commercial disputes, all parties have not uniformly accepted what these decisions entail for future contracts and commercial conditions. As the decisions by the courts are reflected in work to set precedents and guidelines for the future, it is not surprising that there are increasing tensions about how exactly the system should work. The growing commercial values involved – partly through new technological developments – only serve to underline the importance for individual companies of the direction of travel for the entire SEP system.
Fourth, competition authorities are increasingly wary of the imbalances of the current system.
Competition authorities have increasingly taken an interest in how SEPs are used and negotiated, and hence introduced a greater degree of antitrust considerations in the world of standards and patents. Undoubtedly, the emerging role of competition authorities all over the world in SEPs will influence the market and should already now be high up on the agenda in the discussions about how FRAND-encumbered SEPs should be negotiated and contracted.
What has been a voluntary system decided by stakeholders themselves now has clearer limitations for how the market power granted through a standard could be used in actual contracts. While decisions by competition authorities do not necessarily set precedents, they have arguably done so in the field of SEPs, with feedback effects to courts. In addition, both the European Commission and the Federal Trade Commission in the United States have made explicit decisions with regard to the use of injunctions. The economic analysis behind these decisions suggest that the scope of the interest for competition authorities goes beyond the mere issue of injunctions.
Fifth, regulators are about to step in.
Other regulators than competition authorities have started to lay down some markers for how they think the market for FRAND-encumbered SEPs should evolve to support faster diffusion of innovation and the participation of companies with less experience than others of how to manage SEPs. This is a significant development and one that, potentially, can have unprecedented consequences for how the SEP system will evolve. In Europe, there is currently a process underway to possibly establish SEP-guidelines and, given the centrality of the European market for SEPs, it is worthwhile to understand the background, perception and motivations of regulatory authorities taking an interest in the evolution of SEPs.
SEP-Guidelines in Europe
The important role of SEPs was identified by the European Commission as a key issue for promoting a Digital Single Market (DSM) in Europe. Adopted in May 2015, the DSM initiative intends to enhance and promote digital opportunities and ensure that businesses and individuals across the EU can access online services “fairly and freely” (European Commission (2015a). Accomplishing the goals of the DSM has also become one of the key political priorities of the EU, and therefore the aim of establishing a more predictable and balanced framework for SEPs comes with some political tailwind (European Commission 2017; 2016).
This is underlined by the European Commission’s observation that the current SEP framework is delaying the benefits of standardized technologies because of several uncertainties in the current standardization frameworks. Businesses are perceived to be too slow to capture the opportunities emerging from new technologies, or directly deterred from approaching them because of opaque licensing terms related to SEPs and unpredictability in the access of standardized technologies. The concerns identified range from a lack of transparent information to uncertainties of enforcement and unclear pricing of patented technologies. Addressing these issues is considered essential for EU businesses to remain competitive in ICT sectors and in newly emerging markets, like the Internet-of-Things and the implementation and diffusion of digital innovations across sectors.
In the European Commission’s action plan, it is considered a priority to identify areas where the process of standardization should urgently be improved. For that purpose, there has been a number of studies released, as well as a consultation which sought out the opinion of market participants. Importantly, the European Commission also recognizes the need to provide a level playing field globally and therefore seeks to ensure that “EU standardisation remains at the forefront of international technology standardisation.” (European Commission 2017b)
More specifically, the European Commission’s Roadmap concerning SEPs sets out the ambition of making SEPs more predictable and ensuring a balanced system that enables all actors to have access to standardized technologies at terms that are mutually beneficial for SEP holders and implementers. More precisely, the Commission has identified three major problems impeding the development and implementation of standards for which, so far, it only aims to provide guidance and best-practice recommendations (European Commission 2017). The Commission’s positions are as follows:
- Opaque information about SEP exposures: with an increasing number of patents being declared as essential to ICT standardization, the system lacks an effective and reliable tool for licensees to identify which patents and licenses are necessary for them to implement in products.
- Unclear valuation of the patented technologies: there is no widely-accepted valuation method used to calculate the value of licensing and royalty fees, including FRAND fees and non-pecuniary conditions. As a consequence, there are several uncertainties and imponderables in the valuation of patented technologies when they read on a standard, which results in questions concerning the justifiability of royalties, causing a significant lack of predictability regarding legitimate and proportional licensing fees.
- Risks of uncertainty in enforcement: there are several uncertainties in the enforcement of SEPs due to incomplete framework(s) of SEP licensing. This has previously led to costly and long court cases that have given SEPs a bad reputation. Uncertainties in the enforcement of rights can, according to the European Commission, prevent businesses from taking part in the development of IoT and other promising areas of rapid innovation.
The date by which the European Commission wishes to issue guidelines on these matters is the autumn of 2017.
 FRAND is a legal term that stands for Fair, Reasonable and non-Discriminatory licensing conditions. Standardization bodies often request that the company holding a patent for a technology needs to agree to license on FRAND terms in order for the technology to become essential to a standard.
 Many SEP “holders” are at the same time SEP “users” and it is therefore not correct to generally portray this debate as featuring only two groups of companies with opposing views on how to maintain or reform the SEP system.