I have finally got around to reading the leaked draft proposal by the European Commission to overhaul the system of Standard Essential Patents (SEPs) by creating a new framework for determining royalties and resolving SEP disputes (a link to the draft proposal is provided in this post). In essence, the Commission proposes that the EU Intellectual Property Office (EUIPO) – a trademark registry with no current expertise in patents, standards, and SEPs! – will be empowered to mandate the registration of SEPs, regulate their essentiality, and adjudicate on FRAND royalties with the view of reducing the price of using patents.
I had seen some comments from judicious observers that aren’t part of either side in the big but grossly over-simplified debate about “SEP holders/creators versus implementers/users”, that signalled deep frustration with the proposal. I initially thought there must be a misunderstanding of the proposal but having now read it, I fully understand why so many are venting their frustrations. The proposal is due to be released on April 26th – on World IP Day – but the Commission needs to pause this process and have a deep re-think. The proposal isn’t just messy and unbalanced: it would harm Europe’s economic and institutional interest in the world of patents and standards.
It’s surprising the proposal has got this far. Of course, it builds on previous communications from the European Commission – for instance its IP Action Plan from 2020, which called for more transparency and predictability in the licensing of standard essential patents. But efforts to improve the SEP system goes further back in time. The Digital Single Market Initiative from 2015, for instance, made the case for more transparency in the SEP system. It was followed by a SEP roadmap in 2017. There has been plenty of consultations and commissioned proposals and analyses – for instance this one by Charles River Associates and this one by IPlytics.
The Joint Research Centre has also published analyses and held, in the first half of the 2010s, some interesting workshops that aimed at working out a balance between “holders” and “implementers”. ETSI, the European Standards Organisation for telecoms, has been a constant source of knowledge. European antitrust authorities have weighed in through specific cases – for instance, this important case between Motorola and Apple. Courts in especially Germany (but also other EU countries) have gradually built up case law. Importantly, the European Court of Justice ruled in 2015 in the landmark case between Huawei and ZTE by laying out the basic pillars for the process of negotiating and determining the FRAND price (the license royalty) in good faith. And then, of course, there is the Horizontal Guidelines, dating back to 2011, with its strong commitment to FRAND in standards. These guidelines have recently been up for review.
I cite these examples, and this development over time, because the leaked draft proposal breaks with the work and the evolution of policy by the Commission and courts over the years. Obviously, the motivation for the Commission – and many others – to improve SEPs came on the heels of the smartphone patent wars, which led to many injunctions, a rapid growth in litigation, and concerns that either holders or implementers were clogging the arteries of technology diffusion. As a result, the transaction costs for using standards were going up and, if the growth of litigation had continued, legal uncertainty could have a prohibitive effect on technological development, competition, and markets. There were other concerns too – for example, the abuse of dominant position by SEP holders and possible over or under declaration of patents to the standard. Clearly, doubts about the actual “essentiality” of declared patents were proliferating on the side of the “implementers”. A colleague and I tried (but failed) to draw the attention to the “market problem” in the SEP system: how a system based on price commitments (commitment to FRAND royalty based on the value of the technology before its market value was known) could pollute market competition and lead to an outcome where we would be “getting the prices wrong”. Incentives for innovation upstream or downstream would be lower and investments would be allocated in an inefficient way. In the end, we only managed to irritate all sides of the debate.
However, the Commission, along with others, started the SEP-reform process in the 2000s by conceptually anchoring the core problem in the exclusivity right of a patent and the enforced market power of a patent holder when the patent became essential to a standard. In theory, this would cause problems of “hold up”, disturbing value chains and the process of technology diffusion. Holders, the theory went, would deny closure of licensing agreements till the point when the licensee was willing to pay a much higher (above FRAND) price for obtaining access to patented technology. This view was based on some important observations, but the composite view also accommodated the opposite risk – that the prospective licensee could “hold out” the closure of licensing agreements to negotiate a lower price (below FRAND). This understanding of potential risks on the side of both the “holder” and the “implementer” was reinforced by the European Court of Justice in the Huawei v ZTE case, and many decisions that have followed in national courts have gradually reflected both concerns.
Importantly, the situation has changed a lot over the years. Ten years ago, the media was full of reports about how companies in the cellular space were fighting in courts about rights and royalties for patents that were declared essential for a standard. When was the last time you heard anything about such problems in Europe? Clearly, litigation still exists and there are issues that have not been solved by the courts – for instance, deciding what the FRAND royalty should be. However, over the years, courts and competition authorities, and firms and the standardisation bodies, have by and large addressed many fundamental risks that existed in the past. The launch of new ICT products isn’t regularly blocked by injunctions. There are those who complain about a lack of transparency – and there is some truth in that – but the fact is that experience, better knowledge, market and technological change, and jurisprudence have made SEPs easier to understand, use, and transact.
In hindsight, the ten years or so of legal turbulence in the SEP system was perhaps costly but necessary to define the essence of core legal concepts and practices (essentiality, FRAND), and for stakeholders to conform to a market reality that was changing rapidly. This change was markedly strong on the firm side: many new firms emerged in the telecom market and many of the old firms had to specialise in one part of the value chain as they could not compete across it any longer. The result is the highly specialised ICT market we have today. In a way, the Commission’s new proposal could be presented as an effort to address concerns that have already been addressed – substantially if not fully. But it also goes beyond that and now proposes to overhaul SEPs in a way that will disturb the market and undermine the solutions that have emerged.
1. It’s unbalanced. The proposal is deeply unbalanced and seeks to favour “implementers” over “holders”. While the stylised conflict between these two categories is still over-simplified, the last years have of course seen a big push from some new “non-traditional implementers” to redistribute income from upstream technology developers to downstream companies that are consumer-facing or closer to the consumer. The automotive industry, for example, is now a big user of ICT technology and one of those industries that have been lobbying heavily for various interventions to reduce SEP royalties.
Obviously, the system of SEP depends crucially on a balance between “holders” and “implementers”. If that balance goes, development and innovation will suffer. Fewer patents will be declared essential to a standard and “implementers” will have to negotiate about them outside the SEP system. Worse, the incentives to innovate upstream could deteriorate, leading to a slower pace of technology creation.
2. Costs to Europe. If this proposal becomes reality, the most likely consequence is that policy and legal issues about and around SEPs will move out of Europe. The Commission just cannot set an administrative and regulatory process that other markets will have to follow. They just won’t. Companies will rather take their principal disputes out of Europe.
The EU has a uniquely privileged position of being the centre of standard developments in the ICT space – a development that has been market and consensus driven. Therefore, European authorities and courts have had an outsized impact on developing the rules of engagement globally. The Commission’s new standardisation strategy took a first step in weakening this position for Europe. As colleagues and I pointed out in a paper released in mid-March, the Commission’s attempt to exert political control over how standards are set is misguided and risk leading to the opposite outcome: the time and cost of setting standards will go up, and the role of market driven standards may be further weakened by proprietary standards and government-set standards. The leaked SEP proposal exacerbates the problem. The importance and integrity of European standardisation bodies and courts will fray. Europe will lose its status as the central hub for standards, SEPs, and adjudication.
3. Undermining FRAND. The FRAND approach is about having a system that ensures fair and reasonable prices, and that technology is offered to implementers without discrimination. Strangely, the approach by the Commission now seems based on an underlying assumption that prices are too high and that the EUIPO can help to reduce them to a FRAND level. But the FRAND concept is not based on the ability of authorities to determine a price, let alone a price that is the same for everyone. In fact, courts have routinely avoided getting to a position when a FRAND price is established by them or administrative bodies. It would be alien to how the market works and the fact that licensees have technology needs that are very different from each other.
Such a heavy-handed approach to FRAND would likely result in fewer patents being declared SEPs. A licensee often contracts with firms about patents that are SEPs and non-SEPs: quite often, they pay to access a portfolio of different patents. For patents that are not SEPs, FRAND doesn’t apply. Hence, for the typical licensee, they will likely have to pay more for non-SEPs – leading to less transparency and fairness, and to more discrimination.
4. Invalidate the Unified Patent Court. A significant group of EU member states have agreed to establish a Unified Patent Court (UPC) – based on the unitary patent system. The UPC will soon be up and running: the Agreement of the Unitary Patent Court will take effect from June 1st this year and will solidify how European courts make decisions about SEPs. Building up the expertise to have a Unified Patent Court in Europe is not a small achievement. Invalidating its role now by handing power to an EU agency with no expertise about patents seems very, very strange.
5. Reduce Europe’s competitiveness. It is very odd that the Commission is proposing a regime that effectively will reduce license revenues when most of these revenues come from other regions – regions that have more downstream manufacturers of ICT products. Obviously, Asia is the dominant region in many classes of ICT products and the main trade effect of this proposal would be to reduce Europe’s export revenues. I will come back to this effect in a few days in a different post.
There is also a trade-policy effect. The EU is concerned about weak rights for EU high-tech producers to defend their cellular patents in some countries. Last year, it brought a new complaint against China about exactly this problem – having political rather than legal decisions about patent rights, and that Chinese courts routinely issues anti-injunction decisions in SEP cases after a decision by China’s Supreme People’s Court to prohibit application of enforcement based on decisions in non-Chinese courts. A panel has just been established in the WTO. The EU’s case stands on solid legal grounds. What the Commission is proposing now will create a legal mess.