Thursday, 16 March 2017

FRAND licensing: A call for greater transparency

No topic in technology licensing is more vexing than standard-setting organizations (SSO’s), standard essential patent (SEP) owners and FRAND terms. Anders Møller, a recent graduate of Oxford engaged as an independent economist, describes some interesting research that shows how much transparent FRAND licensing negotiations still need to be in order to achieve their expressed goals.

With the IEEE having updated its patent policy in 2015, some standard essential patent (SEP) owners raised concerns about the economic effectiveness of its move. While it is still too early to tell what economic impact their updated patent policy will have, it is worth paying attention to an econometric analysis of the patent policy introduced by VITA (VMEbus International Trade Association ) in 2007, undertaken by the now Chief Economist of the EPO, Professor Yann Ménière, and François Lévêque, Professor at CERNA, MINES ParisTech.

SSOs generally require firms to license their patents for a given piece of technology to users on a Fair, Reasonable and Non-Discriminatory basis, or FRAND. The FRAND principle is adopted to avoid the moral hazard of license holders ex post (after negotiations) using their intellectual property to extract supra-normal rents from licensees, once technologies have become indispensable to a given manufacturing process. This is commonly referred to as patent holdup. As Lévêque and Ménière point out--
“the mainstream view is that the rationale for [F]RAND is to mitigate holdup and that the R in RAND stands for the level of royalty resulting from competition in advance of standard selection (pp. 5-6).”
In turn, this promotes the broader adoption of new standards and, hence, higher royalty earnings for licensors. However, there is no common definition of what constitutes a “reasonable” royalty, which creates vagueness and thus greater uncertainty in licensing negotiations.

Lévêque and Ménière argue that the FRAND principle has worked surprisingly well up until recently, given that both licensors and licensees have an incentive to abide by it (i.e. licensors gain an increase in uptake of their IP while licensees mitigate holdup risk). However, a few cases have been highly publicized involving antitrust litigations over IP holdup. In the words of Lévêque and Ménière, this has “instilled doubts for standard users about [F]RAND as an effective safeguard against holdup (p. 16).”

This creates a social welfare loss because both licensors and licensees are disincentivized to negotiate and license new technology standards. According to the authors--
“the threat of being held up results in allocative and productive inefficiencies that are detrimental to society, especially to consumers for whom standard-compliment products are produced in lower quantities, later and at a higher cost (p. 21).”
So, what can SSOs do about this? Lévêque and Ménière Leveque model two policy approaches. The first is based on the January 2007 updated patent policy of VITA, which states that members “must declare the maximum royalty rate for all patent claims... that may become essential to implement the Draft VSO Specification.” Furthermore, this declaration is “irrevocable,” and subsequent declarations covering the same "may only supersede the prior Declaration if the subsequent Declaration is less restrictive."

This is quite a departure from the practice of simply relying on FRAND in principle and negotiating without disclosures, which Lévêque and Ménière show to be a helpful tactic for SSOs to deal with the with the growing uncertainty associated with what ‘reasonable’ means in the FRAND regime.

Based on a mathematical model, the authors find that licensing commitments before manufacturers sink fixed costs into new product standards “induce lower prices for standard compliant products (p. 41).” This is because the expected costs are always lower when manufacturers are guaranteed a maximum royalty rate than with no assurance at all. Although the licensor accepts a certain amount of risk by committing to charging lower royalties ex ante before demand is realized, this is offset by the promotion of higher technology uptake (as lower risk encourages market entry of more manufacturers). There is therefore a convergence of interests between licensors and consumers as doing otherwise would reduce the consumption of tariff compliant products.

The second policy approach is to make declarations optional, whether of a specific royalty or a ceiling. Lévêque and Ménière’s model shows that – assuming rational action – licensors will always choose either a royalty ceiling or an exact royalty rate, as a high maximum rate is always better than having no assurance in place at all. Moreover, such a flexible policy approach allows licensors to choose the option which maximizes expected profits, thus leading to more innovation which is a significant positive externality.

The authors therefore conclude that “although the VITA IP policy is an attractive one, the policy of IEEE-SA is even preferable”, because it maximises both licensor and consumer benefits. The implications are simple yet profound for policy makers. With the European Commission as well as the Joint Research Council having issued several studies on the topic , and the European Union considering guidelines on SSO policies by early summer of this year, such insights are invaluable.

The study from Professor Lévêque and Professor Ménière clearly shows that there is a need for more transparency in FRAND licensing negotiations and that SSOs need to assume their responsibility so to further clarify what FRAND means. This is needed so to restore confidence in the FRAND regime. A VITA-like policy requiring a specific or maximum royalty rate declared up front is essential to maximize social welfare from standards and the respective patents that read on them.

The challenge for other SSOs, like ETSI or CEN/CENELEC, now lies not only in adopting policies that include flexible disclosure regimes, but also in how to institutionalize the practice by all negotiating parties in order to avoid any one licensor attempting to gain a first-mover advantage. The success of this approach will increase innovation, which is ultimately the goal of a prudent IP framework.

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