September 01, 2014

Background and Introduction

The challenge of determining royalty rates and other licensing terms for standard essential patents that can be accepted by standard setting organizations as reasonable and nondiscriminatory (“RAND”) has recently come into sharper focus.1 Since Judge James Robart’s landmark opinion regarding a RAND royalty rate in Microsoft Corp. v. Motorola, Inc., released on April 25, 2013, RAND royalty rates have been determined in various other patent-related lawsuits. These RAND royalty rate determinations are significant given they will likely directly or indirectly affect how RAND royalty rates are determined in the future.

Despite these recent court decisions, no formal definitions of “nondiscriminatory” exist in the context of RAND. To date, much of the scholarly and other literature on this topic has focused on the definition and general issue of the “reasonable” aspect of RAND, while the “nondiscriminatory” aspect has been given a relatively small amount of consideration. The purpose of this article is to explore the various proposed definitions of, and issues associated with, the “nondiscriminatory” aspect of RAND in an effort to help frame the challenge of determining nondiscriminatory licensing terms. In particular, does “nondiscriminatory” mean that all licensees should be given the same licensing terms or does it allow for different rates to be charged to different licensees?2

The Innovatio Perspective

In his Memorandum Opinion, Findings, Conclusions, and Order dated September 27, 2013, in In re Innovatio IP Ventures, LLC Patent Litigation, Judge James Holderman from the Northern District of Illinois (“the Court”), opined upon a RAND royalty rate Innovatio should charge to Cisco Systems, Inc., Motorola Solutions, Inc., SonicWALL, Inc., Netgear, Inc., and Hewlett-Packard Co. (all end product manufacturers; i.e., “the Manufacturers”) for Innovatio’s portfolio of standard essential patents related to the Wi-Fi telecommunications standard.3 In the opinion, the Court indicated an intention to have Innovatio charge the Manufacturers for use of its standard essential patents at a rate identical to the rate it would charge to chip manufacturers for the same set of patents.

The Court’s articulation of this position is found within its discussion of the Manufacturers’ expert’s methodology to determine a RAND royalty rate:

First, by taking the profit margin on the sale of a chip for a chip manufacturer as the maximum potential royalty, [the approach] accounts for both the principle of non-discrimination and royalty stacking concerns in RAND licensing. Considering the profit of the chip manufacturer on the chip, rather than the profit margins of the Manufacturers on the accused products, is appropriate because a RAND licensor such as Innovatio cannot discriminate between licensees on the basis of their position in the market. Thus, the RAND rate that the court determines here should be the same RAND rate that Innovatio could charge to chip manufacturers on its patent portfolio.4

Simultaneously, the Court rejected Innovatio’s suggested RAND royalty rate calculation that was based, at least in part, on the selling price of the Manufacturers’ end products with Wi-Fi functionality (e.g., laptops, tablets, printers, access points, etc.) adjusted for the portion of the selling price of the end products that is attributable to Wi-Fi functionality (the “Wi-Fi feature factor”). Innovatio proposed that the Wi-Fi feature factor could reasonably be different for different types of end products. According to Innovatio, this difference could have led to variation in royalty rates charged for different Manufacturers’ products.5

The Court’s intention to have Innovatio charge the Manufacturers a royalty rate identical to the rate it would charge to chip manufacturers leads to several questions:

  • Can different licensing terms be charged for different types of products while still upholding the nondiscriminatory aspect of RAND?
  • Can a licensor of standard essential patents agree to different terms with different licensees on any other bases (other than type of product) while still complying with the nondiscriminatory aspect of RAND?
  • Is there merit to an approach that focuses solely on the price and profit margin earned on the sale of the component in which relevant standard essential patents are implemented without consideration of the product in which that component is used?

Other Perspectives

In contrast to Innovatio, other sources indicate a less stringent interpretation of “non-discriminatory” under RAND. For example, one Administrative Law Judge from the U.S. International Trade Commission wrote without elaboration that “The FRAND nondiscrimination requirement prohibits ‘unfair discrimination,’ but it does not require uniform treatment across licensees, nor does it require the same terms for every manufacturer or competitor.”6

Similarly, an examination of the policy-setting process of the European Telecommunications Standard Institute (“ETSI”) regarding the definition of FRAND states:

Given this history, we conclude that any attempt to equate the “non-discriminatory” component of an ETSI FRAND commitment with thoroughgoing “Most Favoured Licensee” obligations would be mistaken as a matter of intent-based contract interpretation…Where the Undertaking had specified that similarly situated licensees had a right to identical terms, the final text of the “Common Objective” document annexed to the final report of the Special Committee on IPR stated, under the heading “Concerns about most favoured licensee provision,” that while “License terms and conditions should be non-discriminatory,” “this does not necessarily imply identical terms”. Instead, under the heading “Commercial freedom”, the document asserted, “Licensing terms and conditions should allow normal business practices for ETSI members. ETSI should not interfere in licensing negotiations”…three out of the four groups reported agreement that non-discriminatory “does not necessarily imply identical terms”, and the fourth group did not comment on that topic…“ND” clearly means less than a Most Favoured Licensee clause, with an MFL clause having been explicitly repealed, and comment at the time of adoption of the present policy signalling [sic] an intention to leave members wide flexibility in agreeing to particular terms with particular licensees depending on the commercial circumstances.7

The standard setting process often involves competitors working together to jointly agree on a solution. Such a process raises a number of potential antitrust concerns including the charging of an unreasonable and discriminatory price for standard essential patents after the standard is agreed upon. On several occasions the U.S. Department of Justice (“DOJ”) has approved the use of different royalty rates for different types of products through business reviews of certain proposed patent licensing arrangements for standard essential patents.8 The purpose of the DOJ business review is for a licensor (often a patent pool holding standard essential patents) to obtain guidance and feedback from the DOJ on its suggested licensing arrangements regarding whether such licensing terms raise antitrust issues. The RAND commitment by all of the participants to a standard setting process is part of the solution to these antitrust concerns.9

As an example of the DOJ approving different royalty rates for the same group of standard essential patents, in one instance the DOJ approved the terms of a patent pool license agreement related to a DVD standard in which a royalty rate of $0.075 is charged per DVD disc while a royalty rate related to DVD players and DVD decoders is equal to four percent of the net sale price of such products with a minimum royalty of $4.00 per player or decoder.10 As another example, the DOJ appears to have approved the use of different royalty rates for different sales volumes of the same products on at least one occasion.11

Although these sources suggest licensing terms need not be identical to be non-discriminatory, they do not provide clear guidance on how different licensing terms can be before they would no longer be nondiscriminatory. The economics literature on the topic of “nondiscriminatory” also provides some guidance; however, caution is required as a consensus does not yet exist here either.12 Although authors in the economics literature often reference the proposition that only “similarly situated” licensees must be given similar licensing terms,13 there is little agreement as to what exactly “similarly situated” means with respect to “nondiscriminatory.”

For example, one article focuses attention on differences in “output levels”14 (e.g., production or sales volumes) while another allows for differences due to the outcome of a hypothetical, pre-standard setting bilateral negotiation considering each party’s post-standard setting bargaining power and business features.15 A third article defines “similarly situated” firms as firms that, prior to the final selection of a technology as the standard, “expect to obtain the same incremental value from the patented technology compared with the next best alternative available to be incorporated into the standard”16 without post-standard setting characteristics taken into account. A fourth article, for reasons that will be discussed herein, interprets the nondiscrimination obligation as applicable only to vertically integrated licensors. For those licensors, their licensees of standard essential patents should be charged no more than the licensors’ final product price less the incremental cost of all inputs to production other than the standard essential patents in question.17 Notably, certain commentators have even stated that the same royalty rates charged to licensees that are not similarly situated may, itself, be discriminatory.18

Defining “Price Discrimination”

Because RAND is part of the solution to antitrust concerns, it is useful to consider related economic and antitrust concepts that underlie the context in which nondiscrimination exists. One of those concepts is the broader topic of price discrimination. Price discrimination is generally defined by economists as the offering of the same product at different unit prices to different buyers. However, price differences that accurately reflect differences due to the cost of supply are not instances of price discrimination. Certain conditions must be met for price discrimination to be possible: 1) the seller must have some market power; 2) the seller must be able to infer buyers’ willingness to pay; and 3) a seller must be able to prevent resale by buyers who pay lower prices. A seller with monopoly power can earn greater profits if it charges more to the buyers who place greater value on its products than if the seller charged uniform prices to all buyers.19

These conditions are potentially met by an intellectual property licensor, particularly one with standard essential patents. By charging more to the buyers who place greater value on the intellectual property, a licensor with monopoly power could earn greater overall revenue (and thus profits) from its various licensees than if royalty rates to the licensees were uniform. In fact, price discrimination is common in the practice of non-RAND, intellectual property licensing.20

From an economic perspective, it is important to note that price discrimination in general is not necessarily a problem that should be avoided. In contrast to uniform pricing by a firm with market power, price discrimination can lead to a greater number of transactions in the marketplace, which can be more efficient from the point of view of the overall economy.21 Of course, price discriminating sellers (e.g., patent licensors) can gain at the expense of some of their buyers (e.g., licensees).22 It is this wealth transfer that creates the potential for a monopolist to abuse its market power by using price discrimination to create an unwanted injury to competition.

The principal U.S. Federal statute addressing illegal price discrimination is Section 2 of the Clayton Act as amended by the Robinson-Patman Act. The Robinson-Patman Act prohibits the sale of two products of like grade and quality at different prices to two different buyers where the price difference may result in injury to competition. Notably, the term “products” in this context relates only to tangible goods and also only to the sale of such products (i.e., the sale or license of intangible assets such as patents are not governed by the statute).23

Although the Robinson-Patman Act does not govern the implementation of RAND in the context of licensing standard essential patents, some of the authors of economic papers on the topic of RAND have used its conceptual prohibition to frame their definition of an undesirable licensing situation. One focus of those articles is the situation in which a standard essential patent owner licenses to its downstream manufacturing rivals at prices different than the internal price it charges to its own downstream manufacturing division or subsidiary. In such a situation, the patent owner’s price discrimination in its licensing terms may provide its downstream division/subsidiary with an advantage over its competitors.24 If this competitive advantage stems from the market power that is a result of the standard setting process, the exploitation of such an advantage may be an improper use of price discrimination.

Some commentators have opined that outside of this particular situation, patent owners have little incentive to conduct price discrimination that they know will be anti-competitive.25 Given this belief, one author concludes, “… only those [licensing] practices which have actually harmed or stand a good chance to actually harm consumer welfare should be prohibited.”26 Another article explains that when “similarly situated” is defined by the measurement of the pre-standard setting incremental benefit generated by the patented technology, the benefit derived by anti-competitive price discrimination is reduced. However, those same authors recognize the practical challenge of enforcing such a definition, especially for vertically integrated firms where measuring the internal price charged to the downstream division/subsidiary is difficult. As an alternative, those authors propose that “similarly situated” be defined as, “any firm that uses [a] common component [employing the patent], even in cases where some firms derive greater value from the patent than do others.”27 We note this proposal is essentially the conclusion that the Court reached in the Innovatio matter.

Conclusion

While there is no clear consensus on the definition of what “nondiscriminatory” means in the context of RAND, most commentators and interested parties believe that the term does not necessarily require the licensing of standard essential patents at identical terms for all licensees, assuming such differences in terms do not produce an antitrust injury to competition. Most believe that it is sufficient to provide only “similarly situated” licensees with similar or identical terms although disagreement exists as to how “similarly situated” should be defined. The Innovatio Court’s reliance on the profit of one component of the relevant end products to develop a single royalty rate for all licensees such that “…Innovatio cannot discriminate between licensees on the basis of their position in the market…” fits with at least one recent interpretation of the nondiscriminatory aspect of RAND, but does not appear to be consistent with most others.

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1 For purposes of this article, we assume that RAND is synonymous with FRAND (i.e., fair, reasonable, and nondiscriminatory). This assumption is consistent with most publications on the issue of RAND royalties.
2 Our discussion of “nondiscriminatory,” consistent with the large majority of the literature on RAND, primarily focuses on the question, “to what extent can licensing terms differ among licensees?” and not to the underlying question of whether all firms or only certain firms should be eligible in the first place to license an owner’s standard essential patents.
3 In re Innovatio IP Ventures, LLC Patent Litigation, No. 11-9308 (N.D. Ill., Sep. 27, 2013) (Memorandum Opinion, Findings, Conclusions, and Order), p. 1.
4 Id. at 74.
5 Id. at 21-22.
6 U.S. International Trade Commission, In the Matter of Certain Wireless Devices With 3G Capabilities and Components Thereof, Investigation No. 337-TA-800, Initial Determination, Administrative Law Judge David P. Shaw, June 28, 2013, p. 432.
7 “Interpreting and Enforcing the Voluntary FRAND Commitment,” Roger G. Brooks and Damien Geradin, International Journal of IT Standards and Standardization Research, 9(1), 1-23, January-June 2011, p. 15-16.
8 Response Letter from Joel I. Klein (Assistant Attorney General, U.S. DOJ) to Garrard R. Beeney (Sullivan & Cromwell), dated December 16, 1998, p. 6 [hereinafter Klein Response Letter, 1998]; Letter from Joel I. Klein (Assistant Attorney General, U.S. DOJ) to Carey R. Ramos (Paul, Weiss, Rifkind, Wharton & Garrison), dated June 10, 1999, p. 6-7 [hereinafter Klein Letter, 1999]; Letter from Thomas O. Barnett (Assistant Attorney General, U.S. DOJ) to William F. Dolan and Geoffrey Oliver (Jones Day), dated October 21, 2008, p. 5 [hereinafter Barnett Letter, 2008].
9 ABA Section of Antitrust Law, “Frequently Asked Antitrust Questions,” Second Edition (2013), p. 154-158 [hereinafter ABA FAQs, 2013].
10 Klein Letter, 1999, supra note 8, at 6-7.
11 Barnett Letter, 2008, supra note 8, at 5.
12 “An Economic Interpretation of FRAND,” Dennis W. Carlton & Allan L. Shampine, Journal of Competition Law & Economics, 2013, 9(3), p. 531-552 at 545 [hereinafter Carlton & Shampine, 2013]; “Fair, Reasonable and Non-Discriminatory (FRAND) Terms: A Challenge for Competition Authorities,” Mario Mariniello, Journal of Competition Law & Economics, 2011, 7(3), p. 523- 541 at 528 [hereinafter Mariniello, 2011].
13 “A Simple Approach to Setting Reasonable Royalties for Standard-Essential Patents,” Mark A. Lemley & Carl Shapiro, Berkeley Technology Law Journal, 2013, Vol. 28:1135, p. 1135-1166 at 1141-1142 [hereinafter Lemley & Shapiro, 2013]; Carlton & Shampine, 2013, supra note 12, at 546; “Nondiscriminatory Pricing: Is Standard Setting Different?” Anne Layne-Farrar, Journal of Competition Law & Economics, 2010, 0(0), p. 1-28 at 20 [hereinafter Layne-Farrar, 2010]; “Standard Essential Patents: Triangulating the End Game (Draft),” Daryl Lim, 2014, 119 Penn State L. Rev.(Forthcoming), p. 30; Mariniello, 2011, supra note 12, at 532.
14 “The Meaning of FRAND, Part I: Royalties,” J. Gregory Sidak, Journal of Competition Law & Economics, 2013, 9(4), p. 931-1055 at 996-997 [hereinafter Sidak, 2013].
15 Mariniello, 2011, supra note 12, at 532.
16 Carlton & Shampine, 2013, supra note 12, at 546.
17 “Reasonable and Nondiscriminatory (RAND) Royalties, Standards Selection, and Control of Market Power,” Daniel G. Swanson and William J. Baumol, Antitrust Law Journal, Volume 73, 2005-2006, p. 1-58 at 30 [hereinafter Swanson & Baumol, 2005-2006].
18 “Standardization and technological innovation: Some reflections on ex-ante licensing, FRAND, and the proper means to reward innovators,” Damien Geradin, TILEC Discussion Paper DP 2006-017, Paper presented to the Conference “Intellectual Property and Competition Law” Brussels, 8 June 2006, p. 10; Sidak, 2013, supra note 14, at 996; Layne-Farrar, 2010, supra note 13, at 5.
19 “Modern Industrial Organization, Third Edition” Dennis W. Carlton and Jeffrey M. Perloff, Addison-Wesley, 2000, p. 274-295 at 277.
20 Swanson & Baumol, 2005-2006, supra note 17, at 24; Layne-Farrar, 2010, supra note 13, at 3.
21 Swanson & Baumol, 2005-2006, supra note 17, at 25-26; Layne-Farrar, 2010, supra note 13, at 3; “Price Discrimination,” R. Preston McAfee, Issues in Competition Law and Policy (ABA Section of Antitrust Law 2008), Chapter 20, p. 465-484 at 481 [hereinafter McAfee, 2008].
22 McAfee, 2008, supra note 21, at 481.
23 ABA FAQs, 2013, supra note 9, at 103-104.
24 Layne-Farrar, 2010, supra note 13, at 3; Swanson & Baumol, 2005-2006, supra note 17, at 26.
25 Layne-Farrar, 2010, supra note 13, at 3; Swanson & Baumol, 2005-2006, supra note 17, at 26.
26 Layne-Farrar, 2010, supra note 13, at 4.
27 Carlton & Shampine, 2013, supra note 12, at 547-548.