Comments on Sidak Part 2: The Ex Ante Contingent Incremental Value Approach (Siebrasse)

Guest Post by Professor Norman Siebrasse, University of New Brunswick Faculty of Law

As I noted at the conclusion of Friday’s post, Professor Sidak’s article on The Meaning of Frand forces us to confront the question of whether SEPs are different from other patents in ways that are relevant to the FRAND royalty analysis. Sidak’s answer is that “[t]he value associated with a standard is joint and common among the SEPs,” (953) – which he refers to as “combinatorial value” – and consequently, “[o]nce a patent is essential to the standard, the hypothetical-negotiation framework used to determine the royalties for implementation patents does not apply” (953). The difficulty with this, as discussed in my last post, and as betrayed by the word “once,” is that this combinatorial value arises ex post; the hypothetical negotiation framework is still applicable ex ante. That SEPs have combinatorial value ex post, therefore does not warrant a difference in the royalty damages analysis.

There is a related point which, to my mind, is more salient to the royalty analysis: the combinatorial value of the standard may be much larger than the sum of the incremental value of the patents taken individually, outside of the standard. That is, the patents that end up being SEPs are more valuable as part of the standard than outside it. (This is of course not true for all patents, but when it is not, the patentee will not normally join the standard.) Suppose there are a number of patented technologies, A though Z, which are useful only if adopted as part of a standard, and which are substitutes in that if eg, X is adopted as the basis for the standard, none of the others would add any value to the standard. However, they are not perfect substitutes, in that some of the resulting standards are better than others. In that case, the ex ante non-SEP value of any of the patents is zero, as is the incremental non-SEP value, because their only value is as part of a standard; and the ex ante expected SEP value of any particular technology is very small, because each is individually unlikely to be adopted; but the ex post SEP value includes hold-up value. What we really want is to get at the incremental value of the technology as part of the standard. How much better will the standard be if A is chosen rather than B?

The solution to this problem, pointed out by Mario Mariniello, Fair, Reasonable and Non-Discriminatory (FRAND) Terms: A Challenge for Competition Authorities, 7 J. Competition L. & Econ. 523, 526 (2011), is that “the licensing terms offered after the adoption of the standard (ex-post) should not be worse than those which the patent holder would have committed to ex-ante in the context of a standard setting contest conditional on the information that is available ex-post” (my emphasis). For convenience, we may call this an “ex ante contingent incremental value approach,” which may be contrasted with an “ex ante expected incremental value approach.”

Mariniello’s approach is still an ex ante negotiation, in the sense that it is assumed to take place before the implementer has sunk costs, which means that the patentee cannot extract any holdup value. Exclusion of holdup value is the key implication of the ex ante negotiation, and it is the point which Sidak disputes. So Mariniello’s approach is at odds with Sidak’s approach in this respect.

Secondly, because the negotiation is conceived of as a contest, albeit between competing standards, the SSOs cannot demand more than the incremental value of their standard over the next best alternative. This means that the incremental value of any potential SEP is the incremental value of the standard which incorporates it, as compared with the next best alternative which is incorporated into a competing standard. This is broadly consistent with Sidak’s argument that “FRAND royalty terms are appropriately derived by viewing the SSO as a joint venture among its member firms that has as its objective the maximization of the joint surplus created by the standard” (953), but more specifically, it is an ex ante contest between a number of SSO / joint ventures, all seeking to maximize their joint surplus. Consequently, the result is still that the patentees cannot extract more than incremental value as compared with the next best standard, and they cannot capture any holdup value.

Finally, Mariniello points out that the contest must be conditional on the information that is available ex-post, and in particular, “conditional on the standard being adopted” (525), and also on knowing the value of the standard once adopted (generally at 525). This ensures that the SEP holder will get a share of the combinatorial value of the standard as a standard, which only emerges once the standard is actually adopted; the patentee is not confined to the ex ante non-SEP value, even though ex ante, the patent is not a SEP. This is perhaps the most controversial aspect of Mariniello’s analysis. Carlton & Shampine, An Economic Interpretation of Frand, 9 J Comp Law & Econ 531, 545 (2013) state that the approach generally accepted by economists defines a reasonable royalty in the FRAND context as “the royalty that would have been negotiated ex ante, before the patented technology at issue had been adopted into the standard and prior to the licensee incurring sunk costs,” and they state (fn 40) that Mariniello does not accept this approach (fn 40). I must say that I read Mariniello’s approach as being a refinement of, rather than a departure from, the standard approach, as the prior literature has generally not been explicit about the information available during the negotiations: see eg Swanson & Baumol, 72 Antitrust LJ 1 (2005); Layne-Farrar et al 74 Antitrust LJ 671(2007). In any event, Mariniello’s approach does seem to me to be correct on this point.

It might be said that it is not necessary to consider the information available ex post, because the best technology will be adopted, so the expected value of the SEP incorporating the best patent is equal to the contingent value. This strikes me as wrong, as it amounts to importing information which is not actually available ex ante into the expected value calculation. In any event, Mariniello’s contingent approach does not require any novel legal principle. Ex post information is routinely taken into account in determining damages. In the hypothetical negotiation, the patent is assumed to be valid and infringed, even though this is ex post information. More generally, after the rate is determined through the hypothetical negotiation, the sales base to which that rate is applied is the actual sales base, determined ex post, not the expected sales base.

The contingent approach also reflects a reasonable negotiation. If the parties actually did negotiate ex ante, why would they do so on the basis of expected value? Such an agreement would give the patentee next to nothing for a valuable contribution if the technology did because the standard, and would require the implementer to pay for a useless technology if it was not adopted. As Mariniello explains, a contingent contract is a straightforward way of dealing with that uncertainty. At the same time, damages assessed on the basis of expected value would under-compensate the patentee. In principle, an expected value contract and a contingent value contract would both give every patentee the same expected return, because in an expected value negotiation, patentees whose technology was not selected would be entitled to a royalty to compensate for the chance that their patent would become a SEP. However, because expected value contracts are not actually entered into, those patentees could never bring an action to recover those royalties.

No doubt there are cases in which two patents make a joint contribution, even ex ante. Suppose patents X and Y are held by different parties. There may be technologies such that if one party refuses to make a FRAND commitment in respect of X, the SSO will necessarily reject Y, because Y is useless without X and vice versa. In that case the technology is such that the value of the patents is “joint ex ante.” But this, it seems to me, is different from Sidak’s point that SEPs have combinatorial value because by definition SEPs are all necessary to implement the standard (932). That means only that the value of all SEPs in a given standard is what I would call “joint ex post”. That the value of SEPs in a standard is necessarily joint ex post does not imply that it is necessarily joint ex ante. In the case of patents which are in fact joint ex ante, it is not clear to me how to apportion the royalties between X and Y if the “XY” technology were adopted. But correct approach, in my view, would still be to determine the incremental value of the XY standard as compared with the next best alternative standard, and then (somehow) apportion that incremental value between X and Y.