Reflections on Holdup and Royalty Stacking, Part 1

In connection with some of my pending scholarship, and in preparation for the upcoming Antitrust & IP conference at which I will be speaking in Brussels, I've been giving some more thought to the question of what the terms "patent holdup" and "royalty stacking" should be understood to mean, and how (if at all) they should be addressed.  Here is Part 1 of my current thinking on the matter.  I'll publish another installment later this week, and would welcome feedback.

I begin with the premise that the "ex ante" bargaining framework--that is, attempting to reconstruct the hypothetical bargain the willing licensor and licensee would have made ex ante, before the infringer incurred costs in reliance on the infringing technology--is in principle the correct one for estimating reasonable royalties in general and FRAND royalties in particular, because it awards the patentee for the contribution of its technology to the state of the art, i.e., the value of the technology over the next-best available noninfringing alternative.  By contrast, an "ex post" bargain, conducted after the date on which the infringer has begun infringing, would in addition reward the patentee in part based upon what the infringer would be willing to pay, ex post, to avoid (potentially substantial) switching costs.   The higher royalties or damages that are the consequence of an ex post approach are social costs to the extent they lead to higher prices and lower output, unless on balance they stimulate more benefits (more invention or disclosure) than they do costs; but it’s hard to see why we should assume that the patentee’s ability to extract a portion of the ex post switching costs would generate more social benefits than costs.  (Indeed, in previous work I have expressed the view that, for purposes of calculating damages, we should assume that the substantive patent law strikes the correct balance between incentives and access.  The law of patent damages should support, and not alter, that balance.)  In addition, those higher costs could inhibit some inventive applications of patented technology.

A brief aside:  note that the "ex ante" approach could take one of two forms, both subject to administrability constraints:  a "pure" ex ante approach, in which we try to reconstruct the ex ante bargain the parties would have made, based only on information that would have been available to them ex ante; and an alternative approach in which we try to reconstruct the ex ante bargain the parties would have made based on all relevant information that is known at trial (ex post), such as the amount and duration of the infringing use.  The German courts phrase the hypothetical bargain in the latter manner, that is, what the parties would have agreed to before the infringement began, if they had foreseen the future development and the duration and amount of use of the patent.  (See my book, p.266.)  I used to think the German approach was doubtful as an economic matter, but Norman Siebrasse and I are now working on a paper in which we argue that it is, basically, correct.  Readers will hear more about that in due course.

In any event, in my view the term "patent holdup" can refer to any situation in which the patentee is able, in effect, to extract a license based on an ex post, as opposed to ex ante, bargain.  This may occur if courts automatically award injunctions for patent infringement, because ex post the infringer will pay more than it would have paid ex ante simply to avoid switching costs.  (It also would arise whenever courts award royalties on the basis of an ex post, as opposed to an ex ante, bargain, as they do in the U.S. when awarding postjudgment royalties in lieu of an injunction.  I've explained before why I think this is wrong.)  So defined, patent holdup to some degree could arise virtually anytime a court awards an injunction in a patent case, though I think it would be a mistake to draw any policy implications on this basis alone.  Injunctions have the virtue of encouraging the parties to negotiate over the value of patent (preferably, though inevitably not always, ex ante), and this is a good thing if we believe that the parties generally have an advantage (in comparison with a court) in determining what that value is.  Nevertheless, there may be cases in which those advantages are outweighed by the social costs of holdup.  In particular, where the potential negative consequences of holdup are both large and systematic—as I think they are in the case of SEPs, because of the large number of interdependent patents that are needed to market a standard-compliant device and, relatedly, the difficulty of designing around the standard ex post—a deviation from the general preference for injunctions is, in my view, justified.  In such cases, the potential harm if injunctions are granted may be unusually large and may outweigh the costs emanating from courts’ informational disadvantage in comparison with the parties with respect to valuing patented technology. Moreover, the owner of a FRAND-encumbered SEP is, by definition, willing to license rather than exclude, and benefits from the widespread adoption of its technology resulting from standardization.  (Some though not all of these factors also may weigh in favor of generally denying injunctions to PAEs, as under current U.S. practice.)  For further discussion, see, e.g., Thomas F. Cotter, Comparative Patent Remedies: A Legal and Economic Analysis 59-60 (2013); Thomas F. Cotter, Make No Little Plans:  Response to Ted Sichelman, Purging Patent Law of “Private Law” Remedies, 92 Tex. L. Rev. See Also 25, 27 (2014) (describing the conditions giving rise to patent holdup as “e.g., when the patent reads on a component of a multicomponent device, the ex ante value of the patent is substantially less than the ex post cost of designing around it, and the infringement is inadvertent”); Thomas F. Cotter, Patent Holdup, Patent Remedies, and Antitrust Responses, 34 J. Corp. L. 1151 (2009) (tracing the evolution of the application of the holdup concept to patent law).

An alternative approach would be to define holdup as occurring only in the (perhaps rare) cases in which the patentee‘s demands measurably retard follow-up innovation.  If so, whether or not hold-up is present arguably becomes an empirical, not merely a theoretical or definitional matter; and as an empirical matter, it doesn’t appear that the contemporary smartphone industry is marked by increasing prices or diminishing innovation.  See Alexander Galetovic et al., Patent Holdup:  Do Patent Holders Hold Up Innovation?, Hoover IP2 Working Paper Series No. 14011 (May 2014), available here.  The problem with this narrower definition of holdup, however, is that it seems to assume that just because prices are falling and innovation is increasing there is no reason to be concerned about patentees extracting royalties that reflect, in part, implementers' ex post switching costs.  It seems to me that this is still a social cost, potentially a substantial one in the case of SEPs, even if at the same time technological progress is, fortunately, mitigating some portion of that cost. Put another way, to assume that price reductions and innovation increases necessarily mean that holdup is exacting no social costs is a little like arguing that, because the price and cost of kerosene was falling throughout the late nineteenth century (as it was according to Dominick Armentano, Antitrust and Monopoly:  Anatomy of a Policy Failure 60 (1982)), there was no need for Congress to enact antitrust laws to remedy monopolistic conduct--or, to use a very different analogy, because we are now living in what may be the most peaceful period in human history, see Steven Pinker, The Better Angels of Our Nature:  Why Violence Has Declined (2011), we can eliminate our armed forces and police.  In my view, whether a response to patentee opportunism is desirable or not depends upon how much better, if at all, conditions would have been in the presence of greater competition.  We can’t just assume that conditions are optimal because prices are falling.  But see Galetovic et al., supra, at 20 (“. . . the performance of SEP industries is remarkable by any realistic standard.  So the ‘without holdup it could be even better’ is apparently saying that it could be even better than anything that is normally observed.”).       

To be sure, there are countervailing concerns that one should take into account as well.  First is the possibility of “reverse holdup,” where implementers abuse their lack of susceptibility to injunctions to negotiate a license that is too low to sustain a healthy rate of innovation (though it seems to me that courts can address such gamesmanship by holding out the possibility of awarding injunctions at least in these types of cases, or by awarding enhanced damages and fees).  Second, perhaps the courts’ posited informational disadvantage is more acute than I am assuming it to be; maybe courts systematically err by awarding damages that are less than those that would have resulted from the ex ante bargain.  If so, however, the better response might be to educate them on how to do better, rather than to counsel them to award injunctions in SEP cases.  Note also that if, as I happen to believe is correct, reasonable royalties and FRAND royalties are (or at least should be) calculated in largely the same manner--and injunctions awarded except in cases in which the risk of holdup threatens substantial social costs--there shouldn’t be much of an incentive on the part of SEP owners or potential owners to stop participating in SSOs or to under-declare.  All that a FRAND commitment adds to the mix is that it’s a commitment, which may give rise to additional legal responses such as breach of contract or promissory estoppel for its breach, but I am inclined to think that the amount of infringement damages (and the availability, or not, of injunctive relief) should be the same regardless of whether there is a FRAND commitment in place or not.  As far as injunctions and damages are concerned, consequences should turn on likely economic realities and not on the existence or not of a FRAND commitment.