Choi on FRAND Royalties and Injunctions

Jay Pil Choi has posted a paper on ssrn titled FRAND Royalties and Injunctions for Standard Essential Patents.  Here is a link to the paper, and here is the abstract:

I develop a stylized model of court procedures that resolve disputes concerning FRAND-encumbered standard essential patents (SEPs). I analyze the effects of injunctions and potential court-imposed FRAND rates on negotiated royalty rates. The SEP-holders’ ability to hold-up is constrained by the prospect of the court-imposed license terms in case of disputes, but is not completely eliminated. Possible mechanisms to address the residual hold-up power of the SEP-holders are discussed.

The paper makes for an interesting read.  Quoting from the FTC's 2011 Report The Evolving IP Marketplace:  Aligning Patent Notice and Remedies with Competition, Professor Choi (correctly, in my view) defines "holdup" in the following manner (p.3):

. . . “the patentee can use the threat of an injunction to obtain royalties covering not only the value of its invention compared to alternatives, but also a portion of the costs that the infringer would incur if it were enjoined and had to switch.” This possibility of overcompensation to the patentee based on hold-up value is especially acute for SEPs that constitute only a limited number of features in the infringing product (Shapiro, 2010).

He also agrees that the ideal value of a FRAND royalty is "the ex ante value of its superiority over the next best alternative available, which is its true economic value" (p.9).  However, he disagrees with the views of some commentators that injunctive relief should never be available for the infringement of SEPs, because he believes this could give rise to "reverse holdup."  Referring in particular to James Ratliff & Daniel L. Rubinfeld, The Use and Threat of Injunctions in the RAND Context, 9 J. Comp. L. & Econ. 1 (2013), Professor Choi writes (p.5):

Ratliff and Rubinfeld (2013) develop a related model, but with a different conclusion. They model a dispute between a SEP owner and an implementer of the standard over the licensee fee and argue that an injunction threat does not necessarily lead to hold-up because the implementer has the option to accept license terms that are determined by a court and thus avoid injunction. In other words, an injunction threat kicks in only when the implementer refuses to accept the court-determined licensing terms. Thus, the initial negotiation between the SEP owner and the implementer does not arise in the shadow of an injunction threat even if it is available, but in the shadow of the expected court-determined FRAND rate. One crucial consequence of the Ratliff and Rubinfeld timing assumption is that the implementer is given an unfair advantage in the royalty negotiation; the implementer has nothing to lose by refusing the initial offer by the SEP-holder, because the implementer always has the option to accept the initial offer once it is certified to be FRAND while the implementer gains in the other case where it is found not to be FRAND.

See also p.14 (stating that "The problem with the Ratliff and Rubinfeld timing is that the implementer has nothing to lose by refusing the initial offer by the SEP-holder, because the implementer always has the option to accept the initial offer once it is certified to be FRAND while the implementer gains in the other case where it is found not to be FRAND").

Professor Choi then models an alternative game in which an implementer who refuses what a court later determines to be a FRAND license is enjoined.  The game has the following steps (pp. 12-13):

Stage 1. The SEP owner and implementer engage in bargaining for licensing royalties.  If they agree on a mutually acceptable rate, the game ends.

Stage 2 (FRAND Determination by Court): If the two parties cannot agree on a licensing fee, then the court will determine if the offer made by the SEP owner (but rejected by the implementer) r₀ is FRAND. There are two cases to consider.

(1) If r₀ is deemed to be FRAND by the court, the SEP-holder has fulfilled its FRAND obligation and is entitled to injunctive relief, as is the case for any other IP holders.

(2) If the court finds r₀ to not be FRAND, it will determine an appropriate FRAND rate r~.

Stage 3.

(1) If r₀ is deemed to be FRAND and an injunction is ordered in Stage 2, the implementer either leaves the market or can further negotiate with the SEP-holder in the shadow of an injunction threat.

(2) If the court imposes a FRAND rate r~, the implementer either accepts the FRAND rate or leaves the market.

The problem with this approach, however, is that judges can make mistakes:  a court may conclude, incorrectly, that the royalty the SEP owner offered and that the implementer rejected was FRAND, when in fact it was above FRAND, and award an injunction.  Given this possibility, Professor Choi shows that the optimal contract offered by the SEP owner will be one in which the rate exceeds the ideal rate (again, the ideal being "the ex ante value of its superiority over the next best alternative available") and that the licensee will accept this rate.  Thus, the 

analysis reveals that the court rule assumed in this paper induces a royalty fee that is excessive from an economic viewpoint. In other words, the threat of injunction overcompensates the SEP owner even if it is encumbered by the FRAND commitment. The reason is that the court'’s estimation of the FRAND rate is inherently imprecise; there is a chance that the court may deem an initial offer by the SEP-owner to be FRAND and grant injunctive relief, even if the initial offer exceeds [the ideal FRAND rate].

To compensate for this defect, Professor Choi proposes a modification under which a court will award an injunction only when "the licensee is thought to be unreasonably incalcitrant in refusing the SEP owner's offer," that is, when the difference between the rejected offer and the higher (or should it be equal to or higher, I wonder?) FRAND rate the court awards exceeds a parameter Professor Choi refers to as the "leniency zone" (p.19).  He doesn't expect courts necessarily to be able to precisely calculate the leniency zone, but the practical payoff of the modification is that "the court should be more conservative in issuing an injunction as a remedy for the SEP-owner when the court is less able to precisely assess the appropriate FRAND rate" (p.21).

As stated, I think this is a very interesting paper, though I wonder if, at the end of the day, Professor Choi's proposal is better than that of Ratliff & Rubinfeld.  I admit I'm still working through the whole "reverse holdup" concept myself, but if I'm understanding the objection correctly it is that the implementer will somehow force the SEP owner to accept a royalty that is lower than FRAND to avoid litigation costs and risk.  But litigation costs and risk are a two-way street, and is there any reason to think the SEP owner will incur higher costs or be more risk-averse than the implementer?  (Indeed, Professor Choi's modification as discussed in the preceding paragraph seems to assume that a court could award a FRAND royalty that is greater than the royalty offered by the SEP owner, so it seems to me that the implementer does face some risk in turning down what may be a favorable offer from the SEP owner, thus contradicting the assumption that under a no-injunction rule "the implementer has nothing to lose by refusing the initial offer by the SEP-holder".)  Moreover, is there really any meaningful difference in the SEP setting to any other setting in which parties cannot agree on the value of something and ultimately have to resort to litigation or ADR to resolve the matter?  And if a court did think the implementer was somehow abusing the system by turning down a clearly FRAND offer, couldn't it sanction the implementer in some other (less potentially overdeterrent) manner such as by awarding an appropriate damages enhancement (in nations where this would be allowed) or attorneys' fees (in nations where this would be allowed)?  Note that even Ratliff and Rubinfeld appear to contemplate that the court could award a higher royalty at least for the prejudgment use of an SEP, in order to provide an incentive for the "implementer to take a license earlier" (Ratliff & Rubinfeld, p.15).

Anyway, I'll have to think about this some more, and would welcome others' comments and observations.  But first go out and read Professor Choi's paper for yourself to see what you think.