An Insightful Analysis of “Fair and Reasonable” in the Determination of FRAND Terms

By Steven Tjoe

In his forthcoming George Mason University Law Review article entitled “The Meaning of ‘Fair and Reasonable’ in the Context of Third-Party Determination of FRAND Terms,” Professor Damien Geradin explores the delicate balance of interests protected by the current system of arm’s length negotiations in the standard-setting process, and the detrimental effect disrupting this balance would have on standards-related technologies and our innovation economy.

Fair, reasonable, and non-discriminatory (“FRAND”) commitments are the subject of frequent criticism in both legal and economic literature.  Many policymakers, practitioners, and academics have argued that the inherent ambiguity in establishing “fair and reasonable” terms creates inefficiencies and perverse incentives for standard-essential patent (“SEP”) holders to exercise ex post opportunism.  Based on this belief, some now argue that the standard-setting organization (“SSO”) contracting process is broken and requires additional legal and regulatory mechanisms to afford standard implementers greater protection.

Professor Geradin’s article brings some much-needed balance to this debate.  By highlighting the economic principles and the carefully negotiated terms underlying current SSO contracting processes, Geradin exposes the pitfalls of many of the reforms suggested.  Geradin’s analysis elucidates the SSO contracting process itself through dissection of the intensive discussions and negotiations giving rise to the prominent ETSI Intellectual Property Rights (“IPR”) policy, a policy that played a fundamental standardization role in the wireless communication field.  The ETSI IPR policy shows that its members understood the notions of “fairness and reasonable” to define a fair balance between the interests of SEP holders and standard implementers – securing the availability of the standards while simultaneously ensuring that SEP holders are “adequately and fairly rewarded for the use of their [intellectual property rights].”

Professor Geradin addresses two potential forms of ex post opportunism – “hold-up” and “royalty stacking” – and observes that though both could occur in theory, there is little evidence to suggest that they occur in real-world patent licensing.  Regarding the hold-up conjecture, Geradin observes that the relative absence of hold-up is consistent with the economics of contracting: parties who repeatedly deal with each other will limit opportunism to protect their reputation.  Similarly, royalty stacking is a rare occurrence in high-technology, where cross-licensing is common and greatly diminishes the risk of royalty-stacking.  Given the absence of empirical evidence demonstrating opportunistic behavior by SEP holders, Geradin cautions against implementing reforms that systematically weaken the bargaining power of SEP holders, as proposed reforms may themselves trigger reciprocal opportunistic behavior – such as “reverse hold-up” – by standard implementers.

In the context of FRAND licensing, Geradin observes that for rewards to be adequate and fair, they must not only compensate SEP holders for their risky R&D investments (including investments in prior failed projects), they must also give SEP holders sufficient incentive to keep investing in the development of standardized technologies.  The negative consequences of systematically offering below-FRAND terms to SEP holders are two-fold.  First, as Geradin eloquently observes, “[i]t is a basic law of finance that capital flows where the best opportunities arise,” and developers of technologies in standardized sectors unduly constrained by low returns may seek opportunities outside the standardized sectors.  Second, without adequate returns, major technological contributors may decide to no longer participate in SSOs in order to avoid being bound by FRAND commitments.  As a result, standards would likely fail to incorporate the best technology available.

Accordingly, Geradin is skeptical of many of the policy measures suggested to provide additional protections to potential licensees and consumers of standardized technologies.  One such measure is the “ex ante incremental value method,” where the rate that would have resulted from ex ante competition between the technology in question and alternative technological solutions serves as a benchmark to whether a royalty is fair and reasonable.  As Geradin observes:

While the pricing of SEPs at incremental value may facilitate the dissemination of the standard in the short-term, the licensing fee resulting from the incremental value of the SEP holder’s technology would certainly not be enough to properly compensate the investment costs and risks [a] company incurred in developing its superior technology, as well as to incentivize it to make investment in new technologies.

With respect to this method, Geradin concludes that the “ex ante incremental rule is thus not so much an instrument to prevent the theoretical risks of hold-up, but a tool to lower royalty rates to the benefit of standard implementers.”  As such, the ex ante incremental value rule could potentially have a devastating impact on innovation incentives and standards.

Geradin next explores the multi-factor test contained in Georgia-Pacific Corp. v. United States Plywood Corp. (“Georgia-Pacific”).  In Georgia-Pacific, a federal district court established a framework by which fifteen factors offering a variety of benchmarks are used to compute reasonable royalty damages by contemplating a “hypothetical negotiation” between a “willing licensor” and “willing licensee” at the time the infringement began.  Geradin observes:

A key strength of the Georgia-Pacific framework is that it is sufficiently flexible to establish a balance between the dual objective of SSO’s IPR policies … which are both to ensure standard dissemination and adequate remuneration of the SEP holder.  In other words, unlike abstract mathematical methods, which … can be easily tipped in favor of the prospective licensee (or the prospective licensor), the multi-factor test at the core of the Georgia-Pacific framework reduces the risk of bias if it is properly carried out.

As such, the Georgia-Pacific framework can better reflect the reality of contract negotiations, where the parties look to a variety of factors, and not some magic formula, to come to mutually acceptable licensing terms.

In the context of FRAND litigation, however, Geradin cautions against potential pitfalls of applying the Georgia-Pacific framework.  At the outset, Geradin notes that licensing agreements are often “highly relationship-specific and thus agreements will be hard to compare.”  Geradin discusses the practice of comparing the rate offered ex post standardization by SEP holders with the rate offered for the same patents ex ante standardization.  Though many are inclined to treat the ex ante rate as a “safe harbor” against any claim of opportunism, Geradin finds that there is little reason why licensors should be prohibited from charging higher rates ex post than ex ante.  Not only may ex post contracts be more efficient in the way they incorporate a clearer understanding of the technology and the market, but also forcing SEP holders to charge similar ex ante and ex post rates deprives SEP holders of giving preferential terms to early adopters of their technology.

Professor Geradin then explores whether patent pools offer a useful benchmark to determine FRAND license terms.  Due to the difficulties of forming pools and the different business models of the relevant patent holders, many standardized sectors simply do not have sizeable patent pools covering their standards.  Even where sizeable patent pools exist, Geradin observes that the pools often will not serve as the right benchmark for FRAND rate determination.  In many standardized sectors, such as in wireless communications, patent pools tend to be used by SEP holders to avoid transactions costs, rather than to obtain FRAND compensation.  Moreover, many patent pools base their method of remuneration on the number of a firm’s patents compared to the size of the pool rather than the relative strength of the patents themselves.  Where numerical proportionality serves as the metric of FRAND compensation, such as in the recent In re Innovatio IP Ventures LLC case, SEP holders have the incentive to inflate the number of patents they contribute to the pool.  Thus, using patent pools as a benchmark runs the risk of setting rates that are well below FRAND.

The potential welfare-reducing consequences of limiting the flexibility of the SSO negotiation process has been well documented in recent legal and economic literature.  As Professor Geradin observes, solutions to perceived FRAND inadequacies that aim to weaken the bargaining position of SEP holders often overreach, in effect triggering the “wholesale devaluation of patents.”  Instead, FRAND determinations should consider the “dynamic nature of standardization” and should be determined by balancing the need to (1) make standards available and, (2) fairly compensate SEP holders.  This delicate balance of interests is necessary to protect the future of standardization.