Comments on Sidak, Part 1: The Ex Ante Incremental Approach (Siebrasse)

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

Professor Sidak’s very long article, The Meaning of Frand, Part I: Royalties, (2013) 9 J of Competition Law & Econ 931, covers a great deal of territory, from a high level critique of the widely accepted ex ante incremental value approach to FRAND royalties, to his own “joint venture” conceptualization, to detailed heuristics and discussion of the leading cases on FRAND. In this post I will focus on the high level issues, and in particular his critique of the ex ante incremental value approach, which is found primarily at 972-73.

I must say that Professor Sidak’s article is not just very long, it is too long. It is written in a discursive, almost stream-of-consciousness style, that makes both his critique and his own views difficult to pin down precisely. With that said, he has a technical economic objection to the ex ante incremental value approach, and a consequent policy objection.

The technical objection is that because of the nature of standards, an ex ante incremental value approach is wrong in principle:

Standard-essential patents can be viewed only in terms of their combinatorial value – not their incremental value. The value associated with a standard is joint and common among the SEPs. Once a patent is essential to the standard, the hypothetical-negotiation framework used to determine the royalties for implementation patents does not apply.

Owing to the complementarity of SEPs, analysis of the incremental value of a patent is insufficient for SEPs because each SEP holds zero incremental value without all other SEPs. (953)

But as Sidak points out, this argument is open to the objection that it “elide[s] the critical distinction between ex ante and ex post valuation” (972). As he explains, “the invalidity of setting a FRAND royalty on the basis of the incremental value of the patent in suit for use in the standard only applies after the SSO has set the standard and all the other SEPs have by definition become essential. Before that point, the SSO usually has options” (972). In my view, this objection to Sidak’s approach is entirely correct, so his rebuttal is crucial to his argument.

To explain his objection, Sidak sets up a simple model in which an SSO faces a choice between two alternatives, A and B, where a standard including patent A is the most valuable, and patent B is the next-best alternative. The implementer’s maximum willingness to pay (MWP) is the incremental value of technology A versus B, the next best alternative. He points out that under the ex ante incremental value approach, the patentee’s minimum willingness to accept (MWA) will be its marginal cost, which is zero if all innovation costs are sunk. Thus, as Sidak says:

If so, then the minimum willingness to accept of the holder of patent A will approach zero, and the hypothetical ex ante bargain at the time of standard adoption might result in a price below the implementers’ maximum willingness to pay. (972)

Consequently,

proponents of the ex ante incremental value rule believe that no patent holder will share in the combinatorial value that is created by the standard except to the extent that the value is captured in the incremental value of the patent (for example, if patent A increases the value of the standard by M, M is the patent’s incremental value). (973)

Sidak asserts this is undesirable from a policy perspective because patentees require a share of the combinatorial value – and even a share of the holdup value (1022) – to provide an adequate incentive to participate in current standard setting (1022), and an adequate incentive to develop the next generation of breakthrough standards (989).

In my view Sidak accurately characterizes the ex ante incremental value approach, but I do not agree that this is problematic as a matter of policy.

While Sidak frames the point that the patentee’s MWA may be zero as a criticism of the ex ante incremental value approach to FRAND, it is pretty standard stuff outside the FRAND context. This does not imply that the royalty that would actually be negotiated by the patentee, or the reasonable royalty that will be awarded by the court, will be zero. In principle patentees might be haggled down to their incremental costs, and if that always happened the patent system would indeed provide inadequate incentives to invent, but this does not seem to be a problem in practice. If there were evidence that the standard royalty was equal to incremental cost, even in some industries, no doubt infringers would bring that evidence forward. I am not aware of any cases in which a royalty of zero was awarded on the basis that the patentee would have been driven down to its incremental cost. In the context of non-FRAND reasonable royalty damages, it is normal that the patentee and the licensee / infringer will split the surplus attributable to the patented invention, whether under the now-rejected 25% rule, or a 50-50 Nash equilibrium, or some other split tied more closely to the facts of the particular case.

Even if the royalty is above zero, it is also true that the royalty may be, and normally will be, below the implementers’ maximum willingness to pay. This just means that the surplus will be normally be split between the patentee and the implementer. This strikes me as sound as a matter of policy. A licensee – whether FRAND or otherwise – gets a share of the surplus, sometimes the majority, because it is required to put its capital at risk to develop the market. It is not only investment leading to patents that requires an incentive, but any kind of risky investment, including the investment in taking a patented invention to a commercialization, whether by implementing a standard or otherwise. I must admit that I do not know of any reason in principle why the precise split between patentees and implementers should be optimal in any broad sense. In the literature I am familiar with, that split is left to the black box of “bargaining power.” In principle it is possible that even though the patentee’s share of the surplus is rarely zero, the patentees’ inadequate bargaining power, either generally, or in some industries, results in sub-optimal incentives to invent. (Though, conversely, it is also possible that the split provides sub-optimal incentives to implementers.) Whether that is so is an interesting theoretical and empirical question, but it relates to the patent system generally. I see nothing in Sidak’s article to persuade me that the problem is any worse in respect of SEPs than for any other patent. (And of course, even if it could be shown that the split was sub-optimal, it is far from clear that judicial tinkering in litigated cases could rectify the problem.)

To recap, that the patentee’s MWA is zero, does not mean that its royalties will actually be zero, either in actual licensing negotiations, or as would be awarded as damages under the incremental ex ante value approach. Nor is there reason to believe that those royalties provide an inadequate incentive to invent.

Now, it is true that if the implementer’s MWP is zero, the patentee will get a zero royalty under the ex ante incremental value approach, and presumably in practice as well. This will be the case if the best non-infringing alternative is just as good as the patented invention. This does indeed mean that the patentee will not be able to recover its costs of invention. I don’t see anything wrong with this result. In the non-FRAND context, if a pharmaceutical company spends hundreds of millions of dollars developing and patenting a new drug, which turns out to be less effective than the existing market standard, it will not be able to sell enough of the drug to recover its costs. That is a good thing; indeed, it is the virtue of the patent system, as compared with other methods of encouraging innovation, that it provides very high-powered incentives for the inventor to work on products that will be better than what exists. If a patentee was guaranteed a positive return on their investment so long as it could get its invention incorporated in a standard, there would be an incentive for the patentee to pay less attention to the quality of its product and more attention to lobbying to get its product included in the standard. That would not promote innovation.

Sidak seems to miss this point, as is illustrated by the example of Airbus and Boeing in competition to supply Lufthansa (at 984) which he provides in the course of critiquing Judge Robart’s FRAND decision. He first makes an argument which wrongly ignores the manufacturer’s incremental costs, which are assuredly not zero in the case of airliners. He then goes on to say:

More generally, there is no assurance under Judge Robart’s approach to defining ex ante incremental value that Lufthansa’s incremental profit will be a large enough payment to Airbus for it to recover the quasi rents (on a per plane basis) of designing and manufacturing an A380.

Judge Robart’s approach provides no assurance that the licensee’s incremental profit from using the patent in suit rather than the next-best noninfringing substitute will translate into a high enough royalty to enable the patent holder to recover the sunk costs of developing the patented technology.

This is absolutely true about Judge Robart’s approach, but it is not a sound criticism. Every inventor takes the chance that it will be unable to charge enough to recover the sunk cost of developing the patented invention. Indeed, the great majority of patented inventions are not commercially exploited, and presumably the sunk costs are not recovered. If the availability of a non-infringing alternative means the most the patentee can charge will only allow it to recover half of its sunk costs, it will still take the deal, as half its costs is better than nothing. This is sound policy from an innovation perspective, as this is an invention that was in fact not worth developing, and the inventor will be encouraged to channels its future efforts in a more productive direction.

As part of his critique of the ex ante incremental value approach, Sidak also remarks that:

Proponents of the ex ante incremental value approach acknowledge that the holder of patent A will have a minimum willingness to accept that exceeds zero if the patent holder would incur an opportunity cost by allowing patent A to be used in the standard rather than outside the standard. . . . Proponents of the ex ante incremental value rule implicitly assume that this scenario is rare or nonexistent. (973)

He does not cite any specific authors who neglect the patentee’s opportunity cost when it is relevant (Robart J explicitly included it in his FRAND analysis (slip op fn 23)), but if opportunity cost has been wrongly ignored by some authors, this is an error on their part, and not a criticism of the ex ante incremental value approach.

To this point I have argued that Sidak’s article does not provide any good reason for treating SEPs differently from other patents. But SEPs clearly are different, in that they are part of a standard. Sidak’s combinatorial value theory does capture an aspect of that difference formally. However, the fact that SEPs have combinatorial value ex post, gives us no reason to abandon the ex ante framework. Combinatorial value is indeed a difference between SEPs and other patents, but it is not a difference that is relevant to the FRAND royalty. With that said, Sidak’s analysis does force us to confront the question of how SEPs are different, and whether any of those differences are relevant to the reasonable royalty analysis. My next post will address this question.

Finally, I’d like to thank Professor Cotter for his invitation to co-blog about this article. While he kindly suggested I write the first post in this series, we exchanged many stimulating emails which have shaped the thoughts I have set out above, and the credit for any insights must be shared.