Fresh Guidance for Owners of Standard-Essential Patents: Reasonable Royalties Can Be Expected; So Can Penalties if You Overreach

Thomas C. Carey

By Thomas Carey. Chair of our Business Practice Group

October 2013 IP Update

Until recently, thousands of companies had agreed to license their standards-essential patents (SEPs) on fair, reasonable and non-discriminatory (FRAND) terms in the course of participating in standard-setting organizations (SSOs), even though they were uncertain as to how or whether those commitments could be enforced or interpreted.  A recent flurry of activity has brought the meaning and enforceability of FRAND commitments into sharp focus.

The Cellphone Wars

The most exceptional event was the August 3, 2013 decision by the US Trade Representative to overturn an exclusion order issued by the US International Trade Commission (ITC), the first such reversal of the ITC in over 25 years[1]. The ITC order would have prevented Apple from bringing certain of its products into the United States because they infringed a Samsung patent essential to the 3G wireless communications standard.

Samsung had participated in the development of that standard.  In doing so, it had committed to make its SEPs available on FRAND terms.  The Apple products in question adhered to the applicable standard and, according to the ITC, used the Samsung technology.  Although Samsung had offered a license to Apple over the course of prolonged negotiations, Samsung was persistent in asking for a license back of certain Apple patents that were not SEPs and not subject to FRAND commitments.

Before the ITC rendered its decision, the Department of Justice and the US Patent and Trademark Office issued a joint statement supporting a theory that we have reported as gaining traction worldwide:  that injunctive relief should not be available to remedy infringement of patents that are the subject of FRAND commitments.  This theory is based on the doctrine that injunctive relief is available only where monetary damages is not an adequate remedy;  by agreeing to license on FRAND terms, the patent holder has conceded that it would be adequately compensated for a license if a reasonable royalty were paid.

An ITC exclusion order is comparable to an injunction in that it prevents the importation, and thus the sale, of the infringing product.  Many observers felt that the ITC should have denied Samsung its requested relief on this basis.

The ITC rejected this argument.  Furthermore, it complained that the parties had not adequately briefed the question in the initial ITC proceedings before the administrative law judge, and therefore it was not in a good position to rule on whether the Samsung patent really was essential to the 3G standard, how important it was to the standard, and what precisely the FRAND obligations were.

One of the ITC’s commissioners argued in dissent that Samsung had violated its FRAND obligations by consistently tying its license offers to Apple to a cross-license of non-SEP patents. While the dissenter did not accept the notion that the ITC could never exclude the importation of products on the basis of infringement of FRAND-burdened SEPs, he felt that no exclusion order should be granted because of Samsung’s failure to offer FRAND terms and the relative unimportance of its patent to the 3G standard.

On August 3, 2013, the US Trade Representative, with the backing of the White House, reversed this ITC’s exclusion order.  The Trade Representative’s decision gave the ITC two succinct instructions in handling similar cases in the future.  It directed the ITC:

  1. To consider whether exclusion orders of products infringing FRAND-burdened patents is an appropriate remedy at the outset of the proceeding, rather than at the end; and
  2. To require the parties to develop the factual record relating to the FRAND issue in the initial ITC administrative proceeding.

The Wi-Fi Wars

1. Microsoft v. MotorolaTwo recent federal district court opinions have gained less public attention, but have done even more to fill in the blanks concerning the FRAND commitment.  The first case was brought by Microsoft against Motorola after it had been acquired by Google.  This story requires some background.

The case involves two separate standards – the 802.11 standard for wireless networking and the H.264 standard for video compression.  These standards were developed over many years by dozens of participants operating under the umbrellas of the Institute of Electrical and Electronics Engineers (IEEE) and the International Telecommunications Union (ITU).  Motorola agreed at the outset of its participation to license its SEPs on FRAND terms.

The 802.11 standard grew out of technology first developed at the University of Hawaii in the 1970s.  The IEEE got involved in advancing the standard in the early 90s and published its first 802.11 standard in 1997.

Over 1,000 companies participated in the effort to develop the standard.  Over 90 companies identified over 350 of their US patents as SEPs and another 59 companies filed blanket statements with the IEEE agreeing to license whatever SEPs they owned on FRAND terms.  Motorola has identified 24 of its patents as essential to the standard.

After the development of the standard, some in the industry formed a patent pool,[2] through which a licensee can obtain licenses to numerous relevant patents in a single transaction.  For the first time, Motorola’s assertion that its patents were essential to the standard was put to test.  An independent party evaluated the patents and determined that they were not essential to the standard.  Thus, they were excluded from the pool.

Motorola participated in the formation of a similar patent pool related to the H.264 video compression standard. After agreeing that the royalty rates to be charged by that pool were reasonable, Motorola decided not to participate in the pool, but rather to license its patents separately.

The H.264 pool was organized by MPEG-LA, a Denver-based firm that licenses patent pools covering SEPs for use of MPEG-2 and other digital video standards.  It involves 26 licensors that own about 275 essential US patents.  MPEG-LA has granted over 1,100 licenses to this patent pool.

During the formation of this pool, a Motorola spokesperson criticized one proposed set of royalty rates, calling for royalties between $.20 and $1.50 per unit, as too expensive and strongly urged the adoption of annual caps on royalties.  Ultimately, MPEG-LA decided on a royalty rate of $0.20 per unit for up to 5 million units and $0.10 per unit thereafter, subject to an annual cap of $6.5 million.

On July 7, 2004, Microsoft joined MPEG-LA as both a licensor and a licensee.  One week later, Microsoft learned that Motorola had decided not to join.

On October 21, 2010, Motorola sent Microsoft an offer to license its patents essential to these standards for a royalty of 2.25% of the selling price of the products utilizing the patented technology.  Motorola’s letter stated that if Windows were installed on a PC that was sold by a third party manufacturer, Motorola would want 2.25% of the selling price of the PC, not the amount that Microsoft received for a copy of Windows.

According to the Microsoft briefs, this would amount to about $4.50 per unit for wireless LAN products, and $11.25 for products (such as the Xbox) using the video compression technology.  On November 9, 2010, Microsoft sued Motorola in the federal district court in Seattle for breaching its obligation to license these patents on FRAND terms.

In the summer of 2011, Motorola sued Microsoft in Germany, seeking injunctive relief to prevent infringement of its SEPs.  In May 2012, Motorola obtained that injunction.  A U.S. court then issued an injunction ordering Motorola not to enforce the injunction that it had obtained in Germany.  However, in light of the possibility of being shut down in Germany, Microsoft relocated its distribution facility from Germany to the Netherlands.  This relocation was completed in June 2012.

The ultimate question presented by Microsoft’s complaint was not whether Motorola’s offer was fair and reasonable.  The question was whether the offer was so unfair and unreasonable as to constitute a breach of the duty of good faith and fair dealing. In April 2013, the judge issued a 200-page “Findings of Fact and Conclusions of Law.”

In it, the judge sought to ascertain how a license negotiation between Motorola and Microsoft would have proceeded had the parties acted reasonably and in light of Motorola’s FRAND obligations. To do so, the judge undertook a painstaking review of the history of the SSO and an evaluation of the importance of the Motorola patents to the standards.  In the end, the court relied heavily on the royalty rates charged by the relevant patent pools.

In its analysis, the court noted that a Microsoft executive had published a blog in which he said that Microsoft paid twice as much in royalties to one of the pools as it received in royalties as a licensor.  From this statement the court inferred that membership in a patent pool had benefits to the licensor (in the form of access to the technology of the other licensors) beyond the mere receipt of royalties; and that therefore the arms-length royalty rate outside of a pool context would be three times the rate charged by the pool.

The court computed the amount that Motorola would have received had it joined each of the pools as licensors and, having computed that royalty rate, tripled the rate to establish the FRAND rate.

The court undertook a slightly different analysis for the 802.11-related patents as they applied to the Xbox because the court was aware of other factors affecting a reasonable royalty rate.  The court noted that Microsoft’s supplier of chips for the XBOX paid a 1% royalty for a license of certain patents; and that an independent consulting firm had made a set of recommendations to Motorola regarding the charges that it should impose for its 802.11 technologies.  (The court adjusted the recommendations of the consultant to account for an erroneous assumption.)  It then averaged the three indicators to arrive at a FRAND royalty rate for the Xbox’s use of Motorola’s wireless technology.

In both cases, the court determined an upper and lower bound for the patents and the royalty rates that Microsoft would have negotiated.  The resulting findings were as follows:

StandardNegotiated FRAND rateUpper boundLower bound
Video.555 cents per unit16.4 cents per unit.555 cents per unit
Wireless LAN3.47 cents per unit for XBOX; .8 cents for all other products19.5 cents per unit.8 cents per unit

 

In most cases, the FRAND rate was set at the lower bound of the range of reasonable rates because Motorola’s patent was found to be of marginal importance.  The upper bound of the reasonable range was established (a) in the case of the video standard, by using the highest rate suggested during the formation of the applicable patent pool (and tripling it); and (b) in the case of the wireless standard, by reference to an analysis provided by Microsoft’s own expert.

These upper bounds can be compared to the following rates sought by Motorola:

FRAND rate Upper bound

Motorola Offer

Multiple

Video

16.4 cents

$11.25

69

Wireless LAN

19.5 cents

$4.50

23

 

Comparing the true FRAND rate that the court determined would have resulted from a negotiation, the following multiples emerge:

FRAND rate

Motorola Offer

Multiple

Video

.555 cents

$11.25

2,027

Wireless LAN

.8 cents

$4.50

562

Wireless – Xbox only

3.47 cents

$4.50

130

 

Further embarrassing to Motorola was its own earlier objection during the formation of the H.264 patent pool that a per-unit rate that topped out at $1.50 for all the SEPs was too high. How then could it call its $11.25 rate for only its patents reasonable?

Despite the gross disproportion between the FRAND rates and the rates in Motorola’s offer, the court referred to the jury the question of whether Motorola had breached its duty of good faith and fair dealing in making its offer.  The jury took less than 4 hours to determine that it had.

On September 9, 2013, the jury found Motorola in breach of its FRAND commitment and determined that Microsoft had suffered damages of $14.5 million as a result, consisting of $3 million in attorneys’ fees and $10.5 million as the cost of relocating its German distribution center.

Motorola asked the court to overrule the jury.  The judge refused.  In an order dated September 24, 2013, the court made some remarkable statements:

  1. By agreeing to FRAND terms, Motorola implicitly surrendered its right to an injunction.  Thus, seeking one in Germany was a bad-faith action.
  2. Microsoft is an intended third-party beneficiary of the contractual commitments made by Motorola to IEEE and ITU.
  3. An initial offer to license that is not fair and reasonable can rightly result in the patent owner having to pay the infringer’s legal fees if it sues for violation of the FRAND commitment.  To support this unusual result, the court noted that the purpose of SSOs – to promote widespread adoption of a standard – would be frustrated if adopters were subjected to bad-faith injunctive actions brought by owners of SEPs.
  4. Motorola’s US entity could not avoid liability for the actions of its German affiliate.  The court found that the conduct of all the Motorola affiliates was interconnected and violated the duty of good faith and fair dealing.

2. In re Innovatio IP Ventures, LLC Patent Litigation.   While Motorola is the first case to establish a FRAND royalty rate, it is not only one.  On October 3, 2013, the federal district court sitting in Chicago issued an opinion in Innovatio, a case in which the litigants had asked it to determine the FRAND royalty rate for a package of SEPs that were relevant to the 802.11 standard.

The judge was respectful of the groundbreaking opinion in Motorola.  However, the judge found one key difference in the case before it:  many of the patents at issue were important to the 802.11 standard and to the infringing products.

The judge reasoned that patent pools tend to result in lower royalty rates than the holder of an important patent could obtain on its own.  Thus, the judge chose not to use the 802.11 patent pool’s royalty rates as a benchmark.  Instead, he adopted a “top down” approach proposed by one of the plaintiff’s experts.

Before applying that test, he addressed the threshold question of whether to apply a royalty against a device (such as a tablet) that utilizes the standard, or to the component within that device (such as a chip) that embodies most of the applicable technology.  He opted to apply the royalties against only the chip, applying the Federal Circuit’s “smallest saleable unit” test.

He then examined the average selling price of the chip, which had been on the market for nearly 15 years.  In that time the average price plummeted by 90% and the unit sales increase 300-fold.  The weighted average price per chip was $3.99.

The court decided against using this weighted average because it felt that the high volumes (and lower price) would not have been anticipated had the parties negotiated a royalty rate at the inception of the standard.  Instead, the court used the unweighted average annual price of the chip, which was $14.85.

To this amount the court applied a profit margin of 12.1%, a figure that was based upon an expert’s evaluation of Broadcom’s operating profit on the sale of wi-fi chips.  The court also accepted the expert’s estimate that there are 3,000 SEPs related to the standard.

Next, the court referred to a study finding that the top 10% of electronics patents account for 84% of the value of all electronics patents.  The judge viewed the plaintiff’s 19 patents as belonging to that top 10% on the basis of his earlier evaluation of them.  Thus, the plaintiff’s share of the 84% that the top 10% would command was deemed to be 19/300.  The royalty calculation thus proceeded as follows:

Plaintiff’s royalty = share of top 10% * share that top 10% commands * chip price * profit margin

                   = 19/300 * 84% * $14.85 * 12.1%

                   = $.0956

Having completed this calculation, the judge noted that the result was within the FRAND range computed in Motorola and about three times the royalty rate deemed reasonable for the license of the Motorola wi-fi patents for use in the XBOX.  The judge concluded that this ratio was appropriate given the greater importance of the Innovatio wi-fi patent portfolio to the standard.

Lessons to be Learned

These developments offer valuable guidance in evaluating whether to join an SSO (thereby making FRAND commitments); having done so, whether to join a patent pool as a licensor; and what to expect if you need to license an SEP from a patent owner that has made FRAND commitments but has not joined a pool.  Among the lessons to be learned are these:

  • The leverage of the owner of a FRAND-burdened patent is lessened by virtue of the FRAND commitment.  The patentee probably cannot get an injunction in the US or Europe, including Germany, where Motorola got its injunction.  In the time since that injunction issued, the EU has woken up to the FRAND issue.
  • Now that the ITC has been taken to the woodshed, it will be most reluctant to issue further exclusion orders to prevent infringement of FRAND-burdened patents.
  • Courts are willing to engage in painstaking evaluations of the strengths and weaknesses of SEPs and to determine FRAND royalty terms in light of those considerations.
  • A court asked to determine a FRAND royalty rate will attempt to ascertain how a license negotiation would have proceeded at the time that the standard was adopted.  That exercise will employ the 15-factor test enumerated in Georgia Pacific v. US Plywood, 318 F.Supp. 1116 (SDNY 1970), which was modified in Motorola to take into account the special circumstances associated with the FRAND commitment.
  • A patentee’s attempt to overreach can have painful consequences.  Motorola not only had to pay for Microsoft’s legal fees, but for the relocation of its distribution facility from Germany to Holland.   Imagine if it was a manufacturing facility that had to be relocated!
  • What you say in the course of the formation of a patent pool can and will be held against you.
  • What your executives disclose on their blogs concerning amounts paid to and derived from a patent pool will be noticed.
  • For more valuable patents, a court may base its calculation by allocating 100% of the profit margin of the product to royalties.
  • In the electronics field, a FRAND royalty rate is likely to be based upon the selling price of the chip used to enable the technology rather than upon the price of the end product, because of the Federal Circuit’s “smallest saleable unit” test.
  • It is risky for the owner of a FRAND-burdened patent to require, as a condition of a license, a license back of patents that are not FRAND-burdened.
  • In litigating a FRAND royalty rate, it is import to present evidence concerning
    • The development of the standard;
    • The patentee’s role in that development;
    • The relative importance of the patentee’s SEPs to the standard and to the defendant’s products;
    • The total number of SEPs, including those owned by patentees having submitted blanket letters of assurance to the SSO;
    • The unit sales, selling prices, and profit margins of the products embodying the technology and the subcomponents critical to that embodiment over the duration of the infringing sales since the adoption of the standard; and
    • Comparable license transactions in the industry.

Conclusions

The law regarding FRAND commitments is developing rapidly. Where once companies had no idea how a court would go about establishing a fair and reasonable royalty rate, they can now examine two painstaking and detailed opinions that do so.

There are many aspects of these decisions that might be questioned in the future. For example, the Motorola judge’s determination that the royalties to be charged by the patent pools should be tripled; and the use of unweighted annual average chip selling prices over a 15-year period to calculate the royalty awarded to Innovatio might well come under scrutiny by commentators and other judges. Nonetheless, these recent decisions are important developments in the law, blazing a trail for others to follow.

 


[1] Apple later obtained an ITC exclusion order relating to certain Samsung wireless devices because they were held to infringe Apple patents that are not FRAND-burdened.  Although Samsung appealed to the US Trade Representative for a reversal of that order, the USTR left the ITC order intact.

[2]Patent pools are generally formed independent of the SSOs and after the adoption of the standard.  One reason for the separate existence of patent pools is that they present antitrust risks that the SSOs would prefer to avoid.