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In a constructive development, the Federal Trade Commission has joined its British counterpart in investigating Nvidia’s proposed $40 billion acquisition of chip designer Arm, a subsidiary of Softbank. Arm provides the technological blueprints for wireless communications devices and, subject to a royalty fee, makes those crown-jewel assets available to all interested firms. Notwithstanding Nvidia’s stated commitment to keep the existing policy in place, there is an obvious risk that the new parent, one of the world’s leading chip makers, would at some time modify this policy with adverse competitive effects.

Ironically, the FTC is likely part of the reason that the Nvidia-Arm transaction is taking place.

Since the mid-2000s, the FTC and other leading competition regulators (except for the U.S. Department of Justice’s Antitrust Division under the leadership of former Assistant Attorney General Makan Delrahim) have intervened extensively in licensing arrangements in wireless device markets, culminating in the FTC’s recent failed suit against Qualcomm. The Nvidia-Arm transaction suggests that these actions may simply lead chip designers to abandon the licensing model and shift toward structures that monetize chip-design R&D through integrated hardware and software ecosystems. Amazon and Apple are already undertaking chip innovation through this model. Antitrust action that accelerates this movement toward in-house chip design is likely to have adverse effects for the competitive health of the wireless ecosystem.

How IP Licensing Promotes Market Access

Since its inception, the wireless communications market has relied on a handful of IP licensors to supply device producers and other intermediate users with a common suite of technology inputs. The result has been an efficient division of labor between firms that specialize in upstream innovation and firms that specialize in production and other downstream functions. Contrary to the standard assumption that IP rights limit access, this licensing-based model ensures technology access to any firm willing to pay the royalty fee.

Efforts by regulators to reengineer existing relationships between innovators and implementers endanger this market structure by inducing innovators to abandon licensing-based business models, which now operate under a cloud of legal insecurity, for integrated business models in which returns on R&D investments are captured internally through hardware and software products. Rather than expanding technology access and intensifying competition, antitrust restraints on licensing freedom are liable to limit technology access and increase market concentration.

Regulatory Intervention and Market Distortion

This interventionist approach has relied on the assertion that innovators can “lock in” producers and extract a disproportionate fee in exchange for access. This prediction has never found support in fact. Contrary to theoretical arguments that patent owners can impose double-digit “royalty stacks” on device producers, empirical researchers have repeatedly found that the estimated range of aggregate rates lies in the single digits. These findings are unsurprising given market performance over more than two decades: adoption has accelerated as quality-adjusted prices have fallen and innovation has never ceased. If rates were exorbitant, market growth would have been slow, and the smartphone would be a luxury for the rich.

Despite these empirical infirmities, the FTC and other competition regulators have persisted in taking action to mitigate “holdup risk” through policy statements and enforcement actions designed to preclude IP licensors from seeking injunctive relief. The result is a one-sided legal environment in which the world’s largest device producers can effectively infringe patents at will, knowing that the worst-case scenario is a “reasonable royalty” award determined by a court, plus attorneys’ fees. Without any credible threat to deny access even after a favorable adjudication on the merits, any IP licensor’s ability to negotiate a royalty rate that reflects the value of its technology contribution is constrained.

Assuming no change in IP licensing policy on the horizon, it is therefore not surprising that an IP licensor would seek to shift toward an integrated business model in which IP is not licensed but embedded within an integrated suite of products and services. Or alternatively, an IP licensor entity might seek to be acquired by a firm that already has such a model in place. Hence, FTC v. Qualcomm leads Arm to Nvidia.

The Error Costs of Non-Evidence-Based Antitrust

These counterproductive effects of antitrust intervention demonstrate the error costs that arise when regulators act based on unverified assertions of impending market failure. Relying on the somewhat improbable assumption that chip suppliers can dictate licensing terms to device producers that are among the world’s largest companies, competition regulators have placed at risk the legal predicates of IP rights and enforceable contracts that have made the wireless-device market an economic success. As antitrust risk intensifies, the return on licensing strategies falls and competitive advantage shifts toward integrated firms that can monetize R&D internally through stand-alone product and service ecosystems.

Far from increasing competitiveness, regulators’ current approach toward IP licensing in wireless markets is likely to reduce it.

David Balto has penned a short apologia of the FTC’s Intel case (HT: Danny Sokol).  Unfortunately his defense (and, unfortunately, the FTC’s case) is woefully misguided.

Balto writes:

Intel has been clearly dominant in the market for central processing units (CPUs) with between 80 percent and 98 percent of the market. The practices at issue in the FTC litigation have been condemned by the Japan Fair Trade Commission in March 2005, by the Korean Fair Trade Commission in June 2008 and by the European Commission in May 2009. In the United States, Advanced Micro Devices Inc. (AMD), Intel’s sole significant rival, sued Intel for a broad range of exclusionary practices in 2005. The New York attorney general brought its own action in November 2009.

Intel has had its day in court in proceedings before the three foreign commissions—and lost. Each of those tribunals found that Intel engaged in severely anti-competitive practices that protected its central processing unit monopoly and excluded its only real CPU rival, AMD.

This is misleading.  First of all “day in court” is not the same as “proceedings before the three foreign commissions,” and it is well-accepted that conviction by a party acting as judge, jury and prosecutor is less than decisive.

Second, Intel has had judgments rendered against it by agencies–not by courts–without any adversarial process to support those judgments.  It has appealed its European Commission judgment to the European General Court (the court formerly known as the Court of First Instance), and it has appealed the claimed human rights violations inherent in the imposition of a $1.5 billion fine without due process to the European Court of Justice.  It has appealed its KFTC ruling to the Seoul High Court.  It acceded to the JFTC’s recommendations, while contesting its findings of fact.  Intel is, in fact, still awaiting its day in court.

Moreover, the practices at issue in the FTC litigation were either NOT before these other tribunals (more on this in a second), or they were evaluated under laws and jurisprudence that differ substantially from US law and jurisprudence–and in ways that many of us believe lead to outcomes that condemn practices that are not, in fact, anticompetitive. (In Europe, for example, the Commission’s decision, citing to EU case law (its Hoffmann-La Roche line of cases), essentially refused to acknowledge that there could be any pro-competitive justifications for Intel’s discounts.  We beg to differ.)

Balto continues:

As each enforcer concluded, Intel—through its exclusive rebate scheme—paid computer manufacturers to buy Intel’s more expensive, less technologically advanced CPUs, resulting in turn in consumers paying higher prices for computers.

Actually, this is not what even these other enforcers concluded.  While some translations of the Korean decision do seem to suggest that, as something of an aside, the KFTC did assert that consumer paid higher prices, the European decision says no such thing, and I doubt that the Japanese recommendation included such a conclusion, either–certainly its English press release indicates no such finding.

Of course this is not surprising.  The theory of the case is that Intel, by offering conditional discounts, induced OEMs to purchase such a large share of their chips from Intel that AMD was unable to reach the minimum sufficient scale required to compete effectively.  But this effect arises, if it does at all, by Intel offering lower, not higher, prices.  While the claim that consumers had “less choice” might follow from this argument, the claim that consumers paid higher prices does not (unless and until AMD is forced out of business and Intel is finally able to reap the rewards of its predatory strategy.  As I have noted, Intel’s shareholders sure must have a long time horizon). Continue Reading…