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Qualcomm is currently in the midst of a high-profile antitrust case against the FTC. At the heart of these proceedings lies Qualcomm’s so-called “No License, No Chips” (NLNC) policy, whereby it purportedly refuses to sell chips to OEMs that have not concluded a license agreement covering its underlying intellectual property. According to the FTC and Qualcomm’s opponents, this ultimately thwarts competition in the chipset market.

Against this backdrop, Mark Lemley, Douglas Melamed, and Steven Salop penned a high-profile amicus brief supporting the FTC’s stance. 

We responded to their brief in a Truth on the Market blog post, and this led to a series of blog exchanges between the amici and ourselves. 

This post summarizes these exchanges.

1. Amicus brief supporting the FTC’s stance, and ICLE brief in support of Qualcomm’s position

The starting point of this blog exchange was an Amicus brief written by Mark Lemley, Douglas Melamed, and Steven Salop (“the amici”) , and signed by 40 law and economics scholars. 

The amici made two key normative claims:

  • Qualcomm’s no license, no chips policy is unlawful under well-established antitrust principles: 
    Qualcomm uses the NLNC policy to make it more expensive for OEMs to purchase competitors’ chipsets, and thereby disadvantages rivals and creates artificial barriers to entry and competition in the chipset markets.”
  • Qualcomm’s refusal to license chip-set rivals reinforces the no license, no chips policy and violates the antitrust laws:
    Qualcomm’s refusal to license chipmakers is also unlawful, in part because it bolsters the NLNC policy.16 In addition, Qualcomm’s refusal to license chipmakers increases the costs of using rival chipsets, excludes rivals, and raises barriers to entry even if NLNC is not itself illegal.

It is important to note that ICLE also filed an amicus brief in these proceedings. Contrary to the amici, ICLE’s scholars concluded that Qualcomm’s behavior did not raise any antitrust concerns and was ultimately a matter of contract law and .

2. ICLE response to the Lemley, Melamed and Salop Amicus brief.

We responded to the amici in a first blog post

The post argued that the amici failed to convincingly show that Qualcomm’s NLNC policy was exclusionary. We notably highlighted two important factors.

  • First, Qualcomm could not use its chipset position and NLNC policy to avert the threat of FRAND litigation, thus extracting supracompetitve royalties:
    Qualcomm will be unable to charge a total price that is significantly above the price of rivals’ chips, plus the FRAND rate for its IP (and expected litigation costs).”
  • Second, Qualcomm’s behavior did not appear to fall within standard patterns of strategic behavior:
    The amici attempt to overcome this weakness by implicitly framing their argument in terms of exclusivity, strategic entry deterrence, and tying […]. But none of these arguments totally overcomes the flaw in their reasoning.” 

3. Amici’s counterargument 

The amici wrote a thoughtful response to our post. Their piece rested on two main arguments:

  • The Amici underlined that their theory of anticompetitive harm did not imply any form of profit sacrifice on Qualcomm’s part (in the chip segment):
    Manne and Auer seem to think that the concern with the no license/no chips policy is that it enables inflated patent royalties to subsidize a profit sacrifice in chip sales, as if the issue were predatory pricing in chips.  But there is no such sacrifice.
  • The deleterious effects of Qualcomm’s behavior were merely a function of its NLNC policy and strong chipset position. In conjunction, these two factors deterred OEMs from pursuing FRAND litigation:
    Qualcomm is able to charge more than $2 for the license only because it uses the power of its chip monopoly to coerce the OEMs to give up the option of negotiating in light of the otherwise applicable constraints on the royalties it can charge.

4. ICLE rebuttal

We then responded to the amici with the following points:

  • We agreed that it would be a problem if Qualcomm could prevent OEMs from negotiating license agreements in the shadow of FRAND litigation:
    The critical question is whether there is a realistic threat of litigation to constrain the royalties commanded by Qualcomm (we believe that Lemley et al. agree with us on this point).”
  • However, Qualcomm’s behavior did not preclude OEMs from pursuing this type of strategy:
    We believe the following facts support our assertion:
    OEMs have pursued various litigation strategies in order to obtain lower rates on Qualcomm’s IP. […]
    For the most part, Qualcomm’s threats to cut off chip supplies were just that: threats. […]
    OEMs also wield powerful threats. […]
    Qualcomm’s chipsets might no longer be “must-buys” in the future.”

 5. Amici’s surrebuttal

The amici sent us a final response (reproduced here in full) :

In their original post, Manne and Auer argued that the antitrust argument against Qualcomm’s no license/no chips policy was based on bad economics and bad law.  They now seem to have abandoned that argument and claim instead – contrary to the extensive factual findings of the district court – that, while Qualcomm threatened to cut off chips, it was a paper tiger that OEMs could, and knew they could, ignore.  The implication is that the Ninth Circuit should affirm the district court on the no license/ no chips issue unless it sets aside the court’s fact findings.  That seems like agreement with the position of our amicus brief.

We will not in this post review the huge factual record.  We do note, however, that Manne and Auer cite in support of their factual argument only that 3 industry giants brought and then settled litigation against Qualcomm.  But all 3 brought antitrust litigation; their doing so hardly proves that contract litigation or what Manne and Auer call “holdout” were viable options for anyone, much less for smaller OEMs.  The fact that Qualcomm found it necessary to actually cut off only one OEM – and then it only took the OEM only 7 days to capitulate – certainly does not prove that Qualcomm’s threats lacked credibility.   Notably, Manne and Auer do not claim that any OEMs bought chips from competitors of Qualcomm (although Apple bought some chips from Intel for a short while). No license/no chips appears to have been a successful, coercive policy, not an easily ignored threat.                                                                                                                                              

6. Concluding remarks

First and foremost, we would like to thank the Amici for thoughtfully engaging with us. This is what the law & economics tradition is all about: moving the ball forward by taking part in vigorous, multidisciplinary, debates.

With that said, we do feel compelled to leave readers with two short remarks. 

First, contrary to what the amici claim, we believe that our position has remained the same throughout these debates. 

Second, and more importantly, we think that everyone agrees that the critical question is whether OEMs were prevented from negotiating licenses in the shadow of FRAND litigation. 

We leave it up to Truth on the Market readers to judge which side of this debate is correct.

[This guest post is authored by Mark A. Lemley, Professor of Law and the Director of Program in Law, Science & Technology at Stanford Law School; A. Douglas Melamed, Professor of the Practice of Law at Stanford Law School and Former Senior Vice President and General Counsel of Intel from 2009 to 2014; and Steven Salop, Professor of Economics and Law at Georgetown Law School. It is part of an ongoing debate between the authors, on one side, and Geoffrey Manne and Dirk Auer, on the other, and has been integrated into our ongoing series on the FTC v. Qualcomm case, where all of the posts in this exchange are collected.]

In their original post, Manne and Auer argued that the antitrust argument against Qualcomm’s no license/no chips policy was based on bad economics and bad law. They now seem to have abandoned that argument and claim instead – contrary to the extensive factual findings of the district court – that, while Qualcomm threatened to cut off chips, it was a paper tiger that OEMs could, and knew they could, ignore. The implication is that the Ninth Circuit should affirm the district court on the no license/ no chips issue unless it sets aside the court’s fact findings. That seems like agreement with the position of our amicus brief.

We will not in this post review the huge factual record. We do note, however, that Manne and Auer cite in support of their factual argument only that 3 industry giants brought and then settled litigation against Qualcomm. But all 3 brought antitrust litigation; their doing so hardly proves that contract litigation or what Manne and Auer call “holdout” were viable options for anyone, much less for smaller OEMs. The fact that Qualcomm found it necessary to actually cut off only one OEM – and then it only took the OEM only 7 days to capitulate – certainly does not prove that Qualcomm’s threats lacked credibility. Notably, Manne and Auer do not claim that any OEMs bought chips from competitors of Qualcomm (although Apple bought some chips from Intel for a short while). No license/no chips appears to have been a successful, coercive policy, not an easily ignored threat.

Last week, we posted a piece on TOTM, criticizing the amicus brief written by Mark Lemley, Douglas Melamed and Steven Salop in the ongoing Qualcomm litigation. The authors prepared a thoughtful response to our piece, which we published today on TOTM. 

In this post, we highlight the points where we agree with the amici (or at least we think so), as well as those where we differ.

Negotiating in the shadow of FRAND litigation

Let us imagine a hypothetical world, where an OEM must source one chipset from Qualcomm (i.e. this segment of the market is non-contestable) and one chipset from either Qualcomm or its  rivals (i.e. this segment is contestable). For both of these chipsets, the OEM must also reach a license agreement with Qualcomm.

We use the same number as the amici: 

  • The OEM has a reserve price of $20 for each chip/license combination. 
  • Rivals can produce chips at a cost of $11. 
  • The hypothetical FRAND benchmark is $2 per chip. 

With these numbers in mind, the critical question is whether there is a realistic threat of litigation to constrain the royalties commanded by Qualcomm (we believe that Lemley et al. agree with us on this point). The following table shows the prices that a hypothetical OEM would be willing to pay in both of these scenarios:

Blue cells are segments where QC can increase its profits if the threat of litigation is removed.

When the threat of litigation is present, Qualcomm obtains a total of $20 for the combination of non-contestable chips and IP. Qualcomm can use its chipset position to evade FRAND and charges the combined monopoly price of $20. At a chipset cost of $11, it would thus make $9 worth of profits. However, it earns only $13 for contestable chips ($2 in profits). This is because competition brings the price of chips down to $11 and Qualcomm does not have a chipset advantage to earn more than the FRAND rate for its IP.

When the threat of litigation is taken off the table, all chipsets effectively become non-contestable. Qualcomm still earns $20 for its previously non-contestable chips. But it can now raise its IP rate above the FRAND benchmark in the previously contestable segment (for example, by charging $10 for the IP). This squeezes its chipset competitors.

If our understanding of the amici’s response is correct, they argue that the combination of Qualcomm’s strong chipset position and its “No License, No Chips” policy (“NLNC”) effectively nullifies the threat of litigation:

Qualcomm is able to charge more than $2 for the license only because it uses the power of its chip monopoly to coerce the OEMs to give up the option of negotiating in light of the otherwise applicable constraints on the royalties it can charge. 

According to the amici, the market thus moves from a state of imperfect competition (where OEMs would pay $33 for two chips and QC’s license) to a world of monopoly (where they pay the full $40).

We beg to differ. 

Our points of disagreement

From an economic standpoint, the critical question is the extent to which Qualcomm’s chipset position and its NLNC policy deter OEMs from obtaining closer-to-FRAND rates.

While the case record is mixed and contains some ambiguities, we think it strongly suggests that Qualcomm’s chipset position and its NLNC policy do not preclude OEMs from using litigation to obtain rates that are close to the FRAND benchmark. There is thus no reason to believe that it can exclude its chipset rivals.

We believe the following facts support our assertion:

  • OEMs have pursued various litigation strategies in order to obtain lower rates on Qualcomm’s IP. As we mentioned in our previous post, this was notably the case for Apple, Samsung and LG. All three companies ultimately reached settlements with Qualcomm (and these settlements were concluded in the shadow of litigation proceedings — indeed, in Apple’s case, on the second day of trial). If anything, this suggests that court proceedings are an integral part of negotiations between Qualcomm and its OEMs.
  • For the most part, Qualcomm’s threats to cut off chip supplies were just that: threats. In any negotiation, parties will try to convince their counterpart that they have a strong outside option. Qualcomm may have done so by posturing that it would not sell chips to OEMs before they concluded a license agreement. 

    However, it seems that only once did Qualcomm apparently follow through with its threats to withhold chips (against Sony). And even then, the supply cutoff lasted only seven days.

    And while many OEMs did take Qualcomm to court in order to obtain more favorable license terms, this never resulted in Qualcomm cutting off their chipset supplies. Other OEMs thus had no reason to believe that litigation would entail disruptions to their chipset supplies.
  • OEMs also wield powerful threats. These include patent holdout, litigation, vertical integration, and purchasing chips from Qualcomm’s rivals. And of course they have aggressively pursued the bringing of this and other litigation around the world by antitrust authorities — even quite possibly manipulating the record to bolster their cases. Here’s how one observer sums up Apple’s activity in this regard:

    “Although we really only managed to get a small glimpse of Qualcomm’s evidence demonstrating the extent of Apple’s coordinated strategy to manipulate the FRAND license rate, that glimpse was particularly enlightening. It demonstrated a decade-long coordinated effort within Apple to systematically engage in what can only fairly be described as manipulation (if not creation of evidence) and classic holdout.

    Qualcomm showed during opening arguments that, dating back to at least 2009, Apple had been laying the foundation for challenging its longstanding relationship with Qualcomm.” (Emphasis added)

    Moreover, the holdout and litigation paths have been strengthened by the eBay case, which significantly reduced the financial risks involved in pursuing a holdout and/or litigation strategy. Given all of this, it is far from obvious that it is Qualcomm who enjoys the stronger bargaining position here.
  • Qualcomm’s chipsets might no longer be “must-buys” in the future. Rivals have gained increasing traction over the past couple of years. And with 5G just around the corner, this momentum could conceivably accelerate. Whether or not one believes that this will ultimately be the case, the trend surely places additional constraints on Qualcomm’s conduct. Aggressive behavior today may spur disgruntled rivals to enter the chipset market or switch suppliers tomorrow.

To summarize, as we understand their response, the delta between supracompetitive and competitive prices is entirely a function of Qualcomm’s ability to charge supra-FRAND prices for its licenses. On this we agree. But, unlike Lemley et al., we do not agree that Qualcomm is in a position to evade its FRAND pledges by using its strong position in the chipset market and its NLNC policy.

Finally, it must be said again: To the extent that that is the problem — the charging of supra-FRAND prices for licenses — the issue is manifestly a contract issue, not an antitrust one. All of the complexity of the case would fall away, and the litigation would be straightforward. But the opponents of Qualcomm’s practices do not really want to ensure that Qualcomm lowers its royalties by this delta; if they did, they would be bringing/supporting FRAND litigation. What the amici and Qualcomm’s contracting partners appear to want is to use antitrust litigation to force Qualcomm to license its technology at even lower rates — to force Qualcomm into a different business model in order to reset the baseline from which FRAND prices are determined (i.e., at the chip level, rather than at the device level). That may be an intelligible business strategy from the perspective of Qualcomm’s competitors, but it certainly isn’t sensible antitrust policy.

[This guest post is authored by Mark A. Lemley, Professor of Law and the Director of Program in Law, Science & Technology at Stanford Law School; A. Douglas Melamed, Professor of the Practice of Law at Stanford Law School and Former Senior Vice President and General Counsel of Intel from 2009 to 2014; and Steven Salop, Professor of Economics and Law at Georgetown Law School. It is a response to the post, “Exclusionary Pricing Without the Exclusion: Unpacking Qualcomm’s No License, No Chips Policy,” by Geoffrey Manne and Dirk Auer, which is itself a response to Lemley, Melamed, and Salop’s amicus brief in FTC v. Qualcomm.]

Geoffrey Manne and Dirk Auer’s defense of Qualcomm’s no license/no chips policy is based on a fundamental misunderstanding of how that policy harms competition.  The harm is straightforward in light of facts proven at trial. In a nutshell, OEMs must buy some chips from Qualcomm or else exit the handset business, even if they would also like to buy additional chips from other suppliers. OEMs must also buy a license to Qualcomm’s standard essential patents, whether they use Qualcomm’s chips or other chips implementing the same industry standards. There is a monopoly price for the package of Qualcomm’s chips plus patent license. Assume that the monopoly price is $20. Assume further that, if Qualcomm’s patents were licensed in a standalone transaction, as they would be if they were owned by a firm that did not also make chips, the market price for the patent license would be $2. In that event, the monopoly price for the chip would be $18, and a chip competitor could undersell Qualcomm if Qualcomm charged the monopoly price of $18 and the competitor could profitably sell chips for a lower price. If the competitor’s cost of producing and selling chips was $11, for example, it could easily undersell Qualcomm and force Qualcomm to lower its chip prices below $18, thereby reducing the price for the package to a level below $20.

However, the no license/no chips policy enables Qualcomm to allocate the package price of $20 any way it wishes. Because the OEMs must buy some chips from Qualcomm, Qualcomm is able to coerce the OEMs to accept any such allocation by threatening not to sell them chips if they do not agree to a license at the specified terms. The prices could thus be $18 and $2; or, for example, they could be $10 for the chips and $10 for the license. If Qualcomm sets the license price at $10 and a chip price of $10, it would continue to realize the monopoly package price of $20. But in that case, a competitor could profitably undersell Qualcomm only if its chip cost were less than 10. A competitor with a cost of $11 would then not be able to successfully enter the market, and Qualcomm would not need to lower its chip prices. That is how the no license/no chip policy blocks entry of chip competitors and maintains Qualcomm’s chip monopoly. 

Manne and Auer’s defense of the no license/no chips policy is deeply flawed. In the first place, Manne and Auer mischaracterize the problem as one in which “Qualcomm undercuts [chipset rivals] on chip prices and recoups its losses by charging supracompetitive royalty rates on its IP.” On the basis of this description of the issue, they argue that, if Qualcomm cannot charge more than $2 for the license, it cannot use license revenues to offset the chip price reduction. And if Qualcomm can charge more than $2 for the license, it does not need a chip monopoly in order to make supracompetitive licensing profits. This argument is wrong both factually and conceptually.  

As a factual matter, there are constraints on Qualcomm’s ability to charge more than $2 for the license if the license is sold by itself. If sold by itself, the license would be negotiated in the shadow of infringement litigation and the royalty would be constrained by the value of the technology claimed by the patent, the risk that the patent would be found to be invalid or not infringed, the “reasonable royalty” contemplated by the patent laws, and the contractual commitment to license on FRAND terms. But Qualcomm is able to circumvent those constraints by coercing OEMs to pay a higher price or else lose access to essential Qualcomm chips. In other words, Qualcomm’s ability to charge more than $2 for the license is not exogenous. Qualcomm is able to charge more than $2 for the license only because it uses the power of its chip monopoly to coerce the OEMs to give up the option of negotiating in light of the otherwise applicable constraints on the royalties it can charge. It is a simple story of bundling with simultaneous recoupment.  

As a conceptual matter, Manne and Auer seem to think that the concern with the no license/no chips policy is that it enables inflated patent royalties to subsidize a profit sacrifice in chip sales, as if the issue were predatory pricing in chips.  But there is no such sacrifice. Money is fungible, and Manne and Auer have it backwards. The problem is that the no license/no chips policy enables Qualcomm to make purely nominal changes by allocating some of its monopoly chip price to the license price. Qualcomm offsets that nominal license price increase when the OEM buys chips from it by lowering the chip price by that amount in order to maintain the package price at the monopoly price.  There is no profit sacrifice for Qualcomm because the lower chip price simply offsets the higher license price. Qualcomm offers no such offset when the OEM buys chips from other suppliers. To the contrary, by using its chip monopoly to increase the license price, it increases the cost to OEMs of using competitors’ chips and is thus able to perpetuate its chip monopoly and maintain its monopoly chip prices and profits. Absent this policy, OEMs would buy more chips from third parties; Qualcomm’s prices and profits would fall; and consumers would benefit.

At the end of the day, Manne and Auer rely on the old “single monopoly profit” or “double counting” idea that a monopolist cannot both charge a monopoly price and extract additional consideration as well. But, again, they have it backwards. Manne and Auer describe the issue as whether Qualcomm can leverage its patent position in the technology markets to increase its market power in chips. But that is not the issue. Qualcomm is not trying to increase profits by leveraging monopoly power from one market into a different market in order to gain additional monopoly profits in the second market. Instead, it is using its existing monopoly power in chips to maintain that monopoly power in the first place. Assuming Qualcomm has a chip monopoly, it is true that it earns the same revenue from OEMs regardless of how it allocates the all-in price of $20 to its chips versus its patents. But by allocating more of the all-in price to the patents (i.e., in our example, $10 instead of $2), Qualcomm is able to maintain its monopoly by preventing rival chipmakers from undercutting the $20 monopoly price of the package. That is how competition and consumers are harmed.

[TOTM: The following is the eighth in a series of posts by TOTM guests and authors on the FTC v. Qualcomm case recently decided by Judge Lucy Koh in the Northern District of California. Other posts in this series are here. The blog post is based on a forthcoming paper regarding patent holdup, co-authored by Dirk Auer and Julian Morris.]

Samsung SGH-F480V – controller board – Qualcomm MSM6280

In his latest book, Tyler Cowen calls big business an “American anti-hero”. Cowen argues that the growing animosity towards successful technology firms is to a large extent unwarranted. After all, these companies have generated tremendous prosperity and jobs.

Though it is less known to the public than its Silicon Valley counterparts, Qualcomm perfectly fits the anti-hero mold. Despite being a key contributor to the communications standards that enabled the proliferation of smartphones around the globe – an estimated 5 Billion people currently own a device – Qualcomm has been on the receiving end of considerable regulatory scrutiny on both sides of the Atlantic (including two in the EU; see here and here). 

In the US, Judge Lucy Koh recently ruled that a combination of anticompetitive practices had enabled Qualcomm to charge “unreasonably high royalty rates” for its CDMA and LTE cellular communications technology. Chief among these practices was Qualcomm’s so-called “no license, no chips” policy, whereby the firm refuses to sell baseband processors to implementers that have not taken out a license for its communications technology. Other grievances included Qualcomm’s purported refusal to license its patents to rival chipmakers, and allegations that it attempted to extract exclusivity obligations from large handset manufacturers, such as Apple. According to Judge Koh, these practices resulted in “unreasonably high” royalty rates that failed to comply with Qualcomm’s FRAND obligations.

Judge Koh’s ruling offers an unfortunate example of the numerous pitfalls that decisionmakers face when they second-guess the distributional outcomes achieved through market forces. This is particularly true in the complex standardization space.

The elephant in the room

The first striking feature of Judge Koh’s ruling is what it omits. Throughout the more than two-hundred-page long document, there is not a single reference to the concepts of holdup or holdout (crucial terms of art for a ruling that grapples with the prices charged by an SEP holder). 

At first sight, this might seem like a semantic quibble. But words are important. Patent holdup (along with the “unreasonable” royalties to which it arguably gives rise) is possible only when a number of cumulative conditions are met. Most importantly, the foundational literature on economic opportunism (here and here) shows that holdup (and holdout) mostly occur when parties have made asset-specific sunk investments. This focus on asset-specific investments is echoed by even the staunchest critics of the standardization status quo (here).

Though such investments may well have been present in the case at hand, there is no evidence that they played any part in the court’s decision. This is not without consequences. If parties did not make sunk relationship-specific investments, then the antitrust case against Qualcomm should have turned upon the alleged exclusion of competitors, not the level of Qualcomm’s royalties. The DOJ said this much in its statement of interest concerning Qualcomm’s motion for partial stay of injunction pending appeal. Conversely, if these investments existed, then patent holdout (whereby implementers refuse to license key pieces of intellectual property) was just as much of a risk as patent holdup (here and here). And yet the court completely overlooked this possibility.

The misguided push for component level pricing

The court also erred by objecting to Qualcomm’s practice of basing license fees on the value of handsets, rather than that of modem chips. In simplified terms, implementers paid Qualcomm a percentage of their devices’ resale price. The court found that this was against Federal Circuit law. Instead, it argued that royalties should be based on the value the smallest salable patent-practicing component (in this case, baseband chips). This conclusion is dubious both as a matter of law and of policy.

From a legal standpoint, the question of the appropriate royalty base seems far less clear-cut than Judge Koh’s ruling might suggest. For instance, Gregory Sidak observes that in TCL v. Ericsson Judge Selna used a device’s net selling price as a basis upon which to calculate FRAND royalties. Likewise, in CSIRO v. Cisco, the Court also declined to use the “smallest saleable practicing component” as a royalty base. And finally, as Jonathan Barnett observes, the Circuit Laser Dynamics case law cited  by Judge Koh relates to the calculation of damages in patent infringement suits. There is no legal reason to believe that its findings should hold any sway outside of that narrow context. It is one thing for courts to decide upon the methodology that they will use to calculate damages in infringement cases – even if it is a contested one. It is a whole other matter to shoehorn private parties into adopting this narrow methodology in their private dealings. 

More importantly, from a policy standpoint, there are important advantages to basing royalty rates on the price of an end-product, rather than that of an intermediate component. This type of pricing notably enables parties to better allocate the risk that is inherent in launching a new product. In simplified terms: implementers want to avoid paying large (fixed) license fees for failed devices; and patent holders want to share in the benefits of successful devices that rely on their inventions. The solution, as Alain Bousquet and his co-authors explain, is to agree on royalty payments that are contingent on success in the market:

Because the demand for a new product is uncertain and/or the potential cost reduction of a new technology is not perfectly known, both seller and buyer may be better off if the payment for the right to use an innovation includes a state-contingent royalty (rather than consisting of just a fixed fee). The inventor wants to benefit from a growing demand for a new product, and the licensee wishes to avoid high payments in case of disappointing sales.

While this explains why parties might opt for royalty-based payments over fixed fees, it does not entirely elucidate the practice of basing royalties on the price of an end device. One explanation is that a technology’s value will often stem from its combination with other goods or technologies. Basing royalties on the value of an end-device enables patent holders to more effectively capture the social benefits that flow from these complementarities.

Imagine the price of the smallest saleable component is identical across all industries, despite it being incorporated into highly heterogeneous devices. For instance, the same modem chip could be incorporated into smartphones (of various price ranges), tablets, vehicles, and other connected devices. The Bousquet line of reasoning (above) suggests that it is efficient for the patent holder to earn higher royalties (from the IP that underpins the modem chips) in those segments where market demand is strongest (i.e. where there are stronger complementarities between the modem chip and the end device).

One way to make royalties more contingent on market success is to use the price of the modem (which is presumably identical across all segments) as a royalty base and negotiate a separate royalty rate for each end device (charging a higher rate for devices that will presumably benefit from stronger consumer demand). But this has important drawbacks. For a start, identifying those segments (or devices) that are most likely to be successful is informationally cumbersome for the inventor. Moreover, this practice could land the patent holder in hot water. Antitrust authorities might naïvely conclude that these varying royalty rates violate the “non-discriminatory” part of FRAND.

A much simpler solution is to apply a single royalty rate (or at least attempt to do so) but use the price of the end device as a royalty base. This ensures that the patent holder’s rewards are not just contingent on the number of devices sold, but also on their value. Royalties will thus more closely track the end-device’s success in the marketplace.   

In short, basing royalties on the value of an end-device is an informationally light way for the inventor to capture some of the unforeseen value that might stem from the inclusion of its technology in an end device. Mandating that royalty rates be based on the value of the smallest saleable component ignores this complex reality.

Prices are almost impossible to reconstruct

Judge Koh was similarly imperceptive when assessing Qualcomm’s contribution to the value of key standards, such as LTE and CDMA. 

For a start, she reasoned that Qualcomm’s royalties were large compared to the number of patents it had contributed to these technologies:

Moreover, Qualcomm’s own documents also show that Qualcomm is not the top standards contributor, which confirms Qualcomm’s own statements that QCT’s monopoly chip market share rather than the value of QTL’s patents sustain QTL’s unreasonably high royalty rates.

Given the tremendous heterogeneity that usually exists between the different technologies that make up a standard, simply counting each firm’s contributions is a crude and misleading way to gauge the value of their patent portfolios. Accordingly, Qualcomm argued that it had made pioneering contributions to technologies such as CDMA, and 4G/5G. Though the value of Qualcomm’s technologies is ultimately an empirical question, the court’s crude patent counting  was unlikely to provide a satisfying answer.

Just as problematically, the court also concluded that Qualcomm’s royalties were unreasonably high because “modem chips do not drive handset value.” In its own words:

Qualcomm’s intellectual property is for communication, and Qualcomm does not own intellectual property on color TFT LCD panel, mega-pixel DSC module, user storage memory, decoration, and mechanical parts. The costs of these non-communication-related components have become more expensive and now contribute 60-70% of the phone value. The phone is not just for communication, but also for computing, movie-playing, video-taking, and data storage.

As Luke Froeb and his co-authors have also observed, the court’s reasoning on this point is particularly unfortunate. Though it is clearly true that superior LCD panels, cameras, and storage increase a handset’s value – regardless of the modem chip that is associated with them – it is equally obvious that improvements to these components are far more valuable to consumers when they are also associated with high-performance communications technology.

For example, though there is undoubtedly standalone value in being able to take improved pictures on a smartphone, this value is multiplied by the ability to instantly share these pictures with friends, and automatically back them up on the cloud. Likewise, improving a smartphone’s LCD panel is more valuable if the device is also equipped with a cutting edge modem (both are necessary for consumers to enjoy high-definition media online).

In more technical terms, the court fails to acknowledge that, in the presence of perfect complements, each good makes an incremental contribution of 100% to the value of the whole. A smartphone’s components would be far less valuable to consumers if they were not associated with a high-performance modem, and vice versa. The fallacy to which the court falls prey is perfectly encapsulated by a quote it cites from Apple’s COO:

Apple invests heavily in the handset’s physical design and enclosures to add value, and those physical handset features clearly have nothing to do with Qualcomm’s cellular patents, it is unfair for Qualcomm to receive royalty revenue on that added value.

The question the court should be asking, however, is whether Apple would have gone to the same lengths to improve its devices were it not for Qualcomm’s complementary communications technology. By ignoring this question, Judge Koh all but guaranteed that her assessment of Qualcomm’s royalty rates would be wide of the mark.

Concluding remarks

In short, the FTC v. Qualcomm case shows that courts will often struggle when they try to act as makeshift price regulators. It thus lends further credence to Gergory Werden and Luke Froeb’s conclusion that:

Nothing is more alien to antitrust than enquiring into the reasonableness of prices. 

This is especially true in complex industries, such as the standardization space. The colossal number of parameters that affect the price for a technology are almost impossible to reproduce in a top-down fashion, as the court attempted to do in the Qualcomm case. As a result, courts will routinely draw poor inferences from factors such as the royalty base agreed upon by parties, the number of patents contributed by a firm, and the complex manner in which an individual technology may contribute to the value of an end-product. Antitrust authorities and courts would thus do well to recall the wise words of Friedrich Hayek:

If we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization.

[TOTM: The following is the first in a series of posts by TOTM guests and authors on the FTC v. Qualcomm case, currently awaiting decision by Judge Lucy Koh in the Northern District of California. The entire series of posts is available here. This post originally appeared on the Federalist Society Blog.]

Just days before leaving office, the outgoing Obama FTC left what should have been an unwelcome parting gift for the incoming Commission: an antitrust suit against Qualcomm. This week the FTC — under a new Chairman and with an entirely new set of Commissioners — finished unwrapping its present, and rested its case in the trial begun earlier this month in FTC v Qualcomm.

This complex case is about an overreaching federal agency seeking to set prices and dictate the business model of one of the world’s most innovative technology companies. As soon-to-be Acting FTC Chairwoman, Maureen Ohlhausen, noted in her dissent from the FTC’s decision to bring the case, it is “an enforcement action based on a flawed legal theory… that lacks economic and evidentiary support…, and that, by its mere issuance, will undermine U.S. intellectual property rights… worldwide.”

Implicit in the FTC’s case is the assumption that Qualcomm charges smartphone makers “too much” for its wireless communications patents — patents that are essential to many smartphones. But, as former FTC and DOJ chief economist, Luke Froeb, puts it, “[n]othing is more alien to antitrust than enquiring into the reasonableness of prices.” Even if Qualcomm’s royalty rates could somehow be deemed “too high” (according to whom?), excessive pricing on its own is not an antitrust violation under U.S. law.

Knowing this, the FTC “dances around that essential element” (in Ohlhausen’s words) and offers instead a convoluted argument that Qualcomm’s business model is anticompetitive. Qualcomm both sells wireless communications chipsets used in mobile phones, as well as licenses the technology on which those chips rely. According to the complaint, by licensing its patents only to end-users (mobile device makers) instead of to chip makers further up the supply chain, Qualcomm is able to threaten to withhold the supply of its chipsets to its licensees and thereby extract onerous terms in its patent license agreements.

There are numerous problems with the FTC’s case. Most fundamental among them is the “no duh” problem: Of course Qualcomm conditions the purchase of its chips on the licensing of its intellectual property; how could it be any other way? The alternative would require Qualcomm to actually facilitate the violation of its property rights by forcing it to sell its chips to device makers even if they refuse its patent license terms. In that world, what device maker would ever agree to pay more than a pittance for a patent license? The likely outcome is that Qualcomm charges more for its chips to compensate (or simply stops making them). Great, the FTC says; then competitors can fill the gap and — voila: the market is more competitive, prices will actually fall, and consumers will reap the benefits.

Except it doesn’t work that way. As many economists, including both the current and a prominent former chief economist of the FTC, have demonstrated, forcing royalty rates lower in such situations is at least as likely to harm competition as to benefit it. There is no sound theoretical or empirical basis for concluding that using antitrust to move royalty rates closer to some theoretical ideal will actually increase consumer welfare. All it does for certain is undermine patent holders’ property rights, virtually ensuring there will be less innovation.

In fact, given this inescapable reality, it is unclear why the current Commission is continuing to pursue the case at all. The bottom line is that, if it wins the case, the current FTC will have done more to undermine intellectual property rights than any other administration’s Commission has been able to accomplish.

It is not difficult to identify the frailties of the case that would readily support the agency backing away from pursuing it further. To begin with, the claim that device makers cannot refuse Qualcomm’s terms because the company effectively controls the market’s supply of mobile broadband modem chips is fanciful. While it’s true that Qualcomm is the largest supplier of these chipsets, it’s an absurdity to claim that device makers have no alternatives. In fact, Qualcomm has faced stiff competition from some of the world’s other most successful companies since well before the FTC brought its case. Samsung — the largest maker of Android phones — developed its own chip to replace Qualcomm’s in 2015, for example. More recently, Intel has provided Apple with all of the chips for its 2018 iPhones, and Apple is rumored to be developing its own 5G cellular chips in-house. In any case, the fact that most device makers have preferred to use Qualcomm’s chips in the past says nothing about the ability of other firms to take business from it.

The possibility (and actuality) of entry from competitors like Intel ensures that sophisticated purchasers like Apple have bargaining leverage. Yet, ironically, the FTC points to Apple’s claimthat Qualcomm “forced” it to use Intel modems in its latest iPhones as evidence of Qualcomm’s dominance. Think about that: Qualcomm “forced” a company worth many times its own value to use a competitor’s chips in its new iPhones — and that shows Qualcomm has a stranglehold on the market?

The FTC implies that Qualcomm’s refusal to license its patents to competing chip makers means that competitors cannot reliably supply the market. Yet Qualcomm has never asserted its patents against a competing chip maker, every one of which uses Qualcomm’s technology without paying any royalties to do so. The FTC nevertheless paints the decision to license only to device makers as the aberrant choice of an exploitative, dominant firm. The reality, however, is that device-level licensing is the norm practiced by every company in the industry — and has been since the 1980s.

Not only that, but Qualcomm has not altered its licensing terms or practices since it was decidedly an upstart challenger in the market — indeed, since before it even started producing chips, and thus before it even had the supposed means to leverage its chip sales to extract anticompetitive licensing terms. It would be a remarkable coincidence if precisely the same licensing structure and the exact same royalty rate served the company’s interests both as a struggling startup and as an alleged rapacious monopolist. Yet that is the implication of the FTC’s theory.

When Qualcomm introduced CDMA technology to the mobile phone industry in 1989, it was a promising but unproven new technology in an industry dominated by different standards. Qualcomm happily encouraged chip makers to promote the standard by enabling them to produce compliant components without paying any royalties; and it willingly licensed its patents to device makers based on a percentage of sales of the handsets that incorporated CDMA chips. Qualcomm thus shared both the financial benefits and the financial risk associated with the development and sales of devices implementing its new technology.

Qualcomm’s favorable (to handset makers) licensing terms may have helped CDMA become one of the industry standards for 2G and 3G devices. But it’s an unsupportable assertion to say that those identical terms are suddenly the source of anticompetitive power, particularly as 2G and 3G are rapidly disappearing from the market and as competing patent holders gain prominence with each successive cellular technology standard.

To be sure, successful handset makers like Apple that sell their devices at a significant premium would prefer to share less of their revenue with Qualcomm. But their success was built in large part on Qualcomm’s technology. They may regret the terms of the deal that propelled CDMA technology to prominence, but Apple’s regret is not the basis of a sound antitrust case.

And although it’s unsurprising that manufacturers of premium handsets would like to use antitrust law to extract better terms from their negotiations with standard-essential patent holders, it is astonishing that the current FTC is carrying on the Obama FTC’s willingness to do it for them.

None of this means that Qualcomm is free to charge an unlimited price: standard-essential patents must be licensed on “FRAND” terms, meaning they must be fair, reasonable, and nondiscriminatory. It is difficult to asses what constitutes FRAND, but the most restrictive method is to estimate what negotiated terms would look like before a patent was incorporated into a standard. “[R]oyalties that are or would be negotiated ex ante with full information are a market bench-mark reflecting legitimate return to innovation,” writes Carl Shapiro, the FTC’s own economic expert in the case.

And that is precisely what happened here: We don’t have to guess what the pre-standard terms of trade would look like; we know them, because they are the same terms that Qualcomm offers now.

We don’t know exactly what the consequence would be for consumers, device makers, and competitors if Qualcomm were forced to accede to the FTC’s benighted vision of how the market should operate. But we do know that the market we actually have is thriving, with new entry at every level, enormous investment in R&D, and continuous technological advance. These aren’t generally the characteristics of a typical monopoly market. While the FTC’s effort to “fix” the market may help Apple and Samsung reap a larger share of the benefits, it will undoubtedly end up only hurting consumers.

On November 10, at the University of Southern California Law School, Assistant Attorney General for Antitrust Makan Delrahim delivered an extremely important policy address on the antitrust treatment of standard setting organizations (SSOs).  Delrahim’s remarks outlined a dramatic shift in the Antitrust Division’s approach to controversies concerning the licensing of standard essential patents (SEPs, patents that “read on” SSO technical standards) that are often subject to “fair, reasonable, and non-discriminatory” (FRAND) licensing obligations imposed by SSOs.  In particular, while Delrahim noted the theoretical concerns of possible “holdups” by SEP holders (when SEP holders threaten to delay licensing until their royalty demands are met), he cogently explained why the problem of “holdouts” by implementers of SEP technologies (when implementers threaten to under-invest in the implementation of a standard, or threaten not to take a license at all, until their royalty demands are met) is a far more serious antitrust concern.  More generally, Delrahim stressed the centrality of patents as property rights, and the need for enforcers not to interfere with the legitimate unilateral exploitation of those rights (whether through licensing, refusals to license, or the filing of injunctive actions).  Underlying Delrahim’s commentary is the understanding that innovation is vitally important to the American economy, and the concern that antitrust enforcers’ efforts in recent years have threatened to undermine innovation by inappropriately interfering in free market licensing negotiations between patentees and licensees.

Important “takeaways” from Delrahim’s speech (with key quotations) are set forth below.

  • Thumb on the scale in favor of implementers: “In particular, I worry that we as enforcers have strayed too far in the direction of accommodating the concerns of technology implementers who participate in standard setting bodies, and perhaps risk undermining incentives for IP creators, who are entitled to an appropriate reward for developing break-through technologies.”
  • Striking the right balance through market forces (as opposed to government-issued best practices): “The dueling interests of innovators and implementers always are in tension, and the tension is resolved through the free market, typically in the form of freely negotiated licensing agreements for royalties or reciprocal licenses.”
  • Holdup as theoretical concern with no evidence that it’s a systemic or widespread problem: He praises Professor Carl Shapiro for his theoretical model of holdup, but stresses that “many of the proposed [antitrust] ‘solutions’ to the hold-up problem are often anathema to the policies underlying the intellectual property system envisioned by our forefathers.”
  • Rejects prior position that antitrust is only concerned with the patent-holder side of the holdup equation, stating that he’s more concerned with holdout given the nature of investments: “Too often lost in the debate over the hold-up problem is recognition of a more serious risk:  the hold-out problem. . . . I view the collective hold-out problem as a more serious impediment to innovation.  Here is why: most importantly, the hold-up and hold-out problems are not symmetric.  What do I mean by that?  It is important to recognize that innovators make an investment before they know whether that investment will ever pay off.  If the implementers hold out, the innovator has no recourse, even if the innovation is successful.  In contrast, the implementer has some buffer against the risk of hold-up because at least some of its investments occur after royalty rates for new technology could have been determined.  Because this asymmetry exists, under-investment by the innovator should be of greater concern than under-investment by the implementer.”
  • What’s at stake: “Every incremental shift in bargaining leverage toward implementers of new technologies acting in concert can undermine incentives to innovate.  I therefore view policy proposals with a one-sided focus on the hold-up issue with great skepticism because they can pose a serious threat to the innovative process.”
  • Breach of FRAND as primarily a contract or fraud, not antitrust issue: “There is a growing trend supporting what I would view as a misuse of antitrust or competition law, purportedly motivated by the fear of so-called patent hold-up, to police private commitments that IP holders make in order to be considered for inclusion in a standard.  This trend is troublesome.  If a patent holder violates its commitments to an SSO, the first and best line of defense, I submit, is the SSO itself and its participants. . . . If a patent holder is alleged to have violated a commitment to a standard setting organization, that action may have some impact on competition.  But, I respectfully submit, that does not mean the heavy hand of antitrust necessarily is the appropriate remedy for the would-be licensee—or the enforcement agency.  There are perfectly adequate and more appropriate common law and statutory remedies available to the SSO or its members.”
  • Recommends that unilateral refusals to license should be per se lawful: “The enforcement of valid patent rights should not be a violation of antitrust law.  A patent holder cannot violate the antitrust laws by properly exercising the rights patents confer, such as seeking an injunction or refusing to license such a patent.  Set aside whether taking these actions might violate the common law.  Under the antitrust laws, I humbly submit that a unilateral refusal to license a valid patent should be per se legal.  Indeed, just this Monday, Chief Judge Diane Wood, a former Deputy Assistant Attorney General at the Antitrust Division, stated that “[e]ven monopolists are almost never required to assist their competitors.”
  • Intent to investigate buyers’ cartel behavior in SSOs: “The prospect of hold-out offers implementers a crucial bargaining chip.  Unlike the unilateral hold-up problem, implementers can impose this leverage before they make significant investments in new technology.  . . . The Antitrust Division will carefully scrutinize what appears to be cartel-like anticompetitive behavior among SSO participants, either on the innovator or implementer side.  The old notion that ‘openness’ alone is sufficient to guard against cartel-like behavior in SSOs may be outdated, given the evolution of SSOs beyond strictly objective technical endeavors. . . . I likewise urge SSOs to be proactive in evaluating their own rules, both at the inception of the organization, and routinely thereafter.  In fact, SSOs would be well advised to implement and maintain internal antitrust compliance programs and regularly assess whether their rules, or the application of those rules, are or may become anticompetitive.”
  • Basing royalties on the “smallest salable component” as a requirement by a concerted agreement of implementers is a possible antitrust violation: “If an SSO pegs its definition of “reasonable” royalties to a single Georgia-Pacific factor that heavily favors either implementers or innovators, then the process that led to such a rule deserves close antitrust scrutiny.  While the so-called ‘smallest salable component’ rule may be a useful tool among many in determining patent infringement damages for multi-component products, its use as a requirement by a concerted agreement of implementers as the exclusive determinant of patent royalties may very well warrant antitrust scrutiny.”
  • Right to Injunctive Relief and holdout incentives: “Patents are a form of property, and the right to exclude is one of the most fundamental bargaining rights a property owner possesses.  Rules that deprive a patent holder from exercising this right—whether imposed by an SSO or by a court—undermine the incentive to innovate and worsen the problem of hold-out.  After all, without the threat of an injunction, the implementer can proceed to infringe without a license, knowing that it is only on the hook only for reasonable royalties.”
  • Seeking or Enforcing Injunctive Relief Generally a Contract Not Antitrust Issue: “It is just as important to recognize that a violation by a patent holder of an SSO rule that restricts a patent-holder’s right to seek injunctive relief should be appropriately the subject of a contract or fraud action, and rarely if ever should be an antitrust violation.”
  • FRAND is Not a Compulsory Licensing Scheme: “We should not transform commitments to license on FRAND terms into a compulsory licensing scheme.  Indeed, we have had strong policies against compulsory licensing, which effectively devalues intellectual property rights, including in most of our trade agreements, such as the TRIPS agreement of the WTO.  If an SSO requires innovators to submit to such a scheme as a condition for inclusion in a standard, we should view the SSO’s rule and the process leading to it with suspicion, and certainly not condemn the use of such injunctive relief as an antitrust violation where a contract remedy is perfectly adequate.”