Antitrust Overreach: Undoing Cooperative Standardization in the Digital Economy

We take for granted that an Apple iPhone can “talk” with a Samsung Galaxy smartphone and a Dell laptop can communicate with an HP printer.  As I describe in a new paper, this ubiquitous interoperability has relied on a standardization infrastructure involving the cooperative efforts of multiple firms. Some of those firms focus on the R&D that contributes technologies toward the standard-setting process and others specialize in embedding those technologies in smartphones, laptops, and other devices.  This multi-firm mechanism contrasts favorably with the historically dominant alternatives of achieving standardization through a single entity: a government monopoly, which suffers from informational deficits and regulatory capture, or a private monopoly, which suffers from the pricing, output, and other distortions inherent in a dominant market position.

Two legal conditions are critical to support rational participation by R&D-focused firms in these cooperative standardization arrangements.  Without reliably enforced IP rights, those firms may decline to disclose valuable technology to other firms in the standard-setting process. Without reliably enforced IP licenses, those firms may be unable to monetize that R&D through supply relationships with producers in the downstream market.

Over roughly the past decade, antitrust regulators and courts in the United States, the European Union, China, and other jurisdictions have adopted policies that endanger the legal “plumbing” behind the cooperative standardization arrangements that drive ubiquitous interoperability.  (A notable exception is the policy shift announced in November 2017 by Makan Delrahim, head of the Department of Justice’s Antitrust Division.)  These policies have relied on the view that the widespread issuance of patents relating to “standard-essential” technologies, and the dispersed ownership of those patents, is liable to impede innovation and inflate prices for consumers.  Most notably, it has been asserted that the owners of standard-essential patents (“SEPs”) engage in “patent holdup” by imposing exorbitant licensing burdens on firms that adopt standardized technologies.

This view has led regulators and courts to largely preclude upstream SEP owners from obtaining injunctions against infringing downstream users and put downward pressure on the damages those entities can secure in patent infringement litigation.  Yet, in the absence of a credible injunction and litigation threat, well-resourced downstream producers have little reason to voluntarily pay the licensing fees sought by upstream innovators, which must resort to litigation to secure a positive return on their R&D investment.  If that is the case, then the more pressing problem may not be patent holdup by upstream innovators but rather patent holdout by downstream producers.

The consensus view that has dominated antitrust policy and commentary in this field suffers from an important shortcoming: It has not been supported by evidence.  Multiple empirical studies have yet to find evidence that upstream patent owners in smartphone and other standardized IT markets are actually engaging in pricing behavior consistent with the theoretical patent holdup model.  In general, these studies have estimated single to mid-digit aggregate royalty rates being paid on average by downstream licensees, a far cry from the double-digit rates that are often alleged.  That result is consistent with an alternative model in which patent owners seek to maximize long-term revenue streams in a repeat-play environment in which no firm has assurance that its technology will be adopted by producers and other implementers in future iterations of the standard (4G, 5G, and so on).  Extracting exorbitant royalty rates in one “period” of the game would be inconsistent with that objective.  That might explain why the smartphone market has consistently experienced price declines (adjusted for quality), adoption across a broad range of income segments, and robust entry into handset manufacturing, all of which is inconsistent with a world in which patent owners are exercising pricing power to “tax” device manufacturers and consumers for a short-term windfall.

If there is little compelling evidence that patent owners are generally behaving badly in standard-dependent IT markets, then the antitrust consensus concerning the “SEP problem” starts to look like the regulatory equivalent of tilting at windmills.  But there is a more worrisome possibility.  If there is so little evidence in support of patent holdup, why has an empirically undemonstrated idea secured such widespread adoption?

Consider the commitment that SEP owners make to “fair, reasonable, and non-discriminatory” (“FRAND”) licensing terms when their technology is included in a standard.  Consistent with patent holdup theory, antitrust regulators have expressed the view that upstream SEP owners dictate “excessive” licensing terms that are inconsistent with this commitment.  However, the political economy of wireless technology markets suggests that it is downstream implementers and other net technology users—both at the firm and national level—that have exerted leverage to secure rigid interpretations of the loosely defined FRAND commitment that depress the royalties owed by those firms to upstream innovators.  Historically, the FRAND commitment arose as a compromise between European telecom monopolists and Motorola, a key upstream innovator in the “GSM” wireless communications market, in which the monopolists sought royalty-free licensing and a no-injunction commitment.  Data I collected from amicus briefs filed in SEP-related infringement litigations during 2014 and 2015 show that large hardware and telecom firms located at downstream points on the IT supply chain consistently advocate interpretations of FRAND that result in lower royalty determinations.  In recent years, competition agencies in China, South Korea, and Taiwan—all countries with substantial net IP deficits—have referenced the FRAND commitment in litigating and then securing settlements with Qualcomm (the key upstream innovator in the “3G” and “4G” wireless markets) that have reduced the patent royalties paid by local device manufacturers.  This political-economic background suggests that antitrust policy actions to protect consumers against SEP owners simply shift value from firms and economies that specialize in generating innovation inputs to firms and economies that specialize in embodying those inputs in products for end-users.

It is unlikely that this is a prudent social choice.  While limiting SEP owners’ ability to enforce and license patents promotes the interests of downstream producers in reduced input costs, it is inconsistent with the public interest in preserving the incentive structure behind the cooperative standard-setting arrangements that drive wireless communications markets.

This post comes to us from Professor Jonathan Barnett at the University of Southern California’s Gould School of Law. It is based on his recent article, “Antitrust Overreach: Undoing Cooperative Standardization in the Digital Economy,” available here.