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Patent Licensing is a Risky Business: Let the Market Strike the Balance

“When risk exists for both parties in a patent dispute – and such risk is reasonably balanced – market-driven, negotiated outcomes are therefore achievable and routinely achieved.”

“If everything seems under control, you’re just not going fast enough.”-Mario Andretti

Risk dialPatent licensing and technology transfer are cornerstones of modern economies, where the efficiencies of collaboration and division of labor do not require firms to be vertically integrated. The Wright brothers did not build commercial aviation, and yet commercial aviation was born thanks to the Wright brothers’ invention. Similarly, a car manufacturer can simply rely on communication technologies developed by telecom experts outside the automotive ecosystem to guarantee connectivity to its fleet and the corresponding massive economic benefits.

This short article focuses on how risk – in the economic and legal sense – changes over time, and what this implies for patent licensing dynamics. Licensing negotiations are not static snapshots in time, they often evolve and change according to developing circumstances, case law, parties’ conduct, and many other factors.

Economic realities suggest that risk-takers – whether they take a risk by investing early and heavily in standards development or by being an early licensee of a new technology – should be adequately rewarded. The higher the risk, the higher the reward and the potential investment. If this balance is lost, closed ecosystems develop. This outcome would be suboptimal for consumers, when global groundbreaking technology solutions are needed (for instance, in the case of wireless standards, such as the 5G standard).

The Notion of Risk

Each one of us faces risk in our everyday activities. Whether we drive or bike to work, downhill ski through moguls in the Rockies, or invest in a brokerage account, most individuals have become very savvy in recognizing and quantifying the risk associated with day-to-day activities. And different individuals have different levels of risk they are comfortable taking. Similarly, businesses face risk on a daily basis, and have adapted to cope with, minimize and leverage all sort of risks, from geopolitical tensions to supply chain costs.

In a fascinating article, Karla Mallette explains how the modern notion of risk, intended as an economic risk that can also carry a reward, was introduced in Medieval Europe by traders. Since money lending was at the time illegal, some sailors started looking for investors that were willing to finance operations in exchange for a share in the profits, in essence taking on the risk of the operations for a (possibly greater) upside.

In financial terms, risk is defined as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. The relationship between risk and return is a cornerstone of contemporary business: the greater the amount of risk an investor is willing to take, the greater the potential return. Moreover, risk, and the associated potential return, is often dynamic (Moody’s credit ratings are an example of the evolving level of risk that investments in a specific country carry, and such ratings have a great impact on the cost of debt for said country, and the interest rates, i.e., the reward, that a lender can charge).

Licensing Negotiations Dynamics

In any business negotiations where goods or services are transacted, a cost / benefit analysis drives the negotiation to an equilibrium, where it makes economic sense for both the seller and the buyer to proceed with the transaction. If such an equilibrium cannot be found so that the negotiating parties cannot find a workable arrangement, the transaction simply does not happen.

Patent licensing, on the other hand, is a unique business: the disposal of the good (the technology covered by the patents) occurs before the user of the technology pays a licensing fee to the patent owner, and in fact it happens before the user has even agreed to pay anything at all for such license. A patent is not self-enforceable, and because of the disclosure requirement in the patent law, the use of the patented technology cannot be easily stopped and is virtually out there for anyone to use before a license is in place or even before a license is negotiated / requested. This is especially true for technologies that are incorporated into a standard, which anyone can implement simply by conforming to publicly available specifications.

What drives negotiations in the patent licensing business, therefore, are mainly two considerations: the cost of litigation, and the likelihood to succeed or lose in litigation. If, for example, I am presented with a portfolio I likely (upon review) infringe – such that the likelihood of getting sued and losing that litigation is thus relatively high – and the cost of a lengthy litigation is something I – say, a small business – cannot afford easily, then my incentive to negotiate a license that I can afford and will save me from all these risks is clearly a driver in the negotiation.

The above exposure-driven negotiation dynamics have been exploited by opportunistic players on both sides of the negotiation, i.e., patent owners and users of patented technology. For example, unscrupulous patent owners have exploited the cost of litigation by settling dubious patent cases at nuisance value, taking advantage of the fact that an alleged infringer, faced with costly litigation to defend from the plaintiff’s claims, will rather settle for a much lower amount. On the other hand, large implementers with significant exposure may find it more cost-effective to litigate or hold-out as long as possible, eventually saving a lot by reducing the royalty burden even by a small amount. As an example, if I sold more than 200 million smartphones a year, even saving $1 in royalty per device would amount to more than $200 million in cost savings. Plenty of reasons and cash to hold out and fight in court any licensing demand!

Risk is Not Static in Negotiations

The risk faced by a licensor and/or a licensee is a dynamic concept and can vary in time. Therefore, the associated negotiation tactics and outcome of such negotiation are also a function of when such negotiation occurs. Not recognizing the dynamic nature of risk can result in several fallacies. Let us look at two in more specificity.

  1. The hypothetical negotiation

The hypothetical negotiation construct arose from the Georgia-Pacific Corp. v. United States Plywood Corp. decision in 1970. The construct provides that a reasonable royalty should be determined by hypothesizing an imaginary negotiation between a patent holder and an infringer over use of a patented invention at the time of first infringement.

Unfortunately, the hypothetical negotiation fails to account for the intervening events that happened from the time of first infringement that might have changed the real or perceived risk by the parties (and therefore the value they place in the associated license). For example, patents in the portfolio may have been invalidated, lowering the risk for the licensee. On the other hand, the licensor might have proven its portfolio in other litigations or licensed it to other licensees, hence increasing the risk for the licensee.

  1. FRAND does not equate to Most Favored Nation

While several courts and the U.S. Department of Justice have recently explained that a commitment to license standard essential patents on fair, reasonable and non-discriminatory (FRAND) terms is not the same of a most favored nation (MFN) clause, some licensees and commentators argue that the same FRAND terms (and in particular the FRAND rate) should be offered to all licensees.

Unfortunately, such a position is not only unpractical – the FRAND rate is only one element in a broader set of FRAND terms, that often differ from licensee to licensee for practical reasons and impact the FRAND rate (for example, an upfront payment may be based on market reports, which might in hindsight differ from actual sales; or sometimes licensees may want to include or exclude some clauses, and the FRAND rate they are willing to pay will account for those special clauses or absence thereof) – but it is also economically wrong.

A licensee that refuses to negotiate, negotiates in bad faith, or waits to get sued only to countersue and insists on taking a license only after all court cases in multiple jurisdictions have been fully adjudicated through multiple levels of appeals should not be offered the same FRAND rate that other willing licensees are paying (incidentally, some commentators have argued that the FRAND commitment itself requires good faith from both parties, and an unwilling licensee should not even be offered the FRAND rate).

The above examples highlight a fundamental economic error that has been overlooked: if a licensee takes a license early, why should that licensee not be rewarded for the risk of taking a license to a portfolio that might later be proven less valuable with more favorable terms? At the same time, if a licensee decides to hold out while other sophisticated industry players take a license, why should the licensee not be penalized for (i) taking an unfair advantage towards other licensees, and (ii) licensing the portfolio only when such portfolio has been proven in the market?

Takeaways

Business realities and economics principles suggest that licensing negotiations are dynamic in nature, because the risk faced by licensors and licensees – which informs the value that licensors and licensees place in a license – changes over time and it is a function of intervening events. When risk exists for both parties in a patent dispute – and such risk is reasonably balanced – market-driven, negotiated outcomes are therefore achievable and routinely achieved.

The concepts explained in this article should be taken into account by courts and regulators to make sure that market forces determine the outcome of negotiations between parties in a licensing transaction, and that supra- or below market rates are not imposed by regulation.

Lastly, economics suggest that risk-takers – whether they take a risk by investing early and heavily in standards development or by being an early licensee of a new technology – should be adequately rewarded. Absent such reward, who would rationally invest in the development and/or deployment of game-changing innovation?

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One comment so far. Add my comment.

  • [Avatar for Greg Magel]
    Greg Magel
    January 12, 2022 10:23 am

    Great food for thought. Well summarized in the “fundamental economic error” paragraph just above Takeaways.

    I would love to see some thoughts on how to implement the suggested “rewards and penalties” from the author and here in the Comments section.

    Also, Mr. (Dr.) Sabattini, I’d be interested in whether you think things should be structured differently in pharma vs. technology (your and my background, where cross-licensing is more common).

    — Greg

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