Guidelines for Patent Pools That Support a Standard
Excerpted from pages 83 - 97 of22 April, 2003
Charles River Associates Ltd.8th Floor St. Helens 1 Undershaft London EC3A 8EE
Robert C. Lind, Anya V. Kleymenova, Marie Miauton and Paul Muysert.
This report was prepared for the European Commission (EC) by Charles River Associates (CRA) to assist the Directorate General for Competition in its review of of Article81 (1) and (3) to patent pools and cross-licensing of intellectual property (IP).
The content of this report does not represent a statement of the views of the EuropeanCommission, of CRA or of the people who have contributed their time and ideas through a series of interviews. The responsibility for opinions expressed and potential errors is that of its authors, primarily, its lead author, Professor Robert C. Lind who made final decisions on its content.
The italicized text below is excerpted from
Chapter V Competition Policy and Multiparty Licensing Rules
Guidelines for Patent Pools That Support a Standard
The analysis of competition guidelines for the creation of patent pools as part of the creation of an industry standard is very different from that for bilateral cross licenses. The business purpose is different, although assembling complimentary IP required for product production is a common goal of both. The institutional setting is also different, in that there are organising agreements and often a standard setting organisation (SSO) is used. There may bean ongoing organisation that manages and reviews the standard and the patent pool of technology that supports it. It is these organisational and process issues that are associated with how a standard is chosen, how the patents in the pool are chosen, how the royalties on various IP rights are established, and how the price of the package licensed is determined, more than the actual form of the licensing agreement itself, that are of the greatest concern to the business, legal and regulatory communities.
Before analysing the competition guidelines that should apply to the standard setting process and to the formation and operation of the patent pools that support them, it is important to be clear about what kind of standard we are talking about and what the purpose is, because that dictates the competitive rules that should apply. For years there have been a wide variety of industry standards. These include product safety standards, product performance standards, and so on. Most of these standards do not involve patent pools, and while such standard setting has long raised competition concerns, this is not what we are talking about here. We are talking about the setting of standards that will provide the basis for the design and production of new classes of products that will be interoperable and that can be produced bya ny firm that chooses to adopt the standard. Thus, the very concept of an industry standard embraces the idea that there will be open competition among firms who wish to adopt it.
Accordingly, interoperability, openness and competition are key elements in the rationale for standard setting and it drives many of the competition rules that should apply.85 This concept of an industry standard is widely shared by business, the legal community and by competition authorities. The same view, from a business perspective, was stated by Scott Peterson of Hewlett Packard at the recent FTC and DOJ hearings:
HP’s long standing approach has been to cooperate on standards and compete on implementation… The use of common protocols and interfaces can expand markets for networks of products that implement those protocols and interfaces… Producers compete by innovating on top of standardized functions. Although the functional characteristics specified in the standard may be the same in all products, innovation builds on these points of commonality….
In addition, standard setting in the case of complex products that require licences to many different pieces of IP requires formation of a patent pool, which can then license the entire package of required IP to firms choosing to adopt the standard. This, if done properly, will greatly reduce the cost of acquiring the IP for those adopting the standard and potentially
85 Also, it is highly unlikely that an industry standard that requires the rights of a significant number of firms could be established by firms acting unilaterally. From this perspective, these exercises are quite different to small scale cross-licensing arrangements.
expands the possible revenue for the owners of the IP by creating expanded opportunities for licensing their IP for use in a new application. Thus, the objective of creating efficiency is at the heart of modern standard setting. To create such efficiency, standards must be designed so that the underlying product is one that has features that consumers want, and that can be produced and sold by competitive firms at a price the consumers will pay. If this is not achieved, the standard will fail entirely or fall far short of its potential for generating demand, economic growth, and efficiency. Therefore, it is essential that the standard setting process be such that it will choose the right mix of product characteristics and choose the least cost pool of available technology to produce this product. Thus, the standard design and choice of technology should be carried out as they would be in any rational, profit-maximizing firm designing a product.
Before exploring the implications of these requirements for the standard setting process, it is important to consider the case for and against industry standards at all. The case for a successful standard is that by cooperating, firms can create a set of project features that consumers want, can assure interoperability of the products of different producers who have adopted the standard, can establish an environment in which a multitude of firms can compete in various markets for products conforming to the standard, and can provide that entry into these markets is relative easy, since one can produce a few or many of the different standardized products. For example, some firms may make only CD’s; others may make CD’s, CD players and CD "burners". Therefore, the standardized product, in all likelihood, will be produced in highly competitive markets. When (demand-side) network effects a represent, establishing standards that allow inter-firm or inter-product compatibility offers the potential for greater realisation of network effects. As increasing network size increases the value of the network to consumers, this is a gain in consumer welfare. Whether or not network effects are present, compatibility through standard setting can deliver a number of other significant benefits. These include decreasing the cost of duplicate equipment needed to participate in multiple networks, and benefits in terms of the average cost of production can be achieved when economies of scale, learning effects and technological spill-over in the development and production of specific components are important. Increased variety can also result from standards. Against this, perhaps the biggest potential drawback of a highly successful standard is that there may not be competition for producing new and better quality standard products. If the standard is highly successful and well-accepted by highly satisfied consumers, this may not be a significant problem, but if the standard becomes outdated or new, better and cheaper solutions become available, it is important that there are incentives for these to be developed and implemented.
There are several ways that this could happen. In cases where a standard has an ongoing governance organization and management capability, that redesign could come internally. To the extent that this does not happen or go far enough, existing users of the standard could team with others to develop a new competing standard. Also individual firms or joint ventures of firms could enter the market with their own proprietary standard and compete for the market. Therefore, one of the important competitive objectives of competition authorities is to ensure that agreements in connection with a standard do not prohibit those who adopt the standard from competing in the future with another open standard or with a proprietary standard. This is seen in the standard conditions set by competition authorities in connection with the approval of proposals for standards.
What is it then that industry standard setting does that might be seen as anticompetitive? The development of a successful industry standard eliminates possible dynamic competition among proprietary standards for the market. Since standard setting associated with patent pools today takes place in industries where there are strong network effects, it is likely that the end result of dynamic competition for the market will either be one monopolist supplying the market or perhaps a very dominant firm supplying the market with the winning technology, although probably still operating along with several marginal competitors.
Therefore, after the initial period of intense competition for the market when price competition is likely to be fierce, and a winner has emerged, prices are likely to be higher than with competition under an industry standard. The competitive standard race will also potentially leave consumers stranded with technology that is of little value, either because it is no longer produced or, more importantly, because it is not interoperable with the winning technology.86
86 A good example of this is recordable DVD formats. For further information, see ‘Battle of the blues’, The Economist Technology Quarterly, December 14, 2002.
Unless one believes that the dynamic process of competition generates a winning technology that is far superior to the industry standard, it is difficult to see how the process of dynamic competition leading to monopoly is preferable to developing a successful industry standard. While there is no definitive way to answer this question, it does appear that what determines the winner of the process of dynamic competition may depend more on who has the resources and correct strategy to take the lead and ride the tide of network effects than on having the best product. Therefore, we believe there is more than enough room for the setting of industry standards and the formation of supporting patent pools, so long as the terms of involvement do not preclude the participants from joining competing ventures and possibly providing future competition to the standard itself.
The basic efficiency and competition enhancing objectives of the standard setting process have led to some generally accepted competition conditions that standard setting and the formation of related patent pools are required to meet. They can be summarized as follows:
1. The IPRs in the pool are complements.
2. Intellectual property for which a royalty is charged must be essential to the standard.
3. Licensees should be free to develop competing products and standards.
4. Licensors should be free to participate in development of competing products and standards.
5. Licences to the pool should be non-exclusive, allowing those licensing technology to the pool to license that technology independently to others.
6. Licences should be issued on a non-discriminatory basis.
7. Royalties paid to the pool should be reasonably related to the level of use of the licensed technologies.
8. Grantback restrictions should be non-exclusive, essential to the pool, and have the same field-of-use as the license from the pool.
These conditions are consistent with those set forth by the DoJ in business letters in response to the MPEG and DVD proposals, and with the terms of EC approval of standards with patent pools. Note that the first two conditions address the concerns that the IP be complementary and that it be essential. This guarantees that there will not be IP in the pool, raising cost, that is not required. To this extent it goes to one objective of standard design which should be cost minimization, given any design. Conditions 3 and 4 are meant to insure that the potential for competing in alternative standards is not foreclosed by participation in the standard. The next two conditions are directed to creating an open pool with all participants having access on non-discriminatory terms. Condition seven requires that royalties be reasonably related to use. This is another non-discriminatory condition assuring that smaller firms adopting the standard will get unit royalty cost roughly equal to larger firms and finally condition eight applies to grantbacks. It is generally consistent with EC policy on grantbacks for licensing in general and could be made identical without changing the thrust of the restriction.
Now consider the six restrictions of concern about licensing terms discussed in the previous section. The first two: setting prices or quantities for products produced under the standard are clearly, and should be, forbidden. Exclusive licences of either technology to the pool or of pool licences is forbidden by conditions 5 and 6. While there often is a field of use defined for the pool and the licences in the pool in order to restrict the scope of the standard and the licences associated with it, the pool cannot grant exclusive licences based upon field of use or discriminate on terms based upon field of use. This is also forbidden under conditions 5 and6. The last restriction on grantbacks is covered as well, as we have discussed. The compliments versus substitutes issue has been clearly addressed as well.
The problem of invalid patents is present for standard setting as it is for all other licensing situations. Therefore, all the restrictions of concern in licensing agreements are forbidden for patent pools associated with standards. This is because of the basic nature, rationale for, and objectives of, industry standards. The sixth type of restriction, grantbacks, can be dealt with in a manner consistent with general EC and US licensing policy.
Creating efficient standards
The question of the setting of a royalty rate and the level of the royalty rate depends on what standard is chosen and the cost of the technology required to support it, but it also will be determined by the process by which the standard is chosen, the process by which the pool technology is chosen, and by whom the standard setting process and formation of the patent pool is run. It is this process, and not the eight conditions prescribed above, that is currently of greatest concern to both business and competition authorities, and it is this area where there are the most unresolved competition issues.
Competition authorities naturally want an effective standard setting process to develop and implement a cost-effective standard with an efficiently designed patent pool. However, competition authorities are also worried that the collaboration coupled with the communication that is needed to do this may facilitate both current and future collusion among producers. They also have concerns that a powerful member of the organizing group will get control of the process and direct it in such a way that the design choice favours its own technology and plays to its own technical and business strengths in a way that disadvantages other technology suppliers, raises the cost of the pooled technology, and puts other producers under the standard at a disadvantage. Thus, by raising the cost of the pooled technology and by weakening competition among the firms using the standard this firm subverts the standard in a way that can lead to higher prices and reduced consumer welfare.
These concerns are legitimate, but the response of the antitrust authorities to remedy these problems may have created other equally serious problems. Because antitrust authorities have taken a tough stand against any communication related to prices and output among competitors in the past, firms and organisations involved in the standard setting process have shied away from the kinds of communication required to design and select a standard in a rational way. A standard is like a product, one cannot design it on the basis of technical performance characteristics alone. There must be a conscious trade off between technical features and price. The objective should be to achieve a cost-effective design of the standard. This requires more than technical experts specifying a design and then assembling the IP rights required to support that design.
There must be an interactive process where the technical designers can develop alternative technical designs and specifications and then cost them out. This means that the designers need to know the price of the technologies they are incorporating. Further, if a design is too expensive, there needs to be a process whereby the team managing the standard setting process can go to a particular IP owner or group and negotiate a lower royalty rate to reduce costs. Alternative designs with lower price tags need to be considered. In order to know what is an acceptable price range for the pool license, the designers need to talk to the firms that will produce under the standard and learn something about at what price they will be willing to commit to producing products based on the standard. This is all common commercial practice in the design and production of products. It serves the consumer because the producers want to offer the consumer the best combination of product features and price. Unfortunately, much of this process is absent or truncated in the standard setting process as it exists today. This is caused by the concern and perception, whether or not correct, that communication of this type involving competitors would draw the wrath of the competition authorities.
Another feature of most commercial transactions is that neither buyers or sellers have to commit to selling or buying without knowing the terms, at least within some limits, on which they will have to buy a product or sell inputs to the production process. In the standard setting process today, firms are asked to commit technology to the pool at fair and reasonable royalty rates and to commit to the standard before knowing the price of the pool licence and all the other terms that may go with it. For example, if a buyer has a patent dispute with a supplier of technology to the pool regarding IP that is unrelated to the pool, can that IP owner that has licensed to the pool unilaterally withdraw its licence to the buyer in the dispute, thus making it impossible for the firm that adopted the standard to produce under it? Without taking a position on whether the latter should be allowed, no firm should have to commit to an arrangement in which the terms of the deal are as unclear. Perhaps terms can be defined only within ranges, but this is often sufficient to allow firms to make an informed choice.
The difficulty of asking firms to commit to buy or sell without a good idea of the price has caused a number of problems in the context of standard setting. First, in the EU it has precipitated legal problems. In the case concerning the ETSI IPR Undertaking, the EC Commission stated:
"The "license by default system". ... an undertaking pursuant to which IPR holders are deprived of their freedom to decide whether or not to grant licenses on their existing and future technology is restrictive of competition: it amounts to a mutual renunciation of gaining competitive advantages thanks to technical efforts and thereby deprives the participants of the incentive to develop new technologies. ... (Dolmans 2002, p15).
In addition, some expert observers believe that the withholding of information about patents that bear on a standard, as was the case with Rambus and Dell, was in part a response to not wanting to commit up front to licensing technology for a royalty rate which was unknown. This is in addition to the incentive created by the IP owner being in a stronger bargaining position with regard to royalty negotiations after the standard is adopted as opposed to before, when there may be a realistic opportunity to design around that IP. However, the response of the antitrust authorities in the Dell and Rambus cases has made it clear that this conduct is unacceptable and will not be tolerated.
Thus, firms involved in the standard setting process appear now to want to make sure that they reveal all possibly relevant patents so that they can have them included and earn royalties. This and the growth in the number of patents that might be needed for a proposed standard means that a large number of patents may be candidates for a pool. This raises several problems and an opportunity. On the one hand, more patents have to be evaluated, although this larger initial set may offer alternatives for the design of the standard if some of them are substitutes. On the other hand, with potentially large numbers of patents in a pool there is the inevitable problem that if even a relatively modest royalty is required for each, this total may make any proposed standard unacceptably expensive. A process should be developed for the standard-setting process that can deal with large numbers of patents that are candidates for the pool. That process should be able to both design a standard and negotiate royalties that will make the standard a viable economic alternative.
Unfortunately, there is no single institutional model of how to achieve this that will be appropriate in all cases. Hundreds, if not thousands, of product standards might be under consideration at any time. These standard setting efforts range from the large, highly visible standards that involve SSOs to consortia of firms that come together to develop a standard to a few firms who get together to develop a standard for interoperability. Such efforts may or may not involve the formation of a patent pool, although the larger, more comprehensive standards often do. What this means is that one approach will not necessarily fit all situations.
Several things appear to be needed to make the standard setting process more effective as a way of bringing interoperable products to consumers at competitive prices. First, the logic of product design requires a process whereby technical cost and demand information is available to the standard design team. Standards that are purely based on technical considerations are not likely to be optimal from a producer’s point of view or from the perspective of enhancing consumer welfare. Cost is clearly critical and tradeoffs need to be considered. A process that allows a sufficient information exchange and up front negotiation is essential to rational standard setting and the choice of the essential technology to support. There seems to be a growing consensus among competition authorities, lawyers, economists and business people who deal with the development of standards and patent pools that this needs to happen. Our discussions with these groups suggest that there is no full-blown model of how this should occur. However, there is agreement that there will almost certainly have to be a variety of approaches to accommodate different circumstances in which standards get set, and patent pools are created to assemble the supporting technology.
What this suggests is that competition authorities should make clear to the business community that they will look favourably on efforts to create rational standards and associated patent pools that involve the provision of necessary information and negotiation prior to the adoption of a standard or the formation of a patent pool. The presumption should be that if the process and information is reasonably related and necessary to the process of rational product design, then it will not be challenged by the antitrust authorities. It probably will take some experimentation to determine what will work and what seems inevitably to lead to competitive problems. The competition authorities may have to be proactive in promoting change in this area because our impression is that standard setting organizations and businesses have for years had the current practice ingrained in their thinking. In fact, someone coming from other than the competition community might ask "How in the world did we get to the present irrational process of designing standards and assembling the IP required to support them?"
On the other hand, the competition authorities should not give the business community free rein to use the opportunity to experiment with better ways to develop standards as an excuse to create imaginative schemes to lessen competition. What competition authorities need to make clear is that they encourage experimentation in this area and will not challenge arrangements and processes of ex ante communication and bargaining that can improve the process, but that they will challenge blatantly anticompetitive conduct and that they will also challenge schemes where there is clear evidence of anticompetitive intent.
There are a number of safeguards that will greatly lessen the chances for abuse. To illustrate how a new model for standard setting might work, let us consider the case of setting a major industry standard that would involve SSOs and that would also have some kind of governance structure housed in a permanent organization that would review periodically the status of the standard and patents in the pool. This governance body and its management should also be able to respond to changes in circumstances or major concerns among its membership about the operation of the standard. What follows is not a set of proposed requirements for standard setting. That would contradict our recommendation for an experimental approach to standard setting. Rather, it is a suggested approach that we believe has a number of features that will make the standard setting process more effective and at the same time much less subject to competitive abuse.
First of all, it is essential that the process be open to all interested firms that may want to adopt the standard and produce and sell goods and services that conform to that standard as well as to firms that have IP that is a candidate for inclusion in the supporting patent pool, and, obviously, firms who may do both. The existence of the standard setting effort should be well publicised through the appropriate industry channels. Second, the governing mechanism should contain representatives from all important groups, and some independent members as well, along the lines of those pools in the aircraft and automobile industries discussed earlier. There will be obvious conflicts of interest among groups on some issues such as the royalty rate for individual technologies and the total price of the licences for the pooled technology. At the same time, all groups have an incentive to compromise in order to make the standard a successful commercial reality. It is important for the integrity of the process and for insuring that one group does not commandeer the process for their own purposes that no one group controls the process.
Third, and probably the most important feature for the new process would be an expanded SSO or some other management group, made up either exclusively or mostly of outside experts, that would do the primary work required by the standard setting process. This group would report to the governing board, and with input from the members would design the standard, evaluate the alternative technical solutions available, cost out the initial design, and be in charge of redesign and negotiations over royalties in an effort to get the total price of the technology package as low as possible.
Getting to a cost-effective standard that will facilitate production and competition by participating firms in a new expanded product market is the object of setting such a standard. What differentiates such standard setting from a large joint venture is that the process is open; it is designed to create an opportunity for all firms, and the money to be made comes from the expanded opportunity to produce and sell goods in a new market, not from control of the standard setting process. This contrasts with a joint venture which in general will be exclusive and where the clear objective is to develop products that will enhance the competitiveness and profitability of its limited membership. For an open standard to serve its open membership and the interests of the consumer well it must be designed to be cost effective.
That requires that cost be minimized for whatever package of technical characteristics is selected, regardless of which technology is chosen. This makes the independence of the standard setting team extremely important.
But there are other benefits of this as well, both from the standpoint of the coherence of the process and from the standpoint of the protection, and therefore the availability, of confidential information from the participants, as well as minimization of the competitive concerns with regard to information collection and use during the standard setting process.
The standard setting management team needs to get a wide variety of information from participants in the standard setting process – information that may be very sensitive and not something those participants would be willing to provide with the knowledge that it would be seen by competitors. For example, a firm might have a candidate technology for the pool on which it has a patent pending but not yet issued. The firm would be willing to license the technology to the pool if the technology were adopted by the standard, but would not want to reveal details on the technology to competitors if it were not to be adopted. Also, the design team needs to get information from future licensees of the pool concerning what they think the cost of producing the good will be given different technical options, what they believe hey would be willing to pay for a licence to support their use of the standard, and what they believe they can charge for different products in the market. All of this is information that competition authorities would just as soon not have discussed on a regular basis by future competitors in the market for the standardized projects. This can be avoided if such communication is between the independent staff and participants rather than between participants.
Another task in which independence is important is in negotiating licences for the pool and in designing the standard around IP, where the owners are not willing to offer a price that makes the pool as competitive as it could be. This could mean serious negotiation with some of the major firms involved in the standard setting process.
The standard setting organization we are describing here is not the typical SSO in existence today, and it needs both business/economic expertise as well as technical expertise specific to the technology required by the standard. This new type of SSO should be formed specifically for the job at hand. It could be drawn from consultants, retired experts in the industry, academics, and so on, but it needs to have a larger role than many SSOs or technical experts have had in the past. For example, in the past, technical experts typically have been used to assess the essentiality of IP after a standard has been chosen. In the system we are proposing, technical experts would be involved in developing alternative technical designs for the standard and advising on technical alternatives that might be available.
One issue that has received a lot of attention from competition analysts is the problem posed by including invalid patents in a patent pool. Invalid patents are no more or less a problem in this context than they are in general. One suggestion has been to use the technical experts associated with the standard setting process to evaluate the validity of patents proposed to the pool. This would add considerably to the time and cost required by the technical management and as one industry observer pointed out, it would not solve the problem. It is unlikely that the owner of the patent would agree with the experts conclusion that the patent was not valid, and the pool would still face infringement litigation if it infringed upon this patent and did not include it in the pool. The dilemma is that as long as patent granting bodies grant some invalid patents, and as long as the only way to settle the issue is expensive time-consuming litigation, there is going to be a problem. This problem is not one that can be solved by evaluation unless it is backed by litigation. In many cases it may, from a business perspective, be more advantageous to pay some royalty rather than incur the costs and possible risks of hold ups associated with litigation.
Obviously, this type of standard setting exercise would require resources from the participants. It is desirable that these resources be drawn widely from the standard setting group in order to insure the independence of the technical management staff. With this type of organizational structure all of the information necessary for the rational design of a standard can be obtained while maintaining the confidentiality of the participants’ information and not requiring competitors and potential competitors to share and widely discuss sensitive information.
This model was developed as an ideal to foster discussion, debate, and perhaps the trial of this model as part of the process of experimentation. What industry representatives are seeking is much more modest; such as, "could we ask, as part of the standard setting process, that the potential providers of technology commit to providing that technology to the pool at some price?" This seems entirely reasonable from a competition prospective, and our conversations with past and present regulators leads us to believe that they would not have a problem with this. However, it shows how wary the business community and SSOs are of doing anything that would run afoul of the antitrust authorities. This is not benefiting the ultimate consumer, the economy, or the business community.
While the model set forth was for the setting of a major standard, the same model and principles can be applied on a smaller scale. For example, for a consortium of firms who want to develop a standard and supporting pool, several independent consultants might be hired to perform all the functions of a larger staff in the previous model. However, whatever the model, the ultimate standard and patent pool should be operated according to the eight basic rules, set out earlier, that are generally accepted by competition authorities worldwide and by the business community.
These rules should be the centrepiece of any guidelines for standard setting along with the requirement that the process be open. The use of independent experts to do much of the design and evaluation of the technical and business options for the standard should be encouraged. While at this point we would not make it a requirement that an independent professional group run the standard setting process, we believe that a standard setting activity led or run by one or a small number of companies inevitably creates greater risk that the process will be driven by the competitive interests of those companies, and that the information exchange needed for the rational design of the standard could be used to facilitate collusion. The governance structure therefore should be such that all major groups are represented and, again, outside independent representation would help instil confidence that the process would not be used to advance the interests of one or a few participants at the expense of competition.
In general, participant standard setting should be given more latitude for experimentation, and its use should be encouraged. The expectation should be that, except in the case of blatant anticompetitive behaviour or behaviour where the proven intent was to restrict competition, that if they follow the basic eight rules, and adopt procedures that are designed to implement a rational standard setting process, they will not be challenged by the competition authorities.
Excerpted from pages 83 - 97 of22 April, 2003
Charles River Associates Ltd.8th Floor St. Helens 1 Undershaft London EC3A 8EE