FRAND royalty rates, where are we going?

The establishment of a proper method to determine FRAND royalty rates is a highly debated issue for a variety of reasons. Standard Essential Patents (SEPs) have a huge impact on the market of technologies and, despite very useful for interoperability, fixation of pro-competitive and pro-consumer prices (Broadcom v. Qualcomm) they do have side effects. The most relevant are:

1. Lock-in effect for potential licensees, generated by the gap between the investment for SEP and the potential failure of its effective implementation in a company.

2. Patent ambush, i.e. the partial disclosure of useful SEP information to the SSO, so that competitors will be hindered in adopting the SEP technology and SSO will be confused as to the choice of right technology to license under FRAND terms.

FRAND licenses commit the holder of the SEP to waive the right to refuse licensing to third parties while having the burden of essentiality for future products to be developed. Moreover FRAND rates must be reasonable. Hence, to what extent is a FRAND rate reasonable as to the value of the royalties to be paid by the licensee?

In order to determine the proper FRAND rate U.S. availed of both theoretical and practical approaches elaborated by courts. Among the theoretical methods, the most relevant are:

1. The twenty-five per cent rule of thumb: it consists of spreading an equal royalty rate of twenty-five per cent on every SEP license and licensee.

2. The ex-ante auctioning model: a model public tender for potential SEP holders. All the patent holders have to disclose their potential rates per unit in order to produce the final product at the lower cost.

The third and most reliable method for determining royalties is by applying the Georgia Pacific Factors (GPFs). And this is a method created and used by courts. It consists of fifteen standard rules that were deemed to operate in the determination of the lower bound of the damages awarded for patent infringement. Because damages and FRAND rates are both calculated through royalties, it is accepted to consider GPFs as a reliable source.

UK Courts adopt a straightforward method, also based on the comparison between damages awarded for past license infringements in the calculation for on-going FRAND rates. In the court ruling Vring v. ZTE, two methods of setting royalties were elaborated but not enacted.

Regardless of the quality of the invention, the alternatives on the market and, in general without taking into account the characteristics of the industry, the 25% rule of thumb is inadequate to reasonably represent FRAND rates. Despite the inaccuracy of the rule, it was widely used in the U.S., as demonstrated in Standard Manufacturing Co. Inc. v. U.S. and the Uniloc case. Whether it might be considered as a viable way of simplifying royalties, it is necessary to look at the present situation, where a 2.25 % royalty in the case Motorola v. Microsoft, was considered too high. The necessity of lower royalty rates is significant as to the essentiality of a multiplicity of patents that need to be guarded against disproportioned and anti-competitive licensing practices (as demonstrated in the UK case, Vringo).

The ex-ante auctioning model is deemed to lead to anticompetitive concerted practices. It also leads to vague licensing terms and to situations that do not reflect real world negotiations. It may also affect the good faith of Standard Setting Organizations (SSOs). SSOs might be encouraged to push for the lowest possible fee per unit to the detriment of the SEP holder's investments. Ex-ante auctioning method was used "in re rambus" using the arm's length principle which describes a virtual situation in which the price is determined by potential negotiations that would have occurred before the standardization and, again, it did not reflect real world negotiations.

The case Microsoft Corp. v. Motorola Inc. demonstrates the significant link between allocation of damages and determination of FRAND rates. In particular the rate, as the damage, must be reasonable and based on the royalties that the licensee or the infringer would have paid. In order to implement those principles into law the Court have used fifteen criteria to determine damages in the previous case Georgia Pacific v. U.S. plywood corp. The most relevant factors highlighted by Court are 1, 2, 6, 8, 10, 12 and 15. The interesting feature about the application of the GPFs is that they have been interpreted as to fit the concept of FRAND rate. They can be grouped as follows:

1. The value and profitability of the patent, taking into account the royalty due for the standard. In particular how the standard will increase the value of the licensee's products and their commercial success in comparison with the foreseeability of hold-ups, royalty stacking, and objective reasonable compensation of the SEP's holder (6, 8, 10, 15).

2. Royalty stacking, i.e. more patents pending on a single product that would increase prices for final consumers of telecommunication technologies (15).

3. Licensing agreements of patent pools, third parties and other marketing indicators. In particular, the comparison between normal patent fees and the royalties given under FRAND rates, the waiver to not refuse licensing, together with licensing under Reasonable terms (1, 2, 12).

As the damage allocation for infringement is insufficient to assess a viable determination of FRAND rates, the court in Motorola focused upon patent pools fee calculation, taking into account side effects of this model on the value of the patent.

The elaboration of the final model of calculation of FRAND royalties takes into account the relationship between the value acquired by joining a patent pool and the value of abstention from the latter. Thereby it identifies a coefficient, which can be a viable guide for the determination of the proper FRAND rate. As a consequence, Georgia Pacific factors represent the infrastructure on which the whole method is built and must be aided through adjustments in the final phase of the calculation if the coefficient is equal one.

The UK model can be widely shaped around Georgia Pacific Factors. The case Nokia OYj v. IPCom GmbH demonstrates the strict relationship between the award of damages following a patent infringement and the calculation of FRAND rates. With due consideration to the differences between these two models, they are both based on royalty adjustments on the value of the damage or SEP. Hence, also the UK system is compatible with Georgia Pacific Factors.

In Vringo v. ZTE the calculation of the FRAND rate was widely based on the court ruling. Two methods were assessed:

1. If the claimant wins the trial, the damage or royalty will be calculated. As a consequence, if the patent is held to be valid and infringed, then the FRAND rate decided within the preliminary issue will take effect.

2.     The court could determine the rate (and terms) which would be arrived at as the outcome of a notional negotiation between a willing licensor and a licensee willing to negotiate without fighting a trial on the merits about the underlying rights.

In conclusion, the fifteen GPFs are objective. As a consequence they can be shaped and adapted on a case-by-case basis. This method may limit the lack of precision of the theoretical methods like the twenty five per cent rule of thumb or the ex-ante auctioning model. In particular GPFs can fix the lacunas in those methods of calculation that consider the value of the patent independently from the FRAND rate involved.

The opportunity cost of FRAND rates is calculated through mathematical terms that do not take into account the evolution of markets as well as alternative technologies, investments in new-born standards and prominent changes. Nevertheless market is getting more uniform than ten years ago. In fact the possibility of concerted practices that lead to anti-competitive conducts is more likely to occur. In light of the above it might not be a case that patent-pool criteria were used in order to calculate FRAND rates as patent-pools are multilateral practices and SEP's licensing is bi or unilateral. This is a sign the market is heavily changing from the twenty five per cent rule of thumb to the coefficient equal to one that explains a total equilibrium of interests.