This presentation by Anne Layne-Farrar from Charles River Associates was made during a roundtable discussion on Competition, Intellectual Property and Standard Setting held at the 122nd meeting of the OECD Competition Committee on 17 December 2014. Find out more at http://www.oecd.org/daf/competition/competition-intellectual-property-standard-setting.htm

1. Holdup & Royalty Stacking: Theory & Evidence
Anne Layne-Farrar
Vice President, CRA
OECD Hearing on IP & Standard Setting, December 17, 2014

2. Private and Confidential
The Origins of Patent Holdup Theory
2
• Holdup is a well-known pricing theory extended to patents in the
mid 1990s
• Two conditions are necessary for holdup to exist:
– Asset specific investments (lock-in)
– Ex post action taking advantage of lock-in
• Risk of holdup wherever condition 1 is met; holdup in practice
only where both conditions are met
– Holdup risks throughout the economy
– In standard setting, holdup risk is present for both licensees and patent
holders (reverse holdup)

3. Private and Confidential
The Origins of the Royalty Stacking Theory
3
• Can be thought of as large scale holdup
• But theoretical origins differ - a special application of Cournot’s
Complements:
– Augustin Cournot (1838):
• When input suppliers (e.g., copper and zinc distributors) are not integrated with
the end product maker (e.g., a brass manufacturer), “double marginalization” can
push end product prices higher than those set by an integrated monopolist
• Input suppliers price independently, do not account for one another’s pricing
– Key assumptions:
• Inputs are complementary and used in fixed proportions; cannot substitute
between them or use more of one with less of the other
• Both inputs have outside markets: other uses for copper and zinc beyond the
production of brass

4. Private and Confidential
Holdup & Stacking for Patents – The Literature
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• Both theories were applied to patents in the 1990s
• Started in biotech:
– Kiley (1992) – “dense thickets of patents” “stunting” growth in
biomed/biotech
• And then moved to high-tech interoperability standards
– Shapiro (2001) - “[t]he need to navigate the patent thicket and holdup is
especially pronounced in industries such as telecommunications and
computing in which formal standard-setting is a core part of bringing new
technologies to market.”
– Lemley & Shapiro (2007) – redesign “extremely costly” or “impossible” for
multi-component standards-compliant products

5. Private and Confidential
Court & Agency Positions: Holdup
5
• For specific rates, most have followed an “ex ante” approach:
– Holdup measured against estimated rate SEP holder could have achieved
in arm’s length negotiations during development of standard, while
technologies competing for inclusion
• Ex. Judge Koh in GPNE v. Apple
• Agencies have used potential for holdup to make policy:
– EC Motorola and Google decisions prohibit those firms from seeking an
injunction for infringement of SEPs
• A credible threat of injunction could provide the opportunity for holdup
• But outside of Germany, only 1 injunction ever granted on a SEP, and it was
revoked

6. Private and Confidential
Court & Agency Positions: Stacking
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• Stacking has been a theoretical argument thus far
– Stacking measured by applying offered rate at issue to all SEP holders
• Ex. Judge Robart (Microsoft v. Motorola) and Judge Holderman (In Re Innovatio)
• Only two courts required case-specific evidence for a stack:
– Judge Davis in Ericsson v. D-Link (District Court, Texas): “The best word to
describe Defendants’ royalty stacking argument is theoretical. …given the
opportunity to present evidence of an actual stack on 802.11n essential
products, Defendants came up empty.”
– Likewise Administrative Law Judge Essex at ITC (in case involving 3G and
4G) noted he would require proof of actual stack

7. Private and Confidential
The Problem with Theoretical Estimates of a Stack
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• Assume a standard with 5 SEP holders, 1 patent each
– Aggregate value for all 5 patents contributed to standard is “10”
– Patent 1 contributes value of 5, patent 2 contributes 2, patents 3 – 5
contribute 1 each
• Suppose patent holder 1 licenses first and seeks fee of 5
– This rate is FRAND, but licensee challenges it as “excessive”
– Judge “tests” the rate by multiplying the offer of 5 by 5 known SEP holders,
determining that the rate “implies” a stack of 25 > known value 10
• Suppose patent holder 5 seeks license first and asks for 2
– This rate is not FRAND and licensee challenges it as “excessive”
– Judge “tests” the rate by multiplying fee of 2 by 5 SEP holders, determining
that the rate “implies” an aggregate rate of 10 = known value 10
• So method yields false positives and false negatives

8. Private and Confidential
Evidence of Holdup & Royalty Stacking
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• No empirical studies on holdup
– Though some ad hoc claims for historical products, like radio and aviation
– Careful historical studies debunk the 1900s examples
• Evidence on stacking is anecdotal and incomplete:
– Lemley & Shapiro (2007): argue a stack exists in 3G mobile telecom based
solely on patent and patent holder counts
– Armstrong, Mueller, & Syrett (2014): argue a stack exists for smartphones
based on “a ‘bottom-up’ analysis of royalties
• Relies on public data, so uses announced maximum rates
• Take opening offers published in court cases (e.g. Microsoft v. Motorola)
• Ignore patent exhaustion, patent pools, and cross-licensing

9. Private and Confidential
Indirect Market Evidence
9
• Majority of SEP licenses concluded without litigation
• If royalty stacking were a systemic problem in standards
industries, we should see evidence of:
– Stagnant or increasing end product prices
– Stagnant product innovation, so few new model releases
– Lack of entry, as patent licensing forms a barrier
• No evidence of any one of these effects has emerged in mobile
and WiFi (the top cited standards for potential stacks), despite
15 years of history
– Handset prices continue to fall, even compared to the CPI
– Industry concentration measures (HHI) continue to fall as well
• (See Malinson online data posts, 2013)
– Entry has been considerable: Apple (2007), Samsung (2010), Huawei
(2010), Xiaomi (2010)

10. Private and Confidential
Why the Disconnect Between Theory and
Evidence?
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• Stacking theory has withstood the test of time, but based on
assumptions:
– Inputs are complements, so this assumption is met
– Many SEPs do not have (meaningful) outside applications, so this
assumption frequently not met
• Other differences with Cournot complements problem:
– Zinc and copper producers operate independently
– But SEP holders cooperate with one another and other SDO members, so
less likely to price independently
– And the cooperation frequently extends over time (repeat play)
• In short, market mechanisms mitigate risks of holdup and royalty
stacking

11. Private and Confidential
Market Mechanisms Curtailing Royalty Stacking
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• Patent enforcement is costly and time consuming
– Only 1% of all patents granted are ever enforced
– For FRAND disputes, only see cases where stakes are big
• Some SEP holders choose not to enforce b/c they are focused
on downstream product markets
• Cross licensing is common in many standardized industries
– This prevents stacking among vertically integrated entities
• Patent pools are another option
– Pool rights into single license, lowers transaction costs and tends to keep
rates lower
• Patent valuation methods that tie royalties paid to value received
necessarily prevent holdup and stacking

12. Private and Confidential
Limitations on Market Mechanisms
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• No single mechanism is a silver bullet
– Cross licensing does not help when SEP holders are not vertically
integrated
– Patent pooling is hard to achieve when interests among rights holders are
diverse
• Layne-Farrar & Lerner (2011) corroborated this in empirical analysis of patent
pools
– Firms with symmetric patent portfolios (size, measures of value) more likely to join patent
pool
– Vertically integrated firms more likely to join pool (symmetric strategies and incentives)
• But taken as a whole, market mechanisms appear to work well
in most instances

13. Private and Confidential
Concluding Remarks
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• Patent valuation is key:
– When done well, holdup not incorporated
– SEP valuations account for other SEP holders
– FRAND defined in relation to the value contribution of the SEPs at hand to
the standard and products compliant with standard
• But
– 1) Values are relative: use matters
– 2) Value cannot be based on a simplistic “if everyone else charged the
same rate” approach