Thursday, July 10, 2008

Are Royalties Too High in High-Tech? Recent Study Says "No"

Over the past few years, a lot of attention has been paid to the level of royalties that are charged by holders of IP rights, especially when patents are essential to an industry standard. The FTC and the DoJ have been especially active trying to control IP costs among various standardized industries.

Recently, Damien Geradin, professor of Competition Law and Economics at Tilburg University, published a paper titled "What's Wrong With Royalties In High Technology Industries?" to see if something is indeed "askew" with high-tech royalties. At the outset, Geradin reviews 4 hypothetical scenarios to see how differently situated patent holders and market participants are positioned to potentially exploit their holdings:

(1) The essential IP is held by 5 vertically-integrated (VI) firms: in the typical case, the 5 VI firms will cross-license, and no royalty will be exchanged, and the 5 firms compete on the downstream market for the relevant product. Alternately, the firms may charge a royalty and pass the royalty cost down to downstream consumers.

(2) The essential IP is held by 5 VI firms and 5 pure manufacturers need a license to compete downstream: Here, the 5 VI firms will typically grant cross-licenses to each other, but the manufacturers would face a cumulative royalty burden.

(3) The essential IP is held by four vertically-integrated firms plus one pure upstream firm and five pure manufacturers need a license to compete downstream: Since the upstream firm will typically be unwilling to agree on a royalty-free cross license (since the IP will be the upstream firm's main source of revenue), each of the VI firms would face a smaller cumulative royalty burden to the upstream firm, while the manufacturers would face a cumulative royalty to the VI and upstream firms.

(4) The essential IP is held entirely by a pure upstream firm and four vertically-integrated firms and five pure manufacturers need a license to compete downstream: Since the upstream firm holds all the IP, the VI firms and the manufacturers would all be in the same boat.

Geradin analyzes each of these scenarios, and concludes that concerns over IP costs on high-tech standard are overblown - "these concerns often reflect a number of misconceptions and a fair amount of misinformation when it comes to evaluating the royalties that are paid by standard implementers." Geradin concludes:

First, there is a great deal of confusion between the minimum cumulative royalty rate, the maximum cumulative royalty rate and the average cumulative royalty rate that apply to the implementation of a standard. While scholars, policy-makers and industry officials have referred to royalty rates as high as 30% in some sectors, they usually fail to mention that those cumulative rates are not common, but instead apply to implementers that have not technologically contributed to the creation of the standard. Those with essential IP tend pay much lower rates and in some cases do not pay any royalty at all. As we have seen above, it is not illegitimate in itself that firms which did not engage in relevant R&D pay two-digit royalty figures to be entitled to implement the technologies developed by others. Risk should, after all, have its rewards. Thus, relying on the highest cumulative royalty rates (e.g., 30%) paid only by a limited number of industry players to argue that royalty rates are generally too high and that reforms are needed to lower them cannot be taken seriously.

Second, there is no automatic connection between the level of cumulative royalty rates and the prices paid by end consumers. This is because the downstream producers’ ability to pass on such rates depends on a number of market factors, as indicated above. More generally, unless cumulative royalties were extremely high, the prices paid by end consumers are much more likely to be influenced by the degree of downstream competition. Thus, high average cumulative royalty rates may simply arise from the fact there are many players on both upstream and downstream markets, and thus a great deal of competition in the market for the relevant product. As end consumer prices must be the focus on competition authorities, one goal should be to ensure that (efficient) pure manufacturers are not excluded from the downstream market.

Third, pure upstream firms and vertically-integrated firms do not have similar incentives. While vertically-integrated firms compete downstream and can thus have incentives to restrict competition at that level, pure upstream firms have no incentives to reduce downstream competition. Quite the contrary, since royalty rates are their main or only source of revenues, their focus is on increasing downstream output and thereby maximizing royalty payments. Upstream firms not only are lacking incentives to discriminate, but on the contrary may adopt strategies designed to encourage or facilitate entry on the relevant downstream market (for instance, by providing technological support and other forms of relevant assistance to new entrants).

Finally, the reforms that have been proposed to modify the FRAND regime should be based on accurate information and should be evaluated to determine that they will not cause problems that are worse than the alleged diseases they offer to treat. Along these lines, competition authorities should refrain from regulating royalties, a complex task these authorities are not well placed to undertake. Instead, their focus should be to protect and promote downstream competition.

Read/download the paper here.

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