Proposed European SEP Regulation Would Undermine Efficiency, Innovation and Economic Growth

The European Commission (EC) is at it again, threatening to regulate standard essential patent (SEP) licensing relationships, despite a lack of evidence that such regulation is appropriate. As summarized by IP Watchdog’s Steve Brachmann:

“The [EC’s SEP regulatory] framework would hand over a great deal of regulatory power to the European Union Intellectual Property Office (EUIPO) to intervene in commercial licensing disputes over telecommunications and other standardized technologies that are covered by SEPs. Those responsibilities would be housed in newly-established “competence center” at the EUIPO charged with maintaining a register of SEPs, conducting so-called “essentiality checks” of patents registered with the EUIPO as SEPs, and administering fair, reasonable and non-discriminatory (FRAND) royalty rates as determined by the agency in lieu of litigation.”

The economically harmful nature of this regulatory framework (and its prior draft) has been highlighted by many expert commentators, including contributors to IPWatchdog (see here, here, and here) and Truth on the Market (see here and here).

Fortunately, the EC’s proposed regulatory framework is still open for public comments. Mindful of that opportunity, on May 23, Mercatus Center scholars Christine McDaniel, Satya Marar, and I filed a public interest submission with the European Commission, focusing on three sets of problems posed by the framework. I summarize our submission below.

Mercatus Scholars’ Submission to the EC

I. The framework is unneeded and imposes costs and resource-intensive responsibilities on an agency that lacks competence.

Negotiations around rates of return for SEP licenses are highly complicated. They are characterized by complex incentives, they typically involve technologically and commercially sophisticated parties, and they can be dramatically and adversely affected by even minor shifts in policy. As such, shifts in policy with regard to SEP licensing should be based on empirical data and a critical appraisal of the likely and potential consequences for global patent markets and innovation-driven industries.

Theoretical claims have been made that the current SEP regime lets holders “hold up” innovation and reduce new technology uptake by levying excessive fees above the incremental contribution of their innovation to finished products. As we show, however, empirical research runs counter to this hypothesis.

Conversely, regulatory and judicial interventions that undermine the negotiating power of SEP holders could increase incentives for innovation “holdout” by implementers. This phenomenon reduces innovation and harms consumers by discouraging the asset-specific investment needed to develop new SEPs.

European Union courts have already attempted to balance incentives for “holdup” and “holdout.” For instance, in Huawei v. ZTE, the Court of Justice of the European Union (CJEU) ruled that SEP holders and implementers must negotiate royalties in good faith before they can seek judicial remedies. Judicial institutions, such as the CJEU and lower courts, possess competence, expertise, and experience in adjudicating these complex disputes and balancing the interests of opposing stakeholders.

By contrast, the proposed regulatory framework imposes such responsibilities on the European Union Intellectual Property Office (EUIPO), a body that “will never have the competency in patents,” according to its own executive director. It would afford the EUIPO the ability to make contrary determinations to judicial organs that possess greater expertise and experience in the area, and that are hence more likely to make sound judgments with regard to policy. It follows that a regulatory innovation that empowers the EUIPO to make SEP determinations is more likely to foster erroneous, economically inefficient decisions.

II. The framework is likely to undermine SEP royalty negotiations and to increase uncertainty and the risk of holdup and holdout.

The framework would allow holders and implementers to apply for nonbinding determinations of FRAND royalty rates for SEPs from third-party arbitrators, and it would authorize them to ask the EUIPO to recommend an aggregate royalty rate if they cannot ultimately agree on one. It also would introduce a nonbinding system of sampling checks to determine the essentiality of an SEP to the underlying standard to be conducted by independent evaluators selected by the EC in accordance with a methodology to be determined by the EC.

The nonbinding royalty rates and essentiality determinations could be adopted by courts adjudicating FRAND disputes across many countries. This would undermine interjurisdictional competition, whereby jurisdictions compete to become the “forum of choice” for disputes, thus encouraging them to adopt novel approaches that facilitate commerce and innovation because the most preferable and trusted forums would attract more parties. Alternatively, courts may ignore nonbinding recommendations, resulting in expensive and time-consuming albeit inconsequential procedures that add no meaningful benefit to negotiations. This could allow implementers to delay the negotiation process or delay payment of royalties as part of holdout.

There are also concerns posed by the proposed regulatory framework’s suggested approach for making nonbinding royalty recommendations. It proposes the establishment of a cumulative standard for royalties, as well as for calculated shares of royalties for each SEP holder, through a top-down approach. Such an approach can be unreliable, misleading, and inaccurate because it relies on patent counting, which treats each patent in a standard as having equal value, even though the economic value of an SEP and the degree of importance that its contribution has to the standard can vary significantly. This approach may also result in aggregate royalty rates being published for SEPs that are eventually found to be invalid by courts.

The top-down approach to producing a single recommended aggregate royalty rate for SEPs also disregards the flexibility and adaptability enabled by private negotiation, whereby the chance of holdup through royalty stacking is averted through tailored contract mechanisms, such as reducing the royalty rate if the licensed SEP is combined with another SEP held by the same owner. The proposal’s approach rejects efficient tailored royalty structures. Such structures  increase the incentives of implementers (licensees) to efficiently invest in deploying the invention and to share information about the invention’s use with the SEP holder or inventor. They may also reduce cost to ultimate consumers.

What’s more, delays, increased costs, and the undermining of property rights enforcement would also arise from the proposed regulatory framework’s stipulation that SEP holders cannot assert their rights against infringers in any national court within the EU or at the Unified Patent Court until after the EUIPO has produced its nonbinding royalty rate recommendation—a process that would take an estimated nine months, regardless of deliberate holdout or evident or egregious intellectual property infringements.

Furthermore, delays are also likely to be even greater than the estimates postulated by the EC in its proposed regulatory framework. Former senior U.S. Government officials note that the framework “appears to permit an unlimited number of stakeholders to participate in each aggregate royalty determination, yet contemplates that the aggregate royalty determinations will be able to occur within six months from the appointment of a conciliator tasked with mediating the aggregate royalty discussions.” Thus, they conclude that the proposed framework “appears to vastly underestimate how difficult it will be to reach consensus on the determinations tasked to the EUIPO.”

In addition, the framework’s singling out of prices also leaves behind other equally important aspects of SEP royalty negotiations, such as conditions for terminating the license, cross-licensing terms, jurisdiction for dispute resolution, and penalties or remedies under the contract. The importance of these terms to the suitability of finalized royalty agreements between holders and implementers means that even if the proposed framework were to result in more consistent pricing across SEP royalty agreements, it would still fail to provide like-to-like comparisons.

III. The framework undermines European and Western innovation, property rights, SEP values, and international competitiveness, while benefiting the geopolitical and economic objectives of rival jurisdictions, and, in particular, China.

The EC’s proposal to intervene in private SEP royalty and essentiality negotiations between implementers and inventors of new technologies sends encouraging signals to foreign jurisdictions that are contemplating similar policies. For instance, the Chinese government and its courts have long sought to favor the interests of Chinese implementers, especially when it comes to foreign- or EU- and U.S.-owned SEPs. They have attempted to overrule global FRAND royalty rate disputes to favor their own implementer firms. In many cases, these firms (for example, Huawei) have close links to the Chinese government and benefit from substantial government subsidies that allow them to undercut foreign competitors for critical and often politically sensitive infrastructure projects in other nations.

The proposal is also likely to embolden U.S. legislators and regulators who are contemplating similar ideas, especially if they have incentives to retaliate with similar policies should the EC regulatory framework undermine the value of U.S.-owned SEPs. For instance, U.S. legislators have already proposed the Standard Essential Royalty Act (SERA), which would overrule the FRAND rate determinations of overseas jurisdictions that pertain to U.S. patents.

The net effect is likely to be the undermining of SEP values, rights, investment, and innovation across western nations.

Adoption of the proposal would also encourage politicized oversight and favor state-owned or subsidized firms in the countries that implement regulations, instituting top-down calculation or limitation of FRAND royalty rates for SEP licenses. Importantly, rival jurisdictions to the European Union, such as China, may resort to similar reforms that impose binding rather than nonbinding royalty rates for European SEPs, thus undermining European innovation and property rights to an even greater degree while raising the relative competitive position of state-backed foreign firms. This would undermine the existing geopolitical and trade policy objectives of the European Union.

Bad Policy

In sum, the May 23 Mercatus public policy submission explains that the EC’s proposed SEP regulatory framework represents bad public policy in many respects:

• It would increase rather than reduce incentives for anti-innovation and anti-consumer holdup and holdout.
• It addresses a problem whose existence lacks empirical support
• It would introduce unnecessary delays, complexity, and commercial uncertainty into SEP royalty negotiations.
• It would significantly increase bureaucratic costs and costs to SEP investors in such disputes.
• It would override competencies of existing courts while conferring responsibilities on bureaucratic agencies that lack such competence and experience.
• It would undermine innovation, investment, output, and the value of and ability to enforce intellectual property rights in European and western countries.
• It would undermine the EU’s geopolitical and trade policy objectives with regard to rival jurisdictions such as China.

For all of these reasons, the EC would be well advised to withdraw its proposed SEP regulatory framework.