The European Commission (EC) recently launched formal antitrust investigations to assess whether Motorola Mobility, Inc. (Motorola) exploited its standard essential patents (SEPs) related to industry standards in wireless networking technologies to distort competition. An SEP is a patent, the rights to which are required for compliance with an industry standard. These investigations highlight the tension between the potential for efficiency gains and the potential for holdup that are both inherent in efforts by standards-setting organizations (SSOs). These issues are intertwined with the strategic incentives generated by network externalities in the rapidly expanding smartphone and wireless networking industries. Firms’ drive to establish their products as leaders in these new markets can generate incentives for anticompetitive strategic behavior, including exploiting patents to raise rivals’ costs or foreclose competition.
The EC will investigate complaints from Apple and Microsoft that Motorola violated commitments to license its SEPs under “fair, reasonable and non-discriminatory” (FRAND) terms and required excessively high royalties for its SEPs. Apple and Microsoft were disturbed because Motorola had brought actions alleging that products, such as the iPhone, iPad and Xbox, that depend on the SEPs for compliance with industry standards had infringed its patents. Motorola has won preliminary rulings from administrative law judges at the U.S. International Trade Commission (ITC) against Apple and Microsoft for infringement of its patents related to cellular network standards and the H.264 video compression standard. Under ITC rules, preliminary rulings are subject to review by the full commission. A final ruling is expected in August 2012 and could result in a ban on imports of the infringing products. Motorola also recently won an injunction against Microsoft in a German court and continues to seek injunctive relief against Apple in Germany.
In high-technology industries, SSOs, such as the Institute of Electrical and Electronics Engineers (IEEE) and the International Telecommunications Union (ITU), enable member firms to agree on common technological standards and thus ensure interoperability among devices, networks, and software. Common standards may create cost savings for firms and reduce switching costs for consumers, which in turn can increase price competition. Once a patent has been chosen as part of the standard, however, the patent holder can “hold up” competitors by refusing to grant licenses or by setting very high royalties. SSOs reduce the likelihood of holdup by adopting rules that require members to identify essential patents and to agree to license their essential patents on FRAND terms. These rules can reduce but may not eliminate the risk of holdup. Since complex technologies often involve multiple interrelated patents and each firm often holds a multitude of complementary patents, the disclosure of essential patents may be imperfect and disputes can arise over which patents are adopted as part of the standard. Since patented technology is novel by definition, it can be difficult to determine a reasonable royalty.
The wireless networking and smartphone industries are particularly susceptible to the exploitation of patents in strategic competition because they are characterized by network externalities. Network externalities exist when the value consumers gain from a product or service increases with the number of users of that product or service, or perhaps related compatible products or services. In the case of wireless connectivity, consumers derive greater benefits from cellular technology if it allows them to connect to more people. In the case of smartphone operating systems, consumers benefit more from a more widely-adopted system because the more users there are, the more likely that manufacturers and software writers will make improved phones and new “apps” that can be used with the system. With network externalities, a single technology or group of compatible technologies may come to dominate the market.
Network externalities drive intense competition in winner-takes-all markets. Compatibility issues in devices, cellular networks and software create a need for standards and the risk of holdup at multiple points of these complementary technologies. Indeed, the EC investigations against Motorola take place amid patent litigation battles among Apple, Google, Microsoft, Motorola, Samsung and others that are competing for dominance in these growing markets. Apple and Microsoft reacted to Motorola’s infringement complaints by filing separate breach-of-contract cases against Motorola for violation of FRAND terms. In coming months, regulators and courts will have to determine whether Motorola has abused its market power from SEPs or merely sought appropriate rewards from its intellectual property.
The threat of holdup also creates an incentive for firms to amass enormous patent portfolios to gain control of SEPs, either to avoid being held up or as a credible threat to hold up other competitors. This amassing of patents is evident in the wireless networking industry. For example, a consortium that includes Apple and Microsoft, as well as Research in Motion, Sony, Ericsson and EMC, will buy over 6,000 patents and applications covering wireless technologies from Nortel Networks for $4.5 billion. Google is preparing to acquire Motorola and its 17,000 plus patents for $12.5 billion. The concentration of large patent portfolios and SEPs in the hands of a few firms could reduce competition.
Antitrust regulators are paying close attention to the potential abuse of market power from SEPs. Besides the Motorola investigation, the EC is also investigating Samsung’s FRAND commitments involving SEPs in 3G mobile telecommunications. U.S. antitrust authorities focused on the possibility of holdup using SEPs in their analysis of the consortium’s bid to buy the Nortel patents. They approved the bid, however, in part because of public statements from Apple and Microsoft that they would not seek injunctions in exercising their SEP rights. Both U.S. and EC antitrust authorities voiced concerns that Google’s acquisition of Motorola would increase market power in wireless networking markets because of the concentration of patents. They found Google’s statement of its SEP licensing commitments to be unclear and were concerned about the potential for abuse. They ultimately decided that the merger in itself would not harm competition and approved the deal, but they promised vigilance on future SEP licensing practices. Developments in the EC investigations of Motorola and in pending litigation will be important in clarifying the antitrust risks involved in using SEPs.