The impact of regulatory events on expected SEP profits

Transcription

1 The impact of regulatory events on expected SEP profits Fiona M. Scott Morton Yale University and NBER PRELIMINARY AND INCOMPLETE ROUGH DRAFT June 2014 Albert Shin provided excellent research assistance.

2 1. Introduction The US high tech sector produces a large number of new patents every year. Convergence of media, computing, and communications functions into small mobile devices have resulted in products that are very complex. Many of the communications and computing products and services most valuable to consumers require a common standard for interoperability. For example, UMTS, or 3G, is a standard incorporated into many mobile handsets that allows those handsets to send signals to, or receive them from, towers with UMTS equipment installed. A standard will embody specific technology, which industry participants all employ, that allows interoperability. The creation of such a standard and the choice of technology to include in it is the responsibility of what is known as a standard setting organization, or SSO. An SSO is comprised of member organizations. Members of an SSO are typically organizations that generate revenue in that industry; membership is voluntary. SSOs typically have established procedures by which they choose a technological path for a new standard. These procedures can take years, as SSO members identify new areas that require standards and assemble working groups to move a standard setting process forward. During this time typically a number of possible technological paths are identified as being feasible choices for the standard, and their owners lobby to have them chosen by the SSO. Ultimately the SSO chooses one technology to employ as the standard. That standard might involve technology in the public domain, or it might involve patented innovations. If the standard cannot be implemented without using (infringing upon) a particular patent, the patent is said to be an SEP. SSOs rules will usually include an Intellectual Property Rights (IPR) policy. Such polices establish what member firms must disclose concerning their IPR and at what point during the standard setting process; IPR policies also specify what licensing obligations members must commit to should they wish their IPR to be included in the standard. A typical restriction requires members to commit to license any IPRs they own that are essential to the standard on Reasonable And Non Discriminatory terms, or Fair, Reasonable, And Non Discriminatory terms (collectively, F/RAND terms). One problem with these commitments is that SSOs typically specify very little as to the meaning of fair or reasonable. This leads to different interpretations by licensors and licensees. Not surprisingly, there are frequently disputes among different parties about what a reasonable royalty might be for a particular portfolio of intellectual property. It is important that the SSO constrain SEP prices because of the substantial market power necessarily enjoyed by the owner of an SEP in a successful standard. Moreover, this market power is achieved through the joint action of SSO members that might otherwise be in competing for consumers to adopt their separate technologies. This joint action is often acceptable for society because it trades off

3 technology competition among SSO members for quicker adoption, less risk, and economies of scale in a successful standard. The risk to society that the F/RAND commitment is designed to prevent is that once a standard is in place, an SEP owner can use its resulting market power to engage in hold up. Hold up occurs when licensees have invested in the standard by making the product, installing useful infrastructure, building production capacity, and, generally, investing in complementary assets of various kinds. At this point the SEP owner approaches such firms with an onerous licensing demand. Assuming the patent is indeed essential and valid, the firm s product must practice the patent in order to be interoperable. The licensee is in a poor bargaining position because the next best option is to re build the factories and infrastructure to conform to a different standard (and get others to join in that project), which is often prohibitively expensive. In such a bargaining setting, unmodified by FRAND, the SEP owner can obtain payment far in excess of the value of the technology alone, and appropriate the profits due to the later complementary investments of others. This is hold up. Such behavior raises licensing costs in the industry, distorts markets for innovation and investment, and discourages adoption of standards. In theory, F/RAND commitments prevent these inefficient outcomes by constraining IPR owners to charge reasonable royalties commensurate with the value of the technology before it was included in a standard. The flaw in the current process is that the method for resolving a dispute over what constitutes a reasonable royalty is to go to court. In the United States, parties in patent trials may request a jury, amplifying the uncertainty and risk already inherent in litigation. Along with whole product royalties, exclusion orders, and other techniques for requesting large sums in court, the patent owner can threaten to place a very large dollar amount in front of the jury. This encourages the licensee to settle for an amount in excess of the reasonable rate. In other words, the current processes for resolving disputes on standard essential patents allow the hold up problem to persist. 2. Events Courts, regulators, and competition authorities have recognized that this problem has existed for many years. Arguably SSOs were best positioned to solve it. The root cause of anticompetitive hold up is the ambiguity in the F/RAND commitment, which is under the control of the SSO. SSOs could reform their IPR policies to create more clarity as to what F/RAND constitutes and design alternative, less expensive, methods to determine the level of a F/RAND royalty in the event of a dispute. 1 The difficulty is that some SSO members benefit from the status quo and 1 See Kuhn, Kai-Uwe, Fiona Scott Morton, and Howard Shelanski () Standard Setting Organizations Can Help Solve the Standard Essential Patents Licensing Problem CPI Antitrust Chronicle, March (special issue).

4 would be financially harmed by reform. Since SSOs operate "by consenus, " any such member can block change. To date, no major SSO has reformed its IPR policy concerning SEPs. Given continuing lack of F/RAND clarity and the welfare loss it causes, those parties being harmed have appealed to other organizations for help: courts, competition authorities, and elected authorities. Because of the number of years without SSO reform, and the increasing importance of technological standards, these organizations have had time to take decisions that affect the business model of those who monetize SEPs. These decisions have either determined what F/RAND is directly, or altered the bargaining power the SEP holder has in a private negotiation by constraining or enabling other options. Such changes, whether positive or negative, should affect the long term revenue outlook for a patent holder whose business model includes montetizing SEPs through holdup. In this paper, I study five events that took place in the 2012 period in the United States that arguably affect the profitability of an SEP and therefore should affect the market price of a firm that earns revenue from SEPs. Below I explain why and how each event would be expected to alter the profits from licensing an SEP. A summary of the events is contained in Table 1. ROBART TRIAL: November BAD NEWS for SEP holders: MMI not doing well in the trial The first event of interest is the breach of contract trial between Microsoft and Motorola Mobility (owned by Google by the time of trial). MMI owned SEPs for two standards and requested $400M annually as a reasonable royalty. Microsoft claimed a reasonable royalty was $1.2M. The judge decided he would have to hold a hearing to determine what the correct range of RAND before he could determine if MMI had breached its contract to license on RAND terms. The trial took place in November 2012 from 13 th to the 29th. The event attracted a lot of interest, with the judge exclaiming that this was the most packed he had ever seen the courtroom. It was clear to observers of the trial that it was not going to end well for MMI. However, it is not clear if and when this information would have leaked out. Furthermore, it may have been viewed as news about MMI and perhaps not SEPs in general. This event has our longest window. ROBART DECISION: 25 April, Pacific time, Thursday BAD NEWS for SEP holders: MMI found to be demanding rates far above RAND Judge Robart determined that the RAND rate in this dispute was $1.8M, very close to Microsoft s rate and very far away from MMI s demand of $400M. For a court to determine a FRAND rate was unprecedented at this time. The methodology and the

5 finding served as precedent for any party negotiating a F/RAND rate going forward. The decision was also news that going forward SEP owners would have less leverage; the decision lowered litigation risk, and reduced expectations for what monetary damages a court might award. The judge s decision was released on April 19, ; the parties were given until the release on April 25 th to redact information before decision was made public. CEA REPORT: 4 June, Tuesday 11am Eastern time BAD NEWS FOR SEP HOLDERS: Council of Economic Advisors at the White House releases report critical of patent trolls and proposing executive and legislative actions Though the report was officially released on June 4 th, by June 3 the Morning WSJ had gotten hold of most of the news and released it. 2 The report was highly critical of patent assertion entities (PAEs). The CEA did make an effort to distinguish SEPs from non SEP patents. The report recommended legislation and also listed executive actions to improve the functioning of patent markets and reduce the leverage a patent troll has. For example, the best approach to resolving today s patent troll problem is not to ban firms specialized in patent assertion, but rather to reduce the extent to which legal rules allow patent owners to capture a disproportionate share of returns to investment. The strength of the conclusions in the report and the list of actions may have been news to market participants. USTR VETO: 3 Aug, Saturday BAD NEWS for SEP holders: The President through the US Trade Representative vetoes an ITC exclusion order against Apple products based on SEP infringement Public comments by the Antitrust Division of DOJ and the FTC urged the ITC not to allow an exclusion order for an SEP for the reasons outlined above. 3 The relevant statute the ITC enforces explicitly states that the interest of competition and consumers should be considered. Despite the agency advice, the ITC ruled to exclude Apple products in an SEP dispute. The process is unusual in that the USTR (part of the executive branch) is then permitted to over rule the ITC s decision. This action is not common and is taken when the President feels policy considerations warrant it. The USTR veto on August 3rd and the accompanying explanation indicate that the USTR is likely to overrule the ITC on similar exclusion orders on intellectual ventures president obama mad hell patentholding firms anymore/ is the website that has the more accurate timestamp. 3 comment unitedstates international trade commission concerning certain wirelesscommunication/1206ftcwirelesscom.pdf

6 SEPs in future. 4 It is possible the veto was not fully anticipated by market participants. In addition, the accompanying explanation may have been news that future exclusion orders would be hard to get. HESSE SPEECH: 8 Nov, Friday (in California; Monday Nov 11 is Veterans Day.) GOOD NEWS for SEP holders: The DOJ Deputy Assistant Attorney General for Antitrust who specializes in IP makes a speech indicating the Antitrust Division of USDOJ will not be preventing SEP holdup under the antitrust laws The speech is entitled The Art of Persuasion: Competition Advocacy at the Intersection of Antitrust and Intellectual Property. The Antitrust Division can enforce the competition laws or it can engage in what is known as competition advocacy, which involves educating other agencies and parties on the benefits of competition. This speech emphasizes the DOJ s role in working with SSOs and their members to persuade them to reform and engage in less SEP holdup. Many affected parties were hoping the DOJ would find SEP holdup to violate antitrust laws and file a lawsuit. This speech is a clear indication that the Division will not take that path, but will instead hope that SSOs become more procompetitive. In sum, I believe the Division s competition advocacy, in combination with the efforts of other agencies and the courts, is bringing some much needed guidance on issues posed by standards essential patents that patent owners have committed to license on F/RAND terms. We will continue our work in this area with the hope that the policies governing the use of such standards essential patents will become even more procompetitive. The content of the speech could have been news to market participants given that the President had recently issued a report clearly indicating that his administration would be working against patent abuses, and the leaders of the Antitrust Division are appointed by the President. We expect the selected events both collectively and individually will move stock prices of firms with significant SEP licensing revenue. These regulatory events alter the bargaining power of the SEP owner going forward and therefore alter expected profits. 4

7 Table 1: Summary of events SEP owner Venue Decision SEP expected profit Date MMI trial MMI US court RAND likely low Fall Nov 13 MMI decision MMI US court RAND is low; high demands are not RAND Improve legal branch rules Samsung Executive No exclusion CEA All Executive USTR veto Hesse speech All branch Executive branch orders on SEPs No antitrust enforcement 29, 2012 Fall April 25, Fall June 4, Fall August 3, Rise Nov 8, Window Nov 13 25, 2012 April 25 30, June 3 8, August 3 8, Nov 8 13, 3. Company Selection The companies that were selected were some of the major players in the standards essential patent industry especially the 4G LTE industry. There are many more firms that hold important communications SEPs that we did not include. However, they also have other lines of business, for example, selling devices or operating systems. Because SEP revenue is such a small proportion of revenues for these firms, it would be unlikely that SEP events would move the firm s stock price in a measurable way. Many firms that obtain most of their revenue from patent licensing are not publicly traded (e.g. Intellectual Ventures). We attempted to determine a company s dependency on patent licensing using public reports such as 20 Fs (foreign) or 10 Ks (domestic).

8 Table 2: SEP holdings by firm Company Patent Licensing Revenue Ticker QCOM 7878 ( revenues derived from patent licensing ) IDCC ( patent licensing ) NOK (While the majority of our current revenues are derived from licenses related to Standard Essential Patents, these only represent approximately 15% of our overall portfolio.) ERIC 6.6 (10.6?) (unclear) Motorola p.94 in the 10 K details the patent s Solutions carrying value (276) (MSI) Rambus (RMBS) Our inventions and technology solutions are offered to our customers through either a patent license or a solutions license. Royalties from licenses accounted for 97%, 99% and 96% of our consolidated revenue for the years ended December 31,, 2012 and 2011, respectively. Today, a majority of our revenues are derived from patent licenses, through which we provide our customers a license to use a certain portion of our broad portfolio of patented inventions. Total Revenue (?) 5 $8,696 (million) We anticipated that the firms that more heavily depended on SEP licensing for their revenue would have stock prices that reacted more strongly. Unfortunately we could not obtain comparable and accurate enough data on all our firms to carry out this test. 4. Methodology We conducted a standard event study using the Capital Asset Pricing Model. The CAPM models the return of a security as a constant plus the return of the market 5 These numbers may be more accessible and clear if we spend more time looking for the numbers in the 20 Fs.

9 portfolio scaled by that security s correlation with the market. For any security i, the model is 0 where and are the period t returns on security i and market portfolio respectively. 6 We used stock market return data from the Bloomberg dataset. The S&P High Tech Index (ticker: SPXEWTUP) was used as the market portfolio. First we estimated and using return data ranging from 200 days before the event to the day before (including non trading days). During this 200 day period, any of our other five events were excluded in estimating and. Using the index and estimated coefficients, we are able to calculate expected returns on each day for each stock. We then obtained abnormal returns during the event windows by taking the difference of the predicted and actual returns. Event windows are set at a standard 5 days including the day of the news and 4 days after, with the exception of event 1 which has a 12 day window. The abnormal returns can be expressed as : To obtain additional power, we calculated a total excess return by firm and also a total excess return by event. Standard errors were calculated for event day t = 0 using = / where is the standard deviation of the regression residuals prior to the event. 78 For each firm we performed one tailed t tests on each event to check if these differences were statistically significant from zero. The shadowed boxes have p values less than MacKinlay, A. Craig, Event Studies in Economics and Finance, Journal of Economic Literature March 1997 p MacKinlay, A. Craig, Event Studies in Economics and Finance, Journal of Economic Literature March 1997 p When we estimated and and calculated the standard errors by compiling all events, the prediction period ranged from 200 days before the first event to the last event.

10 Table 3: Abnormal returns ticker event cum ret std dev t stat p value eric eric eric eric eric idcc idcc idcc idcc idcc msi msi msi msi msi nok nok nok nok nok qcom qcom qcom qcom qcom rmbs rmbs rmbs rmbs rmbs Additionally, we performed a one tailed t test to check if these events collectively had an impact on the stock price by adding the absolute values of the abnormal returns.

11 Table 4: Abnormal returns combined across events by firm ticker Cumulativ std dev t stat p_value eric idcc msi nok qcom rmbs Results Most results were insignificant; there are a very few events with significant abnormal returns, as can be seen in Table 3. There is no obvious pattern to the significant events except that Qualcomm has a disproportionate share of them. An event that is significant for both Rambus and InterDigital is the USTR veto ( 7% with p value 0.12 and 9% return with p value 0.04 respectively). Qualcomm responds to the Robart decision ( 7% at p=0.02) and the Hesse Speech events (+4% with p value 0.07) in the expected direction. The increase in the stock price of Qualcomm suggests that it expected antitrust authorities would limit its profits with enforcement action. Running a one tail t test across all events results in Qualcomm significantly responding to the events (p=0.050). Interestingly, Qualcomm both derives a large fraction of its revenue from patent licensing (about one third) but also specializes in communication technology which is almost all embedded in standards. Thus Qualcomm is particularly exposed to policy concerning Standard Essential Patents. The reasons we believe we could not find an empirical impact of most of the events we studied are several. We suspect that SEP licensing revenue is small compared to other licensing revenue for many of these firms. Changes in that segment of revenues may simply be too small to measure given market noise and other news. To the extent that licensing agreements are long term and cover all types of IP (SEP and non SEP) a change in bargaining power would affect only part of the portfolio and would not show up in revenues for several years. Additionally, if a firm in our sample is complying with the spirit of F/RAND in the first place, these events would not constrain it at all, and therefore would not change the forecast of future profits nor the stock price.