Licensing of Standard Essential Patents (SEPs): Hold-up, reverse hold-up and ex-ante negotiation

Program Director / Faculty Fellow, RIETI

Technologies protected by standard essential patents (SEPs) are reflected in an industry standard under the condition that any rights holder makes the commitment to licensing such patents on fair, reasonable and non-discriminatory (FRAND) terms. However, this licensing process has come under scrutiny, as numerous disputes centering on licensing terms have occurred in recent years. Such disputes may underlie the publication of the Guide to Licensing Negotiations Involving Standard Essential Patents by the Japan Patent Office on June 5, 2018 (Note 1). This column offers brief explanations on the following three major issues in the licensing of SEPs, namely hold-up, reverse hold-up and ex-ante negotiations.


Hold-up is a situation in which only after a standard implementer has made investment into a business, the existence of a SEP is known, and the rights holder demands exorbitant royalties, to which the implementer is forced to comply. The reason why the implementer is forced to accommodate such demand is that it has already incurred sunk cost by investing in the business, and if the rights holder can threaten the implementer by an injunction on the grounds of patent infringements, the implementer faces the risk of not being able to utilize his investment already made. For an example, if investments of 10 billion yen were made by an implementer for generating the revenues of 11 billion yen, the total royalties would have been limited to the amount of the profit of one billion yen or less when licensing negotiations had been conducted prior to the investment. However, conducting negotiations after investments would only guarantee that the total royalties would be limited to the amount of the revenue of 11 billion yen or less, which may exceed the business profit, thereby exposing the implementer to the risk of not being able to recover his investment.

Standards setting organizations are well aware of such risks of SEPs, therefore they only adopt the technology of the companies that have made commitments to licensing SEPs on FRAND terms, as a component of a standard technology.

Nevertheless, unless there is a patent pool that covers the entire spectrum of SEPs, the royalty rates of SEPs are rarely disclosed before the actual licensing negotiations. As a result, it would appear that it is possible for SEP holders to demand large royalties to its implementers, but such demands are only possible only when the courts unconditionally agree to issuing an injunction at the request of the patent holder, which is practically the legal condition for the hold-up. Conversely, if there is no possibility of an injunction, it gives rise to the problem of the "reverse hold-up," explained below.

Reverse hold-up or hold-out

Reverse hold-up (or hold-out) is a situation in which the rights holder cannot receive royalty income because the implementer refuses to engage in a licensing negotiation. Many experts point out that in recent years, the problem of reverse hold-up by implementers has become an even more serious problem than the hold-up by SEP holders.

To illustrate this problem of a reverse hold-up, let us examine the case of a SEP holder, which is a company dedicated to R&D. Under a standard licensing negotiation, this company's R&D investments have already become sunk costs at the time of the licensing negotiations. This is because, normally, negotiations are conducted after the invention is generated and often after the invention is made public and its patent right is established (Note 2). Additionally, because the standard is disclosed, and the rights holder has made the commitment to licensing the SEP on FRAND terms, the implementer can use the SEP at any time it wishes.

Under such circumstances, if there is no threat of injunction from the rights holder, there is little incentive for the implementer to promptly conclude the licensing negotiations with the rights holder. The implementer can even enhance its profit by demanding the decrease of licensing fee by prolonging the negotiation. Furthermore, if the patent becomes invalidated, the implementer will no longer need to pay the licensing fees. On the other hand, the rights holder cannot take back the right of the said implementer to use the technology solely on the grounds of unsuccessful negotiations; and moreover, as the R&D investments are already sunk costs and there is no other way of securing returns on these investments than concluding the licensing agreement. Consequently, the right holder would potentially be forced to lower the licensing fees. Under such circumstances, the negotiation process will become stalled, and even if they are concluded, the royalty the right holder receives can become very low, preventing the patentee to make adequate return from its investment.

In order to address these issues, a penalty on such implementer who refuses to engage in licensing negotiations in good faith would be necessary. One measure is to permit the SEP holder to seek an injunction against such firm. Consequently, there are a number of court cases where, while injunctions are not permitted against such willing licensees, they are permitted against unwilling licensees.

Ex-ante negotiations and incentives

The problems of hold-up and reverse hold-up (or hold-out) stem from the fact that royalties are subject to the variations of bargaining powers in ex-post negotiations. One step to prevent this is to adopt the framework of ex-ante negotiations. In an ex-ante negotiation, royalties, as appropriate incentive for innovation investments, are set in advance, before the sunk investments. This concept of ex-ante negotiation is being widely used in the United States as hypothetical negotiations between the willing licensee and the willing licensor, to determine the amount of damages.

We can confirm that if we assume that the licensing fee will be determined through negotiations by the implementer prior to its investment (hypothetical ex-ante negotiations), then it will generate appropriate incentive for the implementer's investment. If the implementer had conducted licensing negotiations prior to executing investments, the royalties will be set within the amount of expected profits to be generated from the use of the standard. The implementer can choose not to execute the investment, if the higher amount is presented. Consequently, if there is a clear established rule that the royalty fulfilling reasonable licensing terms is the royalty resulting from such an ex-ante negotiations, then it would generate an appropriate incentive for investment by the implementer to use the standards and alleviate the problem of hold-up.

Some believe that ex-ante negotiations should be set even earlier to the point when the alternatives for the standard exist than the point when the standard had been determined. This is because, if the value of the standard were determined by network externality through its wide use (but not the standard technology per se), licensing negotiations conducted after the standard had been widely used would overvalue the contribution of the standard technology. Moreover, licensing negotiations conducted after the establishment of the standard would not reflect the competition among technical alternatives.

However, if the ex-ante negotiation were set earlier to the point where competition for the standard exists, it would be essential for the negotiating rule to secure appropriate incentive for the R&D of the standard technology. If the new standard technology were an importance source for the scale of network externality, it would be critical to reflect such value of new technology in the royalty in order to ensure the appropriate incentive for developing superior standard technology. Additionally, if the difference of the multiple technology options in value (= the value of the proposed technology adopted—the value of the proposed technology that is next in line) is used as the reasonable royalty value of the adopted standard technology, then when the two proposed technologies are similarly superior, the value of not only the technology that was not adopted but also the technology that was adopted would become zero, thereby minimizing the ex-ante incentive for R&D.

Under the patent system, if several companies simultaneously generate similar invention, the first company that has applied acquires the patent (exclusive right). As for the second company, if some progress is recognized compared to the initial patent, then a further patent is awarded for that portion. If no progress is recognized, no patent is awarded. In other words, even if identical inventions are made, the patent system provides an ex-ante incentive for R&D, as the exclusive right is awarded to one party. While the patent race under such incentive is not necessarily the best system, it has played a major role in motivating R&D. In the case of standards, setting royalties for a new standard in line with its additional technical value compared to the existing standard is consistent with the basic concept of the patent system that motivates technological progress. However, the concept of paying royalties in line with the difference in value between the most superior proposals for the new standard and the next superior proposal seems to contradict the basic concept of the patent system, which provides ex-ante incentive for an R&D.

Therefore, if we were to adopt the framework that sets ex-ante negotiations earlier than the point where the standard is set, we would also need to think about the incentives for R&D of standard technology. That is, a standard based innovation requires complementary investments by both the firms developing the standard technology and the firms using the standards. Thus, royalties will need to be determined through ex-ante negotiations that do not contain the elements of hold-ups, and at the same time generate appropriate ex-ante incentive for the R&D for a new standard.

September 18, 2018
  1. ^
  2. ^ However, patent pools are characterized by the granting of a single license at a fixed rate, including those for future patents.

November 12, 2018

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