With the impending advent of 5G cellular technology in a wide variety of devices, the licensing of standard essential patents ("SEPs") will become more important than ever. Companies wishing to incorporate 5G technology into their products, however, may be surprised to find that owners of cellular SEPs are often unwilling to license their patents to the companies that make the cellular components, such as modem chips. Instead, holders of SEPs related to cellular standards (2G, 3G, 4G LTE, 5G NR) have often demanded royalty payments from the companies that incorporate the cellular components into end user devices. For example, SEP holders have demanded royalties from automakers that incorporate cellular components into their vehicles, while refusing to license the manufacturers of the cellular components themselves. SEP holders have argued, among other things, that it is more efficient to license the companies that make end-user devices. In reality, however, this strategy is designed primarily to justify demands for higher royalty payments and results in numerous inefficiencies. These inefficiencies will increase substantially in the context of 5G SEP licensing, given the wide variety of devices that are expected to incorporate 5G technology.

Background

5G standards vastly improve the speed and reliability of cellular communications. Among other applications, 5G technology will facilitate machine-to-machine communications, which is a key building block of the Internet of Things ("IoT"). 5G technology will also be deployed in industrial equipment to enhance reliable communications and inter-operability among equipment. We thus anticipate an explosion in the use of cellular communications, as more companies will find ways to incorporate 5G functionality into a vast array of devices that did not previously use cellular technology.

As with prior cellular standards, companies have identified a large number of patents—comprising more than 20,000 patent families—that are allegedly essential to practicing the 5G standards. According to IPlytics, companies that have declared a substantial number of 5G SEP families include Huawei Technologies (3,325), Samsung Electronics (2,846), LG Electronics (2,463), Nokia (2,308), ZTE (2,204), Ericsson (1,423), and Qualcomm (1,330).

Owners of patents essential to the cellular standards, including 5G standards, have committed to licensing those patents on fair, reasonable, and non-discriminatory ("FRAND") terms. For example, SEP holders belonging to the Alliance for Telecommunications Industry Solutions (ATIS) in the United States have agreed that "essential patent claim(s) will be made available to applicants desiring to utilize the license for the purpose of implementing the standard … under reasonable terms and conditions that are demonstrably free from any unfair discrimination." Courts have held that such FRAND commitments require SEP holders to license their patents "to all comers on terms that are reasonable and nondiscriminatory" (e.g., Microsoft Corp v. Motorola, 696 F.3d 872, 876 (9th Cir. 2012)).

Despite obligations to license all comers on FRAND terms, some SEP owners have taken the position in connection with cellular SEPs that they will not grant licenses to companies that make cellular components, such as modem chips, that implement the standards. Instead, these SEP owners plan to offer licenses only to the companies that manufacture end-user devices incorporating cellular technology, such as cell phones, cars, refrigerators, industrial equipment, and other devices on the IoT.

The motivation for demanding licenses from companies that manufacture end-user devices is fairly obvious. SEP holders would like to base royalties on the relatively higher prices of the end products. For example, a 5% royalty based on the price of a cell phone will be far greater than a 5% royalty on the lower price of the cell phone's 5G modem chip. Similarly, seeking a $15 royalty for a car with cellular capabilities appears less exorbitant than seeking a $15 royalty for the modem chip that will be incorporated into the car (e.g., Avanci's pricing).

To demand lucrative royalties on end-user devices, SEP holders must also refrain from licensing the companies that make the modem chips implementing the cellular standards. Under the doctrine of "patent exhaustion," if a SEP holder licenses the manufacturer of modem chips, the SEP holder would likely forgo the ability to also demand royalties from manufacturers of the end-user devices that incorporate those chips (e.g., Quanta Computer v. LG Electronics, 553 U.S. 617 (2008)).

Refusing to grant licenses to chip vendors that wish to implement the 5G standards, however, arguably violates both FRAND commitments and competition laws. In an effort to justify these potential violations, SEP holders have argued, among other things, that it is more efficient—and therefore pro-competitive—to focus licensing efforts on end-user devices. In particular, some SEP holders and organizations, including IP Europe and the Fair Standards Alliance, have asserted that chip vendors practice fewer cellular SEPs than the companies that make end-user devices. As such, SEP holders allegedly face a choice between licensing an entire portfolio to one company (the manufacturer of the end user device) or, instead, sub-dividing the SEP portfolio and negotiating multiple licenses with companies at various levels in the supply chain.

Licensing End Products Is Not More Efficient

Licensing companies that make 5G-enabled end-user devices is not more efficient than licensing the companies that manufacture the components that implement the 5G standards.  To the contrary, licensing 5G end-user devices will result in at least three significant inefficiencies.

1. Licensing End User Devices Increases Transaction Costs Related to Indemnification

The basic premise of the efficiency arguments advanced by some SEP holders is that one license negotiation is more efficient than two (or more) negotiations. This assertion, however, fails to account for the substantial transaction costs the manufacturer of the end-user device incurs in negotiating indemnification from suppliers.

If the manufacturer of the end-user device "fronts" the entire royalty for 5G implementation, the manufacturer must then negotiate the proper apportionment of the royalty with 5G chipmakers and, potentially, the suppliers of other 5G components. Under these circumstances, licensing only end-user devices does not eliminate negotiations or create a more efficient licensing model. Rather, the owners of the SEPs merely shift the burden to the manufacturer of the end-user device to apportion the royalties.

This burden-shifting is particularly inefficient in markets where there are multiple layers in the supply chain. For example, in the automotive industry, chip vendors may sell modem chips to companies that manufacture network access devices ("NADs"). The NADs are then sold to companies that make telematics control units ("TCUs"). The telematics companies then sell the TCUs to automakers. Demanding 5G SEP royalties from an automaker thus triggers a chain reaction of indemnification demands, with additional transaction costs associated with each layer.

Shifting the burden of apportioning royalties to the manufacturer of end-user devices is also inefficient because the manufacturer often lacks transparency into a SEP holder's patent portfolio, and the ability to determine what portion of the SEPs in the portfolio are attributable to components rather than end-user devices. For example, an automaker may not be in a position to attribute portions of a SEP portfolio among 5G modem chips, NADs, TCUs, and cars.  Because a SEP holder has the most information about its portfolio, the SEP holder is in the best position to efficiently allocate royalty demands between components and end-user devices.

2. Licensing End-User Devices Is Inefficient Due to Information Asymmetry

Manufacturers of end-user devices will also often lack the technical expertise to assess and value a 5G SEP portfolio. This is because 5G standards are predominately implemented in 5G modem chips. As such, the chipmakers are in the best position to determine: (i) whether an alleged SEP is truly essential to practicing the 5G standards and, if so, (ii) the significance of the contribution of that SEP to the standards. By contrast, the manufacturer of an end-user device—such as a refrigerator that uses 5G to communicate on the IoT—may have little, if any, expertise in 5G standards. Such information asymmetry—where SEP licensors have a substantial informational advantage over licensees—is a characteristic of inefficient markets.

3. Licensing End-User Devices Creates Uncertainty and the Potential for Duplicative Royalties

The argument that it is more efficient to license end-user devices is also suspect because it relies on an assumption that suppliers of 5G components will not need to negotiate SEP licenses. At any moment, however, SEP holders could alter their policies and seek to license chipmakers, thus eliminating any efficiency theoretically gained in licensing end-user devices.  For example, upon expiration of an SEP—and after collecting royalties from the manufacturers of end-user devices—SEP holders could decide to seek royalties from suppliers of 5G components. Alternatively, a SEP holder could sell expired (or soon-to-expire) patents to a patent assertion entity that will seek to license the SEPs to previously unlicensed companies. The potential for future, and arguably duplicative, liability results in uncertainty for component suppliers. Again, such uncertainty is a sign of economic inefficiency.

Tips for Manufacturers of 5G Devices

As implementation of the 5G standards intensifies, companies introducing 5G-compatible devices are likely to find that they are the target of an increasing number of licensing demands from SEP holders. For the most part, companies will not be able to solve the inefficiencies arising from this licensing model. There are, however, a few steps that companies can take to prepare for the onslaught of 5G licensing demands.

First, wherever possible, companies should clearly and comprehensively set forth the indemnification responsibilities of the suppliers of 5G components, such as the companies that make 5G modem chips. Such negotiations, however, may be difficult given the current concentration in the market for 5G modem chips.

Second, manufacturers of end-user devices should insist that 5G royalties are calculated based on the cost of the "smallest saleable unit" that practices the SEPs—normally the 5G modem chips.

Third, companies that receive a SEP licensing demand should request supporting documentation from the SEP holder, including a list of alleged SEPs and claim charts showing why the alleged SEPs are essential to practicing the 5G standard. Requesting such information is reasonable given the well-documented problem of companies mis-identifying patents as standards essential.

Fourth, companies should be willing to test royalty rates in litigation and arbitration. While SEP holders will often argue that royalty rates are "well-established," the few cases where FRAND rates have been litigated have almost universally resulted in rates that are lower than those the SEP holders were demanding prior to litigation. Moreover, SEP holders that have refused to license component suppliers will face substantial litigation risk arising from the apparent violation of their FRAND commitments.

Conclusion

Despite arguments from SEP holders to the contrary, it is not more efficient to license cellular SEPs only to manufacturers of end-user devices. Instead, it would be more efficient and practical to grant licenses to the companies that make cellular components. Otherwise, consumers are likely to pay a higher price due to inefficiencies in licensing SEPs that result in inflated royalties, duplicative royalties, and unapportioned royalties. This will be particularly true in the context of the vast array of products that are expected to incorporate 5G technologies.

Robert M. Masters and Jonathan R. DeFosse are partners in Sheppard Mullin's Intellectual Property practice group. Satoshi Matsuo is the General Manager, IPF Department, IPD at Hitachi Ltd.

The views expressed in this article belong to the authors alone. This article does not purport to reflect the opinions or views of Hitachi, Ltd. or Sheppard Mullin Richter & Hampton LLP.