7.3.1 Varieties of Holdup
Despite the centrality of the concept of “holdup,” it does not have any precise definition – or rather, it has a variety of precise definitions. In the broadest sense, holdup is used to mean any mechanism by which a patentee can extract a royalty that is higher than a fair benchmark royalty. In a slightly narrower sense holdup is used to mean any mechanism by which the royalty that might be demanded by a patentee ex post is higher than that which might be demanded ex ante, where ex ante is defined variously as the time at which infringement began, or sunk costs were incurred by the implementer, or, in the SEP context, as the time at which the standard was adopted.
Focusing on the ex ante/ex post version of holdup, Siebrasse & Cotter (Reference Cotter2017a) note that there are three different mechanisms by which ex post royalties may be higher than ex ante royalties. They refer to these as (1) sunk costs holdup, (2) network value appropriation, and (3) the apportionment problem. These are discussed subsequently in this section. Lemley & Shapiro (Reference Shapiro2007a) provide a very influential model of holdup, which extends the holdup analysis to probabilistic patents. All of these mechanisms are said to be a potential source of excess returns to the patentee. High litigation costs are also said to be another potential source of holdup. However, the effect of the distortion due to litigation costs is ambiguous, as is discussed in Section 6 “Holdout/Reverse Holdup.”
1 Sunk Costs Holdup
Farrell et al. (Reference Farrell, Hayes, Shapiro and Sullivan2007) describe “opportunism” or “holdup” as follows: Holdup can arise, in particular, when one party makes investments specific to a relationship before all the terms and conditions of the relationship are agreed upon.
They provide the following example of holdup in a case where the patented technology costs $40 to implement, exclusive of any royalty, and the best alternative technology costs $50, so that the inherent advantage of the patented technology is $10, and a benchmark reasonable royalty is any amount less than this:
[S]uppose that, of the $40 cost of using the patented technology, $25 was spent before the royalty was negotiated and that this $25 is specific to the patented technology, i.e., would be wasted if the user later decided against adopting that technology. Then, at the time of negotiations, the forward-looking cost of using the patented technology (exclusive of royalty) is $40 – $25 = $15, while the cost of using the unpatented technology remains $50 (the $25 already spent has no value if the user adopts the alternative technology) … [T]he maximum royalty that the user is willing to pay remains the added value of the patented technology, but with the key difference that this amount is now $50 – $15 = $35, or $25 more than in our first calculation. Ex post negotiation increases the user’s willingness to pay for the patented technology because the user finds the alternative relatively less attractive after spending $25 on the patented technology. The patented technology’s ex post advantage … exceeds its inherent advantage … by an amount equal to the user’s $25 investment … The patent holder thus captures a share (proportional to its bargaining skill) of sunk investments by the user.
That is, the fact that the user has made transaction-specific investments prior to negotiating for the right to use the technology means that the patentee can capture part of the user’s sunk costs, in addition to the inherent advantage of the patented technology. (This analysis implicitly assumes that the successful patentee will be granted an injunction.) It is convenient to refer to holdup arising from such transaction-specific investments as “sunk costs holdup” where the transaction specificity is left implicit.
Sunk costs holdup relies centrally on the transaction-specific investment being sunk before any negotiations take place. It does not turn on the product being complex, as it can arise when only one patent covers the product. Nor does it turn on the probabilistic nature of the patent, or on the cost of litigation – in the above example, litigation costs are assumed to be zero.
If sunk costs holdup does occur, it has adverse effects on both patentee and implementer behavior. It allows the patentee to capture more than the value of the invention, thus creating an excessive incentive to invest in patented technologies; and the prospect of being held up increases the ex ante risk to the implementer, thus reducing the attractiveness of investments in products that are potentially subject to sunk costs holdup.
2 Network Effect Appropriation
Another type of holdup, applicable primarily in the context of standards, is referred to by Siebrasse & Cotter (Reference Cotter2017a) as network effect appropriation, which they define as follows:
[N]etwork value appropriation, arises whenever the value of a particular technology increases upon standardization due to the presence of network effects. As with sunk costs holdup, an injunction would enable the patentee to extract a higher royalty ex post than it could have negotiated ex ante, and thus again might be described as resulting in the capture of some of the value of the standard – though in this context, the increase in value is due to network effects and does not depend on the presence of transaction-specific sunk costs.
U.S. courts have consistently held that a reasonable royalty should not reflect “any value added by the standardization of that technology.” On its face this appears to say that a patentee should not be able to capture any value arising from network effects, though as Siebrasse & Cotter (Reference Cotter2017a) point out, courts routinely award damages, including ongoing royalties in lieu of an injunction, in the form of running royalties, which do allow the patentee to capture value arising from network effects.
From a policy perspective, Siebrasse & Cotter (Reference Cotter2017a) argue that allowing the patentee to capture some part of the value of a patented technology that arises due to network effects is desirable from a dynamic efficiency perspective, because it provides the correct incentive to invent, and it is not undesirable from a static efficiency perspective, as it has no adverse effects on implementer incentives. While there are many articles arguing that a patentee should not be able to extract a higher royalty ex post than it could have obtained ex ante, which suggests that the patentee should not be able to capture any value arising from network effects, such articles typically do not distinguish between sunk costs and value arising from network effects. The two often go hand in hand, because adopting a standard and the consequent network effects, is often accompanied by substantial sunk costs. Two exceptions are Swanson & Baumol (Reference Swanson and Baumol2005) and Lee & Melamed (Reference Lee and Melamed2016), which both specifically assert that the patentee should not be able to capture value arising from network effects. However, both treat network effect appropriation equivalently to sunk costs holdup, and they do not offer independent policy justification for not allowing the patentee to capture any of the value arising from network effects. Chao (Reference Chao2016) also takes issue with Siebrasse & Cotter (Reference Cotter2017a) on this point, but his discussion turns on what Siebrasse & Cotter (Reference Cotter2017a) characterize as the distinct problem of apportionment, which is discussed in the next section.
3 The Apportionment Problem
Another type of holdup may arise when a patent claims a relatively minor feature of a complex product. If the patentee can get an injunction that prevents sale of the entire product, it can extract part of the value of the entire product, even though the patented technology contributes little to that value. This point is explored at length by Lemley & Shapiro’s model, which is addressed next.
The apportionment problem, when it exists, has the same adverse incentive effects on patentee and implementer incentives as does sunk costs holdup. It allows the patentee to capture more than the value of the invention, creating an excessive incentive to invest in minor patented technologies. The prospect of being held up in this manner increases the ex ante risk to the implementer, thus reducing the attractiveness of investments in products that are potentially subject to the apportionment problem.
The apportionment problem is exacerbated in the context of a standard. As discussed in more detail below, the excessive royalty that can be extracted by a patentee armed with an injunction is generally capped by the losses that would be suffered while the technology is designed around. This implies that if the technology can quickly and easily be removed or designed around, then the royalty overcharge will be small. However, this is not true in the SEP context because licensing terms of SEPs almost always specify that the SEPs are only licensed for use in the products that comply with the standard. That means that if the technology covered by a SEP could easily be designed around or removed as a technical matter, the product would no longer be compliant with the standard and the other licenses to the truly important SEPs would lapse. This would allow the owner of the unimportant SEP to capture the value of the standard as a whole. It is not enough to design around a SEP technically; instead, the implementer would have to be able to lobby the standards organization to remove the technology in question from the standard. While not necessarily impossible, this will certainly be a very lengthy process. In such a case, the “redesign period” referred to in the discussion below should be interpreted to mean the time needed to get the SEP removed from the standard, rather than the time needed for a technical redesign.
4 Probabilistic Holdup: Lemley & Shapiro Model
Lemley & Shapiro (Reference Shapiro2007a) and Shapiro (Reference Shapiro2010) provide a widely discussed model of holdup. Their model incorporates both sunk costs holdup and the apportionment problem, and additionally addresses the effect of the probabilistic nature of patents; that is, the fact that the validity and scope of granted patents is uncertain until they are litigated. Their model extends the simple sunk costs holdup model in two other respects. First, in the simple sunk costs model the implementer’s option is to license or redesign its product to avoid using the patented technology; Lemley & Shapiro develop a more explicit model of the litigation process in which the implementer may choose to redesign either during the litigation period, or after the end of litigation. Second, in the simple model, the implementer is at risk of being held up for transaction-specific sunk costs that are generally conceptualized as being machinery or other tangible goods. Lemley & Shapiro point out that the implementer is also at risk of being held up for lost profits during the period that its product is being redesigned to avoid infringement. Lemley & Shapiro also focus on redesign costs (sometimes referred to as switching costs), rather than sunk costs. (The relationship between switching costs and sunk costs is discussed below.)
They consider two scenarios: a “surprise” scenario in which the implementer is already selling its product when it learns of the patent, and an “early negotiation” scenario in which negotiations take place before the product is designed. For “ironclad” patents – those that are certainly valid – their model is a variant on the standard sunk costs model of holdup; there is no overcharge when ex ante negotiations are possible, and in the ex post scenario the patentee extracts part of the costs of switching to a noninfringing alternative.
When considering probabilistic patents, Lemley & Shapiro further distinguish between two scenarios. If the patent is relatively weak, it will make more sense for the implementer to refrain from redesigning until after it has lost in litigation, in which case its threat point is determined by the sunk costs plus the lost profits on the entire product during the period of redesign. This is the “Litigate” scenario. On the other hand, if the patent is relatively strong, the implementer’s best negotiating strategy is to threaten to redesign its product during litigation (“Redesign and Litigate”), in which case its threat point is determined by the redesign costs. This means that a weak patent will have a higher relative overcharge because it can extract not just redesign costs, but also lost profits on the entire product during the period of redesign. The overcharge is discounted by the probability of validity, so the absolute overcharge for a weak patent will normally be smaller than for a strong patent covering the same technology.
Lemley & Shapiro show that the probabilistic nature of patents can result in an overcharge even when ex ante negotiations are possible. This is because the implementer’s threat is to avoid using the patented technology entirely, and adopt the best noninfringing alternative instead. This is appropriate for an ironclad patent because it allows the patentee to obtain part of the true value of the invention. The problem is that the implementer’s threat is exactly the same, and so the outcome of the negotiation is exactly the same, even if the patent is potentially invalid. This implies an overcharge, because the royalty should be discounted by the probability of invalidity. The problem, as they put it, is that “the accused infringer has chosen to give up without a fight, effectively agreeing to treat a possibly invalid patent as certainly valid, and so the chance that it would have invalidated the patent will not be reflected in the negotiated royalty.” (Because the overcharge can be extracted even when an ex ante negotiation takes place, it is perhaps not strictly correct to refer to it as “holdup,” which normally implies that a higher royalty can be extracted ex post, than could have been negotiated ex ante.)
To summarize their results:
Scenario 1 – Surprise – “Litigate” strategy
Applicable when patent is weak, redesign costs are high.
Overcharge because patentee can extract lost profits on the entire product during redesign, plus redesign costs, both discounted by probability of validity. Because of the discount the absolute value of the overcharge will be small, but because of the lost profits on the entire product, the percentage overcharge will be large.
Overcharge increases with (a) redesign costs; (b) lost profits during redesign period; and (c) value of the product relative to the value of the invention.
Scenario 2 – Surprise – “Litigate & Redesign” strategy
Applicable when patent is strong, redesign costs are low.
Overcharge because P can extract redesign costs, not discounted.
Percentage overcharge (a) increases with redesign costs, and (b) decreases with probability of validity (i.e., is greater for weak patents).
Scenario 3 – Early Negotiation
Either just like surprise case,
Overcharge because implementer’s threat is not to use the invention with certainty, in which case percentage overcharge decreases with the probability of validity.
Their results do not turn directly on the complex nature of the product, but complex products are likely to be subject to a greater overcharge because they are likely to face Scenario 1, in which a weak patent with relatively little value to the product can nonetheless extract a portion of the value of the entire product.
The adverse economic effects of holdup in Lemley & Shapiro’s model in the surprise scenario are the same as for sunk costs holdup (though the mechanism is somewhat different). The economic effects of probabilistic holdup in the early negotiation scenario are slightly different. Again, the patentee is capturing more than the value of its contribution, which creates an excessive incentive to invest in patenting. But in principle the overcharge will not increase the risk to the implementer, because it knows how much it has to pay ex ante. Nor will it cause the implementer to avoid using the patented technology, because the patentee will not charge so much that the implementer would prefer to use the alternative. It will in principle reduce the implementer’s expected profit, thus creating a distortion in the direction of investments. The degree of the distortion will presumably depend on the market structure.
While this model is well-known and influential for its implications respecting injunctive relief, within the context of remedies, and particularly the withholding of injunctive relief, another implication is that additional effort should be devoted to weeding out weak patents before they are licensed or litigated.
5 Sunk Costs, Switching Costs, and Lock-in
Holdup is sometimes described as involving switching cost, on the view that once one technology is selected, it may be that the cost of switching to the alternative technology is prohibitively expensive. This characterization is used most often in the standards context, where the implementer is said to be “locked in” to the standard once it is chosen, but similar reliance on switching costs as giving rise to holdup is also found in other contexts. This contrasts with the traditional focus of the general economic holdup literature on sunk costs, in which holdup occurs when a party tries to charge a higher price than it would have been able to before those sunk costs were incurred. The puzzle is that sunk costs were necessarily incurred in the past – a party cannot be held up for costs that it has not yet incurred – while “switching costs” on the other hand, imply costs that would take place in the future, after failed negotiations, to switch to an alternative, nonstandard technology.
Cotter et al. (Reference Cotter, Golden, Menell and Schwartz2018) provide a general framework for reconciling concepts of switching costs and sunk costs. They explain that the threat of adopting the next best alternative always disciplines the royalty that can be extracted by the patentee, but the value of both the patented technology and the alternative may change. After costs are sunk, the selected technology is more profitable going forward, because the costs of implementation have already been incurred. So sunk costs holdup can be thought of as representing holdup due to the differential profitability of the selected technology ex ante versus ex post. The differential profitability of the alternative technology represents a separate source of holdup. If the profitability of the alternative technology changes, either because its costs change, or because its revenues change – as when it is not selected to be the standard – the disciplining value of the user’s threat to switch also changes. Switching costs as such, in the sense of the forward-looking cost of implementing the alternative technology, are irrelevant to holdup. If the cost of implementing the alternative technology is the same ex ante or ex post, any amount that could be extracted by the patentee ex post, because the implementer wants to avoid incurring those costs, could also have been extracted ex ante. Implementers become “locked in” to a standard, not because of the costs of switching, but because the expected revenue from the alternative technology will have been reduced once the original technology was adopted as part of the standard.
This has practical implications. Lemley & Shapiro (Reference Shapiro2007a) recommend that “the court should evaluate the cost that the infringing firm would have to incur to redesign its product to avoid infringing the patent. If this cost is high relative to the value that the patented technology has added to the infringing firm’s product, no permanent injunction should be issued.” But as Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) point out, the relevant comparison is not the cost of redesign, but the additional cost of adopting the alternative technology ex post as compared with ex ante. Looking only to the cost of redesign risks penalizing “the most valuable patents – precisely, those that are most difficult to circumvent even with full knowledge of the patent.” They note that instead “the policy should indicate that to avoid injunctive relief an infringer must show not only that it is costly to redesign the product in a non-infringing way ex post, but also that it could easily have designed the product in a non-infringing way ex ante if only it had been aware of [the patent holder’s] patent (which again emphasizes the importance of the inadvertent infringement assumption).” The point made by Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) is consistent with the analysis provided by Cotter et al. (Reference Cotter, Golden, Menell and Schwartz2018); it is not the cost of switching to the alternative that is important, but whether the cost of switching has changed.
6 Caveats and Critiques
A number of theoretical critiques of the holdup model are discussed in the remainder of this section. While most of these points were directed at Lemley & Shapiro’s model in particular, several are applicable to sunk costs holdup and the apportionment problem generally, as their model is in some respects simply the best known elaboration of these general problems. There is another general critique of the holdup argument, to the effect that even though holdup might be a problem in theory, there are a number of countervailing mechanisms, such as the potential for ex ante bargaining, that mean it is not a substantial problem in practice. These arguments are discussed subsequently in Section 4 “Mitigating Mechanisms.” The empirical evidence is reviewed in Section 8 “Empirical Evidence.”
b) Litigation Costs and Weak Patents
Golden (Reference Golden2007) argues that “for a weak infringement case for which θ is sufficiently near 0, litigation costs can again be expected to dominate the potential infringer’s concerns.” The intuition is that the implementer’s exposure due to holdup is discounted by probability of validity, while litigation costs, under the U.S. rule (each party bears its own costs), are not. Therefore, for weak patents litigation costs will dominate (so long as litigation costs are roughly independent of the strength of the patent). Recall that in Lemley & Shapiro’s analysis, the overcharge factor – the overcharge as a percentage of the benchmark royalty – is very high for weak patents, but the absolute amount of the overcharge may be relatively small, because the overcharge due to holdup is discounted by the probability of validity, and so is small for a weak patent. One response to this might be that litigation costs drop out of Lemley & Shapiro’s formal model, as they are assumed to be symmetric. But costs are not necessarily symmetric in fact, and in practice negotiations might be driven by litigation costs. In that case, the transaction cost analysis discussed below in Section 7.5.2 would be more pertinent to the potential for holdup (or holdout).
c) Patents Central to the Product
Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) say that “[w]hen the infringed patent is essential to the innovative product … the logic of the holdup problem changes significantly.” They note that “for holdup to be a significant threat not only must the patent cover a single component of a larger complex product, but that one component must be minor (ν small) and a stand-alone product excluding ν must have been commercially and technically feasible ex ante.” This is not really a challenge to Lemley & Shapiro’s central point, which is precisely that holdup is especially severe for a complex product with a minor patented feature. It is true that when the patent is more central to the product, the holdup in Lemley & Shapiro’s ex post scenario is driven by sunk costs (as opposed to the loss of profits from the entire product being held off the market), and in the “early negotiation” case it is driven by the probabilistic nature of the patent. The question then is whether Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) show that these factors do not result in holdup for essential patents. The answer is no.
To support their argument they give the example of the case in which the patentee and the implementer both have technology that is strictly complementary in the sense that both technologies are necessary to the success of the product. The proper benchmark in such a case is the royalty the parties would have negotiated prior to either sinking costs into their respective technologies. If the parties negotiate ex post, and the patentee can obtain an injunction in the case of breakdown, their positions will not have changed much, since either will be able to block the project. The difference is that both will have sunk R&D costs into their technologies, but if those costs are similar, and the bargaining power does not change, then the ex post bargain will be the same as the ex ante bargain.
This argument is evidently directed primarily at the “early negotiation” scenario in which sunk costs are the driver of holdup. While their example is correct so far as it goes, it is not strong support for their proposition. First, there is no particular reason to believe that the R&D costs will generally be similar. An example that approximates the situation they describe is NTP v. Research in Motion. NTP had a patent on a technology essential to RIM’s principal products, but RIM had spent substantial amounts implementing the technology, and there is no reason to believe that NTP’s patent, which was a paper invention never commercialized by the inventor or NTP, had been particularly costly to develop. No doubt there are cases where the patentee’s R&D costs are roughly on the order of the implementer’s technology-specific sunk costs, but that does not justify granting an injunction in cases like NTP v. RIM, simply on the basis that NTP’s technology was essential to the product. The centrality of the patented technology to the product is not a good proxy for symmetry of investment between the patentee and implementer.
Secondly, the example of an implementer that has a strictly complementary technology is largely unrelated to the scenario in which the infringed patent is essential to the innovative product. Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) argue that Lemley & Shapiro are wrong to focus on the implementer’s sunk costs without considering the costs that the patentee had sunk into R&D. This reflects the “true ex ante” argument discussed above. But how does this generalize to a case in which the patentee has a patent that is essential to the product? They say that “since both firms must sink a specific investment before they can contract, both may actually be subject to a hold up problem.” But that is true only if the patentee has no option other than to negotiate with that particular implementer. This emerges from their model because they assume that the patentee and the implementer have strictly complementary technologies. But that is a special case. As Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) themselves point out, if the implementer market is perfectly competitive the patentee will be able to extract the full value of the invention. At the other extreme, if there is a monopsony in the implementer market, then the implementer does indeed have additional leverage, on standard monopsony pricing theory. But that arises from the structure of the implementer market, not because the patented technology is essential or otherwise to the product. In effect, Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) are arguing that when the patentee has a patent that is essential to the product and the implementer is a monopsonist, the patentee should be entitled to an injunction in order to counterbalance that monopsony power. But recall that they are arguing that holdup is only significant when the patent covers a single component of a larger complex product, and one component is minor, and a stand-alone product was commercially and technically feasible ex ante, or, more generally, the infringed patent is essential to the innovative product. It is not clear how any of these are related to a case in which the implementer has monopsony power, whether because it has complementary technology, or for some other reason.
A model of parties with proprietary rights to complementary technologies is entirely appropriate when discussing multiple patentees with patents reading on a product sold by an implementer, as is notoriously the case with SEPs. This does indeed raise a difficult question of how to allocate royalties, and whether any party should be entitled to an injunction. It is not uncommon that one of those patentees with complementary technology might also be an implementer, but it does not follow that all patentees should be entitled to injunctions against all implementers in order to give them appropriate leverage against a particular implementer that happens to also be a patentee.
d) Market Structure
The Lemley & Shapiro model assumes a patentee negotiating with a single downstream firm, and while they make some observations respecting markets with multiple downstream firms, they acknowledge that a thorough discussion is beyond the scope of their article. Elhauge (Reference Elhauge2008) argues that “there is every reason to think the results are totally different if the downstream market is competitive.” The gist of his argument seems to be that in a competitive market the patentee will extract the entire expected value of the invention, and so there cannot be any overcharge because an implementer would prefer to exit the market entirely. He then argues that the royalty the patentee can charge is constrained to no more than νθ:
Assuming damages are properly set at ν times Xi [number of units sold] for any infringing seller, the expected damages for infringement will be νθXi. Thus, if the patent owner tried to charge a royalty of more than νθ, all the downstream firms would decline the license because they would incur expected losses from agreeing.
That is not correct, or at least it is overly simplistic. This statement is addressed at the early negotiation scenario, and in that case the implementer’s threat point is to use the best noninfringing alternative. Suppose the value of the patent is reflected in a cost saving, and the patentee negotiates with one implementer. If the other implementers do not take a license, their costs will be higher than that of the licensee by ν (by the definition of ν). The licensee can afford to pay more than νθ and still undercut the other implementers. On the other hand, if the patentee makes the same offer to all implementers simultaneously, we are essentially back in the scenario of a single downstream firm. If the patentee demands more than ν, they will all prefer to use the alternative, but otherwise they will be willing to pay more than νθ, because they all have to pay the same amount, and so all will earn the same zero economic return that is standard in a competitive market.
Elhauge then says, “[e]ven if the downstream firms had already used the technology inadvertently, the patent owner could not charge more than νθ by trying to holdup the downstream firm for some of the costs of redesign, because if it did so the downstream firm would expect to lose money and prefer to exit the market.” If the implementers were not aware of the patent ex ante, their expected profit in the competitive market would be zero, and all the cost saving of the technology would be passed on to consumers. If the patentee then emerges, any positive royalty, even a royalty of less than νθ, will result in the implementers losing money, unless they raise their prices. If the patentee approaches only one implementer, it will lose money if it takes a license and none of the others do, so it will exit the market and the patentee will get no revenue. If the patentee then approaches another implementer, this process will continue until there are so few implementers left that the market is no longer competitive and the remaining implementer can take a license and raise its prices. In effect, by selectively licensing, the patentee will have transformed a perfectly competitive downstream market into an imperfectly competitive market. There may be circumstances in which that strategy would be rational, but on this route we are no longer dealing with a competitive market, so Elhauge’s point would not apply. Alternatively, the patentee might license all implementers at the same royalty, in which case each implementer could raise its price by the same amount without losing its market. Each implementer would be willing to pay the royalty and stay in the market (strictly, it is indifferent between leaving and staying in the market, but that was also true under ex ante negotiations) until the royalty is so high it would be preferable to redesign the product – which is the standard point that the implementer can be held up for the redesign costs. The implementers would lose money, but they would lose less money than if they left the market; that is the standard sunk costs holdup result. The only real difference is that the implementers cannot be held up for lost economic profits during the redesign phase, because they are not making any economic profits. But if they are making accounting profits because they have fixed costs, they could be held up for those profits.
This is not to say that the market structure does not affect Lemley & Shapiro’s result at all; a thorough discussion is beyond the scope of this chapter, just as it was beyond the scope of Lemley & Shapiro’s original article. But Elhauge’s critique does not give any reason to think that the basic result does not extend to different market structures.
e) Elastic Demand
Elhauge (Reference Elhauge2008) asserts “the Lemley–Shapiro model would overstate royalties because it assumes inelastic output.” It is true that inelastic demand is a dubious assumption. It is also true that the overcharge will be less when demand increases in the presence of the patented technology; the intuition is that when the patented technology adds value to the product, the implementer will normally get value from the patent in the form of increased sales, as well as in the form of a higher price, and the increased profit from increased sales partially offsets the overcharge. But Lemley & Shapiro’s model does not turn on the assumption of inelastic output. That is merely an example they provide by way of illustration. Elasticity of demand will mitigate the overcharge problem to some degree, but it seems unlikely to provide significant relief in the context of complex products, where thousands of patents may read on a single product.
7 Competing Patentees
Lemley & Shapiro state that their analysis is limited to situations in which the patentee’s predominant commercial interest in bringing a patent infringement case is to obtain licensing revenues and it does not apply to settings in which the patent holder practices the invention and seeks to use the patent to exclude a competitor from the market in order to preserve its profit margins. Golden (Reference Golden2007) and Elhauge (Reference Elhauge2008) argue that Lemley & Shapiro’s distinction is not compelling, and they indicate that even patentees seeking only royalties should be entitled to injunctive relief.
The holdup problem faced by the implementer is just as severe whether the patentee competes in the market or not. The key question is therefore whether there are countervailing considerations that imply that a patentee who competes in the market should be granted injunctive relief notwithstanding these holdup concerns.
Lemley & Shapiro’s model considers only reasonable royalty damages, and they equivocate when considering a patent holder who would be entitled to lost profit damages, saying in cases involving “significant” lost profits, they favor a presumption that the patent holder will be granted a permanent injunction,
perhaps with a stay to allow the infringing firm to redesign its product. The presumptive right to a permanent injunction in these cases is justified in part for reasons of equity and in part because of the grave difficulties associated with calculating and awarding lost profits on an ongoing basis.
This suggests that the costs of denying injunctive relief, in the form of increased error costs of damages calculation, are greater in the context of lost profits. There are two problems with this argument.
First, while it is no doubt difficult to assess lost profits on an ongoing basis, it is not easy to accurately quantify a reasonable royalty either. It is not evident that lost profit calculations are generally so much more difficult than reasonable royalty calculations, particularly in the case of complex products, as to justify a sharp distinction between cases in which the patentee is seeking lost profits and those in which it is not.
Moreover, Golden (Reference Golden2007) points out that the difficulty in assessing reasonable royalty damages has traditionally been one of the principal rationales for granting permanent injunctions. Lemley & Shapiro respond by noting that “all that is required for reasonable royalties to play their role in guiding parties to a negotiated settlement in the shadow of litigation is that they be unbiased.” But this same point undermines their distinction between reasonable royalties and lost profits; even if lost profits are more difficult to assess, that makes no difference so long as the errors are unbiased. The important question is not whether lost profit damages are more difficult to assess than reasonable royalties, but whether they are more likely to be biased against the patentee. There is no obvious reason why errors in lost profit damages are less likely to be unbiased than reasonable royalty damages.
Apart from the relative accuracy of the two types of damages, Elhauge (Reference Elhauge2008), and Denicolò et al. (Reference Denicolò, Geradin, Layne-Farrar and Jorge Padilla2008) suggest that the holdup problem might be worse when the patentee is able to seek lost profit damages because it competes in the downstream market. In that case the patentee may hold up the implementers even more because higher royalties provide it with increased market share in the downstream market, as well as directly benefiting from high royalties itself. In effect, the patentee has increased bargaining power when it competes in the downstream market; when it only licenses, the royalty is constrained because it will make nothing if the royalties are so high as to unduly restrict sales, but if the patentee competes in the downstream market that constraint is lifted, as the patentee might anticipate capturing those sales itself.
A distinct reason for preferring injunctive relief in the case of a patentee that practices the invention is that in such a case we should expect the patentee to be more efficient, because if the infringer were more efficient than the patentee, the patentee would have been willing to license. Allowing the patentee to exclude the infringer in such circumstances gives the market to the more efficient producer. However, granting an injunction to a nonpracticing patentee should have the same effect, and the patentee would license to the more efficient producer.
As a final point on this issue, Geradin (Reference Geradin2010a) argues that Lemley & Shapiro’s distinction between patentees seeking lost profits and those seeking reasonable royalties “would unduly affect innovators which have opted for a licensing business model for perfectly legitimate reasons, such as for instance the fact that they do not have the skills or the resources to develop and manufacture products embedding their technologies,” and “effectively tip the market in favor of vertically-integrated incumbents … [, which] would impede efficiency-enhancing specialization allowing firms to focus on what they do best and harm innovation.” However, it is not clear that the lost profit damages per unit, properly assessed, will be greater than the royalties per unit. That will only be true, in an economic sense, if the vertically integrated firm has the capacity to satisfy the market and is a more efficient producer than the implementer, in which case it is not inefficient to give the patentee extra leverage against the implementer. If the vertically integrated firm is actually worse at commercializing the invention, this implies that its lost profits will be less than the reasonable royalty it could have obtained from licensing to a more efficient implementer; as Geradin (Reference Geradin2010a) points out, the innovator is more likely to opt for a licensing model when it does not have the skills or resources to manufacture the product, and the lower return from a royalty reflects these shortcomings. While this follows as a matter of economic logic, it requires that the lost profits calculation properly accounts for the patentee’s costs of production, including fixed costs. If lost profits calculations are excessively generous to the patentee, then the vertically integrated patentee will have greater leverage because of the excessive damages for past infringement whether or not it is granted an injunction. As discussed above, the implementer’s share of the surplus may be best understood as compensation for its investment in the success of the product, through marketing and distribution, etc., which would represent costs to the patentee.
In summary, despite their protestations, Lemley & Shapiro’s holdup model does prima facie apply to patentees who compete with the infringer. This does not imply that their model should be rejected, but it does suggest that their model is incomplete, and/or that the holdup problem needs to be taken seriously in that context as well.