Tuesday, November 18, 2008

Latest Broadcom/Qualcomm Skirmish

This morning, the IP SIG of the telecom council had one of its occasional meetings to review major developments in IP law. IP is obviously very important to the local industry, whether it be Qualcomm’s patent licensing business model or Ron Katznelson’s current efforts to promote patent reform.

I couldn’t make the IP SIG, but on the agenda were three cases. One case was Broadcom v. Qualcomm. Which one? you ask — after all, there are so many. In this case, the lawyers talked about the case that brought findings of legal misconduct and forced Lou Lupin to fall on his sword. Another case scheduled for the IP SIG meeting was the ruling in Quanta v. LG, where the SCOTUS set new standards for doctrine of “patent exhaustion.”

As it turns out, the Quanta ruling plays a prominent role in Broadcom’s latest lawsuit against Qualcomm, filed October 8 in federal court. This filing is just the latest in itsongoing series of litigation intended to force Qualcomm to license its patents on terms that Broadcom finds acceptable: a royalty-free cross license.

When I saw the latest Broadcom v.Qualcomm case, I asked one of San Diego’s leading IP lawyers, USD professor David McGowan, if he would be willing to comment for this blog. I thought of David because he had analyzed the Quanta case for the leading patent blog. I already knew him because we’d met at an open source research conference, and we share a common interest (particularly in IP law) at the intersection of law and economics.

As a special guest commentary, here is Prof. McGowan’s analysis of the original Broadcom complaint. Paragraph numbers refer to the original complaint as filed in the Pacer database system.

Inexhaustible: The Latest Broadcom / Qualcomm Skirmish
By David McGowan
Lyle L. Jones Professor of Competition and Innovation Law
University of San Diego School of Law

Broadcom recently sued Qualcomm for a declaration that certain of Qualcomm’s alleged licensing practices misuse Qualcomm’s patents. The suit is both predictable and plausible in light of the Supreme Court’s recent Quanta opinion.

Based on Qualcomm’s description of its licensing practices, the district court’s decision will likely turn on how it resolves a question left open in Quanta. From an economic point of view I hope the court reads Quanta narrowly. Such a reading would tend to favor Qualcomm. There is a plausible formal case for Broadcom’s claims, however, so the case must be taken seriously.

The complaint alleges Qualcomm double-dips by charging handset manufacturers a royalty on both chipsets and handsets. Qualcomm may earn chipset royalties through sales to handset manufacturers or from licenses to competing chipset manufacturers such as Broadcom. It also charges a royalty directly on handsets.

Broadcom claims the Quanta case holds that a patentee may not charge downstream royalties beyond the first sale of its technology. This claim implies Qualcomm may either charge handset manufacturers a royalty for the handset or for a chipset (directly from Qualcomm or indirectly from Broadcom) but not both. Broadcom is asking the court to declare that it need not pay royalties to Qualcomm when Broadcom sells chipsets to handset manufacturers who pay Qualcomm royalties on handsets. (¶5)

McgowandBroadcom alleges Qualcomm’s double dipping drains from the industry money that could be used to foster innovation and competition. I find this claim implausible. Qualcomm innovates and there is no general reason to favor innovation by Broadcom or handset manufacturers over innovation by Qualcomm. This complaint raises distributional issues, not questions of dynamic efficiency.

Broadcom also alleges Qualcomm’s licenses reduce competition. It offers two theories in support of this claim. The first is that Broadcom must either take Qualcomm licenses or risk infringement action. That theory is doubly flawed. It confuses an effect on a competitor, Broadcom, with an effect on competition generally and it has nothing to do with the double dipping claim, which is the only one to which the Quanta holding might apply. If Broadcom operates under a cloud of infringement that is because Qualcomm has exclusive rights in its inventions not because of its licensing model. Only the serendipitous fact that the licenses were negotiated before Quanta was decided offers Broadcom any maneuvering room here, and that is a legal not an economic point.

The same points hold for the allegation that Qualcomm’s practices deter entry and increase costs. (¶29) That charge would be no different if Qualcomm suppressed all manufacturing other than its own and took all its royalties in chips. It seems to me a charge against the patent system rather than tiered licensing.

The second theory is that Qualcomm licenses favor its products over competitors’ products. Little is said about this claim so it is hard to know what to make of it. At one level it is not clear why Qualcomm would want to do this. Its patents mean it can obtain revenue by royalty from Broadcom or sale to handset manufacturers. Economically it should be indifferent between the two revenues streams. Indeed, if Broadcom is a lower-cost producer than Qualcomm, the latter would maximize profits by charging a high royalty rather than producing itself.

The complaint also refers to Qualcomm using its patents to leverage royalties, and leverage may be what the second theory has in mind. (¶24) It is not clear what Broadcom means by this reference. The facts alleged do not support the typical leverage claim, which is that a firm with market power in one market will use it to extend the duration of power in that market or to extend its power to another market. Rather, this appears to be a case in which single monopoly rent theory has a lot of force.

If handset manufacturers must practice Qualcomm inventions they must deal with Qualcomm, which implies some royalty. It does not imply an infinite royalty, however (Qualcomm wants handset sales so it is in its interest to set a royalty that allows handset manufacturers competitive returns on their investments). Still less does it imply that Qualcomm would earn less charging a single handset royalty than charging a royalty on both handsets and chipsets.

Chipsets and phones are close complements used in a fixed ratio. Basic rational actor assumptions imply Qualcomm will get as much money as it can; they also imply Qualcomm can get that amount at any level of production (either chips or handsets) and cannot get more by charging x at one level and y at another.

Here is a simplified illustration supporting the latter point. Suppose it is the dominant strategy for handset manufacturers to set prices at the average reservation price consumers place on the handset (given the cost of a contract with a carrier). Let’s say the average reservation price is $10, handset manufacturers need to earn $6 per handset, and the only input cost is chipset royalties. In theory QC could charge $4 as a handset royalty or charge $3 for a chipset and $1 as a handset royalty (or $2 and $2, of course). What it could not do is charge $3 for a handset royalty and $2 for a chipset royalty. (There are various qualifications to this logic in the antitrust literature but BC’s complaint does not seem to implicate any of them.)

No doubt this analysis is too crude to capture all the facts of the case. One would need to know the deal structures better than I do to offer more precise analysis. The analysis does raise significant questions, however, which the complaint does not answer.

It is hard to say what is likely to happen. Quanta dealt with an unconditional license and Qualcomm has said its licenses are expressly conditional. The Court did not rule on such licenses. The district court therefore is not bound to rule for Broadcom. If one read the Supreme Court as sending the signal that patentees should only be able to engage in one transaction per product, though, one could extend Quanta to reach the result Broadcom seeks.

As I mentioned I favor the narrow reading. I approach the problem this way. First, as a default matter, do we expect parties or courts reach more socially efficient bargains for the exploitation of inventions? In my view, both economic theory and experience favor parties as the default bargainers. Living markets as they do, they have much better information and much keener incentives to get things right than a generalist judge faced with unfamiliar information spun vigorously by competing advocates.

Second, should courts deviate from that default? The answer may be yes but only if there is a good reason. Absent such a reason the arguments favoring the default rule carry through. In some cases (price fixing for example) there will be an economic reason to abandon the default but there seem to be no such reason here. In other cases precedent might compel a court to abandon a default. Here it does not because the licenses at issue seem to be materially different from those at issue in Quanta. (Nothing in Quanta calls the default itself into question.)

Third, if there is no substantive reason to abandon a sensible default position and precedent does not require abandonment should a court abandon it? To me the question answers itself. Once you get the default right, in my view, you need a reason to move away from it, and there is no such reason here.

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