Tuesday, July 19, 2011

What does $5 buy HTC from Apple? A few songs from iTunes but no patent license

After a trilogy of posts on Apple v. HTC (first reaction to initial determination, infringement claim charts, and a battlemap), I posted an update on Apple v. Samsung earlier today, but there's still so much talk about the fallout from (and potential impact of) the ITC's findings that I'd like to comment on the following question:

Can HTC resolve the situation with Apple (in the event HTC can't reverse the ITC's initial determination or doesn't want to rely on its ability to do so) on the basis of a license deal -- such as the $5-per-device deal it purportedly entered into with Microsoft more than a year ago?

The position taken by most of the financial analysts quoted in the media is that HTC can get away with a license deal. One of them even said that his firm's "worst case" for HTC is based on the assumption of a $5-per-device deal. In my opinion, most of the analysts get this wrong (just like most analysts got the subprime mortgage topic wrong), and the one who says that $5-per-device is the "worst case" is so far off base that I don't have words for it.

You know what $5 would buy HTC from Apple? I said it in the headline: they get to download a few songs from iTunes, but if they want a per-device patent deal for that amount, the answer is just going to be "No way, José".

Seriously. I said before that the only way HTC can get a patent license from Apple is if they bring patents to the table that Apple needs, and in that case I could see a (partial) cross-license happen, with or without some additional payment. But a few bucks per device won't enable HTC to buy a way out of the problem. And the problem is only going to get bigger as Apple has 16 more patents in suit beyond the ones in that first ITC investigation, and may even add more.

Since there are fundamental misconceptions out there, I think it may be helpful to explain the strategic and legal issues at a basic level to all those who might otherwise be confused by fundamentally flawed analysis.

Before I address that question in more detail, I'd also like to comment on the latest news, a statement by Google's chairman Eric Schmidt.

Eric Schmidt's statement

Google's Chairman Eric Schmidt said in Japan today that his company will make sure HTC doesn't lose against Apple. He also asserted that "competitors are responding with lawsuits as they cannot respond through innovations".

In my view, there are many patents out there that are asserted against all sorts of software -- definitely also including Android -- that don't correspond to true innovation. I believe that most "infringement" of software patents is inadvertent. The idea of patents is to reward innovation; unfortunately, they can often serve as a substitute for it.

But Mr. Schmidt oversimplifies the situation by claiming that Android's success has simply provoked litigation from competitors. If Android didn't have traction, hardly anybody would bother to sue -- but Android has a number of intellectual property issues for which Google itself is responsible. It's quite telling that the judge presiding over Oracle's lawsuit against Google issued a formal notice that shows strong suspicions on his side of Google's willful infringement of Java-related intellectual property rights. I also think that the lawsuit brought by eBay and PayPal against Google raises serious questions if even half of the allegations in the original complaint are accurate.

Google has a serious credibility problem in connection with patent enforcement: Google itself was built on a patent (the PageRank patent). It raised many millions of dollars of venture capital on the basis of a patent deal with Stanford University. Purportedly Google's founders didn't even have a formal business plan in place. But they had a patent. They love that patent. They love all of their other patents. They just don't like other companies' patents.

In terms of the ability to prevent HTC from losing the ITC case, anything is possible but the odds are relatively long against them. More than 16 months after Apple's first ITC complaint against HTC, Android was found to infringe two distinct patents, and even worse, four different claims of each patent. That makes for a total of eight infringed patent claims. The deniers need to do away with all eight claims. Again, it's not impossible, but it's an uphill battle, and this is just the start of it: there are 16 more Apple patents already in action against ITC (all of them have been asserted in three different federal lawsuits filed in Delaware, and five of them additionally in a second ITC complaint). That number could still go up.

The question is only how quickly Apple will prevail. Not if.

Let's not forget that Apple is just one (though very important) patent holder asserting rights against Android. There are dozens of lawsuits, including several ITC investigations. In one of them, Motorola appears fairly likely to be defeated by Microsoft.

A patent is an exclusive right -- a patent holder doesn't have to grant a license if he doesn't want to

Some of the comments on the situation between Apple and HTC fail to take into account a very basic fact: a patent is a (time-limited) monopoly. It's an exclusive right. Even if most patent litigation ends with a license deal, patent law itself does not impose any "duty to deal" on a patent holder.

While it's true that the entitlement of a patent holder to an injunction is subject to certain criteria (the four-factor test), an import ban and related injunction is actually the only remedial power that the ITC has. Unlike a federal court, the ITC cannot order damages. So in other words, a patent holder who isn't entitled to an injunction shouldn't go to the ITC in the first place. The ITC takes various considerations (including public interest considerations) into account, but the most important test is called the domestic industry requirement, which has an economic and a technical prong. As the notice on an initial determination issued on Friday states, Apple passed that test with respect to the two patents HTC was found to infringe:

"6. The domestic industry requirement is satisfied with respect to the '263 and the '647 patents."

Again, a patent holder doesn't have to grant a license to his patents. There are only three reasons for which a holder of a U.S. patent will grant a license:

  1. because he wants to accept "an offer that is too good to refuse";

  2. because he previously made a commitment to grant a license on terms within a specified framework such as FRAND (fair, reasonable and non-discriminatory), which standard-setting organizations often make a requirement for those participating in a standardization process; or

  3. because of a requirement ("duty to deal") under antitrust law.

The first possibility is the one we'll have to discuss further, and I don't see that except in connection with a limited cross-license. In my view, HTC won't get a deal just for money, especially not for an amount like $5 per device. The second possibility isn't the case with respect to any of the Apple patents at issue in this case. And the third one, antitrust law, doesn't apply either because Apple doesn't dominate what competition law calls a "relevant product market" in connection with this.

But U.S. patent law itself does not have the concept of a "license of right" (a license to which others are entitled). The Patent Act -- specifically, 35 U.S.C. § 271(d) -- makes it clear that a patent holder's insistence on exclusivity does not constitute patent misuse:

No patent owner otherwise entitled to relief for infringement [...] of a patent shall be denied relief or deemed guilty of misuse or illegal extension of the patent right by reason of [...] (4) [having] refused to license or use any rights to the patents [...]

In a different Android-related ITC case (investigation no. 337-TA-769 of Microsoft's complaint against Barnes & Noble), the ITC staff recently made a filing in which it underscores the discretionary power of patent holders. The ITC staff quotes from various Federal Circuit decisions:

"[C]ourts have noted that the patentee begins with substantial rights under the patent grant. [...] Those rights include the right to suppress the invention while preventing others from using it, to license or refuse to license the invention, to charge such royalties as the leverage of the patent monopoly permits, and to limit the scope of the license to a particular field of use." (emphasis mine)

That is the legal background against which HTC would have to negotiate with Apple. Don't let anyone confuse you about that basic fact. Analysts can say whatever they want, but they don't make or change the law.

Microsoft does whatever it does -- but that doesn't force Apple to do anything

Besides the fact that most patent litigation results in settlements based on royalty-bearing license deals, I believe that those misconceptions about HTC's ability to do a license deal with Apple are attributable in no small part to the fallacious assumption that Microsoft's purported deal with HTC is any indication for the terms and conditions on which Apple might grant a license.

When it comes to patent licenses, comparing Apple to Microsoft is tantamount to comparing apples to bananas. According to its own statements (such as this one), Microsoft "has entered into more than 700 licensing agreements and continues to develop programs that make it possible for customers, partners and competitors to access its IP portfolio." I recently even read about a deal under which they licensed some patents to Volkswagen. I've never seen even one similar announcement by Apple. Maybe there has been an announcement and I couldn't find it though I tried. But either Apple doesn't do such deals at all, or only under exceptional circumstances.

Remember Apple's recent settlement with Nokia? Apple conceded that Nokia will have a license to some technology, "but not the majority of the innovations that make the iPhone unique". For Nokia that's not a problem because they've decided to adopt Windows Phone as their smartphone operating system, so it's Microsoft's responsibility to clear the intellectual property rights. I believe that more than anything else, Apple's statement was meant to indicate to the rest of the industry -- particularly Android device makers -- that Apple's approach is to reserve some of its rights for its own exclusive use (unless you have patents that are critically important to them, you won't get a license to their most important IP).

You can also see that attitude reflected by the statement they always refer to when journalists ask questions about their Android-related patent litigation:

"We can sit by and watch competitors steal our patented inventions, or we can do something about it. We've decided to do something about it. We think competition is healthy, but competitors should create their own original technology, not steal ours."

That's just not the rhetoric of someone who wants to offer a license deal, especially not a $5 license deal. Compare that to, for example, Microsoft's announcement of its lawsuit against Barnes & Noble, Foxconn and Inventec:

"The Android platform infringes a number of Microsoft’s patents, and companies manufacturing and shipping Android devices must respect our intellectual property rights. To facilitate that we have established an industry-wide patent licensing program for Android device manufacturers. HTC, a market leader in Android smartphones, has taken a license under this program. We have tried for over a year to reach licensing agreements with Barnes & Noble, Foxconn and Inventec. Their refusals to take licenses leave us no choice but to bring legal action to defend our innovations and fulfill our responsibility to our customers, partners, and shareholders to safeguard the billions of dollars we invest each year to bring great software products and services to market."

Even though both statements claim an infringement of intellectual property, they are diametrically opposed as far as a possible solution is concerned. Apple's statement doesn't even hint at what a solution could look like. I don't mean to criticize Apple or heap praise on Microsoft. I don't like either company's software patents (nor anybody else's), so if it were up to me, there would neither be lawsuits nor license deals involving them. What I want to point out is that there's a different approach, and that's why any inference from Microsoft's announced deals and purported deal terms is unlikely to result in any accurate assumption concerning Apple's position.

Things get even less accurate when you draw an inference unsupported by the publicly known facts and then mix it with purported but unconfirmed numbers. I have no idea how much HTC pays to Microsoft. It could be $5 as Citigroup says; it could be more; it might be even less. But let's assume -- for the sake of the argument -- that $5 is (more or less) the number.

The same analyst who made that claim said that Microsoft is now looking to an amount closer to $12.50, which suggests that maybe HTC got an "early booking" discount like the person sitting next to you on a plane who may also pay a fraction of your ticket price. Another story is that Microsoft wants $15 per unit from Samsung while Oracle wants $15 to $20 from various Android device makers for its Java-related patents.

Whatever HTC pays to Microsoft, the deal was the first one of a major Android device maker with Microsoft, and it took more than a year until Microsoft announced more such deals. There's nothing in the law -- or no business logic -- why Apple would have to "match" a purported Microsoft royalty demand. I believe the decision makers in Cupertino couldn't care less about the actual or purported terms of Microsoft's deal with HTC.

There's another difference here. HTC also builds Windows-based phones. But HTC doesn't have any partnership whatsoever with Apple. Between those two companies it's purely about patent infringement.

I've said all along that under certain circumstances even Apple may decide to enter into a royalty-bearing license agreement with HTC. I don't believe such an agreement would allow HTC to use all of Apple's intellectual property, and even a partial cross-license could be several times more expensive than HTC's deal with Microsoft.

Apple optimizes for differentiation -- not license fees

The most important reason for which I can't see Apple settle with HTC on sweet terms is Apple's strategic situation. What would Apple gain by charging HTC, say, $5 per device? Nothing useful.

Apple faces a fundamental threat from Android. With 550,000 activations per day, Android has enormous momentum in the market. While it seems that app developers are disappointed that Android users aren't the humongous app buyers that iPhone and iPad users are, there could be a tipping point at which Android's ubiquity also makes it the more profitable platform for app developers -- possibly even the much more lucrative platform.

At that point, the threat to Apple is that the iPhone and iPad could be marginalized by the cheaper, more ubiquitous platform in a similar way as IBM-compatible PCs marginalized the Macintosh.

I remember that time very well, and I'm sure that Steve Jobs and his leadership team will do whatever is in their power not to let history repeat itself in that regard. What happened back in the 1990s is that Macs were better, but they were also much more expensive, and most third-party innovation took place on the PC platform. By third-party innovation I mean software development as well as hardware accessories. After a while, there were only a few areas left in which Macintosh software was still -- arguably -- superior, such as desktop publishing and graphics design. And later, they lost even that advantage.

A $5-per-unit deal with HTC wouldn't have any non-negligible effect in terms of Apple's desire to prevent commoditization. It wouldn't make HTC's Android-based devices significantly more expensive, but it would allow HTC to mimic the iOS user experience.

So where's the point? Such a deal would only make sense if HTC owned patents that Apple desperately needs to license. In that case, Apple might look at $5 as a better-than-nothing proposition. But looking at Apple's strategic situation and its rhetoric, I'm absolutely convinced that Apple would view a $5-per-unit deal as a major defeat. I believe that Apple would even like to avoid a $15 or $20 deal if it could instead maximize the functionality and user experience gap between Android and iOS. Even if, totally hypothetically speaking, Apple could receive $20 times 200 million Android devices per year, that would amount to $4 billion. In a couple of hours Apple will announce its latest financials, but as a ballpark figure, the current run rate of its annual net income is on the order of $20 billion (and increasing rapidly). Compare those numbers, and you can see why it doesn't make sense for Apple to allow commoditization -- and, as a result, potential marginalization -- in exchange for even a significant royalty figure if it can possibly be avoided.

Concerning those numbers, it's important to consider that Apple is just one of many right holders. But Apple is a particularly important one because it takes the toughest stance of all of them. In strategic terms it also has more skin in the game than anyone else.

Apple is not going to let HTC off the hook too easily. You will see. And very likely we will see limitations of Android's user experience and functionality as a result of Apple's IPR enforcement. This is just the early stage of those disputes. Dozens of additional patents are in play.

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