Tuesday, August 9, 2011

The BRIC countries: a safe haven for Android?

Following the expected decision that Apple's second ITC complaint against HTC will be investigated, HTC's stock price fell to an eight-month low according to Bloomberg. Despite HTC's fast growth in day-to-day business, there's definitely concern over the impact the ongoing litigation between Apple and HTC might have, and the terms on which a settlment might be possible.

Today's big news is Apple's preliminary injunction against the Samsung Galaxy Tab 10.1 in the entire European Union except for the Netherlands (where a separate legal proceeding is underway). All these developments make people wonder what the ultimate resolution of Apple's intellectual property disputes with those Android device makers may be.

Last week, the Tech Trader Daily blog (Barron's) reported on a research note by RBC Capital analyst Mike Abramsky, and the following paragraph relates to the ongoing patent wars, including the disputes with HTC and Samsung:

"In its patent battles, Apple may settle with makers of Android-phones rather than seek to bar them, in order to set itself up with favorable agreements in countries such as China that have less rigorous intellectual property rules."

Note that the word "may" is emphasized just as much as "settle". It's a possibility, not a given. Based on the report, it's not clear what exactly Apple told the analyst, and what he just read between the lines or concluded from whatever Apple indicated.

That same analyst was previously reported to suggest that Apple might grant a license to HTC (though he thinks Apple has "the upper hand") for a deal in the $5 range. I've consistently said that that's not going to happen as long as Apple is able to win. If both reports are true, that analyst said three weeks ago that HTC would get away with a low royalty and now, after having met with Apple, believes that the two alternatives are that Apple either tries to block certain Android-based products or agrees on a settlement that has implications in a market like China. The way I interpret it is that his initial take was driven by how those disputes are usually settled, but in his meeting with Apple he presumably saw that Apple's approach is very strategic. They also may have credibly demonstrated a lot of confidence to him that goes way beyond a $5-per-unit type of deal.

In this blog post I look into the global situation. I'll state my conclusion upfront: I think a deal under which Apple would let Android off the hook (though some patents would probably still be kept exclusively) in the U.S. and other jurisdictions in which Apple has strong patent positions in favor of concessions in markets like China could be a win-win only if Google entered into a deal with Apple after changing Android's license from open source to closed source, but it would be a lose-lose between Apple and any given Android device maker (or group of Android device makers).

Settlement terms: anything goes

After last week's famous blog post by Google's chief legal officer David Drummond, no reasonable person can doubt anymore that Android is under serious pressure on the patent front. Someone asked me on Twitter whether Google now hopes for a Get Out of Jail Free card from antitrust regulators. The way I see it, Mr. Drummond's post contains lots of antitrust buzzwords but doesn't really present any evidence or at least credible indication of violations of competition law. That's why I believe this is all going to be decided in the patent arena.

Under patent law itself, a patent holder doesn't have an obligation to grant a license, and is free to propose all sorts of terms and conditions for a license deal. For example, it appears that Lodsys sent a contract to some mobile app developers that stipulates royalties for six years beyond the expiration of the last patent Lodsys actually asserts. It's not illegal to ask for that. After all, the alleged infringer can always say no -- though that may result in litigation, or the inability to be competitive (or to operate at all) in a particular market.

Most smartphone patent litigation takes place in the United States but settlements will frequently relate to the worldwide market, even though U.S. patents are valid only in that market. Without a settlement, a patent holder would have to use patents valid in other markets, such as the UK or Japan, and sue the infringer there as well. But in a settlement, anything can be agreed upon, and parties negotiating a settlement can propose or reject pretty much anything.

I continue to believe that Apple optimizes for product differentiation, not patent licensing revenues. But I always said that a combination of the two is possible, such as Apple charging Android device makers money for a subset of its patents and keeping some patents exclusive, thereby forcing some of them to degrade the user experience and/or reduce the functionality of their Android-based products. We're just not going to see $5 deals until someone really owns some patents that Apple absolutely needs a license to.

So let's look at the hypothetical scenario of Apple settling with some of those Android device makers, such as HTC, in a way that would let those companeis off the hook in the U.S. market and would help Apple in markets in which it wouldn't be able to enforce its patents the way it can in the U.S. and certain other markets.

Apple's relative strength in different jurisdictions

A patent regulates a target market in which it is valid. It is available to domestic as well as foreign companies. It can be asserted agianst domestic as well as foreign companies operating in that market.

U.S.: There's no doubt that Apple's strongest position is in its domestic market. Apple owns more patents there than in any other jurisdiction. And Apple's strategically most important patents in these disputes are software patents, which are not unique to the U.S. but particularly easily enforceable there. The USITC provides a fast track to injunction-like decisions (import bans), while federal courts usually take longer but can also order damages, which are often very substantial under U.S. tort law.

Europe: Apple's European patent holdings are weaker than their U.S. equivalent. In recent years, Apple appears to be filing pretty much every patent application in Europe as well (especially all iPhone-specific patents), and typically in dozens of European countries (which results in substantial translation costs). In earlier years, especially in the 1990s, Apple apparently filed only a part of its patent applications in Europe, maybe to some extent due to uncertainty as to the patentability of software in Europe. Also, Apple's older European patents were registered only in a few major markets (often just in the UK, Germany and France).

While there's a European Patent Office that provides a centralized examination process, there are separate translation and registration costs for each designated country. At a time when Apple wasn't nearly as well-heeled as it is now, it didn't want to spend too much money on the protection of its intellectual property in Europe. The European patent system is also fragmented when it comes to litigation: that's why Apple and Samsuing are suing each other separately in Germany, the UK, France, Italy and the Netherlands.

Meanwhile, Apple can easily afford Europe-wide protection, and the patentability of software is very similar in Europe to the U.S. situation. For example, Apple asserted this set of nine European software patents against Nokia in London and Düsseldorf. Last year I blogged about a German high court ruling that declared software-related concepts just as patentable there as they are in the U.S., and if you're interested in more detail on the European situation, I recommend Falk Metzler's Visae Patentes blog, which just explained the approach outlined by European Patent Office officials at a workshop and some guidance given by the German high court in a very recent ruling.

While it's more difficult in Europe than in the U.S. to get large amounts of damages awarded, it's actually easier in most European countries to obtain permanent (and in some places even preliminary) injunctions against infringing products. For Apple, it's actually better this way.

The bottom line is that Apple could deal decisive blows to Android in Europe if it wanted. It would take time and a significant logistical effort (coordination of litigation across multiple countries, though the five big countries represent the largest part of the Western European market), but it can be done and, if necessary, will be done.

Interestingly, HTC recently filed a lawsuit against Apple in the UK. But there's no reason to assume that HTC is in a stronger position in Europe than in the U.S.

Japan: Patent professionals traditionally refer to the U.S. Patent and Trademark Office (USPTO), the European Patent Office (EPO) and the Japan Patent Office (JPO) as "the trilateral". Those three patent offices cooperate very closely. There's no doubt that certain other markets are gaining relevance at Japan's expense, but the JPO's strong tradition makes it influential beyond the borders of its own country.

Apple's patent position in Japan appears to be comparable to the one in Europe.

Australia: Apple just put Samsung under tremendous pressure with a motion for a preliminary injunction in Australia against the Galaxy Tab 10.1. Apple's patent position in Australia appears to be reasonably strong.

China: Chinese companies have much stronger patent holdings than most people believe. They are fairly innovative and know how to obtain patents. Analysts are not aware of any case in which a foreign company managed to defeat a Chinese counterpart with respect to the Chinese market. It's not that China has a weak patent system -- it's that local players like ZTE and Huawei are very strong and know how to play and win that game.

India: This country has a reputation for rather weak patent protection, not only with respect to software. Nevertheless, software is patentable there. An Indian patent troll who is currently trying to shake down dozens of U.S. companies filed his original patent application in India before filing for international patents.

South America: The patent system in that part of the world is not particularly advanced. There are patent professionals there who are probably doing a good job and trying to generate more awareness for the benefits of patent protection and the risk of not having such protection, but governments of Latin American countries tend to take the most IP-skeptical positions (besides African states) in international trade negotiations. I would expect companies like Apple to increasingly seek patent protection at least in Brazil, but I don't know how likely they would be to prevail in software patent litigation in that region.

Analysis of the viability of settlement terms that include concessions in countries in which Apple has weaker patent positions

The problem is not whether it might be mutually beneficial for Apple and makers of Android-based devices to settle on terms under which Apple does not insist to the full extent on what it might be able to impose on others in markets like the U.S., Europe, Japan and Australia, provided that Apple gets concessions in markets like China and possibly the other BRIC countries. BRIC stands for Brazil, Russia, India and China. Some also refers to BRICS (adding South Africa).

The problem is whether it can really work in a way that makes sense to Apple as well as a given Android device maker (or group of Android device makers). Like I wrote in the first part of this post, I believe it wouldn't -- though it could work between Apple and Google, but only if Google changed Android's business model.

Let's assume Apple lets HTC largely off the hook in the U.S. and elsewhere but imposes functionality restrictions and royalty payments on HTC that would also affect the markets in the BRIC countries. HTC could continue to generate substantial income in the U.S., which is a huge market for that company. Apple could view this as an investment in markets that will be increasingly important in the future. But under such a deal, HTC would weaken itself in the BRIC markets sine there are other Android device makers with which it has to compete. In particular, if you just think of China as one exmaple, Huawei and ZTE might refuse to do any such deal with Apple. In that case, those companies would be able to sell more competitive (cheaper and better) Android devices in China. Those third parties would be the true beneficiaries of that settlement -- not Apple.

Huawei and ZTE also sell Android devices in the U.S. and could theoretically agree on a global deal with Apple, but those are just examples. Once any such device maker weakens itself in the BRIC markets, there will always be other companies who will try to take advantage of that. Arbitrage is the term for this.

Deals of this kind make sense with a moderate per-unit royalty cost, and if they don't weaken the functionality and degrade the user experience of products. But once there's a very high royalty rate involved or a price to pay in terms of product quality (or both), it won't work.

Even if all 39 official Android device makers entered into the same type of deal with Apple, there could be others who would get an Android license from Google in the future, and there are already various device makers who use Android's code on open source terms without licensing the Android trademark and certain closed-source components such as the Android Market from Google. So as long as Google makes large parts of Android's code available on open source terms, there's no way to control and contain this arbitrage problem.

So Apple couldn't just sit down with one or more device makers and define the competitive landscape around the globe. There are too many moving targets and factors beyond control. Ultimately, some of the embattled device makers might actually decide to fight it out in the U.S. and seize the market opportunity there for as long as possible but reserve all options to focus on the BRIC markets in the future.

The only way that Apple and the Android ecosystem could enter into an agreement that both sides could rely on would be a deal between Apple and Google, provided that Google abandons open source licensing with respect to Android (which it may have to do anyway due to the intellectual property issues Android faces) and charges device makers a royalty. In that scenario, which may seem unrealistic today but may not be unrealistic at all in a year or two, there would no longer be any arbitrage opportunities for third parties.

Should the BRIC markets become Android's safe haven while it may be strategically lost due to the software patent situation in the U.S., Europe and certain other countries, Google would probably have to change its business model anyway. Google is not the most popular search engine in China and Russia. Companies targeting those markets might very well do their own Android "forks", i.e., modified versions that don't lock users into Google's search engine and other online services. A license fee would be a much more realistic way for Google to monetize Android in those places than any business model centered around and based upon mobile advertising revenues.

From the perspective of app developers, Android is still much less lucrative a platform than Apple's iOS. The high numbers of activations that Google reports don't correspond to high app revenues. If Android lost the patent war in the U.S., Europe and some other countries and finds most of its future opportunity in the BRIC countries, its activation numbers would still have a lot of potential for growth, but the purchasing power of consumers in those places relative to the U.S. and Europe is, on average, substantially lower, so the fundamental problem of Android being the less profitable app platform wouldn't go away in the near term.

In other words, it's not going to be easy to find common ground between Apple and the Android camp.

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