Tuesday, April 21, 2015

Ericsson's pseudo-sale of patents to Unwired Planet and the rampant problem of privateering

In the first half of this decade, the biggest and most divisive issue in the information and communications technology (ICT) was FRAND: fair, reasonable and non-discriminatory licensing of standard-essential patents (SEPs). That issue hasn't gone away completely. Courts and regulators provided some clarification (in Microsoft v. Motorola, for example). Still, companies will continue to disagree on what constitutes a FRAND offer, on the proper royalty base, on the extent to which standard-setting organizations (SSOs) such as the IEEE should provide guidance, and on circumstances that may or may not warrant an injunction over SEPs. But all of this has a lower profile now.

The biggest ICT patent issue in the second half of this decade is "privateering": the act of large companies feeding trolls with patents in order to maximize their patent monetization income and/or drive up their competitors' total cost of defense. Quite often this raises FRAND issues as well. Many privateering deals involve SEPs and are part of a scheme to circumvent FRAND licensing obligations.

Centuries ago, privateers were pirates who colluded with governments. I recommend two articles, a Bloomberg story from 2013 and a more recent blog post by the von Mises economic institute, that discuss the problem and start with how Queen Elizabeth I of England commissioned Francis Drake to plunder Spanish merchant vessels. Privateers had to share their booty with the governments that backed them.

Today's patent-based privateering is a rampant problem plaguing the industry. The Bloomberg article I just linked to mentioned transactions involving patents held by Alcatel-Lucent, BT, Ericsson, and Nokia--and those are just a few examples. Furthermore, privateering is one of the issues the U.S. Federal Trade Commission is investigating in connection with patent assertion entities (PAEs).

Patents are transferable assets. There are good-faith, genuine patent transfers--and there are transactions of the kind that is styled as a sale but in commercial terms comes down to an arrangement under which a patent assertion entity is essentially a licensing and litigation service provider to the operating company.

Let's start with what a genuine asset sale looks like. If a company or private person sells a used car, it ceases to have any ongoing interest in the car. Such an agreement doesn't restrict the ways in which the purchaser uses the car; it doesn't even prevent the purchaser from selling it to a third party; and the buyer has to pay a (specific) price.

Naturally, a patent transfer has certain additional aspects. If third parties have already been extended a license to a patent or a portfolio, the acquirer must know about and respect those licenses. Also, the seller may want to continue to use the patented inventions. And the purchase price may have a variable component that gives the seller some upside if the patents prove more valuable than originally expected. But apart from that, the structure of a genuine patent sale resembles that of a genuine car sale.

On the website of the Security Exchange Commission (SEC) of the United States I have found a filing--a redacted version of a "Master Sale Agreement" between Ericsson and Unwired Planet over more than 2,000 wireless patents--that is essentially a privateering case study. I looked this up since Unwired Planet's German lawsuits against Google, HTC, Huawei and Samsung over six of the related patents will go to trial in the coming months. It was much easier than I thought to google the deal terms.

I wish to point out that it's not my objective to engage in "Ericsson bashing." Just like last year, when I wrote about an Ericsson slide deck that explains the (bad) reasons for which the Swedish company doesn't extend patent licenses to chipset makers, it's about behavior that is by no means unique to Ericsson. Ericsson (or, in this case, Unwired Planet) just happens to be particularly transparent about it. Even Apple once sold patents to a non-practicing entity (which I believe Apple wouldn't do again since it has meanwhile had to defend itself against at least one privateer). The undisputed number one patent troll feeder in the world is not Ericsson but another Northern European company: Nokia has engaged in various such transactions, and if I were an antitrust regulator, I'd want to ensure that Nokia won't sell any of Alcatel-Lucent's patents to patent assertion entities after the closing of that acquisition. I'll talk some more about Nokia's privateering on another occasion.

I've read the redacted version of the Ericsson-Unwired Planet deal in detail. A couple of structural elements are clearly very different from a traditional sale.

Section 3, Purchase Price, does not state any amount Unwired Planet had to pay upfront. Instead, Ericsson receives a percentage of whatever revenue Unwired Planet will generate with those patents:

(i) 20% of the amount of Cumulative Gross Revenue, until the Cumulative Gross Revenue equals $100,000,000; plus

(ii) 50% of the amount of Cumulative Gross Revenue in excess of $100,000,000, until the Cumulative Gross Revenue equals $500,000,000; plus

(iii) 70% of the amount of Cumulative Gross Revenue in excess of $500,000,000.

The relatively low percentage Ericsson receives on the first $100 million makes it easier for Unwired Planet to recuperate its litigation expenses. Then the percentage goes up to 50%, and above $500 million (i.e., in the event of a significant licensing success), Ericsson receives the lion's share: 70%.

Percentages like that remind me of what I've read about agency deals. For example, when sports bodies commercialize the broadcasting rights related to their events through agencies, this kind of revenue sharing is normal. But this is just not the way a "sale" in the traditional sense works.

The agreement also comes with all sorts of restrictions on the acquirer's business, a right of first refusal on any sale of the patents to a third party, and a "poison pill" for the event of an acquisition: in the event of a change of control of Unwired Planet, Section 3.3 allows Ericsson to terminate the agreement and to demand a "Sale Payment" for its patents, which according to 3.3(c) shall "in no event [...] be less than an amount equal to (x) $1,050,000,000 minus (y) the aggregate amount of all Quarterly Payments actually received by [Ericsson before]." It can be even more based on a valuation of those patents at the relevant time.

Let's connect the dots: Ericsson is convinced that the patents transferred under that agreement are worth, at a minimum, more than $1 billion, but it "sells" them to Unwired Planet based purely on a percentage of future revenues.

If Ericsson had kept those patents, it would have licensed them to other companies as part of its portfolio. That would have been most efficient for everyone, but Ericsson doesn't want to optimize efficiency: it seeks to maximize its patent monetization income, and it apparently believes that even a substantial de facto "agency fee" it pays to Unwired Planet is more than offset by the incremental bottom-line licensing cost to the likes of Google, HTC, Huawei, and Samsung. Ericsson may even think that its portfolio is so large that 2,000 patents more or less don't make any difference for the royalties Ericsson can obtain from licensees, but it's a large enough portfolio that Unwired Planet can go out and demand some additional percentage that is then shared with Ericsson.

Schemes like that give patent licensing--and patent transfers--a bad name.

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