Patent Holdup and Royalty Stacking

Abstract

We study several interconnected problems that arise under the current U.S.patent system when a patent covers one component or feature of a complexproduct, This situation is common in the information technology sector ofthe economy. First, we show using bargaining theory that the threat toobtain a permanent injunction greatly enhances the patent holder'snegotiating power, leading to royalty rates that exceed a natural benchmarklevel based on the value of the patented technology and the strength of thepatent. Such royalty overcharges are especially great for weak patentscovering a minor feature of a product with a sizable price/cost margin.These royalty overcharges do not disappear even if the allegedly infringingfirm is fully aware of the patent when it initially designs its product.However, the holdup problems caused by the threat of injunctions arereduced if courts regularly grant stays to permanent injunctions to givedefendants time to redesign their products to avoid infringement when thisis possible. Second, we show how holdup problems are magnified in thepresence of royalty stacking, i.e., when multiple patents read on a singleproduct. Third, using third-generation cellular telephones and Wi-Fi asleading examples, we illustrate that royalty stacking has become a veryserious problem, especially in the standard-setting context where hundredsor even thousands of patents can read on a single product standard. Fourth,we discuss the use of reasonable royalties to award damages in patentinfringement cases. We report empirical results regarding the measurementof reasonable royalties by the courts and identify various practicalproblems that tend to lead courts to over-estimate reasonable royalties inthe presence of royalty stacking. Finally, we make suggestions for patentreform based on our theoretical and empirical findings.

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