What Makes FRAND Fair? The Just Price, Contract Formation, and the Division of Surplus from Voluntary Exchange
Long before anyone understood what an economist does and why it might matter, Saint Thomas Aquinas had already endeavored to define “the just price.” Seven centuries after Aquinas opined on the just price there emerged a new institution of capitalism, the standard-setting organization (SSO), which by contract typically obligates the owner of standard-essential patents (SEPs) to offer to license its SEPs on fair, reasonable, and nondiscriminatory (FRAND) terms to willing implementers of the standard. (It is notable that some SSOs require that licenses to SEPs be offered on merely reasonable and nondiscriminatory (RAND) terms.) SSOs generally permit each SEP holder to set a FRAND royalty for its SEPs through private bilateral negotiations with each implementer, rather than require the SEP holder to post tariffed rates for all customers. Such voluntary exchange benefits both parties, who divide their aggregate gains from trade, which economists call surplus. This economic principle—that voluntary exchange is mutually beneficial—is as profound as it is simple, and for that reason economists call it, “The Fundamental Theorem of Exchange.”
This question of the meaning of a fair price turns out to have very real legal ramifications in the present day. Rarely do I disagree with Judge Richard Posner, but I do with respect to his view that “fair” is surplusage in the FRAND contract. Judge Posner, sitting by designation as the trial judge in Apple, Inc. v. Motorola, Inc. in 2012 in the Northern District of Illinois, said that, in the context of FRAND, “the word ‘fair’ adds nothing to ‘reasonable’ and ‘nondiscriminatory.’” My previous writings have followed this convention of making no legal or economic distinction between FRAND and RAND royalties, though I have never excluded the possibility that someone might eventually make a compelling argument for why “fair” is not a throwaway word for parties to insert into a contract. And so, I have previously analyzed at length the differences between actual FRAND contracts and actual RAND contracts with respect to how fairness creeps into the constraint to license SEPs on nondiscriminatory terms. This article will show why courts should take the distinction between FRAND contracts and RAND contracts more seriously.
More than 30 years ago, Robert Frank of Cornell University proposed a precise economic definition that is directly relevant to the question of what makes a FRAND royalty fair: “Using the notions of reservation price and surplus, we can construct the following operational definition of a fair transaction: A fair transaction is one in which the surplus is divided (approximately) equally. The transaction becomes increasingly unfair as the division increasingly deviates from equality.”
Frank then explained the problem that unfairness presents: “People will sometimes reject transactions in which the other party gets the lion’s share of the surplus, even though the price at which the product sells may compare favorably with their own reservation price.” This reasoning is very close to the conclusion I had reached before benefiting, late in the process of revising this article over the course of several years, from reading Frank’s 1988 book. Frank and I each find ourselves using Judge Posner as our foil, though for different reasons. Frank criticized Judge Posner’s writings through the mid-1980s as denying what Frank argued was the considerable explanatory power of fairness considerations in law and economics. In contrast, I gently chide Judge Posner for overlooking roughly 25 years later that, by the private ordering of contract law, some SSOs had chosen to impose an obligation of fairness so that (according to my economic interpretation) those SSOs could nudge parties into exercising the degree of moderation in their negotiation demands that is necessary to achieve contract formation reliably and expeditiously.
The irony is that my interpretation of why the word “fair” must have an independent meaning within the FRAND contract is quintessentially Posnerian: a division of surplus that is perceived by both parties to be fair maximizes the probability of contract formation, which in turn immediately benefits the parties to the contract. Thus, fairness clearly promotes static allocative efficiency. Moreover, across time the fairness constraint on the division of surplus also benefits countless consumers, whom the grand edifice of the FRAND contract is surely intended to benefit (though not necessarily by the formal machinery of conferring on those consumers legally enforceable rights of a third-party beneficiary, as the FRAND contract does confer on implementers). As Joseph Schumpeter taught us, it is the consumption of innovative products in the future that delivers radical—not marginal—gains in consumer surplus. Thus, the fairness constraint promotes dynamic efficiency as well. In this respect, Posner’s emphasis on efficiency and Frank’s emphasis on fairness are reconcilable. A lopsided division of surplus is a cost imposed on efficient transactions to the extent that it prevents some otherwise promising negotiations from achieving successful contract formation; if that cost can be eliminated or mitigated, a larger number of efficient transactions will occur. Therefore, regardless of whether one prefers to call it a quest for fairness or a quest for efficiency, an SSO’s constraint on the SEP holder that a royalty for its SEPs be fair is a privately ordered feature of contract—a self-imposed cattle prod—that contributes to a result that proponents of fairness and proponents of efficiency can both applaud.
Thomas Aquinas understood in the Summa Theologica that voluntary exchange produces the just price, which does not have a unique value. If, as I believe, it is more realistic to view voluntary exchange concerning the licensing of standard-essential patents as an infinitely repeated game, then one can explain the constraint of “fairness” in FRAND licensing transactions as a facilitator of efficient contract formation. This explanation does not require one to resort to any normative expression of the aesthetic features of a just or fair distribution of value within the economy. This insight also does not diminish the independent significance of fairness as a goal. To the contrary, it outlines a richer linkage between justice, innovation, and voluntary exchange than appears previously to have been appreciated by either jurists or scholars. And it suggests why the quest for a better understanding of the just price is as salient and profound today as it was in the 13th century.