No-challenge clauses in patent licensing - blessing or curse?

Benno Buehler1

Very preliminary and unfinished draft – please do not cite or distribute

Abstract: This paper analyses the economic effects of commonly used "no-challenge" clauses,

building on the framework of Farrell and Shapiro (2008). No-challenge clauses prevent a licensee from

challenging the validity of licensed patents. These clauses improve the likelihood that weak patents

remain unchallenged but may also reduce litigation costs. We find that no-challenge clauses tend to

increase the expected profit of licensors at the detriment of consumers, in particular in situations with

intense downstream competition among licensees.

Keywords: No-challenge clause, patent, license, validity

Introduction

Licensing agreements commonly contain obligations on the licensee not to challenge the validity of

intellectual property rights which the licensor holds. In a number of decisions both in the US and in

the EU, the inclusion of those provisions (in what follows referred to as no-challenge clauses) into

technology licensing agreements has been treated rather unfavorably. European Courts held in

Windsurfing International v Commission2 and in Bayer v Süllhöfer3, that an obligation on the licensee

not to challenge the validity of the patents covered by the license may restrict competition within the

meaning of Article 101(1) TFEU. No-challenge clauses are also regarded as excluded restrictions and,

thus, removed from the scope of the Technology Transfer Block Exemption Regulation (TTBER)4 and

from the R&D Block Exemption Regulation.5 In the US, the Supreme Court declared in Lear v Adkins6

that a no-challenge clause is unenforceable against licensees that challenge the validity of the patent

and are in breach of the licensing agreement. 7 In MedImmune v Genentech8, the Supreme Court

1 European Commission, DG Competition, Place Madou 1, Office MADO 17/051, B-1049 Brussels,

Belgium; email: benno.buehler@ec.europa.eu. The views expressed are those of the author and cannot

be regarded as stating an official position of the European Commission. 2 Case 193/83 Windsurfing International Inc. v Commission, paras 89-94. 3 Case 65/86 Bayer AG and Maschinenfabrik Hennecke GmbH v Heinz Süllhöfer. 4 Commission Regulation (EC) No. 772/2004 of 27 April 2004 on the Application of Article 81(3) of the

Treaty to categories of technology transfer agreements, [2004] OJ L 123/11. 5 Commission Regulation (EC) No. 1217/2010 of 14 December 2010 on the application of Article 101(3) of

the Treaty on the Functioning of the European Union to certain categories of research and development

agreements, [2010], OJ L L 335/36. 6 Lear, Inc. v Adkins, 395 U.S. 653 (1969). 7 According to Ulmer-Eilfort and Boulware (2007, p 2), this distinction is due to the US law requiring a

controversy to exist in order to bring a suit in a federal court. 8 MedImmune, Inc. v Genentech, Inc., 549 U.S. 118 (2007).

went further by also allowing a licensee complying with all its obligations under the licensing

agreement to challenge the validity of the licensed patent.9

While courts have stressed that contractually ensuring that potentially weak intellectual property

rights remain unchallenged may be against the public interest,10 there are also reasons why no-

challenge clauses may have positive welfare effects. First, the licensor may offer reduced royalty

rates as a compensation for the obligation not to challenge the validity of patens. Second, by virtue

of no-challenge clauses, later (legal) conflicts between the licensor and the licensee and thus

potentially wasteful litigation costs may be avoided. Third, including a no-challenge clause into a

license might induce patent holders to license out their technology in cases where licensing would be

unprofitable in the absence of such a clause. Finally, a higher expected compensation of the licensor

due to these clauses may increase its incentives to innovate in the first place. In fact, the seminal

judgment in Lear, Inc. v Adkins of the US Supreme Court was criticized because of neglecting certain

relevant factors that favored the patentee/licensor.11

This paper builds on the seminal work of Farrell and Shapiro (2008) in order to assess the effects of

no-challenge clauses in an environment of probabilistic patents.12 The patent holder offers licenses to

downstream firms, each of which can accept the license, avoid using the patented technology, or

infringe, prompting litigation. Both parties share the same belief as regards the likelihood that a

given patent is valid and whether a patent is indeed valid may only be determined in court once

litigation has started.

In contrast to Farrell and Shapiro (2008), we assume that after a license has been concluded, the

licensee a chance of learning that the licensed patent is invalid. In that case, the licensee may

challenge the validity of the patent in court if the license does not contain a no-challenge clause. In

order to account for the common justification of no-challenge clauses to avoid costly litigation, the

model also allows for non-negative litigation costs. If the patent is declared invalid, other licensees

also benefit from not having to take a license to the invalidated patent anymore. A no-challenge

clause contractually obliges the licensee not to challenge the validity of the licensed patents even in

case the licensee learns that the patent is invalid.

9 Ulmer-Eilfort and Boulware, (2007), above n 1, p 2. 10 According to the judgments mentioned above, no-challenge clauses prevent the licensee from obtaining

release from the burdens of the license. For instance, in Lear, Inc. v Adkins, 395 U.S. 653 (1969), p 670, the

court argues: 'Surely the equities of the licensor do not weigh very heavily when they are balanced against

the important public interest in permitting full and free competition in the use of ideas which are in reality a

part of the public domain. Licensees may often be the only individuals with enough economic incentive to

challenge the patentability of an inventor's discovery. If they are muzzled, the public may continually be

required to pay tribute to would-be monopolists without need or justification. We think it plain that the

technical requirements of contract doctrine must give way before the demands of the public interest in the

typical situation'. Also, no-challenge clauses may limit market entry for competing products where they

allow otherwise weak intellectual property rights to remain unchallenged. However, in Bayer v Süllhöfer,

the Court also pointed out that a no-challenge clause has no restrictive effect where the license has been

granted for no consideration and the licensee accordingly does not have to suffer the competitive

disadvantage of having to pay fees, or where the license has been granted for consideration but relates to a

technically out-dated procedure not used by the licensee. 11 See Server and Singleton (2011). 12 Although this framework encompasses ironclad (that is, certainly valid) patents as a limit case, no-challenge

clauses don't have any effect in this scenario, since the licensee would anyways have no chance and thus no

incentive to successfully challenge the patent.

In our setting, the inclusion of a no-challenge clause is a commitment that the patent's validity is not

challenged in court even in case the licensee obtains information which would make it otherwise

profitable for it to litigate after the license has been concluded. Such a commitment is valuable for

the patent holder since it would also lose the royalty income from other licensees in case the patent

is declared invalid. At the same time, the royalty reduction of rivals in case the patent is invalidated

limits the upside from successfully challenging the patent's validity from the viewpoint of the

licensee. For this reason, it is relatively cheap for the patent holder to compensate the licensee with

a lower running royalty for the inclusion of a no-challenge clause.

The insertion of no-challenge clauses typically lead to higher expected (running) royalties and

therefore to higher profits of the patent holder and to a loss of consumer surplus. This paper also

identifies situations in which the welfare effects of no-challenge clauses are negative. This is the case

if downstream competition is intense, since then the royalty reduction needed to compensate

licensees for the inclusion of such a clause is particularly low. On the other hand, no-challenge

clauses potentially increase welfare if litigation costs are particularly high.

The implications are important in light of repeated recent lawsuits in which licensors were insisting

on the inclusion of no-challenge clauses as a prerequisite for the licensee to obtain a license to

(standard-) essential patents.13

Similar conclusions seem to apply to provisions that reserve the possibility for the licensor to

terminate an agreement if the licensee challenges the licensed patent. In practice, if a termination

clause is in place, a licensee that challenges the validity of the licensed patents risks losing its license

to those patents and thus possibly the profits generated on the basis of them. Thus, a licensee will

only start an invalidity suit if it is reasonably certain that the intellectual property right is in fact

invalid. 14 This illustrates that a termination clause likely reduces the licensee's incentives to challenge

the validity of licensed patents. These considerations suggest that a termination clause is an

imperfect substitute for a no-challenge clause. Indeed, the inclusion of termination clauses into

licensing agreements has become quite common in the US as a means for licensors to limit the

repercussions that the MedImmune judgment has had on them15. Hence, policy makers may decide

to complement a restriction on no-challenge clauses by limiting also the use of termination clauses.

The Model

As in Farrell and Shapiro (2008) an upstream patent holder offers licenses to symmetric

downstream firms. The patented technology lowers downstream firms’ unit production costs by the

13 See e.g. http://www.fosspatents.com/2012/02/apples-iterative-approach-to-frand.html and

http://www.fosspatents.com/2012/08/google-loses-leverage-as-motorola.html. 14 Discouragement to challenge the validity of licensed patents might also come from the fact that the licensee

would risk either damaging its relationship with the licensor (if the patent is valid) which in some cases

might lead to a greater loss for the licensee than the saved royalties for the licensed technology.

In situations where more than one patent is licensed, challenging one invalid patent may, if the licensor

terminates the contract, result in the licensee losing access to all of the patent rights, including the valid

ones, which could decrease incentives to challenge even further. 15 Server and Singleton (2011), n 35, p 417.

patent size , relative to the next best alternative technology.16 The patented technology is already

available to society and ostensibly covered by a patent that is valid with probability . The patent

holder does not compete against the downstream firms. We also follow Farrell and Shapiro (2008) in

requiring that the patent holder offers a non-discriminatory two-part tariff , to all

(symmetric) downstream firms.17 Moreover, the patent holder may require that the license contains

a no-challenge clause, which imposes the licensee to waive its rights to challenge the validity of the

licensed patents.

In the licensing negotiations, each downstream firm accepts the offered license, uses the alternative

technology or chooses to infringe the patent. In the latter case, the patent holder may sue the

infringer and the validity of the patent is assessed in litigation. If the patent is held invalid, all

downstream firms can use the technology free of charge.18 If instead the patent turns out to be valid,

any licenses already signed remain in force and the patent holder negotiates anew with the

downstream firms that lack licenses.

In contrast to Farrell and Shapiro (2008), once the patent is licensed, each licensee has a chance of

finding evidence that the patent is invalid. Indeed, as argued by the US Supreme Court, licensees

“may often be the only individuals with enough economic incentive to challenge the patentability of

an inventor's discovery.” 19 Moreover, licensees are often also active in research which is closely

related to the licensed technologies and may get further insights when using it.

Formally, if the patent is invalid, a licensee obtains evidence which proves the invalidity of the patent

in court with probability . In the absence of a non-challenge clause, the downstream firms then

simultaneously decide whether to incur litigation costs in order to invalidate the licensed patent.

20 Once the patent is declared invalid, all licensees (also those that have not obtained the signal) will

not have to pay any royalties any more when using the technology.

The downstream oligopoly equilibrium inter alia depends on the downstream firms’ marginal costs.

For ease of notation, we abstract from marginal costs other than the running royalty or the cost

disadvantage when using the alternative technology. Thus, a firm accepting a license with per unit

royalty has marginal cost , and a firm using the alternative technology has marginal cost v. Denote

a downstream firm’s sold quantity and profits gross of any fixed fee if it pays running royalties and

its competitors pay the running royalties by and , respectively. As in Farrell and

Shapiro (2008), we assume satisfies three mild conditions: (i) : a firm's are

16 Equivalently, the technology makes each unit of the product worth an extra to all customers. Encaoua and

Lefouili (2009) also analyze seminal inventions that enable a firm to produce entirely new products. 17 As discussed by Farrell and Shapiro (2008), the literature on multilateral vertical contracting has shown that

the equilibrium outcome depends heavily on the form of contracts allowed, on downstream firms’

information, and on their beliefs about what they cannot observe. Requiring non-discriminatory offers

avoids obtaining extreme results. Moreover, non-discriminatory offers are sometimes used in practice and

are typically required for the licensing of patents incorporated into industry standards. 18 In the US, licensees may avoid further royalty payments, regardless of the provisions of their contract, once

a third party proves that the patent is invalid. See, e.g., Drackett Chemical Co. v. Chamberlain Co., 63 F.2d

853 (6 Cir., 1933). 19 Lear, 395 U.S. at 670-671. 20

can be either interpreted as the litigation cost in case each downstream firm has to incur the litigation

costs independent of how many firms are challenging the validity of the patents or as the expected cost share

a litigating downstream firm has to bear if litigation costs may be split among firms challenge the patent's

validity.

decreasing in its own costs;21 (ii) : a firm’s profits are non-decreasing in the other firms’

costs; (iii) : each firm’s profits fall if all firms’ costs rise in parallel. The total

(upstream and downstream) profits generated per downstream firm if all downstream firms face

royalties is .

Since downstream firms compete against one another, the ensuing downstream prices may fall

below the joint profit maximizing level if the running royalties are sufficiently low. We follow Farrell

and Shapiro (2008) in assuming that is single peaked on the relevant range and that the

monopoly running royalty level , which maximizes the total industry profits is not below the cost

reduction generated by the patent, i.e. . We also assume the running royalty may not exceed

the cost savings brought by the patented technology, that is, .22

Once an invention has been patented, welfare is the sum of the patent holder’s licensing revenues,

the downstream firms’ profits, and the surplus enjoyed by final consumers. refers to welfare if

the running royalty is .23 Increasing reduces output and lowers welfare (i.e. for

) since the downstream price exceeds social marginal cost at all non-negative running

royalty levels.

Results

When the patent holder offers a contract that includes a no-challenge clause, the negotiating parties

know that the licensed patent will not be challenged in the future. Therefore, the possibly discovered

information on the patent's invalidity will remain unused and the outcome will be the same as that

considered in Farrell and Shapiro (2008). Suppose that downstream firm D expects all its rivals to

accept the license which includes a non-challenge clause. If D also accepts, its payoff is

. If it rejects the offer, infringes, is sued, and the patent is found to be valid, D will be hold

down to its reservation payoff when using the alternative technology . Since in case the

patent is invalidated also its competitors may use the formerly patented technology free of charge,

D's expected payoff when rejecting the licensing offer is .

When the offered license does not contain a no-challenge clause, the licensees may exploit

eventually discovered information on the patent's invalidity. In the absence of a no-challenge clause,

a licensee that observes the invalidity signal will challenge the validity of the patent if the litigation

costs fall short of the expected increase in its downstream profits. Let denote the probability that

none of licensees obtains the signal that the licensed patent is invalid. 24 Likewise, denotes the

probability that conditional on one firm having received the signal that the patent is invalid, none of

other licensees obtains the invalidity signal.

Suppose that a licensee expects its competitors to challenge the patent's validity upon receiving an

invalidity signal. If that licensee observes the invalidity signal, the probability that the licensed patent

21 In this paper, functions with subscripts denote the derivative with respect to the nth argument. 22 Such a restriction may be imposed by competition law, since higher royalty levels are likely to be anti-

competitive. See Farrell and Shapiro (2008), footnote 22. 23 The fixed fee enters additively in the patent holder's and the downstream firms' profits. 24 For example, one may assume for simplicity that conditional on the patent being invalid the event of

obtaining evidence is distributed independently across licensees, which yields

is declared invalid because its competitors litigate is . Hence it is profitable for a

downstream firm to challenge the validity of the licensed patent if ( )

. We assume throughout this paper that the litigation costs are small enough to

satisfy this condition, in order to ensure that the insertion of a no-challenge clause indeed affects the

outcome.

When all firms accept a contract without a no-challenge clause, the expected payoff of a licensee is

, (1)

where

.25

In what follows, we first consider the licensing outcome if the parties may also agree on negative

fixed payments and then turn to the alternative scenario where fixed fees are (legally) restricted to

be non-negative.26

Unrestricted fixed fees

If the patent holder cannot include a non-challenge clause into the license, downstream firms will

accept the patent holder's offer iff

or equivalently

. (2)

Since the patent holder's profit increases in the fixed fee, it is optimal to set the fixed fee as high as

possible so as to push the downstream firms down to their reservation payoff. The highest fixed fee

that induces the downstream firms to accept the licensing offer is thus

)/ (nNC refers to "no No-Challenge" clause).

The patent holder’s total expected profit per downstream firm is

, since obtains only royalty payments if the patent is not successfully challenged.

Inserting yields

. For convenience, we assume that is single peaked in on the relevant range.27 The

patent holder thus captures the expected joint profits minus downstream firms’ reservation payoffs.

Even though litigation costs for challenging the validity of the licensed patent are ultimately borne by

the licensee, they reduce the patent holder’s expected profits, since they do not have to be incurred

if no licensing takes place.28

25 At the time when the licensing contract is signed, the probability that a licensee obtains the invalidity signal

is . 26 For a discussion of the non-negativity assumption see Farrell and Shapiro (2008), p. 1357. 27 See also Farrell and Shapiro (2008), footnote 22. 28 This observation is reversed under the alternative assumption that litigation costs also have to be incurred if

a potential licensee chooses to challenge the patent’s validity if the licensing negotiations break down.

However, that alternative assumption does not materially change the effects of including a no-challenge

clause into license contracts, since a no-challenge clause does affect the outside option only through

differences in the running royalty rates.

The profit maximizing running royalty level trades off two effects. On the one hand, increasing the

running royalty level raises the overall industry profit on the relevant range. This is because the

ensuing retail prices for are below the industry monopoly level. On the other hand, a higher

royalty level also improves the outside option of the licensees, since competing downstream

competitors that accept the licensing offer face higher marginal costs. Because of this “rent shifting”

effect, a higher running royalty level forces to concede more of the total profit to the licensee in

order to assure participation. Due to the latter effect, the optimal running royalty level will be

generally below the level that maximizes the industry profits. Formally, these two effects are

captured by the first and the second term of 's marginal expected profits, which are

⁄ . Since the rent-shifting effect is proportional to , it only plays a minor

role for weak patents.

In particular, for weak patents with , it is optimal to set the running

royalty equal to the cost saving obtained through the use of the patent. Licensees are compensated

for the high running royalty by a negative fixed fee of ( ) / .

Consumers gain nothing from the new technology in that case, since each downstream firm’s private

marginal cost is the same as under the alternative technology.

If the negotiating parties agree to include a no-challenge clause, the downstream firm is

contractually held no exploit eventually obtained information on the patent’s validity. The no-

challenge clause therefore basically brings back our model to that of Farrell and Shapiro (2008). The

participation constraint for downstream firms becomes

. (3)

The highest fixed fee that induces the downstream firms to accept the licensing offer is

(NC stand for no-challenge clause) and the total profit of per

downstream firm is . is assumed to be single

peaked in on the relevant range.

Similar considerations as already set out above apply in case a no-challenge clause is included into

the contract. In particular, as shown by Farrell and Shapiro (2008), for weak patents with

, it is optimal charge a running royalty equal to the cost saving obtained through the

licensed technology and to compensate licensees through a negative fixed fee.

Comparing and

immediately yields that the inclusion of a no-challenge clause increases the

highest patent strength for which the maximum running fee will be charged:

. A no-challenge clause affects the running royalties as follows:

Lemma 1: For weak patents with , the patent holder optimally charges a running royalty

which equals the cost saving achieved through the licensed technology, that is

. For , inserting a no-challenge clause increases the ensuing running royalty:

.

Proof: The first part follows from

. An interior solution characterized by the respective

first order condition maximizes the patent holder’s expected profits obtains for in the

absence of a no-challenge clause and for if a no-challenge clause has been inserted,

respectively. Since is single peaked on the relevant range, there is a single that

maximizes . The first order condition ( ) implies ( ) as

⁄ . Since ( ) ⁄ , by continuity there

must be a , such that ( ) . Since is single-peaked,

( ) maximizes □

Intuitively, without a no-challenge clause, the patent holder only benefits from an increased running

royalty in case the patent is not subsequently declared invalid. Hence, a no-challenge clause

increases the probability that the patent holder benefits from a higher running royalty relative to the

probability that the patent would be declared valid after the negotiations breaking down. The rent-

shifting effect thus plays a less important role if firms may not challenge the licensed patent’s

validity, leading to lower running royalties.

The patent holder prefers to include a no-challenge clause if this increases the expected profits.

Formally, a no-challenge clause is profitable if , where

and are the optimal running royalty levels when (not) using a no-challenge clause. Written

explicitly, this condition reads

. (4)

If the patent holder licenses a rather weak patent so that the optimal running royalties equal the cost

savings through the patent, condition (4) simplifies to , which is always satisfied

since . Intuitively, by including a no-challenge clause, the patent holder can maintain a

high running royalty that sustains higher industry profits even in the event that a licensee discovers

information that could be used to invalidate the licensed patent. Moreover, the inclusion of a no-

challenge clause prevents litigation costs for challenging the patent’s validity that ultimately reduce

the patent holder’s expected profits. By continuity, inserting no-challenge clauses is also profitable

for the patent-holder if does not differ by too much from .

Turning to the welfare effects of no-challenge clauses, let

refer to welfare if firms may challenge the licensed patent’s validity and

denote welfare if a no-challenge clause has been inserted. We obtain the following result.

Proposition 1: If , a inserting a no-challenge clauses is welfare decreasing if litigation costs

are small enough, that is, . Patent holders always benefit from a no-challenge

clause whereas consumers are worse off.

Proof: As already discussed in the text, the patent holder would always insert a no-challenge clause if

permitted to do so and the running royalty is = . Hence,

. For a similar reasoning as in the Proof of Theorem 6 of Farrell and

Shapiro (2007), the patent holder prefers to conclude a licensing agreement over the licensee

immediately litigating the patent’s validity. □

The no-challenge clause prevents that weak patents are challenged based on information that

licensees obtain after having taken a license to the technology. As already set out above, the patent

holder always prefers to include such a clause. Hence, only a ban prevents the inclusion of this

clause. According to Proposition 1, through a ban of no-challenge clauses, licensed patents will be

invalidated with probability . In this event the obligation to pay royalties on the relevant technology

is removed, resulting in a reduction of deadweight loss. As long as this positive effect is not offset by

the additional (wasteful) litigation costs, a ban of no-challenge clauses increases welfare.

Since consumer surplus exclusively depends on the end prices which in turn depend on the running

royalties, a ban of no-challenge clauses improves consumer surplus in case of particularly weak

patents. Since the running royalties are typically lower in the absence of a no-challenge clause also

for patents with , a similar result is likely to obtain for stronger patents.

Negative fixed fees not feasible

Negative fixed fees, which emerge especially in case of weak patents as set out in the previous

section, are not always feasible or used in practice.29 This section therefore examines the effects of

no-challenge clauses in scenarios where the negative fixed fees are not feasible. Due to the

assumption that and are single peaked in on the relevant range, whenever the fixed

license fee would be negative if it were feasible, it will be licensed with no fixed fee.

If all downstream firms bear a pure running royalty , the patent holder's expected profit per

downstream firm if the patent's validity can be challenged is

. In what follows, we assume that prefers licensing with linear royalties instead of litigating

and then licensing (possibly with a positive fixed fee) in case the patent is valid.30 Since

increases and decreases on , increases on the relevant range. So, the patent

holder will license at the highest royalty that downstream firms will accept. The optimal royalty

is then implicitly defined by

( ) ( ) . (5)

As before, a downstream firm only has a limited gain from invalidating the licensed patent since its

competitors will also not require a license any more. Hence, after successfully invalidating the patent,

a downstream firm will benefit from lower industry costs, but have no competitive advantage over its

rivals. Its profits thus raise from to . Put differently, the upside is proportional to and

to . On the other hand, if the downstream firm litigates and loses, it will be at a

cost disadvantage of relative to its licensed rivals, so its downside from litigating is

proportional to and to .

Farrell and Shapiro (2008) define the oligopoly’s relativity coefficient

as the relative importance of small changes in its own costs versus small changes in

industry-wide costs in terms of downstream profit (evaluated at ).31 In case of intense

downstream competition, small cost changes of one downstream firm relative to its competitors

have a large effect on that firm's profits relative to the change in industry profits. Hence, increases

in the strength of downstream competition. For example, Farrell and Shapiro (2007) show that

29 See Farrell and Shapiro (2008), footnote 35. 30 See Farrell and Shapiro (2008), footnotes 37 and 38. 31 Note that as .

if downstream firms are symmetric Cournot oligopolists with constant marginal costs and

linear or constant-elasticity demand.32

Based on condition (5), can be determined and for small is approximately

[ ⁄ ]

⁄ .33 By inspection, one sees that the royalties decrease in

, since the

licensee's willingness to pay is diminished by litigation expenses the downstream firm has to incur

once the license it taken.

If the parties have agreed on a no-challenge clause, the patent will certainly not be invalidated and

by a similar reasoning as above, the optimal running royalty is defined by

( ) ( ) . (6)

After dividing equation (5) by , it differs from equation (6) only by the probabilities and

and the additional term that captures the litigation costs. Therefore, we have

. 34

In the proof of the following proposition, we show that for small ,

. Since in the

absence of a no-challenge clause the running royalties are only paid if the patent remains valid,

which occurs with probability , the expected running royalty payments are lower than those in case

a no-challenge clause has been inserted. Moreover, consumers are risk-loving in the royalty rate35, so

consumer surplus increases if no-challenge clauses are banned.

Proposition 2: If pure running royalties are charged and if the retail prices are linear in the

running royalty 36, then for small the insertion of no-challenge clauses is harmful to consumers

and increases the profit of the patent holder.

Proof: Rearranging equation (5) and applying the mean value theorem and yields

with . Since , for small , can be approximated by

. Using the definition of and

simplifying yields the expression in the text. Since ,

approaches the expression in the text arbitrarily close as . The expression of is derived by

Farrell and Shapiro (2008) in the proof of Theorem 8.

Dividing the approximations of and yields

[

⁄ ]

⁄

since the first term in brackets of the numerator is smaller than 1 and since

32 Farrell and Shapiro (2008) also mention that if the downstream industry is a Bertrand duopoly with

differentiated products, is higher, the closer substitutes are the two downstream products. 33 See the proof of the next proposition. 34 See also Farrell and Shapiro (2008), Theorem 8. 35 See Farrell and Shapiro (2008), proof of Theorem 2. 36 In a wide range of simple oligopoly models (e.g. Cournot oligopoly with linear demand or constant elasticity

demand, the standard Hotelling duopoly model, differentiated-product Bertrand oligopoly with linear

demand) is linear.

⁄ . Hence, for small enough . Therefore the patent holder’s profit

increases in that case.

Farrell and Shapiro (2008) prove in Theorem 2 that is convex in if is weakly concave

in Inserting a no-challenge clause induces downstream firms to pay the running royalty

with certainty instead of paying with probability and with probability . Moreover,

since , the mean royalty per unit increases through the no-challenge clause.

Hence, consumer surplus decreases. □

Intuitively, the no-challenge clause is a commitment that the patent's validity is not challenged in

court even in case the licensee obtains information which would make it profitable for the licensee to

do so. Such a commitment is valuable for the patent holder since in case the patent is declared

invalid, it would also lose the royalty income from other licensees. At the same time, the royalty

reduction of rivals in case the patent is invalidated limits the upside from successfully challenging the

patent's validity from the viewpoint of the licensee. For this reason, it is relatively cheap for the

patent holder to compensate the licensee with a lower running royalty for the inclusion of a no-

challenge clause.

Note that offering a license in the first place in order to prevent the licensee from initially challenging

the patent's validity increases the patent holder's expected profits by exploiting the same effect as

set out in the previous paragraph. By including a no-challenge clause, the patent holder ensures that

even this effect is also exploited in situations where the licensee would be otherwise tempted

challenge the patent's validity despite a license being in place.

The next proposition assesses the welfare effect of no-challenge clauses. Define

, and . The expected welfare is

if firms may challenge the licensed patent’s validity and

if a no-challenge clause is in place.

Proposition 3: If pure running royalties are charged, the insertion of a no-challenge clause has the

welfare effect .

Proof: Applying the Mean Value Theorem to and using , there exist

uch that . Since

and ,

.

According to Proposition 3 the welfare effects of no-challenge clauses depend on the impact of such

a clause on the expected running royalty rates and the litigation costs, but also on the curvature of

welfare . Clearly, a ban of no-challenge clauses raises wasteful litigation costs since licensees are

not contractually prevented from invalidating patents. However, these costs at the same time lead to

lower expected running royalties and may be overcompensated by lower mean running royalties as

set out in Proposition 2. Finally, banning no-challenge clauses changes the distribution of royalties.

Both the sign and the direction of this effect depends on the curvature of . However, if the

curvature of or is small, the magnitude of this effect is limited (and is close to 1).

From Proposition 3, a ban of no-challenge clauses in a scenario of pure running royalties is likely to

have a positive welfare if the welfare gain through a lower expected running royalty level is large

compared to the additional litigation costs. Using the result of Proposition 3 and the approximations

of and yields [

⁄ ]

⁄ . Hence, for small (which implies is close to 1), banning

no-challenge clauses is welfare improving if the litigation costs are sufficiently low, in particular in

scenarios of intense downstream competition (implying a large relativity coefficient ).

While the approximations of and only rough in case of larger innovations, Farrell and

Shapiro (2008) show that with Cournot downstream competition, verifying the licensed patent's

validity may substantially bring down the expected royalty rate, especially if downstream

competition is intense. In such a scenario, it also appears plausible that a ban of no-challenge clause

improves welfare if litigation costs are relatively low.

Discussion

Termination clauses

So-called termination clauses that reserve the possibility for the licensor to terminate an agreement

if the licensee decides to challenge the patent are suspected to have similar effects than no-

challenge clauses. As a reaction to Medimmune, licensors have more frequently included termination

clauses into in licensing agreements.37 In practice, the termination of the license may result in a

severe profit loss of the licensee, whereas without such a provision the original licensing agreement

is normally not directly affected if the patent is found valid by courts.38 Hence, the licensee will only

risk losing its license if it is reasonably certain that the intellectual property right is in fact invalid.39

Note that in our model, we assume for simplicity that upon receiving the invalidity signal, the

licensee knows for sure that the licensed patent is invalid. It appears to be more realistic to assume

that invalidity signal given an indication that the patent might be invalid, but does not provide

certainty. Under such an alternative assumption, it is indeed plausible that a termination clause may

induce the licensee not to challenge the patent's validity. In line with this observation, legal scholars

argue that in practice the termination clause corresponds to the no-challenge clause, since the

licensee will not risk losing its license unless it is certain that the intellectual property right is in fact

invalid.40

No-challenge clauses in settlement agreements

37 Another alternative might be for the licensor to agree to a lower royalty rate if the licensee does not

challenge the licensed patents or, alternatively, for the licensor to charge a higher royalty rate after an

unsuccessful challenge. See Ulmer-Eilfort and Boulware (2007), p 3. 38 Morris (2008), p 122; Ulmer-Eilfort and Boulware (2007), p 3. 39 In situations where more than one patent is licensed, challenging one invalid patent may, if the licensor

terminates the contract, result in the licensee losing access to all of the patent rights, including the valid

ones, which could decrease incentives to challenge even further. 40 See e.g. Ulmer-Eilfort and Boulware (2007), p 6.

Settlement agreements with the aim of putting litigation to an end in some instances contain no-

challenge clauses. It has been argued that the very purpose of settlement agreements is to settle

existing disputes and avoid future ones, including that the parties agree not to challenge the covered

intellectual property rights any more.41 In Bayer v Süllhöfer, despite the arguments presented by the

Commission42, the Court stated that Article 101(1) TFEU made "no distinction between agreements

whose purpose is to put an end to litigation and those concluded with other aims in mind".43

With a view to the results above, settlement agreements may be signed in situations where further

litigation costs would be high. In light of the main results of this paper, resorting to a no-challenge

clause in order to avoid high future litigation costs may in special circumstances be indeed welfare

increasing. In any case, such agreements potentially have in themselves welfare-decreasing effects as

pointed out by Shapiro (2003).

Incentives to innovate

As a ban of no-challenge clauses typically reduced the patent holder's profits, such a policy may also

result in reduced incentives to innovate. To investigate this question, one would need to weight

whether the negative effect on innovation outweigh the social benefits of having more weak patents

invalidated by courts.44

Conclusion

This paper has analyzed the effects of no-challenge clauses in a scenario where licensees may learn

about a patent's validity. The results tend to confirm the critical treatment of these provisions in

several key judgments. No challenge clauses appear to be particularly harmful in scenarios where

downstream competition among licensees is fierce and where litigation costs are limited.

These results suggest that arguments of legal scholars that the licensees should be prevented from

'attacking' the license namely due to the better understanding of the licensed technology or that

inclusion of such a clause would help ensure the protection of the principles of good faith and fair

dealing45 should be treated with great care.

This paper has not investigated litigation costs of the patent holder as a possible justification of no-

challenge clauses. It has been argued that a no-challenge clause might facilitate the grant of a license

and dissemination of technology. In particular, this may apply to small firms that may otherwise fear

the risk of litigation when licensing to bigger companies.46 Given that no-challenge clauses tend to

raise the patent holder's licensing profits, it appears indeed theoretically conceivable that patent

holders may find it unprofitable to grant a license if there is a high risk that they will subsequently

have to bear large costs once the validity of their licensed patent is challenged.

41 See Ulmer-Eilfort and Boulware (2007), p 6. See also TTBER, para 209. 42 The Commission argued that Article 101(1) did not apply to no-challenge clauses insofar as the following

four conditions were fulfilled: (i) the clause is included in a settlement putting an end to litigation pending

before a national court, (ii) there are no other clauses restricting competition, (iii) the clause relates solely to

the right in issue, and (iv) that right is manifestly unlikely to be revoked (Orstavik (2005) p 13). 43 Case 65/86 Bayer AG and Maschinenfabrik Hennecke GmbH v Heinz Süllhöfer, para 15. 44 See e.g. Farrell and Shapiro (2008a), section II B. 45 Ulmer-Eilfort and Boulware, (2007), p 6-7. 46 See Orstavik (2005), p 11 and 15; Morris (2009), p 3.

In Bayer v Süllhöfer, the Court has pointed out that a no-challenge clause has no restrictive effect

where the licence has been granted for no consideration and the licensee accordingly does not have

to suffer the competitive disadvantage of having to pay fees. 47 While our model cannot formally

explain why patent licenses are granted without any royalty, one explanation could be that a licensee

that is likely to find information on a patent's invalidity is compensated for not challenging the

patent's validity with a royalty-free license. Such a license could indeed have a negative welfare

effect.

Finally, the effects of no-challenge clauses are likely to differ according to the setting in which they

are used. For example, the no-challenge clauses may be also used in a scenario where the patent

holder is also active on the downstream markets. The analysis of this situation is left for future

research.

47 Case 65/86 Bayer AG and Maschinenfabrik Hennecke GmbH v Heinz Süllhöfer. However, Ostravik (2005,

p.11) points out that even a royalty-free license may contain other restrictions of competition.

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