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The Paradox of Patent Assertion Entities

Monday, August 12, 2013

The federal government is taking some big steps to reform patent law with PAEs, but what kind of new regulation is really needed?

In March 2011, the Federal Trade Commission (FTC) released The Evolving IP Marketplace: Aligning Patent Notice and Remedies with Competition, its antitrust policy review of the patent marketplace in which it unveiled the term “patent assertion entities” (PAEs) as a substitute for the derisive term “patent trolls.”

According to the FTC, a PAE describes a business model that “focuses on purchasing and asserting patents against manufacturers already using the technology (after infringement and lock-in have occurred), rather than developing and transferring technology” to licensees, thus simply transferring a legal right not to be sued for the transfer of money. Moreover, PAEs are differentiated from the broader technical term of “non-practicing entities” (NPEs), which can include development firms that offer their patented technologies to licensees in advance, university research laboratories, and licensing agents that offer enforcement and negotiation services for patent owners, technology entrepreneurs (some failed), and major technology companies spinning off their patents to capitalize on their value.

Critics of PAEs argue that they impose a de facto tax on innovation that undermines the intent of the U.S. patent system and that they extract financial compensation through systematic plaintiff overcompensation from innovating companies. PAEs also, the critics tell us, prevent companies from knowing which patents are covered (thus enabling “ex post” licensing demands), are not constrained by exposure to counter-claims or reputational effects of abusive practices, and create costly, time-consuming barriers for U.S. businesses (especially small, entrepreneurial businesses) to release new, innovative products to the American consumer.

In contrast, supporters of the PAE business model argue that these entities promote innovation by enhancing the value of patents, thus monetizing the reward to the inventor. Proponents also claim that PAEs offer lower search and bargaining costs, add a high degree of liquidity that increases innovation incentives, improve the business environment for risk management of investments in R&D activities, and ensure that financial compensation is received by entrepreneurial inventors by licensing, licensing and selling back, and securitizing their patents.

Due to the narrow circumstances under which novel approaches to antitrust theory will likely have to be applied to PAE activity, a major question remains: will antitrust policy actually have a significant impact on 'illegal' PAE activities?

The FTC and the Department of Justice (DOJ) are in the process of assessing the impact of PAE activities on innovation and competition and their implications for antitrust enforcement and policy. According to a June 19, 2013 New York Times article, Edith Ramirez, chairwoman of the FTC, planned to ask the full commission to approve an agency inquiry, a 6a(b) study of the so-called “patent troll” issue, that will include the issuance of subpoenas to PAE companies, and will focus on gathering information from both small, so-called “legal shells” which gather patents and issue “demand letters” citing infringement, as well as large firms, such as Mosaid and Intellectual Ventures, who manage portfolios of patents that they license. Yet, due to the narrow circumstances under which novel approaches to antitrust theory will likely have to be applied to PAE activity, a major question remains: will antitrust policy actually have a significant impact on “illegal” PAE activities?

The answer is not necessarily. As Carl Shapiro, an economist at the University of California-Berkeley argues, what is of lesser importance is whether the patented invention is vertically integrated with the patent assertion function. Instead, the more pressing question is how the PAE’s impact on innovation affects the total costs imposed on the defendant, the reward to the original patentee/inventor, and the industry contribution of the defendants and patentees to innovation. 

A one-size-fits-all antitrust enforcement policy approach is not one I would recommend. As Boston University legal researchers James Bessen, Jennifer Ford, and Michael J. Meurer have found, PAE litigation is heavily concentrated in the information technology (IT) sector, with approximately 75 percent of PAE-asserted patents covering computer and communications-related inventions, and 62 percent covering software-related patents. Because of the component-driven, intangible nature of IT, some critics urge the U.S. Congress to undertake targeted reforms in this industry sector. As Reuven Brenner, lecturer at McGill University’s Desautels Faculty of Management, asks in a recent Wall Street Journal opinion piece: what would happen if the life of patents in some industries, such as software, were shortened to three to five years (as suggested by Amazon founder Jeff Bezos)? Brenner’s question (and Bezos’s suggested policy alternative) has merit and is seriously worth considering, as software inventions do not require the same amount of time to earn back their investment as those found in the more capital intensive, high-risk biotechnology or pharmaceutical industries.

Another reform specifically proposed to address PAE patent abuses is to adopt “loser pays” in IT patent litigation, which, as the name implies, would force the loser of the case to pay for all legal fees. Considering that the overwhelming majority of PAE cases fall in the IT sector and that one recent study by legal scholars John R. Allison, Mark A. Lemley, and Joshua Walker found that 92.4 percent of merit judgments (once-litigated study group) were found for the defendants in such cases, I recommend pursuing such an approach because it would serve as a useful complement to the shortened patent life approach suggested by Jeff Bezos.

Michael A. Carrier, a Rutgers University School of Law-Camden professor, has recently suggested six specific policy actions that the FTC and DOJ can consider in reference to antitrust policy limitations on enforcement actions against PAEs:

  • First, the agencies can revise their jointly-issued intellectual property guidelines from 1995, or at least offer guidance on potential harms arising from the creation and exploitation of massive patent portfolios.
  • Second, the agencies could require transparency in evaluating patent-based behavior.
  • Third, the agencies could forbid any acquisition by a PAE (or an operating company) that does not agree to honor “reasonable and non-discriminatory” (RAND) agreements entered into by its predecessor.
  • Fourth, the agencies could apply Section 7 of the Clayton Act to mergers and acquisitions involving PAEs.
  • Fifth, Section 1 of the Sherman Act also might be applicable in certain settings involving collusion.
  • Sixth, PAE behavior involving incipient or “frontier” behavior could potentially constitute an unfair method of competition prohibited by Section 5 of the Federal Trade Commission Act.

One major advantage of Carrier’s suggestions is that they do not require any new legislation, only changes (where and when appropriate) in antitrust policy enforcement behavior by the FTC and the DOJ.

Yet I would still suggest that the paradox of PAEs ultimately exists in the nature of the U.S. patent system, not in antitrust policy. In the United States, patents are recognized as a legal instrument of private property rights. In contrast, the patent systems of other countries recognize patents as an instrument of a nation’s industrial policy. While similar in their recognition of the initial ownership rights associated with the invention, in many other countries it is necessary for actual manufacturing to occur within a prescribed period after the patent is awarded in order for the patentee to retain ownership rights over the patent. A lack of commercialization can be deemed as an abuse of one’s patent rights and lead to forfeiture of those rights. In the United States, the federal government does not require patentees to actively manufacture a product or provide a service based on a patent. All a patentee needs to do is pay the patent maintenance fees and wait until the patent term expires.

At its core, however, this criticism has less to do with issues related to antitrust policy and enforcement and more to do with the nature of public policy relating to the extent of property rights recognized by today’s patent law and policy.

Thus, the nature of U.S. antitrust policy enforcement of PAE activity ultimately lies at the doorstep of U.S. patent law. Critics of PAEs believe that these entities operate in a way that is contrary to the purpose and constitutional intent of the U.S. patent system; that is, they encourage neither the innovation nor commercialization of new products and services for the benefit of the American public. Their purpose is to simply monetize patents and obstruct manufacturers who are in the process of commercializing new, technologically complex products. At its core, however, this criticism has less to do with issues related to antitrust policy and enforcement and more to do with the nature of public policy relating to the extent of property rights recognized by today’s patent law and policy.

That important debate, however, has yet to begin in earnest, and will not likely do so until PAE antitrust issues are thoroughly vetted and other, less daunting patent policy reforms are considered as a potential solution. I believe that the latter patent policy reforms will be, and should be, addressed first. To this end, the Obama administration recently offered a list of seven legislative recommendations and announced five executive actions that it believes will “bring about greater transparency to the patent system and level the playing field for innovators.” Specifically, President Obama focused these efforts on PAEs that, in the president’s words, “don’t actually produce anything themselves,” and instead develop a business model “to essentially leverage and hijack somebody else’s idea and see if they can extort some money out of them.”

The legislative recommendations to the U.S. Congress include requiring that patentees and applicants disclose the “real-party-in-interest”; permitting increased discretion in awarding fees to prevailing parties in patent cases (similar to the legal standard that applies in copyright infringement cases); expanding the U.S. Patent and Trademark Office’s (PTO) transitional program for business method patents to include computer-enabled patents; providing off-the-shelf use by consumers and businesses (with better legal protection against liability); changing the International Trade Commission (ITC) standard for obtaining an injunction (to align it with the existing four-factor test in the U.S. Supreme Court’s eBay v. MercExchange holding); using demand letter transparency to reduce abusive lawsuits; and ensuring that the ITC has adequate flexibility in hiring qualified administrative law judges.

The announced executive actions, to be administered by the PTO or ITC, include making “real party-in-interest” the new default (i.e., by requiring patent applicants and owners to regularly update ownership information); tightening functional claims (especially pertaining to software applications); empowering downstream users (i.e., retailers, consumers, and other end-users of patented technology) through information; expanding dedicated outreach and study with stakeholders, including patent holders, research institutions, consumer advocates, public interest groups, and academic scholars; and strengthening the enforcement process of ITC exclusion orders barring the importation of infringing goods (in cooperation with U.S. Customs and Border Protection).

I would still suggest that the paradox of PAEs ultimately exists in the nature of the U.S. patent system, not in antitrust policy.

There is growing evidence of an emerging bipartisan effort in the 113th Congress to legislatively address many of the most egregious issues related to PAE abuses. In the first six months of this Congress, there have been six proposed bills addressing PAE activities introduced, including the re-introduction of H.R. 845 - “Saving High-Tech Innovators from Egregious Legal Disputes Act of 2013” (“SHIELD Act”), co-sponsored by Representatives Peter DeFazio (D-Oregon) and Jason Chafetz (R-Utah), which in its latest incarnation applies to all patents (not simply software patents) and requires that NPEs that are unsuccessful in suing for patent infringement pay the defendants legal costs if they lose their lawsuit, and S.845/H.R.2766 - “Patent Quality Improvement Act of 2013” (”STOP Act”), sponsored by Senator Charles Schumer (D-New York), and co-sponsored by Darrell Issa (R-California), Judy Chu (D-California), and Jared Huffman (D-California) respectively, which establishes a new process in which technology patents get reviewed by the PTO before being litigated for alleged infringement, ostensibly to eliminate “frivolous” claims brought by PAEs.

Moreover, in a June 4, 2013 op-ed piece appearing in The New York Times, the chief judge of the Court of Appeals for the Federal Circuit, Randall Rader, along with law school co-authors Colleen Chen, of Santa Clara University, and David Hrcik, of Mercer University, call for judges to utilize their authority (under Section 285 of the U.S. Patent Act) to require PAEs that bring losing patent lawsuits to pay reasonable attorney fees to the defendants. There appears to be a consensus developing among all three branches of the federal government concerning the existing problems associated with PAEs

In conclusion, the Obama administration’s executive actions do not require Congressional approval, and will likely result in some modest improvement in transparency and increased PTO level of scrutiny of software patent applications. But serious Congressional policy debate likely will begin in this fall’s session, reflecting a significant opportunity to develop a common legislative agenda on Capitol Hill for much needed, focused bipartisan patent law reform addressing PAE litigation abuse.

Thomas A. Hemphill is associate professor of strategy, innovation and public policy at the University of Michigan-Flint’s School of Management.

FURTHER READING: Hemphill also writes “U.S. Manufacturing’s Brave New World” and “Deregulating Occupations: Is Michigan Leading the Way?” Michael M. Rosen offers insight on “Software Patents: Reform, Not Repeal” and writes “Patents Defended.” James Pethokoukis explains “Why One-Size-Fits-All Patent Law Is a Bad Idea” while Roger Bate looks at “New Delhi’s Patent Malpractice” and joins Suresh Sati to argue that “Effective Intellectual Property Protections Are Key to Future.”

Image by Dianna Ingram/Bergman Group

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