Professor Robert P. Merges
University of California at Berkeley School of Law
November 15, 2011
Something big is afoot in the world of patent-related transactions. It is easy to tick off a growing list of head-turning deals in which household-name companies have bought and sold patent portfolios in recent years: Nortel, Motorola, Nokia, Microsoft, Apple, Oracle. While it is true that patent licensing has long been part of the IP landscape, and that patent sales and assignments have also been fairly common, these recent deals have two features that set them apart from past transactions: the massive number of patents involved, and the sense that the market for patents is now quite distinct, even divorced, from underlying product markets. In the words of one commentator, this newly emerging market “floats above” traditional markets. It is, this commentator says, “unmoored” from underlying products or even technology.1
Predictably, players in the market have made reassuring noises. These are sophisticated companies, market grownups. They know what they are doing. They are innovative and successful. If they are participating, even though outside observers may not completely understand what is going on, there must be a good reason.
On the other hand, neutral observers, watching and hearing all this, have sounded the alarm. Where have we seen this before? Household-name companies, bedrocks of the economic landscape, are participating in a market that seems to have little connection to traditional economic activity. The assets being traded are complex, designed by highly trained professionals. They are bought and sold in markets that “float above” or “shadow from behind” traditional markets, and their role is to facilitate traditional economic activity – to guard against risk in new and sophisticated ways. They represent bets by highly informed players about complex future developments. They are confusing to the average person, but they are ultimately efficient.
If this sounds vaguely familiar, try this substitution: For Nortel, try Lehman Brothers. For Nokia, try AIG. For Apple, try Bank of America. It is this sense of associations that I think lies behind the collective unease that accompanies this new patent market.
But of course, we can’t very well understand economic activity solely on the basis of loose analogies. And it would make no sense at all to regulate a newly emerging market simply because it creates a sense of unease based on recently past events. No, the way forward is to take a close, objective look at this market, and see what it is all about. And then to chart a course of study that will help us as a society understand its likely consequences and what we should do to shape it and turn it in a positive direction.
What We Know: Growth of the Market for “Disembodied” Patents
At the outset, one thing we have learned is that the label “patent troll” sparks a lot of strong reactions. One alternative that seemed to gain some traction was “Non-Practicing Entity” or NPE, but this caused controversy because of its focus on whether a patent owner manufactures or sells actual products, which seems to taint various players in the patent ecosystem who have long been respected for actual innovation despite not themselves making or selling products – including universities, research institutes, and well-respected “pure idea shops” like Dolby Labs. As a consequence of this controversy, the Federal Trade Commission in its 2011 report on The Evolving IP Marketplace uses the term Patent Assertion Entities (PAEs) instead.2
Whatever terminology is used, we have learned that the heart of the problem is twofold. First, there is now a market for what might be called “disembodied” patent rights – patent transactions that do not include the transfer of physical products or technological know-how. What is transferred is a pure legal right. Second, the market for these rights is particularly dependent on court enforcement and litigation outcomes. Because patent assets are subject to a great deal of uncertainty with respect to validity, scope, and ultimate money value, reasonable transacting parties can and often do disagree over appropriate licensing terms. To take just one problem area, patent claims are quite often ambiguous, and because the scope of these claims determines crucially the market value of a given patent, it is difficult for transacting parties to agree on precisely which products being sold by a prospective licensee infringe the claims in the patent(s) held by the prospective licensor.
Uncertainty over individual patent assets is one reason why the market for disembodied patents is so closely related to the rise of the patent portfolio as the standard unit of analysis in this business. As with large stock portfolios, a large patent portfolio helps to diversify away much of the risk of owning patents. It is no surprise, then, that many of the transactions in this market involve very large and thus highly visible portfolios. But not all transactions are on this scale. Aggregators such as Intellectual Ventures sometimes buy portfolios of various sizes. But at least as often they acquire individual patents and bundle them together to strengthen their holdings in a given technology area or industry. The sheer bulk of their portfolio in various fields explains why many companies, even those with doubts about the efficacy of patents in their industry, have entered into partnerships with Intellectual Ventures.
So we definitely know that pure patent transactions are increasing in number and in dollar volume. We know that they are drawing attention from investment banks and private equity firms, as well as the usual participants: the patent aggregators like Intellectual Ventures and Acacia, and the law firms and independent inventors that fed the first generation of the patent transaction revolution. So the situation looks like this: Many, many patents are changing hands in a newly emerging market for disembodied patent rights. And those rights are both complex and especially susceptible to inclusion in litigation at some point.
What We Know: The Nature of Disembodied Patents in Litigation
We also now know, based on a number of recent studies, that troll patents are not necessarily equivalent to low-quality patents. Although there are various ways to capture the idea of patent quality using statistical proxies, a pair of recent studies agree that those troll patents that are asserted in litigation are no worse in quality, and in many cases are superior in quality, to patents asserted in litigation by non-trolls.3 And so, at least if we consider quality in a superficial sense, one common objection to trolling that was heard in its early days seems to have been disproven. Trolling is not simply a matter of aggressive litigation-oriented companies acquiring low-quality patents. At least where those patents are litigated, they are, using the measures commonly associated with quality in the patent field, perfectly legitimate assets.
On one level this seems a bit of a surprise. After all, it was commonly thought that one prominent feature of troll patents was their low quality. This was the basis of the oft-repeated analogy between trolls and personal injury lawyers. The idea was that low-value claims, which are expensive to litigate, and also once in a while devastating to the defendant, were being used to underpin a business model in which lawsuit settlement was the primary goal.4 The analogy depends on weak legal claims, however; the value of the settlement is carefully calibrated to be just a bit less than the expected cost of litigation plus potential damages. While there are no doubt some patent holders still pursuing this model, the newer data cited just above seem to indicate that at least some trolls pursue litigation for reasons other than a quick, cheap settlement. Some expect to win after a full trial and appeal.
On another level, however, the new data are not so surprising. They show that patent assertion-oriented business models are more diverse than was thought. Together with trends in the acquisition of larger and larger patent portfolios by companies willing to assert patents in litigation, they show that patent assertion entities are behaving quite rationally. It makes sense, after acquiring a large portfolio of patents, to demonstrate to potential licensees that you are willing to assert at least some of them in litigation. This undoubtedly raises the economic returns from the entire portfolio. And of course, in choosing which patents to assert, it makes sense to pick some high-quality patents. These have the best chance of surviving litigation, and of establishing the overall quality of the portfolio and a very useful reputation for the willingness to enforce the patents in it.
What We Do Not Yet Know
But of course, this first wave of studies can hardly be said to have put the big questions to rest entirely. There is a deeper sense in which patent assertion companies, and the troll phenomenon as well, might be considered troubling. What if a perfectly solid patent, a high quality patent as patents go, is not the real issue at all. What if the issue is whether pure patent transactions, standing alone, contribute to the underlying goals of the patent system? Or, put simply: What if it is the nature of patent assertions, and not the quality of the patents with which they are conducted, that is the main issue?
To get at these issues requires much more knowledge than we currently have. It goes well beyond a simple analysis of the patents that are asserted in litigation by various types of companies (operating companies, assertion entities, trolls, etc.). It requires a much deeper understanding of some key relationships; to wit:
- When an inventor or company sells a patent, do the proceeds reward past R&D, contribute to future R&D, or generally encourage any behavior that is socially constructive?5
- Do high-quality patents indicate intrinsic technological merit, and at least the possibility of underlying economic value, or do they in some cases at least represent only effective investments in patent research and patent drafting? In other words, do we trust that the requirements of patentability as well as the administrative procedures for acquiring patents are good at screening out patents that do not contribute to socially valuable goals?
- When a failed company – one that has failed entirely in the market for products, or at least has failed to successfully manage a line of business for which it had accumulated a patent portfolio – sells a patent portfolio, does this represent a useful salvage event, one that gives a partial reward for having tried to innovate, and perhaps encourages future innovative efforts through the promise of a salvage-value payout in the event of failure?
- Do venture capitalists and other early-stage investors think of the salvage value of a patent portfolio when making investment decisions, or are they at least beginning to understand that this is a viable consideration given the growth in the market for patent portfolios from failed companies?
A Thought Experiment: Secondary Markets in Winner-Take-All Industries
In thinking about the market for pure patent transactions (and in participating in it on those occasions when I have),6 I have in some cases wondered if secondary patent markets serve a useful purpose in winner-take-all industries. These are industries where the economics of network goods typically dictate that one or a very few winners will emerge; technical standards and technological platforms are two common examples.7 So for example the iPhone platform, and now in addition the emerging Android platform, have come to dominate the market for mobile phone devices and applications. Users benefit in various ways from the convergence into a single platform, which sometimes is controlled by a single company. But mobile phones are enormously complex devices; the contemporary phone incorporates dozens of significant advances, some of which originated with the dominant platform companies (Apple in the case of the iPhone) but many of which did not. Many small companies that hoped to become players in the mobile market have fallen by the wayside as the market converged on a few big winners. The original dreams of these companies’ founders are now dead.
Even so, to the extent that the now-dominant platforms incorporate features developed by smaller, innovative companies, it seems appropriate for the few large “winners” to compensate the smaller companies whose technological contributions ended up in the dominant platform. Indeed, the secondary patent market may represent the only way for a small company that lost out in the product market to see some return on the contributions it made to the eventual winner. In such a scenario, the secondary patent market serves as a fallback profit-making opportunity for the small companies that so often lose out in winner-take-all industries.
This all sounds good, maybe, but why do I call it a thought experiment? Because, again, we have little data so far with which to test it. And also because there is a counter-narrative, an opposing story, which is also plausible (at least in some cases) and which is far more troubling. This is the story of the ex-post rent-seeking use of patents to capture a dominant firm’s sunk cost investments. In this story, the patent market might well be just called “a market for rent-seeking instruments.” Participants in this market shop around for patents that cover important components or portions of a successful company’s product. These patents, in this story, do not represent markers of prior successful innovations. They are merely well-drafted and malleable legal instruments that can be nuanced and stretched to cover various features of a product with a large market. These instruments are especially valuable when they are especially broad, capable of covering many technological variants and therefore difficult to avoid through legal argumentation or product work-arounds.
It is this scenario the Federal Trade Commission had in mind when arguing that competition authorities need to distinguish between “ex-ante” patent licensing and “ex-post” transactions.8 Ex-ante licensing occurs when a product is being designed, and is often accompanied by the transfer of technological know-how to help the licensee build the product. Ex-post licensing is purely rent-seeking; it is designed to capture the value of the licensee’s own investments, typically after the licensee has sunk significant costs in a product design and is therefore “locked in” to an infringing configuration.
Patent Rules and Doctrines: Testing for Real Innovation
The difference between the two stories I just presented is this: In the first, a small company contributes a socially valuable innovation that is embodied in a patent that is later sold to an assertion entity. In the second, the assertion entity shops for patents that effectively cover a successful product sold by a dominant company. The patent in this story does not represent any real innovation but rather is an effectively drafted legal instrument that facilitates the capturing of some of the value created by the dominant company.
When the issue is stated this way, it is easy to see what policies are implicated. Patents must represent real innovations. The Patent Office, and especially the courts, must be vigilant in applying patent law. Much depends on their skill. The legal requirements of patent validity, the standards for patent infringement (i.e., whether a patent claim covers a given technological variant), and the doctrines measuring patent damages and determining when an injunction is warranted must all be applied with a keen sense of what is at stake. The secondary market for patents has created more opportunities for more patents to be asserted against more products. As a consequence, the detailed rules of patent law – which collectively embody the essential policy requirement that patents represent true innovations – must be applied with even greater rigor and care than in the past. The market for disembodied patents puts more pressure on patent institutions to draw the proper line between significant inventions and merely clever rent-seeking instruments. A high error rate in this task could undermine the role of patents in fostering innovation, and ultimately call the entire patent system into doubt.9