The debate on "patent trolls" rages on. The current discussion in the legal, political, and business communities has focused on the effects that newly proposed legislative and executive proposals will have on so called "patent trolls." The outcome of these discussions will impact investors in some form or fashion, yet investors may not have the tools to fully appreciate the underlying issues. First, some basic definitions.
Patent attorneys categorize "patent trolls" as falling under a broader umbrella of non-practicing entities (NPEs) - companies that license patents without actually manufacturing or using the patented invention, e.g., by producing or selling the goods or services. Note, NPEs may include holding companies set up for R&D and licensing operations, universities, individual inventors and other entities. Patent trolls are a subset of NPE's unified by their proclivity to engage in various highly criticized tactics.
What types of malicious tactics do true patent trolls, as opposed to more-palatable NPE's such as universities, employ? One tactic is to buy patents out of bankruptcy from firms that have no choice but to sell these intangible, but nevertheless often-valuable, assets for pennies on the dollar. Another is to set up fake offices in patentee-friendly venues, such as Eastern District of Texas, Eastern District of Virginia and Delaware to establish jurisdiction for the inevitable lawsuits against (sometimes large numbers of) unsuspecting companies. Even more vexing is the practice of suing small "mom-and-pop" local small businesses to establish jurisdiction over larger co-defendants - a tactic that frequently forces these small businesses to shut down operations completely. Yet another criticized tactic is to shake-down profitable companies by demanding nuisance costs, which typically force settlement by offering slightly less than the six-and seven-figure litigation costs required to defend a litigation. Typically, these tactics rely upon asserting bad quality patents with fuzzy and unusually broad claims against a variety of products and services. And finally, privateering tactics, whereby patent trolls create random no-name holding companies to hide the true owner of the asserted patents. All of these tactics have garnered criticism. In the case of privateering, the reason the trolls wish to hide their true identity is to avoid the threat of counterclaims. For instance, Nokia (NYSE:NOK) sold many of its patents to Vringo (NASDAQ:VRNG) for the presumed purpose that Vringo can sue Nokia's competitors and collect large potential damages without jeopardizing the potential downside from counterclaims against Nokia. Vringo's suit against ZTE (OTCPK:ZTCOF), one of Nokia's competitors, provides upside for Nokia without risking the potential downside wrought by counterclaims unleashed through ZTE's large patent portfolio. Instead, Vringo is a perfect candidate to act as Nokia's enforcer.
What is the supposed economic impact of these patent trolls and why should investors care?
One frequently cited study claimed that in 2011 alone, patent trolls cost American technology companies over $29 billion. Armed with this study, leading hi-tech companies such as Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT) have launched a campaign against patent trolls by working with the USPTO, Congress, and the software industry to support legislation directed at shutting them down. For instance, the SHIELD Act (Saving High-Tech Innovators from Egregious Legal Disputes)(ironically supported by EFF which is funded by Mark Cuban, infamous Vringo investor) and the Goodlatte and Leahy patent reform bill have gained much attention lately. Google also proposed forming cooperative licensing groups and a series of royalty-free licensing agreement structures among participants to "encourage innovation." In addition, the White House has also proposed executive action against trolls. Taken together, all of these latest developments represent risk to investors seeking to exploit opportunities in the high yield potential in the patent monetization space. Despite these apparent setbacks, there remains potential upside for investors in the publicly traded patent monetization firms. The studies, and statistics quoted in these studies, are flawed.
Recall the infamous "$29 billion study" mentioned above. The study asserts that NPE's (non-practicing entities) are costing the economy more than $29 billion each year. But the study is based upon a broad definition of an NPE that covers any person, corporation or university that asserts its patent through litigation without actually using it to manufacture a product. Essentially, the $29 billion figure covers many more entities than just "patent trolls." This, of course, begs the question - are the new proposals targeting every university in the world, every start-up company planning to take its product to market, and large corporations who hoard hundreds of thousands of patents without actually practicing them? [e.g., IBM (NYSE:IBM), Facebook (NASDAQ:FB), Google, Microsoft, Apple (NASDAQ:AAPL), etc.] Recently, Facebook bought 650 patents from Microsoft for $550 million. Are they a potential patent troll? If we try and more accurately define trolls by their behavior, we will need to wait and see if and how they use the patents. Simply accumulating patent assets and generating value out of those assets (e.g., via licensing, cross-licensing, assignment, sale, etc.) does not a make you a troll.
In its zeal to deter troll behavior, the legislative and executive proposals threaten to chill legitimate use of the patent system. For example, under the veil of "reducing NPE lawsuits", the Goodlatte-Leahy patent bill discriminates against start-up companies that may not be ready to manufacture. The barriers to entry for small technology start-ups are significant. Faced with competition from Google, Microsoft and other tech "giants", many small companies that have discovered valuable technological innovations have limited capability to enter the market. The patent system offers protection for these companies against giants seeking to capitalize off their research and development. That protection often comes in the form of allowing these companies to enforce-and effectively monetize-their inventions through litigation. Yet, by labeling these companies "trolls", and enacting legislation that penalizes them from attempting to capitalize on their own inventions, Congress shores up the "tech leverage" in the hands of the giants. Goliath wins, and David is left without his sling.
Thus, the question remains - what is the true effect proposed legislative measures have on technological startups?
The Three Branches of Government
First things first. For any proposed law to carry weight, the executive (White House), legislative (bills in Congress) and judiciary branches of the U.S. government have to be aligned on all of the issues. This is not the case right now and any new legislation may take years if not decades to pass. For now, the White House is only issuing "legislative recommendations" and some executive actions for the USPTO to follow.
Recovery of litigation costs from "losing" patentees
The SHIELD Act proposed to combat "trolls" by forcing them to pay all litigation costs if they lose. The presumption is forcing them to pay a penalty for losing-in the form of attorneys' fees, which is typically unheard of in American litigation-then frivolous, unjustified "troll" suits will diminish. The irony behind this proposal is that it already exists in the Patent Act. Section 285 of the Patent Act already allows for fee shifting in the event a patentee brought a frivolous patent suit. That section has forced more sophisticated patent assertion companies to concentrate on quality patents, which are carefully vetted to avoid early dismissals or any accusations of frivolity. More importantly, the SHIELD Act, even if passed, faces serious constitutional concerns. Given that fee-shifting is not the norm in American jurisprudence, a legislative measure that would sanction fee-shifting for one particular type of case-patent cases-at the exclusion of all others, raises significant concerns under substantive due process and equal protection clauses of the Constitution.
Furthermore, the recently enacted America Invents Act, which took six years to pass, allows for post-grant proceedings. These are similar to a full-blown patent trial, except that they are limited to invalidity issues only. This alone should lead to a much more cost effective way to knock out bad patents. With respect to poor infringement allegations, many courts throughout the country have already started holding early Markman hearings on case-dispositive issues and granting summary judgments of non-infringement to end weak cases early with limited expenses to the defendants.
Moreover, Rule 11 of the Federal Rules of Civil Procedure alone, if strictly enforced, should flush out the filing of weak claims and result in award of attorneys' fees to the winning side.
In addition, the inter partes review proceedings have already significantly reduced the cost of defending against invalid patents. Companies, upon receipt of demand letters by their end-users, are frequently petitioning for inter partes review when appropriate, and therefore, cutting off patent "trolls" before a full-blown litigation can get started.
In sum, both the Patent Act and the Federal Rules of Civil Procedure already afford considerable mechanisms to guard against frivolous patent suits. If properly enforced, these existing measures could go a long way toward stemming the criticism currently waged against patent monetization companies, without putting them out of business.
Patent Examination Changes
The solution behind improving the quality of granted patents or successfully challenging the existing patents has little, if anything, to do with NPEs or their tactics. It lies within the U.S. Patent and Trademark Office. Such improvements are indeed necessary, but they will take years to implement and will only affect patents which have not yet issued and a limited number of existing patents. Moreover, some of the proposals such as "tightening functional claiming" and "empowering downstream users" are simply unrealistic because no new rules or standards providing guidance for examiners are actually proposed. We can only assume that the ultimate goal is to provide greater scrutiny towards functional language in software-based applications, hence rejecting those more often than not. As for the end-user issue (patent trolls have been increasingly targeting end-users of products rather than manufacturers), all that the USPTO can really do to "empower" end-users, without Congress stepping in, is to educate them about the patent system. Of course, all of the information is out there already and there is not much more the USPTO can do in that regard.
Change the patent system all together
Over the last few decades, the United States has shifted from a manufacturing economy, to a service economy, and now to a knowledge economy. A number of small tech start-ups have made significant innovative contributions to the building reservoir of technological knowledge. Armed only with their patents, small inventors are entitled to capitalize upon their inventions. Yet, because barriers to entry bar them from manufacturing their product, they are labeled trolls. In the alternative, they sell their patents to licensing companies who have the resources to enforce their patents for them. These licensing companies are also labeled trolls. Given this, Congress will be forced to walk a fine line between squashing these trolls, and protecting the U.S. economy that in many ways is built upon the knowledge contributions from small inventors.
Requirement to disclose the patent beneficiary
Trolling is not just a game played by the small guys. The big technology companies have also got into the act, albeit surreptitiously through privateering. In attempt to discourage patent privateering, some have proposed that an entity seeking to enforce a patent must disclose the entity that stands to benefit from any settlement or lawsuit. Such disclosure of all existing interests, and their corresponding percentages in a patent prior to a lawsuit may discourage some privateering, but it is unlikely to significantly affect the existing regime, let alone eliminate it completely since it's often unclear which entity qualifies as the "real party in interest." Furthermore, this is hardly a make or break issue, since good lawyering can lead to discovery of all of the interested parties through publicly available assignment records. (Admittedly, if the information is not publicly available, the discovery process may take months, long after defendants have had to commit to litigation.) On the other hand, an executive order requiring the USPTO to force patentees to regularly update ownership information could have some impact on licensing decisions when faced with a patent lawsuit - companies will be able to demand the entirety of the real party's in interest patent portfolio to be licensed rather than paying a settlement fee for a single patent to a holding company.
Either way, the patent assertion companies investors are concerned about, such as Vringo, Copytele (COPY.OB), Acacia (NASDAQ:ACTG), VirnetX (NYSEMKT:VHC), Worlds Inc. (OTCQB:WDDD), Marathon PG (NASDAQ:MARA), Parkervision (NASDAQ:PRKR), Blue Calypso (OTCQB:BCYP) and others, by their nature, are publicly-traded and are subject to the SEC disclosure rules and regulations, and thus have already insulated themselves from most of the above mentioned troll-like practices.
Raise the injunctive standards in ITC proceedings
Since the Supreme Court's 2006 eBay decision, which put a stop to NPE's ability to obtain injunctive relief at a district court level, the more aggressive NPEs have moved on to another forum - the International Trade Commission (ITC), where the threat of an exclusion order (the only available remedy which prevents importation of an infringing product) is often used to holdup defendants for licensing fees. This, of course, resulted in a double standard within the U.S. patent system. Whether or not the ITC will join district courts in barring injunctive relief to purely licensing entities will require statutory enactment to be resolved. Apart from being a lengthy process, such a proposal will have little to no effect at all on the new breed of the highly sophisticated publicly traded NPEs that use the district courts as their venue of choice. After all, plaintiffs cannot get any monetary damages at the ITC.
How to deal with curbing abusive troll practices is a difficult question, because of the real risk of hurting innocent parties in the process. Because of that risk, changes will be implemented slowly if at all. What investors need to do is keep up with those changes if and when they occur, and look for potential impact on any investments they are in or considering. In the meantime, the patent assertion sector presents some very intriguing investment opportunities - that can and should be evaluated on an individual basis.
Disclosure: I am long MARA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.