Evaluating The Cost Of Patent Litigation: A Primer For Investors

by: Markman Advisors

The patent litigation space remains one of tremendous interest for investors. Irrespective of whether their interest is in large-cap companies embroiled in large-scale patent litigation like Samsung (OTC:SSNLF) & Apple (NASDAQ:AAPL), or in the burgeoning publicly-traded patent assertion entity sector led by companies like Vringo (VRNG), Parkervision (NASDAQ:PRKR), Acacia (NASDAQ:ACTG) and Marathon Patent Group (NASDAQ:MARA), investors remain intrigued by the possible outsized returns and high profile of patent litigation activity. Accompanying that interest, however, is an awareness that patent litigation is an expensive endeavor. Evaluating the impact of that expense on a particular company remains a challenge for investors, who are usually not privy to the inner workings of the legal marketplace for patent litigation services, and are often informed of the costs of a particular case or set of cases after the fact, in a SEC filing, earnings report or some other public disclosure. Despite this general opacity, it is indisputable that patent litigation costs remain a pressing area of concern for companies of all sizes, whether they be patent assertion entities looking to secure big verdicts or settlements in an effort to boost their share price, or large multinational corporations engaged in multi-front patent litigation against competitors and NPEs (Non-Practicing Entities). (See our article here for more on the legislative efforts to combat malicious tactics of such entities.)

The reason that patent litigation costs are an area of concern for companies, and by extension investors, is simple. Patent litigation is expensive, irrespective of which side of a case a company finds itself on. And the single biggest contributor to the high cost of patent litigation? Outside counsel fees, or the cost of hiring experienced counsel with both patent and litigation experience to handle a particular case. Just as there is a wide range of potential patent litigators available for companies to hire, so there are a wide variety of fee structures that have been deployed in order to retain their services. New structures continue to be experimented with, as companies search for the right formula to secure the services of competent, driven, and skilled attorneys who will handle their case with efficiency and aplomb. And win -- but not at the expense of creating a pyrrhic victory, where the only true winner from a financial sense are the lawyers who have feasted at the legal fee buffet at the expense of the litigants.

Just how expensive are outside counsel fees in patent litigation? Some examples. At the highest end, consider the reported expenditure on outside counsel by Samsung on their series of "smartphone wars" patent cases with Apple (discussed here). While we are not privy to the exact numbers, reports are that Samsung has already incurred legal costs in the hundreds of millions of dollars on just those set of cases. And surely Apple, with its own army of lawyers (from three different leading law firms), has spent serious money on those cases as well. Of course, the overwhelming majority of patent cases are not of the scale or importance of Apple v. Samsung. That said, it is important to have a sense of the range of costs at the high end. Another example of continuing patent litigation activity is the ongoing "Hatch-Waxman" battles between large pharmaceutical companies and generic drug manufacturers. Each of those cases (and a large generic company like Teva (NYSE:TEVA) could be involved in dozens at a time) normally carries a litigation budget in the millions -- for each side.

What about the plaintiff cases, where a patent assertion company sues a variety of large companies in the hopes of extracting quick settlements? While the patent assertion companies themselves are typically represented by contingency firms (who usually reserve 40-50% of the recovery, with the higher amount usually depending on whether they are also covering other litigation expenses in addition to their own fees), defense costs for such cases can easily rise into the millions. Especially if such a case goes to trial. And the patent assertion companies know that a minimum outlay for the defense of these cases can reach into the hundreds of thousands of dollars for each defendant very quickly. Indeed, this fact alone is what drives many of the quick settlements in this space and allows arguably questionable patents to generate some revenue. In all we are talking real money, particularly for frequent litigants like Samsung, Apple, Google (NASDAQ:GOOG) and other technology companies, in addition to major retailers (whether online or brick & mortar) whose websites are frequently targeted by non-practicing entity patent-holders. Add in the aforementioned patent litigation activity in the pharma sector, and it is clear that patent litigation costs are a big expense for many publicly-traded companies. How those companies handle those costs, and seek to contain them, is an important area of inquiry for investors.

Another class of patent litigants worthy of consideration are the growing number of "patent plays" or publicly-traded companies in the business of acquiring patents and asserting them against large companies in the hopes of generating large settlements or damages awards at trial. Investors have learned that these stocks can be very volatile, but also very rewarding, particularly when these companies receive good news in one of their cases, or when they acquire a particularly attractive portfolio of patents for asserting in the future. While the costs and potential benefits of those acquisitions are usually easily assessed by investors through the normal disclosure process (and the importance of evaluating these companies on their patent "pipeline" can't be overstated), it is more difficult to evaluate whether a company is pursuing a sound strategy in regards to its hiring of outside counsel to help monetize its patents. And make no mistake, the handling of litigation costs should be a critical factor for investors when choosing which of these patent assertion companies to invest in, as well as a crucial evaluation tool for assessing the quality of management. Investors can form their own opinions, but in our view, any publicly-traded patent assertion company that is paying their counsel their full hourly rates, or diluting potential shareholder value by hiring lawyers on "full" (i.e. 35% or more) contingency rather than investing in the case so as to protect the upside to the company from a large recovery, should be questioned. Put simply, for a patent assertion company, its litigation costs are its principle vendor cost, and any cost that single-handedly eats into 35 to 50 percent of the company's revenue deserves scrutiny. On the flip side, companies that have or do enter into creative fee arrangements with outside patent litigation counsel should be applauded for doing what investors would applaud any brick-and-mortar company for doing - i.e., smartly managing the costs of its bricks and its mortar. In all cases, investors should demand and deserve an explanation from management as to the search process used to retain outside counsel, and why a particular fee arrangement is in place for any existing cases.

Recently, Unwired Planet (UPIP), a patent play with pending cases against the likes of Google and Blackberry (NASDAQ:BBRY), announced a new fee arrangement it had reached with its outside counsel, the McKool Smith law firm. Under the terms of the deal, Unwired Planet will pay McKool $500,000/month for a period of 24 months (making the total deal one for $12 million in cash for three cases), plus a percentage of any recovery, with the percentage amount higher the earlier a settlement is reached. Based on the disclosed numbers, Unwired Planet is committing to paying its outside lawyers an average of $4 million per case, a large amount by nearly every standard, especially for a plaintiff. Interestingly, public statements by Unwired Planet's executives indicate that this deal will save the company around 50% on their costs going forward, indicating that these cases were costing the company in the range of $1 million per month. Clearly, very few companies can withstand such a burn rate, especially considering the need for these companies to acquire additional patents, and file as many cases as possible so as to maximize the chance of generating shareholder value through their core patent assertion activities. Give credit to Unwired Planet for reducing their existing costs, and at least trying to secure a favorable deal with a reputable law firm. Another factor that seems favorable for Unwired Planet is the apparent commitment that they secured from McKool Smith that certain of the firm's top attorneys would be handling their matters. This is important, because the composition of the legal team is as important as the amount it costs to put that team on the field, and variation of skill level and experience can vary widely even within a law firm. And a deal to pay a law firm a flat-fee for a representation will usually -- in the absence of a specific commitment otherwise -- incentivize that firm to have as much of the work done as possible by cheaper, less experienced attorneys within the firm. (A notable exception here is when a less experienced attorney is actually better than the experienced one) This incentive to "push work down" and free up the more experienced lawyers to work on more lucrative matters is a frequent problem in contingency engagements as well. Unwired Planet appears to have avoided this sand trap.

On the flip side, the raw numbers of the deal suggest that Unwired Planet is paying a premium to secure McKool's services. That is fine, but clearly not a long-term strategy that would be very appealing to investors, who would probably want management to look for the best deal possible on every case, and avoid tying up cash that could be used to acquire more assets for the company. Of course, it is difficult on the outside to fully evaluate a deal like this, especially since there is no way of knowing what alternatives Unwired Planet considered, or what offers it received to handle the representation from other firms of McKool's caliber. The caliber of the lawyers is something the market rightly pays attention to, and hiring outside counsel serves a number of important purposes in a patent case (such as preservation of the attorney-client privilege), even for serial litigants who might otherwise be tempted to create internal teams to handle litigation tasks so as to keep costs down. There is a place for the latter approach, just as there is a case to be made that companies should strongly value their flexibility to add or subtract from their litigation teams as needed. An easy example? Patent cases can be filed nationwide, and while there is often great value to a company to have their core outside litigation team located close by, quite frequently cases are filed and even come to trial in far-flung jurisdictions. In those cases, hiring a well-regarded trial attorney to help present the case to the jury can be of great value. From an investor perspective, how a company wields its cash is a critical concern, particularly for a non-revenue generating or lightly capitalized patent assertion entity. Securing solid representation, while maintaining flexibility to add firepower when necessary, while preserving that cash is a challenge that the management of companies that hope to succeed in this competitive landscape must meet.

Ultimately, every company hoping to make it big in patent assertion (or for larger companies fighting off patent challenges, where the hope is avoiding big damages awards) needs to get this critical task -- finding and securing the services of effective outside counsel at a manageable (and investor-friendly) expenditure of cash outlay and upside preservation -- right if they hope to build a sustainable and attractive business. Aligning incentives with the lawyers who will be arguing the company's cause in court is therefore critical.

To that end, companies should seek out qualified lawyers who are willing to: 1) handle matters on a flat-fee basis, 2) retain some upside in the recovery in exchange, but have that upside tied to the success of the company as a whole rather than on one particular case, 3) commit to having only experienced lawyers on the core team, and have that core team assign the highest level of priority to servicing the cases they are retained to handle, 4) be flexible in working with other outside counsel and vendors who may be needed to achieve a result in a particular case, and 5) be willing to commit to handling multiple cases so that each new case does not bring a new negotiation. In short, companies need to be looking to generate win-win relationships with a core group of qualified lawyers, and be willing to share the details of those relationships with investors in a transparent matter.

What is clear is that the traditional legal fee structures no longer work for frequent patent litigants, and especially when an investor is placing a bet on a company that lacks the resources of a Samsung, the need for an alternative approach to outside counsel costs is paramount. One can only expect that deals involving publicly-traded patent assertion entities (like Unwired Planet's recent one) and outside counsel teams will continue to be announced and implemented. The long-term viability of the patent play sector may depend on how well those deals turn out.

Disclosure: I am long PRKR. 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.

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