Patent Assertion Entities

Patrick McBride

Director of Patents

Red Hat, Inc.

Patent Law Institute

Duke Law School

May 16, 2013

• Today we’re going to talk about

• How software patents fuel patent assertion

entities (PAEs)

• How PAEs jeopardize the central purpose of our

patent system by failing to promote innovation

• And how operating companies worsen the

problem when they commission PAEs as patent

privateers

• Introducing myself

Agenda

• Some facts about PAEs

• PAE nomenclature

• Software patents

• PAEs

• PAE privateers

• The facts about PAEs are sobering:

• PAEs file four times as many cases today as in 2005

• PAE lawsuits account for 62% of all recently filed patent cases

• Big companies face hundreds of PAE lawsuits, but small- and

medium-sized companies are the most frequent targets

• PAE claims cost U.S. companies $29 billion in 2011; $80 billion

when accounting for all costs – direct and indirect

• PAEs continue to threaten injunctions via exclusion orders in the

International Trade Commission (ITC)

• PAEs continue to exploit information asymmetries arising from

poor notice of patents and resulting inadvertent infringement to

appropriate sunk costs from firms locked into product design

choices

PAEs and their Brethren

• Non-Practicing Entity (NPE) – An entity that owns or controls patents

it does not practice (e.g., a PAE or a university)

• Patent Assertion Entity (PAE) – An NPE primarily in the business of

asserting patents

• Patent Aggregator – An NPE that generates revenue by “catching”

and sometimes “releasing” patents on behalf of its members

• Former Operating Company – A PAE that at one time practiced or

attempted to practice some of the patents it asserts

• R&D Labs – A PAE that invented many of the inventions embodied in

the patents it asserts

• Practicing Entity Asserter – An otherwise practicing entity that asserts

patents against non-competitors in fields in which it does not directly

compete

Software Patents

• A primary objective of our patent system is to promote innovation

that would not have otherwise occurred

• The nature of patentable subject matter should be considered

with this objective in mind

• It is commonly assumed that patents always promote innovation,

but this is not the case

• Changes in U.S. law in the 1990s allowed the proliferation of

software patents, but there is evidence this change

• was unnecessary for software innovation and

• has actually hindered innovation

Software Patents

• The history of software innovation shows remarkable progress

before software patents became generally available

• Innovative open source software projects such as the GNU

Project began to appear by the early 1980s

• At that time, there were few software patents, and case law

limited their availability (e.g., Diamond v. Diehr)

• U.S. case law allowing software patents dates from the mid-

1990s (e.g., In re Alappat)

• But major innovations in proprietary software long pre-date the

availability of such patents, including products such as Microsoft

Word, WordPerfect, Oracle Database, and Lotus 1-2-3

• Competitive forces, rather than patents, spurred development of

these innovative products

Software Patents

• Case law in the mid-1990s, however, changed the landscape

• Today, software patents proliferate, comprising at present many

hundreds of thousands of issued assets

• This proliferation of software patents has raised significant new

risks for both open source and proprietary software developers

• Software innovation is generally incremental in nature — that is,

new products typically build on products built previously

• Software innovation is rapid and product cycles are short

• Major software products are complex, involving many thousands

or even millions of lines of code, and often contain many

thousands of distinguishable features that are potentially the

subject of someone else’s patent

• In these conditions, software patents create particular problems

Software Patents

• First, there is no reliable, economically practical method for

identifying and searching the hundreds of thousands of existing

software patents that would allow a software developer to take

the existence of a third party patent into account before bringing

a software product to market (known as “ex ante” clearance)

• There are too many distinct features to search on

• There are too many software patents to search against

• Product cycles are too short, making patent clearance

impractical

• Note too that the difficulty of searching software patents makes

them of little use in advancing innovation by disclosing new

technology: from a software developer’s point of view, it is

completely impractical to seek new ideas in patents, and few if

any do so

Software Patents

• Second, software patents are generally claimed in relatively

abstract, ill-defined language, compared with patents concerning

other subject matter

• Their boundaries typically are vague, and it is often not possible

to be confident that a particular patent does not read on a

particular feature of a software product

• Thus simply by virtue of producing and marketing an innovative

software product, a software developer assumes the risk of

inadvertent infringement and a costly patent lawsuit that is not

reasonably measurable or avoidable

Software Patents

• Large technology companies like Red Hat have addressed the

risk of inadvertent patent infringement by building defensive

patent portfolios, the idea being that a large patent portfolio will

deter other companies from bringing a patent lawsuit, because of

the risk of a countersuit

• Companies with such portfolios often seek patent peace by

entering into cross-licensing agreements with other large

companies that have their own patent portfolios

• Red Hat has supplemented its defensive gathering of patents

with a public Patent Promise under which it pledges not to

enforce its patents against certain parties who use open source

software

Software Patents

• Ironically, even after all the many millions of dollars spent on this

deterrence strategy, it is almost useless against today’s most

common patent aggressor - PAEs

• The proliferation of software patents has fueled an entire

business model in which PAEs exploit the weaknesses we’ve

just described, namely:

• The impracticality of clearing software patents ex ante

• The vague claim language of software patents

• The availability of thousands of software patents for purchase

Software Patents

• PAEs’ entire business model is typically built around:

• Acquiring patents (most frequently software patents) at low

cost with a view to extorting licensing fees or bringing lawsuits

against operating businesses

• They frequently conceal their identities and holdings until the

companies that are their targets, which have no knowledge of

the relevant patents, are locked in to a product and business

strategy

• Then they demand ransom

• Economists refer to this as “ex post” licensing, and consider it

to be the least desirable for society, yet it’s the bread-and-

butter of PAEs

• And note that because such entities create nothing and have no

productive operations, they are not deterred by the possibility of

a patent countersuit by their targets

Software Patents

• PAEs primarily target software, and software vendors and users

are unusually burdened with this PAE problem

• For example, the distribution of technologies that PAEs sue on is

different than the distribution of technologies that non-PAEs sue

on

• To wit, from 1990-2009, more than 25 percent of non-PAE cases

involved Drug / Medical patents while fewer than one percent of

PAE cases involved such patents

• PAEs assert software patents in 65% of their cases

• Another statistic: 1/3 of all purchase transactions by PAEs are for

software patents

Software Patents

• In sum, legal changes in the U.S. that have allowed

software patents have not served the purpose of promoting

innovation

• Experience has shown that such patents are not only

unnecessary, but actually detrimental

• They discourage innovation, by imposing costs and risks on

software development that would not otherwise exist

• They also fail to encourage innovation, by exhibiting little

evidence of producing innovation that would not otherwise

have occurred, and much evidence of producing

“innovation” that serves procedural and strategic purposes

rather than bettering society

PAEs

• As I’ve said, PAE activities are inconsistent with the fundamental

goal of the patent system – that is, “to Promote the Progress of

Science and the Useful Arts”

• PAEs impose an ever-rising “tax” on software vendors and other

innovative industries

• PAEs are exploiting fuzzy patent boundaries and targeting

inadvertent infringers to extract economic rents that often far

exceed the value of the underlying technologies

• A patent system that enables the appropriation of sunk costs

through excessive rents and damage awards that do not track

the value of a patented invention compared to alternatives can

deprive us of the benefits of competition among technologies

PAEs

• When a PAE asserts a patent obtained from a third party against

an operating company, the company’s royalty payment may

raise costs to consumers, but it obtains only the avoidance of

infringement litigation, not the benefit of the technology itself

(which it already had)

• Put differently, the company’s costs will increase and its return

on investment will decrease after it has developed and

commercialized a product based on certain assumptions about

its return on investment (assumptions that did not take the

existence of the third party patent into account)

• In short, by seeking to hold up firms that have commercialized

products, PAEs threaten to distort competition in technology

markets, raise prices and decrease incentives to innovate

PAEs

• Recent data indicate that the number of exploitative suits and

economic rents extracted by PAEs is growing dramatically and

the worst is yet to come

• Both the number of PAEs and the number of patents held by

PAEs are increasing

• PAE “innovation” in rent-extraction techniques is occurring

rapidly and spreading by imitation

• Without public policy reforms, the costs PAEs impose – in the

form of defense costs, licensing fees and litigation awards – will

continue to rise

PAEs

• Patent Lawsuits Filed By PAEs Nearly Doubled from 2007 To

2011

• In a recent 12-month period, 4,125 of the 6,934 defendants

(59%) named in patent cases were named by PAE plaintiffs

• In 2011, operating companies mounted nearly 6,000 litigation

defenses against PAEs, a more than 400% increase since 2005

• Today, lawsuits filed by PAEs account for 62% of all patent

cases

PAEs

• The dramatic increase in PAE-related litigation:

PAEs

• PAEs have focused much of their attention and resources on the

information technology industry

• There are a number of reasons for this:

• Companies in the industry often enter bankruptcy or become

so distressed they are willing to sell off their patents

• Products in this field are often covered by many patents

• IT patents are relatively easy to procure as paper inventions

– i.e., without constructing an actual embodiment of the

invention

PAEs

• The costs imposed by PAEs are mostly deadweight losses, as they do

not incentivize innovation by providing income to inventors

• Of the $29 billion in revenues PAEs extracted from productive

companies in 2011, less than 25 percent flowed to inventors

• In 2011, PAEs imposed $80 billion dollars in costs on defendants

while less than two percent of that amount represented transfers to

independent inventors

• PAEs have inflicted $500 billion in costs on publicly-traded companies

since 1990

• And only 29% of PAE patents come from small inventors; 43% come

from large firms

• The evidence shows that PAEs impose massive costs yet bring tiny

benefits to inventors

PAEs

• PAEs do not make a significant contribution to technology or innovation

• Rather, they assert patents against innocent infringers who independently developed their products

• Virtually every PAE case filed—and even the overwhelming majority of those in which the PAE wins and claims that the defendant was a willful infringer—involve not theft or even copying with a legitimate effort to design around but independent development by the defendant

• PAEs assert patents much later in the patent’s term than other patent plaintiffs, showing that they must wait for others to independently develop and commercialize the technology

• The PAE business model requires lying in wait for inadvertent infringement and thus operates as a pure tax on innovation

PAEs

• The costs of defending a patent infringement suit are startling

• According to industry estimates, the median cost of patent

litigation breaks down as follows:

PAEs

• Combine the legal costs with settlement costs, and the cost is

$1.75 million per case for small/medium companies and $8.79

million per case for large companies

• Add to these out-of-pocket costs the loss of time, energy and

creativity of managers, engineers and scientists caught up in the

litigation process

• These substantial costs drive many defendants to settle even

the most unmeritorious of claims

• Non-litigated patent assertions are responsible for much of the

direct costs imposed by PAEs on operating companies

Privateering

• The outsourcing of patent enforcement by operating companies

– companies that develop technology and sell products – to

PAEs has disturbing competitive implications

• So-called “privateering” amplifies the threat to innovation and

competition already posed by PAEs

• Some operating companies appear to be outsourcing patent

enforcement to PAEs and providing incentives to those PAEs to

enforce patents against the operating company’s rivals

• Privateering poses numerous perils to competition, consumers

and innovation

Privateering

• First, privateering detrimentally alters enforcement incentives

• For example, when two operating companies each possess

patents that implicate the other’s products, a common outcome

is cross-licensing or a stand-off

• Outsourcing alters these incentives in ways that raise costs and

harm competition

• Most PAEs are immune to patent countersuits

• Transferring patents to a PAE can shift symmetric patent peace

into asymmetric patent aggression

Privateering

• Privateering allows the operating company to have it both ways:

• The company can continue to deter patent suits by another operating company by virtue of its remaining patents

• And it can encourage offensive actions against its rivals through strategic patent transfers to a PAE

• The company may extract value from its own patents that it otherwise might not have been able to achieve

• Specifically, when a company has a very large patent portfolio, the marginal value of a few patents may be quite small in securing cross-licenses or patent peace with another company

• But when transferred to a PAE, those once marginal patents could potentially generate significant returns

• This activity can be met in kind, but escalating patent conflicts through mutual PAE outsourcing merely imposes additional costs that ultimately harms consumers and undermines competition

Privateering

• Second, privateering can threaten to create royalty stacking and result in exploitation

• Some patent holders make “no royalty stacking” pledges to induce standards organizations and industry participants to adopt their technology over alternatives

• By transferring patents essential to implement the standardized technology to multiple PAEs, a company can seek to evade its no royalty stacking commitment

• There is no obligation by the PAEs and operating company collectively to honor the pledge

• Disaggregation of a patent portfolio to PAEs thus can enable the very royalty stacking that a patent holder’s “no stacking” pledge was designed to prevent

Privateering

• Third, operating companies may combine the above tactics with contractual commitments to raise rivals’ costs

• An operating company might parcel out pieces of a previously-unified patent portfolio to multiple PAEs pursuant to terms that give the PAEs significant incentives to raise rivals’ costs

• For example, an operating company might retain the right to pull back the transferred patents if royalties secured by PAEs do not meet certain milestones

• Or the transferring operating company and PAEs might agree to target the transferring operating company’s rivals

• The operating company thereby may succeed in saddling rivals with additional costs that enable the transferring company (or its allies) to undermine competition

Privateering

• Another mechanism is a specific agreement on enforcement

targets or retained licenses to the transferred patents that

protect the transferring firm’s customers or strategic allies

• For example, if a firm selling a product sought to arm a PAE

against purveyors of competing products, it could transfer

patents to the PAE while retaining licenses that shield its

customers from suit

• Under those restraints, the PAE could only target customers’

implementations of the transferring firm’s competitors’ products

• Customers might favor the transferring firm’s products because

they benefit from the retained license and because they can

avoid the cost of litigation brought by the PAE

Take-Aways

• PAEs impose massive deadweight costs on the IT sector with little innovation to show

• Unique among types of patents, software patents have fueled the PAE business model, thus drawing into question the appropriateness of software as patentable subject matter

• Some operating companies are exacerbating the problem of PAEs by teaming up with them to raise rivals’ costs

Thank you!