Trolling for “Patent Trolls”

Richard Epstein 

On June 4, a White House Task Force released a report boldly claiming that the patent system in this country is seriously flawed and requires prompt corrective legislative and executive action. The White House’s current complaint focuses on frivolous litigation by patent trolls, now dubbed patent assertion entities (PAEs). They were formerly known as non-practicing entities (NPEs).

These entities are “companies that do not make products, but buy up or own patents and sue businesses they claim are infringing on those rights in order to collect licensing fees.” The report claims that they are disrupting technological innovation by engaging in frivolous litigation that places established firms in a hopeless bind: either they must agree to an undeserved cash settlement, or they must litigate in court where they typically prevail, but often at a ruinous cost.

In the words of President Obama, these entities “don’t actually produce anything themselves.” Their business model relies on “leverage[ing] and hijack[ing] somebody else’s idea [to] see if they can extort some money out of them." The report goes on to state: “These entities are commonly known as ‘patent trolls.’ Likewise, the so-called ‘Smartphone Patent Wars’ have ballooned in recent years and today, several major companies spend more on patent litigation and defensive acquisition than on research and development.”

The Patent Trifecta: Make, License, Sue

The President’s harsh condemnation of patent trolls relies on a report entitled Patent Assertion and U.S. Innovation prepared by the National Economic Council and the Council of Economic Advisers. That report criticizes patent trolls because they neither make nor license any known product, but scrounge around for obsolete patents on which they issue a barrage of demand letters both against all sorts of parties that make useful goods and products, and then on their customers who have just purchased those products in the ordinary course of business. But there are good reasons to question the President’s reasoning.

First, it is critical to isolate the source of the President’s grievance. Let us imagine, for starters, that there are firms whose sole function is to engage in the licensing and enforcement of patents, wholly apart from their manufacture and use. This approach represents a high level of sensible specialization in the life-cycle of creating and enforcing patents.

In this case, it would be a terrible mistake of patent policy to insist that the only firms that should be entitled to enforce patents are those that are actually in the business of making tangible products with their patented technologies. Of course, there is nothing whatsoever wrong with savvy full-service firms taking this approach. After all, their routine business activities could easily generate new ideas for patentable inventions that the firm could then exploit synergistically through its own research arm. But by the same token, there is much to be said for an alternative business model in which specialization takes place along a different axis.

Thus, firms with inventive expertise in a given technical or scientific area can use that expertise to generate a portfolio of newly patented technologies that they can license to other firms to make products to sell to other companies. The capital requirements for entering into this business are far smaller than those of any firm that has to invest in the heavy capital and labor costs associated with the production of any intermediate or final goods. It is a massive burden on innovation to require firms that want to enter one segment of the market to invest in other areas as well. Non-practicing entities are thus a huge boon to the market.

That point is implicitly recognized by the President, given the timely renaming of non-practicing entities (NPEs) as patent assertion entities (PAE) in the report. That terminological switch reads like a sound, if backhanded, endorsement of the gains from economic specialization. But that same logic calls into question the condemnation that the report issues to PAEs, which do not license patents, but catch others for their violations of patents that PAEs have acquired from other firms.

Any claim of patent abuse becomes even more tenuous given the potential for further social gains from developing specialized enforcement entities. There is no reason why the firms who sue for infringement must also be in the licensing business as well. By way of comparison, think of lending companies that sell off all their commercial paper that is in default to firms that specialize in debt collection. That additional market separation generates two sources of real social gain. First, it encourages specialization that allows firms that know how to invest to spin off their other activities. Second, the better enforcement of valid patent claims increases the incentives to invest in these useful technologies in the first place. Their extreme specialization does not warrant any blanket condemnation.

Two Empirical Puzzles

Recognizing this, the Patent Assertion Report rests on two instructive findings. First, it relies on economic studies published by James Bessen, Jennifer Ford, and Michael J. Meurer in Regulation Magazine. These authors claim that between 2000 and 2010, patent litigation produced a cumulative loss of $87.6 billion to firms targeted for suit, of which only $7.6 billion represented gains to NPEs, a whopping difference of over ten-fold. But that particular finding seems highly suspect because the astute if rapacious NPEs could make a further bargain and substantially increase their own returns by allowing further economic activities by the targeted entities in exchange for a larger royalty. Why then is this not done?

One possible explanation is that this dramatic result does not capture the whole picture. Further on, the Patent Assertion Report observes that companies that do practice patents have formed similar operations to protect their own portfolios. One recommendation of the report is that all parties that sue must disclose the real party in interest that stands behind their claim. Put these two pieces of evidence together, and it could well be the case that the gains racked up by the NPE/PAEs are in fact recorded on the books of some affiliated entity not included in the study, but which should surely be included in the overall picture. Yet the Patent Assertion Report makes no effort to track down that second source of gain.

Good Plaintiffs, Bad Defendants

The incomplete empirics on the troll question raise yet another possibility of how to think of the role of the PAEs, or indeed of any patent plaintiff. I start from the simple proposition that litigation is a form of regulated aggression whereby the plaintiff always seeks to coerce payment or some other form of relief from the recalcitrant defendant. There is no question that any effort to invoke the power of the state to remedy grievances is fraught with abuse.

But what the President and the report do not acknowledge is that abuse on these matters is always a two-sided proposition. One form of abuse involves a plaintiff seeking to impose an undeserved sanction on the defendant. A second form of abuse involves a defendant seeking to evade some well-deserved sanction demanded by a plaintiff in the right.

In order to make any sense out of the patent troll issue, someone has to form an independent view of the merits of any particular piece of litigation. The proper attitude on that question is to take a healthy skepticism of any claim that places all the blame on all parties on one side of any issue. No one would say that plaintiffs who sue in torts and contracts are always in the wrong, so that the defendant should be able to win just by showing up in court. The reason we have trials is to vet the evidence of both fact and law before letting courts and juries make decisions in individual cases. It could easily happen that in some settings the bulk of the abuse lies with plaintiffs and in others with defendants, so that abuse runs in both directions at any time.

Indeed in this case, it is easy to supply an alternative narrative that has a lot of credence in patent circles. The initial point here is that the 2011 America Invents Act that the President wrongly praises in his White House statement was in fact opposed by many small independent inventors, and strongly backed by large corporations. The source of the conflict of interest is that the large companies not only have their own patent portfolios, but they also make use of technologies that may have been first invented by smaller firms.

There is a constant drumbeat in the patent literature to the effect that “The America Invents Act Punishes Innovators” by many of its complex provisions dealing, for example, with the proper use of prior art. The particulars of this extensive indictment are not important here, but what does matter is the persistent and credible charge that the large technology companies, which are strongly behind the AIA and the new round of proposed changes, use the court system to stonewall legitimate inventors who lack financial resources in order to discourage similar litigation by other inventors.

The President and the Patent Assertion Report are wrong to base policy on any blanket assertion that only PAEs can hijack and extort. Those same charges, now with the roles reversed, can be made of defendants for whom scorched earth tactics are a way of life.

The key point to note is that bad-actor defendants can increase the overall costs of running the patent system just as bad-actor plaintiffs can. Their unwarranted success adds administrative costs and undermines the incentives of small inventors to innovate. In the abstract, there is the no way to decide which of the two parties to any dispute is wearing the white or the black hat.

The President’s reference to “the Smart Phone Wars” gives rise to the obvious question of whether the President knows whether Apple or Samsung is in the right or whether the amount of money they spend on litigation makes sense in light of the complexity of the issues and the size of the stakes. It is also critical to take with a huge grain of salt the President’s cavalier claim that “several major companies spend more on patent litigation and defensive acquisition than on research and development.” That statement is true if two or three firms out of hundreds had that profile for one or two years. It is frankly incredible to think that this proposition holds true across the board.

Be Smart, Go Slow

The President’s critique of the patent system is surely overblown. Its concern with the high cost of litigation, however, suggests that the more fruitful way to deal with problems is to address issues of civil procedure that go far beyond the patent law. Excess discovery by plaintiffs and defendants alike is a serious concern because current rules give both parties far too much leeway in initiating dragnet discovery claims. Greater judicial oversight in large cases could help rein in costs.

The situation could be further improved by forcing both parties to pay modest sums to run huge document searches of both paper and on-line records. These sensible steps do not prompt foolish patent-specific legislative and administrative reforms that are not warranted by the available evidence. The President should back off his one-sided critique and work to create a more balanced and nuanced reform agenda of the patent system.