The fundamental power granted by holding patent is to block others from making use of the invention, unless they pay you a licensing fee. Inevitably, this power looks pretty good when you are the patent-holder, and not so good when you are being sued for infringing on someone else\’s patent. Just to complicate matters, some companies that bring suit for patent infringement didn\’t actually do the inventing themselves, nor do these companies actually make a product. The neutral name for these firms are \”patent assertion entities.\” A less-neutral name, when some of these firms act in a way that seems to misuse patent law as a genteel method of extorting payments from other firms, is to call them \”patent trolls.\”

There is nothing illegal about buying patents, or enforcing patent rights by requiring a license fee. Indeed, it can be a useful service for a firm to collect a group of closely-related patents and then license all of those patents as a group, so that firms wishing to use those patents can negotiate with a single entity. Is it possible to divide up the \”patent assertion entities\” in some defensible way, to distinguish the trolls from the rest?

The Federal Trade Commission has the authority to collect confidential business information. \”[T]he FTC analyzed information from 22 Responding PAEs and over 2,500 of both their Affiliates and other related entities.\” The FTC describes it findings in an October 2016 study: Patent Assertion Entity Activity. The report runs well over 200 pages, including a review of existing research literature and the relevant court cases, together with past FTC thinking on this subject over the last decade or so. It you want to get up to speed on this topic, this report is the place to start.The FTC defines the subject of its study this way:

The term “patent assertion entity,” or PAE, as used by the Commission in this report and elsewhere, refers to a firm that primarily acquires patents and seeks to generate revenue by asserting them against accused infringers. As the term underscores, PAE business models focus on asserting patents that the firm has acquired from third parties, rather than obtained from the U.S. Patent and Trademark Office (USPTO) through prosecution. Patents are a PAE’s principal asset; a PAE does not manufacture, distribute, or sell products. Merely holding a patent, however, does not generate revenue for a PAE. Instead, the firm generates revenue by licensing that patent or, more rarely, by obtaining court-ordered damages in successful patent infringement litigation. Furthermore, a PAE generally initiates negotiations that may lead to a license by communicating a demand for payment to, or filing an infringement suit against, an accused infringer.

The report cites some evidence from other studies that a greater share of patent infringement lawsuits are being brought by \”non-practicing entities,\” which is to say firms that own the patents but don\’t make anything. \”[T]he share of infringement cases brought by NPEs has grown over time, from below 30% of all cases in 2009 to over 60% in 2014, and that about 89% of NPE cases appear to have been filed by PAEs.\”

Basically, the FTC argues that the \”patent assertion entities\” can be divided fairly neatly into two \”two distinct PAE business models: Portfolio PAEs and Litigation PAEs.\” The FTC steers away from using the term \”patent trolls,\” which in this report mainly comes up in quotations from other articles buried in the footnotes. But \”litigation PAEs\” is the category that most people are thinking of when they refer to \”patent trolls.\” Here is how \”portfolio PAEs\” functioned:

\”Portfolio PAEs most closely resembled the licensing arms of manufacturing firms; they were highly capitalized and often raised money from investors that included both investment funds and manufacturing firms. Typically, these investors received a share of the Portfolio PAE’s future revenue and a license to the Portfolio PAE’s patents. …

\”Portfolio PAEs typically conducted business in the following manner. First, they acquired portfolios of patents. Portfolio PAEs frequently acquired patents from manufacturing firms by making large up-front payments to the owner. Some Portfolio PAEs acquired hundreds or thousands of patents in individual transactions, often purchasing these patents from manufacturing firms. Other Portfolio PAEs acquired smaller numbers of patents per transaction and aggregated them into larger portfolios. Regardless of acquisition model, Portfolio PAEs then organized acquired patents into one or more portfolios, each containing hundreds if not thousands of patents and offered these portfolios for licensing. …

\”Portfolio PAEs negotiated licenses covering large portfolios, often containing hundreds or thousands of patents, frequently without first suing the alleged infringer. The value of these licenses was typically in the millions of dollars. Although Portfolio PAEs accounted for only 9% of the reported licenses in the study, they generated 80% of the reported revenue, or approximately $3.2 billion.  …

In particular, notice that the investors in these \”portfolio PAEs\” are often companies, which the get access to the patents in the portfolio. Thus, these institutions can be viewed as ameliorating the \”patent thicket\” problem, where there are so many closely related and interlocking patents in some areas that it becomes difficult for innovators to function.

Litigation PAEs look different.

\”The Litigation PAE business model frequently employed one or more affiliate entities, usually set up as limited liability companies (LLCs), each created to acquire and assert a small portfolio of patents, without bundling or aggregating acquired patents into larger portfolios. … Regardless of whether they sent demand letters, Litigation PAEs almost always sued potential licensees in district court before beginning license negotiations.  … Litigation PAEs tended to be thinly capitalized. Many had between one and three individual owners, often with no other employees and no offices outside of their owners’ homes. In fact, several Litigation PAEs were simply individual entrepreneurs who relied entirely on outside attorneys and professionals to maintain records regarding their assertion activity. …

\”Litigation PAEs typically sued potential licensees and settled shortly afterward by entering into license agreements with defendants covering small portfolios, often containing fewer than ten patents.  The licenses typically yielded total royalties of less than $300,000.  … The American Intellectual Property Law Association (AIPLA), which periodically surveys the costs of patent litigation, recently reported that defending an NPE patent lawsuit through the end of discovery costs between $300,000 and $2.5 million, depending on the amount in controversy. By this estimate, 77% of Litigation PAEs’ settlements fell below a de facto benchmark for the nuisance cost of litigation. This suggests that discovery costs, and not the technological value of the patent, may set the benchmark for settlement value in Litigation PAE cases. … Given the relatively low dollar amounts of the licenses, the behavior of Litigation PAEs is consistent with nuisance litigation.

\”For each separate patent portfolio that they acquired, Litigation PAEs characteristically
created a new affiliate entity, which often held ten patents or less. They generally operated with little or no working capital and relied on agreements to share future revenue with patent sellers to fund their businesses. Litigation PAEs filed 96% of the cases in the study and accounted for 91% of the reported licenses, but only 20% of the reported revenue, or approximately $800 million.\”

The report also notes that this problem is really centered in the electronics and software industries. \”Of all the patents held by PAEs in the FTC’s study, 88% fell under the Computers & Communications or Other Electrical & Electronic technology categories, and more than 75% of the Study PAEs’ overall holdings were software-related patents.\”

The policy question of how to draw legal distinctions put the brakes on the patent trolls without unduly hindering legitimate protection of patent rights raises some tricky questions, but the report offers some general guidance:

The FTC recognizes that infringement litigation plays an important role in protecting patent rights, and that a robust judicial system promotes respect for the patent laws. Nuisance infringement litigation, however, can tax judicial resources and divert attention away from productive business behavior. With this balance in mind, the FTC proposes reforms to: 1) address discovery burden and cost asymmetries in PAE litigation; 2) provide the courts and defendants with more information about the plaintiffs that have filed infringement lawsuits; 3) streamline multiple cases brought against defendants on the same theories of infringement; and 4) provide sufficient notice of these infringement theories as courts continue to develop heightened pleading requirements for patent cases.

For a previous discussion of these issues, I recommend \”The New Patent Intermediaries: Platforms, Defensive Aggregators, and Super-Aggregators,\” by Andrei Hagiu and David B. Yoffie, which appeared in the Winter 2013 issue of the Journal of Economic Perspectives.

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