Patent Trolls Are Worse Than You Think

Technology firms that are not even party to a patent fight are hit with shrapnel
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The essentials

  • Some holding companies buy up patents solely to extract licencing fees or out of court settlements from target firms that may have infringed on one of its patents.
  • They have been shown to reduce innovation in target firms and make it harder for them to obtain venture capital funding.
  • Researchers found that firms using similar disputed technology but not party to the patent dispute are hit with “spillover costs.”
  • These costs include a loss in market value and higher operational expenses.

They are known as non-practicing entities or NPEs but if you observe them in action you’ll understand why they’re more often referred to as “patent trolls.”

Ever since the Wright brothers and Alexander Graham Bell rocked the world with their innovations, patent wars have been great theatre. In those days, patents would be contested by firms (now known as practicing entities or PEs) that were actually trying to commercialize their own innovations. Today, a litigant could very well be an NPE holding company that exists solely to shake down firms that may have infringed on one of its patents.

The NPE business model is simple. Stay alert to technology firms that go bankrupt. Buy up their patents. Identify companies that may use technology similar to a patent in your portfolio. Demand the target pay a licensing fee. Threaten it with legal action if it doesn’t comply.

NPEs get under the skin of many technology firms because of their tactics. Since their raison d’etre is patent litigation, NPEs are trigger happy — they are three times more likely to sue on a given patent than are PEs.

Patent trolls are also known for launching notoriously weak cases, but they don’t care. They bank on the fact that these cases are very expensive to litigate: legal fees can easily rise to US$25 million per case. Because of that, targets often settle a case — even a frivolous one — out of court rather than gamble on a fickle jury.

Tallying the Spillover Costs

The trolls may be good for lawyers and their own investors but they’re bad for innovators. It has been estimated that NPE lawsuits in the U.S. were associated with half a trillion dollars of lost wealth to defendants from 1990 to 2010. Beyond the legal costs, they’ve been shown to reduce innovation in target firms and make it harder for these defendants to obtain venture capital funding.

Tempting as it is to focus solely on the drama between the troll and its target, there are many other firms — so-called “technology peers” — that may incorporate similar disputed technology that can be hit hard by these cases, says Yu Hou, associate professor and KPMG Fellow of Accounting at Smith School of Business, Queen’s University. Unfortunately, no one has ever tried to identify and tally those potential spillover costs.

Hou and colleagues Feng Chen and Gordon Richardson of Rotman School of Management tried to fill that gap. They analyzed proprietary patent litigation data in the U.S. for the period between 2000 and 2017. They found that the collateral damage from patent trolls is much larger than previously thought, and is not limited to legal costs.

“Our results suggest that there are significant spillover effects for technology peers who are deemed by investors to be at risk of being sued for patent infringement, and that these effects go beyond potential legal and settlement costs,” the researchers conclude in their working paper.

Here’s what Hou and colleagues uncovered:

Patent trolls cast a wide net.

On average, NPEs litigate a particular patent in six different legal campaigns compared to 1.8 campaigns for a PE-owned patent. In each campaign, an NPE sues 3.3 defendants, on average, compared to 1.7 defendants in each PE litigation.

Technology peers that are not party to a patent litigation case lose value big time.

For patent troll litigations, firms that are technologically-related to a defendent incur an average market value loss of $29.8 million when a lawsuit is announced. The corresponding market value loss for each technology peer involved in PE litigations is only $9.2 million, the researchers say.

Patent troll litigation has a chilling effect on at-risk firms.

To protect against the risk of being included in a patent litigation case, at-risk technology peers can incur significant operational expenses. The researchers studied 10-K risk-factor disclosures of 100 technology firms in their sample that were on the periphery of patent troll cases. They found that 42 firms mentioned the possible need for “workaround R&D” to redesign an existing product or develop substitute technologies; 60 mentioned the potential need to exit a product line; and 44 obtained a licence or paid royalties to the plaintiff for a patent-infringing product.

At-risk firms are right to be worried that trolls will come after them.

The likelihood of at-risk technology peers being sued by NPEs increases by 14 percent in the year subsequent to a defendant firm being sued by an NPE. By contrast, the likelihood of an at-risk technology peer being sued by a PE increases by only four percent under the same conditions.

Anti-troll laws work.

Several U.S. states have passed anti-troll laws to limit NPEs’ ability to target local firms. These laws do mitigate the spillover effects, the researchers note. The spillover effects for at-risk peers dropped after the passage of the laws.

Canadian regulators will be encouraged to learn that legislation can be an effective lever to check the power of patent trolls. In October 2018, the federal government introduced amendments to the Patent Act to create new minimum requirements for patent demand letters. This should allow potential defendants to better assess the merits of a patent infringement claim.

Technology companies that live in fear of trolls can use all the help they can get. They have few ways to fight back on their own. They can’t even count on the threat of “mutually assured destruction” — going on the offensive by threatening a counterclaim can be laughed off — since an NPE has no profit-generating operations that can be attacked. If government regulation can hold off the trolls, they say, bring it on.

Alan Morantz

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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