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Monday, April 8, 2013

Jim Besson and Mike Meuer on Patent Assertion Entities

Posted by Jim Besson and Mike Meuer

Patent Assertion Entities: Costs and Benefits

As Congress considers the SHIELD Act, it is helpful to review some of the empirical evidence on the economics Patent Assertion Entities (PAEs). In particular, we can summarize recent research on the magnitude of both the negative and positive effects of these actors.

How much do PAEs cost the firms they attack?

We performed three different estimates using different samples, different methods and different definitions of PAEs:

1. Publicly listed PAEs

The first sample comes from data on the 10 publicly listed firms that were predominantly in the patent assertion business during the period from 2005 to 2010 (Acacia, Asure, Interdigital, Mosaid, Network-1, OPTi, Rambus, Tessera, Virnetx, and Wi-Lan). These companies accounted for about one sixth of all PAE lawsuits filed during this period. Although these companies might not represent
the entire universe of PAEs, the greater amount of available financial information helps paint a rich picture of their business. We matched these patent trolls to the lawsuits filed listed in Patent Freedom’s database of patent trolls. Patent Freedom is an independent company that collects data on
PAEs and provides advice and risk assessment (see our paper The Private and Social Costs of Patent Trolls for details on this database and the matching). During the period from 2005 through 2010, licensing revenues totaled nearly $6 billion. The mean licensing revenue per lawsuit defense comes to $3.8 million in 2010 dollars. This figure includes licensing revenues from non-litigated patent assertions. But it understates the magnitude of licensing revenues per suit because it does not account for accruals — much of the revenue from lawsuits filed in 2010 was not collected in 2010 (and there were many more lawsuits in 2010 than in earlier years). Extrapolating from this sample to Patent Freedom’s database, we multiply $3.8 million times the 5,307 defendants counted in 2011, coming to aggregate estimated payments to PAEs of $20 billion.

2. Survey of defendant firms

We also surveyed 82 defendant firms to obtain information about their settlement costs and legal costs both from litigated and unlitigated patent assertion from PAEs (see The Direct Costs of NPE Disputes). The confidential survey was conducted by RPX, but it also included defendants who were not clients of RPX. RPX is another firm that collects data on PAEs, including their own database, and provides risk management services. These defendant firms conducted 1,184 defenses in lawsuits with PAEs from 2005 through 2011. This sample is not representative of the entire universe of PAE litigations listed in the RPX database — these firms tend to be larger than average and they are sued more often. We created a model to correct for these biases and extrapolated our estimates to the 5,842 defenses that RPX counts for 2011. The resulting estimate was that the costs to all the firms defending PAE assertions in 2011, including accrued costs and legal expenses comes to $29 billion. This aggregate cost is a bit larger but it includes more, namely defendant legal costs and accrued settlement costs.

3. Lost wealth of publicly listed defendants

We also estimated the wealth that investors in publicly traded firms lost when the firms were sued by PAEs (see The Private and Social Costs of Patent Trolls). We used standard event study methods that filter out the effects of overall market movements and also of other events affecting each individual firm’s stock price. Theoretically, this loss of wealth should be much larger than the other estimates because it includes more: it includes lost profits, including discounted value of future profits that might be affected by the lawsuit. Defendant lose profits aside from direct payments to PAEs and legal costs; management and engineering resources might be distracted from business needs because of the suit, customers may cancel or delay purchases, firms might postpone innovative improvements. Case studies show that all of these things do happen and that they sometimes have a quite substantial impact (e.g., 30% revenues lost in one careful case study). Our event studies provide an estimate of annual lost wealth of about $80 billion.

***

Thus we use three different methods and three different samples to estimate the cost of PAE patent assertions to defendant firms. Considering the different concepts measured in each study, the results are quite consistent. Some people have criticized the survey study for having an unrepresentative sample. While none of the three samples of defendants we have studied are fully representative of
all PAE defendants, the similarities in the results suggest that sampling issues do not introduce substantial biases. Although our numbers might seem large, it pays to bear in mind that the distribution of these costs is highly skewed. A small number of very big payouts account for most of the aggregate cost. For example, the mean cost to defendants in the second study is about $5 million per defense, but the median cost is only around $100,000. Thus the “typical” cost of a PAE defense might be around $100,000 yet the aggregate cost can still be $29 billion.

How much do PAEs benefit inventors?

Many people argue that PAEs provide an important benefit by helping inventors enforce their patents. Inventors, especially small inventors, might not have the resources or ability to conduct patent litigation. The PAEs license their technology or purchase their patents thus monetizing inventors’ patents. This serves to provide important incentives that otherwise might not be provided. In
this way, it is claimed, PAEs make markets more efficient.

Some critics of this argument point out that these incentives might not be the right incentives. They argue that these are incentives to patent, not incentives to innovate — that too many PAE patents are vaguely worded, overly broad exercises in patent draftsmanship rather than real innovations. Also, typical PAE patents are quite old — the mean age is eight years from issue — often covering old
technologies but being asserted broadly to cover subsequently developed technologies.

Setting that argument aside, we can ask how much of the license fees incurred by defendant firms actually flows to inventors, especially to small inventors? We studied the 10-K reports of publicly listed PAE firms over the period from 2002-2011 to answer this question. First, it is important to note that not all PAEs are in the business of helping third party inventors enforce their patent rights. Some do not license or acquire patents, but instead conduct R&D to file their own patents. Others were once operating companies that obtained patents as part of their ongoing businesses; having now ceased production, they became patent assertion entities with these patents. Using the 10-K reports of publicly listed PAE firms, we estimated the flows of funds to third party inventors as royalties and as patent acquisitions, as well as the flows to PAE’s own R&D departments including capitalized development costs when the PAE exited an operating business. We find that royalty payments and patent acquisition costs paid to independent inventors averaged $59 million (in 2010 dollars) per year for these firms. Many of these third party inventors, however, were large firms — researchers have found that 45% of PAE patents come from large firms. These figures pale in comparison to the costs that patent suits by these firms imposed on defendants—$1.2 billion in out-of-pocket costs per year and annual business costs to defendants were much larger based on our event study estimates. Even internal R&D expenditures by PAE firms, averaging $169 million per year, do not change the picture.

Costs and benefits

Certain commentators praise PAEs because they transfer rents from large technology firms to small inventors. In the case of publicly traded PAEs, they do this very badly. It seems that a tiny fraction of the costs imposed on defendants is transferred to small inventors by PAEs. If advocates of PAE activity have information showing that non-public PAEs are more efficient we hope they will bring it forward. We are skeptical such a claim could be true. We hasten to add that PAE lawsuits burden high-tech start-ups and not just large incumbent firms. The RPX database reveals that 82% of the firms defending against PAE patents have less than $100 million in revenue. The median firm has only $10.3 million in revenue. While large firms deal with more suits per firm and while they pay more per suit on average, the cost of litigation to small firms is larger relative to firm revenues on average. Thus small firms bear a proportionately higher “tax” on innovation yet, despite the rhetoric, PAEs do
precious little to monetize innovation by small inventors.

 

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