24 October 2011


'The Private and Social Costs of Patent Trolls' (Boston University School of Law, Law and Economics Research Paper No. 11-45) by James Bessen, Michael Meurer & Jennifer Ford argues that -
In the past, non-practicing entities (NPEs) - firms that license patents without producing goods - have facilitated technology markets and increased rents for small inventors. Is this also true for today’s NPEs? Or are they “patent trolls” who opportunistically litigate over software patents with unpredictable boundaries? Using stock market event studies around patent lawsuit filings, we find that NPE lawsuits are associated with half a trillion dollars of lost wealth to defendants from 1990 through 2010, mostly from technology companies. Moreover, very little of this loss represents a transfer to small inventors. Instead, it implies reduced innovation incentives
The authors go on to state that -
In 2010, operating companies in the US found themselves in lawsuits initiated by nonpracticing entities (NPEs) more than 2,600 times, over five times more often than in 2004 (Patent Freedom 2011). Is this a good thing or a bad thing?

NPEs are firms that do not produce goods, rather they acquire patents in order to license them to others. In principle, NPEs can perform the socially valuable function of facilitating markets for technology. Some inventors lack the resources and expertise needed to successfully license their technologies or, if necessary, to enforce their patents. NPEs provide a way for these inventors to earn rents that they might not otherwise realize, thus providing them with greater incentives to innovate. For example, economic historians find evidence of a robust market for technology during the nineteenth century that allowed individual inventors to earn returns on their inventions in the era before the rise of the large R&D laboratories (Lamoreaux and Sokoloff 1999). Optimists argue that the current crop of NPEs perform a similar function and should not be discouraged (Hosie 2008, McDonough 2006, Shrestha 2010, Myhrvold 2010, Morgan 2008).

On the other hand, the recent surge in NPE-related litigation may be more insidious. Critics, including many technology firms, compare these NPEs to the mythical trolls who hide under bridges built by other people, unexpectedly popping up to demand payment of tolls (see, for example, Temple 2011). The critics call these NPEs “patent trolls,” claiming that they buy up vaguely worded patents that can be construed to cover established technologies and use them opportunistically to extract licensing fees from the real innovators. Indeed, there has been a general and dramatic rise in patent litigation that some analysts attribute to rapid growth in the number of patents with unclear or unpredictable boundaries (Bessen and Meurer 2008, FTC 2011). To the extent that the recent NPEs opportunistically assert “fuzzy patents” against real technology firms, they can decrease the incentives for these firms to innovate. Innovators deciding to invest in new technology have to consider the risk of inadvertent infringement as a cost of doing business. This risk reduces the rents they can expect to earn on their investment and hence decreases their willingness to invest.

Using empirical evidence, this paper investigates the effect of the current crop of NPE litigation on innovation incentives and on social welfare. We begin by estimating the private losses to publicly listed companies who are defendants in NPE patent litigation by measuring the reaction of the defendant firm’s share price during the days following the filing of the lawsuit.

Using a database of patent lawsuits collected by Patent Freedom (2011), we perform 4,114 of these event studies from 1990 through 2010. In theory, investors respond to the news of a lawsuit filing by reducing their expectations of future earnings for the defendant firm. This reduction should reflect all the costs the firm faces from the suit, including lost business, fees paid to settle the case, etc., depending on how investors expect the suit to be resolved. Investors also consider the loss or delay of profits from future opportunities. The total change in expected profits is reflected by a drop in the share price.

Of course, other events also affect the share price on any given day, including events that affect the market generally and idiosyncratic events that affect the firm being studied. We use standard methods to control for the effect of the market and we average over a large number of lawsuits to filter out random idiosyncratic price changes. This allows us to estimate the average percentage change in the defendant’s stock price for each lawsuit filing and the change in market capitalization of outstanding common stock. Aggregating the change in market capitalization over two decades, we find that the aggregate loss of wealth to these firms exceeds half a trillion dollars. Over the last four years, the loss of wealth exceeds $83 billion per year.

This private loss might seem surprisingly large, but it does not necessarily mean that this litigation harms society. The effect on society depends on two considerations.

First, there is a static effect on net social welfare. To the extent that litigation involves socially wasteful activity, such as a diversion of firm resources from production to litigation support, it reduces social welfare. Such activity implies a “deadweight” loss. On the other hand, to the extent that the losses just represent transfers of wealth from one party to another — perhaps from large defendants to independent inventors — then the static effect on social welfare could be neutral. Second, there is a dynamic effect: this litigation could increase or decrease innovation incentives overall, thus affecting future social welfare. The large private losses seem to imply a disincentive for the defendants, who are largely technology firms after all. But perhaps transfers to the patent holders constitute a positive incentive to them that more than compensates for the disincentives imposed on the defendant firms. Then the dynamic effect could be to increase innovation incentives overall.

Some general evidence leans against such an optimistic evaluation. The literature on litigation commonly finds that the loss of wealth experienced by defendants is, in fact, largely a deadweight social loss; little of it flows to the plaintiffs (Bhagat and Romano 2002). Moreover, the large magnitude of lost wealth in these patent cases seems hard to reconcile with a story of transfers to independent inventors — in recent years the losses comprise a significant fraction of total US R&D spending. If these losses were offset by massive transfers to independent inventors, we think we would have heard or read reports documenting this bonanza and a corresponding surge in research activities by small inventors. There is little evidence that NPE litigation has produced massive transfers to independent – or any other sort of – inventor.

Nevertheless it is helpful to look specifically at evidence of the wealth actually transferred to NPEs and to inventors as a result of NPE litigation. Using the financial statements of publicly listed NPE firms, we obtain upper bound estimates on these transfers. We find that relatively little of the wealth lost by defendant firms shows up as a transfer to NPEs and relatively little of the funds flowing to NPEs is transferred to outside inventors.

These findings allow us to draw some conclusions about the effect of the recent surge in NPE litigation on markets for technology, how the current crop of NPEs are different from those in the past, and how this affects innovation incentives.