Are Non-Practicing Entities The Problem?

What if (Almost) Everything You Thought You Knew About America’s “Broken” Patent System Was Wrong?

What follows is the second installment in the four-part “Myths of the Patent Wars” series.

The necessary legislative effort to curb bad actors in the patent industry has been “hijacked” by a small handful of very powerful global technology companies intent on forcing broader changes in the patent system to make it better serve their business interests.

Under the banner of “patent reform,” these giant firms have spent tens of millions of dollars on lobbyists and media relations to promulgate a series of dramatic but false claims about America’s supposedly-“broken” patent system — claims that are now almost universally accepted as true by the media, Congress, and the public at large.

In Part 1 of this series, we examined the false claim that an “explosion of patent litigation greater than any in history” is imposing an unwarranted burden on industry and diverting resources better spent on innovation. In fact, today’s patent litigation rate is less than half what it was during the golden age of American innovation in the 19th century Industrial Revolution — a revolution which thrust the U.S. into the top ranks of industrial nations.

Today we will look at the second great myth of the patent wars:

Claim #2: Non-practicing entities (NPEs) are a new breed of parasitic patent litigants who hinder economic growth and contribute nothing to society.

The Facts: Leave aside for a moment the fact that despite all the crocodile tears shed by large technology firms over “abusive NPEs,” virtually every one of them — Hewlett-Packard, Cisco, Apple, Google, et. al. — operate their own internal NPE units and intellectual property holding companies that buy, sell, and litigate patents never used in their products. And they will sue anyone who infringes their non-practiced patents and fails to take a license. This cognitive dissonance — some would say “hypocrisy” — is exemplified in a letter Google sent April 5 to the Justice Department and Federal Trade Commission condemning NPEs, also called “patent assertion entities” or PAEs, which failed to mention that Google itself is an investor in the biggest PAE of them all, Intellectual Ventures.

And leave aside for the moment the Government Accounting Office’s report on NPEs issued in August 2013.  In the America Invents Act, Congress directed the GAO, the independent, nonpartisan agency that works for Congress, to include “recommendations for any changes to laws and regulations that will minimize any negative impact of patent litigation.”  Many expected the GAO report to damn NPEs.  But after completing its extensive research, the GAO elected to make no legislative or regulatory recommendations, to the disappointment of anti-patent lobbyists. Instead of condemning NPEs, the GAO emphasized at the very outset of its report that our nation’s history is filled with examples of inventors who did not develop products based on the patented technologies.

Of far greater importance is the little-known fact that the Founders of this nation deliberately and quite consciously authorized the creation of non-practicing entities 234 years ago as a way to kick-start the development of the new American economy.

Remember, at the time of its founding, America’s was a backward agrarian economy, almost wholly-dependent on imports, and lacking in any significant domestic industry. In fact, the U.S. at the time had a standard of living lower than that of many South American countries.

So in addition to creating lasting democratic institutions of governance, the Founders also faced the critical task of finding some way to unleash the latent creative and productive potential of the American citizenry. As Thomas Jefferson wrote to his daughter Martha in 1787, precisely because America was deprived of British imports and left to its own devices, “we are obliged to invent and execute; to find means within ourselves, and not to lean on others.”

But how, exactly, could they do that?

The Founders had studied the elitist British patent system, and they knew that patent fees there were 11 times the per capita income of the average citizen and that patent holders were required to “work” their patents — i.e., manufacture products based on their inventions. According to Bowdoin College historian Zorina Khan — her book “The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920” earned the Alice Hanson Jones prize in 2005 for outstanding work in economic history — they also knew that these high fees and “working requirements” restricted innovation activity primarily to a tiny handful of wealthy individuals with the factories (or the capital to build factories) needed to manufacture products. (In fact, says professor Khan, the exclusion of the “working classes” was regarded by British parliamentarians as one of the chief virtues of their patent system!) High fees and “working requirements” also tended to skew invention towards incumbent capital-intensive industries, rather than the disruptive new industries that usually spark great economic advances.

Clearly, the British patent model would not work for an America whose only asset (other than its natural resources) was a population widely-regarded as unusually enterprising. Unlike the tenant farmers and laborers that made up the bulk of England’s rigid class society, most Americans were free-holding small farmers, merchants, shopkeepers, artisans, and mechanics — the forerunners of what we today call the middle class — who were possessed of what 18^th century publisher Hezekiah Niles called “a universal ambition to go forward.”

To rapidly develop the new U.S. economy, therefore, the Founders “quite self-consciously” (to quote economic historians Naomi Lamoreaux at Yale and the late Kenneth Sokoloff of UCLA) tried to design a patent system that could do what no other had ever done before — stimulate the inventive genius and entrepreneurial energy of the common man. Simply put, they tried to expand the pool of inventors to include as many people as possible, even those without the wealth or resources to commercialize their own inventions.

So they first of all set patent fees to a level an ordinary citizen could afford — less than 5 percent of the rate in Britain. Second, they decided against imposing “working requirements” on patentees. During the debate over HR-41 (the bill that became the first patent law in 1790), says Khan, “the Senate suggested requiring patentees to make products based on the patent or license others to do so, but the House rejected this as an infringement of patentee rights.” And third, they wrote the patent law expressly to facilitate the licensing and sale of patent rights, thereby creating the world’s first patent licensing industry and market in new technology.

The result, as Jefferson would write 13 years later, has “given a spring to invention beyond my conception.” Indeed, the low patent fees, lack of working requirements, and ability to license patent rights turned inventing into a new income-earning career path for thousands of poor but technically-creative citizens. Whereas most of Britain’s few hundred inventors came from privilege, the vast majority of America’s many thousands of inventors came from humble beginnings. They were farmers, workers, merchants, mechanics, and artisans for the most part.

Indeed, of the 160 so-called “great inventors” of early nineteenth century America, over 70 percent had only a primary or secondary school education. Half had little or no formal schooling at all. And many of the most famous names in American invention — Matthias Baldwin (locomotive), George Eastman (roll film), Elias Howe (sewing machine), and Thomas Edison (electric light and phonograph) — had to leave school early to support their families.

“The rapid growth of inventive activity during early American industrialization was characterized by a disproportionate increase in the involvement of segments of the population with relatively common sets of skills and knowledge,” note Sokoloff and Khan. “Rather than being accounted for by an elite who possessed rare technical knowledge or commanded large amounts of financial resources, the rise in patenting coincided with a broadening of the ranks of patentees to encompass many individuals, occupations, and geographic districts.”

America quickly became a nation of tinkerers. And as more and more citizens saw that they could make a living by applying a little “Yankee ingenuity” to the problems of agriculture and industry, the U.S. per capita patenting rate — defined as the percentage of citizens who became inventors — soared until by the Civil War it was triple that of Britain, according to the annual reports of the commissioner of patents in both countries. Each U.S. patentee was also far prolific than his or her British counterpart, so by mid-century, the U.S. was patenting five times the number of inventions as Britain each year, even though our populations were then equal in size. By 1885, our per capita patenting rate was more than quadruple the rate in Britain, and approximately 85 percent of all U.S. patents were licensed.

Patent licensing, in fact, was the principal means by which new inventions were commercialized during the decades before in-house corporate R&D departments emerged in the early 20^th century. Publications such as Scientific American were founded expressly to facilitate the trade in patents, and it regularly featured descriptions of new and interesting patents, which commercial enterprises then licensed or purchased to use in their product development efforts.

American Bell Telephone’s new product pipeline, for example, operated like most others at the time. According to its 1894 annual report, the company’s R&D department licensed 73 patents from outside inventors, while developing only 12 from its own employees.

In the words of the Congressionally mandated Government Accounting Office (GAO) report on NPEs, “History is filled with examples of successful inventors who did not develop products based on the technologies they patented.” It specifically cited the case of Elias Howe, who patented a method of making a lockstitch but did not produce sewing machines. Instead, Howe licensed his patents to the Singer Company, which then deployed Howe’s invention in its sewing machines.

Such patent licensing, scholars now know, was facilitated by an array of intermediaries — lawyers, venture financiers, and patent licensing agents — who “lowered the transaction costs and improved the efficiency” of the trade in and commercialization of patented technology. “By enabling, indeed encouraging, inventors to focus on what they did best [i.e., invention], this division of labor gave rise to the most technologically fertile period in American history.”

The Founders’ decision to foster NPEs and patent licensing proved crucial to America’s rapid technological progress and economic growth. Indeed, patent records from the 19^th century reveal that more than two-thirds of the “great inventors” of the Industrial Revolution, including Thomas Edison and Elias Howe, were NPEs who specialized in invention and licensed some or all of their patents to outside enterprises for development into new products.

The result of this division of labor was exactly as Adam Smith predicted:

“Observers attributed much of the country’s rapid technological progress to its distinctive patent system,” noted Lamoreaux and Sokoloff. “Quite revolutionary in design at inception, the U.S. patent system came to be much admired for providing broad access to property rights in new technological knowledge and for facilitating trade in patented technologies. These features attracted the technologically creative, even those who lacked the capital to directly exploit their inventions . . . and also fostered a division of labor between the conduct of inventive activity and the application of technical discoveries to actual production.”

The benefits of that division of labor remain visible today, embodied in the thousands of university and other NPE patents licensed by companies large and small each year, as well as by the positive U.S. balance of trade in patent licensing, estimated to be worth $150 billion annually in 2006. Over the last 30 years, more than 5,000 new products and 7,000 new companies have been launched with the help of university NPE patents. And industry technology licensors like Dolby and Qualcomm help the U.S. maintain its technology leadership in critical economic sectors.

President Obama was clearly unaware of this history when he condemned all NPEs as “patent trolls” on February 14, 2013, saying, “They don’t actually produce anything themselves.”

Once again, there is indeed a species of NPE that files strike suits using low-quality patents to extort settlements from small firms unable to pay the cost of standing up to them in court — the patent law equivalent of the ambulance chasers of personal injury law. But these abusive litigants should not be confused with legitimate NPEs whose primary business is invention and/or licensing, not litigation.

TO BE CONTINUED: Up next we will address the ITC and whether there really are excessive damages in patent infringement disputes.