Patents Impending

Rivette, a former patent attorney who cowrote Rembrandts in the Attic: Unlocking the Hidden Value of Patents, sees the online legal slugfest in a bigger picture. Patents typically surge at the start of a new industry when few barriers to entry exist. That happened during the Industrial Revolution of the 1870s and ’80s, when new patents soared 56% a year, powered by the railroad, telegraph, telephone and electric industries. It happened again between 1902 and 1916, when patents more than doubled as the auto and aircraft industries geared up.

As an industry takes shape, capital increasingly flows in and large competitors emerge. That’s when patent disputes flare. “New technology companies would never be able to grow and achieve scale without patent protection from large competitors,” adds Rivette. “The only difference today is that it’s happening at Net speed, compressing what used to take 30 to 40 years into seven.”

In today’s knowledge economy, where intellectual assets are rapidly replacing bricks-and-mortar as the source of wealth and competitive advantage, patents are more crucial than ever. The Internet has introduced factors that didn’t exist with earlier technologies, says Chicago patent attorney Tom Scavone, who represents Coolsavings. “The cost of putting up a Web site is relatively small, and the capital is readily available to scale up a business,” he explains. “Patents are critical in protecting innovators from others who would imitate and draw traffic from their site.”

Coolsavings has patented a way to distribute promotional coupons via the Web, but it’s far from the lone player. Coolsavings is suing six Internet companies and is being sued by two others over the use of these promotional methods. It has reached licensing agreements with two others. “We don’t necessarily want to eliminate the competition,” says Scavone. “We want them to respect Coolsavings’ intellectual property.”

Signature Financial, an East Coast investment firm, obtained a patent in 1993 for its “hub and spoke” investment structure, which uses software to link its central assets to a series of mutual funds. After licensing negotiations broke down, State Street Bank challenged the patent. An appeals court sided with Signature, ruling that because its process had a useful result—an updated mutual fund share price—it deserved patent protection.

Two well-known examples of method patents are Amazon.com’s one click ordering system, which allows repeat shoppers to complete an order without rekeying shipping and credit card data, and Priceline’s way of letting consumers name their price for airline tickets, then checking with airlines for takers. Among other business-process defenders, software vendor Open Market has obtained patents for the shopping cart software used by many retail sites, as well as its method of accepting credit-card payments. And Netcentives has patented its way of awarding frequent-flier miles to online shoppers.

Mothernature.com’s Barach isn’t the first to fear that patenting business methods could stifle innovation and competition. “The problem is their scope and identifying what’s truly novel,” says Lawrence Lessig, professor at Harvard Law School’s Berkman Center for the Internet & Society. “In the physical world, an innovation must be substantive in process or technology to be patentable. But the Internet is technology-pervasive by definition. It’s all novel.”

Lessig, well-known for filing an amicus brief in the Microsoft antitrust case, questions one-click buying in particular: “Should the translation of an ordinary process be considered novel in cyberspace? High-end department stores offer the equivalent all the time.” Lessig recommends that Congress conduct a regulatory impact study on business method patents. Without that, he fears legal licensing will overtake innovation. “Any idea or technology will have to be scrutinized by lawyers, placing a large transaction cost on innovation. Are we returning to a time when only the large are permitted to innovate?”

Rivette’s message hasn’t escaped Internet upstarts who are elevating intellectual property strategies to a new level. “Any company that has a technological center needs to understand and appreciate the role intellectual property plays in the overall business plan,” says Coolsaving’s Scavone. “They have to be aware of its strategic importance and be adequately counseled.”

Net companies are approaching this strategy in various ways. The first is defensive: protect and defend ideas from others who would copy or patent them. If other companies assert patent claims, they can cross-license the patents rather than pay royalties or engage in litigation.

A second approach is offensive. Patents can be asserted against competitors, forcing them to pay a licensing fee or settlement. Patent licensing and settlements in the U.S. have grown from $3 billion in 1980 to $110 billion last year, a 20% annual growth rate. IBM, which tops the list of U.S. patent assignees with 2,657, earned about $1 billion from its patents last year, up from just $30 million a decade ago.

“Patents are particularly valuable when you have an innovative business method or process that is easy to re-engineer or copy,” says Christopher Jones, vice president of financial research and strategy at Financial Engines, which offers online financial advice to consumers. The company, cofounded by Nobel laureate William F. Sharpe, has invested more than $15 million to develop its forecasting models, along with a user interface that gives investors the probable outcomes of their financial decisions. “In our case, we felt that a large number of companies would eventually find our outcomes-based investment approach a compelling way to offer advice,” says Jones. “Unfortunately our user interface is easy to copy. Our patent puts us in the position to protect our investment and collect royalties.”

A third strategy is market-driven: Get third-party validation of intellectual property as a way to increase the valuation of the company in the eyes of investors. “Being able to point to your patent portfolio can be very useful with investors,” says Jones. That’s also a good way to recognize employees who contribute to the state of the art, he adds: “There’s definitely an emotional appeal to having your name on a patent.”

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Stern, who represents defendants in both cases, says Allcare claims to own the rights to a fully integrated health care system. Its suit alleges that the entire health care industry—including giants like Cerner, McKesson HBOC, Merck-Medco and Healtheon/WebMD—is infringing on its patent. The case is currently pending in the U.S. District Court for the Northern District of Texas. In the second case, Interactive Gift alleges that it owns the commercial rights for downloading software and other information over the Internet for a fee. The firm is suing 18 other companies. The case was dismissed by a lower court last summer and is now on appeal in federal court.

“I don’t take pride in saying that the only people who are reaping the benefits from cases like these are the lawyers,” says Stern. “It’s not like we need the work. There are plenty of legitimate cases where there are real innovations.” Though the federal courts have failed to put on the brakes, Stern insists the real problem is with the patent office, which he believes has abrogated its responsibility to the courts.

As the number of patent applications has soared over the last decade, Congress has cut the office’s budget. It can’t hire new examiners, and Stern says the result is that the office simply issues patents. “The patent office lacks the tools and resources to do the job of acting as a screen.”

The lack of screening from the patent office means the cost has shifted to the private sector. Defendants are saddled with huge expenses, and the court system is overtaxed. A 1999 survey by the American Intellectual Property Law Association put the cost of patent lawsuits at $1.5 million on average, with a quarter exceeding $2.5 million. These costs don’t include the burden a trial imposes on executives’ time, along with the diversion of otherwise productive resources. As more cases clog the courts, the time it takes to litigate a case—hence the cost—is increasing. In the Silicon Valley, the number of patent infringement cases doubled in the last five years, and Bay Area lawyers reportedly charge hefty premiums.

Like other civil cases, more than 90% of patent lawsuits are settled before trial. Critics say patent claimants are banking on it. Weighing the fees and costs of going to court, a decision to settle is usually justifiable on a cost-benefit basis. And juries find the patent at issue valid in 70% of cases that go to trial.

One reason for the high win-rate is that a patent is presumed valid unless proven otherwise. Unlike most civil cases, defendants must prove that a patent is invalid by offering “clear and convincing” evidence. In legal circles, this is equivalent to proving a murder defendant is guilty “beyond a reasonable doubt.” Juries are instructed that they must reach a firm moral conviction before invalidating a patent.

Others agree, but see a solution in the Internet itself. One of the difficulties in screening new patent applications is determining whether the innovation in question is really new. “Historically there was a body of data that told you what was around before,” says John E. Daniel, a patent attorney at Kramer, Levin, Naftalis & Frankel, New York, who represents clients like Nokia and Honda. “In the case of business methods, there isn’t a comprehensive database like in the case of carburetors to determine if the business method or idea has been practiced before. In many cases, claims are just too broad.”