The Two-Edged Sword: The Competitive Implications of Finance Patents

1. The Two-Edged Sword:The Competitive Implications of Finance Patents Josh Lerner Harvard University and NBER

2. This paper • Goal 1--To document basic facts: • About financial services patenting overall. • About mix of patenting. • Goal 2 --To explore scenarios for the future: • Future trends? • Competitive structure? • Based on large-sample research and interviews: • Based in part on work with Peter Tufano and Adam Jaffe.

3. 1. Backdrop • Patent policy has changed dramatically over past two decades: • Expansion of patentable subject matter. • Increased willingness to sustain patent-holder rights. • Increased investment in patenting and litigation by corporations, government, and universities.

4. The shift • Creation of Court of Appeals for the Federal Circuit: • Centralized appellate court created in 1982. • Presented at time as benign change to address “forum shopping” by litigants.

5. The shift (2) • Shift to a more “pro-patent” stance: • 62% of infringement findings upheld in previous 30 years. • 90% in first 8 years of CAFC. • Important doctrinal shifts in a number of areas.

6. Consequences • Greater willingness to file for and litigate awards: • Doubling in patent filings by U.S. corporations since 1988: • Somewhat reflects pace of technical change. • >3X increase in patent litigation. • Increase in internal resources devoted to patent activities.

7. Issues of patent quality • Lack of experienced examiners. • Difficulties in retaining examiners. • Challenges relating to information technology within patent office. • Particular challenges when substantial non-patent prior art.

8. A shifting competitive environment • Growth of litigation between new and established firms: • Established firms have sought to license portfolios of long-issued patents. • May lead in some cases to substantial transfers from newest (and far more innovative) firms. • May affect newer firms’ choices when deciding which innovations to pursue.

9. A shifting competitive environment (2) • Growth of individual inventors who seek to “hold up” established players: • Unilateral nature of threat (e.g., preliminary injunctions). • Uncertainty of litigation. • Often settlement is the preferred response.

10. 2. The financial services patenting boom • Many system-wide shifts seen in particularly dramatic form here. • Traditional ambiguity in common law countries: • Apparently allowed in Darcy v. Allin (U.K. 1602). • Excluded in subsequent decisions: • Hotel Security Checking v. Lorraine Co. (1908) established “business method exception” to patentability in U.S. • Contrast with civil law countries

11. The financial services patenting boom (2) • While USPTO began issuing awards in 1970s, questions about validity: • Only two filed cases prior to 1996 settled before trial. • Many financial institutions relied on trade secrets: • Potentially infinite life (Coca-Cola). • Need not (must not) reveal. • Can prosecute those who misappropriate idea. • But no protection against independent discovery, “reverse engineering.”

12. The State Street case • Signature Financial obtained patent on “hub and spoke” system of mutual fund management in 1993. • Approached mutual fund custodians to license, with some success. • Licensing talks with State Street Bank & Trust proved unsuccessful. • State Street sued in 1996 to have patent declared invalid.

13. The State Street case (2) • Federal District of Massachusetts made summary judgment in favor of State Street: • “Jurisprudential quagmire.” • Signature appealed to CAFC, which reversed decision in July 1998: The [district] court relied on the judicially-created, so-called “business method” exception to statutory subject matter. We take this opportunity to lay this ill-conceived exception to rest. • Supreme Court refused to hear appeal in January 1999. • Many of same quality issues.

14. Example 1: Daughtery patent • “Apparatus and process for executing an expirationless option transaction”: • “The common denominator among the variety of prior art systems for transacting asset-based options are that they are only capable of transacting options which expire after a certain period of time.” • Only three academic citations. • Does not cite Samuelson [1965] and Merton and Samuelson [1969]. • Does cite Merton [1973], but misrepresents!

15. Example 2: Traub patent • “Estimation method and system for complex securities using low-discrepancy sequences”: • Broad claims for application of quasi-Monte Carlo techniques in finance. • 18 math citations, but important novelty questions. • Only one finance citation: • Does not include Cheyette [1992], Joy, Boyle and Tan [1994], Tan and Boyle [1997], etc.

16. 3. What are competitive implications of finance patents? • Overall trends. • Distributions of awards. • Regression analyses. • Insights from interviews.

17. Looking at overall trends • Patents are sorted into >100,000 subclasses. • Focus on key subclasses: • 705/35: Finance • 705/36: Portfolio selection, planning or analysis. • 705/37: Trading, matching or bidding. • 705/38: Credit (risk) processing or loan processing. • 705/4: Insurance (some only).

18. Characterizing finance patents • Download from USPTO web site (through 2000): • Applicant and assignee name. • Application and award dates. • Patent classification. • Prior art cited. • Examination history. • Gathered detailed information from files for subset.

19. Patent awards by year

20. Looking at applications • Often cannot observe applications before successful. • Can estimate, however, based on total business method applications. • Calculate in two ways: • Assuming finance has constant share. • Assuming trend in share. • Suggests 3- to 4-fold increase.

21. Application trends

22. Patenting distribution • Diverse awardees: • Merrill Lynch, Citigroup largest. • But many vendors (computer firms), patent “boutiques.” • Disproportionate representation of U.S. corporations and individuals. • Little foreign presence. • Little academic presence.

23. Most frequent patentees

24. Most frequent patenting types

25. Which financial institutions are most active? • Consider patenting by well-documented financial institutions: investment banks. • Estimate “patent production functions”: • Often estimated in productivity literature. • Look at successful U.S. applications in three six-year periods: • 1980-85, 1986-91, 1992-97.

26. Regression analyses • Look at simple patent counts. • Also adjust for citations: • Legal importance and empirical validation of measure. • Use top 25 debt and top 25 equity underwriters (29 to 33 firms). • Control variables: • Volume of equity issuance. • Volume of debt issuance. • Reputational ranking. • Academic links (proxied for byshare of FM and JPM board seats).

27. Findings • Larger banks patent more: • Particularly those with more debt issuance. • Academic linkages matter: • One standard deviation increase more than doubles patenting rate.

28. Interviews • To better understand impact, discussed with number of financial institutions: • Included patent lawyers and financial innovators. • Help from SIA’s Patent Subcommittee in arranging. • Issues covered included: • Does the increased possibility of patenting affect business decisions? • Which inventions are being patented? • How is the new patent regime affecting the rate of financial innovations? • How is the new patent regime affecting the manner in which financial innovations are being pursued? • How is the new patent regime affecting the type of innovation being carried out?

29. Five key themes • Realization of financial patents’ importance is now widespread. • Reluctance of major institutions to do battle with one another. • But changing attitudes with current downturn. • Legal harassment from “paper competitors” is on the rise. • Traditional relationships with vendors are experiencing stresses.

30. Scenario 1: Biotechnology • Allowing patent protection in 1980 triggered a new industry: • Facilitated widespread entry by venture-backed firms. • Patents allowed licensing arrangements, other ties with established pharmaceutical firms. Similarly, financial patents might usher in new entrants, changing structures.

31. Scenario 2: Semiconductors • Intense emphasis on patenting in past two decades: • But Hall and Ziedonis find little evidence of increased innovation as cause. • Rather, established firms have focused on building patent “arsenals” that are cross-licensed. • Patent portfolios make it very difficult for new firms to enter industry. Similarly, financial patents might reinforce positions of established players.

32. Wrapping up • Still very early in the process: • Difficult to predict. • Nonetheless clear that: • Financial patents are likely to play an increasing role in industry. • May have profound effects on industry structure.