Vermont Takes Charge

Vermont has begun a two-fronted battle against what it deems bad-faith patent-assertion entities (PAEs)[i], which some commentators, including some in the Obama administration, have disparaged as “trolls.”

On May 22, Vermont Governor Peter Shumlin signed into law H. 299, with the aim of ending “bad faith assertions of patent infringement” in the state by giving Vermont companies and the state attorney general the ability to sue for such litigation abuses.

Instead of defining the offending conduct, H. 299 lists factors meant to help judges spot bad faith, including sending a demand letter that lacks basic information about the infringement claim, demanding payment or a response within an unreasonably short period of time, failing to conduct an analysis of the target’s business or products or to compare them to the patent claims, and continuing to assert a patent that a court has found to be invalid. The target of such a demand can sue the PAE and seek damages, costs and fees.

On the same day, Vermont’s attorney general filed a civil complaint against MPHJ Technology Investments LLC under the Vermont Consumer Protection Act. The state’s complaint accused MPHJ of unfair and deceptive commercial practices by sending a series of letters to many small businesses and non-profit organizations in Vermont that falsely stated that “many” businesses had taken licenses to the MPHJ patents, falsely stated that MPHJ would sue those businesses that did not pay for licenses, and made these threats without undertaking any investigation of the actual business practices of the target companies.

The MPHJ patents included claims directed to the use of a scanner to send an image of a document by e-mail to someone on a corporate network. The complaint alleges that MPHJ operated in Vermont through a web of 40 special-purpose entities, presumably as a means of shielding itself from liability that might arise in individual lawsuits.

The lawsuit is not asserted under the new Vermont legislation, but under the Vermont consumer protection statute, which prohibits “unfair and deceptive” trade practices, language that has found its way into the laws of most states and originated with the Federal Trade Commission Act in 1914.

Is Vermont’s Initiative Stillborn Because of Federal Preemption?

Both the lawsuit and the new legislation are groundbreaking. But because patent rights are primarily governed by federal law, both will inevitably face preemption challenges. These challenges may arise when a state attempts to govern or regulate a subject that is exclusively a matter of federal law. Indeed, MPHJ has asked to transfer the lawsuit to federal court, arguing that the state law claim against it is preempted by federal patent law.

The Federal Circuit held in 1999 that federal patent law does not preempt allegations of state-law unfair competition that require a showing of bad faith. In a 2004 decision, it elaborated on this subject by saying that, to survive federal preemption, the allegedly bad-faith patent assertion “must be objectively baseless in the sense that no reasonable litigant could realistically expect success on the merits. If an objective litigant could conclude that the suit is reasonably calculated to elicit a favorable outcome, the suit is immunized.” This standard is referred to as “objective baselessness.”

One indicator of bad faith under H. 299 is a demand letter that does not “provide factual allegations concerning the specific areas in which the target’s products, services, and technology infringe the patent.” Although MPHJ is not accused of violating H. 299, it is instructive to consider how that statute might apply to it.

MPHJ did not provide the factual information required by H. 299 in its demand letter, relying instead on the likelihood that companies of a certain size are using the patented “scanner to e-mail” technology. While it is easy to see how this sort of demand letter might be viewed as evidence of subjective bad faith — because MPHJ acted with no actual knowledge of the target’s practices — it is hard to see how it could be viewed as an assertion that “no reasonable litigant could realistically expect” to succeed.

Thus, H.299 might be applied in instances that would result in federal preemption. However, the statute might withstand scrutiny if it is enforced with precision only against persons asserting claims that are objectively baseless.

In fact, a case for objective baselessness might be made against MPHJ. The Attorney General’s complaint alleges that MPHJ’s many subsidiaries sent demand letters falsely claiming that they held exclusive licenses. Without an exclusive license, the entity lacks the right to sue for infringement. If this allegation is correct, the standard of objective bad faith may well be met.

The Federal Response

The FTC / DOJ Workshop

As controversies surrounding the business practices of some PAEs continue, the federal government searches for an appropriate response. The difficulty lies in not throwing out the baby with the bath water. How do we stop abuses of the patent system without unintentionally weakening patent rights for all?

PAEs argue that they benefit patent owners, including individual inventors and academic institutions, by providing an active secondary market that has increased the liquidity of patents. According to a 2011 FTC report, both large and small companies are better able to find buyers for patent portfolios they no longer need or wish to maintain. Selling those portfolios allows companies to recoup some of their investment in research and development. That, in turn, allows support for future innovative efforts.

However, Washington is nursing an increasingly hostile sentiment towards PAEs. The DOJ Antitrust Division and the FTC jointly hosted a workshop to explore the issue of PAEs in December 2012. Since then, there has been a growing consensus that modern patent law needs to further regulate PAE practices.

In letters to the FTC and the DOJ, Dell Inc., Hewlett-Packard Co., Adobe Systems Inc., and others urged the government to investigate PAEs, contending that PAEs pose grave risks to competition and innovation and that much of their activity “remains opaque,” giving good cause for the FTC to use its full range of investigative tools, including subpoena powers.

On June 20, FTC Chairwoman Edith Ramirez called for such an investigation into PAE activity. PAE activity is not only growing, she said, it is changing shape. PAEs are increasingly targeting retail establishments, and Ms. Ramirez sees an increase in “privateering,” by which an operating company transfers its patents to PAEs so that they may assert them against parties that the operating company would prefer not to attack directly. She expressed skepticism about the benefits that PAEs are said to provide, such as a last-resort exit strategy for investors in failed start-ups.

Most important, Ms. Ramirez said that the FTC is prepared to use its statutory authority to rein in PAEs’ activity. Section 5 of the FTC Act forbids unfair and deceptive trade practices, and is substantially identical to the Vermont statute that was the basis for the complaint against MPHJ. If the FTC does go in that direction, Vermont will have led the way.

The Leahy – Goodlatte Proposal

There are several legislative proposals on the table. The one with the best chance for prompt legislative action is the discussion draft that Rep. Robert W. Goodlatte (R-Va) and Sen. Patrick J. Leahy (D-Vt) released on May 23. This draft bill would increase the transparency of patent ownership by requiring any entity that sends 20 or more demand letters during a 365-day period to record any “real party in interest” with the PTO. The proposal defines this term to include anyone who, in the last six years, had held a financial interest, however small, in the patent or in the party asserting the patent.

The bill would also allow any patent litigant to file written settlement offers with the court as part of the record. If the award obtained by the plaintiff is less than what was offered by the defendant in settlement (or if the award is greater than what was offered by the plaintiff in settlement), the judge would generally be required to order the offered party to pay the offeror’s costs and expenses, including attorney’s fees. The bill would also authorize the court to shift costs to a real party in interest if the actual party in suit cannot pay.

Further, the bill would let a “covered manufacturer” intervene in any infringement lawsuit against its customers and obtain a stay of the case pending the resolution of the patent controversy in a case against the manufacturer.

The Presidential Response

On June 4, President Obama issued five executive orders and seven legislative recommendations that aim to protect innovators from frivolous litigation and improve the quality of the U.S. patent system. And the National Economic Council and the Council of Economic Advisers released a report, titled Patent Assertion and U.S. Innovation, which echoes the negative sentiment of the FTC and calls for bold legislative changes.

According to the report, suits brought by PAEs have jumped nearly 250% in the last two years, rising from 29% of all infringement suits to 62%. It further estimates that PAEs may have threatened over 100,000 companies with patent infringement in the last year.

The President has ordered the PTO to adopt rules that will require patent applicants and owners involved in proceedings before the PTO to provide and update real-party-in-interest information. The Presidential report recommends legislation that would require any party sending a demand letter, filing an infringement suit, or seeking PTO review of a patent to disclose the real party in interest; create a national, searchable database of patent infringement demand letters; and enable the PTO or the district courts to impose sanctions for non-compliance.

Our observations

Several changes to the patent system adopted in the America Invents Act (AIA) have just now taken effect. For example, there is a new procedure for challenging business method patents, which, as we report in this issue of the IP Update, has already resulted in the invalidation of a patent in an administrative proceeding. We believe that these new aspects of the patent law will have a salutary effect on some of the problems that have vexed the business community.

For example, Xerox and Ricoh have jointly filed for an inter partes review of one of the patents asserted by MPHJ. The inter partes review process, newly created as part of the AIA, replaced the old reexamination process and is designed to be speedier. In a joint statement, Xerox and Ricoh note that MPHJ targets small and medium-sized businesses, including many of the companies’ customers. Thus, the federal regime now in place may make the Vermont attorney general’s action unnecessary.

With so many government actors weighing in on the future of PAEs, their practices face further regulation. At the least, in view of the various pending legislative proposals, PAEs should expect to be required to disclose the identities of their direct and remote owners; and those owners may eventually be exposed to awards of fees and costs granted to those who successfully defend against patent claims asserted by the PAEs. In addition, PAE activities that had once taken place out of the public eye may soon be exposed to public scrutiny through the FTC investigative process.

In our view, whether or not the patent holder is a practicing entity is the wrong question. If the aim of patent reform is to increase creativity and innovation, the focus should be on improving the institutional mechanisms used to address patent validity and patent infringement and to curb abuses regardless of patent ownership.

[i] PAEs and their closely-related cousins, the non-practicing entities (NPEs), do not make the products covered by their patents. Instead, they monetize their patents through sales and licensing to fund other activities. For example, a university that uses licensing proceeds to fund further research activities is an NPE.

PAEs exist solely to enforce patents, engaging in little or no inventive activity of their own. In doing so, they help to create a secondary market for patents, which benefits individual inventors and smaller companies that lack the resources to engage in manufacturing or to enforce their patents against infringers. These individuals and small businesses are thus unable to benefit from their patented inventions, but PAEs may purchase them for enforcement purposes.

Nevertheless, some dubious business practices have become associated with PAEs.