How Patent Trolls Use Economies Of Scale To Force Settlements

Here's something to not be proud of: 61% of all patent lawsuits filed in the U.S. in 2012 (up to Dec. 1)  were brought by non-practicing entities. Or, as we like to call them in the media, patent trolls. 

This percentage is pretty depressing, since it's up from 29% of 2010 patent suits and 45% of 2011 lawsuits, but there's some good news buried in the same stats: The total number of defendants sued in all patent lawsuits went down from about 5,600 in 2011 to about 3,000 up through the third quarter of this year.

The rise in patent trolling is a reflection of simple economies of scale, according to Santa Clara University law professor Colleen Chien. Because of the way patent trolls can do work their revenue models, the risk vs. reward of launching any lawsuit are minimized… and what risks there are can be spread across suing multiple defendants. 

Just Don't Call Them Trolls

Chien doesn't like to use the term "patent trolls," or even "non-practicing entities." Instead, she prefers to describe companies that generate revenue solely through the enforcement of intellectual property they have acquired as patent assertion entities (PAEs). 

Sheesh. But there's also some evidence that these PAEs actually do some good in the start-up ecosystem.

To understand why it's suddenly more profitable to be a PAE (and the role PAEs play), it's helpful to understand how the costs of traditional lawsuit add up. When a company like Apple sues Google over patents, there are a lot of up-front costs sunk into the lawsuit, such as the direct costs of research, discovery and hiring a legal team. Add to that the indirect costs, such as getting countersued, and damage to the plaintiff's reputation. Stack those costs against the unknown reward of a settlement or judgment, and it's clear that launching a suit isn't worth it unless the payoff is really big.

Trolls Can Sue For Less

PAEs, right off the bat, have several advantages in this environment.

First, forget about the indirect costs: you can't countersue a PAE, and seriously, how much worse can the reputation of troll get?

The direct costs are kept down by hiring law firms on contingent fees… they get paid only when they win or get a settlement. This can lower the up-front legal fees by 75%. To further mitigate this cost, PAEs often name multiple defendants, spreading the net while keeping the direct legal fees down. That can also lower the risk of losing a judgement.

Ironically, the way PAEs have scaled the lawsuit economy not only makes it easier for PAEs to assert their patents, but also makes it more economical for defendants to settle, no matter the merits of the case. Because the plaintiff costs are lower than the defense's costs, and because there's always the risk of a huge settlement or judgement, it simply makes sense for defendants to suck it up and settle earlier.

The model is fueling a cottage industry of these PAEs, and patent lawsuits in general. In 2010, there were 2,521 patent lawsuits in the U.S. In 2011, that number rose to 3,353. And through Dec. 1, the number of patent lawsuits filed in 2012 was a whopping 4,171.

Despite the numbers of lawsuits going up, the number of actual defendants is going down. In 2011, PAEs alone named a high of 3,018 defendants. Through 2012's third quarter, PAE sued only 1,788 defendants.

Chien believes the drop is due to new rules in the America Invents Act. "It's harder to name more defendants per suit, requiring PAEs to split their suits up and making it 'not worth it' to sue smaller companies," Chien wrote in her presentation. But it's not clear if these lawsuits are netting PAEs more or less money, because of the non-public way many of these lawsuits get settled out of court.

Do Patent Trolls Perform A Service?

Chien argued that PAEs, which tend to target smaller companies that might be more more likely to settle, can also be of actual benefit to smaller startups. PAEs can buy or litigate the patents of startups or individual investors looking to raise money by monetizing their own patents. They can sell the patents outright to the PAE or have the PAE litigate for patent licensing revenue on their behalf.

But value is tempered by the fact that smaller companies often find themselves in a PAE's cross-hairs. It can be like winning the lottery for a PAE to send a summonds toward a hot new startup that's getting a lot of funding. Put both sides together and it's not clear if PAEs are harming or helping the startup ecosystem. Chien asserts that business model is compelling enough to warrant a shift in the perception of PAEs as "trolls."

"Vilifying 'trolls' won't make them go away. But understanding and challenging their economics might," Chien told me after this article was initially posted.

Can Companies Fight Back?

Fighting PAEs can be hard, but it's not impossible. Chien notes that in the 1880s, the railroads got hammered by inventors' patent lawsuits even as they were expanding throughout the country and pulling in huge revenue. The railroads eventually banded together with patent associations, and individual inventors were forced to drop their lawsuits. It could be argued that the railroads squashed plenty of legitimate patent assertions, but history gives the railroads the win.

Similar patent associations may be the key to checking the PAEs that now dominate the patent legal system. Otherwise, startups are going to remain in a world of legal pain.

Image courtesy of Shutterstock.