04/12/2013 04:15 pm ET Updated Jun 12, 2013

As Congress and Enforcers Contemplate Patent Trolls, Don't Forget about Privateering

Congress is beginning to pay attention to the significant problem of patent assertion entities ("PAEs") or, as they are sometimes called, patent trolls. Patent trolls' business model is to acquire patents not to pursue innovation, but instead as a tool of litigation. They sue innovative companies or end users such as retailers using the high cost of litigation to extort settlements. Rather than providing incentives to innovate, trolls simply drive up costs and, ultimately prices, for consumers. The costs of patent trolls exceed $29 billion annually and those costs are just increasing as trolls exploit flaws in our patent and litigation system.

On March 14 the House Judiciary Committee held a hearing on the problem of trolls. The Federal Trade Commission and Department of Justice also held a workshop on trolls in December, and are currently reviewing public comments from businesses, academics, and trade associations who strongly believe action needs to be taken to address the problem.

A key part of their focus has been on another harmful--and growing--patent troll-related business practice: patent privateering. Privateering is the practice by which established operating companies arm trolls with patents and deploy them to engage in expensive, incessant litigation against competitors. This Trojan horse approach allows companies to accrue the benefits of the egregious troll conduct without incurring any of the risks. And more often than not it is used as a competitive weapon to try to raise costs and dampen competition from rival operating companies.

Several forms of privateering exist. Operating companies sometimes create shell or holding companies for their patents. More often, though, operating companies transfer patents to trolls that have demonstrated a particular talent for "monetizing" patents. The transferring operating company typically maintains a perpetual royalty-free license for itself, and often extends a similar courtesy to business partners. The terms of the deal usually contain a payment schedule that enables the troll to earn more for meeting certain litigation milestones, thereby incentivizing the troll to leverage patents against the operating company's competitors. The operating company may also maintain a right to a portion of the proceeds.

A few factors distinguish the privateering model from traditional patent troll behavior. First, while trolls are generally known for using older, vaguer patents, trolls affiliated with established companies may be equipped with "better" patents (whether that description is accurate or not), given that the patents originate with an operating company. These patents can wreak relatively more havoc on the competitive playing field. Second, privateering lets an operating company split up its patent portfolio, arming each troll it enlists with a sub-portfolio. This allows the company to obtain more royalties than it could otherwise obtain if its portfolio had remained intact. It also forces competitors to handle lawsuits on multiple fronts and to negotiate licensing agreements with multiple parties. This is exceedingly complex and expensive, and distracts businesses from their core activities. And finally, privateering lets trolls integrate additional patents with those it is already asserting, enhancing the negotiating value of the troll's arsenal against potential infringers.

Why do operating companies do this? Easy. First, they make money by collecting royalties. Second, they are able to plague competitors with costly litigation. This litigation may raise the costs of rival products, reduce competition and dampen innovation. Third, using trolls prevents a countersuit or antitrust counterclaim, both of which would be a virtual certainty if the operating entity itself asserted the patents. Indeed, the threat of counter-litigation often leads firms to enter into efficient cross licensing arrangements. Finally, to the extent that the patents assigned by the operating company are subject to fair and reasonable licensing terms or no royalty-stacking pledges, the use of a troll provides an opportunity to ignore and avoid these commitments.

The harm from privateering is readily apparent. The transfer of patents to patent trolls increases the likelihood of inefficient, aggressive enforcement of patents and is sure to lead to higher royalties, higher costs for consumers, and therefore deadweight social loss. Patent peace will be less likely because privateering deters procompetitive cross-licensing. Furthermore, depending on the technology in question and the arrangement with the troll, privateering may lead to industry-wide lock-in of one technology over another merely to avoid litigation headaches.

A recent Bloomberg article cited some of the most prominent examples of privateering, including MOSAID, a well known patent troll, which in 2011 acquired 2,000 patents jointly controlled by Microsoft and Nokia. MOSAID called this acquisition "a transformative event" and predicted that the acquisition "will drive revenue growth, profits, and shareholder value over the next decade." Microsoft declared that it was looking to "unlock the considerable value" of these patents. In the documents submitted to the Canadian Securities Administrators, the contract between MOSAID and Microsoft/Nokia calls for MOSAID to reach "minimum royalty milestones" and Microsoft/Nokia's right to collect a "shortfall payment."

More recently, Swedish telecommunications pioneer Ericsson announced that it entered into an agreement with known troll Unwired Planet (formerly Openwave Systems), in which Ericsson agreed to assign 2,185 patents so that Unwired Planet may enforce them. Ericsson's deal with Unwired Planet is very similar to Microsoft/Nokia's deal with MOSAID, as Unwired Planet is fully incentivized to assert Ericsson's patents as aggressively as possible. The agreement is reported to contain a payment schedule that rewards Unwired Planet for success, and even contains a commitment by Ericsson to continue developing, obtaining, and feeding more patents to Unwired Planet over the years. This is very similar to what Robin Feldman described in Giants Among Us, wherein notorious PAE Intellectual Ventures continues to obtain patents from patent farms in Brazil.

Operating companies offer up a variety of excuses for their involvement in patent privateering. They say they're looking for an efficient way to outsource their patent litigation; another way to realize a return on large investments in portfolio development; and a legitimate way to participate in the secondary market for patents. More often, however, operating companies that transfer patents to trolls offer no justification whatsoever and attempt to hide their privateering arrangements from the public eye. There are undoubtedly a host of other existing privateering deals that have yet to rise to the surface, and operating companies will structure their privateering deals to cover their tracks in even more creative ways. Whatever the case may be, the ultimate intent of entities that feed privateers is clear: to spur litigation to impose costs, monetize patent assets and raise costs for their competitors. Like the conduct of patent trolls, it has turned the patent system on its head, making patents a tool of litigation instead of innovation. Privateering harms competition and consumers, and deserves continued attention from regulators.

David Balto is a former policy director of the Federal Trade Commission, attorney-adviser to Chairman Robert Pitofsky, and antitrust lawyer at the U.S. Department of Justice. He has been a Senior Fellow at the Center for American Progress and has worked with the International Center on Law and Economics, both of which receive funding from many organizations including Google. Mr. Balto has also published research and authored scholarship for Google on technology policy topics. Mr. Balto thanks Brendan Coffman, a former associate in his firm, for his thoughtful assistance in the preparation of this article.