Broken Symmetry

Dr. PatentLove

or: How I learned to Stop Worrying and Love Proposed Patent Reform.

The blawgosphere is alive with discussion of proposed patent reform.  Patent Troll Tracker today mocked Dennis Crouch for his support of the status quo.  Here at Patent Prospector, we maintain a healthy amount of skepticism about the proposed legislation.  Patent Hawk earlier pointed out how the new damages apportionment rules could potentially raise the cost of litigation for accused infringers by requiring the disclosure of more (highly proprietary) information about the cost, revenue, and profit of accused products and processes.  For my part, in an earlier post I called the new damages apportionment rules "the crudest and most error-prone way to handle bad patents."  The worry is that judges and juries will tend to "split the baby" by lowering some damages awards, which in may cases are properly justified by the economic value of a patented technology.  The political reality is that a Congressional amendment to the law suggests the inference that current reasonable royalty awards have been too favorable to patentees.  (See, for example, how many injunctions have been awarded to non-practicing entities since Mercexchange v. eBay.)  Information asymmetries between judge or jury and the expert witnesses and parties should be part of the equation in designing the rules, as some recent antitrust law scholarship suggests.

Despite this skepticism, I cannot agree with Dennis that "the proposed patent reforms now being debated by the Senate do virtually nothing to address these serious problems and instead potentially cause harm to the current regime."  Specifically, Dennis points out "massively overlapping claims" as a problem for the current patent system.  Since earlier posting strong criticism of the proposed damages apportionment rules, I've come around to seeing how the proposed rules could actually improve the efficiency of patent markets afflicted with the transactions costs associated with "massively overlapping claims."  Here's how:

First, to define the problem, a patent thicket can arise when multiple patents cover a product, and each of the multiple patentees (rationally) tries to encompass as much of the profit as possible.  The multiple patentees may behave this way even without fraudulent intent because each patentee tends to have more information about the value of their own invention than does any other patentee or the accused infringer.  All the accused infringer can do is try to pay as little as possible for each license.  But in some (perhaps many) cases the result is either underproduction of the patented product or a feast for the earlier licensors and famine for the later.

More generally, this problem can be identified in markets in which complementary inputs are provided by multiple firms to a producer selling in a competitive market.  French mathematician and economist A.A. Cournot pointed out that the producer will tend to underproduce in these circumstances because each complementary input supplier will try to encompass all of the profit.  Profs. Lemley and Shapiro have argued (with empirical support) that "stacked" patent royalties can resemble Cournot complements in their economic effect on production.

How do proposed damages apportionment rules help untangle patent thickets? The new rules explicitly provide that patentees seeking a "reasonable royalty" (i.e., the proposed rules don't change how damages for "lost profits" are calculated) may receive only a portion of the profits from a patented invention when neither the "entire market value" nor the "marketplace licensing" measures of damages appear to provide an accurate measure of the economic value a claimed invention has contributed to an infringing product or process.

By definition, where a patent thicket exists, the "entire market value" measure for "reasonable royalties" does not apply.  The problem of Cournot complements remains, however, even when existing "marketplace licenses" are available as a measure of reasonable royalties.  Thus, the "apportionment" provision of the proposed rules is useful to the extent that it tells judges and juries to think about how big or small the slices of the pie need to be to ensure that everyone who contributed to its baking gets a slice.

Here's another way to look at it:  From the point of view of everyone in the market for ideas (except, perhaps, the opportunistic few  who help themselves to the pie first), patent thickets are bad.  Because no participant in the market has complete information; nobody is going to agree about how the pie gets sliced.  Cournot knew that markets could solve his problem: owners of complementary inputs can integrate.  In patent markets, this can be achieved through patent pooling.  But patent pools often cannot be formed; transaction costs go up as fast as N(N-1)/2 where N is the number of patentees in the market.  And when patent pools are not formed, the difficult job of deciding how the pie will be sliced up must be done by other institutions in society, including, as a last resort, the judicial system.

To be absolutely clear: in my view, the proposed rules regarding damages apportionment could be improved.  In particular, I would much prefer to see the magic words "availability of non-infringing alternatives" somewhere in the statute.  (There is still no better way to define the economic value of an invention than by comparison to its alternatives.  Why not make that explicit in the statute?)  Nonetheless, I felt a desire to clarify some of my earlier overstatements.  The proposed damages apportionment rules may not, in fact, be disastrous for the emerging market for ideas.  In instances where a patent thicket has developed, apportionment could conceivably lead to more efficient production, and more efficient allocations of profit among all patentees who have contributed to the product or process sold.

Can the law firm business model be fixed?

The billable hour is a terrible metric for either the value of client services or of associate contributions thereto -- its two primary uses.  The trouble is that there seem to be few alternatives.  The reasons are obvious enough in each case.  Clients are good at knowing whether they're in legal trouble or not, but bad at knowing whether their outside counsel is working efficiently to keep them out of legal trouble.  Partners are better at knowing whether associates are working efficiently -- they know whether they're getting the work they need and also what they're billing the client for that work.  Unfortunately, partners have a perverse incentive to bill more rather than less for associate (and partner) time -- their own bottom line is tied to the billable hour.

To most stakeholders (client, partner, associate, employees), this looks like an train wreck.  In other parts of the economy, principal-agent problems of this scale could not persist.  But the lack of client transparency into the quality of legal services seems to be keeping the business model on life support.  Can the business model be fixed?

The practice of law is a diverse and varied pursuit.  There cannot be a solution that will work for every field.  To wit, there are some areas of law (such as plaintiff class action work) where alternative fee structures are the norm.  Thus, improvements to the business model will probably be area-of-law specific.

I'll focus on corporate transactions.  Here is my humble suggestion for how companies might get more efficient work from outside corporate counsel for much transactional work: bundle insurance and legal services.

Part (not all) of why corporate management pay for D&O/E&O insurance and transactional lawyers is for a similar economic purpose: to hedge against the downside risk of future lawsuits.  There are, of course, a host of other reasons why managers pay for good outside counsel, such as information about the market.  Outside counsel that specializes in a particular type of transaction may be far more knowledgeable about what is going on in a particularly industry than managers who may be entering for the first time.

Nonetheless, the downside risk of a lawsuit is something that good transactional lawyers will seek to avoid by drafting and refining transactional documents with an eye toward future plaintiffs.  And many corporations take a "belt-and-suspenders" approach by paying for both insurance and extra hours on the proxy statement.

Why not bundle D&O/E&O insurance with transactional legal fees in the following way: inform outside counsel that their pay will be based on an hourly fee that reflects the fair value of the information and services aside from the hedge against lawsuits, then pay a bonus at the end of the year based on the difference between what the insurance premiums are and what they would have been had the insurance policies paid out.

The benefit here is that insurance companies are good at quantifying the value of downside risk avoided.  By bundling the costs in the books, company management could make a more accurate assessment of that part of the value of their transactional services.

Human Capital Development on Small and Large Scales

I've read two great books in the past few weeks.  One is about management and institutional design.  The other is about personality and social psychology.  I believe that the theories presented in the two books are related.

Charles G. Koch, in The Science of Success: How Market Based Management Built the World's Largest Private Company, describes how his company has grown exponentially by harnessing its human capital through a culture that encourages experimentation, differentiation of individual skills, understanding of opportunity costs and divisions of labor, and transparency.  In a sentence, his view is that successful companies maintain growth by focussing on what and how they produce economic value.  In economists' jargon, "value" here means allocative efficiency.

Carol Dweck, in Mindset: The New Psychology of Success, describes how an individual's attitude toward hardship or adversity has dramatic long-term consequences for personal development (of skills and relationships).  The "fixed mindset" manifests as a need to achieve short-term goals for validation of the individual's self-conception as successful.  The "growth mindset" manifests as a need to be challenged and see improvement over the long-term regardless of whether particular short-term goals are met.

The affinity of these two theories is rather startling.  Individuals demonstrating Dweck's "growth mindset" would flourish in a company implementing market based management.  It would not be unreasonable to say that one way to live the "growth mindset," would be to apply market based management to one's day-to-day decisionmaking.