Thursday 27 September 2012

Patent Valuation, T.S. Eliot and the Theatre of the Absurd

It is one of the most famous stanzas of modern English language poetry. Thus T.S. Eliot
concluded his poem-- "The Hollow Men":
This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.
And so it seems to being going with the Eastman Kodak patent portfolio and, more generally, pace the recent jury award to Apple in its lawsuit against Samsung, the patent valuation bubble that we have been witnessing. We have several times over during the past year questioned (here, here and here) the basis for the oversized valuations that have been ascribed to various patent portfolios, including Motorola Mobility and AOL. But at least these valuations were connected with real transactions, where a willing buyer and a willing seller agreed on price.

But what about the most curious of these jumbo valuations, namely the amount ascribed to the portfolio of Kodak Eastman patents--up to $2.6 billion dollars-- as the company is in throes of Chapter 11 bankruptcy proceedings in the U.S. and is itself was being valued at only at a fraction of the proposed valuation of its patent portfolio? It just did not seem to make sense to this commentator.

Well, it seems that, when all is said and done, T.S. Eliot's observation may prove to have been a more accurate assessment of the Kodak portfolio than that of all the investment bankers, IP asset valuators and the like. An article by Mike Spector and Dana Mattioli, which appeared in the September 14, 2012 edition of here (a hardcopy version appeared in the September 15th U.S. edition of the newspaper), says it all—"Kodak Patent Auction Fails." Announcing with great fanfare that the portfolio would be put to auction in order to fetch an amount equal to the portfolio valuation estimates, the reality has told a different tale.

As observed in the article, the bids came in, but each for a different "shape, size and combination" of the portfolio. More importantly, while participants in the bidding appear to have include companies such as Apple and Google and patent aggregators Intellectual Ventures here and RPX Corporation here, the amounts actually offered look at first blush to be a rounding error, ranging from $150 million to $250 million. As a result, the company has revisited the feasibility of the auction process. Instead of providing the bankruptcy court with "serial" extensions for the conclusion of the patent auction, Kodak has notified the court that is simply "adjourning the sale hearing until further notice." This means that if the company reaches a deal, it will notify the court. However, the auction is no longer part of the case docket. The article ascribes the troubles besetting the auction to the concern felt by the bidders "that Kodak already squeezed much of the value from the portfolio with repeated litigation and licensing." If so, and if that is the underlying reason for the disappointing bids, then the question is: Weren't the data points not clear at the time when the $2 billion plus valuations were being made? If the answer is "yes", then how we account for the chasmic difference in valuations? If the answer is "no", what does this tell us about the valuation process?

Let me be clear: I am aware that patent valuation (and IP valuation more generally) is a difficult and often inexact exercise. If the IP under scrutiny does not have a current income stream or some other ready metric to determine valuation, there are few if any other clear market indicators to assist in the evaluation process. As such, any such effort is at best merely an estimate, even a rough estimate, no matter how skilled the person making the valuation.

That said, the discrepancy in connection with the Kodak portfolio raises questions beyond those that are connected with any patent valuation. It strains credulity to believe that anyone can conduct a reliable valuation of a portfolio of 1000 or more patents within the time frame in which most valuations are meant to be carried out. If that is true, then what exactly were the parameters being considered in doing the valuation under the circumstances? Perhaps more importantly, what was the input of the investment bankers in determining the valuation of the Kodak (and other patent portfolios)? Are the interests of the bankers aligned with the valuation specialists; are either or both fully aligned with the company? If not, why not? And where was the mainstream media in doing more critical reporting of the issue?

I have been arguing for some time that the recent spate of oversized patent portfolios provides great theatre, but little more, for those who want to show "how valuable patents can be." I agree that patents can be valuable, even very valuable, but in most industries, that value is seen far from the spotlight of the media. Maybe it is time for the curtain to be dropped on this theatre of the absurd.

Saturday 15 September 2012

An Innovation Cliff? Is It P&G's Problem or All Our Problem?

Forget Silicon Valley and Apple. If one really wants to understand long-term success in innovation, one should leave the California West Coast and sojourn in the US Midwest. In particular, one should focus on the likes of 3M (in Minneapolis) here and Procter & Gamble (in Cincinnati) here. Is is here, where solid and even stolid trump racy and edgy, that retail innovation has been taking place for multiple decades. What happens at companies like 3M and P&G is crucial to the future countenance of innovation, not merely in the U.S. but globally. For that reason, an article that appeared in the September 7, 2012 issue of Bloomberg Businessweek is worthy of special note.

Entitled "P&G’s 1,000 PhDs Not Enough to Crank Up New Blockbusters" here, the article, written by Lauren Coleman-Lochner and Carol Hymowitz, describes the relative decline in successful innovative activity at P&G, the world's largest consumer product company (think Crest and Pringles) and it offers various explanations for the current state of innovative affairs. P&G is described by a former innovation officer, Larry Huston, as being "largely a branded science company." At the business level, this means that company flourishes when it can "charge premium prices for cutting-edge products." At the product development level, this means that, in the words of Tuck School of Business professor Peter Golder, "P&G is built on creating new categories, and innovation is in its DNA, but they need to rediscover it." If not, the continued likelihood of customers being willing to pay more for a P&G product than other products in the same product space, especially in tough economic times, will prove to be a monumental challenge.

Against this background, consider the P&G innovation scorecard:
1. P&G has not had a homegrown product blockbuster in a decade. This is so, despite employing more than 1,000 PhDs as part of an innovation staff of 8,000 employees spread across 26 innovation facilities world-wide.  
2. R&D spending as a percentage of sales has declined since 2006 (from 3% to 2.60%).  
3. In the words of analyst Victoria Collin, P&G's product offerings have focused on"reformulating, not inventing products." 
 Of particular interest are two factors that the article considers in connection with this relative decline in P&G's innovative activity--outside collaborations and the deleterious affect of decentralized R&D.

As for outside collaboration, the article is unclear how successful it has been. The article gave one example of collaborative success (a wrinkle-reducing ingredient obtained from a French company), but we are not told whether this an isolated instance or merely one example of many successful relationships. The only hint at the answer to this question is that, except for this mention of the wrinkle-reducing ingredient, the rest of the article focuses entirely on internal R&D/innovation activities by the company. This suggests that outside collaborations may not be contributing materially to P&G's innovative activities, although this conclusion may simply be an artifact of the article rather than a reflection of actual circumstances.

As for in-house R&D, the article provides much more information. It seems that, together with more outside collaborations, former CEO A.G. Lafley decentralized R&D activities, giving responsibility to business-unit heads for product development. Presumably, the thinking was that innovation would be enhanced by bringing R&D closer to the business unit likely to commercialize such developments. The result? As they say --au contraire. Between the years 2003-2008, sales from new products declined by nearly 50%. By the year 2009, so-called big product breakthroughs had declined to six a year at the most. Whether an example of unintended consequences or maladroit management ab initio, the ultimate affect of the move to drive innovation closer to the business units was to slow down innovation at the price of tying research results to short-term profit considerations.

Perhaps the biggest question is whether P&G's current innovation slowdown is due more to managerial missteps, such as those described above, or whether there is something more fundamental going on. A similar question is being asked in connection with impending patent cliff faced by the pharmaceutical industry. For both, the issue is the way in which managerial decisions impact on a company's innovation. If the better answer is that managerial errors are largely responsible, then in principle what is needed is primarily for corrective managerial measures to be taken.

Consider, however, another explanation, namely that, for reasons not fully understood, spurts of innovative activity are punctuated by cyclical declines in innovation. Managerial decisions may have marginal impact, but they are not likely, on their own, to accelerate the time line from a period of less innovation to one of higher innovation. This view was well-summarized by the thoughtful Swedish academic Ove Granstrand, who described the ups and downs of innovation activity as "the nature of nature". For a company as large as P&G, a lot rides on getting right the answer to the question above. This is especially if the Granstrand view of innovation is the more correct one. In such a case, too much managerial change intended to accelerate, of whatever kind, may be a drain on resources and less effective in the ultimate result than no, or little change at all.

Friday 14 September 2012

EU Electronic Communications Law -- a book review

EU Electronic Communications Law – Competition and Regulation in the European Telecommunications Market (second edition), by Paul Nihoul and Peter Rodford, was published last year by Oxford University Press.  IP Finance welcomes this review of it from Fredericka Argent (formerly with the IFPI and now a trainee solicitor in the London office of Covington & Burling LLP):
"With the growth and increasing importance of fixed and mobile technologies, broadcasting networks and the internet industry governing the way we communicate, work and relax, there is no better time as lawyers to have an understanding of the regulations around the electronic communications sector. While this in-depth and well-written book is not light bedtime reading, it could qualify an essential reference book for practitioners and academics in the fields of technology and competition law. Indeed, businesspeople and public bodies in the European telecommunications sector may also find it a useful guide to their industry. The authors state that their aim is to provide a neutral, practical guide to electronic communications law that may help those engaged in commercial litigation and negotiation. They seem to have been successful in this regard.

We are introduced to the book with an explanation that the rules surrounding the electronic communications sector fall into several different but co-existing categories: from rules dealing specifically with electronic activities to rules that apply to competition law generally. The European Parliament, Council and the European Commission regulate different areas, which has led to different institutions and authorities administering different bodies of rules and discrepancies in those rules forming. Although the emphasis in this book is placed on the European Union regulation, the authors stress that there is a need for practitioners to take heed of national laws and international rules agreed within the World Trade Organisation (WTO).

The authors helpfully take us step by step through the various topics and provide a logical framework for tackling each layer of complexity in the regulations. The book is comprehensive but also easy to read as a reference book – both in terms of the content and in terms of the way it is laid out: it is split up into five large chapters and subdivided into several ‘mini-chapters’, which are clearly signposted using headings, a neat layout and a detailed index.

Chapter 1 sets out the background to the creation of the new regulatory framework (the ‘RF’), which is the current framework regulating electronic communications in the European Union (notably, the RF does not directly regulate the content of communications). The multitude of directives and legislative instruments that make up the RF are set out and the relationship between the RF and competition law is examined – this being an important theme running through the entire book. The authors usefully detail scenarios and principles that can be drawn from the related case law. Of particular interest was this chapter’s focus on the elimination of ‘special and exclusive rights’ that were granted to the European electronic communications markets prior to the reform to the RF. The book addresses the economic, political and legal considerations behind the introduction of competition into the communications sector via ‘liberalisation directives’ in the RF – something that was missing under the old European structure, which had created national monopolies for electronic communications undertakings. We are also introduced to the ‘basic regulatory principles’ – such as non-discrimination and transparency – that national bodies are required to observe. The chapter then moves to a discussion of issues relating to the (predominantly private) ownership of telecommunications bodies and the regulation over the acquisition of shares in these undertakings, a topic which may be particularly helpful for lawyers and those working in the telecommunications industry.

Chapter 2 looks at the authorisations and certain formalities that undertakings may be required to comply with before commencing market activity on electronic communications markets. Chapter 3 examines undertakings’ access to facilities in order to engage in market activity and the situation where resources are controlled by third parties. Next, chapter 4 addresses, in detail, the obligation on telecommunications services to provide a universal service (defined as ‘a package of services that are to be made available at a specified quality level to all end users at an affordable price’) in accordance with public policy objectives. Practical issues are also dealt with here, such as how a universal service can be financed.

Perhaps, however, the most interesting chapter of this book is the final one, which was introduced in this second edition. The chapter addresses the protection of users on a contractual level and from the point of view of data protection and privacy in telecommunications. This is a topical issue, and readers will be familiar with the media’s reporting of stories: from internet service providers being asked to take responsibility for the data transmitted by their subscribers, to accusations against search engines and social networks of breaching users’ privacy. Indeed, in July 2012, the European Commission released a consultation on plans to draft new regulations on cyber security in EU businesses . This chapter recognises these concerns, particularly in the online environment, and takes an in-depth look at the nature and scope of the directives that have been implemented to address the issues that arise as well as wider policy thinking. Issues covered include: security questions surrounding traffic data, confidentiality of communications and the storage of information on cookies. The remainder of the chapter examines dispute resolution mechanisms and strategies, a resource that will undoubtedly be helpful to practitioners. The authors address the types of conflict (including inter-institutional conflict) that may emerge in litigation on national, European and international levels from sector specific regulation, liberalisation directives and general competition law and the interaction between these rules in the electronic communications market.

At every stage in this book, the authors take us carefully through various sets of rules and principles that have been established in European Electronic Communications law and the aim to both harmonise and liberalise the EU legislative regime in order to ensure that competition thrives throughout the sector and that the telecommunications industry successfully provides a public service. Key areas of convergence and conflict are drawn out and explained in context, as we are guided through the multi-layered rules, authorities and institutions that regulate this sector. Where appropriate, case law is examined and commercial realities are considered. For any practitioner, academic or businessperson engaged in the telecommunications industry, this book would provide excellent reading material".
Bibliographical details: ISBN: 978-0-19-960186-8. Hard cover, pp 474. Price: £195. Web page here

Monday 3 September 2012

Are there too many patents?

After too long an interval, the IP Finance weblog is delighted to welcome back one of our star guest bloggers, Keith Mallinson (WiseHarbor), who has in the past provided some sharp and pertinent insights into the use of patents and FRAND licensing within the wireless and mobile telecoms sector. In this post he turns his attention to a topic that has attracted debate in not just telecoms but many other sectors, arguing against the claims that the mass of patents currently in force stifles innovation and discourages investment.  He writes:

There aren’t too many patents
Innovation is the lifeblood of various technology markets including pharmaceuticals, software, telecommunications, consumer and automotive electronics. It is facilitated by R&D investments and secured from misappropriation by patenting. Meddling with patent law to discriminate among different types of inventions, industries or business models is unwarranted and would be harmful.
It is generally agreed that patents encourage innovation in “static” or “non-sequential” developments where a patent corresponds to a single product, and upfront costs are high, such as in drug development. However, the enormous success of standards-based technologies such as those implemented in video codecs (e.g., H.264) and in mobile communications (e.g., GSM, UMTS and LTE)—each including hundreds or thousands of standards-essential patents (SEPs)—show that the patent system also works well when innovation is both “sequential” (each successive innovation builds on its predecessors) and “complementary” (various different innovations are combined).

Specious theories
With the rise in patent litigation among some well-known smartphone technology companies, various theories of harm are being promoted seeking to radically undermine the patent system. Most recently, following US Judge Richard Posner’s June 2012 Opinion and Order including his decision to dismiss a case in which Apple and Motorola had sued each other for alleged smartphone patent infringement, the judge published an article in the Atlantic entitled “Why there are too many patents in America”. He is persuaded that the pharmaceutical industry “really does need” patent protection, but he would have patent law discriminate among different types of inventions or particular industries.  However, his theory of differences fails when tested with examples in software and telecommunications.
Similarly, a report commissioned by the UK Prime Minister and written by Professor Ian Hargreaves entitled Digital Opportunity: A Review of Intellectual Property and Growth, May 2011, states that patent “thickets” with “strategic” patenting in software and telecoms is a problem, as illustrated in Figure 1. His report cites academic research erroneously asserting that, in contrast to industries with non-sequential developments which underlie the traditional justification for patents, in industries with many sequential and complementary technologies—the software industry is given as an example—consumers and even technology innovators could be better off if there were no patents.

Figure 1: “Which Technologies are Causing the Problem?”
Source: Digital Opportunity: A Review of Intellectual Property and Growth, May 2011, by Professor Ian Hargreaves, based on WIPO Statistics Database, September 2010

Pharma is not unique
The context of Judge Posner’s article is a comparison of pharmaceuticals versus software and communications technologies. Patented software in mobile phone user interfaces, operating systems and for communications functions have figured prominently along with industrial design rights in recent litigation among smartphone technology companies. Judge Posner incorrectly asserts, or overstates, three reasons why pharmaceuticals is different to other industries, in justification for weaker or no patent protection elsewhere: high R&D costs; long delays after patenting before revenues are generated; and low production costs.

Cost of inventing – R&D comparisons
Whereas pharmaceuticals companies typically have R&D spending levels, as a percentage of sales, five times higher than an average of only 3.3% among 1,400 leading companies according to The 2011 EU Industrial R&D Investment Scoreboard, the corresponding percentages for software product companies are very similar to pharmaceutical companies, as shown in Figure 2. Microsoft’s total R&D expenditure ($9.8 billion over the last year) exceeds that of any pharmaceutical company.

R&D Investment Intensity and Gross Profit Margins are Similar for Major Pharmaceutical and Software Product Companies
Annual R&D
Gross Profit Margin
CHF 8,266
Pharmaceutical Average
Red Hat
Software average

Increases in R&D investment since the 2009 downturn have been most significant in both pharmaceuticals and ICT and have fuelled economic growth. The top 50 Scoreboard companies invested €194 billion ($243 billion) in 2010, accounting for 42.5 % of the total R&D investment by the companies. Thirty-eight companies in the top 50 showed positive R&D investment growth over the preceding year including: Merck US (47 %), Abbot (35.7 %), Pfizer (21.4 %), LG (39.5 %), Oracle (38.9 %), Google (32.3 %), and Samsung (24.9 %).

Time on market for patented technologies
Whereas half of a 20-year patent term can elapse before a drug is clinically tested and approved for sale, there can also be similar length delays before patented ICT technologies are fully commercialised for adoption globally. For example, it took many years before new cellular technologies were adopted around the world with generational advances from 1G analogue to 2G (with mostly TDMA-based technology systems), then to 3G CDMA-based systems and most recently to 4G OFDMA-based systems. These new technologies have been brought to market commercially in nine year intervals, with peak sales reached after around 16 years, as indicated in Figure 3. Patented pharmaceuticals tend to reach peak sales sooner. However, European legislature has allowed extensions for pharmaceutical patentees through Supplementary Protection Certificates.

Figure 3 
Pioneering cellular technology innovation was undertaken around one generation ahead of widespread implementation. CDMA technologies were developed for cellular by Qualcomm, Motorola and others by the early 1990s, but it was 1999 before these were adopted by ETSI and 3GPP in the UMTS 3G standard with WCDMA. These organisations have defined the cellular technologies for 80% of mobile users worldwide since the mid 1990s. UMTS was gradually introduced by mobile operators over several years. Japan’s NTT DoCoMo was a solitary frontrunner with UMTS from 2001. UMTS was not commercially deployed until 2003 in Europe, until 2005 in the US by AT&T and until 2008 by T-Mobile USA. Prior to the UMTS standard, CDMA technologies in the cdmaOne standard were generally excluded by regulation except in the Americas, Korea and Japan. The oldest CDMA patents expired from around 2010.
Similarly, OFDMA-based technologies for cellular communications were implemented by Flarion in Flash-OFDM and by many others in WiMAX from the mid 2000s, but market demand was niche and commercial performance for suppliers was poor until OFDMA cellular technologies were standardised for LTE by 3GPP with its Release 8 in 2008. The first LTE network was launched at the end of 2009.
Widespread availability and adoption follows as network technologies are rolled out over several years. This is subject to national spectrum licensing and construction cycles that are capital intensive and time consuming. For example, LTE is still not available in the UK. In contrast, blockbuster drugs can be distributed most extensively through well-established product distribution channels once national regulatory approvals are given.

Cost of producing – Gross Profit Margin comparisons
Judge Posner correctly states that “the cost of producing, as distinct from inventing and obtaining approval for selling, a drug tends to be very low, which means that if copying were permitted, drug companies that had not incurred the cost of invention and testing could undercut the price charged by the inventing company yet make a tidy profit, and so the inventing company would never recover its cost.” However, as also illustrated in Figure 2, the gross profit margins of pharmaceutical and software companies are around the same high levels. This is unsurprising given the ease with which software functions or entire programs can be copied. It makes software companies just as vulnerable to undercutting. Low cost copying and counterfeiting—notably in China—is a major problem with various ICT products.

Best of both worlds with SEP licensing
Academic research cited by Professor Hargreaves, and its 2009 re-publication entitled “Sequential innovation, and imitation” by James Bessen and Eric Maskin makes some sweeping statements, including asserting patentees’ unwillingness to collaborate with other innovators, that do not apply in the extensive context of ICT standards that include SEPs.  The authors appear oblivious and make no mention of these in their articles. The authors claim that “patents may actually reduce welfare: by blocking innovation”. They assert that “licensing may fail” and so complementary technologies will not be shared among innovators. They lend feeble support to their notion that companies will not collaborate or share by citing a distant example in the oil industry where only 12 out of 3,000 oil fields were completely covered by joint production agreements despite economic and regulatory incentives.
Yet it is precisely those industry sectors and R&D activities under criticism by Professor Hargreaves where ICT SEP patentees provide open and non-discriminatory access to their technologies for other innovators and product manufacturers. Standards setting organisations (SSOs), patent disclosures and conformance testing arrangements enable all-comers to implement technologies most easily. Agreements to license to all on (Fair) Reasonable and Non-Discriminatory terms invariably prevail, despite some well-publicised disputes. In some cases, licensing (e.g., Bluetooth) is overwhelmingly royalty-free through a patent pool. In mobile communications technologies licensing costs are predominantly eliminated through cross-licensing. For example, while 40% market share leader, Nokia stated that “until 2007 it has paid less than 3 percent aggregate license fees on WCDMA handset sales under all its patent license agreements”. While concluding that patent holders cannot make enough in licensing fees to make up for a loss of market share in downstream markets, Bessen and Maskin concede in a footnote that their findings “might change if the firms developed complementary innovations that could be advantageously be cross-licensed.” This is exactly what occurs with SEPs, but they make no further comments.

Licensing SEPs fosters downstream market development and competition, and upstream collaboration by sharing and building upon the fruits of innovation. Video and cellular standards, for example, have been phenomenally successful with billions of users and flourishing supply sectors. Thousands of patents have been declared to ETSI as likely to be essential to 3GPP standards including GSM, UMTS and LTE. Hundreds of companies collaborate in development of these standards. Most develop or manufacture products that implement the standards in downstream markets. Some of these specialise in upstream technology development but do not themselves implement their new technologies in products. They also deserve compensation for their innovation efforts. The thriving mobile phone sector with reducing prices, increasing choice and blossoming smartphone functionality has been described in several of my previous IP Finance postings, including this one from July 2011.
This article also rebuts the discredited Swanson and Baumol ex-ante IP auctioning proposal that Judge Posner cites in his Opinion and Order. By timing SEP auctions after upstream innovators have sunk their enabling technology development costs, but before downstream companies have sunk their product development costs, it would in theory be possible to drive IP prices below upstream innovation costs on a one-off basis. However, in a dynamic marketplace, such loss-making R&D would soon dry up to the detriment of everybody.
In addition (to numerous problems with that particular method of fixing prices) evidence presented in my article shows that consumers are doing rather well amid the efficient status quo in licensing SEPs. With standards of great complexity and involving hundreds or thousands of patents in mobile communications each covering different portions of each standard, it would be very cumbersome to administer IP auctions and there would be all manner of undesirable consequences. Whereas standards-based technologies are selected in a collective process on the basis of technical merit by a wide assortment of companies who generally negotiate licensing terms on a separate bilateral basis, auctions create a high risk of collusion among purchasers and would likely unduly emphasise price over other important factors (such as functionality, features, performance, and even total system cost and price to consumers).

A new world in ICT
The means of innovation has changed significantly over the last 30 years with a revolution in ICT industries. The rise of personal computing, the Internet, mobile communications, globalisation and the demise of national monopolies in telecommunications has increased upstream specialisation in R&D, increased collective efforts in standards-based innovation and increased competition among technologies, standards and companies.  Some ICT developments tasks are so extensive and economies of scale in production and distribution are so great that collaboration with voluntary sharing of intellectual property on a widespread basis through licensing has proven indispensible.  The patent system has underpinned change and growth as ICT’s global economic share has increased with the advance of personal computing, media and communications including extensive software functionality and technical standardisation.
The patent system is not perfect, but it is not broken and certainly does not require the radical change proposed by Posner and Hargreaves. There are some bad actors by both infringers as well as patentees, as I have also discussed in another of my IP Finance articles, but courts can and do redress imbalances under the existing law. There is no justification to exclude or discriminate against software and other industry sectors, methods of patent licensing or business models.  The consequences of any such exclusions or discriminatory changes to the patent system run the high risk of stifling the very innovation that these sectors generate.