When patent trolls were simply sharks

Jun 07, 2013

FORTUNE -- Complaints about patent trolls have reached such a level that the White House is now pushing for reform. Some people might believe the problem to be relatively new. And it is, in a way. But there were patent trolls in the 19th century, and they behaved in much the same way as modern ones, causing railroads and farmers to form trade groups to protect themselves. Back then, the trolls were called "sharks."

A fascinating recent paper issued by the Yale economics department shows several parallels between that time and our time. Then, as now, the trouble really started as soon as the lawyers got involved. And the economic conditions were similar: Unlike during the heyday of corporate research and development in the mid-20th century, the market for software patents is largely made up of small firms, just as there were a lot of independent inventors in the mid- to late-19th century. Now, as then, there is the problem of informational asymmetry to contend with. And the functions of software, like those of many of that era's inventions, are often broad and vaguely defined. (The paper is titled "Patent Alchemy: The Market for Technology in U.S. History. The authors are Naomi R. Lamoreaux, Kenneth L. Sokoloff, and Dhanoos Sutthiphisal. It was published by Business History Review.)

In fact, the dominance of corporate R&D was the anomaly. There is "actually nothing new about the practice of extracting economic value from patents by selling off or licensing the rights," the authors note. "During most periods of U.S. history, it was as common for inventors to profit from their creativity in this way as by starting their own firms or working as salaried employees" in a corporate research division.

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Not that selling or licensing off patents is by itself a problem. Thomas Edison "depended heavily on assignments to finance the early stages of his career," according to the paper. He transferred the rights to 20 of his first 25 patents. But the existence of a robust market for patents is what brings in the trolls, or sharks. Inventors who held on to and exploited their own patents represented less than a quarter of the patents issued in the late 19th century. The other three-quarters were up for grabs, and it was often rank opportunists or outright fraudsters who did the grabbing.

The lawyers swooped in after the passage of the Patent Act of 1836, when the government started examining patents to ensure there were no prior patents on the same technology. This created a need for expertise. Inventors also began hiring agents (often patent lawyers) to sell and license patents on their behalf in local markets around the country, as well as nationally. Most of these agents seem to have been legit, but a lot of them weren't. Some of them would sell patents that didn't actually exist. Others would sell or license them and not inform the inventors, keeping the fees or proceeds for themselves. Inventors could market their patents themselves, but that was incredibly expensive and time-consuming.

Compared to the level of fraud, "sharks" were a relatively minor problem, but they affected the farming and railroad industries in a big way. One shark, Thomas Sayles, bought the rights to three patents on a railroad braking system. If a railroad licensed one of the patents, he would sue for infringement on one of the other two. The railroads joined up to take him on, winning a case before the Supreme Court in 1878. The Court's decision in effect limited the amount that sharks could get from lawsuits: "Infringers" were thereafter liable only for the incremental value they derived from employing a particular patented technology in lieu of possible substitutes.

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Farmers weren't quite as successful in fending off the sharks, at least at first. "During the 1870s and '80s," the paper notes, "western farmers were deluged with threats of legal action" based on alleged infringement. The patents were often on "inventions" like barbed wire and milk cans. "These cases seem to have flourished because there was uncertainty about the value and legitimacy of many of the patents ... " Many farmers formed associations to strengthen their legal fight. In many cases -- including the barbed-wire case -- they lost. "Nonetheless," the farmer's increasingly well-organized opposition took its toll on the sharks' business, "by forcing them to pay more to litigate and by the fact that the sharks' methods were publicized, giving them less political cover. By the 1890s, the problem had "largely abated," the authors note.

Patent trolling seems like a new phenomenon to many of us because most of us grew up during a time when corporations dominated the patent market. But the economic environment is much different now, and in important ways more like it was in the 19th century. In 1970, small firms owned just 5% of patents issued worldwide. By 1990, that had grown to about one-third, and it's growing still. As large firms looked for places to reduce costs, their R&D departments were often the first to have their budgets cut, and firms looked outside for new technologies. Between 1980 and 2005, the R&D expenditures of companies with 25,000 or more employees fell from about two-thirds of the total to about one third.

"As in the past, the growth of the market for technology has given rise to new problems of asymmetric information that opportunists can exploit to their advantage," the authors note. This is especially true of software, where the functions -- like those of barbed wire -- are wide-ranging and vague. Abstraction and multitudinous potential applications are inherent in software, and are just what a troll looks for when shopping around for someone to sue.

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The authors conclude that "it is not clear that the 'troll' problem" today is "commensurately more serious than it was in the earlier period." But that conclusion is based on the level of success of cases that are decided in court: Most often, the trolls lose. But the authors themselves recognize that "trolls can still do a lot of economic damage just by threatening litigation." Terms of settlements aren't usually known, nor is the level to which patent trolls stifle innovation. It's clearly a lot.

Beyond government initiatives like those proposed by the White House, the authors expect the backlash against patent trolls to grow. "As in the late 19th century, one might expect defendants to revise their assessments of the probability of winning and start fighting more of these cases in court, perhaps again basing together in associations for that purpose."

In fact, that's already occurring. It could be that the panic we're seeing among champions of innovation is actually the beginning of the end of patent trolls, at least in the current era.

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