A MODEL OF PATENT TROLLS

• Author: Jay Pil Choi,Heiko Gerlach
• Published date: 01 November 2018
• Date: 01 November 2018
• DOI: http://doi.org/10.1111/iere.12330

INTERNATIONAL ECONOMIC REVIEW

Vol. 59, No. 4, November 2018 DOI: 10.1111/iere.12330

A MODEL OF PATENT TROLLS∗

BYJAY PIL CHOI AND HEIKO GERLACH1

Michigan State University, U.S.A., and Yonsei University, South Korea; University of

Queensland, Australia

This article develops a model of patent trolls to understand various litigation strategies employed by nonprac-

ticing entities (NPEs). When an NPE faces multiple potential infringers who use related technologies, it can gain

a credible threat to litigate even when it has no such credibility vis-`

a-vis any single potential infringer in isola-

tion. This is due to an information externality generated by an early litigation outcome for subsequent litigation.

Successful litigation creates an option value against future potential infringers through Bayesian updating. We

discuss policy implications including legal fee shifting and the use of injunctive relief.

1. INTRODUCTION

The patent system is designed to protect and promote innovation by granting innovators

exclusive rights to commercially exploit their inventions for a limited period of time. However,

patent law does not require that only the inventor enforce the patent. Patents can be transferred

to other parties and be enforced by whoever owns them (Lemley and Melamed, 2013). Recently,

the emergence of nonpracticing entities (NPEs) as a major driver of patent litigation has

spawned a heated debate on their role in the overall patent system and their impacts on

innovation. NPEs, also derisively called “patent trolls,” are a new organizational form whose sole

purpose is to use patents primarily to obtain license fees instead of to support the development

of technology.2They amass patents not for the purpose of commercializing a new product but

to litigate and demand licensing fees.

The proponents of NPEs emphasize potential positive roles of NPEs. They argue that NPEs

help small independent inventors to monetize their intellectual property (IP) rights against

potential misappropriation by established companies, thereby inducing more innovation by

small inventors. In contrast, the opponents are concerned that NPEs simply raise the costs of

innovation and can drag down the innovation process. Due to their business models, they seek

patents to pursue “freedom to litigate” instead of “freedom to operate.” The value of a patent

thus can be based on the “exclusion value” instead of the “intrinsic value” when it is held by NPEs

(Chien, 2010). More importantly, the recent surge in the number of lawsuits initiated by patent

trolls became a cause for concern for businesses and policymakers alike.3One recent statistic

shows that patent trolls are responsible for 67% of all patent lawsuits (Morton and Shapiro,

2014). Bessen et al. (2011) estimate that trolls cost the economy $500 billion over the last

20 years, mostly in the IT industry.

∗Manuscript received May 2016; revised March 2017.

1We would like to thank the editor Harold Cole and two anonymous referees as well as Scott Baker, Erik Hovenkamp,

Louis Kaplow, Scott Duke Kominers, Jorge Lemus, Alvaro Parra, Kathy Spier, Emanuele Tarantino, and participants in

various conferences and seminars for valuable discussions and comments. Jay Pil Choi was supported by the Ministry of

Education of the Republic of Korea and the National Research Foundation of Korea (NRF-2016S1A5A2A01022389).

Please address correspondence to: Heiko Gerlach, School of Economics, University of Queensland, St Lucia, QLD

4072, Australia. Phone +61-7-3346-0572. Fax +61-7-3365-6666. E-mail: h.gerlach@uq.edu.au.

2NPEs are also called patent-asserting entities (PAEs).

3President Obama expressed his concern about the harmful effects of patent trolls in a speech. See Reuters, “Obama

Says Patent Reform Needs to Go Farther,” February 14, 2013.

2075

C

(2018) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

2076 CHOI AND GERLACH

This article develops a model of patent trolls to understand various litigation strategies

employed by NPEs. We show that when an NPE faces multiple potential infringers who use

related technologies, it can gain a credible threat to litigate even when it has no such credibility

vis-`

a-vis any single potential infringer in isolation. This is due to an information externality

generated by an early court outcome for subsequent litigation. Successful litigation creates

an option value against future potential infringers through Bayesian updating. This renders a

credible litigation threat against the initial defendant and allows the NPE to extract more rents.

Lemley and Melamed (2013) point out that patent trolls do not employ a unitary business

model, and there are at least three different troll business models. A “lottery-ticket” troll is

an owner of a patent that reads on a significant technology area. They target big established

firms with an uncertain shot at a big payout. It is particularly important to these trolls that the

perceived probability of infringement is high when they face their big practicing entity (PE)

target. By contrast, “bottom-feeder” trolls are not particularly concerned as to whether the

patent is infringed or not. They rely on the high cost of patent litigation and aim to settle for

small amounts of money. Finally, “patent aggregator” trolls acquire huge patent portfolios to

convince a target company to pay royalties for the portfolio license.

Our article formalizes how the exclusion value is created by the credible threat to litigate and

explores its implications for NPEs’ litigation strategies. For instance, consider bottom-feeder

trolls who search for “quick, low-value settlements for a variety of patents.”4The logic is that

the defendants prefer to settle for small amounts of money instead of pay the high cost of

patent litigation that could easily run into millions. However, high litigation costs cut both

ways, and the logic begs the question of why defendants would consider the litigation threat by

bottom feeders seriously. Given the considerable litigation costs relative to a meager expected

payout, why do they not ignore the threat? We do not rely on a reputational mechanism but

rather provide a theory of litigation credibility based on information externalities. We show

that an NPE may have a patent portfolio that is not strong enough to make its litigation threat

credible in isolation, but, in the presence of multiple defendants, the litigation threat becomes

credible due to its option value for other future defendants. As pointed out by Lemley and

Melamed (2013), “the universe of technology users against which a troll might assert patents

is ... potentially much larger than the group of competitors against which a practicing entity is

likely to assert its patents.”

To understand the role of information externalities in patent litigation, consider the following

simple numerical example. First, consider a situation in which an NPE faces only one PE that

uses its patented technology. Let the PE’s profit be 20, and, if the NPE is successful against

the PE in its litigation, it can extract half of the PE’s profit via Nash bargaining with the threat

of injunction. The probability that the PE’s patent is valid and infringed by the PE is given

by 1/4, and the legal cost for each party is 4. Then the expected payoff from litigation for the

NPE is given by (1/4) ×10 −4=−1.5<0, and the NPE’s litigation threat is not credible.

Now suppose that there are two PEs with the same profit level of 20. For simplicity, these

two PEs are not competing each other, but are assumed to use the same technology. This

implies that the infringement by the two PEs is perfectly correlated.5In this case, litigation

against one PE reveals perfect information about the infringement by the other PE. Thus, if the

NPE wins against one PE, it has a credible threat to litigate against the remaining PE and can

extract 10 for sure. This implies that the NPE’s threat against the first PE is credible because

(1/4) ×(10 +10) −4=1>0. The NPE and the targeted PE will settle out of court to save

litigation costs. With Nash bargaining, the NPE will be able to receive a licensing fee of 5 from

the targeted PE due to the presence of another PE that offers an additional option value for

the initial litigation. We thus show how the presence of other potential infringers enhances the

credibility of the patent holder’s litigation threats and enables him to “double dip.” However,

4See Lemley and Melamed (2013, p. 2126).

5According to the legal principle of “res judicata,” a matter that has been judged on the merits may not, generally,

be relitigated.

A MODEL OF PATENT TROLLS 2077

note that the NPE no longer has any credible threat against the remaining PE once it extracts

the licensing fee from the first PE. This simple example also suggests that the NPE may have

higher incentives to acquire patent portfolios for the purpose of litigation vis-´

a-vis PEs. Suppose

that the target firm is randomly selected because the two firms are symmetric. Then, each firm’s

expected licensing cost is 2.5. As a result, each PE will have incentives to bid up to 2.5 if the

patent is up for sale, whereas the NPE has incentives to bid up to 5. Acquiring the patent in this

example is like providing a public good between the PEs because if one PE acquires the patent,

the other PE benefits as much because the acquiring PE will not have any credible threat against

the other PE. This type of provision of public good problem can also explain the emergence of

defensive aggregators.

Hovenkamp (2013) is related to our article in that he considers the NPE’s incentives to

litigate and the credibility of litigation threat. However, the mechanism by which the NPE

gains credibility with weak patents is very different. He develops a dynamic model of predatory

litigation that relies on the NPE’s litigious reputation and behavioral type of “impressionable”

PEs that are easily intimidated by the NPE’s predatory litigation behavior. In contrast, we do

not assume any asymmetric information about firms’ types, and our main results are driven by

information externalities across litigation suits. Lemus and Temnyalov (2017) analyze the role

of PAEs on litigation and innovation incentives. To address this issue, they consider a model

in which a PAE is allowed to acquire patents from PEs and compare the equilibrium in such a

setup to a situation in the absence of the PAE. They identify two effects created by the PAE

that are immune to counterlitigation: an enhanced patent monetization effect and the loss of

the value of defensive patent portfolios. They show that when the former effect dominates the

latter, PAEs can enhance innovation incentives and social welfare. The main focus of their

paper, however, is different from ours and can be complementary to ours in understanding the

tactics and roles of NPEs/PAEs in the overall patent system. They are concerned with the price

of patent acquisition by the PAE and how this, in turn, changes the returns to R&D. We are

more interested in the litigation strategies of NPEs and focus on litigation externalities, which

are absent in their model.

Choi (1998) considers the implications of information externality in patent litigation but in

a different context. He considers a setting in which a patent holder is the incumbent facing

multiple potential entrants. Launching a patent suit in face of entry can be a risky proposition

for the incumbent because of potentially harmful information that would invite further entry if

its patent is invalidated. He explores the implications of such information revelation on entry

dynamics and shows that the nature of the entry game can be one of either waiting or preemption

depending on the strength of the patent. However, the nature of information revelation in Choi

(1998) is different from ours because the patent holder is a PE and the issue is entry dynamics

instead of extraction of rents by NPEs.

There is also a small set of papers in the law and economics literature considering strategic

implications of information from trial outcomes for subsequent litigation and settlement. Che

and Yi (1993) consider a situation in which a single uninformed defendant faces multiple

informed plaintiffs, and, once a precedent is set, it can have a lasting effect on successive

trial outcomes. Daughety and Reinganum (1999) consider an incomplete information model in

which an initially uninformed plaintiff makes a menu of settlement demands of the informed

defendant who faces other potential plaintiffs. They show that the possibility that there are

other plaintiffs the defendant might face improves the current plaintiff’s bargaining position, as

the outcome of the current case may invite further follow-on suits. As a result, the defendant

may be willing to pay “hush money” to keep the negotiation outcome confidential. By contrast,

we use a different model framework with symmetric information and focus on issues arising

from IP litigation incentives of NPEs.

The remainder of the article is organized in the following way: In Section 2, we set up a simple

model of patent litigation with information externalities. To illustrate the main idea, we consider

one NPE that can assert its patent portfolio against multiple PEs in a predetermined order and

analyze the implications for the credibility of the litigation threat. In Section 3, we endogenize