Wednesday, December 04, 2013

Legal Insurance as a Commitment Strategy: A Solution to the Patent Troll Problem

One intellectual property issue that has gotten a lot of attention lately is the problem of non-practicing entities, referred to by their critics as patent trolls—firms that buy up an inventory of patents not in order to practice them but in order to sue other firms for infringing them. Patents protect ideas and ideas have fuzzy boundaries. That makes possible a strategy of suing on weak cases not because you expect to win but in order to be paid to drop the suit. It may make sense for the targeted firm to settle for an amount less than the cost of litigating the case  if it wins and considerably less than the cost if it loses. A large firm that knows it could be targeted multiple times might go to court in order to deter future suits, but that makes less sense for a small firm, especially one that will be bankrupted if it loses and badly hurt even if it wins.

The purpose of this post is to suggest a way in which small firms could protect themselves against such suits and ask why it is not in common use. The solution I am proposing is litigation insurance to cover most or all of the cost of defending against such a suit. While most insurance costs more than it is worth from an actuarial point of view, this kind of insurance might well be worth more than it costs.

Ordinary insurance costs its customers more than it pays them for two reasons. The obvious one is that, in addition to paying out claims, an insurance company has to rent offices, hire claims adjustors and salesmen, bear a variety of additional expenses. The less obvious reason is that insurance reduces the incentive of the insured to take costly precautions against whatever the insurance covers. If my house has no fire insurance, it is worth it to me to take any precaution—installing  a sprinkler system, say—whose expected payoff in reducing the chance that the house will burn down is greater than its cost. If I am insured for 90% of the loss, it only pays to take those precautions whose benefit is at least ten times their cost. The inefficiency of worthwhile precautions not taken reflects what economists refer to as moral hazard. The benefit that balances those costs is the fact that the money the insurance company pays comes when something has happened, such as my house burning down, that makes money especially valuable to me.
Litigation insurance has those costs as well but, for a firm likely to be targeted by a patent troll, it also has a large potential benefit: Deterrence. Insurance which covers litigation cost but not out of court settlement makes settling less of a temptation, increasing the chance that the suit will go to court. The more likely it is that the plaintiff will have to litigate, the less profitable it is to bring the suit in the first place. Insofar as the effect of the insurance is to keep you from being sued, it provides a benefit that costs the insurer nothing. 

I have a (currently unpublished) article that uses what I have learned by looking at feud societies such as saga period Iceland to explain why non-practicing entities present a special problem for patent litigation and borrows an idea from the legal system of Periclean Athens to suggest a legal solution. The private solution I am suggesting here is in part inspired by yet another legal system I have written on, privately enforced criminal law in 18th century England. Part of what made that system work was the existence of associations for the prosecution of felons, the members of which paid in advance into a fund used to pay the cost of prosecuting anyone who committed a felony against one of them. The real function of such associations, I believe, was not insurance but deterrence: The membership list of the association was published in the local newspaper for the felons to read, in order that they would know who not to target.

Which leaves me with a puzzle: Why isn't the equivalent approach used against patent trolls—or if it is, why doesn't it work?


Joe said...

Huge information asymmetry / "moral hazard" problems. How would such insurance be priced? Obviously it can't be purely based on possible losses (value of the insured firm) because that would incentivize brazen infringement and even collusion between insured infringers and trolls. OTOH the kind of due diligence needed to establish risk/exposure might be almost as expensive as (successful) defense against a suit.
Insurance that covered defence only against specific (named/numbered) patents with respect to specific, final products/designs might be more feasible, but would still be somewhat expensive (it's not that easy to figure out which patents to be worried about) and might increase damages in a successful suit since it would prove respondent was aware of the possibility of infringement.


Daublin said...

A simpler solution is to have penalties for raising a patent suit and failing. In particular, penalties for raising a patent suit and the result of the trial being that the patent is rendered invalid.

Anyway, what you say makes sense, too, but it's a sad world if things go that way. As things stand, a software company can start as two guys with zero capital beyond a few personal computers. In the world you describe, it takes a higher commitment to get started.

Aside from your main topic, it's worth considering why it matters that the entity is non-practicing. If the patent is unsound, then there's no fixing the situation; we need a better patent office. If the patent is sound, then even if the practicing *firm* holds the rights, they're going to create a legal *department*. I see little difference between having a legal department and out-sourcing it to a separate firm.

Regarding ,"That makes possible a strategy of suing on weak cases not because you expect to win but in order to be paid to drop the suit," I think that's just the norm in Western law! It turns an all-or-nothing court decision into something with a number of gradations.

Norm said...

Would the insurance be for the cost of litigation only or of litigation and damages? Seems to me it might work best if the firm retained the exposure for damages due to actually losing a case, but could afford (since the cost is paid through insurance) litigation. This puts the troll at risk of losing, but wouldn't destroy the value of a valid patent.

David Friedman said...

I apparently wasn't clear. I was suggesting insurance that only covered litigation costs--neither damages nor out of court settlements.

dWj said...

I wouldn't think of this as an "intellectual property issue"; there are certainly credible allegations that, for example, Jesse Jackson and Al Sharpton have used threats of bogus lawsuits (among other things) to extort payments. It might be a particular problem in IP because of the fuzzy boundaries you note; it's harder to be sure which side of the line you're on a lot more of the time.

I think the second reason you give for why insurance "costs its customers more than it pays" doesn't quite do that; it costs its customers more than the customers would lose if they didn't insure, which is the relevant comparator here anyway. The problem is that, because of the insurance, they suffer bigger losses (which the insurance then pays) than if they hadn't insured, thus the insurance has to pay out more if they buy it than they would lose if they didn't.

Joe said...

If you meant insurance to cover costs of litigation only, doesn't that already exist?

Joe said...

I.e. "liability insurance".

jimbino said...

It's the terrible inefficiency of insurance that makes litigation appealing and the terrible inefficiency of litigation that makes insurance appealing.

It's the terrible inefficiency of the Amerikan medical care market that makes health insurance appealing and the efficiency of the electronics market that makes extended warranties unappealing. said...

Litigation insurance is quite common in the part of the world I live in. We have an annoying neighbour who keeps threatening to sue us for trivialities, and we just shrug, and say "bring it on". We're insured. Our household insurance policy covers this.

Then there are companies that offer protection against patent trolls as part of their service offerings. Red Hat is an example: