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?