Volume 5, Number 7 - November 2004
Patent Cross-Licenses: A Financial Asset Hedge
Patent Strategy & Management
By Andrew W. Carter and Robert J. Block, and Fayth A. Bloomer

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In today's age of strong patent rights, enhanced visibility and budgetary clout is the norm for intellectual property professionals - and are generally regarded as good things. With the creation of the Federal Circuit Court for Patent Appeals in 1982, we have seen a number of distinct pro-patent trends. These have included a robust presumption of patent validity, higher damage calculations for acts of infringement, more flexible approval standards introduced by the PTO and, an increasingly granted right on the part of patent holders to seek injunctive relief stops the production of infringing products. Prior to the creation of the unitary Patent Circuit, patent-rights were less certain to be enforced through either the award of high monetary damages or sweeping injunctive relief.

"Strong patent rights" as a phrase has a vigorous, unequivocally healthy sound to it. Weak patent rights would not be desirable. A potentially less loaded and more descriptive phrase may be: "patent value inflation." To say that we live in an era of inflating patent values suggests something of the planning challenges that inflation of any core asset or commodity invariably delivers.

It is not surprising that economists have found a more elegant label for this problem. A classic 1968 article by Hardin in Science diagnosed the "tragedy of the commons" in which the phenomenon of too many owners of a common resource, with attendant rights of use, can lead to overuse (and depletion) of the resource. More recently, patent value inflation has been identified as fueling the tragedy of the "anti-commons" in which too many owners with the right to exclude others from a resource, leads to under-use of the resource. Economists have, of late, devoted a very considerable amount of effort examining this dilemma. Some have even argued that the pooling or cross-licensing of complementary patents should be distinguished from the pooling or cross-licensing of substitutes as a pro-competitive pathway out of the "patent thicket."

There is a nascent (or in the case of a few visionary players such as Microsoft, actually an adolescent) 'swaps market' developing for IP rights being used as financial instruments. Derivatives, as such, are not anti-competitive, but are rather anti-risk. If we view cross-licensing through the lens of financial risk management, we get the clearest picture of deal-maker motivation. This has consequences for deal-makers, regulators and IP professionals.

FINANCIAL SWAPS
A "swap" is defined at the baseline level as the exchange of a thing for another thing, and the word is derived from middle-English - Chaucer would have recognized it as "striking hands in a bargain." Modern bargains involve cash flows from financial obligations, classically trading fixed for floating payments, or payments denominated in different currencies. The value driver in such a case may involve one party's relative efficiency (or advantage) in accessing fixed or floating funding or, more simply, accounting for complementary risk profiles.

In financial markets, swaps are thus driven by comparative advantage, a phrase coined and defined by Ricardo in the early 19th century. Yet the first modern financial swap is understood to have been consummated in 1981 between the World Bank and IBM exchanging dollar payment for Swiss franc and Deutschemark obligations. Ricardo's principles were put into practice immediately in the trade of commodities and simple tangible assets, yet much more slowly in the exchange of derivative financial assets.

However, after having caught on only very slowly to these early insights, the financial markets have quickly made up for lost time. By the year 2000, the value of swap transactions was approximately 10,000 times the 1981 level. Nearly $50 trillion in notional deal value was outstanding globally by that time; about 2/3 of that notional value was represented by interest rate swaps.

Ricardo was prescient, but not that prescient. The financial markets were motivated to implement his insights as a result of increases in financial asset volatility. Volatility means the velocity of the change or fluctuation in value for core financial assets. When IBM and World Bank pioneered the first modern swap, interest rates had been set at 17% by Paul Volker, while they remained at the bargain rate of 12% in Switzerland. The value of the dollar changed dramatically and rapidly in relation to the value of other major currencies. Markets reacted to volatility by cooperatively and collaboratively managing risk. Twenty-three years and tens of trillions of dollars after that first transaction, few Treasury professionals recall a world without financial swaps.

Patent thickets and patent anti-commons theoreticians are identifying increases in financial asset volatility for patents and hence for R&D expenditures. The patent gods have conferred certain blessings: our corporate R&D expenditures are more likely to result in the granting of patent rights, and those rights are more likely to be valuable either in the assessment of damages or the use in securing injunctive relief. We can see the direct line of payoff in R&D.

Yet these blessings are distinctly mixed. These relatively more valuable assets are also sharply more vulnerable because of more numerous (and commensurately valuable) blocking patents. In point of fact, as the literature suggests, the value inflation and volatility is not so much in patents (which are aggregates of patent claims) as in the patent claims themselves which more frequently overlap. Examples of research niches that have been burdened by significant patent claim overlap include vitamin A Golden rice, assays & diagnostics for TB and malaria, and fixed dose combinations (ARVs).

With billions in returns on R&D dollars riding on the strength of overlapping and volatile patent claims, risk-averse decision-makers will be motivated to turn to a swaps market. The value of financial assets may seem more opaque compared to patent claims, but until hedging mechanisms were perfected, the bond yield curve was hostage to central bankers in the same way that the "patent yield curve" is determined by the CAFC or the PTO.

Most patent cross-licensing agreements (including more complex pooling agreements) are exercises in applying well-understood financial engineering techniques to less well-understood underlying assets. It took the markets 150 years to take Ricardo's insights down the path from cotton to currency, but only another 20 to embrace intangibles. Since intangibles now comprise the vast majority of the market capitalization for the Fortune 500, it is unsurprising that the related value at risk would be managed with more sophistication.

Techniques from the derivatives markets are now being lifted bodily from the floor of the Chicago Board of Trade and applied to patent disputes. Recently Microsoft agreed to pay Sun $900 million for a covenant covering Sun patents to the date of the agreement, with an option to extend the payment each year for a maximum of 10 years. If Microsoft pays the annualized option premium for all 10 years (an aggregate premium of $450M) the companies will automatically strike a perpetual cross-licensing agreement for their respective patent portfolios. In the meantime, the parties can supercede this agreement with a cross-licensing deal in negotiations that are currently pending.

Microsoft has negotiated a series of call options related to, but not coextensive with, Sun's IP (for example, the parties can sue each other for infringement but cannot collect monetary damages). The contract offers Microsoft an embedded swaption - the right, but not the obligation to enter into a portfolio swap of IP with Sun at the end of the 10 year period. Microsoft will undoubtedly re-price and re-value this transaction annually based on its assessment of the value of emerging Sun IP. The "alliance" thus created is close to a pure financial play - it is not a joint venture, a pool or a marketing alliance. Microsoft has chosen to hedge the risk presented by Sun's patents with a combination of cash and its own patent value, but in a way that is very efficiently "marked to market" on an annualized basis.

SWAPTIONS VS. FUTURE RISKS
As patent valuation technique advance (and standardize), and Treasury specialists work more collaboratively with Intellectual Property specialists, expect the trend in financial innovation to increase and accelerate. IP risk management will necessarily become holistic. The insurance market-place for patent infringement risk is limited for some of the same reasons that the insurance market-place for earnings-per-share risk or interest rate risk is limited. Risks that can be managed with "vanilla" cross-licenses, or caps/collars/options and swaptions will reduce volatility to the level where insurance policy coverage can become meaningful.

No corporate treasurer would permit even millions of dollars in interest rate or currency exposures to go unhedged. Yet billions of dollars in R&D value can be effectively protected by the swap - sometimes cashless - of relatively few well-drafted patent claims. In an age of accelerating patent and intangible asset value, treasury departments must lend its expertise and concentrate their attention in this arena.

Andrew W. Carter (acarter@oceantomo.com ) is a Managing Director and co-founder of Ocean Tomo, an intellectual capital merchant banc.

Robert J. Block (rblock@oceantomo.com ) is the Managing Director in charge of Ocean Tomo's IP Risk Management practice.

Fayth A. Bloomer (fbloomer@oceantomo.com ) is an Analyst in Ocean Tomo's Chicago office.

REPRINTED WITH PERMISSION FROM THE VOLUME 5, NUMBER 7 - NOVEMBER 2004 EDITION OF THE PATENT STRATEGY & MANAGEMENT © 2004 ALM PROPERTIES, INC.
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