21st Century Innovation Systems for Japan and the United States: Lessons from a Decade of Change: Report of a Symposium (2009)

Bronwyn H. Hall¹

University of California at Berkeley

This paper was written for the symposium in January 2006, when many were optimistic that a patent reform bill would soon pass in Congress and be signed into law. Because of the delay between the symposium and the publication of the report, the description that it contains of the current state of legislation in this area is inevitably out of date. However, because the paper is documentation of what was said at the symposium, I have left it as it stands, while adding a postscript that updates the situation to mid-2008.

During the first half of this decade, the chorus of critics of the current operation of the U.S. patent system has increased in size, and even included the occasional member of the popular press. The outcry has culminated in a series of reports by governmental and public interest organizations recommending a number of reforms to the system.² Based for the most part on the recommendations in these reports, a bill (H. R. 2795) was recently introduced in the U.S. Congress that would introduce a number of far-reaching changes to the system. Hearings related to the proposed changes in the bill have been held in the Senate and the House, and in the various subcommittees it has been substantially revised, in response to critiques by stakeholders in the system. At the present time it is not clear when and whether and in what form legislation will issue, but that something will come out of the process seems almost certain.

My presentation today discusses the economic rationale for the patent system, briefly reviews the changes to the U. S. patent (and innovation) system that have led to the current situation, and summarizes the arguments behind the calls for reform. It then discusses in more detail the issues that are under consideration for legislation and the current prospects for that legislation.

For an economist, the central patent policy question is whether the patent system, which entails costs and benefits, increases innovative activity on net.³ In testimony before the Federal Trade Commission/Department of Justice (FTC/DOJ) hearings on Competition and Intellectual Property Law in the Knowledge-Based Economy, I offered a simple chart as a framework for thinking about costs and benefits of patents (Table 1).

This chart is intended to suggest that in addition to the familiar arguments that patents increase innovation via incentive effects and diffusion and decrease competition because they create temporary monopolies, there are offsetting effects in both cases that have become more apparent in recent years.⁴ These offsetting

effects are the tendency of patents to increase the costs of subsequent innovators, especially when these innovators need to combine inventions from many sources, as well as the fact that patents may help competition by facilitating the vertical disintegration of knowledge-intensive industries and helping new entrants.

As the chart illustrates, the body of economic theory that lies behind it yields an inconclusive answer to the question of whether patents encourage innovation generally. We therefore turn to the empirical evidence on this question, which comes in several flavors: survey evidence, cross-country studies, and studies within individual patent systems. The conclusions from the empirical studies that I have surveyed in the past are several in number. The first is that introducing or strengthening a patent system (lengthening the term, broadening subject matter coverage, etc.) unambiguously results in an increase in patenting and in the strategic uses of patents (Lerner 2002; Baldwin et al. 2000; Hall and Ziedonis 2001).

Second, it is much less clear that these changes result in an increase in innovative activity, although they may redirect such activity toward things that are patentable and/or are not subject to being kept secret within the firm (Moser 2001; Lerner 2002; Baldwin et al. 2000). Third, if there is an increase in innovation due to patents, it is likely to be centered in the pharmaceutical and biotechnology areas, and possibly specialty chemicals (Levin et al. 1987; Cohen et al. 2001; Arora et al. 2001).

Fourth and finally, the existence and strength of the patent system DOES affect the organization of industry, by allowing trade in knowledge, which facilitates the vertical disintegration of knowledge-based industries and the entry of new firms that possess only intangible assets (Hall and Ziedonis 2001; Arora et al. 2003; Arora and Merges 2004).

Thus, the bottom line from the empirical evidence is that the patent system provides clear incentives for innovation in only a few sectors, but that firms and industries do respond to its presence, both by making use of the system and by sometimes tailoring their innovative strategies to its presence. As Edith Penrose said some time ago when speaking to the same question, “If national patent laws did not exist, it would be difficult to make a conclusive case for introducing them; but the fact that they do exist shifts the burden of proof and it is equally difficult to make a really conclusive case for abolishing them.”⁵

As with (almost) all governmental institutions, the U.S. patent system has evolved and continues to evolve, in ways that are ultimately driven by forces related both to a perception of increased global competition, especially in knowledge-intensive sectors, and to technological change itself. The expansion of subject matter coverage, the strengthening of the enforcement system, and the encouragement of patenting by upstream actors can all be seen as driven by these forces.

Unfortunately (from the perspective of optimal policy), many of the changes in patent policy in the United States during the past two decades have been a result of court decisions, especially those of the Court of Appeals of the Federal Circuit (CAFC), and to a lesser extent by the Supreme Court. Addressed as they are to the features of individual cases, these decisions do not always consider the broader policy implications as they set precedents. As a result of a series of court decisions by these bodies, the subject matter eligible for patenting has been extended to new technologies (biotechnology), technologies previously not subject to patent protection (business methods, software), and to upstream scientific research tools, materials, and discoveries (Madey v. Duke, 2002). The rights of patent holders vis-à-vis alleged infringers have been strengthened by such decisions as Polaroid v. Kodak (1986/1991), which yielded a major damage award to Polaroid and shut down Kodak’s instant camera business.

Of course in many ways these court decisions were the consequence of legislative changes in 1982, during which the CAFC was created, and the strengthening of the position of patent holders by a number of procedural changes in the courts. In a comparison of appeals cases from 1953 to 1978 and from 1982 to 1990, the share of District Court decisions finding validity and infringement that were upheld by the higher court increased from 62 percent to 90 percent. Decisions of invalidity and no infringement were reversed 12 percent of the time before the Federal Circuit’s creation, and 18 percent afterward. Moreover, the rate of preliminary injunctions increased dramatically.⁶

The early 1980s was also the period when the well-known Bayh-Dole Act become law, leading to the emergence of new players such as many universities and public research institutions, as well as an increase in activity at institutions that had already been patenting some of their research results.

The 1988 Process Patent Amendments Act enabled U.S. process patent holders to block the import of foreign products produced by methods infringing their patents as well as to hold domestic sellers or users of a product made by a patented process liable for infringement.

From the 1980s onward there was also a marked evolution in the attitude of the Justice Department’s Antitrust Division and the Federal Trade Commission toward business conduct involving patents, resulting in a much more nuanced and pro-patent position (FTC 2003). In 1981 the division’s deputy assistant attorney general abandoned a list of nine licensing practices that the department a decade earlier had characterized as automatically illegal. The 1988 Justice Department Antitrust Enforcement Guidelines for International Operations outlined the consumer benefits from intellectual property licensing and adopted a rule-of-reason approach to such issues. In 1995 the Justice Department and the Federal Trade Commission jointly issued Antitrust Guidelines for the Licensing of Intellectual Property, reiterating the 1988 principles and declaring that “the Agencies do not presume that intellectual property creates market power in the antitrust context” and intellectual property licensing is “generally pro-competitive.”

Taken together, these changes all add up to a considerable strengthening of patent holder rights and broadening of the reach of the patent system. As I summarize in the next section, the response to these changes on the part of private firms has been dramatic.

The most obvious response to these changes in the patent system was the increase in patenting across many sectors, leading to a doubling of patent applications and grants during the 10-year period between 1992 and 2002. In Hall (2005), I showed that the time series of aggregate patent applications in the United States displayed a structural break in 1984, with the annual growth rate increasing from zero to over 6 percent. Such a growth rate will produce a doubling in twelve years. I also showed that most of the growth was due to increased patenting by firms in the information and communication technology (ICT) sectors, which is consistent with the view that much of it is for defensive reasons (Arora et al. 2001; Hall and Ziedonis 2001; Hicks et al. 2001). At the same time, the contribution of increased university and public research institution patenting to growth was relatively small. From a regional perspective, over half the growth was due to inventors in the United States, one third to those in Asia, and the small remainder to inventors in Europe. Thus the growth was driven by the behavior of the ICT sector in the United States and Asia.

A number of other behavioral changes have accompanied this increase in patenting: slightly higher renewal rates, more frequent assertion of patents, a doubling of U.S. District Court patent suits from 1988 to 2001, and some evidence that the probability of a patent-related suit has increased recently (Bessen and Meurer 2005). The complexity of patents in terms of the number of claims and citations of prior art has grown, and patentees tend to invest more in the process of application and examination. In testimony before Congress, the current Director of the U.S. Patent and Trademark Office (USPTO), Jon Dudas, reported that more than 100,000 of the 355,000 patent applications filed in 2004 were continuations of applications that had been previously reviewed by an examiner. He also reports on the problem of “super-sized” applications submitted by a minority of applicants (7 percent of the applications account for 25 per cent of the claims examined; some are submitted on CD-ROMs with thousands of claims).

In addition, many critics have argued that the sheer volume of patent applications threatens to degrade the quality of issued patents or lengthen the backlog or both. On the backlog there is no doubt. In April 2005, Dudas reported that pendency in data-processing technologies stood at three years and growing, and that without intervention, the current backlog of applications awaiting first review could double from 500,000 to a million in the next 5 years.

Finding hard evidence of a decline in quality is more difficult, although a number of legal scholars and practitioners have been vocal on the subject, sometimes not for quotation. There are several reasons to believe that quality (especially the application of the nonobviousness criterion of patentability) has suffered as the number of applications has grown. First, the number of patent examiners has not kept pace with the increase in workload represented by the increased number and growing complexity of the applications. Second, there does seem to have been a dilution of the application of the nonobviousness standard in biotechnology (due to court decisions) and some limitations on applying it properly to business method patent applications, in part because of the absence of adequate written prior art documents.

Third, patent approval rates at the USPTO are higher than in some other major nations’ patent offices (notably the European Patent Office), even before adjusting for the impact of the continuation process (which makes the ultimate grant rate for any given application higher). Finally, some changes in the treatment of genomic and business methods application were introduced (the second pair of eyes for business methods patents and the requirement of a specific application or use of a new gene sequence) that resulted in a slowing down of patent grants in those fields, suggesting that the previous bar may have been set too low.

During the FTC/DOJ hearings on the patent system and antitrust policy in 2002, a number of industry representatives expressed concerns about the difficulty of negotiating the patent thicket in their area and the risk of being “held up” ex post by a patent on a technology that was only a small component of their product. This complaint was heard largely from those in the complex-product industries

(the ICT sector), such as Robert Barr, then Vice-President for Intellectual Property and Worldwide Patent Counsel at Cisco Corporation. He described two types of problems faced by firms in the sector: first, the large stockpiling of patents necessary as a defensive measure against others in the industry and, second, the threat posed by small entities that have nothing at risk themselves and may not even be producers. On the first, Barr says the following:

On the second problem (that of being attacked ex post by a small entity that does not face much risk of infringement itself):

The first of the problems Barr describes is clearly a case of mutually assured destruction that leaves the firms in question no better off than if they were not accumulating massive numbers of patents for defensive purposes, and yet at the same time is a very costly strategy. Increasing the administrative costs of patents to firms or reforms within the industry itself to discourage this behavior would seem to be the obvious solution, since it would be in the interest of all firms involved to reduce spending on this activity. However, the second problem is more controversial: The small entities that assert patents in this way may have legitimate claims to ownership of some of the technology in a large firm’s product. Some observers have even questioned how common this kind of patent assertion is.⁸

Nevertheless, the ICT industry in general has been very concerned about these kinds of assertions and their consequences for the incentives to invest in complex technologies that might potentially incorporate a piece of technology that leads to a dispute that cannot be resolved by cross-licensing.

The final area where change in patenting practice and IP management has raised concern in policy circles is the increased patenting of “research tools” and its consequences. Walsh et al. (2003) interviewed some 70 players in the biotechnology research area and found that by and large intellectual property in biotechnology is being managed relatively successfully. Because of increasing patent assertion and the extension of patentability to life forms and gene sequences, the associated costs of research are somewhat higher and research can sometimes be slowed, but it is rarely blocked altogether. There are, however, occasional cases of restricted access to foundational discoveries and to some diagnostic genetic tests. A number of “working solutions” have evolved, including negotiated licenses and royalty payments. Patents are also circumvented by inventing around them, using substitute research tools, and locating research activity offshore. Institutional responses include the National Institutes of Health guidelines encouraging research grantees to facilitate access to patented research tools and the steps taken by several research organizations to place results in the public domain, where they become patent-defeating prior art.

During the past year and partly in response to the National Academy of Sciences (NAS) and FTC reports as well as the position taken by the AIPLA, Congress has shown considerable interest in patent reform. Several hearings presided over by Senator Orrin Hatch (R-UT) have been held in the Senate, and in June 2005, Representative Lamar Smith (R-TX) introduced a Patent Reform Bill (H.R. 2795) in the House and held a subcommittee hearing on June 9, 2005. Based on testimony and the input received from various stakeholders, Smith published a substitute bill and held hearings on it in September 2005. A summary list of hearings held is shown in Table 2.

A number of interested groups have thrown their support behind the principle of patent reform, although they do not necessarily agree on all the individual items in the proposed bill. These groups are the American Intellectual Property Law Association (AIPLA), the Intellectual Property Owners Association (IPO), the IP Law section of the American Bar Association, the Biotechnology Industry Organization (BIO), and the Business Software Alliance (BSA). A coalition formed by 37 large patentholding firms (9 chemical, 16 pharmaceutical, and 12 in a number of other sectors), the AIPLA, and the IPO has presented a reform package that is similar to but not identical to the substitute H.R. 2795 bill published by Smith in September.

The original H. R. 2795 bill contained the following provisions:

1. Changes the current “first to invent” standard to “first inventor to file” (§3). This is an important step in achieving international harmonization and was accompanied by a rewrite of the prior art rules that has caused some controversy in the legal profession but is a necessary part of harmonization. Accompanying this change was the preservation of a one-year grace period after publication, intended to benefit small inventors and university researchers. Also accompanying it was an extension of prior user rights to all U.S. manufacturers of all inventions to protect those who use trade secrecy instead of the patent system. These changes are in the revised bills.

2. Eliminates the subjective “best mode” requirement from §112 of the Patent Act, delineating objective criteria that an inventor must set forth in an application (§4). This change also represents a move toward harmonization. It remains in the revised bill.

3. Imposes a duty of candor and good faith on parties to contested cases before the patent office, eliminating inequitable conduct as a defense of patent unenforce-ability (§5), unless at least one claim in the patent has already been found invalid.

4. Reduces the scope of willful infringement by raising the standard of proof required and limits the amount of damages a patent holder can collect from an infringer (§6). The substitute bill of Smith and the coalition reform package both change the wording but still try to limit the situations where treble damages can be assessed to cases where notice of infringement has clearly been given by the patent holder.

5. Limits patentees’ ability to obtain injunctions (§7). This has proved very controversial and has been removed from the substitute bill and coalition reform package.

6. Authorizes the director of the patent office to regulate continuation applications (§8). Again, this is controversial and has been removed.

7. Establishes a new post-grant opposition system in the patent office (§9) with a 9-month window. A second window of 6 months at the time of litigation has since been removed, but of course reexamination could still be requested. The substitute bills contain changes intended to increase the take up of inter partes reexamination.

8. Allows members of the public to introduce new information to the patent office up to six months after the date of publication of the patent application to challenge the patent and to provide a final quality check (§10).

As indicated above, in committee a number of these provisions have been dropped or weakened, largely due to opposition from the pharmaceutical and biotechnology sector, but also from a number of large chemical firms, 3M, General Electric, and large companies in traditional technologies that are more or less satisfied with the current system. The provision that allows the patent office to restrict continuations has been removed because of biotechnology industry opposition; this industry has been and continues to be a heavy user of continuations (Graham 2002).

An interesting recent development on the continuation issue has come from the USPTO itself in the form of a set of proposed rule changes and request for comment in the Federal Register of January 3, 2006. As was clear from the Dudas testimony cited earlier, continuations have become of major concern to the office because they take examiner time away from new applications and often require reconsideration of material that has already been examined. Therefore, they are proposing that all continuations (including continuations-in-part and divisionals) other than the first be accompanied by a “showing as to why the amendment, argument, or evidence presented could not have been previously submitted.”⁹ It is not immediately clear that the change will have the desired effect, since it appears to call for even more documentation to be submitted with each continuation; presumably they are hoping that the requirement will reduce the actual number of continuations by sending a clear message to potential applicants.

The concerns of the computing sector lie in other areas. Apparently the Business Software Alliance (BSA) (representing Intel, Microsoft, and other big software producers) was strongly in favor of three “reforms”—a second window on opposition, no automatic injunctions where infringement is found, and the requirement that infringement damage calculations should be based on the contribution of the patented technology to the value of the product. They backed down on the first in the face of fierce pharmaceutical opposition. The second (and possibly the third) has been taken up by the Supreme Court when it granted certiorari in the eBay/Merc-Exchange case, although the outcome of that case is not yet known.¹⁰

What effect that will have on legislation in this coming session is unclear, and the opposing sides appear not to have reached agreement on the question of either injunctions or damages when the patented technology is a small piece of the product. For reasons that are not entirely obvious, the pharmaceutical industry has been very opposed to changes in this area, whereas the computer hardware and software sectors are strongly in favor. Most observers (e.g., see Mark Lemley’s testimony to the Senate subcommittee on June 7, 2005) would argue that the two sectors (pharmaceutical/biotechnology/medical devices on the one hand and information and communication technologies on the other) use the patent system in very different ways and face very different problems of enforcement and litigation because of the nature of their products and the technologies they involve. Apparently the pharma sector is reluctant to change a system that they perceive is working to their benefit, especially in directions that might weaken it, even though some of the proposed changes would have little impact on those whose products are not based on complex technologies where a patent on a very small piece of the product can wield disproportionate power.

With respect to injunctions, the concern of upstream research entities such as the Wisconsin Alumni Research Foundation (WARF) is easy to understand. The wording in the bill appears to require injury to the patent holder from absence of an injunction, which sounds like a patent “working” requirement. This requirement is likely to be difficult for universities and public research institutions to meet, and they are therefore opposed to any change in this area. On the other hand, such a provision is clearly targeted to the damage done by so-called “patent trolls.” These are entities that are able to hold firms up for much larger sums than they would ordinarily receive in the form of licensing revenue because they have the capability to shut down an entire product line via injunction, even though their piece of the technology in the product might be very small.

In any case, many think a bill of some sort will pass in the next Congress, given the interest that has been raised by the hearings and the known problems in the patent system. However, it is known that the current House Judiciary Chair, James Sensenbrenner (R-Wisconsin) is sensitive to the concerns of WARF, which are similar to those of the pharma/biotech sector, whereas Smith (who introduced the bill) is possibly more attuned to the problems of the ICT sector in his home state of Texas. Because the committee chair is in a position to stop the bill from exiting committee if he or she does not like it, there is some incentive for delay on the part of those who would like to introduce changes in the use of injunctions and the apportionment of damages until the current chair is replaced.

As predicted, the stalemate over patent legislation in the 109th Congress continued and H.R. 2795 expired in committee. During the 110th Congress that began in January 2007, the issue was revived in late March of that year with the

introduction of two bipartisan bicameral bills, H.R. 1098 in the House and S. 1145 in the Senate. This Patent Reform Act was the first put forward in the two houses simulataneously and with the backing of both parties.¹¹ Hearings on these bills were held by the House of Representatives in April of 2007 and by the Senate in July of the same year. This was followed by debate and markup of the bills; the House bill was reported out to the floor and passed on September 8, 2007 by a vote of 220-175. However, the Senate bill remains stalled in the Judiciary Committee and was taken off the calendar in May 2008.

The state of the two bills as of March 2008 has been summarized by the Intellectual Property Owners Association.¹² A summary of the more important and less technical features is given below.

• First inventor-to-file, which also eliminates the one-year grace period, except for the patent assignee and joint research agreements. The House bill makes this contingent on other jurisdictions following the U.S. on the grace period.

• Public use and on-sale activity outside the U.S. considered as prior art; pre-issuance submittal of prior art by third parties allowed.

• Damage apportionment to be selected by the court from the set (a) entire market value, (b) economic value attributable to invention’s specific contribution over prior art, and a floor on damages equal to “reasonable royalty” from non-exclusive licensing. There are differences between the two bills in this area.

• Limitations on treble damages to cases with clear and convincing evidence of specific notice by the plaintiff, intentional copying, or continuing to sell the infringing product after being adjudged an infringer. Trials would be bifurcated so that willfulness is not considered until the patent has been found valid and infringed.

• Post-grant review window, either one (in the case of the House) or two (in the case of the Senate, where the second window is triggered only by an infringement charge. limited discovery. The House bill expands inter partes re-exam in lieu of the second window.

• Publication of all applications at 18 months, House bill contains an exception for those not patenting abroad (18 months or 3 months after 2nd office action).

• Mandatory search reports authorized (at the discretion of the USPTO) with an exception for micro entities.

• Additional flexibility for the USPTO in fee-setting and rule-setting.

At the time of writing, the prospects for patent reform in Congress seem low—as discussed earlier in this article, the gap between the needs of the IT

industry and those of the chemical industries seems to be very wide, making compromise difficult to reach. The most contentious areas remain damage apportionment and the operation of a second window for post-grant review.

In the meantime, things have been happening outside the legislative system, both in the executive system (the USPTO) and the judicial system (the Supreme Court). As discussed earlier, the USPTO has proposed changes in several areas, notably regarding continuations, but also increases in fees for applications with a large number of claims and providing applicants with a route toward accelerated examination.¹³ Some of these changes have become the subject of litigation (Tafas v. Dudas) and are currently stayed awaiting the results of an appeal to the Federal Circuit by the USPTO.

Also, together with Professor Beth Noveck of New York Law School, the USPTO launched a one-year pilot of a Web-based project on the 18th of June, 2007, entitled Peer-to-Patent, that allows anyone to evaluate software patent applications that have been voluntarily submitted for public evaluation.¹⁴ In July of 2008, this project was deemed successful and the pilot was extended another year, and expanded to class 705 (business method) patents.

The Supreme Court has also weighed in on patent policy, with two important decisions in 2007. On April 30, 2007, the Court reversed the CAFC decision in KSR International Co. v. Teleflex Inc., with a precedential opinion that clarifies the meaning of non-obviousness. In particular, the court held that the obviousness inquiry “must ask whether the improvement is more than the predictable use of prior art elements according to their established functions.” Essentially this decision removes the requirement that there be some suggestion to combine elements in the prior art for a determination of obviousness.

The second important decision by the court was in eBay Inc. et al. v. MercExchange LLC, which clarified the legal standard for granting injunctive relief in an infringement suit. The court held that granting an injunction should not be automatic, but should rely on a four-factor test to determine whether it is appropriate:

1. The plaintiff must suffer an irreparable injury in its absence;

2. Remedies available at law are inadequate compensation for that injury;

3. Considering the balance in hardships between the plaintiff and defendant, a remedy in equity is warranted; and

4. The public interest would not be disserved by a permanent injunction.

The implication of this decision is to shift the threat point of the plaintiff in any negotiation over licensing royalties. Formerly, failure to reach agreement

meant the possibility that (a portion of) the defendant’s business might be shut down in cases where there was a finding of infringement. Under the eBay decision, the courts would determine some level of royalties based on the contribution of the patented invention to the product in the absence of agreement (and in the presence of a finding of infringement).

Summing up, this is the state of patent reform in August 2008: changes to the law are stalled in the U.S. Congress, administrative reforms to patent prosecution at the USPTO await court decisions, and two of the more egregious problems with the operation of the system have been dialed back by the Supreme Court.

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