If pharma has high-quality patents IPRs should not be an issue, says hedge fund investor

Perhaps the patent story of the year so far has been the inter partes reviews (IPR) launched at the Patent Trial and Appeal Board (PTAB) against a series of pharmaceutical patents by hedge fund investors. Kyle Bass, founder of Hayman Capital Management, and former IPNav CEO Erich Spangenberg began the process in February with challenges to two Acorda Therapeutics patents (they have since filed further reviews, most recently against Jazz Pharmaceuticals).

Then, in March, Ferro Ferrum Capital, a fund controlled by former Wall Street banker Kevin Barnes, filed a challenge to an Allergan patent.  After that review was filed we contacted Barnes to see if he was prepared to be interviewed about this growing threat to the pharmaceutical industry. He agreed, although he declined to comment specifically on the Allergan IPR or about his investment strategy. However, in a conversation that revealed a lot about the way an activist shareholder views the IPR process, he did have plenty to say about big pharma’s reaction to recent events and why Congress’s legislative lethargy still leaves him plenty of time to profit.

Tell us about your recent career

I’ve worked on Wall Street for over a decade and I am an economist/financier by background. I worked at two long-short hedge funds – Kerrisdale Capital and Absaroka Capital, which are known as activist investors with a focus on event-driven opportunities. Before that I worked in the investment banking group at JPMorgan. So I bring sort of the finance hat to the IP space. I think, in a knowledge-based economy, intellectual property continues to be a more and more important consideration and a more important asset in the current economic paradigm.

Was it a sector that you studied at JP Morgan and the two hedge funds?

At both of the funds I was a generalist so invested primarily in equities but across industry groups. Over the last four years I became very active in the IP space specifically in regards to some of the publicly traded NPEs because there were a lot of event opportunities around court decisions and other rulings and that sort of stuff. I’m not a patent attorney by training but I developed kind of a practitioner’s understanding of the litigation process, damage awards, monetisation etc. 

When did you strike out on your own with your new fund?

In 2014 – that’s when I started uniquely focusing on opportunities related to the IP space. Deep Lake Holdings is the holding company and then for each of the respective opportunities there’s a separate LLC below that so those are what are utilised for the IPR filings and those were set up at the beginning of the summer last year.

When you were originally looking at the investment prospects in the space, what stood out, where did you see the best opportunities, what did you make of the coverage of the sector as you looked at it?

Obviously it was a very opportunistic sector to be involved in. There are many court rulings and mergers and acquisitions that demonstrated the value of IP in corporate transactions. It was very clear, as part of the smartphone wars and then the Nortel bankruptcy, that there was strategic value in having a significant portfolio of IP as kind of a blocking position and also from an anti-litigation perspective. And then, from a trading perspective, for some of the public companies like Virnetx and Vringo and InterDigital and some of the others where their sole corporate value relates to their ability to monetise their patent portfolio, those are situations that I monitored very closely and we positioned around events both on a long and short basis.

As an investor in this space how do you view the regulatory and policy climate?

Obviously the policy environment is in flux and in a post-Alice world the value of software patents is even further in question. But at the end of the day, from a public policy perspective, I think it’s important for high-quality IP to be protected while low-quality IP is really just a tax on other innovators. It doesn’t really benefit any other worthy patent holders when there are these trolls sending out demand letters for fax machines and that sort of stuff.

When did you start to become interested in IPRs and the possibilities around them?

I followed the AIA through its Congressional approval process and then the first few months of filings which were pretty slow. Then, as a track record emerged of the “death squad” in action on poor quality patents, it became more and more interesting and there were more precedents that one could look at for the value of the process. So, at the end of 2013 it became pretty clear that the IPR was going to be a major opportunity going forward. Or at least a paradigm shift from traditional re-exams and other disputes involving low patent quality validity.

So as you see that change what do you start to think in terms of taking advantage of the opportunities around IPRs?

As an activist investor any time you can catalyse an event that creates opportunities. For the IPR investment strategy, instead of having to wait around for a district court ruling in the Eastern District of Texas, with a defined 18 month timeline and the ability to make business decisions thereafter, it’s a much more appropriate resolution for patent validity.

Why did you pursue the opportunity in pharma?

I think in the pharma space one thing that’s interesting is that a lot of branded companies engage in ”evergreening” and other low innovation or no innovation techniques to extend their Orange Book exclusivity. Those sorts of shenanigans are really just a tax on true innovation and, more importantly, help contribute to the significant increase in prescription drug pricing in the US and they have created an opportunity around the IPR space to help, from a public policy perspective, create drug price competition and lower consumer drug prices. 

What have you made of the reaction? Bio and pharma have not surprisingly reacted very strongly against these filings.

I think that at the end of the day this is a public policy decision and although the pharma lobbyists have raised a big stink about third party filers, to quote Shakespeare: “The lady doth protest too much, methinks.” If they have high-quality innovation they shouldn’t be concerned about it, it will help them avoid low-quality assertion threats with regards to their manufacturing and distribution and other products. For true innovation this will only make their Orange Book listed franchises more valuable. It’s unfortunate when the bio lobbyists are putting out press releases lambasting Kyle Bass and others for exercising their statutory rights in front of the patent office.

Have you had any connection with Kyle Bass or Erich Spangenberg?

To be clear I’ve had no connection with Kyle Bass or Erich Spangenberg.

As you have explained this strategy to investors, how quickly do they get it?

For the folks that are familiar with the pharma space their biggest question has been how quickly are the pharma lobbyists going to get the patent office to change the rules because they’re well aware of all the shenanigans with “evergreening” and other games that go on for patent exclusivity. So there’s no real surprise there. For other folks that aren’t as familiar with the pharma space, there are some more generic questions about the role of third-party filers. But, at the end of the day, in light of the public benefit of lowering drug prices and allowing true competition for well-known compounds, there’s a pretty quick understanding by those that are financially savvy and understand how capital markets are allocated and work, that this is a pretty normal process.

And how quickly do you think the pharma lobbyists are going to be able to change the process?

I don’t think they will be able to. I think they’re going to raise a big stink and host a lot of steak dinners down in DC and other things but ultimately the proposed changes on changing the standard and requiring an act of infringement before allowing a third party to file, I don’t view those as insurmountable hurdles to my business objectives.

Is there anything in the changes being proposed in the STRONG Patents Act or what the USPTO is looking at which would affect your strategy?     

The PTO’s changes to date with regards to page limits on revised claims and that sort of stuff are reasonable changes and well within the statute. Obviously there are also a bunch of competing proposals in Congress right now whether it be the STRONG Patents Act or others. I’m not a lobbyist or expert on what’s actually going to make it through, but just anecdotally in following those proceedings, Congress always seems to take three or four more sessions than people anticipate. So, if there is eventually something that is passed and the President eventually signs it and if that actually happens before there’s a federal election, I’ll have plenty of time to adjust. It was a clear standard that was passed by Congress previously and there’s a lot of folks outside of the pharma space who realise the value of an IPR for a prompt resolution on patent validity. No disrespect to patent examiners but when they’re only allocated 20 or 30 hours to review a patent application and they have 100 other applications on their desk, they’re never going to have the resources to independently determine patent validity versus multi-billion dollar pharmaceutical enterprises that are pushing these “evergreen” patents. So the IPR provides a very important private market resolution to determine patent validity where each side has all the resources that they want to bring to bear on the issue and it allows a clear and transparent public hearing on patent validity and it brings the best available experts to the table. The patent examiners are never going to be able to access the same expert witnesses and hear both sides in the same detail that the IPR process quickly gets to and that’s the beauty of the well-designed format that an IPR provides.

There’s a big focus from the USPTO on patent quality so do you see those efforts in the medium to longer term stifling the IPR opportunity?

I respect the patent office’s efforts to increase patent quality and I know those efforts have been going on for a while but at the end of the day, a government regulatory agency is just not going to have the same resources to bring to the table that two competing, private companies will have for a dispute like this. That’s the value of the IPR – it’s a fair soccer pitch and the best players come out and it’s a transparent process. Ultimately the PTO is not going to be able to hire enough referees to check everything on the front side, there’s just too high a volume of patents coming through and this avoids the issue that you can’t do this sort of diligence when one out of a thousand patents ends up being commercially viable. The IPR is a back-end solution to patent quality but that’s where the best use of resources is because they can’t do this level of diligence on every application. It would take 18 months longer and there’s no way that every patent applicant can hire several University professors and other distinguished PhDs to discuss validity and other prior art issues. If your patent is for a hamster wheel or something and you’re a private inventor you’re not going to have those resources to get a patent through.   

Do you see other investors following your lead?

In a knowledge-based economy where more and more capital opportunities are delineated by intellectual property, more and more equity investors are focused on proceedings at the PTO and the events and the opportunities that are around those proceedings. If you’re allocating capital you have to have an understanding of what’s affecting a company’s value and therefore investors would be negligent if they weren’t following these proceedings.  

Where do you see these opportunities in say, five years time?

For high-quality innovation there continues to be an opportunity to fund significant breakthroughs in bio-similars and other major pharma innovations but the prior, innovation-retarding model of “evergreening” and product expansions and other settlement agreements to maintain patent exclusivity is not going to work in a paradigm where the government and insurance companies are very focused on prescription drug costs and providing best quality care at lower prices. When pharma companies are spending more money on share repurchases and asset acquisitions than they are on R&D, it’s hard for them to argue that they need these continued, out-sized monopolistic pricing increases to fund future growth. There’s a dichotomy that’s ongoing and the market is trying to correct.

Is there anything they can do, short of getting rid of the IPR process that they can do to stop these kind of challenges?

From a public policy perspective this pre-dates the IPR. You go back to Hatch-Waxman Act with regards to generic entry and the paragraph III and paragraph IV process, although that Act achieved some of its goals, ultimately the litigation costs and the time associated with those appeals has not really unleashed all of the potential for generic competition for pharmaceuticals and so the IPR is an important step forward in separating true pharma innovation and what’s just evergreen expansion.