Lines of defence

A “sophisticated scheme for gambling on litigation”, leading to “more lawsuits, more litigation uncertainty, higher settlement payoffs to satisfy cash-hungry funders and in some instances, even corruption,” said Lisa Rickard, president of the US Chamber of Commerc Institute for Legal Reform, in a March post on the D&O Diary blog about third-party litigation funding (TPLF).

It is fair to say that as its star has risen over the past few years, litigation finance has attracted no small amount of criticism. Perhaps foremost among the complaints is that giving investors the opportunity to fund lawsuits will fuel an increase in litigation. To the naysayers, litigation funding amounts to gambling on the outcome of a lawsuit; and they fear that investors will gamble more and more often as they take ever-greater risks, put forward larger sums of capital and pour their money into a wider array of cases to chase returns.

Proponents of TPLF would respond that they are providing an important service to society. Their investments, they argue, grant cash-strapped rights holders such as small and medium-sized enterprises, universities and lone inventors access to justice, and the enhanced possibility that they will get some reward for their innovative efforts.

When it comes to IP disputes, TPLF companies have focused on providing finance on the plaintiff side. The model for trying to get a return on investment from funding patent assertions is relatively straightforward – the funder takes some cut of damages awarded to the plaintiff.

Of course, it is not just patent owners that often lack the wherewithal to engage in litigation. Defending against a patent assertion is an expensive proposition too. But developing a model of funding defendants in patent cases is much trickier than supporting plaintiffs, as the defendant will typically not end up financially better off even when the outcome of litigation is favourable.

Speaking to IAM back in issue 56, when we first reported on the expansion in IP litigation finance, Michael Cannata of litigation funder Patent Monetization Inc remarked that TPLF for defendants “would be difficult, because the investor would be putting up capital up with no clear way of getting a return”. But, he added: “This industry is so new and there are a lot of creative people involved in it, so I’m sure that somebody is going to figure out a way to put out defendant-type financing and get their return some other way.”

It would appear that Cannata’s prediction has come true. Although they are few in number, a handful of firms have begun to offer defence-side TPLF products – and respondents to patent assertions represent a particularly attractive opportunity for lawsuit investors.

Chicago-based Gerchen Keller Capital is one of these. Founded almost two years ago, the firm is pioneering litigation finance for defendants, while it also offers the more traditional funding model for plaintiffs. “We do fund a lot of patentee cases – it is an easier model to apply on the plaintiff side – but defence funding is far from impossible,” says co-founder and managing director Ashley Keller.

Ashley Keller, managing director, Gerchen Keller Capital

“We like patent risk - we’re comfortable with it, we embrace it, and if the environment shifts… we’ll just adjust our risk models appropriately”

Defining the win

Under Gerchen Keller’s model, the key to defence-side litigation finance is the ability to define what a win is and a defendant which is willing to put an economic value on a win. Once such definitions have been agreed, coming up with a funding arrangement is not significantly different in conceptual terms from drawing up a solution on the plaintiff side, Keller suggests. “When you are funding a plaintiff, there’s a pot of money that you hope to get at the end, and some of that will be shared with the funder for taking the risk of paying legal fees and costs,” he says.

Crafting a financing structure for a defendant is in large part an exercise in doing the reverse. The objective for the defendant is to avoid, as much as possible, the eventuality of paying out that pot of money. Therefore, the defence side can define what constitutes a ‘win’ by calculating the financial savings – and the longer-term strategic advantages – it can secure. “Essentially, once you have identified a win parameter and put a monetary value on it, the economic calculation can be quite similar to funding on the plaintiff side,” explains Keller.

This is why Keller believes that, of the variety of different commercial disputes in which his firm provides funding to parties, patent cases are particularly amenable to defence-side financing solutions. “When a plaintiff asserts a patent against a competitor, there is typically a threat of an injunction, and in a lot of industries the defendant will go down to the penny to work out what it is worth to them to still be able to sell their products in the marketplace and what it would cost for them if they were no longer able to do that,” he says.

To illustrate this, Keller uses the example of Hatch-Waxman litigation in the United States where a pharmaceutical originator company sues a manufacturer that has developed a generic version of one of its drugs that is soon to come off-patent. “If you are the generic and you want to launch a product where the branded company has patents, you will know down to the penny what it is worth to you to be able to launch and have your 180 days of exclusivity when you’re the only generic ready to launch in the marketplace,” he says. “The generic will know what the margins will look like and how much profit can be captured in the subsequent six months.” In this situation, the generic manufacturer will typically be in the position of a defendant, as the patent owner will sue it as soon as it has made its intentions to launch its product clear. “So the generic has to go through a patent trial, and if it wins as a defendant, it has potentially got a lot of money coming its way,” he says. “That shows how there are places in the patent world where defining a win for a defendant and putting a monetary value on that definition is a relatively easier exercise than trying to do the same in many antitrust or breach of contract suits, for example. In that way, I think patents can actually lend themselves quite well to defence-side financing.”

Science or art?

However, the Hatch-Waxman example is a fairly straightforward scenario where a monopolised marketplace transforms into a duopoly and the defendant will likely have a fairly clear idea as to the economic impact of litigation on its business. In other industries, it is likely to be far more difficult for a defendant in a patent suit to work out what could be considered as a favourable outcome.

For Keller and his team, that means plenty of extensive discussion with prospective clients and their counsel at the outset of a case. “It is crucial to sharpen everyone’s attention on the key issues and to isolate where the biggest risks are,” he says. “The objective is to be able to spend time with each other and come up with the definition of what a win should look like.” One way of doing that is from what Keller calls a ‘bottom-up’ perspective. “Among other things, we will look at the individual merits of the plaintiff’s case, what we think the prior art risks are and what the remedies might be,” he says. “For example, if the plaintiff is an NPE [non-practising entity], it is going to be limited to being awarded a reasonable royalty in the United States. On the other hand, if the plaintiff is a competitor, there may be a real threat of equitable injunctive relief that could forestall the sale of products from marketplace.” Taking all of these factors into account allows the funder to assess the case and help the defendant to understand what is likely to be the best possible outcome of the litigation considering the particular circumstances.

Nevertheless, reaching a conclusion about what a ‘win’ realistically looks like and getting the defendant to accept that conclusion can be two quite different things. As is often the case in patent litigation, emotions come into play – and that is just as true for the defence side as it is for the IP owner that feels its rights have been infringed. For many parties which find themselves on the receiving end of a patent suit, acceding in any way to what they regard as unfair demands from a patentee is nothing less than capitulation. As such, defendants may often have unrealistic expectations of what can be achieved in the courtroom; and for a third-party funder stepping in to try to define what an acceptable outcome is for the client, this can prove to be something of a headache.

For this reason, it is perhaps no surprise that Gerchen Keller is highly selective about the clients it takes on. “As a general rule, we prefer to deal with more experienced defendants who have been involved in many IP cases and understand that there are lots of risks involved for all the parties,” says Keller. “For the sort of entity that’s never been in a patent suit before, their view is often that a win is, ‘Us not paying anything, the case getting dismissed on summary judgment and the court finding the plaintiff’s patent invalid and not infringed.’ That’s great, but not necessarily a realistic view. There are very few cases where the defendant’s position is so strong that the expected value of the plaintiff’s award is zero.” Dealing with more experienced players which have been embroiled in patent suits before makes it a lot easier for Keller’s team to engage them in conversation centred around risk and reward. “If the defendant’s position is, ‘We will only consider it a win if we don’t pay a dime to the other side,’ it is going to be much more difficult for us as a funder to get involved and come up with a financing solution.”

As a result, Gerchen Keller will not typically be working with first-time litigants. While the firm provides litigation finance to small businesses and individual inventors, it has also done so for larger companies, including Fortune 500 corporations. “You would be right in assuming that general interest in our products comes from SMEs, as they are often cash strapped and don’t necessarily have the resources to run a lawsuit,” says Keller. “But it also comes from large companies that may have the cash on hand to pay legal fees and costs, but for a variety of reasons – such as budgeting, internal pressures on the general counsel’s office or the need to deliver shareholder value in a regular rather than a ‘lumpy’ way, as litigation tends to work – they turn to us as a provider.”

Figure 1. Estimated number of defendants in US patent infringement lawsuits 2007-2011

Source: “Assessing factors that affect patent infringement litigation could help improve patent quality”, US Government Accountability Office, August 2013

NB: Defendant estimates are representative of all patent infringement lawsuits and error bars display 95% confidence intervals

Trolls fighting trolls

Taking a proportion of the savings made by a successful defendant is one way of making defence-side funding a worthwhile investment. But there is scope for other players on this nascent scene employing different models to try to reap returns.

IP Navigation Group (IPNav) affiliate IP Claims Management Advisers (ipCM) is one such provider. Set up by IPNav founder Erich Spangenberg, ipCM has acted as a funder for a number of companies that have been the subject of patent lawsuits. The company did not respond to IAM’s request for comment, but we did speak to one of its clients about the solution that ipCM provided to assist it in its defence against several patent assertions.

Start-up Ditto hit the headlines back in May 2013 when it launched an (ultimately unsuccessful) crowdfunding campaign to try to raise cash after it was hit with patent infringement lawsuits filed by a larger competitor and an NPE (see box on pXX). Despite its liberal use of anti-‘troll’ rhetoric during its fundraising efforts, Ditto eventually partnered with ipCM, which agreed to provide capital for its defence in return for an equity stake in the company.

Ditto co-founder and CEO Kate Endress had found many traditional capital providers unwilling to help her company fight its cases. “Everyone was giving us quotes and it was consistently in the millions to get this to go away,” she says. “I went back into the Silicon Valley investment community and what I found was a real unwillingness to participate in a lawsuit of this nature or invest in us so that we could win, partially because it was coming from a competitor – and a huge one at that [one of the plaintiffs suing Ditto is 1-800 Contacts, a subsidiary of WellPoint]. I also talked to several lawyers and every single one who looked at our case said that they really believed we could win it, but none of them would take equity for my hours.”

As it turned out, Endress eventually found a solution in the most unlikely of places. “I spoke at a patent reform conference in Santa Clara and that’s where I first got introduced to Erich [Spangenberg],” she says. “I’m sure you can imagine that when I first met him, I was putting him in a group of people that I did not care much for, to say the least! During our first interaction I had gritted teeth and was visibly upset.” However, after talking for a while, the IPNav founder told Endress that her company’s plight presented an arbitrage opportunity for him. He offered to take equity in Ditto, and in return would provide access to IPNav’s extensive resources in order for it to fight its patent suits. “I realised I needed someone credible on my team that made us look a lot less vulnerable,” says Endress. “And the more we talked, I had to admit it made sense from a rational perspective. The reality was that what he was offering was absolutely the best offer that we had on the table. Erich was the only guy that gave us a solution.”

According to Endress, the deal with ipCM and IPNav is contingency based. Ditto has itself come under fire from some quarters for accepting a helping hand from a company that is associated with one of the most notorious NPEs out there. “In my view, Ditto is being helped to fight a patent troll by IPNav, which is a patent troll itself,” she says. “Of course, that sounds weird if you really don’t dig into the details, and you can draw assumptions about the overall oddity of that scenario. It looks like we partnered up with the bigger bully – and I can tell you that that’s not totally untrue.” For Endress, Ditto had no other options and IPNav/ipCM was the only company to offer a market-based solution that was fair. “[Spangenberg]’s not hosing us on valuation; he’s not putting a gun to our heads – he gave us the only option that was viable,” she says. “Otherwise, we would go out of business. And I look at every entrepreneur and I think they would make the same choice I did.”

Under the equity-based model of defence-side funding that ipCM used in this situation, it is clear how the financier can do its best to ensure a return. Keller says that while his firm would consider a similar solution in return for equity in the client’s business, it has not yet done this. Furthermore, the hands-off nature of its outcome-based approach can be much more appealing to many defendants, which would rather not give up ownership of part of their company. “Our counterparties generally find it attractive that our capital is what we call limited recourse,” he says. “That means that the only thing we get to look at for recovery is the amount of savings generated on the defence side that we have agreed to upfront. But we are open minded to taking equity in the right circumstances and we certainly have the flexibility under our investment mandate to do that.”

Alternative options

Equity and outcome-focused options for financing the defence side in litigation come with pros and cons for defendants. Gerchen Keller’s model leaves the case largely in the hands of the defendant itself, giving it the final say over issues such as the hiring of counsel and where the capital provided by the funder ends up being spent. What’s more, for many defendants, renouncing part of the ownership of their business would be an unwelcome prospect; though going down such a route may provide them with easier access to more resources when it comes to fighting their case, particularly when an established force in the IP marketplace such as IPNav is backing them.

But these two methods for financing defendants engaged in IP litigation are not just in competition with one another. Other market players are offering different products to enable companies to handle risk when they find themselves the target of a patent assertion.

Paul Scola, senior vice president, RPX

“There are all sorts of applications of capital in the protection or insuring of the defence”

RPX – traditionally known as a defensive patent aggregator – began offering litigation insurance to its paying subscribers a few years ago, in addition to the defensive patent aggregation for which it is traditionally known. This insurance service is specifically designed for companies that face the risk of being sued by NPEs. “It is geared towards making that NPE portion of patent risk manageable and predictable for operating companies,” says Paul Scola, senior vice president responsible for insurance services at RPX. “We put a cap on the risk for the operating company and they retain some of the risk in terms of a deductible.”

For Scola, RPX’s experience in acquiring potentially problematic assets to take them off the market and out of reach of NPEs has given the firm the basis to craft an effective insurance solution for companies that are likely to be defendants in suits brought by NPEs. “We understand the risk very well, in that we can manage it more effectively than the operating company can on its own,” he says.

Scola is somewhat sceptical of the sustainability in the defence-side TPLF model. Investors are clearly interested in getting returns above all else; and, on the surface at least, it would seem much more difficult to achieve that by funding defendants than on the more tried-and-tested plaintiff side. As such, he suggests, an insurance policy provided by a long-term player in the IP market could be a safer option for many. “It sounds very similar to the plaintiff-side litigation buy-out model,” he says. “I think [TPLF providers] are probably targeting a different market from us. We built our product very methodically and we’ve been testing it and slowly expanding the limits and capacity required to support to heavier and heavier risk.”

Nevertheless, he recognises that some players in the space will have the necessary expertise to turn such a proposition into a success. “You can understand that someone like IPNav – which understands how a litigation campaign works and has a lot of the same tools we have – would be able to create an efficiency in the model which they can exploit or use to drive some profitability,” he says.

Moreover, Scola points out that defence-side TPLF and patent insurance could be complementary to one another – though he reiterates that specialist expertise is crucial when it comes to selecting defence funding options. “There are all sorts of applications of capital in the protection or insuring of the defence,” he says. “We often bring in extra capital behind us in the form of reinsurance, and that’s not dissimilar to what is happening here [with TPLF]. We will be creative in trying to continue to solve these problems, and there’s nothing we wouldn’t look at – though we would certainly prefer to work with someone with knowledge of the patent space and an understanding of patent risk, rather than a regular reinsurer who we’d have to spend time bringing up to speed.”

Getting a return

Whatever your views, there is no doubt that TPLF is an extremely risky business; and without the obvious opportunity for returns presented by plaintiff-side funding, it is perhaps surprising that investors would have any interest at all in providing capital to a defendant.

Nevertheless, it would appear that many have been enticed by what Gerchen Keller has to offer. The firm currently has around $300 million in assets under management; about one-third of that capital is invested in IP cases, with defence-side funding arrangements accounting for a significant proportion.

Keller believes that investing in IP litigation – on both the defendant and plaintiff sides – is attractive for a number of reasons. First, IP disputes involve a specialised skillset in terms of predicting likely outcomes. “I’m not saying it is easy to do a breach of contract case – it’s not – but in the main, any lawyer can take a contract, read it, hear what the parties say about each other’s conduct and have some indication of whether the case has merit,” he suggests. “But nowhere near as many people can look at a patent, read through the spec, look at the claims, look for potentially infringing products and quickly come up with a conclusion as to whether the defendant is infringing or the plaintiff’s patent is invalid. That is a more difficult and intricate exercise – and we like that, because having that skillset at hand gives us a competitive advantage.”

Another draw for investors is that litigation investments – and patent litigation investments in particular – are not closely correlated with their other assets. Investments in real estate-related stocks, for example, have a high correlation to disposable income levels and market performance more generally; things to which litigation events are not typically correlated. “Additionally, the particular IP cases within our portfolio don’t correlate strongly with one another, so there is no covariance,’ Keller explains. “That means that if we have a patent case that reads onto Product A, it is independent of our separate patent investment that reads onto Product B.”

Challenges on the horizon?

However, this low level of correlation between different patent cases – and between patent cases and other investments – could be compromised depending on the progress of the patent reform movement in the United States. “There could be increased correlation if Congress decided it wanted to dramatically change the patent law,” says Keller. “That is because a change in the law would affect everybody who holds a patent, regardless of the technology or industry it relates to. Legislative reform could lead to correlation within our portfolio of patent cases that wouldn’t otherwise be there.”

However, Keller sees opportunities as well as challenges in the prospect for a reformed US patent system. “Our basic view is that unless Congress does something completely draconian and abolishes the patent system as we know it, there will still be high-quality inventions out there which get patent protection, as well as strong defence cases,” he says. “So if any of these reform proposals were to become law, on the offensive side we may have to be choosier, but there will still be places where we can make investments and get good returns.” And on the defence side, he adds, a reformed patent law may make it easier to beat back a patent assertion and make such opportunities even more attractive investments. “We like patent risk – we’re comfortable with it, we embrace it and if the environment shifts because Congress shifts it, we’ll just adjust our risk models appropriately,” he says.

Overall, he believes that the market itself presents the biggest challenge to TPLF providers, and to IP investors more broadly. “There have been a couple of massive patent transactions in recent years which meant that some people may have got a little ahead of themselves in terms of what patents can be worth,” he concludes. “But that has also created opportunity for thoughtful, careful choosers of quality investments. Ten years ago, it was much easier for people with capital to just say, ‘I will invest in patents and make money.’ Today, you have to be a more sophisticated player in this space because the easy returns are not there anymore. But the returns can be found if you are disciplined and have a high reject ratio.”