Patents For Innovative Financial Products - Changing The Business Of Financial Innovation

Saturday, October 1, 2005 - 01:00

There is a new paradigm appearing in the financial industry that is revolutionizing business practices for financial innovation. This is a developing "patent big bang" that will change forever how innovative financial products, such as novel structured products, are brought to market.

This financial patent revolution was precipitated by the recent development that allowed new financial products to be patented. This reality was clarified in the 1998 decision by the U.S. Federal Circuit, Signature Financial Corporation v. State Street Bank. After this case, a dramatically increased volume of applications for patents for innovative financial products was seen at the U.S. Patent Office. These applications are now coming out of the Patent Office as issued U.S. patents. For example, we now see patents for structured products, derivatives, mutual funds, debt, bonds, tax shelters, business plans and business methods. Related to this development, we are also seeing many more patents for related software systems for trading, data feeds, and other software support for the financial industry. For these developments to be patentable, they must be to some extent new, or in the language of patent law, they must have a "non-obvious" measure of "novelty."

Patents = Market Share

Patents give the patent owner exclusive rights to the claimed invention for the term of the patent, which now runs to 20 years from the date that the patent application is filed. This is, in effect, a temporary "patent monopoly" for the patented financial product or software system. The patented product cannot be copied by others without the permission of the patent owner. The patent owner may license the patent to all if he chooses, for whatever royalties may be agreed to. Alternatively, the patent owner may refuse all licenses and pursue a sole source strategy.

Patents As Profit Centers: The "Patent Big Bang"

As a result of the advent of patents for financial products, the business of patents for financial innovation can itself be a profit center. That is, the patents may be licensed or enforced in litigation for damage awards in a manner that results in a net profit for the patent owner. This, of course, can be in addition to the conventional profitable issuance and trading of the patented financial product itself.

As a result of this trend towards patents as a profit center, we are seeing the initial ripples of the "patent big bang" in financial services. That is, players in financial markets, including major financial institutions, boutiques, and individuals, are developing patent portfolios, and may seek to make them profit centers through licensing and infringement litigation. Two recent examples of this trend to squeeze profits from patents can be pointed out. One example is the litigation by E-Speed (owned by Cantor Fitzgerald) against the New York Mercantile Exchange. This litigation involved a patent for a bond trading system and ended in the NYMEX paying an $8 million settlement to E-Speed in the litigation. Another recent example of this trend to make patents cash flow is the litigation between Mopex and the American Stock Exchange regarding a patent allegedly for exchange traded funds (ETFs) traded on the American Stock Exchange.

Patent Defense And Offense

With the advent of patents for innovative financial products and services, such new products and services may not now be freely copied or sold without caution. Before an innovative new financial product is sold, participants in the project now should make a defensive analysis of their potential patent infringement exposure regarding the patents of others. This may entail searching for and obtaining a legal review of any related prior U.S. patents and pending patent applications, obtaining an opinion letter of non-infringement from outside counsel, seeking licenses from patent holders where necessary, or inventing around problem patents (that is, modifying the planned product to minimize the risk of infringement while still offering a similar competitive product in the marketplace). Often this defensive analysis for new investment products is executed in parallel with the offensive project of attempting to obtain patents for the same new planned product.

Patent Demand Letters

We are also seeing increased traffic in "patent demand letters" alleging patent infringement, and perhaps offering a license as an alternative to enforcement litigation. These demand letters should not be ignored and do merit analysis. They are sometimes the beginning of less than cordial license negotiations, or may be the first step in positioning for infringement litigation. These demand letters bear one similarity to birthday presents for those of us beyond a certain age, that is, it is truly better to give than to receive. But to send one's own patent infringement demand letters, one must have a patent portfolio.

Patent Due Diligence And Full Material Disclosure For Novel Securities

We are also seeing for financial innovations, increasing patent due diligence for full material disclosure for financial innovations. This may include disclosure of the risk of issuing and investing in financial products in innovative markets, which may have exposure to future patents that may not even exist until after the initial offering is made and trading begins. We can anticipate that this will lead to new deal terms, including new patent representations and warranties, indemnification, disclosure, and other laying-off of risk, in prospectuses, underwriting agreements, trust arrangements, exchange listing agreements, and other contracts.

The Culture Of Confidentiality

We are also beginning to see the rise of a "culture of confidentiality" in the financial innovation business. That is, if an individual or group develops a new financial innovation, it is best that they keep this secret until after any patent application is made, or at least until after the decision to make such an application is reviewed and determined. A financial innovator certainly does not want to find that his new product is patented by a later copier that merely beat the innovator to the Patent Office. (Nobody wants to be sued for "infringing" their own invention.)

The Migration From Defensive To Offensive Patent Strategy

Although patent portfolios are often initially developed for defensive reasons, the expenses of developing such a patent portfolio, and the opportunity to make profits from this investment in patents, will tend to push financial patent owners to "monetize" their patent portfolios, that is, to make a cash-flowing profit center from their patents. This will encourage aggressive licensing of the patents supported by increased infringement litigation. In some cases, this patent exploitation may be an organizational imperative. That is, to obtain the overhead budget for this new expense item, for patents for financial products, a promise may be made internally to make the patent function a profit center within a relatively short term.

Monetizing Patents: The Push To Consider It

This trend to patent monetization developed in the 1990s among an increasing number of Fortune 500 companies that traditionally have held patent portfolios. During the 1990s, several Fortune 500 companies famously made their patent portfolios cash-flowing profit centers, often with the highest profit margins of any line of business in the company. One very large computer company, for example, collected last year about $1.5 billion from its patent portfolio, and is reported to claim a profit margin on these collections of between 98 and 99 percent. Some commentators have even suggested that a corporate patent holder (including an owner of financial product patents that may have been originally developed for defensive purposes) is exposed to a possible waste of corporate assets if the corporation does not consider taking reasonable steps to make its financial product patent portfolio a cash-flowing profit center. For financial products, these developments may result in negotiation, licensing, and royalty payments for innovative financial products, with some litigation to add strength to the licensing program. For financial software systems and data systems, this trend may lead to litigation among competing vendors to obtain an injunction against infringement, market share, and enforcement of a patent "monopoly" position in the marketplace, with no offers of licenses. This litigation among vendors may sometimes include buyers and users of the software system as co-defendants in infringement litigation. This year, we have seen several litigation matters among financial software vendors that have actually named customers as co-defendants, or threatened to do the same.

Innovators Win, Copiers Lose, And The Public Is Better Served

However these trends continue to develop, patents for innovative financial products will increase the financial rewards and incentives for successful financial innovation, and penalize uncreative copiers of new financial products, to an extent never before seen in the industry. This will increase the pace of financial innovation in the marketplace and better serve the public with improved financial products. It will also lead to further adoption of patent practices that have long been traditional in other patent-sensitive industries, but which represent a revolution in practice and incentives in the financial industry.

Stephen Glazier is the author of (1 ) Patent Strategies for Business, (2 ) E-Patent Strategies, and (3) Technology Deals. Complimentary copies of these books are available on request. Mr. Glazier is a Partner in the Washington DC office of Kirkpatrick & Lockhart Nicholson Graham LLP. He may be reached at (202) 778-9045. This article is adapted from a recent oral presentation and discussion by Stephen Glazier at the New York Stock Exchange to the Structured Products Association.

Please email the author at sglazier@klng.com with questions about this article.