The Federal Trade Commission has released a long-awaited report on “patent assertion entities” (PAEs). As defined by the FTC, a “patent assertion entity” is a company that, as a primary business function, acquires patents from third parties and seeks to generate revenue by asserting them against accused infringers. These firms typically generate revenue by licensing these patents or, more rarely, through successful patent litigation. Such firms also typically open patent license negotiations by immediately demanding payment or filing a patent infringement suit.

The FTC made use of its subpoena power to obtain data on more than 2000 patent holding companies that it determined fit the PAE mold. It found that only a small minority of these PAEs had ever asserted their patent rights in court. The FTC found that, generally, these companies could be separated into two different categories: “portfolio PAEs” and “litigation PAEs.”

“Portfolio PAEs” assembled large portfolios, often containing hundreds or thousands of patents, and received most of their money through licensing. Typically, they were able to do this without first suing the alleged infringers. While “portfolio PAEs” accounted for only a small portion of the licenses in the study (around 9%), these licenses accounted for an overwhelming majority of the total revenue of all licenses looked at in the study (around 80%, or approximately $3.2 billion in licensing revenue). These entities typically received most of their initial startup capital from investors, which included institutional investors and manufacturing firms.

“Litigation PAEs” typically operated by suing potential licensees and using the threat of prolonged litigation to induce defendants to settle and take licenses. These companies typically operated using small portfolios, usually containing fewer than ten patents. The typical charge for these licenses was just under the lower bound of early-stage costs for defending against a patent suit; as a result, the FTC has concluded that such lawsuits are “consistent with nuisance litigation.” However, while these litigation PAEs represented most of the litigation activity within the FTC’s study (around 96%), and were responsible for most of the licenses examined by the study (around 91%), these PAEs only received around 20% of the total licensing revenue.

Several interesting results came out of the FTC study. First, it did not appear that many (if any) patent defendants negotiated patent licenses when faced with a demand letter from a litigation PAE, and that in essentially all cases, the PAE had to file suit against the defendant to bring them to the negotiating table.

Second, while a large number of the patents that were asserted by PAEs had to do with either information and communications technology (ICT) or computer software, most of the litigation PAE targets were not in the software industry; instead, it appeared that the largest plurality of PAE targets were in the consumer retail industry. These targets included, for example, store retailers that operated fixed point-of-sale operations and non-store retailers (such as Internet sites) that directly sold products.

The FTC’s findings also suggest that many of the solutions put in place with the stated goal of curbing the abuses of litigation PAEs, such as legal fee shifting, may not be as effective as hoped. Most litigation PAEs are small companies with few assets, and most PAE litigation appears to settle early, before an award of fees is considered. The FTC has prepared some of its own ideas, such as discovery reform, which may help to curb the abuses of litigation PAEs where past reform efforts have failed.

Specifically, the FTC noted that the discovery process is structured so as to be incredibly expensive for patent defendants early on in a litigation. In PAE litigation, the reverse is not true; because PAEs, as defined, do not invent, develop, or manufacture products that incorporate the patented technology and typically are not at any real risk of being countersued, they generally have much less discoverable information than the accused infringer. This is used by many litigation PAEs to grab the upper hand in a settlement; since discovery is so expensive and so one-sided, it is usually cheaper for a patent defendant to settle for a relatively small amount rather than pay even more money to continue through the discovery process.

As such, the FTC has proposed developing rules and case management practices directed at addressing this discovery burden and other cost asymmetries in PAE litigation. Specifically, the FTC has urged courts to develop, under Rule 26 of the Federal Rules of Civil Procedure (FRCP Rule 26), plans for discovery that specifically take into account the disparity in discovery requirements in PAE litigation. For example, The FTC recommends crafting discovery plans so as to limit the scope of discovery before certain preliminary motions have been resolved, and so as to require early disclosure of claim, infringement, and invalidity contentions in PAE litigation. The FTC also proposes amending Rule 26 to codify its suggestions into the Federal Rules.

The FTC has also proposed greater initial disclosure requirements for patent plaintiffs. For example, the FTC recommends requiring patent plaintiffs to provide early disclosure of what damages theories they intend to be using in the remainder of the case. The FTC also notes that patent pleading requirements have recently changed, such that patent infringement pleadings now require that a patent plaintiff allege with greater specificity how a defendant infringes their patent; the FTC notes that this maps with the general thrust of its recommendations for patent litigation reform.

The FTC has also proposed streamlining the process for determining the ownership and control of a litigation PAE. Specifically, it proposes amending FRCP Rule 7.1, which requires all nongovernmental corporate parties to identify “any parent corporation and any publicly held corporation owning 10% or more of its stock” in its “first appearance, pleading, petition, motion, response, or other request addressed to the court,” to be broader. The FTC proposes, among other examples, adopting language similar to that used in the Civil Local Rules of the Northern District of California, which requires parties appearing before the court to disclose any known financial interest of a third party in the litigation.

One final proposal from the FTC is intended to halt or reduce the practice of patent plaintiffs suing the customers of a manufacturer for infringement, based on the customers’ use of an infringing product made by the manufacturer. It appears that some litigation PAEs have allegedly used this as a tactic to gain leverage over manufacturing companies against which they have brought patent litigation. Others have done it to take advantage of the fact that a manufacturer’s customers are far less well-equipped to defend against a patent suit than the manufacturer would be, as the manufacturer is likely to have a much better understanding of the disputed technology. Therefore, in cases involving simultaneous infringement lawsuits directed against manufacturers and customers, the FTC proposes allowing, and encouraging, district courts to stay actions against the customers until the manufacturer suit has been resolved.

The FTC’s comments are likely to influence future patent reform. The FTC has been known to carry a great deal of influence in Congress with regard to legislation in which it has an interest, and has devoted a significant amount of effort and expense to preparing this report and is not expected to let it go easily. As such, while a number of patent reform bills introduced into Congress in the past, such as the Innovation Act and the PATENT Act, have stalled because of an apparent lack of interest, the same will likely not be true for any bills that may be introduced that implement some or all of the FTC’s proposals, which will most likely be supported by aggressive lobbying from the FTC. Because of this, the findings of this report should be given ample consideration.