Authored by York M. Faulkner
Traditionally, the value of intellectual property (IP) was measured by its ability to secure market share for its owners. This was done by excluding competitors from selling products with the patented features or from utilizing efficient patented processes in providing competing goods or services. The innovator's objective was to discover useful technology, practice the technology in the marketplace and secure exclusive rights in the technology through patenting. Recently in the US, a new model of monetizing IP has taken hold, conceptualizing IP rights as a type of "toll booth" along the path that industries wish to follow. The toll booth model does not require the IP owner to practice the patented technology to make goods or provide services. Rather, the value of the IP rights is measured by the use of the technology by others and what they are willing (or compelled as the case may be) to pay to use the rights.
In its early history, this toll booth model was pursued by individual inventors of modest means who, in many ways, sought simple vindication of their claims of IP ownership against infringers. Today, the model is exploited by sophisticated and well-financed entities that neither practice the technology nor create it. Instead, these entities called Non-Practicing Entities (NPEs), purchase IP portfolios for the sole purpose of erecting toll booths at the most lucrative and strategic crossroads of industry. The portfolios are acquired from individual inventors, distressed startup companies or from each other in open auctions. NPEs assert their IP rights against industry actors who appear to utilize the technology, extending the carrot of licensing and wielding the stick of litigation to extract royalties for the use of the technology.
No systematic or sustained NPE litigation has been observed in China (with an exception in the copyright area). We tend to agree with the conclusion of Roger Sang in his article, "Are NPEs Coming to China,"1 that ". . . it will be difficult for NPEs to copy their business model in China. Perhaps it makes sense for NPEs (and practicing entities) to include China as a battlefield in a multi-nation patent war, but making a business based on asserting patents in China alone won't be as easy as in the Eastern District of Texas!"
However, this conclusion is largely drawn upon the current western NPE model. When NPEs finally land in China, they will likely demonstrate some local twist. Each year, China's IP environment experiences dramatic changes. In the past, many worried that China was lagging behind the rest of the world in patent filings and was also weak on patent enforcement. These concerns are gradually passing. Understanding the current innovation environment helps us determine whether a Chinese NPE business model can succeed in the near future.
Does China have enough patents?
Fundamental to the NPE business model is the notion that industry participants must, at some point, pass by the patent toll booth. NPEs rely substantially on IP rights which are held and "assertable" by others to create the technological intersections in which they erect their toll booths. Faced with the prospect of paying NPE royalties, each NPE licensing target rationally considers its ability to design around, or steer clear of, the NPE's patent portfolio. Often, the way around the NPE toll booth is blocked by IP owned by competitors, with whom licensing negotiations would either be impractical or futile. As such, there is a certain critical mass of patent exclusionary rights needed within any given industry to create an environment in which NPEs can operate and thrive. The data set forth in Chart 1 demonstrates that the quantum of Chinese patent rights is growing at an accelerating pace.
Chart 1: China patent statistics2
Graph based on statistics from the SIPO website
According to available statistics, it is estimated that more than one million Chinese patent applications were filed in 2010 alone, and just under 800,000 patents issued. By comparison, State Intellectual Property Office (SIPO) statistics show that in 2009, only 582,000 patent applications were filed, and 308,000 patents issued in China. About 9.7% of the granted patents were invention patents. These granted patents and applications are mainly in the field of telecommunications and digital communication technology.
In recent years, the pace of Chinese companies' foreign filings has also increased.Table 1: Recent milestones
Source: WIPO annual statistics
|Chinese PCT Filings
|% of All Global Filings
In 2005, China's PCT applications surpassed 2,500, entering the top 10 filing countries for the first time. During the 2008 economic recession, global PCT filings increased only 2.3%. In contrast, Chinese PCT filings increased 11.9%, making China the sixth top filing country. In 2009, global PCT filing dropped 4.5%, while Chinese PCT filings increased 30% relative to 2008, moving China into fifth place among the top 10 filing countries.
As a result, the Chinese patent landscape is rapidly transforming. As the value of Chinese companies becomes increasingly dependent upon innovation, their investment in IP protection is understandably expanding. In addition to market forces compelling IP investment, the Chinese government has also been working to facilitate and direct that investment.
To qualify for certain high tech company tax reductions and other benefits, Chinese companies need to have their own patents and inventions for these incentive programs, which are becoming more and more mandatory by the government. IP ownership weighs heavily in the government's evaluation of companies for those benefits. For example, 30% of the evaluation score alone depends on whether the enterprise owns core IP and patents (which can be obtained through assignment). The other three factors in the evaluation are: (1) whether the company's technology can be transferred into production (real use) – 30%; (2) business R&D capacity – 20%; and (3) business growth index – 20%.
In addition, China's Security Regulatory Commission (CSRC) has tightened its requirements and examination procedures for evaluating a company's IPO request. Among other things, the CSRC has a minimum requirement for invention patents (not applications), giving greater weight to patents from the company's own applications and lesser weight to patents acquired by purchase or assignment. These new rules are specific to IP and went into effect in late 2009.
State and local government also provide certain funding to encourage PCT filing. In some programs, a PCT filer can often obtain enough government funds to cover the filing costs.
Chinese enterprises exploring foreign market
While exploring foreign markets, Chinese companies have learned by experience that there can be significant benefits in obtaining patent protection for their inventions in the overseas markets. Many Chinese companies, therefore, have become very active in seeking overseas patent protection for their IP.
According to the WIPO statistics, Huawei has been the top PCT applicant worldwide since 2008. In that year, 75% of Huawei's sales were from overseas markets. Huawei now consistently devotes 10% of its revenue to its own R&D. As of the end of 2009, Huawei filed around 40,000 patent applications internationally (according to a Huawei IP manager), obtained 9,400 Chinese patents and filed 7,000 PCT applications. 90% of Huawei's patents and patent applications are invention patents. In addition, Huawei has joined 91 international standards organizations, including ITU, 3GPP, 3GPP2, ETSI, IETF, OMA and IEEE. Huawei is also one of the few Chinese companies that has learned the importance of cross-licensing and, with its growing portfolio of patents, is quickly mastering the art of licensing.
Huawei's example demonstrates that Chinese companies must patent their own inventions both at home and abroad to fully participate and thrive in international markets. To succeed in the global trading environment, companies must therefore focus on invention patents (instead of UM or design patents) and pay attention to not only the quantity of patent applications, but also to improving the quality of those applications. Chinese companies began investing heavily overseas in 2006-2007. In 2008, Chinese companies spent $53 billion on foreign acquisitions. A famous case is Lenovo's acquisition of IBM PC. That $1.25 billion deal included full assignment of the trademark "Think" and all of its core patents. Whether such acquisitions will ultimately prove to be a successful business model is beyond the scope of this article, but the transaction shows a short cut for Chinese companies to obtain high quantity patents and, when combined with the advantages of low production costs in China, Chinese companies can rapidly expand their overseas operations. There are now 20 Chinese companies in the world top 500.
Universities are an important source for patent pooling
In China's current environment, universities are gradually becoming aware of the benefits of IPR protection. Many colleges and universities have developed incentive policies to encourage researchers to actively apply for patents. Table 2 provides some recent statistics on patent filings by Chinese universities. Table 2: Top 5 patent filing universities, 2009
Source: SIPO official site
||Harbin Industrial University
||Shanghai Jiaotong University
|| Beijing University of Aeronautics
Zhejiang University, is a good example of what to expect in the future. It files about 2,000 patent applications per year, and this number will only increase in the coming years. In 2001, Zhejiang University instituted a formal "method for patent fund management" to encourage faculty members to apply for patents. According to the method, the university pays the patent annuity for three years after a patent is granted, and two-thirds of all filing costs, including government fee and agent fees, are paid by the university. Invention patents receive about three times as much sponsorship as UM and/or design patents receive. University sponsored patent applications are filed as "duty inventions" with the university identified as the first applicant. Some other universities authorize awards to inventors as well as paying longer annuities.
One issue that these universities are facing is deciding what to do with their issued patents. Initially, merely filing applications was the main focus of their efforts. But with thousands of patents already in hand, large annuity fees will soon become a burden, creating an incentive for the universities to find ways to make profits out of the growing numbers of patents that they own.
China's investment environment
In addition to industries with limited numbers of patents, two other environmental conditions face NPEs that may wish to set up shop in China: (1) limited investment capital (setting up an NPE in the US typically requires at least $50M); and (2) limited numbers of IP professionals—especially Chinese local professionals.
Let us first examine whether Chinese private equity (PE) and venture capital (VC) companies will invest in NPEs. There are at least five kinds of investment enterprises in China.3
- Foreign Venture Capital Funds: Beginning in 2003, foreign venture capital firms began viewing Chinese enterprises as attractive investment targets. Examples include Baodu, Shanda Interactive Entertainment's investment. As China's domestic capital market exit mechanisms gradually improve, foreign venture capital investment is expected to rapidly increase. Will they invest in NPEs?
- Foreign Private Equity Funds: Top PE firms such as Warburg Pincus, TPG and The Carlyle Group, etc. are increasing their involvement in Chinese enterprise investments. However, since they are typically interested only in later-stage operations, it is less likely that PEs will invest in newly-emerging NPEs, especially in an unproven environment such as China.
- China Domestic PEs: Two of the earliest and most successful Chinese PE companies are Shanghai Dinghui Investment (founded in 2002) and Honey Capital (founded in 2003). As typical PE firms, Chinese PEs are also interested primarily (if not solely) in late-stage Chinese enterprises. As a result, it is unlikely that these PEs will be a source of startup capital for Chinese NPEs.
- Industry Investment Funds: Although these funds have significant capital, they are limited in their focus and are highly regulated. Each fund has its own targeted industry or industries in which it invests. Moreover, their investments typically need to be pre-approved by certain government authorities.
- Domestic VCs: This investment group will be fast growing according to Mr. Zhou, one of China's most active VCs. Chinese venture capital comes mainly from Chinese private enterprises. Domestic VCs typically (if not completely) aim their resources at pre-initial public offering (IPO) companies within a variety of industries. Since their investments are more diversified than other investment funds, will domestic VCs invest in NPEs? A funding partner of a Chinese VC firm said, "China currently has its hands full of investment opportunities with huge returns—on average 25%-30% at least. Winning one patent litigation will give me only RMB 200,000 after spending three to four years, this is not worth my money or effort."
This sentiment is shared by other investors, and it is often the case that a VC firm's investment decisions are influenced heavily by the individual partners' personal backgrounds, experiences, and connections.
Recently, we have interviewed several well-connected Chinese investors, including funding partners of local Chinese PE funds and managing directors of the some of the largest investment companies in China and Hong Kong. Only one out of the seven investors whom we interviewed had any prior contact or discussions with NPEs, which were not operating in mainland China. None of the investors, personally or their companies, expressed any current interest in investing in NPE litigation which, to them, obviously is very new. This also reflects the general sentiment of Chinese investment in IP.
Chinese angel investors have been active in China since at least 2007. Compared with the five groups above, they contribute much smaller investments per opportunity, which makes one wonder if angel investment alone could support an NPE involved in multiple litigations lasting as long as three to four years each.
What do IP judges say about NPEs
NPE litigation has been particularly potent in the US, largely because the NPEs are not industry participants susceptible to infringement counterclaims. Similarly, NPEs do not typically have large stores of documents and data subject to discovery in litigation and, therefore, do not share the same degree of burden in litigation as borne by their targets. However, NPEs do encounter some disadvantages. Due to the fact that they do not practice the technology, there is little chance that they can succeed in winning a court-ordered injunction against their targets, excluding them from the market. NPEs are typically not entitled to an award of lost profits and generally must settle for damage awards measured as a reasonable royalty. Moreover, their failure to practice the technology puts NPEs at a disadvantage in attempting to assert a home forum for their litigation.
Will NPEs be treated any differently in a typical litigation in China? An experienced IP judge in China said, "China is still behind with regard to having enough IP protection. So we will not treat an NPE case any differently [from a typical IP infringement case]." Is this good news for NPEs? Maybe, but the first thing that a company sued by an NPE would likely wish to fully explain to the court is how NPEs make money and their perceived unfairness of the litigation. To what extent the Chinese courts will be influenced by the plight of NPE "victims" is yet unknown.
What is known, at least statistically, is that the financial rewards of patent litigation in China are not as great as those in US patent litigation. Overall, compared to the US, recoveries from Chinese patent lawsuits are much smaller. This is in part due to the fact that China does not have punitive damages in its current legal system, and has no means for enhancing patent damages awards for willful infringement.
Nevertheless, historical statistics may not fully describe the opportunities for large patent awards in Chinese courts. For example, 75% of current Chinese patent applications are filed by small to mid-sized Chinese companies which often lack the resources needed to fully, and profitably, enforce their patents. If the patent holder cannot sufficiently prove: (a) the defendant's profit from infringement, (b) the damage that the patent holder suffered because of the defendant's infringement, or (c) a comparable market price for licensing its patent to show the value of the infringed patent, it is internally agreed by IP judges, subject to the merits of the case, that damages awarded for each invention patent should sometimes be limited to RMB 200,000 (up to 500,000); RMB 150,000 for a UM case; and RMB 50,000 to 100,000 for a design patent case. Many of the historical patent damages awards have been limited to these baseline amounts.
However, it is quite possible that well-funded NPEs could fare much better in Chinese courts. In China's current legal system and judicial practices, IP judges have no reason to treat an NPE case any differently from other patent litigation cases. Consequently, if an NPE requests a permanent injunction during the patent litigation and the court finds infringement, there is currently nothing that would prevent the court from enjoining the infringement. Injunctions are a powerful tool for NPEs and the biggest threat to accused infringers (even more than the risk of paying damages).
Copyright NPE cases
Getty Images China (Getty) obtained authorization from an American company who owns copyrights to a portfolio of pictures. Getty investigated hundreds of Chinese companies who used their pictures and initiated multiple lawsuits in mainland China. Getty has successfully obtained numerous damages awards ranging between RMB 4,000-10,000 per picture. Overall, Getty has initiated thousands of copyright lawsuits in China and has won more than $10 million.
China's IP trading platform
IP trading platforms have started showing up and are growing rapidly. Some are government sponsored trading platforms for IP.
For example, China Technology Exchange (CTEX), a technology transaction service provider jointly established by the State Council, the Ministry of Science, the SIPO and Beijing Municipal Government, organized a patent auction in Beijing in December 2010 where 90 patents owned by the Chinese Academy of Science's Institute of Computing Technology (ICT) were sold. Another 320 ICT patents will be auctioned off in 2011.4
There are also patent pools sponsored and managed by Chinese local government which aim to offer patent licensing programs to support local business and improve their competitiveness.
Generally speaking, IP trading platforms are still new and have several challenges: they are only at the initial establishment of the physical platform; their market size is very limited, due to their small amount of transactions; and the business model is not mature. The platforms need service providers to provide assessments on patent evaluation and risk assessment.
Due to the amount of patents and overall environment, however, several transaction types are expected to soon blossom including: assignment, license, cross-license, entrusted R&D, enterprise cooperation and mergers.
There is currently little evidence of NPE-like patent litigation in China. Although the quantity of issued patents in China is rapidly increasing, there will need to be an overall improvement of the quality and scope of the issued invention patents. Concurrently, the pool of local patent attorneys, technology experts and information retrieval analysts will need to be expanded before NPEs and the investors who fund them will be prepared to launch their litigation-based strategies in China. Nevertheless, China's legal environment and economic climate is dynamic and rapidly changing. The abuse of trademark rights and copyrights has recently caught the attention of China's Supreme Court, which has been active in adjudicating those rights favorably to the IP owners. The Supreme Court's protection of IP rights thus far has been measured and reasoned. We predict that the court will permit NPE litigation but, at the same time, it will be receptive to eBay-like restrictions on an NPE's ability to obtain injunctive relief, striking a balance between non-practicing IP owners and accused infringers. Traditional patent enforcement litigation initiated by practicing entities will lead the way for NPEs, demonstrating how patents can be successfully enforced in China. The initial targets of NPEs in China will likely be foreign entities which conduct business in China, have deep pockets and may appear as non-sympathetic defendants. This first wave of NPE activity in China will likely be backed by foreign investment of NPEs seeking to gain leverage over their targets in ongoing litigation in the US by threatening their Chinese supply chains. If that wave of NPE activity proves successful, it will launch a second, more far-reaching wave of domestic NPE litigation.
Although conditions are not at this time ideal for NPEs, the growing wealth and success of Chinese companies and a judiciary that appears receptive to NPE litigation make the advent of Chinese NPE litigation something that is on an approaching horizon in the not too distant future. While there is much to be learned from the US experience with NPEs, the NPE model will undoubtedly be imported into China with some localised flavor or twist that will help make NPE litigation successful in China sooner, rather than later.
1 PATENTMATH strategy blog: http://patentmath.com/are-npes-coming-to-china/.
2 SIPO website, http://english.sipo.gov.cn/statistics/.
3 See Zhou Wei, Understanding Private Equity Fund.
4 "Range of patents go on the auction block," China Daily (8 December 2010).
Originally printed in Intellectual Property Magazine (www.intellectualpropertymagazine.com). Reprinted with permission. This article is for informational purposes, is not intended to constitute legal advice, and may be considered advertising under applicable state laws. This article is only the opinion of the authors and is not attributable to Finnegan, Henderson, Farabow, Garrett & Dunner, LLP, or the firm's clients.