The Fundamental Problem House IP Subcommittee Witnesses Overlooked in Litigation Financing Hearing
“Kochan confuses the fundamental nature of TPLF. It is not a cause to a problem that inflicts the court system. Rather, it is a market response to the transactional costs imposed by courts to measure and enforce patent rights.”
Professor Donald Kochan
The House Judiciary Subcommittee on Courts, Intellectual Property, and the Internet held a hearing on June 12, 2024 titled the “The U.S. Intellectual Property System and the Impact of Litigation Financed by Third-Party Investors and Foreign Entities.” They were tasked with examining the impact of third-party funding and foreign entities regarding U.S. patent litigation.
Of note, Donald Kochan, Professor of Law and Executive Director of the Law and Economics Center, Antonin Scalia Law School, George Mason University, was called as a witness to provide his expert testimony regarding the impact of third-party litigation funding (TPLF) on the courts. He made the argument that TPLF fundamentally corrupts the courts by converting them into a speculative market, by leveraging the court as an investment vehicle for private gain. Kochan argued that TPLF activity will serve to flood the courts, thereby reducing accessibility to the courts. For courts to remain a neutral, accessible forum to facilitate the market, they must be insulated from the market.
Kochan is correct in the importance of the courts remaining a neutral forum to facilitate the market. As Nobel Laureate Douglass C. North commented:
“Indeed, the difficultly of creating a relatively impartial judicial system that enforces agreements has been a critical stumbling block in the path of economic development. In the Western world the evolution of courts, legal systems, and a relatively impartial system of judicial enforcement has played a major role in permitting the development of a complex system of contracting that can extend over time and space, an essential requirement for economic specialization.”
Kochan is also correct in that, for courts to facilitate the market and complex transactions, the courts must remain accessible as a forum for parties to enforce legal claims and clarify personal rights.
But Kochan misunderstands why courts are not accessible to patent holders, and ignores a fundamental economic principle that causes him to misdiagnose a symptom for a cause.
Namely, Kochan presumes that left to their own devices, courts are accessible. And the introduction of TPLF into the court system reduces the accessibility of the courts, because the TPLF business model creates incentives to flood the courts with more litigation, thereby consuming limited judicial resources.
But the inaccessibility of the court system is not due to increased litigation caused by TPLF. In fact, according to the Judge that Kochan cited as one of the most active in calling out the dangers of TPLF and a leader in demanding TPLF disclosure, non-practicing entity cases funded by third parties “’require virtually no work’ because they tend to settle early.” Rather, it is competitor patent litigation that is the most “work-intensive.”
The factor that reduces accessibility to the courts, which Kochan overlooks, is a fundamental economic driver taught by North: the transactional costs required to measure patent rights, namely a patent’s scope, validity, and value.
Transactional Costs Reduce Accessibility to the Courts
If you are a patent holder and wanted to enforce your rights against an alleged infringer in court, what would you need?
First, obviously, you would need legal title to the patent. Second, you would need at least a few million dollars of disposable cash.
Why so much cash? Because when you file a patent infringement lawsuit in district court, the court sets a case management schedule for your case. The case management schedule typically requires two to three years of litigation, several months of fact and expert discovery, and extensive expert reports and trial testimony regarding infringement, validity, and damages. This schedule typically requires a patent holder to spend years in litigation and millions of dollars in attorney’s fees and costs, to determine the most basic informational attributes of a patent: its scope, validity, and value. And this doesn’t include the additional cost and time for appeal, and further costs and time that may come if certain issues are remanded back to the district court.
This cash requirement to bring a patent case through trial and appeal is the accessibility hurdle that Kochan overlooks. Why?
Because according to the market principles of Adam Smith, as a free market grows, division of labor and exchangeability of specializations increase. As the innovation market grows, the specializations between the inventor and financier split. Outside of the rare exception, one actor specializes to become the inventor, while another specializes to become the financier. See here for more analysis on Adam Smith and the patent market.
But the transactional costs imposed by a court’s case management schedule create the requirement for a patent holder to seek another party’s participation to finance the patent litigation. This requirement of the participation of a third-party financier is the factor that reduces accessibility to the court by the patent holder.
According to the 2022 GAO study on Third-Party Litigation Financing, TPLF’s take on only a small percentage of patent cases presented to them, ranging from just 4-5% for those that reported. That means a substantial majority (e.g., 95-96%) of cases from patent holders are declined by third-party litigation funders, likely leaving them with insufficient funding to bring a patent infringement lawsuit.
Put simply, most patent holders don’t have millions of dollars of disposable cash to fund a patent litigation, and most patent holders won’t receive backing to fund a patent litigation.
Hence, the vast majority of patent holders are denied access to the courts, because of the court-imposed transactional costs to measure and enforce patent rights.
Market Demand for TPLF
As a corollary, and another factor that Kochan overlooks, is that the cost structure imposed by case management schedules creates the demand for TPLF.
To clarify, patent holders don’t want TPLF. Why?
Because litigation financing is debilitatingly expensive. If a litigation financer invests, e.g., $5 million in a case, then the patent holder could easily need to earn $20 million before the patent holder sees any return on licensing the patented technology. The cost of financing creates such an enormous hurdle to the patent holder, the patent holder may not earn a return, even if the case results in a successful settlement or verdict in favor of the patent holder.
Hence, Kochan confuses the fundamental nature of TPLF. It is not a cause to a problem that inflicts the court system. Rather, it is a market response to the transactional costs imposed by courts to measure and enforce patent rights.
Focus Should be on Reducing Transactional Costs
The failure of Kochan to identify transactional costs is the glaring hole in his analysis, and causes him to incorrectly dismiss the TPLF “access to justice” argument as “propaganda.”
As North points out:
“Efficient markets are a consequence of institutions that provide low-cost measurement and enforcement of contracts at a particular moment, . . .”
See here and here for an more in-depth analysis regarding transactional costs and patent litigation.
While Kochan is correct that courts are needed to facilitate markets, he overlooks that where a court system fails to provide low-cost measurement and enforcement of patent rights, this leads to market inefficiencies, which is a failure by the court system to adequately facilitate the market.
Less Demonization, More Facilitation
North set forth another simple, yet profound observation:
“[t]he success stories of economic history describe institutional innovations that have lowered the costs of transacting and allowed more of the gains from trade to be captured, thereby permitting the expansion of markets.”
Instead of demonizing the TPLF business model and advocating for its eradication, which would only serve to exacerbate the problem of court inaccessibility, this author invites Kochan to instead focus on finding innovative ways reduce the transactional costs to determine the most basic informational attributes of a patent: its scope, validity, and value. This would enable and further a court’s function to facilitate markets.
