As an undergraduate and masters student at Georgia Tech's management school, Vergil Daughtery developed an interest in financial derivatives-financial products whose value is "derived" from some other, underlying, financial instrument. His finance class spent several weeks discussing the Black-Scholes option-pricing model, published in 1972 and recognized with a Nobel Prize in 1997. This model lets an investor determine the value of an option by entering a few simple measures into a calculator or spreadsheet.

As Daughtery explained: "We were studying [this], and I just couldn't understand why there always had to be a time component in the model." So he decided to put his idea into action. Soon after completing his master's degree, Daughtery began working for a non-profit agency that sets up group homes for disabled people. During his spare time, he undertook a series of filings for patent protection on his options-valuing idea. In particular, he claimed in his filings to have made an important financial innovation: figuring out how to price an expiration-less option. Unlike the Black-Scholes formula, which generated values only for options that last a finite period of time, Daughtery's discovery would let investors price options that last forever.

Today, Daughtery has received three patents on his idea, and has a number of applications pending. The patents gave him broad rights to expiration-less options. To commercialize this idea, he established a new company, Economic Inventions, and began encouraging investment banks and securities firms to take licences to his patents. A recent press release highlighted negotiations with the Chicago Board of Trade.

At first blush, this account reads like an all-American success story. Patents have enabled a young, ambitious inventor to get on the playing field. Without his patents, Daughtery would almost certainly not been able to enter into negotiations with large financial corporations. As one commentator noted: "Not only can you invent a new way of doing business and effectively control that new way from a lakeside in North Carolina, you don't have to be some snobby Harvard or Stanford PhD to do it."

There's just one problem: infinitely lived options are not a new idea. In fact, it is considerably easier to value infinitely lived options than to value those with a distinct life span, which is why a Nobel Prize was awarded for solving the finite-lived option pricing problem. Economist Paul Samuelson (both alone and with Bob Merton) had solved the pricing of perpetual options in the mid-1960s, well before Fischer Black, Myron Scholes, and Merton analyzed the pricing of finite-lived options. To be sure, most introductory MBA finance classes don't get around to discussing the pricing of perpetual options because they are not as ubiquitous as finite-lived options. Nonetheless, the subject has been dissected in literally dozens of articles, many written by Nobel Laureates such as Merton and Samuelson.

It's not surprising that Daughtery didn't realize his discovery had already been made many years before. But why didn't the USPTO examiners figure out that his solution wasn't novel? While Allen MacDonald, the examiner who approved Daughtery's initial application, did search earlier works, his hunt was astonishingly inadequate. For instance, he spent much of his time reviewing earlier patent applications. But because few earlier patent awards existed for financial methods, this quest revealed little. Certainly, it had not occurred to Bob Merton or Paul Samuelson to patent their pioneering work on infinitely lived options in the 1960s, and no one had filed for a patent on such options prior to Daughtery. The examiner did also search various literature databases for the phrase that had been employed by Daughtery: "expirationless options". This turned up nothing because the finance literature used the phrase "perpetual options" instead.

This episode is symptomatic of the profound problems with the US patent system. The US Congress set us on this road in 1982 when it created a centralized appellate court for patent cases, the Court of Appeals for the Federal Circuit. A decade later, Congress compounded this folly by ordering that the USPTO, which up until then had been funded by tax revenues, instead fund itself through the fees it collects for patent applications. Both changes were described as administrative and procedural rather than substantive. It is now apparent that together they have resulted in the most profound transformation in US patent policy and practice since 1836, making it easier to obtain patents, easier to enforce patents against others, easier to extract large financial awards from such enforcement, and harder for those accused of infringing patents to challenge the patents' validity. These changes pose considerable dangers for the long-term health of the US economy and its global competitiveness.

Figure 1: Annual patent applications and awards

Patent problems and solutions

Flawed as it is at times, the free-enterprise system has demonstrated a unique ability to generate new technology: industrialized capitalist economies have increased their productivity more in the last two centuries than in all the millennia of previous human history. The basis for this advance is firms' pursuit of profit, which forces them to innovate. This incentive depends fundamentally on the smooth functioning of the institutions that determine and administer ownership of the fruits of research and development.

Instead, the US patent system costs companies and individuals billions of dollars and millions of man-hours annually to obtain patents and fight frivolous law suits. Often, patent holders succeed in court, despite their problematic claims. In other cases, the two parties ultimately settle the dispute. In many cases, a small firm will conclude it is just too difficult and uncertain to dispute a patent, despite the fact that the award is very problematic.

In making these decisions, the firms are often swayed by the poor odds facing infringers at trial: in recent years, as many as two-thirds of patent-holders have succeeded in litigation at the district court level, as opposed to an average success rate of 32% in the decades before these reforms. The cost of litigation is also a factor. A recent survey suggests that the median cost of litigating a substantial patent case is today about $4 million.

These facts have led observers such as the Federal Trade Commission and National Academy of Sciences, both of whom have released major studies of the patent system in the past year, to conclude the US patent system has significant problems.

To stop this waste and inject some sanity back into the patent process, we must create a more rational patent system. Our patent policy reform agenda rests on three related proposals. First, create incentives and opportunities for parties to challenge the novelty of an invention before the USPTO grants a patent. Second, provide multiple levels of application review, with examiners devoting successively more time and effort as an application proceeds to higher levels. The idea would be to avoid wasting money on unimportant patents, while taking sufficient care to avoid mistakes where the stakes are high. Finally, in cases involving claims of patent invalidity based on the existence of prior art - previously issued patents or public disclosures covering the invention at issue - replace juries with judges who could call on experts, called special masters, for guidance. The change would give parties threatened by invalid patents a better opportunity to make their case.

The first two proposals aim to make the USPTO more effective at reasonable cost. The third addresses the reality that the best of all possible USPTOs will still make mistakes, and so we need a court system that is capable of correcting them.

As the tide of patent applications rose in the early 1990s, Congress converted the USPTO from an agency funded by tax revenues, which collected nominal fees for patent applications, into one funded solely by those fees. Indeed, the Office has become a profit centre for the government, collecting more in application fees than it costs to run the agency at present staffing levels. In some years, more than $200 million in excess USPTO revenues have flowed into general federal coffers, even as examiners remain underpaid and overworked. Nor do these diversions show any signs of ebbing: in mid-September 2004, the Senate Appropriation Committee voted to raise patent fees, but rejected a proposed House of Representatives initiative to place the additional revenues into a trust fund that would only be accessible to the USPTO.

The result is that today, the USPTO views itself as an organization whose mission is to serve patent applicants quickly at the lowest possible cost. Not surprisingly, there has been a widely perceived decline in the rigour with which patent applications are reviewed. This perceived lack of rigour, in turn, encourages more people to apply for dubious patents.

Figure 2: Number of patent suits filed at district level

Understanding the system

Having outlined the three broad reform goals (see box opposite), the next step is to understand some basic realities about the system. Patent examinations - and examiners - are never going to be perfect. Therefore, we cannot hope to have a system in which no bad patents are ever issued. What is important is to have a system with fewer bad patents. And, since there will always be mistakes, it is crucial that the system functions reasonably well despite the issuance of some bad patents.

Most patents are, and always will be, worthless and unimportant. This is not a feature of the patent office; it is a feature of the innovation process. The significance of a new idea usually cannot be known when it is first developed, because that significance depends on subsequent developments, both technological and economic. The upshot is that many good ideas are patented that never actually turn out to be worth anything.

Most days, patent examiners are like officials in the last minute of an American football game where one team is already winning by 30 points. They go through the motions of making rulings, because rulings have to be made, but they don't matter to the outcome of the game.

The key difference is that in the patent game, much of the time no one knows whether this particular case is going to matter or not. It is as if nobody - the officials, the players, and the coaches - have any idea of the score of the game, or if the game even matters. But they all take it seriously because there is some chance that the particular game they are playing will turn out (months or years later) to be important. For the ones that do turn out to be important, it will matter a lot if patents are granted that should have been. But for the others, the vast majority of all applications, there will never be important technological or economic consequences. This fact suggests that it would be inefficient to spend a lot of time and money on careful examination of all patent applications.

To make patent examination more efficient, we must go beyond thinking about what patent examiners do to consider how the nature of the examination process affects the behaviour of inventors and firms. The rate of applications has skyrocketed in the past two decades because patents are so easy to get that inventions that no one would have bothered to patent before now look like they are worth a try. This perception promotes a vicious cycle in which bad examination increases the application rate, which in turn overwhelms the examiners, reducing examination quality further.

Similarly, the Federal Circuit's rulings that have increased the chances of patent holders prevailing in infringement suits (see box overleaf) have encouraged patent holders to sue. The number of patent infringement suits filed in the year before the Federal Circuit was enacted, 1981, was 795. In 2003, three-and-a-half times as many cases were filed - 2,814 such suits. At the same time, many alleged infringers, knowing that the Federal Circuit tends to side with patent holders, don't bother to fight, even when they believe that the patents being used to threaten them are not valid.

Much of the information needed to decide if a given application should be granted a patent - particularly information about what related technologies already exist - is in the hands of competitors of the applicant, rather than in the hands of the USPTO. There should be strong incentives for firms to share this information. If a competitor has filed a patent application, the last thing a rival company would want is for them to be issued a patent on an application that would have been rejected if the USPTO had known about the rival's technology. So the rival has a strong incentive to provide this information, if only the USPTO would give it an opportunity to do so, and if taking advantage of such an opportunity does not create strategic disadvantages for the rival down the road. Creating opportunities of this sort is another way that the system could exploit the incentives of private parties in order to increase efficiency.

But before we swoon over the beauty of incentives, we must recognize the potential for them to be misused. In particular, competitors will opportunistically exploit any provision created for outsiders to provide the USPTO with information. Even in the case of good applications, if companies can easily throw some kind of speed bump in their competitor's path, they will probably be happy to do so.

Achieving reform

Our proposed revamping of USPTO procedures starts with the idea that a process with multiple potential levels of review will most efficiently balance the need to bring in outside information with the reality that most patents are unimportant. Examination would begin as it does now, with the review of an application by an examiner and no participation by other parties. If, however, the examiner determines that a patent should be issued, there would then be an opportunity for what we call pre-grant opposition. A public notice of the intention to issue a patent would be followed by a brief period in which other parties could submit evidence that the patent is not really new. This pre-grant opposition would not give outside parties any opportunity to argue their case, and they would not have access to legal discovery processes to produce additional evidence of prior art. It would simply be an opportunity for parties to put information before the examiner.

If, after reviewing this evidence, the examiner decides to issue the patent, there would be a final opportunity for review in the form of a request for re-examination. This request would have to make a case for why the patent is invalid, and the USPTO could decline to grant the re-examination request. But if it agrees, an independent examiner would completely review the initial decision, and offer the party requesting re-examination a chance to argue its case.

The procedure would naturally focus attention on the most potentially important applications. Most patents would never receive anything other than the most basic examinations. But for those applications that really mattered, parties would have an incentive and opportunities to bring information in their possession before the USPTO, and the USPTO would have more resources to help it make the right decision in the cases that really matter.

Breaking the vicious cycle of bad examination and bad patent applications is the key to reform of the patent process. But as we have emphasized, there are always going to be mistakes, and so it is important that the court system operate as efficiently as possible to rectify those mistakes, while also permitting owners of valid patents to enforce the legal rights the patent conveys. The Federal Circuit has significantly tilted the legal playing field in favour of patentees.

The question of juries

A common complaint of attorneys who defend infringement suits relates to the right of jury trial. They argue that the evidence in a patent case can be highly technical, and the average juror has little competence to understand and evaluate it. Having decisions made by people who can't really understand the evidence increases the uncertainty surrounding the outcome, which is a big reason why accused infringers often settle rather than fight even when they think they have a pretty good case.

More subtly, jurors' inability to grasp technical evidence may interact with the presumption of validity - the rule that patents must be presumed legitimate unless proven otherwise - in a way that helps patentees and hurts accused infringers. To prevail in an infringement case, an accused infringer has to present clear and convincing evidence that the patent is invalid. But if the jurors are simply befuddled by the evidence, they will most likely conclude that neither side has made a convincing case. Thus the clear and convincing evidence standard combined with decision-making by juries makes it likely that the patent holder, the plaintiff, will win on validity questions - which is why most holders ask for a jury trial!

The right to a jury of one's peers is a venerated concept in Anglo-American law. But there is no real sense in which a patent jury is, in fact, a jury of peers. If we left patent cases to judges rather than juries, we would still not have scientists and engineers, the true peers of the inventor, deciding the case. But at least judges spend their professional lives evaluating evidence in many different disciplines, and have typically developed some ability to sort through it. Further, a judge always has the ability to appoint a "master", an outside specialist in the service of the court, who can rule on the judge's specific technical questions.

The Federal Circuit has, in fact, put some limits on the role of juries in patent cases. In particular, it is the job of the judge, not the jury, to interpret - or construe - the patent's claims: the judge assists the jury by interpreting the technical language of what the patent covers. But when it comes to understanding when the subject of a patent application lacks novelty or obviousness - which the accused infringer must convincingly prove to invalidate the patent - the jury gets no such help.

There is no logical or substantive reason why a lay jury is the appropriate decision-making body for these questions. It would be entirely feasible for the judge to construe the novelty and obviousness of the patented invention relative to some other invention, just as the judge construes the claims of the patents. The ultimate question of patent validity could still be left up to the jury. If, for example, the judge ruled that the patent at issue is not original relative to some other invention, there might still be a dispute as to whether that other invention was, in fact, already discovered at the time of patent filing. The jury could then appropriately decide that question, based on testimony and documentary evidence about the date of the invention in question.

If the USPTO and the trial process were revamped, then patent litigation would be the appropriate last resort when disputes over patent claims cannot be resolved any other way. There would still be patent suits, and they would still be expensive. In areas where technology is changing rapidly, and there are numerous competing and overlapping claims, there would still be considerable uncertainty about who has the rights to what technology. But we will have reduced the pervasive and damaging fear that almost any product or process is always at risk of an infringement claim. And when claims are made based on patents of questionable validity, accused infringers would negotiate from a position where both parties expect a reasonably competent determination as to novelty and non-obviousness. That fact alone would reduce the incentive to pay royalties and settle rather than undertake a challenge that is risky, no matter how questionable the validity of the asserted patent.

We need to make sure that, before they can be used to restrict the commercial activities of competitors, patents have had the appropriate scrutiny necessary to ensure their validity. At the same time, we need to accept that the USPTO will still make mistakes, and create a judicial system that deals with those mistakes in a balanced way. Doing this without a budget-busting increase in resources for the USPTO will require that the system be significantly modified. The modifications should be carefully tuned to create incentives so that private parties have the incentive and opportunity to bring information to bear, but have limited incentive and opportunity to sabotage the process.

This article was first published in 'Managing Intellectual Property' magazine issue 149, May 2005