Rebuttable

- Making the case for the formation of national climate-change insurance markets

     In mitigating the impacts of climate change, market-based regulations (aka, cap-&-trade) have been championed as the preferred policy tool. (See my previous post on regulations, markets, & innovations.) EU has adopted cap-&-trade regulations for carbon emissions and established carbon credit markets, under the Kyoto Protocol, since 2005. And the northeastern states in US have been auctioning off carbon emission allowances to the power generators under the RGGI (Regional Greenhouse Gas Initiative) platform since 2008. California is set to begin emission trading soon.

     The prices of the carbon credits traded in EU and under RGGI, however, have plunged precipitously. (See here & here.) Moreover, the Chicago Climate Exchange ceased trading carbon credit products in 2010. Recently, Canada withdrew from the Kyoto Protocol, and New Jersey broke away from RGGI. These developments raised serious doubts whether markets can be an effective policy tool with respect to climate change.

      If not viewed as a policy tool, nonetheless, the carbon markets have done exactly what they are supposed to do. – Efficiently reflecting the aggregate balance of supply and demand. The decline in carbon prices reflects (among others) the over supply of credits issued by the EU governments, and the under demand in US & China for lack of policy supports (and also in EU for the weak economy). Therefore, as much as policy-makers and businesses engage in the wishful thinking that the markets would do the dirty works on their behalf, the markets know better to call their bluff.

     The lessons: Markets cannot function as an effective regulatory tool without adequate policy supports or implementation. On their own, however, markets can function as an efficient signal as to the aggregate impacts of supply and demand factors, including policy supports and economical conditions.

     These lessons learned from the market-based efforts in climate change mitigation may have some important bearings on climate change adaptation. Adaptation has taken a back seat to mitigation in the climate change debates. This is understandable. After all, it makes sense to target directly the root of the problems (free emission of carbon). Moreover, reducing carbon emissions is associated with one clear objective, finite risk parameters (atmospheric CO2 concentration, mean temperature, & mean sea level), acceptable predictive models with large data sets, quantifiable risk levels and reduction targets, tangible commercial products, well-articulated technological solutions, and a definable timeframe.

     Adapting to climate change, on the other hand, has none of these characteristics. There is not one central theme, but rather a murky set of sundry tasks that must be performed locally in response to unpredictable local conditions (eg, hurricane, flood, drought, extreme precipitation, sea level rise, heat wave, biodiversity changes, vegetation shifts, disease spread, healthcare, allocation of water & food, etc). And, there is no easily identifiable tangible commercial products associated with climate change adaptation. Adaptation, in short, is simply a tough sale!

     The falling carbon prices, however, attests to the difficulties in achieving the mitigation goals considered necessary to maintain the atmospheric CO2 concentration at comfortable levels. Adaptation, therefore, is increasingly becoming an inevitable reality in the 21^st century. And yet, even though the public sectors have taken initiatives to address adaptation needs (see eg here), for the private sectors, adaptation remains a murky set of ill-defined speculative sundry tasks, and very little concrete actions have been taken to address the issues. (Eg, see here.) Without the extensive participation of the private sectors, public sector efforts in adaptation will not likely to be effective.

     This is where I think markets may play a useful policy role in stimulating private sector adaptation efforts, not as a regulatory tool but by providing a signal as to the aggregate balance of the supply & demand factors, including climate science developments, policy supports, or economic conditions. Specifically, the market I have in mind is the catastrophe insurance market.

     Currently, climate sciences are still unable to reliably forecast local climate variations (city or town) for more than a few days into the future. (Even if some high-resolution modeling tools may exist, my guess is they are likely to be extremely pricy and not widely available.) As a result, the most common way for businesses or individuals to manage their climate change risks is to purchase catastrophe insurances. These insurance markets thus provide a signal as to the aggregate supply & demand for climate change risk shifting, which in turn point to the aggregate supply & demand for adaptation.

     If these insurance market prices are widely accessible to the general public, like the prices of Treasury and other debt securities widely available to the public through the media or internet, they may serve to better inform the public of the state of climate change risks, and thus stimulate more concrete actions. In most markets in US, both private insurance carriers and public governments (states & federal) offer climate-related insurance coverage, such as flood or hurricane insurance policies. (Eg, see here.) In fact, in some markets, the federal government plays a significant role. For example, by 2007, the federal National Flood Insurance Program (NFIP), established in 1968, has become the primary flood insurer in US. (See here.)

     Therefore, the federal government should establish an agency to oversee and underwrite all federal climate-related insurances, and also ensure the establishments of sound and secure secondary markets in these insurance products and extensive distribution of the pricing information to the general public. Just like the Treasury securities markets, such national climate-related insurance markets may serve as a benchmark for the creation and pricing of other related markets, and as the basis for the creation of other analysis and decision-making tools. These national markets, pricing information, and additional tools should hopefully raise the public awareness of the risks of climate change, and thus the needs for adaptation, and facilitate informed and educated concrete actions in adaptation.

     Of course, this is a very primitive idea. Many further considerations need yet to be worked out. For example, many insurance policies are not standardized, unlike Treasury securities. The premiums may not properly reflect the market supply & demand because of government subsidies. The markets may lack liquidity if the risks rise above a certain threshold. But, hopefully this will be a start!!!

     UC Berkeley Law School conducted a comprehensive patent survey in 2008, asking young start-up technology companies to respond to several patent-related questions. (See here and here.) More specifically, the survey included the following questions (not exhaustive):

• Frequency of patenting;

• Reasons for seeking or not seeking patents;

• Comparisons of patents and other strategies in attaining competitive advantages;

• Reasoning for acquiring licenses from other companies;

• Perceptions of patents as incentives for engaging in innovation;

• Perceptions of importance of patents in securing outside investments.

     The ~1300 companies that responded to the survey encompassed the software, computer hardware, biotechnology, and medical device industries. More than 700 of them, however, were software companies. One of the co-authors, Pamela Pamuelson, wrote an interesting article in 2010 summarizing the survey results particularly of software companies. Below is a quick recap of her summaries:

1. Competitive advantage: The companies rated the strategies in gaining competitive advantages in the following order: (a) first-mover advantage; (b) complementary assets; (c) copyright, (d) secrecy (e) trademark (f) reverse engineering, & (g) patent.

2. Why patents: (a) to prevent competitors from using the technology; (b) to enhance reputation; & (c) to secure investments (including IPO).

3. Why not patents: (a) costs; (b) unpatentability of invention; (c) ease in designing around; (d) satisfaction in trade secrecy.

     Therefore, the first finding of the survey is that software startups generally do not consider patents important in gaining competitive advantages. Unlike biotech or medical device companies, software companies prefer using first-mover advantage, complementary assets, copyright, trade secret, trademark, or reverse engineering to compete in the marketplace. (Click on thumbnail above to view original chart.)

     The survey also revealed, however, that those companies backed by VC were much more likely to apply for patents than non-VC-backed companies. -- The software startups that participated in the survey were originally selected from 2 databases: ~500 from Dunn & Breadstreet (DB) and ~200 from VentureXpert (VX). About 10-15% of the DB companies and all of the VX companies were backed by VCs. In responding to the question whether they currently held or were seeking patents, only ~1/4 of the DB companies (with 85-90% not backed by VC) answered positively. On the other hand, ~2/3 of the VX companies answered positively.

     From the survey results, it appears software startups use patents primarily to attract or retain VC investments, rather than as a competitive advantage in the marketplace. It is not clear, however, whether the change in strategy toward patents (with or without VC investments) was caused by the perception of the software entrepreneurs regarding VCs, or by the actual requirements of the VCs.

     But, perceived or not, the fact that VCs and software entrepreneurs may hold such different views toward the values of patents is significant. It points to the need of a flexible patent system.

     Recently, Marc Andreesen, the co-founder of Netscape, wrote an interesting article titled “Why software is eating the world”. (See here.) Basically, the article is a recap of the Web movements during the past 10 years since the internet bubble burst in the early part of the last decade. Indeed, Andreesen cited numerous software-focused companies that are biting into the market shares of many old-timer hardware-based companies. These software companies are mostly household names such as Amazon, Netflix, Pixar, Google, Groupon, etc.

     Given the controversies that have been associated with software patents, I was curious how these “new” software companies approach patents. So, I looked up the US patents and patent applications held by the companies mentioned in Andreesen’s article. See table below.

     It’s pretty clear and not surprising from the table that older companies tend to build up larger patent portfolios than younger ones. This can happen due to the natural growth of a company’s products and technologies with time, and the consequential growth of its patent portfolio. However, the severe backlogs and delays in USPTO can also significantly impede patent protections for younger companies. (Eg, see here, where the inventor of a cloud-based video game technology waited for 8 years to receive a patent.)

     Therefore, younger (and smaller*) technology companies do not really benefit much from the existing patent system, particularly for software companies. Even if they have the funding to submit patent applications, they will not receive the protections for the first 3-8 years of their operations. Admittedly, it is also less likely that they will be burdened with patent infringement lawsuits (until later, when and if they survive and grow bigger), but neither will smaller companies be able to effectively protect their inventions from being siphoned off by others, or to protect their investments.

     Our patent systems have increasingly become the battlefield for large corporations. (Witness the fierce billion-dollar battle over the Nortel patent portfolios between Google, Apple, RIM, Microsoft, etc.) In that case, why not simply exempt smaller companies from patent infringements, expanding the fair use of patents? That seems to be only fair!

* P.S. Younger companies may not necessarily be smaller. Among the companies in the table above, Groupon, Zynga, or Twitter probably can no longer be considered "small". However, generally being young and being small do tend to go hand-in-hand.

     Just read a scathing opinion piece on Bloomberg.com advocating the shuttering of SEC. (See here.) Why? The fast spinning revolving door between the regulator and the industry it regulates, and the resulting festering conflicts of interest. The author, William Cohan, cited another article published in the recent Rolling Stone issue by Matt Taibbi, detailing a whistleblower’s allegations that the agency had been destroying internal investigation records at least for the past 17 years. (See here.)

     On the spinning revolving door, the Rolling Stone article listed the names of the 5 past directors of the Enforcement Division at SEC from 1985-2009, and their employers directly after their SEC tenures. I have copied the list below.

     It was reported recently that the hedge funds founded by George Soros, the fabled money manager, had decided to close themselves to outside investors and return about $1b of outsider money. (See, eg, here.) According to the news reports, the Soros fund managers stated in a letter to investors that they made the decision to avoid registering with the SEC. The letter indicated that the funds previously were able to avoid registration through some exemptions, but those exemptions are no longer available subsequent to the Dodd-Frank Act.

     Prior to Dodd-Frank, the Investment Adviser Act required investment advisers ("IA") to register with the SEC, but provided several exemptions[1], including the “private fund” exemption, which exempted IAs having less than 15 clients during the past 12 months and not holding themselves out generally to the public as IAs. (See footnote 1.c.) Since Dodd-Frank eliminated only the private fund exemption, leaving the other exemptions intact, it is fair to conclude that the Soros funds avoided registration through the private fund exemption. In place of the “private fund” exemption, however, Dodd-Frank introduces a “family office” exemption (§409), allowing IAs that are “family offices” to be exempted from registration[2]. Thus, by returning the outsider money, the Soros fund will supposedly qualify as a “family office” and continue to be exempted from registration.

     It is not possible to know for sure why the Soros fund manager would rather turn away money than register with the SEC. But I would guess it’s because they want to avoid the disclosure & record keeping requirements. In terms of disclosure, an IA registers with the SEC by submitting Form ADV, which includes 2 parts, Part I and Part II. (See here.) Part I is primarily form-based, whereas Part II is narrative-based. Without going into the details, I have listed in the table below the main disclosure items in each part.

- Tiptoeing for a balance, or taming of the shrew

     Many people have discussed the case, Bilski v. Kappos, and so I will not repeat it. (See, e.g., here & here.) As a quick introduction, Bilski was an inventor who applied for a patent on a “method of hedging commodity transactions”; USPTO rejected it; it was appealed eventually to the US Supreme Court; and on 6/28/2010, the Supreme Court rejected the patent application as well.

     Bilski did not involve software directly, but its sibling category, “business methods” (specifically, “method of hedging”). Software, however, invariably involves steps (ie, methods) of computation, and therefore the general holding in Bilski with respect to method-type inventions could be applied to software patents by analogy.

     The big-picture issue in Bilski was the threshold question, “What type of ‘method’ inventions are not eligible for patents regardless of whether they are new, ingenious, or properly disclosed to the public?” The Supreme Court held that if these “method-type” inventions are simply “abstract ideas”, then they would not be eligible for patent protections, categorically. (Four of the justices would have held that all business methods were not patentable.) The Court, however, declined to give a clear guidance on how to define “abstract ideas”, and simply threw the ball back to the lower court (ie, Appellate Court of the Federal Circuit; no pun intended) to find the solution.

     Most people agree with the principle that “abstract ideas” should not be eligible for patent monopolies. The principle has been a fundamental cornerstone of US patent laws since as early as the nineteen century. (E.g., Rubber-Tip Pencil Company v. Howard, 87 U. S. 498 (1874)) The devil, however, is in the details. And the real battlefield is in how USPTO and the courts decide which inventions are “abstract ideas”.

     With respect to software inventions, BPAI (Board of Patent Appeals and Interferences of USPTO) in its recent decisions appears to have equated “abstract ideas” with the term “software per se”. Moreover, BPAI has shown increasing tendency to dispose of software patent applications based on the “software per se” ground since 2007. (See table below.)

     I have listed below some of the software applications that have been rejected in 2010, post-Bilski, by BPAI on the “software per se” ground.

     In these cases, BPAI referred to MPEP 2106.01(I), which is titled “Functional Descriptive Material: ‘Data Structures’ Representing Descriptive Material Per Se Or Computer Programs Representing Computer Listings Per Se”. The term “software per se” under BPAI, therefore, seems to refer to “data structure per se” and “computer listing per se”. Furthermore, the texts of the MPEP section distinguish the “per se” category based on whether the software or data structure defines “structural and functional interrelationships” between the software or data structure and other claimed elements of the computer. The section, however, does not define any standard or test in determining whether such “structural and functional interrelationships” have been sufficiently defined to avoid the “software per se” rejection.

     Note that not all applications that had been rejected by the examiner on the “software per se” ground were affirmed by BPAI. See, e.g., Ex Parte Thornton et al, 01/06/2011. ("A system that manages the updates of land parcel drawings.") Moreover, in its first opinion after Bilski, (Research Corp Tech v. Microsoft), the Appellate Court of Federal Circuit on 12/8/2010 held that a method of generating halftone images was patent eligible. This holding contradicted with BPAI’s earlier determination in Ex Parte Hong (see table above), which also involved methods of processing pixel images. It remains to be seen whether BPAI will modify its position toward all software patent applications following Research Copr Tech, or distinguish the opinion on its facts.

     Even after the anxiously anticipated Bilski opinion, there is still no clear legal guidance in deciding whether or not a software invention is simply an “abstract idea” and thus barred categorically from patent protections. This void will certainly result in more confusions and inconsistencies at USPTO and the various courts, and thus impart greater uncertainties in the software patent application processes.

- Are trade secrets patentable?

     The media reported early last week that an ex-employee of Goldman Sachs had been arrested by the federal authorities for allegedly stealing the codes of the company's proprietary trading system. (See here & here.) According to the reports, US prosecutors told the court that the revelation of the secret codes would cost the company "millions upon millions of dollars". What is more, the prosecutors said that the stolen codes could be used to "manipulate markets in unfair ways". It also appeared that the ex-employee left GS in June this year to work for another company also engaging in the business of proprietary trading.

     This piece of news did not raise too many eyebrows in the markets. GS's stock prices were virtually unchanged through the week. It does raise a few interesting related questions, though. For example, if the codes can indeed be used to unfairly manipulate markets when fallen in the wrong hands, did GS take advantage of that malign capacity while it had the secret possession? Also, did the ex-employee sign any non-compete agreement that should have prohibited him from working in a similar field?

     I am not going to talk about these questions in this posting. Rather, I would like to focus on another question related to the intertwined paths of trade secret and patent. -- Now that the cat is out of the bag, can GS seek to patent the previously secret strategies to prevent others from using them? Or, more generally, even if the secret codes had not been stolen, can GS patent the strategies after profiting (supposedly) from them secretly for some time?

     On a first look, there seems to be little reason for GS to pursue patents for the stolen strategies. Proprietary trading firms normally prefer to keep their strategies confidential, because if too many people trade the same strategy at the same time, any profit opportunities will quickly disappear. Even though theoretically a patent may allow the owner to stop others from using the strategies when they are no longer proprietary, figuring out who is/are using the strategies and enforcing the patents can be challenging. Moreover, it may take years to obtain a patent, when the strategies will most surely have outlived their usefulness.

     There is, however, no guarantee that others will not obtain patents and seek to prevent GS from using the strategies. Also, it is not entirely impossible to find out whether the major players (maybe not all the players) are using the same strategies. Patents therefore may be effective and useful in preventing these major players from using the same strategies. In addition, even if the strategies have lost their values in proprietary trading, they may still have significant values in hedging, corporate financing, preventing "unfair market manipulations", non-proprietary trading for clients, risk management, and other uses.

     Whether the secret strategies are patentable will depend generally on the normal criteria, principally whether the strategies are new and non-obvious. A more specifically related issue here is whether the past secret use of the strategies by GS would preclude the strategies from the patent grant.

     This issue arises because the main goal of the patent grant is to encourage public disclosure of inventions. It would contradict this goal, if an inventor is permitted to keep an invention secret and profit from it for a long period of time, and then continue to be eligible for the patent monopoly when trade secret is no longer a desirable or viable strategy.

     The patent law does not explicitly address this issue. The Patent Act requires an inventor to submit a patent application within one year only if the invention is "in public use". (Patent Act §102(b)) The courts, however, have broadly construed the term "public use" in this context to include most commercial activities, excluding only strictly confidential uses. For example, the courts have held that giving corset steels to a close friend to wear intimately without restrictions was public use (Egbert v. Lippmann, US Supreme Court, 1881); selling to the public a product manufactured by a secret method was public use for the secret method (Metallizing Engineering v. Kenyon Bearing, Second Circuit Court, 1946); limited market testing of a product manufactured by a secret method was public use for the secret method (Dippin' Dots v. Mosey, Federal Circuit Court, 2007).

     Giving these previous cases, does the "secret" use of the strategies by GS in the public markets to profit for itself (and perhaps for its clients) constitute "public use"? (Assume that GS invented the strategies and has used the strategies for more than one year since the invention.)

     I have not found any case that directly addresses this fact pattern. And, it can be argued that because GS used the strategies strictly in confidence, not giving up the strategies to the public domain, the uses were not "public use", even though GS did profit from them. The previous lines of cases, however, were not concerned about whether the public had learned about the invention. Rather, the core of the holdings was that the inventor had given up the patent rights by keeping the invention secret for too long.

     Therefore, it is most likely that GS will not be able to obtain a US patent on the secret strategies. Other countries, however, may still allow trade secrets to be patentable.

-- The value and vanity of fame

[Note: In this posting, the term "trademark" includes both trademark and service mark. Also, jurisdictionally I refer primarily to federal trademark protections, not state protections, except where explicitly stated otherwise.]

     Trademark protections are generally limited by national boundaries. A trademark that is protected in, say, Germany does not automatically mean it will be protected in US. Particularly, trademark protections are conditioned on "use", but this "use" generally is limited geographically only to uses within US territories. Therefore, a trademark first used in a foreign country may not necessarily be protected in US, if it was not first used in US.

     In an increasingly globalized economy, such territorial limit is bound to give rise to an increasing number of disputes. The recession and the consequential shift of focus to the domestic economy in many developing countries (particularly BRIC: Brazil, Russia, India, & China) will only accelerate the trend. -- Many small, strictly domestic businesses in these developing countries will benefit from the thriving domestic economy and grow quickly into national franchises. At that point, these businesses will seriously plan expansions into the US markets, but might find their trademarks already used by others in US. It's predictable that many of these foreign businesses will challenge the existing US trademarks, in an attempt to extend their foreign trademark protections to US.

     In general, because of the territorial limit of trademark protections described above, these foreign businesses will not prevail. US courts, nonetheless, have recognized an exception to the territorial limit of trademark protections, and have granted protections to foreign trademarks (that were used in US later than other domestic trademarks) if they are "famous" or "well-known" in US. This "well-know mark" exception, however, is not derived from express US trademark laws, and as a consequence has created conflicts among different courts.

     Consider first a case in California. A large supermarket chain in Mexico had used and registered the mark GIGANTE in Mexico (but not in US) since 1960s. A US company opened two food stores in California in 1990s and called them "Gigante Market". Then beginning in 1999, the Mexican supermarket chain entered the US market and opened several stores in Los Angeles and called them "Gigante". Lawsuits ensued to determine who, the US company or the Mexican supermarket, has right to the GIGANTE mark. The 9th Circuit Court recognized the "well-known mark" exception and held that the Mexican supermarket chain, which first used the GIGANTE mark in Mexico, could have rights to the mark in US, if the mark was determined to have been "well-known" in California, among other factors.

     In 2007, however, the 2nd Circuit Court in NY reached an opposite conclusion from the 9th Circuit Court. In the NY case, the ITC Hotel established Bukhara Restaurant in 1977 in New Delhi, India. The restaurant was voted Best Asian restaurant and one of the top 50 in the world by Restaurant Magazine of UK in 2007. ITC did open a restaurant in Manhattan in 1987 but closed it in 1991. In 1999, several ex-employees of the original Bukhara Restaurant opened two restaurants in Manhattan. The new restaurants were named Bukhara Grill and had similar interior deco as the original ones. The New Delhi Bukhara sued the New York Bukhara, asserting the "well-known mark" protection. The 2nd Circuit Court, however, refused to recognize the "well-known mark" exception, citing absence of a clear intention of the Congress to enact such an exception into federal trademark laws.

     As a result, currently foreign "well-known marks" can be protected by federal laws in the states within the 9th Circuit (AK, AZ, CA, HI, ID, MT, NV, OR, WA), but not in NY. The conflict will need to be resolved by the Supreme Court or by the Congress.

     Finally, I note that the 2nd Circuit Court in the Bukhara case eventually asked the NY State's highest court to help answer whether a foreign "well know mark" may be protected under NY state laws. The NY's highest court answered, "Yes", although under the theory of misappropriation of commercial advantages in the unfair competition context, not as a "well-known mark" exception to the territorial limit on trademark protections.

The pursuit of fame

Turns out to be not in vain,

Insofar as a mark of trade

Is the center of the realm.

It's the federal or the state

That will be the game.