The Microcap Speculator

I believe that two recent Supreme Court decisions have made the patent licensing business model considerably more risky. As a result, all of the following companies are less attractive investments:

ARM Holdings (ARMHY)
Rambus (RMBS)
Acacia Technology (ACTG)
Burst.com (BRST.PK)
Forgent Networks (FORG)
Neomagic Corp. (NMGC)
Patriot Scientific (PTSC.OB)
Star Scientific (STSI)
…and many others

Last year, in MercExchange v. Ebay, the Supreme Court vacated a long-standing presumption that courts should issue permanent injunctions to stop patent infringement. The high Court ruled that a fair royalty could suffice, especially where the plaintiff is not currently practicing the invention. In a concurring opinion, Justice Kennedy (joined by Justices Stevens, Souter, and Breyer) took direct aim at patent licensing companies:

“In cases now arising trial courts should bear in mind that in many instances the nature of the patent being enforced and the economic function of the patent holder present considerations quite unlike earlier cases. An industry has developed in which firms use patents not as a basis for producing and selling goods but, instead, primarily for obtaining licensing fees. … For these firms, an injunction, and the potentially serious sanctions arising from its violation, can be employed as a bargaining tool to charge exorbitant fees to companies that seek to buy licenses to practice the patent. … When the patented invention is but a small component of the product the companies seek to produce and the threat of an injunction is employed simply for undue leverage in negotiations, legal damages may well be sufficient to compensate for the infringement and an injunction may not serve the public interest.”

Yesterday’s decision, KSR v. Teleflex, may be even more significant. In that decision, the Supreme Court made it significantly easier for patents to be attacked on the ground that they were “obvious” in light of prior art. In SCOTUSblog, Michael Barclay of Silicon Valley law firm Wilson Sonsini explained: “This decision makes it far easier to invalidate patents based on obviousness. Thus, this is the most important patent case of the last 20 years, and perhaps since the passage of the 1952 Patent Act. Virtually every litigated patent case includes an assertion of obviousness – and ones that might not have included that defense up until now are more likely to do so. The PTO examines every patent application for obviousness. [The case] will thus have an enormous impact on both the prosecution and litigation aspects of patent practice.” (emphasis added by yours truly).

DISCLOSURE: I have no position in any of the companies mentioned here. Not a recommendation to buy or sell any security. For informational and educational purposes only.

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Burst.com (BRST.PK) is a patent licensing company that owns a handful of patents that appear to this layman to broadly cover cached streaming of audio and video. Like Patriot Scientific (PTSC.OB), Burst.com’s business model is to seek licensing agreements and, failing that, litigate against operating companies it believes are infringing on its patents. One key difference is that while Burst.com has had some success litigating–specifically a $60 million settlement it wrangled from Microsoft–it has had little success negotiating licenses.

Now the company is locked in a struggle for its future with Apple Computer (AAPL). After licensing negotiations with Apple broke down, Apple filed a declaratory judgment seeking a ruling that Burst’s patents are invalid. Burst countersued, alleging that Apple’s iPod, iTunes, iTMS, and QuickTime violate valid Burst patents. BusinessWeek gives a good summary of the dispute:

While big companies have been complaining that the patent system is tilted against them, [Burst.com CEO] Lang believes his tale demonstrates that the opposite is often true. “There’s a million ways for a plaintiff to lose a patent case but only one way to win,” he says. “So if you’re a big rich company, why not go ahead and go through the [legal] process? Maybe the little guy will run out of money, or run out of courage.”The validity of Lang’s tale of woe will ultimately have to be determined by the courts, but right now he is not winning many friends in Silicon Valley. Burst is asserting very broad patents, and Lang has been making the rounds with veiled threats of infringement actions. He’s aiming for big payments. While Lang won’t discuss his hopes for the Apple claim, his lawyer cites as a point of reference other cases in which plaintiffs were rewarded more than 2% of infringing revenues. That would be about $200 million so far for Apple. “Burst.com approached Apple claiming that some of our products violate their patents, but we don’t agree,” says an Apple spokesperson. On Jan. 4, Apple filed a suit seeking to invalidate Burst’s patents.

While Lang is controversial, his record as a tech clairvoyant is impressive. When the rest of the world was focused on stuffing 500 channels onto cable TV, he was devising ways to use digital networks to deliver content more efficiently and reliably. Lang recognized that shows could be sent faster than they could be viewed — in “bursts” that took full advantage of momentary increases in network capacity, rather than in constant “streams.” Indeed, at the 1991 Consumer Electronics Show, Lang drew a crowd with a demo in which 15-minute segments of a PBS documentary were zipped to a TV across the booth in seconds. “They were demonstrating things that other people couldn’t do,” says tech pundit Robert X. Cringeley.

According to Burst.com’s website, there are roughly 40.8 million shares outstanding, fully diluted. At Friday’s closing price of $0.95, that gives Burst a market cap of about $38.8 million. It is fair to say there is no Burst.com without the patents. Either the patents are upheld, and the company has a shot at becoming the next Patriot Scientific, or they are deemed invalid and the company becomes worthless.

I still don’t know enough about this situation to have a feel for the likely outcome, and my recent debacle with IMA Exploration (IMR) certainly does not inspire me to lay down good money for a company that could fall apart with the stroke of a judge’s pen. However, I do have a pretty good idea of when it could get interesting. The key event of a patent trial is often the claim construction, or Markman, ruling. How a court views the words used in a patent will often determine who wins and who loses at the ultimate trial. For the Apple-Burst litigation, the Markman hearing is scheduled for early 2007. I wouldn’t be too surprised to see Burst shares heat up just before then.

DISCLOSURE: I have no position in BRST.PK or any of the other stocks mentioned in this article. Not a recommendation to buy or sell any security. For informational and educational purposes only.

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