Reversing the Ebay ruling backslides innovation and growth. Automatic injunctions restrict R&D budgets, crowd-out competition and unlock NPE’s.

The main goal of the patent system is to protect innovation and thus to spur growth. Whether this goal is achieved depends on how patents are defined and protected, which itself depends on how the legal system resolves intellectual-property disputes. Indeed, the courts appear to have played an increasingly important role in the patent system (Cohen et al., 2019). Over the last thirty years, lawsuits involving patents more than tripled (Figure 1) and their estimated cost surpassed $300 billion (Bessen et al., 2018). In part, this shift in patent enforcement has been connected with the increase in patent-holders’ rights over the past decades (Jaffe and Lerner, 2011).1

In principle, increasing the rights of patent-holders should have positive effects on innovation. However, this simple logic may fail for several reasons. For instance, stronger rights for patent-holders may actually have detrimental effects on innovation when we account for the role of competition (Arrow, 1962; Aghion and Howitt, 1992) or we consider innovation as a cumulative process (Scotchmer, 1991; Bessen and Maskin, 2009). Furthermore, the idea that stronger patent rights will increase innovation also hinges on the assumption that patent enforcement is sufficiently effective in resolving legal disputes. In practice, the patent system is characterized by a lot of uncertainty (Lemley and Shapiro, 2005) and enforcement tends to be a noisy process (Jaffe and Lerner, 2011). In this context, strong patent rights may actually increase the cost that frivolous patent litigation can impose on innovative firms, which in turn may curb innovation and growth (Bessen and Meurer, 2008b; Boldrin and Levine, 2002). Therefore, to understand the connection between patent protection and innovation, we need to also consider how changes in patent rights affect enforcement. This issue is particularly crucial today, given the increasing importance of intangible assets to the modern corporation (e.g. Corrado and Hulten, 2010; Eisfeldt and Papanikolaou, 2014; Peters and Taylor, 2017).

Consistent with this hypothesis, this paper shows that a reduction of patent holders’ rights - which lowered the costs of patent litigation for defendants – may have positive effect on corporate innovation. To examine this issue, I develop a new research design that exploits a landmark Supreme Court decision “eBay v. MercExchange” (2006). The ruling ended the practice of automatically granting a permanent injunction after a patent violation. The issuance of an injunction forces the defendant firm to shut down any operation related to the violated technology, regardless of the nature or magnitude of the infringement. Given this large operational risk, the presence of automatic injunction gave patent holders a very strong bargaining position in IP disputes and negotiations (Section 2.1). With the 2006 decision, courts were allowed to decide on a case-by-case basis whether an injunction was appropriate, therefore increasing court flexibility to remedy patent disputes and lowering the potential cost for defendants.

A prominent example that demonstrates the important role of automatic injunction in patent litigation before 2006 is the lawsuit initiated by NTP Inc. against Research in Motion (RIM), the maker of BlackBerry, in the early 2000s. The district court sided with NTP and found RIM guilty of infringing on a few of NTP’s patents. With the objective of avoiding an injunction, RIM started to negotiate with NTP. Even if the infringement covered only a small fraction of the portfolio of patents used to run the BlackBerry system, an injunction order would likely have led to a shutdown of the whole system. Leveraging on its ability to obtain an injunction, NTP was able to negotiate a record settlement of more than $610 million, approximately half of RIM’s revenues in the previous year. Interestingly, years later some of the claims contained in NTP patents were deemed invalid, as RIM had argued initially. According to several experts, the presence of an automatic injunction played a fundamental role in the decision to settle early and the size of the transfer.2

In general, the overall impact of the “eBay v. MercExchange” decision is ex-ante ambiguous. On the one hand, removing the automatic injunction may lower deterrence against violations (e.g., Epstein, 2008), therefore reducing the incentives to innovate. On the other hand, this increase in court flexibility may actually positively affect innovation by reducing the costs that patent litigation may impose on innovative firms. In fact, the presence of a “near-mandatory” injunction increases the extent to which companies can be held up by a plaintiff (Lemley and Shapiro, 2006; Shapiro, 2010, 2016a), as clear from the RIM-NTP case. In general, leveraging on the high degree of uncertainty in the patent system (Lemley and Shapiro, 2005), the injunction threat may help plaintiffs to obtain large settlements even if accusations are based on frivolous claims or minor violations.3 In this context, the new rules should reduce the hold-up costs of litigation, therefore positively affecting the incentives and financial ability to do R&D investments.4

The post-eBay changes in patent enforcement suggests that the impact that the decision had on litigation costs may have been substantial (e.g. Bessen and Meurer, 2008a; Holte, 2015; Shapiro, 2010; Tang, 2006; Venkatesan, 2009). In aggregate, Chien and Lemley (2012) found that the likelihood of obtaining an injunction after the Supreme Court ruling decreased by at least 25%. However, injunctions are still granted in the majority of cases, suggesting that this remedy is still available to firms in case of a violation. Furthermore, the decline in injunction rates was larger for cases where the firms involved are not competitors or when the case involves a patent assertion entity (PAE) (Seaman, 2016). In line with this result, I find that public PAEs experienced large negative returns around the time of the court decision, with average cumulative returns of about -10%.

Given the theoretical ambiguity, this paper empirically studies the effect of the ruling by estimating a difference-in-difference model that exploits variation in firm exposure to patent litigation in 2006 to identify companies that are more likely to be affected by the eBay ruling. The intuition for this choice is simple: while the shock potentially touched every firm, companies that operate in areas where patent litigation is more intense should be relatively more affected by the decision. I construct this measure of exposure as a weighted-average of litigation activity across all the technology areas in which a firm operates, where the weights are given by the share of patents in each USTPO technology class for the firm. Therefore, this measure captures exposure to litigation coming from the area in which the company operates, and it is orthogonal to endogenous decisions of the firm to engage in patent litigation. As a validation, I show that heterogeneity in exposure to the shock predicts variation in abnormal returns the day in which the decision was made public. In particular, firms more exposed to litigation outperformed less exposed firms when the ruling was released.

As a first step, I use this model to examine how the decision affected patent applications for a sample of almost twenty thousand innovative firms. Firms that were more exposed to litigation before the decision increased patenting more after the decision. In particular, a one-standard-deviation increase in exposure leads to a 3% higher application rate – which translates into almost one extra patent in the two years after the shock – and a 2% increase in the probability to patent anything. As discussed in the paper, these results are not driven by differential trends across heterogeneously exposed firms, and they are robust to control for industry trends – measured by the main technology area of the firm (Hall et al., 2001) – as well as other confounding factors. Furthermore, I also argue that my findings cannot be explained by other contemporaneous legal changes.

To better characterize the effect of the decision on innovation, I then extend this analysis in different directions. First, I find that the change in enforcement led to a shift in patent quality. While increasing their patenting relatively more, firms more exposed to patent litigation did not lower the average quality of their output. Instead, they became relatively more likely to develop a potential “breakthrough innovation” (Kerr 2010; Lin et al. 2016), defined as a patent that is at the top of the citation distribution within the same patent class and year group. Second, using different metrics (Abrams et al., 2013; Srinivasan, 2018), I show that the shock also decreased the share of defensive patents for highly affected firms. Third, I show that the ruling had a positive effect on R&D investment for public innovative firms.

Altogether, these results confirm that the positive effect on patenting did not simply reflect an increase in defensive activity (Hall and Ziedonis, 2001) or a shift in the incentives to file for a patent. Instead, these results are consistent with the idea that the change in enforcement caused by the ruling positively affected innovation. This suggests that the reduction in plaintiff bargaining power reduced some of the distortions caused by the litigation environment. In line with this hypothesis, I also show that the R&D effect was more pronounced for firms that were more likely to be involved in litigation as a defendant.

Finally, I examine how an improvement in enforcement rules may affect the process of innovation. First, enforcement seems to influence innovation because it determines the relative returns of different R&D projects. Consistent with this hypothesis, I find that after the Supreme Court ruling, firms marginally reshuffled their internal resources toward projects that are in higher litigation areas, at least at the extensive margin. Second, enforcement rules seem to also affect R&D because they exacerbate the financing problems of innovation (Brown et al., 2009; Hall and Lerner, 2010). In fact, companies operating in high-litigation environments are forced to devote a larger share of resources for defensive activities (Cohen et al., 2019, 2016b) and spend more money on settlements or licensing.5 In the presence of financial frictions, this increase in costs may negatively impact the ability to undertake investments. Consistent with this implication, firms that were more likely to be financially constrained before the decision increased R&D intensity in its aftermath. These findings establish the important role played by financial constraints in explaining the negative effects of patent litigation.