Hedge funds use IPR to target patents while short-selling stock---investors profit while pharma companies lose their patents---that discourages innovation.

Imagine a well-known pharmaceutical company produces several patent-protected drugs. One of the company's drugs is protected by a single patent and the patent's validity is challenged and subsequently [*303] invalidated in a post-grant review proceeding 1 in front of the United States Patent and Trademark Office (USPTO). As a result, the pharmaceutical company's shares immediately plummet. Recognizing an opportunity for profit, hedge funds have recently adopted a new investment strategy in which they take a short position in a pharmaceutical company's stock and then challenge the validity of one or more of that company's pharmaceutical patents. By taking a short position, hedge funds are essentially betting that the patent will be invalidated and stock prices will fall. As a result, the shareholder's loss likely goes into the hedge fund's pockets. Unfortunately for the shareholders, hedge funds are not prohibited from petitioning for post-grant review and this investment behavior is legal.

The Leahy-Smith America Invents Act (AIA), patent reform legislation enacted in 2011, 2 significantly developed post-grant patent opposition procedures, which permit individuals to challenge the validity of patents after grant by the USPTO. Among the major changes the statute introduced is a new post-grant review proceeding, known as inter partes review (IPR), which does not require a challenger to have legal standing. 3 Therefore, any unrelated third-party may request review of an issued [*304] patent. 4 The absence of a standing requirement opens the door for investors and hedge funds to instigate IPR proceedings; pharmaceutical patents in particular have become a major target of these investor-initiated post-grant patent challenges. Investors challenging pharmaceutical patents do so mainly through IPR proceedings.

This novel investment strategy has made headlines recently 5 as investors utilize IPR to short-sell the pharmaceutical company's stock while also requesting USPTO review of the pharmaceutical company's patents. An investor can benefit from short-selling by pocketing the difference between the price at which it sells borrowed shares and the lower price at which it buys back the shares when it closes its short position. 6 Short-selling is an investment strategy used when an investor believes that the value of a stock will decline, such as when the investor believes a stock is overvalued. 7 Additionally, a short position may be taken to hedge the downside risk of a long position in the same or a closely related security. 8

If the patent is invalidated, the company's stock price predictably decreases because patents are major assets for pharmaceutical companies. Thus, by successfully invalidating a patent through IPR, the investor wins on their bet against the company's stock price and reaps the financial benefits. While invalidating patents may benefit society--such as by bringing other innovations into the public domain and lowering pharmaceutical prices--critics argue that investors utilize this strategy to abuse the IPR system for their own financial benefit. 9 They argue this type of investment behavior in fact discourages innovation, since few [*305] pharmaceutical companies will invest in research and development without strong patent protection.

This Note argues that the utilization of the IPR system by third-parties should be promoted to invalidate weak patents, thereby allowing generic pharmaceuticals to enter the market. However, to prevent abuse of the IPR system, individuals should be prevented from taking a short position against a company while also initiating an IPR proceeding against one or more of the company's patents.

Part I of this Note provides background information on patents, the AIA, and IPR. Part II examines the effects of investor challenges to pharmaceutical patents on the patent regime. Part III identifies solutions to prevent investment behavior that abuses the IPR system. Finally, Part IV proposes to curb investor abuse of the IPR system through financial regulation by the Securities and Exchange Commission (SEC), Congress, or the courts in furtherance of the purpose of the Securities Exchange Act of 1934 (Exchange Act). 10

I. PATENT CHALLENGES UNDER THE AIA

A. PATENTS

A patent grants an inventor a limited monopoly on their invention. The patent system incentivizes innovation by ensuring that an inventor will be able to benefit financially from their invention. 11 When examining patent applications, the USPTO determines whether an invention meets the five requirements of patentability: patentable subject matter, utility, [*306] novelty, nonobviousness, and disclosure. 12 Although patents are reviewed for validity by the USPTO, many patents are invalidated post-grant. 13

With a patent in place, generic competition is prohibited until the patent's expiration. 14 Therefore, during the patent's term, only the pharmaceutical company holding the patent on a specific drug may produce that drug. 15 After the expiration of the patent, other companies may enter the market to compete for market share with the original producer. 16 The drug produced by the original maker tends to be referred to as a branded drug, while its new competitors are termed generic drugs. 17

[*307] Patent expiration tends to lower pharmaceutical prices because it allows generic competitors to enter the market. 18 As a result, the patent invalidation benefits not only the litigants but the public-at-large because it allows competitors to enter the market sooner. However, the business of invalidating patents is a double-edged sword. Invalidating pharmaceutical patents may not allow biotechnology companies to recoup their research and development costs. 19 Therefore, without strong patent protection, few pharmaceutical companies are willing to incur these expenses, which stymies medical innovation to society's detriment.