Articles

Patents Continue To Gain Visibility, Value In The Lucrative Derivatives, Hedge Fund, And Allied Financial Services Market

John Spaccarotella*

In June of this year, the New York Mercantile Exchange (“NYMEX”) and the Philadelphia Mercantile Exchange (“PHLX”) announced that the United States Patent and Trademark Office had published their United States utility patent application for a “Method and System for Securitizing Contracts Valued on an Index.”1 The invention, the brainchild of a joint venture between NYMEX and PHLX, purports to allow investors — for the first time in U.S. markets — to trade securities linked to the value of a commodity index without having to actually participate in the physical market itself.

The bigger news underlying the Exchanges’ proprietary claims to such a fundamental and broad trading methodology may be, though, that hundreds of patent applications directed to derivative contracts, hedge funds, and related financial market-enabling algorithms have been filed in the United States in each of the past several years.

The Exchanges’ press release thus had significance for several reasons. From a competitive standpoint, it served to publicize the Exchanges’ new and allegedly-proprietary product and technology to current and potential clients. It also was no doubt intended, from a legal perspective, to place competitors on notice of the Exchanges’ potential intellectual property rights and, presumably, their willingness to enforce those rights. Finally, the product developed jointly by both Exchanges is emblematic of major changes that have been taking place in the financial industry as bankers and traders have come to realize that their specialized financial products and investment methods may be susceptible to protection under the United States patent laws, thus providing potentially-significant competitive advantages to innovative financial services companies who take action to protect their trading strategies and specialized products under the patent system.

Post-State Street: Broad Patentability For Business Methods In The United States

In 1998, the United States Court of Appeals for the Federal Circuit decided, in State Street Bank & Trust Co. v. Signature Financial Group, that methods of doing business could qualify as patentable subject matter under the U.S. Patent Code.2 In State Street, the patent in suit was directed to a computerized system and method for managing a mutual fund investment. In upholding the patentability of the patent’s claims, the Federal Circuit held clearly, for the first time, that a financial service algorithm that involved the manipulation and management of electronic funds was patentable subject matter under 35 U.S.C. § 101.

The court’s holding represented a revolutionary alteration in the financial industry intellectual property landscape and resulted in a land grab at the Patent and Trademark Office for patents on systems and methods of doing financial business. In 1998, prior to the State Street decision, only 1,340 such patent applications were filed.3 In 1999, the year after State Street was decided, that number more than doubled, from 1,340 to 2,821. This tally steadily increased until 2001, when it reached a high of 8,700. After this apogee, the number of business method patent filings stabilized and started a gradual decline; as of 2004, the number of business method patent applications filed was about 6,200 – still a highly significant increase vis à vis the pre-State Street figures.

The range of subject matter of the business method patents that companies are applying for (and obtaining) is expansive. Patent applications are being filed, and patents are subsequently being issued, claiming techniques and systems in subject matter as diverse as:

Methods and Systems of Trading
· Portfolio planning
· Portfolio selection
· Order generation
· Order management
· Portfolio analysis

Methods for Optimizing Rates of Returns

Electronic Negotiation

Methods and Systems for Compliance
· Pre-trade compliance
· Post-trade compliance

Methods for Offlaying of Risk
· Tax avoidance
· Insurance
· Reinsurance

Methods of Portfolio Valuation

And as the number of patents to such subject matter increases, aggressive efforts by patent holders to enforce and derive revenue from their intellectual property rights and their investments are also increasing apace.

Examples Of Enforcement: eSpeed And Trading Technologies

The strategic value of a U.S. patent comes from the limited monopoly and power to exclude that it grants to its owner. Effective exercise of that power, though, requires that the patent holder assert, and if necessary, enforce, the patent against alleged infringers. Considering the amount of money that flows through the financial industry on a daily basis, it is no surprise that especially high stakes can be involved in patent infringement suits within the industry.

Companies such as eSpeed and Trading Technologies, Inc., who have made significant financial investments in their proprietary technology, have been at the forefront of aggressive efforts to derive patent royalty revenue streams from clients and rivals, including each other, and have not shied away from using litigation as one of the methods for obtaining such revenue streams. When damages demands are based upon a royalty model reflecting a percentage of substantial gross financial transaction revenues, it becomes evident that the stakes in such litigation can potentially be quite large.

As assignee of over a dozen United States patents and many more pending applications, eSpeed, a leading technology provider for the electronic trading market and a spin-off of Cantor Fitzgerald, has been a pioneer in enforcing its patent rights. In patent infringement actions brought as to just one of eSpeed’s patents relating to trading and trade-settlement platforms, the company has negotiated multi-million dollar settlement payments . And eSpeed has also been busy on other litigation fronts, joining battle with one of its principal would-be rivals, Trading Technologies International, Inc. (“TT”).4

Trading Technologies owns two patents that it asserts cover trading software that displays multiple prices on an order entry screen, which allows traders to judge “market depth,” i.e., the quantity of a particular security likely to be available at a particular price or range of prices (a parameter of interest for investors trading in large quantities of stock, given that an instantaneous “ask” price may correlate with a block of stock smaller than that which a buyer wishes to purchase, and that additional shares may be available only at higher prices). After purportedly investing over $40,000,000 in its technology, TT claims that its software is used for over 50 percent of all futures contracts traded. In recent months, TT has been filing patent infringement suits against competitors and clients on an almost-weekly basis. In addition to an action it filed against eSpeed, TT has patent litigation currently pending against hedge fund manager Man Group and former licensee Refco, to name a couple of current examples. And TT reports that it has entered into six negotiated settlements, including licenses with Kingstree Trading, Goldenberg, Hehmeyer and Co., Advantage Futures, and the U.K.-based Patsystems. TT’s most recently-announced settlement, with NinjaTrader, came less than a week after TT filed a patent infringement complaint against NinjaTrader. While the settlement terms for most of TT’s agreements are not known, NinjaTrader, after admitting infringement, agreed to pay TT a variable royalty of at least 10 cents per contract for all futures contracts traded in conjunction with NinjaTrader’s trading platform.

The Current And Future Role Of U.S. Patents In The Changing Financial Services Industry

The recently-announced Philadelphia Stock Exchange/NYSE joint venture, and the patent application that was announced as a central and market-differentiating selling point of the new product, is indicative of broader changes and consolidations in the industry, some of which have been (or can reasonably be predicted to be) driven or characterized by a significant focus on obtaining and enforcing intellectual property rights in specific trading platforms or technologies.

In another transaction in which proprietary technology (and ultimately, perhaps, patent rights based on such technology) may have been a driving force in the financial markets, the NYSE announced this Spring a plan to merge with Archipelago Holdings, which owns the electronic exchange communication network (“ECN”) ArcaEx.

Many firms are mulling investments in ECNs and their technologies for several reasons, including the concern that NASDAQ and the New York Stock Exchange may raise trading fees.  Firms may be interested in the possibility of profiting from further consolidation in the sector by controlling as much technology as possible (and by inference, as much associated intellectual property) that is relevant to the most advanced and lucrative trading platforms.

Another example of a segment of the financial industry in which patents might provide a competitive advantage is prime brokerage services to hedge funds. For some years, this hotly-contested market has been dominated, at the institutional level, by three major investment banks — Bear Stearns, Morgan Stanley, and Goldman Sachs. Recently, though, Citigroup and UBS have looked to increase their pieces of the pie in this booming service area. In doing so, these smaller prime brokerage players have looked to build relationships with high-profile start up hedge funds and fund managers and have invested particularly heavily — Citigroup estimates that it is in the process of spending hundreds of millions of dollars — in their technology platforms.

Will intellectual property be one of the weapons that these rival institutions wield effectively in attempts to increase their share of the lucrative hedge fund services business? It might well prove to be. Institutional money managers and their servicing companies have not in the past had much incentive to view acquisition and enforcement of patent rights as one of the arrows in their competitive quiver. If they thought of intellectual property as conferring market advantage or differentiation, they likely did so only in terms of proprietary analytic methods or formulas, which could be maintained as trade secrets.

But trade secrets, unlike patented technologies, require constant diligence to maintain in confidence, lest their secret nature, and legal protection, be forfeited. Also, a fund or money management technique structured or administered using, in part, trade secret analytic, pricing, or trading rules may be capable of being duplicated by competitors who reverse-engineer the technique so as to duplicate many or all of its advantageous performance characteristics. Trade secrets confer no protection against “clean room” reverse engineering (patents do forbid even such “independent” duplication of the patented method or product). Finally, the scope of trade secrets is simply more limited than that of patents, as trade secrets have little potential to duplicate such fundamental (and often public-facing) features of a fund as its portfolio/asset makeup and structuring.

Algorithm and business method patents, conversely, have the theoretical capability of conferring exclusivity as to even fundamental structuring decisions made by fund managers (so long as the claimed structure or structuring method meets the Patent Code’s statutory requirements of utility, novelty, and non-obviousness, as well as the requirement that the claims must have adequate technical support and enabling explanation in the written description of the patent document).

Investment banks or funds (or their servicing brokers) in the past have differentiated themselves from their competitors in the marketplace based upon their industry reputation, past performance, and their trade secret asset analysis and modeling methods.  The potential ability to market their products to investors as being exclusive and non-replicable by their competitors — based on U.S. patent protection — may prove attractive from a competitive standpoint, and provide a higher degree of differentiation than previously available.

To be sure, there are limits to the potency and value of patents in the financial industry (as in any other industry). Product life-cycles and market trends are notoriously short-lived in the financial markets, whereas U.S. patent applications (especially in the burgeoning software and business method subject matter area) may spend almost three years following their initial filing in the Patent Office before even receiving the first substantive response from the Office (which is likely to be a rejection that will require more months or years of prosecution before any enforceable patent issues).

Additionally, for all the perceived promise of financial industry patents, and despite the fact that significant litigation has occurred and real money has changed hands (usually as to nuts-and-bolts trade or fund management facilitating infrastructure such as that claimed by TT), there is sparse litigation and enforcement history as to the broadest type of financial industry patents (such as patents that purport to cover all funds or investment instruments that follow an allegedly novel analytic, pricing, or risk-optimization protocol).

Nonetheless, awareness of patent and other intellectual property issues may prove advisable and advantageous even for the most skeptical of fund managers or investment product providers who continue to have doubts regarding the ultimate efficacy of patents as an effective offensive weapon or marketing tool against competitors. This is so because even those institutions that do not choose to obtain and aggressively attempt enforcement (through litigation or licensing) of a substantial patent portfolio may benefit from acquiring and asserting a judiciously-selected patent portfolio in defensive contexts. Assertion of a defendant company’s own patents against an aggressor, as potentially-invalidating prior art, or as the basis of a counterclaim for infringement against the aggressor, is a time-honored and often effective way to respond to what is almost certainly a growing trend of greater affirmative assertion of patents by and against banks and other financial markets players, whose pockets are perceived to be capacious.

Investments in financial product patents are not guaranteed to yield a bonanza, but should be viewed as simply one of the many legal and market-power tools or assets available to those directly or indirectly involved in managing money, creating or administering investment products, and devising and implementing complexly-structured financial transactions. They may prove to have value in offensive, revenue-generating contexts, in excluding competitors from particularly lucrative market segments in which the patent holder can show entitlement to exclusive patent rights, and in defending against patent enforcement efforts by other companies.

At a minimum, the extreme rapidity with which patents have gone from almost an irrelevancy, to the subject of great interest, debate, investment, and assertion efforts, within the money management industries militates in favor of close consideration as to where future trends may lead, and what affirmative and defensive steps prudent financial services companies may wish to take to balance properly the risks and rewards that may be offered by the still-evolving law and economics of patents on business methods and algorithms.

__________________________________________________________________
1 PHLX.com News Release, at http://www.phlx.com/news/pr2005/05pr062205.htm (June 22, 2005).
2 State Street Bank & Trust Co. v. Signature Financial Group, 149 F.3d 1368, 47 U.S.P.Q.2d 1596 (Fed. Cir. 1998).
3 United States Patent and Trademark Office, at http://www.uspto.gov/web/menu/pbmethod/applicationfiling.htm.
4 Trading Technologies, Inc. v. eSpeed, Inc., No. 04-5132 (N.D. Ill. filed Aug. 12, 2004).

*Summer Associate Kimberly Gavin contributed substantially to the preparation of this article

The materials in this document are made available by Baker Botts L.L.P. for informational purposes only and are not legal advice. The transmission and receipt of information contained in the document do not form or constitute an attorney-client relationship. Persons receiving the information in this document should not act upon the information without seeking professional legal counsel. The materials in this document may not reflect the most current legal developments, verdicts or settlements, and should not be considered an indication of future results. If these materials are inconsistent with the rules governing attorney communications in a particular jurisdiction, and the materials result in a client contact in such jurisdiction, Baker Botts may be prohibited from assuming representation of the client contact.

UNSUBSCRIBE: If you would like to be removed from this list and no longer receive updates, please click here.