1. U.S. Software Patents: Good News or Bad News? Stuart Graham College of Management, Georgia Institute of Technology David C. Mowery Haas School of Business, U.C. Berkeley

2. Outline The debate over software patents. Functions of patents: possible consequences of increased SW patenting. Trends in patenting by US software and systems firms in the “strong patent regime,” 1987 - present. SW patent “quality.” Patenting and “open-source” software. Conclusions.

3. The controversy Has growth in software patents been associated with declining patent quality? Has growth in software patenting been associated with declines in innovation? With declining R&D spending? With increased market power for established firms? Should a “sui generis” patent regime be created for software and/or should patenting be prohibited in software (EU debate)?

4. Functions of patents Create incentives for invention. Require disclosure of technical details of invention. –Disclosure may enable follow-on inventors to utilize work of others. Create incentives for inventor or others to invest in commercialization of invention. Support markets for IP. –Often associated with a vertically specialized industry structure. In “defensive” patent strategies, patents may be used as chips for cross-licensing negotiations.

5. Causes and effects of increased patenting in the US SW industry Causes: –Market trends: Rapid adoption of desktop computers in the 1980s => patents, other formal instruments for IP protection become more important to capturing returns to product innovation for specialized packaged-SW firms. –Policy developments: Judicial decisions, US Patent Office policy support expanded role for patents in SW. Effects –Innovation: Little evidence of change during past 50 years in rates of invention, innovation in software. Although measures are lacking, innovation appears to be high in both the “nonpatent,” “pro-patent” periods. –Industry structure: Vertical specialization in SW industry appears in 1970s & early 1980s, predating “pro-patent” era.

6. The response to the “pro-patent” US regime in software, 1987-2003 Defining software patents is a significant empirical challenge: –Look at patent classes that exist throughout 1995-2000 accounting for majority of patents issuing to leading software-only firms throughout the 1995-2003 period. –Resulting sample tends to “overweight” packaged SW patents. Trends in software patenting as a share of overall U.S. patenting. Patenting by 100 largest packaged-SW firms, 1987-2003, as a share of overall software patenting. Patenting by large electronic systems firms, 1987-2003, as a share of overall software patenting. Trends in the “patent propensity” of the 15 largest packaged-SW specialist firms, 1987-2002. The “patent/Software R&D$$” ratio for IBM and Microsoft, 1994-2003.

7. Software patenting increased from 2.1% to 7.4% of all patents during 1987-1998; share has remained between 6.9% and 7.4% since 1999.

8. 100 largest packaged-SW firms’ share of SW patenting grew from <.1% in 1987 to 4.7% in 2002 and 4.1% in 2003. Removing Microsoft lowers peak share from 4.7% to 1.3%.

9. Twelve US & Japanese electronic systems firms account for a substantially larger share of SW patents during 1987-2003 (21% - 28%), but share declines after 2000.

10. Patent/software-specific R&D investment has risen since 1987 within 15 largest packaged-SW specialist firms, with or without Microsoft, but patent/R&D$$ ratio is essentially flat after 2000.

11. IBM IBM displays a much higher patent/(SW-specific) R&D ratio than Microsoft throughout 1993-2002. Share of SW patents within IBM’s overall portfolio increases from 27% to 42% during 1987-2003, and is higher than those of other systems firms (10% to 17%).

12. Software patent “quality” Are software patents “junk patents,” and does it matter? –Proliferation of low-quality patents may create a web of conflicting property rights that impede follow-on innovation. –Uncertainty over “quality” (validity) of patents may slow or deter follow-on innovators concerned over litigation exposure. Software patents are difficult for US Patent & Trademark Office to review, because of limited patent-based prior art. –A common problem in new areas of inventive activity. US has weak administrative procedures (re- examination) for challenges to patent validity. –Proposals now before Congress to introduce a post-issue “opposition” proceeding. –But opposition proceeding per se may not resolve uncertainty concerning patent validity very quickly (Hall et al., 2003). Evidence in Figure does not indicate a dramatic drop in “quality” of software patents assigned to firms, but this indicator is a limited one.

13. Patent “quality” appears to increase slightly during 1987-2000 for all SW patents assigned to US firms; trends for SW patents assigned to packaged-SW specialist and Systems firms are essentially flat.

14. Open-source software: Challenge to patents? Open-source software, shared among users, has a long history. –“Shareware” appeared in 1958; UNIX was a “user-driven” SW operating system that evolved into numerous competing standards. –Internet creates new possibilities for “collective innovatoin” without fragmentation of the “dominant design.” Open-source software has expanded its share among users in segments dominated by technically sophisticated users (server, operating systems). –Share remains modest in “mass-market” applications, but it is growing. –“User-driven” innovation that requires highly sophisticated users. Although open-source appears to pose challenges to patented software, the situation is complex: –IBM, a leading patenter in software, has “opened up” a portion of its software patent portfolio to support open-source innovation. But the “crown jewels” in IBM’s SW patent portfolio remain proprietary. –Red Hat, a leading supporter of open-source applications software, now is patenting some complementary products. The “open-source” model thus is likely to incorporate elements of patented, nonpatented intellectual property in the future.

15. Conclusions Patenting in packaged SW has increased since 1987 in response to policy and market changes. –Great example of “co-evolution.” Current data don’t suggest strong links among increased patenting, R&D spending, vertical specialization, or innovative performance in the US SW industry. –Trends suggest that post-1970s change in feasibility of SW patenting => higher levels of patenting. –“Dot bomb” downturn in IT markets appears to have slowed growth in SW patenting. Patenting behavior of packaged-SW specialists contrasts with that of systems firms. –Systems firms account for higher share of overall SW patents. –IBM patent propensity >> Microsoft.

16. Conclusions (2) Citation-based indicators do not reveal declines in the “quality” of large packaged-SW firms’ patents during 1990s. Focus on development of stronger “quality controls” in patent issue, rather than attempting to define a sui generis regime for software (including prohibition of patenting). –Any sui generis regime must (among other things) develop a politically and economically defensible definition of a “software patent,” which may be impossible for such a pervasive technology. –Weakness in existing US procedures affects many “frontier” areas of patenting other than software in which patent-based prior art is lacking.

17. Evolution of the US legal regime for software IP Copyright protection for software endorsed in 1979 by Congress. “Look & feel” cases decided by U.S. courts initially strengthened copyright protection, but later cases (e.g., Borland) limited its reach. –Copyright criticized in late 1980s by Menell for lack of a sufficiently high “quality” threshold; patents viewed as preferable. Software patents (esp. since creation of the Court of Appeals for Federal Circuit in 1982) have been given more favorable treatment. 1994: Stac Electronics decision underscored the importance of patents. 1998: State Street upheld a financial “business methods” patent.

18. Patents & market value Software “specialists”: –R&D stocks negative, nonsignificant. –Patent stocks positive, nonsignificant. –Microsoft dummy variable positive, significant. –“zero-patent” dummy variable negative, nonsignificant. – “Citation/patent” variable positive, nonsignificant for measures of self- citations/patent, nonself-citations/patent.

19. Regression with robust standard errors Number of obs = 278 F( 21, 256) = 9.17 Prob > F = 0.0000 R-squared = 0.3327 Root MSE =.39 ------------------------------------------------------------------------------ | Robust HC3 log_q | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- k_a | -.0414703.1267563 -0.33 0.744 -.2910881.2081475 p_k |.4617576.3048762 1.51 0.131 -.1386271 1.062142 c_p |.0009819.0019889 0.49 0.622 -.0029348.0048985 sc_p |.0237355.0274568 0.86 0.388 -.0303344.0778054 msft |.3807435.0841929 4.52 0.000.2149446.5465425 nonpat | -.1506781.0709059 -2.13 0.035 -.2903113 -.011045 _Iyeara_1988 | -.1394341.1621663 -0.86 0.391 -.4587841.1799158 _Iyeara_1989 | -.3247195.1812059 -1.79 0.074 -.6815636.0321245 _Iyeara_1990 | -.2768279.163821 -1.69 0.092 -.5994362.0457805 _Iyeara_1991 |.0068548.2017079 0.03 0.973 -.3903632.4040728 _Iyeara_1992 | -.3604141.1490577 -2.42 0.016 -.6539494 -.0668788 _Iyeara_1993 | -.339154.1568459 -2.16 0.032 -.6480265 -.0302816 _Iyeara_1994 | -.3029479.1474002 -2.06 0.041 -.5932192 -.0126765 _Iyeara_1995 | -.1641403.1493861 -1.10 0.273 -.4583225.1300418 _Iyeara_1996 | -.3465946.1462781 -2.37 0.019 -.6346563 -.0585329 _Iyeara_1997 | -.492964.155972 -3.16 0.002 -.8001156 -.1858123 _Iyeara_1998 | -.3471741.1651327 -2.10 0.036 -.6723655 -.0219826 _Iyeara_1999 | -.1357026.150038 -0.90 0.367 -.4311685.1597633 _Iyeara_2000 | -.6713705.1798965 -3.73 0.000 -1.025636 -.317105 _Iyeara_2001 | -.5628939.1743057 -3.23 0.001 -.9061496 -.2196382 _Iyeara_2002 | -.6627265.1858164 -3.57 0.000 -1.02865 -.2968031 _cons |.724995.1378405 5.26 0.000.4535493.9964406 ------------------------------------------------------------------------------

20. Systems firms R&D stocks positive, significant at 5-6%. Software patent stocks positive, significant at 2%. Non-software patent stocks negative, significant at 2%. Nonself citations/patent negative & nonsignificant for SW patents, positive & significant for non-SW patents. Self-citations/patent positive & significant for SW and non-SW patents. “Zero-patent” dummy positive, significant. Larger sample; results are still somewhat strange. –Overall, consistent with a pattern of “defensive patenting” in non- software fields? Individual non-SW patents do not enhance firms’ market value. –Patents without citations have no measurable effect on market value.

21. Regression with robust standard errors Number of obs = 9330 F( 23, 9306) = 26.32 Prob > F = 0.0000 R-squared = 0.0915 Root MSE = 1.0075 ------------------------------------------------------------------------------ | Robust HC3 log_q | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- k_a |.0511002.0262129 1.95 0.051 -.0002828.1024832 sw_k |.1531996.06427 2.38 0.017.0272164.2791828 nsw_k | -.0224915.00948 -2.37 0.018 -.0410744 -.0039086 swnsc_p | -.0001004.0011058 -0.09 0.928 -.002268.0020671 nswnsc_p |.011221.0018053 6.22 0.000.0076822.0147598 swsc_p |.0251443.0126252 1.99 0.046.0003961.0498924 nswsc_p |.0274082.0080038 3.42 0.001.0117191.0430974 nonpat |.3165821.0286691 11.04 0.000.2603843.3727798 _Iyeara_1988 |.0626769.0506434 1.24 0.216 -.0365952.1619489 _Iyeara_1989 |.0237409.0534289 0.44 0.657 -.0809915.1284733 _Iyeara_1990 | -.3181831.0561421 -5.67 0.000 -.4282339 -.2081324 _Iyeara_1991 | -.0388334.0576816 -0.67 0.501 -.1519021.0742352 _Iyeara_1992 |.0650597.0550394 1.18 0.237 -.0428295.172949 _Iyeara_1993 |.1528974.0551215 2.77 0.006.0448473.2609476 _Iyeara_1994 |.1000545.053014 1.89 0.059 -.0038646.2039735 _Iyeara_1995 |.3796126.0541267 7.01 0.000.2735124.4857129 _Iyeara_1996 |.3083593.0526239 5.86 0.000.2052048.4115138 _Iyeara_1997 |.2335444.0528645 4.42 0.000.1299183.3371705 _Iyeara_1998 |.0509885.0599157 0.85 0.395 -.0664594.1684364 _Iyeara_1999 |.5805904.0669306 8.67 0.000.4493917.711789 _Iyeara_2000 |.093357.0651828 1.43 0.152 -.0344155.2211295 _Iyeara_2001 |.1465358.0665287 2.20 0.028.016125.2769466 _Iyeara_2002 | -.3268941.0755768 -4.33 0.000 -.4750412 -.178747 _cons | -.1050454.045623 -2.30 0.021 -.1944765 -.0156143

22. Patents and firm market value (caution: work in progress) Based on Hall, Jaffe, Trajtenberg (2000). Another measure of the economic significance of SW patents: How do equity markets value them? Basic model: Tobin’s Q (market value premium over book value) = F(R&D “capital,” Patent “capital”). –Flows of R&D, patents are capitalized, depreciated to create stocks, deflated by firm assets. –Should patents be weighted by citation frequency (i.e., importance)? –How should “self-citations” be treated? Two samples of firms, covering 1987-2002: –Publicly traded SW “specialist” firms (19 firms). –“Systems” firms (larger sample: >620), separating SW and non- SW patents.

23. Development of the US software industry 1945-68: Software largely produced by systems manufacturers. 1969-75: “Unbundling” of software and hardware pricing and sales begins; independent software vendors begin to enter. 1978-93: Development & adoption of the desktop personal computer creates a mass market for “packaged” or “standard” software. 1994-present: The Internet becomes an important market and channel for distribution and application of software. –New low-cost distribution, marketing channels for packaged software. –Expanded areas for application of software as complements to a Web-based service or product. –New possibilities for “open-source” software.