07/25/17

Trading on the Outcomes of Patent Challenges Short-Selling Petitioners and Possible Modifications to the Inter Partes Review Process

Trading on the Outcomes of Patent Challenges Short-Selling Petitioners and Possible Modifications to the Inter Partes Review Process

Feng Ye

Imagine investing in a pharmaceutical company A that sells drug B. Before investing, you researched company A and saw its high profit margin and its monopoly over drug B were protected by a patent. Naturally, you were excited about your research results, so you purchase company A’s stock. After purchasing, someone tells you that the patent covering drug B is invalid and he shorted – basically, bet against – the stock of company A. You are confident about your research on company A, so you ignore him. Later, while attending an investment conference, you overhear a hedge fund manager brag about successfully short-selling stock. You eavesdrop closer, as the manager whispers about driving a company’s stock price down by challenging its patents. Later, you find out that the hedge fund manager publically expressed interest in aggressively challenging low quality patents through inter partes review. While researching inter partes review, you find that Company A’s patent covering drug B was just targeted in a petition for inter partes review.

Fearing that the Patent Office would invalidate the patent covering drug B, you panic and immediately sell the stock. Other investors find out about the challenge to the patent and sell, and the stock price of company A falls; the short seller gains, while you lose.

This hypothetical has become a reality to many investors because patents are important to valuation of a company. Third party challengers can seemingly inflict stock-price drop through an efficient patent invalidation mechanism provided at the United States Patent and Trademark Office, while betting against the targeted company’s stock price. Patents have long been recognized as double-edged swords: on one side, they aid and incentivize innovation; on the other, they tie up the future use of the claimed technology. Even Thomas Jefferson recognized the difficulty of “drawing a line between the things which are worth to the public the embarrassment of an exclusive patent, and those which are not.” Consequently and understandably, patent examiners at the United States Patent and Trademark Office (USPTO) sometimes make mistakes about whether a claimed invention is patentable because of ambiguity, misapplication, or misinterpretation of the patent law, or simply the inability to spend enough time exhausting the prior art.

When such mistakes occur and when patent owners assert their invalid patent right to exclude others, the accused infringers often have to challenge the validity of the patents in a lengthy and costly litigation. Recognizing the need for an expedited, low-cost alternative to patent litigations for reviewing certain aspects of patent validity, Congress introduced various patent challenging mechanisms at the USPTO over the years, from ex parte reexamination and the short-lived inter partes reexamination (IPRex) to the new inter partes review (IPR) and post-grant review (PGR) proceedings enacted with Leahy-Smith America Invents Act (AIA). Congress created IPR and PGR (sometimes collectively referred to as post grant challenges) in AIA as expedited, low-cost mechanisms to improve patent quality. These post grant challenges have been generally regarded as successful and necessary.

Because patents can be central to a company’s competitive position, revenue, and the basis from which it can continue to innovate, they can significantly impact the company’s stock and earnings performance. Indeed, for the companies that heavily rely on patents for their market position, news from USPTO regarding their important patents can greatly impact their stock price. Consequently, investors have frequently traded stocks in anticipation of or in response to significant patent events such as patent litigation, a USPTO Office action, patent issuance, and patent expiration. Based on the efficient market theory, such trading is necessary for the market to incorporate the information related to the patents to the stock price and ensure efficient allocation of capital among alternative investment opportunities.

Stock trading is not limited to buying stock or selling the stock that one owns. Short selling, where a person sells stock he does not own, waits for a stock price drop, and buys the stocks back at lower price for a profit, has always been the subject of lively debates, especially during a decline of the stock market. Critics, notably politicians and CEOs, “rail against short selling as a manipulative tool that artificially pushes share prices below their fundamental values” and thus severely limits the ability of the shorted company to raise capital. In sharp contrast, most finance theorists argue that short selling often plays an important role in capital markets. Regulators and academics generally agree that the activities of short sellers are beneficial to the economy when stock prices are rising. One study found short selling to encompass thirtyone percent of all trading for NASDAQ-listed stocks and twenty-four percent of all New York Stock Exchange-listed stocks. Short selling is undeniably an important tool and a valuable trading strategy for stock market participants.

Because short sellers trade on events or information that can drive the stock price down and because patent challenges can negatively impact a company’s market position and consequently its stock price, one may logically conceive a strategy to short sell a company’s stock based on challenges to a few of its critical patents. However, when hedge fund trader Kyle Bass used such a strategy of shorting pharmaceutical companies after challenging their patents, he caused outcry from the pharmaceutical industry and some Congresspersons.

This Comment argues that the combination of patent challenges and short selling, both of which separately confer potential benefits to the society, is socially detrimental and warrants distinctive treatment from acceptable forms of short selling. This Comment also discusses the best ways to constrain and potentially prohibit such short selling strategies.

Part II of this Comment analyzes the short-selling IPR petitioner’s strategy. Questions addressed include whether short-selling IPR petitioners do more harm than good by simply profiting from investors’ fears, whether such instituted IPRs remove the low quality patents from the system to benefit the consumers and the capital market, and how companies and investors will be affected if the short-selling IPR petition strategy was adopted by more hedge funds. Part III examines the available defenses the pharmaceutical industry has to combat such patent challenges, how the USPTO can prevent the challenges, and whether these defenses and mechanisms are adequate. Part IV discusses potential solutions, and implications if adopted, to discourage abuse from short-selling IPR petitioners by using solutions in current legislative proposals. Part V suggests that Congress should allow the USPTO to discourage abuse from short-selling IPR petitioners by using rule-making authority and discretionary authority, rather than seeking a Congressional Act.

98 J. Pat. & Trademark Off. Soc’y 557(2016)

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