Patent spending

Financial technology battles are spilling over into an unlikely venue: the U.S. Patent Office. Applications are up, disputes are flaring , the lawyers and courts could be busy for years.

By Hal Lux
March 2001
Institutional Investor Magazine

Myles Harrington owns a securities firm and an idea. Of the two, the idea may be the most valuable.

Harrington's small, Pittsburgh-based company, Grant Street Group, helps municipalities and federal agencies auction new bond issues directly to online investors, bypassing investment banks. Three years ago, the company, struggling to become profitable, applied to the U.S. Patent and Trademark Office for a patent on its computerized MuniAuction underwriting system. Last December it finally got one. Now, patent in hand, Grant Street is broadening its business.

Sources say that the company has sent a letter to Thomson Financial, which runs a similar fixed-income auction system, seeking to discuss arrangements that would keep Thomson from infringing on Grant Street,s patent for a "process and apparatus for conducting auctions over electronic networks." Harrington won,t talk about the letter or any other firms he might be targeting, but he's serious about enforcing his patent. "We,re going to raise a war chest and litigate if necessary," he says.

Similar warnings could soon be in the mail all over Wall Street. After virtually ignoring intellectual-property law for decades, the financial services industry is taking out patents in record numbers, hiring lawyers who specialize in the area and filing an increasing number of related lawsuits. It has even revved up its laggard Washington lobbying effort, aiming to impose more order on the whole patenting process. To date, most of the activity has been defensive: Better to buy some protection from the U.S. Patent Office than to face lawsuits or long-term licensing fees.

The developments mark a noteworthy reversal for Wall Street. With notable exceptions , Merrill Lynch & Co. patented and fiercely protected its groundbreaking Cash Management Account in the 1980s , few industries have been as easygoing about intellectual property as finance. Firms gleefully borrowed each others, ideas , copycatting new products almost as soon as they were launched. Indeed, contemporary finance owes much of its success to its embrace of academic breakthroughs like the capital asset pricing model and the Black-Scholes option pricing model, whose authors won Nobel prizes, not patents. Soon, though, the financial industry may begin to resemble the technology business, where patents are a fact of competitive life. In fact, many recent legal cases stem from the financial services industry's increasing appetite for new technologies.

"This is an industry that has not historically sought patents," says Scott Kursman, an assistant general counsel to the Securities Industry Association who works on patent issues.

Staking a claim to intellectual property is now the industry's main goal. No official statistics are kept by the Patent Office, but intellectual-property attorneys estimate that the number of finance-related applications has at least tripled in each of the last two years. Merrill Lynch, which patented its CMA in 1982, received only 12 patents during the 1990s but has 27 applications pending. FMR Corp., the parent of Fidelity Investments, which held no patents until 1999, has obtained ten in the last two years. Vanguard Group still has none, but the firm just hired its first in-house intellectual-property lawyer. And Barclays Global Investors, which hasn,t filed for a patent in more than five years, is debating whether to make the registration of innovations a standard business policy.

"The number of patent applications from financial firms is going up exponentially," says Patrick Romain, senior intellectual-property lawyer at Merrill Lynch. "It's hard to say by what percentage, because at many investment banks it's up from a base of zero. It's a circle-the-wagons reaction for some firms , just patent as much as you can."

Many firms fear that if they don,t lay claim to their intellectual property, others will. Several recent legal actions have stirred the waters, notably a landmark 1998 lawsuit in which State Street Bank and Trust Co. unsuccessfully challenged Signature Financial Group's patent on a mutual fund administration system. State Street had hoped to license Signature,s technology, but when the two sides failed to reach an agreement, State Street sued to invalidate the patent, claiming that such a general process could not be patented. The U.S. Court of Appeals for the Federal Circuit ruled that such systems could indeed be patented.

Though the two parties later reached a confidential settlement, Signature's victory shattered the long-standing notion that most Wall Street inventions could not be protected. Suddenly, monopoly rights to every important financial product and service were , at least in theory , up for grabs. "We thought we could become subject to patent bandits," says the SIA,s Kursman. Adds Josh Wymard, assistant general counsel to the Nasdaq stock market, which received a patent last year for a computer system that performs stock index rebalancing: "It's like the Cold War. Now everyone is trying to lock up what they,ve developed. Patenting is on everyone's radar screen."

Consider the American Stock Exchange. Last year it sued a New York,based financial product development company called Mopex after the latter claimed that some of the exchange's popular stock index products , specifically, real-time-traded funds known as SPDRs , were infringing on a patent that had been filed in 1995 and granted to Mopex in 1998 for a system "administering a mutual fund to permit real-time trading of that fund." Mopex began soliciting payments from the Amex in February 1999, despite the fact that the exchange had been offering one version of the disputed product since 1993.

But Richard Himelhoch, counsel to Mopex, says that the Amex's new versions of SPDRs, introduced after the patent was filed, employ a radically different structure, which infringes on his client's patented system. "Millions and millions are being made by exchanges and market makers trading these products," says Himelhoch. "Patent holders have a right to reasonable royalties." The suit may come to trial this year.

A settlement last year in a major patent infringement case has further stoked Wall Street,s anxieties. After three years of litigation, AT&T Corp. agreed to settle its dispute with well-known patent-portfolio owner Ronald Katz of Ronald A. Katz Technology Licensing, through a licensing arrangement. At issue were the inventor's computer telephony patents for basic customer services like automatic credit card activation and automated fund transfers. Katz is negotiating with more than a dozen financial firms to set up similar licensing deals.

What concerns many Wall Street firms is how exposed they are: Their deep pockets make them logical targets for patent holders and their lawyers. A patent gives an inventor the right to exploit his innovation for a period of 20 years. Once a patent is assigned, only a judge can rescind the grant. "Patent litigation is very expensive. We,ve been told a patent disallowance trial costs a million dollars," says Joanne Medero, chief counsel for Barclays Global Investors. "There's going to be a lot of incentive to settle these cases."

The scope of so-called business method patents has Wall Street worried as well. These patents are by nature general and vague, because they cover processes rather than physical products. Patent examiners who may not understand the intricacies of modern finance could end up granting a company monopoly rights to broad patches of the Street. Certainly, the names of some recent business method patents seem to cover entire financial sectors. Citigroup recently obtained a patent for a "system and method for performing an electronic financial transaction." Nobel laureate William Sharpe,s online 401(k) advice company, Financial Engines, owns the rights to a "financial advisory system."

Obviously, those defending patent holders don,t view licensing demands as mere money grabs. Steven Friedman, the lawyer who represented Signature against State Street, says it's only natural, if shortsighted, for those with a "countereconomic interest" , such as the bankers who prefer the pre,State Street status quo , to argue that patenting has no place in financial services or that the trend is likely to get completely out of hand. "They made the same arguments about computers and biotech," asserts Friedman, who says there's no logical reason to protect any industry from patent laws. "The system has an amazing capacity to absorb new technology."

The stakes can be very high. In 1991 Eastman Kodak Co. was forced to pay $925 million when a court was ruled that Kodak's marketing of an instant camera was an infringement on a patent held by Polaroid Corp. Financial firms and exchanges also have to cope with skittish investors, who tend to shun financial products tainted by even a hint of legal uncertainty. If there,s an ownership dispute, long-term securities, which can change hands several times a day, may be even harder to recall or unwind than physical assets.

Ultimately, the validity of patents rests with the Patent Office's ability to discern true innovation. On that score, the agency so far gets mixed reviews from financial services companies. Even the Patent Office concedes that it lacks experience with financial products. "It is an emerging technology for us, just like the electric motor once was," acknowledges John Love, the office's group director, who supervises the 20 patent examiners evaluating most finance-related applications. "There are growing pains. We,ve been hiring examiners with MBAs. We,ve been building up our patent databases for business."

Fearing that an inexperienced arbiter of financial innovation may grant patents too readily, industry trade groups are trying to give the Patent Office a crash course in finance. The SIA has met several times with senior officials, and the Financial Services Roundtable, which represents many of the largest U.S. banks, securities firms and insurance companies, has formed a business method patents working group. In December it briefed patent examiners in Washington.

Pending legislation could significantly reduce some of the risk to financial companies. Last year two Democratic members of Congress, Howard Berman of California and Rick Boucher of Virginia, introduced the Business Method Patent Improvement Act, which would shift the legal burden of proof to patent holders, on the assumption that even business methods already granted patents were not unique.

For all the current interest, financial patents are hardly new. In 1799 Jacob Perkins received the first financial patent for a device for "detecting counterfeit notes." Other early patents of this kind covered coin-counting machines, interest calculation tables and lotteries. In 1922 a Virginia resident obtained a patent for an innovative insurance system; in 1969 a pair of Massachusetts inventors patented booklets and cards for use in a credit system. By 1972 an Illinois man was able to patent an electronic system for tracking credit transactions.

But it was Merrill Lynch's 1982 award for its Cash Management Account that heralded the modern era of financial patenting. A marketing breakthrough that tied a traditional brokerage account to banklike transaction services, Merrill's CMA relied on computers to transfer idle customer balances into interest-bearing accounts. When competitors launched similar products, Merrill demanded $10 annual licensing fees for each customer account they opened, according to press accounts at the time. (A Merrill spokesman today says the firm merely "approached the infringers.") But the patent withstood legal challenges. In 1983 Dean Witter Reynolds agreed to pay Merrill $1 million to settle an infringement suit. PaineWebber settled in 1984, after a court refused its request to overturn the CMA patent.

Financial patents and disputes remained rare throughout the 1990s. Major institutions like Goldman, Sachs & Co., the New York Stock Exchange and Prudential Insurance Co. received no patents, according to a search of the Patent Office database. Even a growing commercial interest in software patents during the 1990s bypassed finance. Notable exceptions were Merrill, which the database lists as the assignee for 27 patents, and Citigroup, which claims more than 80, including one for a door lock for ATM vestibules.

But the rest of Wall Street lagged. Before the State Street decision, no-holds-barred product stealing , often carried out with creative flair , was an accepted practice. Nowhere was this more apparent than in the booming business of developing new financial instruments. From junk bonds to mortgage-backed securities to over-the-counter derivatives, innovation flourished as financial companies brazenly copied each others, work. They called it "reverse engineering." Academic theories like Black-Scholes and the capital asset pricing model flowed freely from universities to the financial industry, where they provided frameworks for the global derivatives market and the institutional investment business. Innovators might grumble, but they rarely complained publicly and almost never sued. The SIA's Kursman notes that such copying was at times encouraged because a raft of similar products created market liquidity, which was good for everyone.

Of course, investment banks, rush to offer competitive products sometimes clashed with the mores of the new world of high technology. Grant Street,s Harrington says he encountered poaching when his bond auction system went online. "We noticed that some of our prime competitors had thousands of hits on our Web site," says Harrington. The Internet allowed him to identify the competition. Now that he holds a patent, he can challenge imitators directly.

Given the shifts in patent law, openly competitive "sharing" may become an antiquated practice. Says Fish

& Richardson intellectual-property attorney Denis Maloney, "If Black-

Scholes were invented today, one could get a patent on it."

Where will Wall Street's newfound patent awareness lead? "I think it's going to have a monumental impact," says John Burke, legal counsel to the Financial Services Roundtable's technology division. "But I can,t tell you how it's all going to shake out."

Others see the recent surge in interest in intellectual property as the inevitable result of the marriage of high finance and high technology. "We believe we,ve come up with techniques that allow us to automate many things that were previously done by highly paid human experts," says Christopher Jones, head of research and strategy for Financial Engines. "What we,re looking at is a maturation of financial services in general. The business is much more technology-intensive than it was even a few years ago."

"When you bring technology to bear on a process, you create the possibility for real innovation," says Daniel Huttenlocher, a Cornell University computer science professor who collected 17 patents for machine vision before going to work for the San Francisco,

based online institutional trading firm Intelligent Markets. Technologies that most people would assume are ideal for patenting, like robots, aren,t that different from online financial systems, argues Huttenlocher. "You can look at and feel the robot," he says. "But what's important in a lot of robotics is how you use the machine to streamline a process. The analogy to the financial services industry is a good one."

Some financial industry veterans are skeptical of the assertion that technology entrepreneurs are reinventing finance. "The Internet is a communications channel," says Nate Most, the prolific inventor who in the 1980s dreamed up SPDRs, the Amex product that has recently come under fire from Mopex. Most also doubts that many financial firms will be willing to pay substantial royalties to patent holders. "Unless it's a really amazing idea, no one's going to use it," he predicts.

Says BGI lawyer Medero, a former appointments official in the Reagan White House: "I,m a big believer in property. And some people will deserve royalties. The danger is that you give patents to good financial observers rather than to good financial inventors."

"The U.S. Court of Appeals has made it pretty clear that these patents are to be taken seriously," says Paul Berman, an intellectual-property lawyer with Covington & Burling. Adds Grant Street,s Harrington: "There is an uninformed bias that these patents are worthless. But in all subsequent cases involving business method patents, the courts have stood by the patent."

The costs for the financial industry are potentially huge. Should Mopex prevail over the Amex, the exchange would be forced to either pay Mopex royalties on SPDRs or withdraw, or revise, a successful product. Other exchanges and mutual fund companies planning to launch similar exchange-traded products would have to avoid using Mopex's methods or pay up.

The situation is not without irony. "When we started on SPDRs [in 1993], we tried to get a patent," says inventor Most, who has consulted on similar products for such firms as Morgan Stanley Dean Witter and Barclays Global Investors. "But the Patent Office said you couldn,t. If the Amex had been able to patent it, it would have been very profitable."

Katz has also been actively demanding licensing fees for technology he claims as his own. He has a record as an innovator and a vendor to banks: In the 1960s he helped found Telecredit, an early credit- and check-authorization system. His patents, however, cover more general computer and customer service methods that would likely be used in online financial services or traditional telephone call centers.

Katz estimates that he has signed licensing deals worth $300 million in the past five years, and he,s probably just getting started. AT&T, which had battled a patent infringement claim with Katz for three years, losing a U.S. District Court judgment to him in 1999, settled last November for an undisclosed amount. "Katz's success has certainly caught the attention of the financial world," says one attorney.

The AT&T case focused on an interactive voice system , the type of patent that financial firms might argue is vague. "The court didn,t find them vague," says Katz, adding that "the resolution of that case has had a very salutary effect" on his other negotiations. In February First Union Securities agreed to pay Katz an undisclosed fee to license various patents.

There's no word on what financial institution might be next.