The biotechnology and pharmaceutical industry reluctantly admits that its best intellectual property minds somehow missed the arbitrage business opportunity created by the inter partes review process under the America Invents Act of 2011.

As a result, the industry today finds itself in the crosshairs of a new emerging investment strategy, a predicament that underscores the dangers of the unintended consequences of legislation and why less is often more. Those unintended consequences also may explain why the next round of patent reform has been shelved until after the election as the different stakeholders reconsider their options.

The AIA was teed up in large part as a reaction to the problem of so-called patent trolls, or non practicing entities who don’t make anything from patents and only seek to profit from licensing patents and bringing infringement suits. In the end, however, the legislation took a broader form and the biotech industry signed on to it because of the move to a first to file standard from a first to invent standard. The biotech industry wanted first to file in order to harmonize the U.S. standards with those of other major markets.

“We supported first to file because it was the right thing to do,” said Hans Sauer, the deputy general counsel for IP at the Biotechnology Industry Organization. “It helps make the patent law more predictable and rational. It also defeated secret prior art.”

To get first to file, the biotech industry went along with the creation of the IPR process and the 11th hour addition of the covered business method, or CBM, process at the PTAB. The biotech industry supported the IPR and CBM processes, even though biotech companies didn’t have anywhere near as big a patent troll problem as technology companies who were driving support for the IPR process. It was a decision they would soon regret.

“Whether this was wise, we have no opinion,” Sauer said. “The IPR process is now part of the landscape. It’s the biggest new thing announced in the AIA. It had the biggest transformational effect that we didn’t foresee.”

“Looking back we probably should have foreseen it. Having agreed to a patent review process that applied different claims construction standards than the district courts, it created an arbitrage opportunity. People often look to arbitrage opportunities to build new businesses."

That arbitrage between the different claims construction standards of the Patent Trial and Appeal Board and the district courts created a business opportunity and spawned billionaire Hayman Capital Management hedge fund manager J. Kyle Bass and IP Navigation Group founder and owner Erich Spangenberg’s Coalition for Affordable Drugs.

Bass and Spangenberg’s coalition has now won institution of 7 IPRs against weak drug patents from the PTAB. The seven include 4 against Celgene Corp., and 3 against Shire Plc. The PTAB also has denied four petitions filed by the coalition including three against Biogen Idec and one against Acorda Therapeutics.

Bass and Spangenberg’s coalition has yet to invalidate a single patent and may never do so, though patent market observers say it is likely to invalidate a few.

To be sure, Bass and Spangenberg and their copycats don’t need to invalidate a single patent to make money, because the profitability of their investment strategy hinges on carefully placed short sales of stock of the companies whose patents they challenge.

In the early days, the markets were easily spooked by IPRs and often reacted quite negatively, playing into Bass and Spangenberg’s hands. More recently, investors are taking a more sophisticated view of the IPRs and short selling, which may make Bass and Spangenberg’s strategy a little harder. Indeed, going forward they may have to see an IPR through to invalidation before their short selling strategy pays off.

For their part, Bass and Spangenberg have always stressed that their intention is not to settle as some IPR trolls have tried to do in the past.

Spangenberg has been accused of offering to not file an IPR against a company if it paid him a substantial settlement, but that was before the coalition was created.

Since then, Bass and Spangenberg have pledged to see their IPRs through to a final decision in order to invalidate weak patents.

Interestingly, Bass and Spangenberg have also hitched their bets to the growing public policy issue of ridiculously high drug prices. Spangenberg has even launched a public crusade against the practice of evergreening, which he says is the practice of extending the monopoly protection of a patent by simply filing a new patent for a minor innovation.

“Of course, nobody was thinking at the time that people would exploit the IPR process,” Sauer said. “We spent a lot of time discussing the PTAB process. I don’t remember it being discussed that way. The only thing we had to go by was the old ex partes re-examination process. We thought IPRs would be more numerous than ex partes re-exams. We made the wrong assumption about the kind of people who would bring IPRs. We also didn’t foresee filings of IPRs by generic drug makers.”

Over the past year, the biotech industry has been lobbying hard for some changes to the AIA including an exemption-—some say carve out—-from the IPR process.

Sauer explains it this way.

“One thing not often understood is that we want the exemption for just therapeutics, not the entire industry. The rationale for seeking a limited exemption for approved medicines is grounded in the regulatory and legal framework that already exists.”

The framework he cites was created by the Hatch-Waxman Act of 1984, which created a safe harbor from infringement suits for companies who were doing drug development based on patents. The biotech industry is the only industry that has such a safe harbor, he said.

Hatch-Waxman allows a company to develop a drug without threat of infringement action until its drug is approved by the Food and Drug Administration. After approval, the developer must declare that a patent is either not infringed or is invalid and then face challenges in court.

Sauer said Hatch-Waxman is one of the reasons the U.S. has a more vibrant market for generic drug makers than Europe. Indeed, he said some 90% of prescriptions in the U.S. are for generic drugs.

Biotech companies also have grown concerned that generic drug companies “can use the IPR process to do an end run around the Hatch-Waxman process,” Sauer said.

“The exemption we’re asking for is, if it’s an application for an approved drug, then it becomes subject to Hatch-Waxman. After that, Hatch-Waxman should be the procedure and not the IPR process.”

Other industries including e-commerce and technology oppose giving the biotech industry such special treatment because they too have seen an increase in the number of IPRs filed by competitors and trolls alike.

“I have heard other industries saying we’re suffering too and I can see there’s a reaction to only exempting the pharma industry from the IPR process. Other industries want to make the whole process better.”

Sauer said an exemption was never the first option. “Originally we wanted the IPR process to use the same claims construction approach as the district courts. That didn’t work out.”

A few wise men in the biotech industry believe the IPR process should be scrapped in its entirety, though most see that as very unlikely.

“The IPR procedure went live on September 12, 2012,” said Robert Armitage, a former lobbyist for Eli Lilly Co. and its representative on the Coalition for 21st Century Patent Reform, in testimony to Congress in April. “It has, in its short life, become notorious. In more than one public forum, I’ve advocated for the outright repeal of the IPR procedure. I’ve done so for many reasons, one of which is to make needed room for the far more comprehensive and potentially far more important post-grant review procedure. If the IPR procedure is to survive, it needs more fixing than the laudable administrative measures now being implemented by the USPTO. I believe it needs structural changes that only Congress can make.”

Armitage declined to comment for this article.

In the meantime, most patent market observers say patent reform is highly unlikely before the next election because too many stakeholders have too many competing interests to support new legislation.

The different sectors of the patent market are not as unified as they were for the AIA. The technology industry seems fairly happy with the results of the AIA and the IPR process, which has helped it challenge patents owned by NPEs and sees no pressing need for change.

Similarly, the Innovation Alliance, which includes Qualcomm, Dolby Labs, InterDigital (IDCC), Tessera Technologies (TSRA) and other companies who profit from licensing their technology rather than making and selling products, also is opposed to current patent reform legislation, saying in a June 10 letter to Reps. Bob Goodlatte and John Conyers that amendments to HR 9 don’t go far enough in curbing abuse of the IPR process.

During a conference call with analysts and investors on InterDigital’s third quarter earnings, CEO William Merritt said the company has been working with Qualcomm to explain to lawmakers that the commonly held wisdom about patents "is not fact based." He said InterDigital’s efforts helped to "appropriately" shelve patent reform until after the election.

Brian Pomper, a representative of the Innovation Alliance, declined to comment.

The higher education community, which often relies on NPEs to monetize its patents, has a number of reservations about the AIA and believes that the debate over patent trolls is overblown.

A joint statement from the Association of American Universities, the Association of Public & Land-Grant Universities, BIO, IA, the Medical Device Manufacturers Association, the National Small Business Association, the National Venture Capital Association, the Pharmaceutical Research and Manufacturers of America, the Small Business Technology Council and the Alliance of U.S. Startups and Inventors for Jobs on June 25, said they “stand united in our continued opposition to H.R. 9, the
Innovation Act, as it is currently drafted. The bill needs significant work and should not be considered for floor action in the House of Representatives in its current form. As drafted, H.R. 9 would dramatically weaken intellectual property rights and undermine a patent system that is vital to incentivizing innovation and job creation in our country. The bill also fails to adequately address abusive practices against legitimate patent owners.”

While Sauer and otherd in the pharmaceutical industry see Bass and Spangenberg's coalition, its consumer protectionist proclamations and Spangenberg’s crusade against evergreening as cynical, others see something hypocritical and cynical in the industry’s campaign against Bass and Spangenberg.

“To me all the complaining going on in D.C. now by biotech and pharma companies about Kyle Bass and his IPRs shows hypocrisy and perhaps also political incompetence,” said a lobbyist who spoke on condition of anonymity.

“It may for shareholders also show that the management of these companies should be held accountable for spending so much money lobbying in D.C. and missing the threat of IPR in AIA. The fact that they are pressing hard now for a carve out to exempt them from IPRs proves this incompetence. If these companies believe their patents are so good then why not face IPR challenges on the merits and before they blow much more money on time on FDA approvals?”

Recent activist investor fights with Dupont and Qualcomm suggest that shareholders are unhappy with management decisions on research and development. Whether that extends to their backfired lobbying for patent reform remains an open question.

Jana Partners, the investment manager run by Barry Rosenstein, invested $2 billion in Qualcomm and has been seeking to force management to spin off its chipmaking and licensing businesses. Billionaire Nelson Peltz’s Trian Partners lost in a bid to join Dupont’s board and try to break up the company.

Representatives for Rosenstein and Peltz didn’t respond to requests for comment on their attitude toward companies’ lobbying efforts for patent reform.

The AIA was largely driven by the lobbying efforts of the Coalition for 21st Century Patent Reform, which included representatives from Johnson & Johnson, Eli Lilly & Co., 3M, General Electric Co., Dupont, Caterpillar and Procter & Gamble.

Philip Johnson, senior vice president intellectual property policy and strategy at Johnson & Johnson, and Kevin Rhodes of 3M, didn’t return telephone calls seeking comment.

Gary Griswold, formerly of 3M, declined to comment.

Carl Horton of General Electric, and P. Michael Walker, formerly of DuPont, couldn’t be reached for comment.

Brian Walsh, a representative of the Coalition for 21st Century Patent Reform, couldn’t be reached for comment.

“Shareholders should be upset that just a few patent lawyers acting as lobbyists spent 20 years on patent reforms that created several regimes to challenge patents at the USPTO to only now complain that a hedge fund person is a huge threat because he files IPRs and goes long and short on stocks,” the lobbyist said. “How could these giant companies make such a key mistake in their approach to the rules so critical to their industry and asset values?”

He added that these same biotech and pharma giants overtly create schemes to game the system: reverse payments to generics, evergreening patents, offshoring patents via patent box, and more recently the tax inversion of moving U.S. firms offshore and using the tax savings to buy up more U.S. companies and patents.

“Even the USPTO recognized the hollowness of the ‘profiteering’ accusation that BIO and pharma hurl at Bass,” the lobbyist said. “People get involved in patents to make money to pay back what they spent on R&D and to disrupt the status quo with new products and services.”

—To reach the reporter responsible for this story, please contact Dan Lonkevich at 707 318-7899 or at dan@thepatentinvestor.com