Patents in Finance: Non-Obviousness Not Always Obvious
By Christopher Faille
Financial Correspondent
Monday, July 25, 2005
CHICAGO (HedgeWorld.com)—Trading Technologies Inc. has filed a new spate of lawsuits alleging the infringement of its rights under patents issued in July and August 2004.
Lawsuits against Refco, Man Financial, and eSpeed are pending, but TT has reached settlements with many affected parties, including Advantage Futures LLC, a futures commission merchant, and Patsystems plc, a competing independent software vendor (ISV).
The new lawsuit defendants include two other rival ISVs, GL Trade SA and Nyfix Inc., as well as Peregrine Financial Group Inc., a futures brokerage.
Peregrine seems inclined to fight. In an interview Friday, Russell Wasendorf, the chairman and founder of PFG, said that "several patent attorneys have looked at our system and looked at their system and said there's no infringement."
Controversy over the reach of patent rights in the financial or trading context is nothing new. Veterans of these battles speak almost nostalgically of the days when the Wagner patent was the bone of contention Previous HedgeWorld Story, but it does seem to be intensifying.
Under U.S. law, a patent can issue for anything that is novel, useful, and non-obvious. Each of these terms has come under scrutiny in different context, but there seems little doubt that the ladder-type display indicating depth of market that TT has patented is "useful," and since it hasn't been around forever it must once have been "novel." Probably the most intense disputes occur around non-obviousness, which relates to the state of "prior art."
Josh Lerner, professor, investment banking, Harvard Business School, recently coauthored a book about what he believes is the present state of disrepair of the patent system in the United States with Adam B. Jaffe, dean of arts & sciences at Brandeis University, Waltham, Mass.
Mr. Lerner said in an interview that the test of non-obviousness is "in terms of prior art" and "is one of something that would not be obvious to someone who is schooled in the art." He said he was aware of the controversy over TT's patents in general terms but didn't know of it specifically to discuss its merits or its applicability in the instant lawsuits.
Mr. Lerner was more forthcoming about another patent recently in the news, the patent on expirationless options Previous HedgeWorld Story, a new instrument that will begin trading at the Philadelphia Stock Exchange this autumn.
Mr. Lerner said "when you look at the file" of the patent application, "you can see that the patent examiner thinks there's something out there [indicating prior art], but he doesn't know how to find it." This is part of a more general problem, he said: the patent office is under pressure to "maximize revenues while minimizing expenses," so examiners give out too many patents, putting the burden on the courts to straighten it out.
Specifically, Mr. Lerner considers an article by Paul Samuelson, "The Rational Theory of Warrant Pricing," in Industrial Management Review (Spring 1965), an example of prior art. Professor Samuelson pursued the matter in another article in the same periodical that he coauthored in 1969 with Robert C. Merton, "A Complete Model of Warrant Pricing That Maximizes Utility."
Both of these articles speak of "warrants," not of "options." But Mr. Lerner said that someone schooled in finance, in the state of the field in 1969, would have seen the "obviousness" of extending the idea to options.
To this, Vergil Daugherty, the chief executive of Economic Inventions LLC, which has licensed the exclusive patent rights to XPOs to NexTrade, which in turn has reached agreement on listing them with the Philadelphia Stock Exchange, replies that Samuelson-Merton doesn't represent prior art, because they got the idea all wrong. The 1969 paper indicates that the 1965 paper got it all wrong, and the 1969 paper continued to misconstrue the basic concept, by holding that the value of a perpetual warrant would be identical to the value of the underlying stock regardless of the strike price. This, Mr. Daugherty contends, is impossible, because if it happened, then the difference of strike prices would create an opportunity for arbitrage (by definition, an inefficiency), and traders would exploit that until a new equilibrium arose in which the prices of the warrants did reflect the different strike prices. That is, he is confident, exactly what will happen beginning this fall.
Furthermore, he explained in recent e-mails, "none of these papers possessed the required ‘inventive step' of ‘interaction with the real world' required for patentability." He also described the issue of patentability as a "red herring," while the "real issue" about the new instrument is its utility.
Even if it's a scarlet sushi in the big picture, such continued disputes over patents are very much a part of the world of derivatives today.
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