Like their software predecessors in the 1980s and their fallen Internet brethren of the 1990s, managers of financial products and services are entering a brave new world where management of intellectual property assets has become vital to protecting their bottom line. This new management challenge is a result of the steady expansion by the courts of what innovations are subject to patent protection. Not only managers and their counsel in financial institutions such as banks, brokerage houses, stock and commodity exchanges, and insurance companies, but also finance professionals in every industry now need to be versed in how patents can affect their business.
Patentable Subject Matter
To be entitled to a patent, two basic criteria must be satisfied. First, the innovation must be patentable subject matter, which traditionally meant it relates to technology. 35 U.S.C. § 101. Second, the innovation must represent a non-obvious advance over the existing state of that technology. 35 U.S.C. §§ 102 and 103. For nearly the entire history of financial products, patents played a limited role. In fact, for 30 years the battleground of what were appropriate subject matter categories for patents focused on emerging technologies like software and biotechnology. However, the evolution of what are appropriate subject matter categories has now opened the door of the Patent Office to financial innovations.
The Evolving Standard
The availability of patent protection for financial innovations had its roots in the evolving availability of patents for computer software; however, this evolution had inauspicious beginnings. In 1972, the Supreme Court ruled that the computer software method of converting binary coded decimal numbers into binary numbers was not patentable subject matter by equating pure software to a mathematical algorithm. Gottschalk v. Benson, 409 U.S. 63 (1972). Similarly, in Parker v. Flook, 437 U.S. 584 (1978) the Supreme Court ruled that a computer software method of updating alarm limits in a chemical refining process was not made patentable by the addition of "conventional, post-solution applications." These and similar early decisions resulted in the paradigm that software was not patentable and caused the reliance of the burgeoning software industry on copyright instead of patent protection.
In a series of subsequent decisions, however, courts began to chip away at this rule. In 1981, the Supreme Court ruled that a process for curing rubber was patentable subject matter, despite the fact that all of the hardware involved in the curing process was well-known and the only new technology was the controlling software. Diamond v. Diehr, 450 U.S. 175 (1981). In this same year on a different technology front, the Supreme Court ruled that a living organism could be patented Â– in this case a new strain of bacteria having the capacity to degrade crude oil in oil spills. Diamond v. Chakrabarty, 447 U.S. 303 (1981). Thus, 1981 marked the genesis of the expansion of what are appropriate subject matter categories for patent protection, including the possibility of protecting software by patents.
The Federal Circuit Court of Appeals
Soon after these Supreme Court decisions, a change in the court system provided further fuel to the evolution of what are appropriate subject matter categories for patent protection. Prior to 1982, each of the twelve regional federal appellate courts heard appeals in patent cases. The Federal Courts Improvement Act of 1982 withdrew jurisdiction for patent appeals from the twelve regional federal appellate courts and vested almost exclusive patent appellate jurisdiction in a newly created court - the U.S. Circuit Court of Appeals for the Federal Circuit (the "Federal Circuit").[i] Prior to the centralization of appellate patent authority, there was great divergence in the interpretation of the patent laws among the regional courts of appeals. This divergence lead to uncertainty in the application of the law, forum shopping and a general degradation of the value of patents. Legislative history notes the most compelling reason for the creation of the Federal Circuit was to obtain greater uniformity in patent law, thereby making patents more stable and predictable.[ii]
Using the Supreme Court's decisions as a springboard, the Federal Circuit took up the cause of expanding the subject matter categories for which patent protection was available with a vengeance. In 1989, the Federal Circuit found that a voice recognition apparatus made up almost entirely of software was patentable subject matter. In re Iwahashi, 888 F.2d 1370 (Fed. Cir. 1989). In 1992, the Federal Circuit found that the use of electrocardiograph signals to determine a the susceptibility of a patient to a heart attack was patentable subject matter, despite the fact that, once again, the apparatus was nearly entirely software. Arrhythmia Research Technology, Inc. v. Corazonix Corp., 958 F.2d 1053 (Fed. Cir. 1992). And in 1994, the Federal Circuit found that the conversion of waveform data into pixel illumination data for display on an oscilloscope was patentable subject matter. In re Alappat, 33 F.3d 1526 (Fed. Cir. 1994).[iii]
Thus, by the mid 1990s the exceptions had all but swallowed the general rule that software was a mathematical algorithm and nearly all computer software qualified as patentable subject matter.[iv] Because the software industry had over 20 years of development without the need to be mindful of how patent rights affected their business, this expansion of patent protection into the software field was not without growing pains. The Patent Office received few software related applications in this 20 year period, and its library of technological know-how against which a patent application is judged to determine whether it is patentable was inadequate.[v] This resulted in the Patent Office issuing patents for software related applications that covered what the industry believed was in the public domain. In addition, software programmers and managers who had spent their entire career without an awareness of patents suddenly were thrust into dealing with patents as part of their management responsibilities.[vi]
State Street v. Signature Financial Group
It was in this time frame, in March 1991, that Signature Financial Group filed a patent application directed towards a computerized system for managing a mutual fund investment structure that Signature referred to as its "Hub and Spoke" configuration.[vii] In this "Hub and Spoke" arrangement, mutual fund "Spokes" pooled their assets in an investment portfolio "Hub." The "Hub" that held the investment portfolio was qualified as a partnership for federal income tax purposes, thus receiving "flow-through" tax treatment. The mutual fund "Spokes" invested as partners in the partnership portfolio "Hub." This "Hub and Spoke" arrangement allowed for commingling the assets of two or more mutual funds.
When this patent application issued on March 9, 1993, negotiations commenced with State Street Bank for a license.[viii] After negotiations broke down, State Street brought a declaratory judgement action to invalidate the patent. State Street argued that the financial service data processing system was not an appropriate subject matter category for patent protection both because it was merely an algorithm and a "business method."
The so-called "business method" exception to patentable subject matter had its roots in a 1908 Second Circuit decision, Hotel Checking Co. v. Lorraine Co., 160 F. 467 (2d Cir. 1908). There, a method of bookkeeping designed to prevent fraud by waiters was ruled unpatentable subject matter. In so holding, the Court stated, "[a] system of transacting business disconnected from the means for carrying out the system is not [patentable subject matter]." 160 F. at 469.[ix]
On March 26, 1996, the trial court bought State Street's argument, ruling that the patent was invalid. State Street v. Signature Financial Group, Inc., 927 F. Supp. 502 (D. Mass. 1996), reversed, 149 F.3d 1368 (Fed. Cir. 1999). On appeal, the Federal Circuit overturned the District Court. State Street v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1999). The Federal Circuit rejected State Street's argument that the financial service data processing system was merely a "business method" that could not be patented, categorically stating "[w]e take this opportunity to lay this ill-conceived exception to rest." 149 F.3d at 1375. The Court also rejected State Street's argument that the system was merely an algorithm. Thus, the Court ruled that a financial service algorithm that moved electronic funds to take advantage of tax strategies was patentable subject matter.
This decision was widely reported in the press.[x] This publicity lead to a near hysterical rush to the Patent Office to patent nearly anything that could loosely be categorized as a "business method," particularly in the area of e-commerce. Much of this hysteria undoubtedly went too far. All the State Street Court determined was that the excuse that something was a "business method" was insufficient to preclude it as patentable subject matter. An insightful case is Haagen-Dazs, Inc. v. Frusen Gladje Ltd. A.B., 210 U.S.P.Q. 204 (S.D.N.Y 1980). There, the New York creators of the successful gourmet ice cream Haagen-Dazs sued to shut-down a subsequent entry named Frusen Gladje. Despite the fact that both offerings had Scandinavian marketing themes, the court refused to stop Frusen Gladje, ruling that Haagen-Dazs' "unique Scandinavia marketing theme" was not protectable.[xi] It seems unlikely that a marketing theme such as this would qualify as patentable subject matter, even with the demise of the "business method" exception. However, what was largely lost in the post State Street e-patent hysteria was that the innovation which provided the basis for the State Street decision was a financial product, not an Internet innovation.
A Brave New World
Publicity surrounding litigation involving two financial patents may change that focus.[xii] The first involves a patent that the owners' allege covers electronic futures trading systems.[xiii] The patent was granted in February 1990 to Susan Wagner. From 1981-1982, Ms. Wagner was the executive director of the Commodities and Futures Trading Commission. Ms. Wagner first assigned the patent to World Energy Exchange, which was subsequently acquired in the early 1990s by a Dallas based intellectual property company, Electronic Trading Systems Corp. The suit was originally brought by Electronic Trading Systems against the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange and eSpeed, Inc., a subsidiary of Cantor Fitzgerald.[xiv] A partial settlement between Electronic Trading Systems and Cantor removed eSpeed as a defendant, after which eSpeed joined as a plaintiff against the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange.[xv] The Chicago Board of Trade and the Chicago Mercantile Exchange recently settled the case, with each making an initial payment of $5 million and five subsequent annual payments of $2 million, leaving the New York Mercantile Exchange as the remaining defendant.[xvi] Ironically, days after the settlement by Chicago Board of Trade and the Chicago Mercantile Exchange, it was reported that Richard Sandor, founder of the Climate Exchange, uncovered a document related to his work in the late 1960s at the University of California, Berkley, that calls the validity of the Wagner patent into question.[xvii]
The second lawsuit involves a patent that the owners' allege covers certain exchange-traded funds ("ETFs").[xviii] For example, Standard and Poor's Depositary Receipts ("SPDR"), commonly known as "Spiders," are ETFs that hold shares of all of the companies in the Standard & Poor's 500 Composite Stock Price Index ("S&P 500Â®"). The patent itself admits SPDRs predate the patent and therefor cannot infringe.[xix] The lawsuit alleges that a second generation of ETFs, such as the Select Sector Standard & Poor's Depositary Receipts ("Select Sector SPDRs") infringe the patent.[xx]
Select Sector SPDRs are ETFs that hold shares of certain industry segments of the constituent stocks of the S&P 500Â® as opposed to the entire S&P 500Â®. The companies included in each Select Sector Index are chosen on the basis of general industry classification. For example, the Energy Select Sector SPDR includes stocks from, among others, ExxonMobil Corp., Royal Dutch Petroleum Co., and ChevronTexaco Corp; the Consumer Discretionary Select Sector SPDR includes stocks from, among others, Wal-Mart Stores, Walt Disney Co., and General Motors Corp. To succeed in this lawsuit, the patent owner must convince the court to draw a fine line between the SPDR product that the patent cannot cover and the Special Select SPDR products alleged to infringe the patent.
With its roots in biotechnology, evolution from software patents, and growth following the demise of the "business method" exception, what is patentable subject matter has expanded into the financial arena. As with the application of patents to the software industry, the expansion into the financial arena will undoubtedly involve some growing pains. Those banks, brokerage houses, stock and commodity exchanges, insurance companies and other financial businesses whose managers and counsel are versed in how patents can affect their business will be ready for this brave new world.
Copyright 2002 Paul E. Schaafsma (B.S. Engineering, Purdue University; J.D. Loyola University of Chicago School of Law; M.B.A. Northwestern University's Kellogg Graduate School of Management). The author is a partner in the Chicago office of Foley and Lardner, who concentrates his practice on the acquisition, commercialization and enforcement of intellectual property, including financial product patents. He recently published "The Entrepreneur's Guide to Managing Intellectual Property," PSI Research - Oasis Press; ISBN: 1555716172; (March 1, 2002)(available at Amazon.com; barnesandnoble.com). Any views expressed are solely of those of the author.
[i] Federal Courts Improvement Act of 1982, P.L. 97-164, 96 Stat. 25, 28 U.S.C. §1295 (April 2, 1982).
[ii] House Rep. No. 97-312, 97th Cong., 1st Sess. (1981), at 20 - 23.
[iii] This progression also occurred in biotechnology: in 1988, the Patent Office issued U.S. Patent No. 4,736,866, directed at a rodent genetically engineered to grow cancer cells Â– now affectionately known as the "Harvard mouse."
[iv] Remaining categories of unpatentable subject matter are laws of nature, physical phenomena, and abstract ideas. Diamond v. Diehr, 450 U.S. at 185.
[v] This can be contrasted with for example the pharmaceutical industry, where patent protection is sought for nearly every innovation and the Patent Office's library of prior developments is quite thorough.
[vi] This again can be contrasted with the pharmaceutical industry where researchers and managers are often inventors on pharmaceutical patents and have dealt with patent rights their entire careers.
[vii] U.S. Patent Application No. 667,777 titled "Data Processing System for Hub and Spoke Financial Services Configuration."
[viii] U.S. Patent No. 5,193,056.
[ix] See also In re Patton, 127 F.2d 324 (C.C.P.A. 1942)(system of transacting business not patentable subject matter). But see In re Johnston, 502 F. 2d 765 (C.C.P.A. 1974), rev'd on other grounds, 425 U.S. 219 (1976)(an automatic record keeping system claim on a machine (a digital computer) held patentable); Paine, Webber, Jackson & Curtis, Inc. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 564 F. Supp. 1358 (D. Del 1994)(a "Cash Management Account" held patentable).
[x] See, for example, "'State Street' Sets Seismic Precedent," The National Law Journal (September 21, 1998) "What's Next - A Patent for the 401(k)?" Business Week (October 26, 1998); "Barbed Wire on the Internet," Forbes (17 May 1999).
[xi] Because the Court found the two trademarks "Haagen-Daz" and "Frusen Gladje" were not confusingly similar, there was no trademark infringement; likewise, because the Court found the products bore little physical resemblance, there was no trade dress or copyright infringement.
[xii] See, for example, "AMEX in Suit Over 'Open End' Fund Securitization Process," HedgeWorld Daily News, August 22, 2000; "Patent Poses Problem for Amex Exchange Â– Traded Funds," The Wall Street Journal, September 20, 2000; "Cantor Fitzgerald Wins a Round in Patent Dispute," The Wall Street Journal, October 25, 2001; "Patent Dispute Hits Exchange as IPO Nears," Financial Times, May 7, 2002.
[xiii] U.S. Patent No. 4,903,201 titled, "Automated Futures Trading Exchange."
[xiv] Electronic Trading Systems Corporation v. The Board of Trade of the City of Chicago, et al, Civil Action No. 3:99-CV-1016-M (N.D. Texas).
[xv] eSpeed bought the patent for $1.75 million plus stock, amounting to a total of $3 million. "Patent agreement renews fight. (Electronic Trading Jeopardy)," Futures: Mag. Commodities & Options, May 1, 2002.
[xvi] "CME, CBOT to Pay eSpeed $30M in Patent Dispute," Securities Industry News, September 2, 2002. The Intercontinental Exchange also has licensed the patent for $2 million per year, plus an additional 10 cents per order over $50,000 until patent expires in February 2007. "Patent agreement renews fight. (Electronic Trading Jeopardy)."
[xvii] "Sandor's Document May Challenge eSpeed's Wagner Patent," Securities Week, Vol. 29, No. 36 (September 9, 2002).
[xviii] U.S. Patent No 6,088,685 titled, "Open End Mutual Fund Securitization Process." American Stock Exchange v. Mopex, Civil Action No. 00 Civ. 5943 (S.D.N.Y.); Mopex, Inc., v, Chicago Stock Exchange, Inc., et al., Case No. 01c-0302 9 (N.D. Ill.).
[xix] The SPDRs cannot infringe because a patent may not encompass something in the body of preexisting technological know-how against which a patent application is judged under the second criteria for patenting - whether the invention must represent a non-obvious advance in the state of the art. Stewart-Warner Corp. v. City of Pontiac, 767 F.2d 1563, 1572 (Fed. Cir. 1985).
[xx] The other financial products accused of infringement include iShares funds and streetTRACKS funds.