How to Achieve Innovation through Outsourcing: Shifting the Paradigm
March 19, 2010 by Bierce & Kenerson, P.C.
Can an enterprise customer get real innovation through outsourcing? It depends. After looking at a case study in contract manufacturing and finance and accounting outsourcing, we can draw some lessons on the squeaky wheel that will need lubrication beyond effective governance.
New Product Development. Recently, Bierce & Kenerson, P.C. was engaged by a global enterprise to assist in a two-phase deal with a supplier. In phase one, the parties entered into an agreement for the joint development of a new type of product to retrofit an old product using new energy-efficient technology. In phase two, the enterprise customer agreed to either buy the new product from the supplier or to pay a royalty for the value of the supplier’s intellectual property and development efforts. The risk of failure was essentially nil, since the enterprise customer could have developed the product alone. Yet it chose to work in tandem with the supplier to achieve a speedier path to market for a hot product with a big potential demand in order to avoid loss of market share to well-financed agile competitors.
The contract development process took much longer than the product development process for several reasons.
o Market Positioning. First, the customer and supplier had not really reached agreement on issues of exclusivity, market positioning and branding. Having already committed resources for joint development of a new innovative product offering to the enterprise’s customers, the enterprise customer lost some of its bargaining power (and actually lost some goodwill in the marketplace) until these issues were resolved in the master supply agreement.
o Financial Viability and Contingency Planning. Second, the supplier was a new entrant into the market, with venture funding but no strong ongoing revenue stream. Financial viability issues challenged the paradigm, requiring careful scenario analysis and negotiation of step-in rights using various sources of goods, services and intellectual property rights. Both parties had different compliance issues arising from separate provisions of securities disclosure laws, including the Sarbanes-Oxley Act of 2002.
o Publicity. Third, the supplier was a publicly traded company for which the new deal would require public disclosure under investor protection laws. The enterprise customer had not focused on managing the public message that might be presented by the supplier. Initially, the supplier was considering issuing messages – through its Marketing Department – that suggested that the enterprise customer could not develop the new product through its own skill, ingenuity, foresight and initiative. The supplier wanted to build its own goodwill on the back of its customer, while the customer wanted an OEM relationship. Modifications of the supply agreement were negotiated so that it would not constitute a “material” relationship for disclosure to investors. This delayed disclosure and thus enabled the enterprise customer to pursue the OEM strategy until after its entry into the new market under its own name.
o Teamwork and Leadership. Fourth, initially, the enterprise customer’s internal teams lacked a management leader to pull together all the participants in a pre-deal analysis of the entire impact. The Sales Department wanted new product to compete with new customers. The R&D Department responded to the Sales Department’s push by offering innovation through joint development with a potential competitor. The Finance Department did not kill the deal even though it lacked a strong business continuity plan. The Legal Department was told that it did not need to bind the parties in one master relationship agreement because deal terms were still being worked out for phase two (production and delivery). As the relationship evolved, the team coalesced and aligned their common interests for achieving, selling and supporting the innovative new product.
New Service Development. Use of third parties to assist in development of new lines of service face similar issues.
o Continuous Process Improvement. It is a best practice in outsourcing deals for service providers to deliver “continuous process improvement.” In designing the outsourcing relationship, the parties need to distinguish between incremental process improvements that come from learning how to be more efficient at a given process, on one hand, and major shifts in business process design that can yield dramatic cost savings. To overcome the hurdle, some dealmakers simply accept that, if there is no measurable “process improvement,” the service provider will drop the price over time in lieu of real process improvement. This is no substitute for true innovation through joint design.
o Intellectual Property. It is a best practice in outsourcing deals to allocate rights in existing and future intellectual property. In advance of a master services agreement, the parties must therefore distinguish between ordinary intellectual property that comes from continuous process improvement and that which flows from some form of capital investment by either party or both parties. Neither party wants to be foreclosed from using improvements or new breakthroughs. The challenge is to agree in advance on scenarios for each case and to provide rewards and governance criteria to minimize disputes on governance as the “innovation” unfolds during the course of the relationship.
o Competition by Service Providers. It is also a best practice for service providers to use “state of the art” service delivery platform – people, process, technology and business processes — to deliver competitive services. In designing their business relationship, the parties to an outsourcing need to distinguish between the service provider’s competitive service delivery platform and the enterprise customer’s unique brand and goodwill in the marketplace. Management of the business reputation and goodwill of each party to a joint innovation project thus becomes a critical contract and business element for negotiation. It requires careful scenario analysis involving business opportunities in new markets and existing markets, capital investment and ROI hurdle rates as well as contractual provisions consistent with applicable antitrust and competition laws.
o Joint Venture. It is a best practice in outsourcing for the parties to expressly disclaim they are in a joint venture. In effect, this eliminates a fiduciary duty to account for profits from the joint efforts. This clause could defeat joint efforts in innovation, since it segregates benefits and promotes potential competition.
Designing Relationships for Innovation. These examples underscore that outsourcing and OEM contract manufacturing cannot be relied upon to achieve “innovation” without a clear business plan. That plan must include the key factors that are considered in any joint venture. Each party needs to focus on its investment, the proprietary nature of its investment and the ultimate uses of those innovations. Ultimately these impact innovation’s on marketing, branding, sales, customer relationships, goodwill, competitive positioning and new product development. The parties need effective communication on evolution of the innovation and how to share future benefits and ongoing investment, if any, in maintenance.
In short, without an innovation strategy, outsourcing is unlikely to yield much other than some cost savings and some gain sharing. In any event, even such a narrow goal risks an inability to reach agreement. The parties must first reach agreement on allocating ownership of any resulting intellectual property rights and understanding the impact on each party’s competitive positioning.
Most importantly, implementing an innovation strategy will require a governance plan for managing collaboration and competition. A governance plan will identify conflicts of interest and principles for collaboratively resolving conflicts.
Patents in Outsourcing: Strategy and Practice for Business Process Patents and International Trade in Services
October 9, 2009 by Bierce & Kenerson, P.C.
Should a service provider develop a patent portfolio? In performing outsourced services, the service provider performs certain business processes that range from information technology to office procedures. Since U.S. courts have interpreted patent laws to make business processes eligible for patent protection, the patent law has played a small but growing role in business process outsourcing. This article addresses some key issues in patent law in outsourcing, including validity, infringement, extraterritoriality and the role of patents in outsourcing.
What is a Patent?
A patent is a statutory monopoly that allows the inventor to practice an invention, to allow others to use the invention under terms and conditions that the inventor considers acceptable and to prevent unlicensed persons from using the invention. Under U.S. law, an invention must be novel, useful and non-obvious to one skilled in the existing “art” (science). It is the specific claims in the specification of the invention that are entitled to the statutory monopoly. In patent applications, claims are written as independent (and therefore unrelated to any other claim) or dependent (and therefore viable only if the related independent claim is valid).
Impact on Competition.
Quite simply, patents stifle competition. For this reason, courts and regulators have adopted limitations on abuses of patents, such as tying the use of non-patented goods or services to patented goods or processes.The Specification.
The patent application must set forth the “specification” that describes the exact scope of an invention and its method of “manufacture” in sufficient detail that it describes what is left to the public outside the scope. Markman v. Westview Instruments, Inc., 116 S. Ct. 1384, 517 U.S. 370, 373 (1996). The specification consists of two parts:
- a detailed “written description of the invention and of the manner and process of making and using it, in such full, clear and concise, and exact terms as to enable any person skilled in the art … to make and use the same.” 35 U.S.C. 112, para. 1.
- a conclusion “with one or more claims particularly pointing out and distinctly claiming the subject matter which the applicant regards as his invention.” 35 U.S.C. 112, para. 2.
General Definition of Patentable Processes.
Patentable process “inventions” must involve a “process, art or method, and include… a new use of a known process, machine, manufacture, composition of matter, or material.” 35 USC 100(b). “Whoever invents or discovers any new and useful process, machine, manufacture or composition of matter, or any new and useful improvement thereof, may obtain a patent therefore,” subject to the patent law’s other provisions. 35 U.S.C. 101.Software Patents.
Software patents have been issued in the United States since 1982, when Merrill Lynch patented a financial transaction software application that links securities brokerage accounts with” cash management accounts.” U.S. Patent No. 4,346,442. While early judicial decisions quibbled that the processing of data was not an eligible process, the courts and the U.S. Patent and Trademark Office have generally accepted the patentability of software.Business Process Patents.
Business methods are the sequence of steps that are undertaken to engaged in a specific business activity. Until 1998, a business method was considered to be an idea, and business methods as ideas were not patentable. In July, 1998, the U.S. Court of Appeals for the Federal Circuit did away with that interpretation of the U.S. patent law. The case, State Street v. Signature Financial, legitimized the patentability of software that Signature had written to enable it to administer mutual funds more efficiently. The software merely embodied a business process. The court’s language was broad enough to embrace any business process (as long as it was new and “nonobvious” and had a “useful, concrete, and tangible result”). Congress has done nothing to restrict this judicial interpretation.
Validity.
Once issued by the U.S. Patent and Trademark Office, a patent is presumed valid. 35 U.S.C. 282. The party who seeks to invalidate a patent or any individual claims has the burden of establishing invalidity. To meet this burden of proof, the party seeking to invalidate must prove the invalidity by “clear and convincing evidence,” a standard that is very high. Helifix Ltd. v. Blok-Lok Ltd., 208 F.3d 1339, 1346 (Fed. Cir. 2000). In making its proof, the party seeking to invalidate may rely upon a variety of arguments. Such arguments may include an assertion that the patent holder engaged in “fraud on the patent office” by failing to disclose relevant “prior art” that would have prevented the issuance of the patent in the first place.
In litigation seeking to invalidate a patent, the first issue is one to be decided by the judge: what is the scope of the claims in the patent? The second issue is one for the jury: has infringement occurred? Markman v. Westview Instruments, Inc., 116 S. Ct. 1384, 517 U.S. 370, 384-391 (1996).
Enforcement of Patent Rights.
Enforcement of patent rights presents problems both for the patent holder and for the alleged infringer. The patent holder risks invalidation of the patent, thereby losing the right to claim royalties from all licensees. The alleged infringer (who may include an unhappy licensee unwilling to pay future royalties) may risk heavy damages.
Doctrine of Equivalents.
Judicial interpretation of patent claims adopt two approaches: literal and interpretive. Under historical case law, the monopoly of a patent claim extents beyond the literal description and covers “equivalents” as well. Applying some judicial discretion in the interpretation of the literal scope, the doctrine thus allows an infringement claim where the differences between the accused device or process and the patent claim are “insubstantial” and represent only “trivial changes.”Prosecution History Estoppel.
Affirming this principle, the U.S. Supreme Court has restricted it by noting that the patent applicant’s modifications to its application forms a “prosecution history” that can serve as estoppel for any purpose under the patent law, not merely relating to eligibility (by narrowing it to deal with prior art). Festo Corp. v. Shoketsu Kinzogo Kogyo Kabushiki Co., Ltd., 535 U.S.722 (2002). At common law, the equitable principle of estoppel serves as an enforceable bar to assertion of a right or claim of right. The Festo decision permits alleged infringers to review the file history and rely upon any concessions or limitations made by the patent applicant as a basis for limiting the scope of the patent claims. Prosecution history estoppel under Festo thus opens the flood gates for competition who read the file history and look for concessions made by the applicant.In Honeywell Int’l Inc. v. Hamilton Sundstrand Corp., 2004 WL 1202997 (Fed. Cir. June 2, 2004), the Court of Appeals for the Federal Circuit ruled that, in the patent prosecution process, the applicant is deemed to have waived the full breadth of a broad independent claim when it re-writes the claim to be more specific. Historically, patent prosecution involves the normal process of writing a “stand-alone” (independent) claim followed by a subsequent dependent claim (relying on the “stand-alone” claim’s basic premise). When the patent examiner rejects the stand-alone claim and asks the applicant to rewrite it to convert the dependent claim into a new stand-alone claim, the applicant may do so. In doing so, the applicant is deemed to abandon the full scope of the original stand-alone claim, and to rely only on the dependent claim.
Under the Festo decision as interpreted in Honeywell, rewriting the dependent claim into an independent claim form, accompanied by abandonment of the original broad independent claim, creates a presumption of “prosecution history estoppel” that nullifies the “abandoned” claim. As a result, patent applicants will probably be more prudent and narrowly focused when considering use of broad independent claims.
For outsourcing, this means that only narrowly defined claims will pass muster. Outsourcing services providers hoping to rely on patent protections will therefore be exposed to greater risks of competition due to lack of broad patent monopoly.
Defenses by Alleged Infringers.
The alleged infringer may allege various defenses, such as:
- non-infringement
- absence of liability for infringement
- inenforceability.
- invalidity of the patent or any claim for substantive or procedural reasons. 35 U.S.C. 282
Extraterritoriality in Patent Law.
Patent law is a creature of the national law. Each country applies its own rules. U.S. patents do not cover the business processes or manufacturing process used in another country. John Mohr & Sons v. Vacudyne Corp., 354 F. Supp. 1113 (N.D. Ill. 1973).
However, goods made abroad using processes patented in the United States are subject to exclusion, upon importation, unless licensed by the U.S. patent holder. Exclusion requires registration of the patent with customs services. Enforcement of exclusion is hardly 100% effective.
Services performed abroad that result in delivery of information in the United States are generally not subject to U.S. patent protection. In that case, where a portion of the services are rendered in the United States, a U.S. business process patent will cover the U.S. portion of the services.
Patent Conventions.
A number of international conventions, beginning with the Paris Convention of 1886, accords certain procedural rights in countries that adhere to them. The World Trade Organization’s Agreement on Trade-Related Intellectual Property requires participating countries to comply with the Paris Convention and certain other intellectual property conventions. WTO members must treat foreign nationals on a non-discriminatory basis in respect of the patent laws. The Patent Cooperation Treaty provides a mechanism by which an applicant can file a single application that, when certain requirements have been fulfilled, is equivalent to a regular national filing in each designated Contracting State. There are currently over 112 PCT Contracting States.
Relevance to Outsourcing.
Patent protection — or the lack of it — can affect the service provider’s ability to perform the scope of work under the outsourcing services agreement. Patents may be relevant to outsourcing, but not necessarily.
Comparative Advantage.
In the field of business process outsourcing, the service provider can achieve competitive advantage by having a patented process, since it allows that provider to perform that process without paying royalties and without patent infringement claims or litigation.Defensive Strategy.
Having a pool of patents can be useful to avoid having to pay costs of infringement litigation and infringement damages. Without any patents, the service provider has nothing to barter in a cross-licensing transaction that could be proposed as a settlement.Branding Strategy.
One service provider uses part of the title to a U.S. patent as the phrase that defines its service brand: “On Demand Process….” [U.S. Patent No. 6,370,676] Public relations consultants and business developers might review the service provider’s patent portfolio for similar defining clues to brand development. Conversely, branding strategists should be consulted for strategic nomenclature of patent applications.Termination for Cause.
Ordinarily, the enterprise customer relies upon the service provider’s indemnity against infringement in lieu of adopting a right to terminate for cause in the event of infringement. Such indemnities are customary. Enterprise customers might wish to consider whether reliance on such indemnification is sufficient as a remedy in case the service provider’s business process is determined to be infringing on some third party’s rights. Similarly, service providers should engage in appropriate research to determine whether their method of performing or delivering the services infringes, or risks infringing, a valid U.S. patent. In either event, the issuance of new patents to cover existing processes could be problematic for the business relationship.
BPO Patent Strategy in Practice: Who Actually Patents What?
We conducted a search of U.S. patents issued to leading outsourcing service providers in information technology, human resources and manufacturing. The results were not surprising.
- ITO and Consulting.
Outsourcers that specialize in managing IT and in consulting services do not hold many patents. Such service providers generally engage in “ordinary” and “well known” business processes that are ineligible for patenting, such as installing, configuring, fine-tuning, hosting and maintaining current versions of some commercial “off-the-shelf” software. Where the customer requires extensive customization, the work product normally belongs to the customer as a special project for a separate fee. Alternatively, the parties agree that the service provider will own and market the work product under agreed financial and operating conditions.To the extent that ITO service providers do apply for patents, the patents tend to be in:
- a niche area (e.g., a system for cashing checks for persons without bank accounts where the customer must engage in some self-service task, U.S. Patent No. 6,038,553), or
- a generic function (e.g., data processing apparatus and corresponding methods for the retrieval of data stored in a database or as computer files, notably, methods and systems to facilitate refinement of queries intended to specify data to be retrieved from a target data collection, U.S. Patent No. 6,678,679).
- HRO.
Outsourcers that specialize in human resources management generally do not hold any patents. For example, a search of two HRO industry leaders showed that neither owns any U.S. patent.
- Business Process Outsourcing.
Business process outsourcing that relies upon software may be a good candidate for patent protection, but only for patenting the software. At this stage, the difference between a software developer and a service provider gets murky. Generally, BPO outsourcers do not pursue patent strategies but use other methods for protecting intellectual property and competitive advantage. Exceptionally, they may patent their software to defend against third party software developers. - Original Equipment Manufacturing.
Outsourcers that serve as contract manufacturers logically focus energy on preserving their rights to conduct “contract manufacturing” in the United States and other countries. Companies such as Celestica, Jabil Circuit, Sanmina-SCI and Solectron have each developed some patents that relate to generic operations, not to specific product designs or manufacturing processes unique to their customers. As to the latter, the contract manufacturers require their customers to license any customer technology used in the manufacturing process, or at least refrain from suing over the contract manufacturer’s use of such process or any equivalents.
Factors Affecting an Outsourcer’s Patent Strategy.
Limitations of a Patent Strategy in Outsourcing.
Patent strategies depend on obtaining global monopoly through global patenting. The limitations on patenting of business methods in a global digital economy suggest that patenting is not the solution for protecting a service providers proprietary processes.
- Costs of Global Patenting.
Assuming that a service provider wished to achieve global exclusivity, it would have to file patent applications in at least the 112 countries that are members of the Patent Cooperation Treaty, in addition to dozens more. The cost of prosecuting and maintaining patents is high, and could be worthless if “copycat” service providers were to infringe virtually all claims except for a few.
- Costs of Prosecuting Patent Infringers.
A “plain vanilla” patent infringement lawsuit costs an estimated $750,000 as a minimum. To such out-of-pocket costs, the patent holder must add the opportunity cost of the executive and technical personnel whose time is diverted towards the litigation process, the portion of their salaries, benefits and overhead allocable to the litigation process, and the costs of enforcing a judgment.
- Uncertainties of Patent Scope and Validity.
The patent application process contains many uncertainties. As to scope, under the Festo doctrine, any concession made by the applicant can be used as an “admission against interest” by a defendant. Patent holders making a concession to the patent examiner in any country may be deemed to have made the same concession in all other countries. Alleged infringers will scour the patent prosecution files in all relevant countries and look for such concessions. As to validity, any prior art (including customary usages of the trade, the technical literature and other pre-existing patents) that is not disclosed to the patent office could jeopardize the entire patent.
- Risks of Counterclaims of Patent Abuse.
In any litigation, the plaintiff risks counterclaims by the defendant. In patent cases, the counterclaims could include antitrust violations subject to triple damages under U.S. law or for simple damages as “abuse of dominant market position” under European Union law. For market leaders, the costs of defending counterclaims can be greater than the costs of pursuing a basic infringement claim. Also, where patent applications fail to disclose substantial prior art the use of the patents to monopolize a field of business activity could arguably constitute patent abuse.
- Inconsistencies of Law, Legal Systems and Results.
Given the exclusive right of each country to adopt its own patent rules, service providers considering a patent strategy must accept the fact that what is patentable in one country might not be patentable in another country. “Whipsaw” in application of legal principles leads to unpredictability and inequity.
- Loss of Secrecy.
Because patents must be published to be enforceable, the inventor immediately loses all secrecy. (Exceptionally, a few patents are not published where interests of “national defense” apply.) Thus, pure “software” or pure “business method” might not be patentable in countries where competitors could use the software or method to perform the same service and export the results to the country that grants patent protection. Given the availability (and advisability) of encryption technologies and privacy methods, the foreign use of the software or method would likely go undetected, with no resulting enforcement of patent rights.
- Gambling with “Best Embodiment” Rules.
Sophisticated businesses -whether service providers or enterprise customers – engage in a game of hiding trade secrets and patenting a business process. The rules of this game are limited by the principle that the patent application must disclose the “best embodiment” of the full process.
- The Business Process Paradox in the Outsourcing Life Cycle.
Both parties in an outsourcing contract should understand the implications of what we call “the business process patent paradox.” Patents owned by the service provider make it stronger against competition and may enable the enterprise customer to enjoy the benefits of the service provider’s innovation investments. Yet, upon termination the customer would need to be converted to a non-infringing process or be given an evergreen patent license usable by the customer or its successor service provider. Perversely, this patent paradox may inhibit the basic efficiencies of outsourcing, namely, scalability, portability, transparency, audit ability and periodic renewal or replacement. One exception applies. In contract manufacturing, the customer might wish to patent its processes in the countries where infringement is most likely, such as by the contract manufacturer at the end of the OEM manufacturing agreement.
Advantages of Trade Secrecy.
Many outsourcing service providers prefer to retain their comparative advantage by using trade secrets. Trade secret protection does not protect against patent infringement. Trade secrets do not provide adequate protection where the trade secret becomes generally known. This risk is high in a digital global economy where information can be copied and stored in many ways that are not traceable to the authorized recipient of the trade secret. Optimally, the service provider will develop and use proprietary software covered by patents. Even then, the patents might not disclose the full process.
Best Practices.
Patents could play a pivotal role in the competitiveness, viability and continuity of services provided by a service provider.
Enterprise Customers.
- Enterprise’s Own Proprietary Processes.
An enterprise customer that wants its service provider to perform “proprietary” business processes will need to consider the impact of that contractual requirement on its own risk profile, its willingness to indemnify the service provider appropriately and its ability to do, or hire others to do, alternative processes that are not infringing. Hiring a service provider to perform such processes might contradict other commercial policies, such as not outsourcing “core” business processes and maintaining certain processes confidential as a competitive advantage, even though such confidentiality is customarily protectible under a non-disclosure agreement. - Due Diligence and Selection Process.
Enterprise customers should ask the service provider for a description and list of all patents that the service provider owns or has pending. - Indemnification.
The customary solution to patent infringement is to require the service provider to indemnify the enterprise customer in case of any alleged or actual infringement by the service provider of third-party patents and other intellectual property rights. - Termination of Contract.
Historically, intellectual property infringement is not an event of default in outsourcing contracts. This situation will probably continue. Other contractual solutions exist that may allow the customer to enjoy the benefit of the contract or to terminate.
Service Providers.
- Due Diligence.
The service provider should ask the enterprise customer about any patents and other protect able intellectual property that the customer would require the service provider to use (or that might be needed to perform the agreed services). As a defensive measure, the service provider should understand the applicability of any customer-owned patents and its impact on its own intellectual property strategies.
- Contract Provisions.
The infringement indemnity may extend to the interaction between the customer and the service provider’s business methods and processes. Appropriate allocation of liability and indemnification should be considered to avoid extending the infringement indemnity beyond processes that the service provider controls.