How Can an Investment Invalidate a Patent?

Persons. 37 C.F.R. '1.27(a)(1) states that solo inventors, in their capacity as individuals, can qualify as small entities. To qualify, an individual must simply not have assigned, granted, conveyed, or licensed rights in the invention, or be under an obligation to assign, grant, convey, or license such rights, to a large entity. Persons who license their rights to the U.S. government resulting from a rights determination under Executive Order 10096 can still qualify as a small entity, however. If, for example, an individual inventor has developed a new airplane engine and already convinced a 500-plus employee firm to license the invention prior to applying for a patent, the individual inventor will be treated as a large entity and must pay the associated large entity fees.

Nonprofits. Under 37 C.F.R. '1.27(a)(3), the nonprofit organization must be either a university or other institution of higher learning located in any country; an organization described in Internal Revenue Service code 26 U.S.C. '501(c)(3) and exempt from taxation under 26 U.S.C. '501(a); a nonprofit scientific or educational organization qualified under a state nonprofit organization statute; or a nonprofit organization in another country which, if it were located in the United States, would qualify as a nonprofit organization under 26 U.S.C. '501(c)(3) or under a state nonprofit organization statute. Furthermore, the nonprofit organization must not have assigned, granted, conveyed, or licensed, or be under the obligation to assign, grant, convey, or license, rights in the invention to a large entity. However, a license to a federal agency resulting from a funding agreement with that agency pursuant to 35 U.S.C. '202(c)(4) does not disqualify a nonprofit organization from small entity status.

Small businesses. Small business concerns are more difficult to evaluate for small entity status. 37 C.F.R. '1.27(a)(2) states that, to qualify as a small entity, a business concern must meet the requirements set forth in the SBA regulation 13 C.F.R. '121, and the business concern must not have assigned, granted, conveyed, or licensed, or be under the obligation to assign, grant, convey, or license, rights in the invention to a large entity. As with nonprofit organizations, a license to a federal agency resulting from a funding agreement with that agency pursuant to 35 U.S.C. '202(c)(4) does not disqualify a business concern from small entity status.

A review of 13 C.F.R. '121.802 indicates that, for patent fee adjustment purposes, a business concern can qualify for small entity status provided the number of employees at the business concern, including affiliates, does not exceed 500. But this regulation introduces two questions: 1) what is meant by “employees”; and 2) what is meant by “affiliates”?

According to 13 C.F.R. '121.106, the number of employees is defined as the average number of individuals employed by the business concern on a full-time, part-time, temporary, or other basis for each of the pay periods for the past 12 calendar months. Where a business concern has not been in business for 12 months, the average number of employees across all pay periods is used instead. Furthermore, part-time employees are counted the same as full-time employees. Although the SBA will generally look at the totality of the circumstances, including factors relevant for tax purposes, when evaluating the number of employees, it can be important for the business concern to properly evaluate its number of employees prior to asserting small entity status.

The definition of an affiliate is found at 13 C.F.R. '121.103(a)(1): “Concerns are affiliates of each other when one concern controls or has the power to control the other, or a third party or parties controls or has the power to control both.” Furthermore, in 13 C.F.R. '121.103 (a)(2): “SBA considers factors such as ownership, management, previous relationships with or ties to another concern, and contractual relationships, in determining whether affiliation exists.” Thus, where Mr. X is CEO of A Corp, which employs 400 people, and is the chairman of the board for B Corp, which employs 101 people, Mr. X's involvement means that neither A Corp nor B Corp qualify as small entities.

The same would be true where a venture capital fund, VCFund, has invested in the above-described A Corp and B Corp and, because of those investments, has either a controlling interest in the companies or can otherwise exercise control over the companies. For example, control may be exercisable where, although VCFund does not hold a controlling interest in A Corp or B Corp, the interest held by VCFund exceed those of other investors in the respective companies.

Although 13 C.F.R. '121.103 (b)(5)(i) at first seems to contradict this last scenario, the exceptions set forth in 13 C.F.R. '121.103(b)(5) apply only for “financial, management, or technical assistance under the Small Business Investment Act of 1958.” The Small Business Investment Act of 1958 is concerned with setting up the Small Business Investment Division of the SBA and sets out specific loan programs, technology transfer initiatives, and the like, but does not discuss reducing government fees generally or patent prosecution costs specifically, nor does it define the terms “financial,” “management” or “technical assistance.”

Unfortunately, a prudent corporation is forced to assume that the exceptions set forth under 13 C.F.R. '121.103(b) do not apply to patent fee reductions. This means that, ironically, many companies which would qualify as small businesses for the purposes of SBA loans and the like may need to pay large entity patent related fees as a result of this loophole in the law. This loophole can be readily fixed by amending 13 C.F.R. '121.103(b)(5) to also apply to patent fee reductions.

Another potentially problematic scenario arises when the invention is licensed to a large entity or the client is subject to a control transaction which makes the client a large entity during the patent's prosecution or while the patent is in force ' if something like this happens, is the client still a small entity? According to 37 C.F.R. '1.27(g)(1), once small entity status is established in a patent application, fees as a small entity may be paid in the application without regard to change in status until the issue fee or maintenance fee is due. Thus, government fees incurred during prosecution, such as extra claims fees for claims added during prosecution, may appropriately be paid as a small entity, assuming the client was, or had a good faith reason to believe it was, a small entity at the time of filing.

In the scenario outlined above, once the patent is ready to issue and when any maintenance fees come due, then the issue and maintenance fees must be paid as a large entity. Fortunately, 37 C.F.R. '1.27(h) is fairly lenient with respect to how unintentional, improper filings as a small entity are treated. According to the statute, any attempt to fraudulently establish status as a small entity, or pay fees as a small entity, shall be considered as a fraud practiced or attempted on the USPTO. Furthermore, improperly, and with the intent to deceive, establishing status as a small entity, or paying fees as a small entity, shall be considered as a fraud practiced or attempted on the USPTO. However, as long as any small-entity assertions are made without any intent to deceive, the improper assertion should not be considered fraud.

There have only been two cases in which improperly paying a small entity fee has been alleged, and the courts in both cases looked to whether the improper filing was done intentionally. In DH Technology, Inc. v. Synergystex Intern., Inc., 154 F.3d 1333 (Fed. Cir. 1998), DH Technology, Inc. (DHT) had paid the small entity issue fee despite, at the relevant time, exceeding the maximum number of employees permitted to qualify as a small business concern. The Court of Appeals for the Federal Circuit, which has appellate jurisdiction of all patent-related matters and is thus highly influential in patent law, was careful to distinguish between unintentional, “good faith” filing mistakes and those that are designed to fraudulently pay the small entity fee while maintaining an enforceable patent. Ultimately, the court remanded the case to the District Court to assess whether DHT acted in “good faith.” Id. at 1343.

In Turbocare Corp. v. General Electric Company, 45 F.Supp.2d 110, the court held that where an informed applicant in the patentee's shoes, operating in good faith, would likely have paid the small entity fee, the invalidation of the patent for such a minor mistake is too dire a consequence to be considered. Thus, it seems that the courts will not consider good faith errors to be fraud, which would otherwise invalidate the patent.

While this result is likely to ultimately benefit most patent holders, it is important to take a step back and look at small entity evaluation not only from a purely legal perspective, but also from an economic perspective. In DH Technology, 154 F.3d at 1343, the Federal Circuit was careful to emphasize the District Court's comment that, to avoid such issues in litigation” … where there is even the slightest doubt about an applicant's entitlement to claim small entity status, the applicant would be foolish not to pay the full issue fee.” Id. at 1343.

Simply put, patent attorneys or agents prosecuting a patent for a client may inadvertently open the client's patent to attack by not properly investigating the structure of the client's business and encouraging the client to pay the large entity fee. While any unintentional mischaracterizations of the business may be excused by the courts, the cost of litigating such an issue for a small business with even a modest patent portfolio is likely to be significantly higher than the additional filing fees.

Ironically, through a simple loophole in the federal regulations, one of the primary groups that Congress intended to benefit from the reduced patent fees may not be able to take advantage of the fee reductions. The small businesses that are the unfortunate victims of this loophole are fortunate that the courts have thus far been lenient in cases where small entity status was improperly claimed but resulted from unintentional error. However, in times when some companies are operating on thin margins and looking to cut costs wherever possible, and in light of the significant fee increases recently announced by the USPTO, the courts may be less willing to view improperly established small entity status as an unintentional mistake.

For most small businesses, if there are any questions about qualifying as a small entity, it is likely to be less expensive to pay the large entity fees up front to avoid the cost of litigating the issue later and to avoid loss of patent rights.

Structuring a venture capital investment is almost always tricky, but if both sides aren't careful, they may inadvertently create problems with any pending patent applications the target company is prosecuting. The U.S. Patent and Trademark Office (USPTO) allows certain parties, such as small businesses (referred to generally as “small entities”), to pay reduced fees. This can be a big benefit to small businesses and individual inventors, many of which have only limited funds with which to prosecute a patent application.

Most patent attorneys and patent agents evaluate a client for small entity status based on the “500 employee rule” ' that is, if the client has fewer than 500 employees, they are a small entity. This rule serves well for a quick “ball park” determination and the elimination of large clients from eligibility, however determining whether a party truly qualifies as a small entity is more complicated. For example, in certain circumstances, a company that would qualify as a small business under the Small Business Administration's (SBA) loan qualification guidelines might not qualify as a small entity for the purpose of paying reduced USPTO fees. Improperly claiming small entity status during patent prosecution can open a patent to attack during litigation, and the cost of defending against such a claim can easily exceed the savings on government fees. Careful evaluation of a company's small entity status is therefore warranted before claiming such status.

Through 35 U.S.C. '41(h), Congress has authorized the USPTO to allow small entities to pay reduced patent filing and prosecution fees. The USPTO has implemented this in 37 C.F.R. '1.27, and 37 C.F.R. '1.27(a) sets forth some basic rules for evaluating when a party qualifies as a small entity. The evaluation is based on three different classifications: persons, nonprofit organizations, and small business concerns.

Persons. 37 C.F.R. '1.27(a)(1) states that solo inventors, in their capacity as individuals, can qualify as small entities. To qualify, an individual must simply not have assigned, granted, conveyed, or licensed rights in the invention, or be under an obligation to assign, grant, convey, or license such rights, to a large entity. Persons who license their rights to the U.S. government resulting from a rights determination under Executive Order 10096 can still qualify as a small entity, however. If, for example, an individual inventor has developed a new airplane engine and already convinced a 500-plus employee firm to license the invention prior to applying for a patent, the individual inventor will be treated as a large entity and must pay the associated large entity fees.

Nonprofits. Under 37 C.F.R. '1.27(a)(3), the nonprofit organization must be either a university or other institution of higher learning located in any country; an organization described in Internal Revenue Service code 26 U.S.C. '501(c)(3) and exempt from taxation under 26 U.S.C. '501(a); a nonprofit scientific or educational organization qualified under a state nonprofit organization statute; or a nonprofit organization in another country which, if it were located in the United States, would qualify as a nonprofit organization under 26 U.S.C. '501(c)(3) or under a state nonprofit organization statute. Furthermore, the nonprofit organization must not have assigned, granted, conveyed, or licensed, or be under the obligation to assign, grant, convey, or license, rights in the invention to a large entity. However, a license to a federal agency resulting from a funding agreement with that agency pursuant to 35 U.S.C. '202(c)(4) does not disqualify a nonprofit organization from small entity status.

Small businesses. Small business concerns are more difficult to evaluate for small entity status. 37 C.F.R. '1.27(a)(2) states that, to qualify as a small entity, a business concern must meet the requirements set forth in the SBA regulation 13 C.F.R. '121, and the business concern must not have assigned, granted, conveyed, or licensed, or be under the obligation to assign, grant, convey, or license, rights in the invention to a large entity. As with nonprofit organizations, a license to a federal agency resulting from a funding agreement with that agency pursuant to 35 U.S.C. '202(c)(4) does not disqualify a business concern from small entity status.

A review of 13 C.F.R. '121.802 indicates that, for patent fee adjustment purposes, a business concern can qualify for small entity status provided the number of employees at the business concern, including affiliates, does not exceed 500. But this regulation introduces two questions: 1) what is meant by “employees”; and 2) what is meant by “affiliates”?

According to 13 C.F.R. '121.106, the number of employees is defined as the average number of individuals employed by the business concern on a full-time, part-time, temporary, or other basis for each of the pay periods for the past 12 calendar months. Where a business concern has not been in business for 12 months, the average number of employees across all pay periods is used instead. Furthermore, part-time employees are counted the same as full-time employees. Although the SBA will generally look at the totality of the circumstances, including factors relevant for tax purposes, when evaluating the number of employees, it can be important for the business concern to properly evaluate its number of employees prior to asserting small entity status.

The definition of an affiliate is found at 13 C.F.R. '121.103(a)(1): “Concerns are affiliates of each other when one concern controls or has the power to control the other, or a third party or parties controls or has the power to control both.” Furthermore, in 13 C.F.R. '121.103 (a)(2): “SBA considers factors such as ownership, management, previous relationships with or ties to another concern, and contractual relationships, in determining whether affiliation exists.” Thus, where Mr. X is CEO of A Corp, which employs 400 people, and is the chairman of the board for B Corp, which employs 101 people, Mr. X's involvement means that neither A Corp nor B Corp qualify as small entities.

The same would be true where a venture capital fund, VCFund, has invested in the above-described A Corp and B Corp and, because of those investments, has either a controlling interest in the companies or can otherwise exercise control over the companies. For example, control may be exercisable where, although VCFund does not hold a controlling interest in A Corp or B Corp, the interest held by VCFund exceed those of other investors in the respective companies.

Although 13 C.F.R. '121.103 (b)(5)(i) at first seems to contradict this last scenario, the exceptions set forth in 13 C.F.R. '121.103(b)(5) apply only for “financial, management, or technical assistance under the Small Business Investment Act of 1958.” The Small Business Investment Act of 1958 is concerned with setting up the Small Business Investment Division of the SBA and sets out specific loan programs, technology transfer initiatives, and the like, but does not discuss reducing government fees generally or patent prosecution costs specifically, nor does it define the terms “financial,” “management” or “technical assistance.”

Unfortunately, a prudent corporation is forced to assume that the exceptions set forth under 13 C.F.R. '121.103(b) do not apply to patent fee reductions. This means that, ironically, many companies which would qualify as small businesses for the purposes of SBA loans and the like may need to pay large entity patent related fees as a result of this loophole in the law. This loophole can be readily fixed by amending 13 C.F.R. '121.103(b)(5) to also apply to patent fee reductions.

Another potentially problematic scenario arises when the invention is licensed to a large entity or the client is subject to a control transaction which makes the client a large entity during the patent's prosecution or while the patent is in force ' if something like this happens, is the client still a small entity? According to 37 C.F.R. '1.27(g)(1), once small entity status is established in a patent application, fees as a small entity may be paid in the application without regard to change in status until the issue fee or maintenance fee is due. Thus, government fees incurred during prosecution, such as extra claims fees for claims added during prosecution, may appropriately be paid as a small entity, assuming the client was, or had a good faith reason to believe it was, a small entity at the time of filing.

In the scenario outlined above, once the patent is ready to issue and when any maintenance fees come due, then the issue and maintenance fees must be paid as a large entity. Fortunately, 37 C.F.R. '1.27(h) is fairly lenient with respect to how unintentional, improper filings as a small entity are treated. According to the statute, any attempt to fraudulently establish status as a small entity, or pay fees as a small entity, shall be considered as a fraud practiced or attempted on the USPTO. Furthermore, improperly, and with the intent to deceive, establishing status as a small entity, or paying fees as a small entity, shall be considered as a fraud practiced or attempted on the USPTO. However, as long as any small-entity assertions are made without any intent to deceive, the improper assertion should not be considered fraud.

There have only been two cases in which improperly paying a small entity fee has been alleged, and the courts in both cases looked to whether the improper filing was done intentionally. In DH Technology, Inc. v. Synergystex Intern., Inc. , 154 F.3d 1333 (Fed. Cir. 1998), DH Technology, Inc. (DHT) had paid the small entity issue fee despite, at the relevant time, exceeding the maximum number of employees permitted to qualify as a small business concern. The Court of Appeals for the Federal Circuit, which has appellate jurisdiction of all patent-related matters and is thus highly influential in patent law, was careful to distinguish between unintentional, “good faith” filing mistakes and those that are designed to fraudulently pay the small entity fee while maintaining an enforceable patent. Ultimately, the court remanded the case to the District Court to assess whether DHT acted in “good faith.” Id. at 1343.

In Turbocare Corp. v. General Electric Company , 45 F.Supp.2d 110, the court held that where an informed applicant in the patentee's shoes, operating in good faith, would likely have paid the small entity fee, the invalidation of the patent for such a minor mistake is too dire a consequence to be considered. Thus, it seems that the courts will not consider good faith errors to be fraud, which would otherwise invalidate the patent.

While this result is likely to ultimately benefit most patent holders, it is important to take a step back and look at small entity evaluation not only from a purely legal perspective, but also from an economic perspective. In DH Technology, 154 F.3d at 1343, the Federal Circuit was careful to emphasize the District Court's comment that, to avoid such issues in litigation” … where there is even the slightest doubt about an applicant's entitlement to claim small entity status, the applicant would be foolish not to pay the full issue fee.” Id. at 1343.

Simply put, patent attorneys or agents prosecuting a patent for a client may inadvertently open the client's patent to attack by not properly investigating the structure of the client's business and encouraging the client to pay the large entity fee. While any unintentional mischaracterizations of the business may be excused by the courts, the cost of litigating such an issue for a small business with even a modest patent portfolio is likely to be significantly higher than the additional filing fees.

Ironically, through a simple loophole in the federal regulations, one of the primary groups that Congress intended to benefit from the reduced patent fees may not be able to take advantage of the fee reductions. The small businesses that are the unfortunate victims of this loophole are fortunate that the courts have thus far been lenient in cases where small entity status was improperly claimed but resulted from unintentional error. However, in times when some companies are operating on thin margins and looking to cut costs wherever possible, and in light of the significant fee increases recently announced by the USPTO, the courts may be less willing to view improperly established small entity status as an unintentional mistake.

For most small businesses, if there are any questions about qualifying as a small entity, it is likely to be less expensive to pay the large entity fees up front to avoid the cost of litigating the issue later and to avoid loss of patent rights.