David S. Rose got a nasty surprise last month when he opened a thick envelope from E-data Corp. in Secaucus, N.J. Rose, chairman and CEO of a New York Internet-software startup, Ex Machina Inc., was told that his company might be infringing E-data's patent on electronic commerce. He knew from earlier press reports that E-data had sued a dozen other companies over similar claims, so he took the threat seriously.
E-data was making a bold attack, saying it was due royalties for a broad range of online transactions. The patent, if valid, could net E-data millions of dollars, Rose realized. And if other patent holders followed E-data's example, a wave of aggressive patent enforcement could stifle commercial activity on the Net.
But as Rose studied E-data's patent, something about the terrain it covered seemed disturbingly familiar. "I'm not a lawyer," Rose says, chuckling, "but how can you get a patent on something that already exists?"
PROPER REVIEW? Rose quickly determined that the patent didn't apply to his company, but he had news for the lawyers wrangling with E-data's claims. He remembered a small startup called Telephone Software Connection in Torrance, Calif., which let users of Apple II computers--including Rose--download programs automatically over telephone lines. The idea was supposed to be covered by E-data's patent. But Telephone Software, which is no longer in business, was doing it in 1980--three years before E-data's patent was filed. If a patent's claims cover technology that existed previously, a judge can render it invalid.
Today, as the Internet expands by leaps and bounds, E-data's claims strike many experts as both obvious and overly broad. They fear that many more patents like it may be lurking--unexploited--in the portfolios of giant companies that collect software patents like shells on a beach. That's one reason E-data's legal battle has riveted the attention of software and patent experts across America and spawned discussion groups on the World Wide Web.
A central question is whether E-data's application received proper review by the patent office. U.S. District Court Judge Barbara S. Jones will begin to dig for answers next month, when E-data lawyers explain in court how the activities of 14 software and publishing companies it has sued infringe its patent. The defendants--a who's who of software and publishing powerhouses, including CompuServe, Broderbund, Ziff-Davis, and The McGraw-Hill Companies (owner of BUSINESS WEEK)--will argue that E-data's patent echoes ideas that were current in the marketplace prior to 1983. That was their legal strategy even before Rose made the link with Telephone Software Connection. Rose simply gave the publishers' lawyers more ammunition.
If the patent office had searched more widely, it would have found numerous press write-ups on Telephone Software Connection, founded by entrepreneur Ed Magnin in 1979. In 1980, for example, Popular Mechanics went so far as to predict that Magnin could be "the first in a long line of industrious computer-age merchants." Magnin himself is eager to tell his story. "E-data is trying to stifle electronic commerce," he says. "I don't think the government is going to let them."
Even critics of E-data's patent, however, respect its author's intelligence and energy. In 1983, in 36 pages of painstaking detail, inventor Charles C. Freeny Jr. sketched out his idea for a network of "information manufacturing machines" that could swap encrypted digital information over phone lines. The language of the patent defines this information as the content of "tapes, videodisks, handheld calculators, handheld electronic games, greeting cards, maps, and sheet music," and it also specifies digital payment schemes. Says Calvert D. Crary, a litigation analyst at securities firm Auerbach, Pollak & Richardson in Stamford, Conn.: "This guy definitely had an insight."
In 1989, Freeny sold the patent to an electronic distribution company called Avedas Inc. When that company foundered, the patent was bought by another startup, Interactive Gift Express, which later changed its name to E-data and is now devoted exclusively to exploiting the Freeny patent.
The company is a lean, three-person operation run by retired investment banker Arnold Freilich. Convicted of stock fraud in 1978, Freilich was barred from stockbroking. But as CEO of E-data, he has racked up some early successes with the Freeny patent. In September, 1995, after months of negotiations, he persuaded IBM to sign a license. Freilich also struck a deal with graphics software giant Adobe Systems Inc. and others. IBM and Adobe say the agreements prohibit them from discussing the terms of their licenses. But information from E-data states that, in general, fees may range from a few thousand dollars up to $40,000 a year.
Hardly a mortal burden. Still, Freilich's modus operandi has incensed many of the companies he has approached. E-data has sent out 25,000 glossy information packages containing copies of the Freeny patent, licensing forms, and other materials. Freilich dubs the mailings "amnesty packages," because they offer discounted licensing terms to companies who sign early--before they are sued. "We are not out to undermine the world, destroy the economy, or hurt small companies," says E-data lawyer and patent-litigation veteran David Fink. "We just want reasonable royalties."
CATCHING THE BUG. But patent attorney John P. Sumner of Merchant & Gould in Minneapolis calls the whole approach "flippant." Usually, he says "a patent holder has a clear idea that a company is infringing before it sends out notice."
Even if E-data's patent is overturned, as seems likely, disputes over software patents won't disappear. Some 20,000 software patents were granted in the early '90s, and more than 7,000 will be issued this year (chart, page 65), says Greg Aharonian, founder of Internet Patent News Service. Many, like the Freeny patent, get approved without due consideration of related technology, or "prior art," Aharonian charges.
Until recently, most software patents were held by huge hardware companies such as IBM, Motorola, and Fujitsu. But those companies often didn't exploit them. Now that's changing. IBM has begun to license its patents more aggressively. And software goliath Microsoft Corp. has caught the same bug. Half of the company's 140-odd patents were obtained in the last two years. Whatever the outcome of E-data's lawsuits, software patents have come of age: In the eyes of many managers, they are simply too valuable to leave unexploited.