VirnetX (NYSEMKT:VHC) investors had a rough time on Tuesday. The stock plunged nearly 60% in a matter of minutes as a U.S. Court of Appeals decision threatened to destroy the company's sole source of revenue. The court tossed out a $368 million patent infringement damage award against Apple (NASDAQ:AAPL), sending the case back to a lower court.
Management spun the event as a mixed decision. "While we are disappointed that the Federal Circuit has vacated portions of the judgment for further proceedings, we are bolstered by the fact that the patents were again found valid and that it was confirmed that Apple's VPN on Demand functionality infringes the VirnetX patents," said VirnetX CEO Kendall Larsen in a prepared statement. "We look forward to readdressing the FaceTime infringement and damages issues as soon as possible."
However, that rosy-cheeked outlook ignores the large setbacks in this decision.
Federal Circuit judges Sharon Prost and Raymond Chen said that all four of VirnetX's patents in this suit appear to be valid, but that the District Court in Tyler, Texas, misinterpreted many of the patent claims.
In particular, the $368 million in fines rested on two patents lumping Apple's FaceTime video chat system together with secure VPN links. The Court of Appeals disagreed, eviscerating the largest and most valuable portion of the original damage award. Moreover, some claims were stricken from the two patents that were correctly applied to Apple's mobile VPN On Demand feature, undermining VirnetX's damage claims even further.
In plain English, VirnetX was found to have stretched its security patents to cover Apple features that had nothing to do with a strict reading of the same patents.
This is the second market-moving patent case reversal handed down by the U.S. Court of Appeals for the Federal Circuit in little more than a month. In mid-August, the court rejected Vringo's (NASDAQ:VRNG) patent claims about placing advertisements next to online search results. That day, Vringo shares fell more than 70% because the court found the patents trivial and unenforceable.
Chen, who signed the VirnetX decision, also served on the Vringo case. That time, he was in opposition to the final verdict. Now, he agreed with Chief Judge Prost's conclusions and her highly critical view of VirnetX's prospects.
The ultimate poker chip
Investing in patent managers such as VirnetX and Vringo comes with this type of risk. Their business models are built on playing the patent and judicial systems in a certain way, and the companies often hope to get rich on dubious claims.
In Vringo's case, putting two modern and patentable technologies together doesn't produce another innovation worthy of patent protection. Meanwhile, VirnetX wanted to stretch its security innovations to cover a whole new set of ideas.
These approaches might fly in lower courts, but the higher levels of our judicial system are starting to reject them. In some cases, lower-level District Courts side with the defendants as well. This is news in a patent lawsuit market that has led to many seemingly baseless damage awards and avoidable settlements.
That's not to say that every appeals decision will go against the patent holders, or that every accused infringer is innocent.
But the days of easy patent-suit money might be over. I sure wouldn't buy VirnetX or Vringo in the hopes of another sudden reversal. The potential gains in a big court win might be tempting, but there's a very real risk that these stocks will be worth absolutely zero if the courts continue to challenge their increasingly unrealistic patent claims.