The Quiet Tech Risk

[This column was edited later today to remove a statement that Intel reportedly would not support Rambus memory in future versions of the Pentium 4. The source has retracted his statement.]

A short distance from the White House, the federal courtroom was packed yesterday morning. It was standing room only in a sea of suits, save this writer and a law clerk's visiting parents. Imagine the hourly billings! Ken Starr was there. He wasn't working pro bono, and he brought an army. The occasion? In a minute, but first...

... a portfolio update
Last week, this column trumpeted (just once I'd like to say "Flugelhorned" or "Alphorned") our intent to sell shares of S&P Depositary Receipts (AMEX: SPY) ("SPDRs") so we could purchase shares of online lending exchange LendingTree within the next five business days, in accordance with our Foolish trading policy. Mirabile dictu, within moments the after-market price jumped over 6% from the day's $12.30 close! Shares opened up 7.7% in the morning, at $13.25, and closed at $13.99 on almost 2.5 times average volume. Then followed closes of $14.24 and $14.10.

The following morning after our announcement, we sold 120 SPDRs at $107.70. We pulled the LendingTree trigger yesterday, buying 916 shares at $13.709 (how do they do that?), with an $8 commission. Yes, I'm mad we paid more, but that's the price we pay for sharing our trades to the world before we make them. And we're not going to stop putting our real money where our mouths are and telling the world first, whether our decisions prove to be good, bad, or in between. Try to find any other self-styled financial goo-roo that does that.

Back to the program
Why was all this legal firepower assembled in Our Nation's Capital? Patents. The legal rights to exclude anyone else from using your inventions without a license. In a world where technology changes faster than teen fashions, patents are big money. Yesterday, semiconductor maker Infineon (NYSE: IFX) and memory chip technology company Rambus (Nasdaq: RMBS) squared off to appeal last year's trial court patent infringement verdict that went badly for plaintiff Rambus.

Patents can be very important to Rule Breaker investors. We want to buy companies with sustainable competitive advantages, and our strategy recognizes that patents may provide or bolster that advantage. Patents protect intellectual property -- the kind of property innovative companies may use to create new businesses or revolutionize existing ones. Think Qualcomm's (Nasdaq: QCOM) CDMA wireless communications technology, Cree's (Nasdaq: CREE) advanced materials manufacturing prowess, or any monoclonal antibody technology from the companies featured in our most recent issue of The Motley Fool Select. Or our holding Amgen (Nasdaq: AMGN), which would be worth much less today if it had lost its key patent case against Genetics Institute years ago or failed to settle with Johnson & Johnson (NYSE: JNJ) over the shares of ownership of erythropoeitin, the protein forming Amgen's blockbuster anemia drug Epogen.

But any investor whose company uses innovative technology must be prepared not only to see that technology superseded by another more nimble competitor, but to learn that even if your company has the best mousetrap, its patents may not protect it from infringement. In a classic Rule Breaker column, Zeke Ashton laid out the problem. His example? Rambus, one half of yesterday's courtroom battle.

IP companies
Rambus is an engineering research company that holds patents on a revolutionary technology to make computer memory work faster. Its RDRAM became the memory of choice for the first iteration of Intel's Pentium 4 processor, and it now dominates the workstation, performance PC, and gaming markets (through the top-selling PlayStation 2). But it does not dominate the consumer PC market, today lorded over by SDRAM and relatively new DDR SDRAM. Because Rambus believes that those two memory types infringe on its patents, it sued memory maker Infineon. That was the subject of yesterday's appeals court argument.

Like U.K.-based ARM Holdings (Nasdaq: ARMHY), Rambus does not manufacture products using its technology. These companies license their patented technology to others who make stuff, and they provide the engineering know-how to make it work. Typical contract terms involve an upfront licensing fee and then a royalty on products sold that employ the IP. So-called IP companies like ARM and Rambus that do not control their own manufacturing are both blessed and cursed: They can innovate at will, heedless of the enormous costs of switching their own manufacturing, but they are at the mercy of others to incorporate, make, and sell their technology. In short, Rambus needs the memory manufacturers to make its RDRAM.

Because Rambus and ARM are their patents -- their IP -- they must defend themselves without mercy against those they believe infringe their patents, those who would use their inventions without paying for a license. Because investors are at an enormous loss evaluating whether Company X can defend its IP against an Company Y or survive a challenge from Company Z alleging infringement of its patents, stocks of IP companies with any patent uncertainty experience enormous volatility. When Nazomi Communications sued ARM for infringement last week, ARM's stock fell 23% in three days. When CertCo sued PayPal (Nasdaq: PYPL) for infringement, it delayed PayChum's February IPO.

Ditto Rambus. Zeke described Rambus's big loss last year against Infineon in the trial court: The court "not only ruled that the Rambus patents were not infringed upon, but also found that Rambus had committed fraud in its dealings with an industry group that was working on developing common standards for the memory industry in the early '90s, and ordered Rambus to pay $3.5 million in punitive damages (later reduced to $350,000). Rambus stock fell from the low $40s in March and drifted lower as news leaked out that the trial was not going its way. (Rambus's stock is under $10 as of this writing [July 2001], a loss of more than 75% of its value.)"

The appeal
Rambus and Infineon both appealed aspects of the trial court result with which they disagreed to the specialized appeals court that hears all patent appeals. The theory is that by concentrating this highly technical area of law in one Court of Appeals for the Federal Circuit, the judges will make better decisions, providing clearer rules and lowering business risk.

The oral argument was great theater. Former Bush Administration Solicitor General and Clinton Independent Counsel Kenneth Starr, for whom I have great professional respect, delivered an argument that was long on rhetorical hiccoughs and short on substance. Yes, I am a Rambus shareholder, but I'll bet even Infineon partisans agree. But theater aside, appeals courts decide cases on written briefs and the trial court record, and in our system it's always harder to persuade judges to overturn a lower court ruling than to sustain it.

And Rambus shareholders are already losers, down by my calculations roughly 5-10 cents a share in earnings lost to legal fees, their stock suffering due to uncertainty. This money cannot be replaced, and the drain may  continue. That Rambus and Infineon did not settle means that one or both of the parties is fighting to the death, and there are other suits -- Micron has sued Rambus, and Rambus has cases against combinations of Micron Technology (NYSE: MU), Infineon and Hynix in Germany and Italy. Settlement is always the preferred outcome, and with Rambus, it seems farther away.

I cannot predict what the court will do in this case, but I do know one thing: No matter who wins here, everyone will keep fighting and spending money on lawyers until they negotiate a settlement. Settlement is best for everyone. Short of that, though, IP companies have no choice but to defend patents and fight. Rule Breaker investors thinking of investing in them or any newer companies with innovative technology need to take patent risk into account. It's not the place for retirement money or money for your children's education, to say the least!

Want to see sparks fly? It's just a short click to our Rambus discussion board, where I go to learn the real skinny on the company, technology, and industry, from legal experts to computer industry insiders. Be warned: Thick skin's sometimes required. Do you think IP companies like Rambus and ARM have a future? Let us know on the Rambus board and the ARM Holdings discussion board.

Have a Foolish week! Updated portfolio returns below. 

Tom Jacobs (TMF Tom9) is happy to report that he has no intellectual property risk. At press time, he owned shares of Rambus and ARM Holdings. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 6/03/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      -6.01%**   -3.98%   --      -5.95%
Month     -2.95%**   -2.48%   --      -3.29%
Year     -20.03%**   -9.35%   --     -19.89%
CAGR***
 since 
 8/4/94   23.48%     11.03%  12.93%   10.39%