In economics, arbitrage is the practice of taking advantage of a state of imbalance between two or more markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices.
When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state. A person who engages in arbitrage is called an arbitrageur. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives and currencies.
If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium. An arbitrage equilibrium is a precondition for a general economic equilibrium.
It is hard to dislike the Wall Street Journal's Law Blog. Today a posting by Peter Lattman quotes a Washington Post story with background on the Research In Motion/NTP case. I think it illustrates an interesting market trend. The trend towards exotic arbitrage.
There was never any dispute that Research in Motion Ltd., the Canadian firm that introduced the world to the BlackBerry in 1999, came up with its own technology to power the wireless e-mail device.
But Thomas Campana Jr., co-founder of a small McLean firm called NTP Inc., noticed an uncanny resemblance between the BlackBerry technology and a technology he had developed years earlier.
When he and business partner Donald Stout contacted RIM in 2000 about obtaining a license for the NTP technology, however, they didn’t get a response. (emphasis added)
Six years later, the dispute has been settled, with RIM agreeing to pay $612.5 million to NTP to resolve the patent dispute. I keep hearing the words "nuisance suit" used to describe NTP's action, but for some reason the authors of that sort of text never mention that RIM had an offer of $450 million on the table. Hardly the kind of price one would expect a firm to voluntarily offer to dispose of a mere "nuisance." These authors also seem to forget that a jury found against RIM on 5 patents. They also found that the infringement was "willful." Ouch.
Also remember that RIM was hardly underrepresented. Jones Day and Howrey Simon Arnold & White, RIM's attorneys, are about as big as those guns can get. I wonder what their bill was. NTP spent at least $7 million. The return to NTP after legal fees? Assuming we amoritize the legal expenses equally over the timeframe of the lawsuit, with about a 20% boost to the first year for "start up legal expenses" and minus the 33% cut the patent firm will take, I show IRR returns to equity for NTP of around 1,090%. Wow. Rim, by contrast, took a $294.2 million "litigation charge" back in April of last year. That number seems large to me. I wonder what it is composed of.
How did things get so far? Said U.S. district court judge James Spencer: "It seems to me that some of the folk took it personally, and that's how it got this far." NTP started talking settlement immediately. According to NTP's Donald Stout: "We were always surprised that RIM didn't want to explore settlement. We had a very preliminary discussion after the suit started. They offered us nothing, so we said, 'Here we go.'" Arrogance on the part of RIM? Imagine that.
Of course, the case has stirred up a lot of loud squawking about reforming the patent system in the United States. To some degree I believe these calls are warranted. In other ways, I think this "egregious" case isn't all that egregious. Recall from the text above that RIM had a chance to deal directly with NTP and come to an arrangement (back when the valuations were small and a fairly harmless deal could have been struck). RIM decided instead to stonewall. In this, I think it is quite easy to underestimate the importance of the date. 2000. The high-flying, invincible tech attitude that drove the markets to the outer reaches of the atmosphere also made it easy to blow off a small McLean, Virgina firm writing with patent concerns. (They aren't even in California, for christsakes! How can they be a serious tech company?)
There is an issue in patent law in the United States that is somewhat obscure, but also important. In short, the critical element is that the patent holder has a lighter legal burden to meet than the potential infringer. This is where the arbitrage part comes in.
I define arbitrage a bit differently. I define an arbitrage opportunity as any case where costs, returns or price differs between two choices in an amount in excess of the switching costs. Using cashflow as a criteria, which the Wikipedia definition does, seems wrong to me.
A patent with its potential for injunctive relief, is really an option on an injunction. In fact, options theory is often used to put values on patents via Black-Scholes. One author, Alan C. Marco, goes so far as to develop a real options theory for patent litigation.
All this is a long way of getting to the point that because there is a perceived "mispricing" between patent holders and accused infringers, (the cost of an option on an injunction and therefore some finite level of expected value) is far below the cost to the accused infringer to dispose of the matter. Arbitrage theory would suggest that money will quickly pour into patents with litigation potential. Of course, this is already happening and firms that do nothing but hold patents and litigate them have cropped up. To the extent they have investors to cover the litigation costs for a percentage of the carry (NTP had 20 stockholders in addition to the founders and the founders gave away only about 50% of the ownership in NTP to 20 other shareholders) they already look like a hedge fund.
As conventional arbitrage opportunities begin to thin (that's what happens when you pour money into an arbitrage opportunity; it approaches equilibrium) hedge funds in particular, beset by hyper-expectations they have managed poorly over the last several years, will be forced to look for more creative opportunities. Enron's trading desk took advantage of these sorts of imbalances in the California energy market, which cannot have been designed by anything other than Stanford grads. You cannot have your cake and eat it too in a near-liquid market. Arbitrageurs will eat your lunch, and then happily snack on the cake you were counting on for dessert.
So, what areas might we see big growth in? Anyplace where there are regulatory or other mispricing issues. Patent Litigation Arbitrage is clearly on the rise. (We had one firm recently pitch us on funding a bankrupcy filing for a residual in the assets, not that this is a new thing). And, of course, NTP just woke up the sleeping bears by nabbing an entire year of EBITDA from RIM. Minority Shareholder (Shareholder Activism) Arbitrage (read: Greenmail Arbitrage) is nothing new, but the focus on shareholder rights and the increasing levels of suspicion afforded management in the wake of Enron, SarOx and the like are the incentives here. Hello Carl Icahn. And, of course, SarOx arbitrage (i.e. "Going Private").