Intellectual Property: A Discussion

June 18, 2007

Intellectual PropertyIntellectual property (IP) has emerged as one of the biggest issues in the indexing space. Cases like Dow Jones & Co. v. International Securities Exchange, Inc. have challenged the idea that index providers can charge licensing fees on products related to their indexes. Already, a federal appeals court has ruled that providers do not have those rights for options tied to index-based ETFs; many think there could be additional challenges to index-related IP rights in the future.

The Journal of Indexes convened a focused panel on the topic at the Information Management Network World Series of ETFs conference in Miami, Florida, on March 26, 2007. The following is a synopsis of that panel discussion.

At the conclusion of the panel transcript, Hartmut Graf provides a separate analysis of the state of index IP rights in Europe, where index developers face perhaps an even more immediate challenge.

Jim Wiandt, Journal of Indexes (Wiandt): I think everyone is aware that there are a lot of significant developments happening in the industry right now in terms of intellectual property. There are some things that are in flux, and the business has shifted around as well. Today, we’ve pulled together some of the leading thinkers in this space, and we have plenty of questions for each them.

Let’s start with Cliff Weber. Cliff is executive vice president of development and strategy at the American Stock Exchange (AMEX). The AMEX has been at the center of some of the main intellectual property disputes in the industry. The one I remember most famously is the Mopex lawsuit, which to me at the time was the epitome of the frivolous money-hunting lawsuit.

The AMEX had been trading ETFs for years, and Mopex filed a patent on the ETF structure, and then sued the AMEX for violation. Fortunately, the case came out the right way … after a lot of time and effort.

Cliff Weber (Weber): Actually, in the Mopex case, they didn’t sue us; we sued them. The way they had written the claims in their patent, they actually excluded the SPDRs and the UIT structures (trading on the AMEX at the time). But as the exchange where ETF activity was occurring, we felt like we had to make sure that there weren’t impediments to the evolution of the ETF marketplace. That’s why we went after Mopex.

I agree: it worked out the right way.

The AMEX has been involved in index IP issues for a long time. In addition to listing ETFs and other products on the exchange, we have our own indexes that we create, publish, calculate and use as the basis for index options trading and other products (including ETFs).

I think one of the key things that has happened since I’ve been at the AMEX has been the way that business method patents have gained acceptance. Everyone talks about the explosion in ETFs, but the number of business method patents out there has exploded as well. Since the State Street vs. Signature Financial case, which gave the imprimatur to business method patents, the number of patents has just exploded.

I think exchanges and other financial parties are increasingly turning to intellectual property as a way to protect the investments they have made in developing new products and getting them out into the marketplace. You can see it in the ETF space in terms of the numbers of patents that have either been applied for or issued to everyone from Vanguard to Bank of New York to Deutsche Bank to the AMEX. Even index providers have filed patents. Going forward, with all the things that have been applied for, there are going to be conflicts, and it will be interesting to see just how things resolve themselves.

Wiandt: I want to bring Jon Mazer into the conversation. Jon is a partner at Fox, Horan and Camerini in New York. He wrote an article in the Journal of Indexes that really summarized what is going on in the industry and talked about some of the case history and what that might mean. Jon has been researching all the case law and the history, particularly around the ISE lawsuits and the right of indexers to license various tradable products.

Jon, I was hoping that you could give us an overview of the case history, and your view on what the open issues are and how things could evolve going forward.

Jon Mazer (Mazer): Let me start in the beginning. Back in 1919, there was a case called INS, which was the first case that really spelled out the concept of misappropriation. One news service was gathering information that was time–sensitive, and was transmitting that information over a wire. Another news service took that information and sold it to somebody else for a profit. This case went all the way up to the U.S. Supreme Court, which crafted a tort out of this fact pattern called “misappropriation.”

In the early 1980s, before ETFs existed, there wasn’t much going on in indexing besides Vanguard’s S&P 500 fund. But at that point, there were two significant decisions that the index providers prevailed on. One was in New York, called Comex; another one was in Chicago, called the Board of Trade. In the Board of Trade case, the Supreme Court of Illinois held that it was a misappropriation to create a futures contract that was directly based on the Dow Jones Industrial Average without licensing that index from Dow Jones & Co. At that time, Dow Jones had not licensed that index for a competing product.

The original INS misappropriation case had focused on the fact that one service took a product from a competitor; a fact which could have forced that initial product to shut down. In Board of Trade, the court found that the listings of these new products would not impact the long-term viability of the Dow Jones Industrial Average; after all, they weren’t competing with any other product offered by Dow Jones. Despite this, the court ruled in favor of Dow Jones, and prevented the product from being created.

Wiandt: On what basis did they rule?

Mazer: In Board of Trade, the Supreme Court of Illinois ruled that it was a misappropriation of the index provider’s rights to make a product based on the make-up of an index without the permission of the index provider.

The index providers brought a similar claim in a case called Comex in New York, which centered on the attempts by one exchange to launch a futures product tied to the S&P 500. In that case, the court granted a preliminary injunction against the futures contract based on two facts: First, the judge ruled that there was a misappropriation of the index; and second, it ruled that there was a risk of public harm if the products were allowed to list. The judge worried that, if he didn’t grant a preliminary injunction while the dispute was pending, and if Comex went out and sold the product, people who purchased those contracts could be harmed if a judge instituted an injunction at a later date.

The case went up to appeal to the Second Circuit, where the court upheld the preliminary injunction, not because of misappropriation, but because of the potential public harm.

Those two cases were the basis for the next 15 to 20 years of IP index law, during which the index providers refused to let firms create products based on their indexes unless a licensing fee was paid. The index providers also engaged in a practice of licensing some of their products in exclusive fashions. Even if companies were willing to pay for it, they could not get a license. This has resulted in what appears to me to be tens of millions and probably hundreds of millions of dollars in revenues to the index providers.

What you see in this decade is that the number of index products has increased dramatically, and we have some further litigation over the subject of licensing fees. The index providers have in several cases sought to expand the scope of those earlier holdings, but they have been unsuccessful.

Case number one concerns options on ETFs, the Dow Jones vs. ISE case. The court looking at that issue said when there is a licensed ETF, the index providers have no intellectual property rights that extend to prevent the trading of options on that ETF. There’s also a case in which the court held that facilitating trading in ETFs is not a misappropriation of the index providers’ intellectual property rights in the make-up of their index.

In sum, the earlier cases were quite favorable to the index providers. But over time, the index providers have sought to expand their rights to other areas, and the courts have said no, we’re not going any further. Most recently, in the Dow Jones vs. ISE case, the court said, or implied, that it viewed the findings even in the earlier cases as somewhat questionable. I think the ISE correctly picked up on that theme and has recently brought a very direct challenge to the scope of the index providers’ rights by challenging their right to collect license fees on options traded, not against ETFs, but directly against the index.

Where is it all heading? My feeling is that the trend is going against the index providers, although it still can go a variety of ways. Most of this litigation has concerned the Dow Jones Industrial Average and the S&P 500, the two most popular indexes. My feeling is that these indexes are in a weaker position than less well known indexes, because one of the issues in deciding whether the index provider has these rights is the question of whether the index will continue to exist if people are allowed to launch products without paying the licensing fees. I think a reasonably strong case can be made that the Dow and the S&P 500 will continue to exist. I think that there are lots of other indexes, though, that might disappear without licensing revenues.

Also, none of these cases concern mutual funds or ETFs … yet. There could be distinctions between the options and future contracts, and the ETFs and mutual funds, which are less directly linked to the index itself.

Wiandt: Al Neubert, who has worked at Dow Jones and has been a member of the Index Committee at S&P, has worked on these issues for some time. Al, what’s your view on some of the things that Jon said, and on where the rights to charge licensing fees stand for index providers?

Al Neubert (Neubert): I have a very strong viewpoint on this, as I was involved with one of the original cases, S&P vs. Comex. There’s one technical aspect to that case that hasn’t been discussed: Comex actually created its own index, the Comex 500, which was essentially taking the S&P 500, subscribing to S&P publications to get the weightings, and then calculating its own index. The issue became: Can somebody really do this on their own and come up with exactly the same thing?

The analogy I always bring up is this: We know Coca-Cola claims it has a secret formula locked up in a vault in Atlanta. Can somebody create exactly the same beverage that Coca-Cola does? The testimony given by S&P proved that indeed nobody can; you cannot replicate the exact values of the S&P 500, even using the weights supplied by S&P. It is that difficult. It all is a case of the timing and the weightings, which are determined by intellectual input from the index provider. These index providers have very large staffs who scour company data to come up with those weightings. It’s not obvious. If I were to ask everybody in this room to come up with the number of common shares outstanding of General Motors, we’re probably going to come up with as many guesses as there are people. The pricing and the timing of pricing calculations between different systems is another variable that makes it impossible to accurately replicate index values, even if you have the same shares outstanding in two index portfolios tracking the same index.

That is really the premise behind this: It really is intellectual property, because somebody really has to go through a lot of work to determine what those weightings are and to keep them updated in terms of corporate actions. So that was the crux of the argument.

People say we don’t need a license because this stuff is publicly available. I argue: Why is it that you want the S&P 500 or the Dow Jones 30? Why don’t you create the Amex 500 or the Comex 500? There’s a reason for the value in that name that’s been built up over time. And this notion that index providers make millions of dollars didn’t seem to prevent Bill Gates from making billions of dollars in licensing software. So I don’t think it’s an economic issue of greed on the part of index providers. I think it’s a real issue of intellectual property and misappropriation.

Wiandt: Let’s go to Andrew Deutsch, a partner at DLA Piper with a focus on intellectual property. Most recently, Andy has been involved in probably the most prominent lawsuit in the industry right now, which is the ISE vs. Dow Jones case involving options on ETFs. The question for Andy is: Should there be any right to use publicly available indexes or other IP, or to charge licensing fees on financial products? What are the key boundaries and distinctions in those rights?

Andrew Deutsch (Deutsch): Let me start with a disclaimer, which is that I’m speaking for myself, not for either the ISE or any other client, and that I am trying to talk as a student of the law.

I’d like to play off of what Cliff was talking about. We have patents, copyrights and trademarks, and we have patent, copyright and trademark laws made by Congress after a lot of deliberation and after all the interested parties have been heard from. For example, the prevailing copyright act is the Copyright Act of 1976, which took 14 years of hearings and many different bills to pass.

The problem with the misappropriation theory in a broad sense is that it’s made by individual judges on individual facts, but these judges are not in the same position as a legislature to hear and weigh everything. The courts have a specific set of facts in front of them, but then they declare a very broad principle, which later courts end up having to apply.

There are a number of different policies at stake, in my view, when you talk about intellectual property protection and misappropriation. On the one hand, you have the policy that came out of the Dow Jones case in Illinois in 1983, where four out of seven judges said we’re going to favor the idea of allowing more indexes to flourish by creating a broad protection. But three out of the seven justices said no, there’s no direct competition here. Four to three. Also, that particular precedent doesn’t bind anybody except other Illinois judges. So the question remains entirely open, for example, in the current case that is pending in the Southern District of New York, for the judges to take a different position. Contrast that with copyright, trademark and patent law, which is national, and where judges everywhere have to follow it.

So there’s a real problem in placing your trust in misappropriation law. Fifty states have 50 misappropriation laws, and in most of them, they don’t even have judicial precedents. As a basis for intellectual property protection, I’d be concerned about that if I were defending the intellectual property rights of index providers.

When Congress enacted the copyright law, it said that facts that are published are free for everybody to use; states can’t regulate them. But most of the claims that you can bring under the misappropriation rubric are deemed preempted; in other words, you can’t bring that state misappropriation claim, you can only bring it as a federal copyright claim. And that issue is essentially the gist of what’s going on in the current index options case. What ISE is arguing is that index options are settled on the basis of one number published once a month, and that that number is the only thing they’re taking. That is really a claim of copyright, not of misappropriation, and it’s not a valid copyright claim because you can’t copyright facts.

There was a decision last year that was out of the Southern District of New York, the ICE case, which held exactly that position in the context of settlement prices for crude oil. ICE essentially made all the same allegations that the index providers would make: we create these settlement prices through creativity; we decide should it be this price or should it be that price. They said we really have a copyright on this. Well, they lost. The courts said you don’t have a copyright; that’s really just a fact you’ve published; and other people can use it for a settlement basis.

Wiandt: Has that been appealed?

Deutsch: Yes, it is under appeal. But do you know what’s not under appeal? That it’s being phrased as a copyright claim. The argument on the other side is it’s copyright-able, but nobody’s arguing that this isn’t really something that ought to be brought as a copyright claim. And if that’s the case, that’s probably three quarters of the ISE’s argument in its lawsuit with Dow Jones and McGraw Hill.

So you have a copyright law, which expresses a policy other than protection. It expresses a policy that facts ought to be available for use. Now, whether and to what extent judges will take these competing policies into consideration, we’ll see. That’s what is currently before the courts. But it is an area in which the underlying support for the misappropriation theory is weakened.

Wiandt: The idea of misappropriation is the idea that you’re directly competing with the person that you’re taking the information from, right?

Mazer: Well, not according to the case Mr. Deutsch refers to, Dow Jones, which I’ve been calling the Board of Trade case. In that case, the Supreme Court of Illinois held that Dow Jones wasn’t selling a product similar to the futures contracts the Chicago Board of Trade was trying to launch; nonetheless, the court ruled in favor of Dow Jones. There was a vigorous dissent in that case and, in fact, there were one or two reversals before it even got up to the Supreme Court of Illinois. The dissent in that case was extremely critical of the majority for what it viewed as expanding this concept of misappropriation to situations where there is no competition between the parties.

Wiandt: So what is the definition? If you were going to put together a one sentence definition of what a misappropriation is that would fit with what the majority in that case said…

Mazer:I think Mr. Deutsch would agree that the definition is whatever the judgment in the case said it is.

Deutsch: Here’s how lucid it is: The INS case said, “You shall not reap what you have not sown.” Well, if you apply that principle, there is no financial services business, because everybody relies on investments that other people have made in the past. So that’s not a very good limiting principle, and that’s always been the problem with misappropriation. It’s got a very cloudy doctrinal underpinning, and a lot of it seems to end up in what the judge had for breakfast that morning.

There was a case out of Delaware about 15 years ago that said the NFL [National Football League] couldn’t stop the Delaware Lottery from having a lottery based upon NFL scores, because that pushed the concept of misappropriation too far. Well, I think you can draw an analogy on that at least to the availability of published index numbers as the basis for the settlement of some sort of traded product.

Wiandt: What are some of the differentiating issues in funds and ETFs versus options and options on indexes that could determine where those cases might go?

Mazer: If you’re talking about options directly on the index, you’re talking about something that doesn’t have a defined value other than because of the index. If there’s no index, there’s no way to say what the value of the contract is. That gives a direct connection between the index and the financial product that can’t really be severed.

Wiandt: You’re saying there is no difference? The number is the same as having to have the whole portfolio to replicate in an ETF: you need every component, exactly the right way?

Mazer: No, I’m saying the opposite, which is that in the case of options, you need the index to know what the value of the option is. In the case of ETFs or mutual funds, the trustee holds a basket of stocks, and if the index disappears, the value of the ETF can be figured out by dividing the value of the stocks in the basket.

Wiandt: Without the index, the option would have to shut down, because there would be nothing to value it by; the fund could still run from where it was.

Mazer: The option would have to shut down or generate the index itself, if that’s possible.

Wiandt: It couldn’t continue, and it couldn’t shift to reflect the asset class going forward. The fund wouldn’t have to shut down right then.

Weber: It just wouldn’t be tracking anything anymore.

Audience Member: I understand the case for the index provider. My question is, once the options start trading on an ETF, is there a licensing fee to the ETF?

Weber: This is something I know because the AMEX was involved. The kind of case people talk about regarding this issue is the Golden Nugget case. The Golden Nugget Casino had their stock trading in the secondary market, and the AMEX listed an option on that stock, which the casino did not want. They challenged the listing, and it was determined that once there’s a security trading in the secondary market, the issuer cannot stop an exchange from listing an option on it.

Mazer: And that case was the basis for the later decision, that there was no way to stop an exchange from listing options on an ETF without a license, because the court said that’s the same thing as listing an option on a stock.

Audience Member: So what would happen if the index shut down and you still had an ETF? From a regulatory perspective, I know that the ETF has to have an objective outside index, right?

Weber: There would need to be a replacement index that would substitute for the previous index.

Wiandt: Could the product issuer create the index themselves, or would there need to be a special exemption to do that, like for WisdomTree?

Weber: Historically, the SEC [Securities and Exchange Commission] has preferred to see a division between the issuer and the index provider. WisdomTree recently was able to get approval from the SEC to launch a product as both the advisor and the index provider, and they have certain provisions to separate those two aspects.

Wiandt: Right. There is an internal Chinese wall between the production of the numbers and the running of the funds. And the indexes have very transparent methodologies.

Weber: So that there is no special information that’s available to the advisor with regard to what’s going on in the index and vice versa. As long as there are certain provisions made there to keep those two independent of each other, it can be done.

Wiandt: Let’s say we have a doomsday scenario for the index providers, where there is some case that says index providers no longer have the right to charge licensing fees for any products, whether they are funds, ETFs, futures, options, anything. What do you think would happen to the industry in that case?

Neubert: You just took away, probably, 70 to 80 percent of the revenues and profits of each of the index providers, turning them into money-losing operations. And I think if each of them were faced with that, their option would be to cease and desist all at the same time: the nuclear option. I think the world’s financial markets would see the results of that very quickly. That, to me, is the ultimate Sword of Damocles that they hold over the financial markets.

Wiandt: Couldn’t the index providers charge on a per case basis, or charge for certain data? Could there still be a business there?

Neubert: I think once you’ve removed the value at the top end, then there’s no value in the brand or anything else, and I think the whole thing melts down.

Weber: Data also is becoming a very important aspect of where the exchange business models are going: selling data, capturing data and packaging it and re-marketing it. There are users of that data who are questioning the charges, whether it should be made available either free or more reasonably to the end users.

Deutsch: These issues get a little closer to the core of the original INS case. They are taking all the data and selling it, which is in many ways almost the same fact as the Supreme Court had in front of it with the wire services in the original misappropriation case. You can make the argument that no one would go into this business if somebody could free ride in that respect. So I think just from misappropriation theory, there is a stronger protection for real time data than there is for one number a month that’s used as a settlement price for an options contract.

Wiandt: To revisit this doomsday scenario … my feeling is that it’s not very likely. What’s your take?

Mazer: The way I address that question is to do an analysis of the facts to determine if these indexes really would shut down. If that’s right factually, there’s a powerful argument in favor of granting the index providers a larger scope of intellectual property rights—including the right to prevent the creation of a new security based on the index. Because if their lack of that right would cause the indexes to cease to exist, the case law says it is a factor we consider in saying whether they should have that right or not.

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