Last Friday, Apple (AAPL) was hit with a $1.2 billion class action for allegedly bricking — i.e., intentionally disabling — the iPhones of customers who had used unauthorized “unlocking” software on their phones (enabling them to use carriers other than AT&T) or unauthorized applications on their handsets (like non-Apple ringtone software). AT&T Mobility (T) is also named as a co-defendant.

The suit seeks $1.2 billion in damages, alleging violations of the federal antitrust laws, California unfair business practices laws, and the tort of “computer or chattel trespass.” It also claims that Apple’s customer warranty and license agreements, by forbidding customers from using third-party software on their phones, violate the Magnuson-Moss Warranty Act. (For the text of that act, see section (c) of the statute linked here.)

Both Apple and AT&T, through spokespersons, declined comment. Here is the complaint, and the suit’s official web site, set up by the plaintiffs lawyers, is here. (Don’t miss the picture of Steve Jobs in the iPhone screen looking suitably Satanic.)

The case stems from a series of unusual events that began with a carefully worded press release from Apple on September 24. (These events have been extensively covered in the blagosphere, but a good place to begin might be with my colleague Philip Elmer-DeWitt’s Apple 2.0 post, here.)

“Apple has discovered,” it said, “that many of the unauthorized iPhone unlocking programs available on the Internet cause irreparable damage to the iPhone’s software, which will likely result in the modified iPhone becoming permanently inoperable when a future Apple-supplied iPhone software update is installed.” It went on to warn that “unauthorized modifications” to the iPhone’s software violated the customer’s license agreement and voided the warranty.”

Four days later the company released version 1.1.1 of its iPhone operating system which did, indeed, cause problems, with many of the expensive phones being disabled — some permanently.

The suit alleges that none of these problems were actually inadvertent or inevitable byproducts of necessary upgrades, but were, instead, intentionally engineered efforts to punish customers for using competitors’ applications or services instead of Apple’s and AT&T’s. It also asserts that Apple customer service personnel were instructed to refuse to help customers restore the damaged phones to service, even though inexpensive fixes were technically feasible.

In an email, lead plaintiffs counsel Max Folkenflik, of New York’s Folkenflik & McGerity, says that he is seeking certification of a class that would include all purchasers of iPhones, regardless of whether the phones were actually disabled by Apple’s release of version 1.1.1. “All purchasers have less choice and pay higher prices than they would in a competitive market,” he writes. “Freedom of choice is worth money in the same way that markets value liquid investments over illiquid investments. The fact that unlocked iPhones sold for more than locked iPhones provides evidence for that conclusion if any were needed.”

He then totes up the damages as follows. “Our actual damage estimate of $200 million is based on a 2 million member class,” which is based on the number of iPhone customers that are predicted by December. He then theorizes that each purchaser suffered about $100 in injury due to “higher voice and data costs, avoidable roaming charges, fees for termination of T-Mobile plans, and the reduction of value based on the locked up technology.”

The antitrust laws and the California statute allow trebling of damages, which would bring the figure up to $600 milion. Then he also seeks punitive damages under the tort count (chattel trespass) of an additional $600 million, pushing the total figure up to $1.2 billion.

Though the suit raises many thorny issues, one of the more eyebrow-raising claims accuses Apple of monopolistic practices on the theory that the iPhone is such a distinctive device that it constitutes its own market — i.e., no other cell phone manufacturer even rises to the level of being a competitor. Since Apple obviously enjoys a monopoly over the iPhone market, the suit claims it is now illegally trying to extend that monopoly into other areas, including phone service and handset software.

To support the claim that the iPhone should be deemed to constitute its own market, the plaintiffs allege: “For many users, including the Plaintiffs and the Class, there was no product available which offered anywhere near the same combination of services and ease of use.”

It seems that being sued for antitrust violations may be overtaking plagiarism as the sincerest form of flattery.

The U.S. Supreme Court stopped with the wrist-slaps yesterday, and delivered a right cross to the jaw of the federal patent appeals court. Then the justices cupped their hands astride their mouths and shouted in unison: Fewer patents!

In the latest in a series of rebukes, the Court unanimously told the U.S. Court of Appeals for the Federal Circuit and, by extension, the U.S. Patent and Trademark Office, that each had been approving and enforcing patents for inventions that were just too obvious to merit the honor. The ruling came in KSR International v. Teleflex, a case involving an adjustable truck accelerator pedal. (For details of the case, see earlier post here.) (The Court also handed Microsoft (MSFT) an important victory in a different patent case yesterday, Microsoft v. AT&T (T), which pared back the applicability of U.S. patents to software distributed abroad. Microsoft was the defendant in that case. Microsoft general counsel Brad Smith tells the Wall Street Journal’s Jess Bravin today (click here) that the ruling will lop off about 60% of its exposure in the 45 patent cases pending against it today. For my earlier postings relating to that case, see here and here.)

“Granting patent protection to advances that would occur in the ordinary course without real innovation retards progress,” Justice Anthony Kennedy wrote in the KSR case. And in case the lower court thought it hadn’t heard him correctly, he said it again: “The results of ordinary innovation are not subject of exclusive rights under the patent laws. Were it otherwise, patents might stifle, rather than promote, the progress of useful arts.”

The case involved a common situation: an invention that consists of combining, allegedly in a clever way, two earlier innovations, each of which has already been the subject of a patent. The patent appeals court had developed a test — which Kennedy said they were applying in a “narrow, rigid manner” — that, in practice, made it difficult to deny a patent to such combinations, no matter how obvious they might have seemed. As I read it, the ruling comes close to reversing that presumption, stressing “the need for caution in granting a patent” in those circumstances, because it “withdraws what is already known into the field of its monopoly and diminishes the resources available to skillful men.” The ruling also made clear that if a judge thinks an invention is obvious, he can dismiss the case before trial without having to let a jury make that determination. That significantly decreases the settlement value of a dubious patent. (A patent that is likely to make it all the way to a jury before it’s rejected has greater settlement value — because it will inflict more transaction costs on the defendant — than one that will likely get dismissed before trial on summary judgment.)

Just how significant the ruling was came across yesterday afternoon at an unusual press conference convened by the legal team for Teleflex, which was the losing party in the case. Press conferences by losing parties aren’t that common, and when they occur they are usually occasions for stressing silver linings and arguing that the Court’s ruling is actually much narrower than might appear at first glance. (After all, the lawyers are still representing their client, and that’s what the client will typically need to argue in his next case.)

But there wasn’t much gilding of the lily at this press conference. Robert Sterne, a patent lawyer for 29 years and the founding partner of the intellectual property firm of Sterne, Kessler, Goldstein & Fox, had this to say: The ruling will make it “harder, more costly, and more time consuming for inventors to obtain U.S. patents in all areas of technology, particularly mechanical inventions and software and methods of doing business.” He added that the pharmaceutical industry would probably be impacted, too, since drug companies try to prolong the terms of their strong patents with dubious, supplemental ones that might not measure up under the new standard.

Sterne also said he thought the ruling represented such a departure from existing practice that there would “most likely need to be guidelines issued by US Patent and Trademark Office to explain to the [examiners] what the implications will be from a practical point of view.”

At the same conference, Supreme Court advocate Tom Goldstein of Akin Gump Strauss Hauer & Feld, who had argued the case for Teleflex, wasn’t downplaying the significance of the loss either: “It’s fair to say that the economic consequences of the obviousness doctrine runs to the trillions of dollars. It’s the gateway to getting a patent, and intellectual property is at the heart of the American economic system.”

Fittingly, the ruling came down the same day that The American Lawyer announced that the Washington law firm of Wiley, Rein & Fielding had posted average profits-per-partner of almost $4.5 million, the largest number the magazine has ever recorded. The number catapulted Wiley Rein to first place in the nation in that category from just a 92nd-place showing last year. (For American Lawyer story and listings, see here and here.) The reason: its 61 equity partners were sharing a $245 million contingent fee award the firm received last year as its share of the $612 million settlement its client, NTP, won from Blackberry-manufacturer Research In Motion (RIMM). This was the case in which all Blackberry users in the country were threatened with service disruption after a jury found that RIM had violated patents held by NTP, which is an investment group that produces nothing and is composed largely of still more patent lawyers. NTP’s patents had all been tentatively declared invalid by the PTO upon reexamination at the time of the settlement, but the judge was threatening to issue an injunction anyway. Although the RIM litigation hinged on a slightly different issue — novelty, rather than obviousness — it brought home the extraordinary power of these fabulously valuable, yet puzzlingly evanescent property rights, which seem to vanish and reappear depending on whom has spoken to the PTO last.

Since Google (GOOG) announced its proposed $3.1 billion acquisition of DoubleClick earlier this month, Microsoft (MSFT) general counsel Brad Smith has been one of the most outspoken in urging antitrust regulators to closely scrutinize it. AT&T (T) has also publicly expressed concern, and the deal is also understood to be of great interest to Time Warner (TWX), (the parent company of Fortune’s publisher), Yahoo (YHOO), and nearly every big web publisher and advertising agency.

Obviously, the role of antitrust enforcement watchdog is a new one for Smith and for Microsoft, but such ironies won’t blunt the impact of any meritorious argument they might raise. I interviewed him last week about his perspectives on the deal. Below are excerpts. (I’ve edited my questions to make them sound more articulate than they really were. Also, I wasn’t taping, so Smith’s answers are just captured here as best I could using pen-and-paper notetaking.)

Q. For the time being, no one is asking outright that the deal be blocked. Instead, they’re just urging antitrust regulators to make a “second request.” [A second request for information indicates that the antitrust authority--either the Department of Justice or Federal Trade commission--has decided to initiate a full-bore, analysis that will probably take six to nine months to complete. The second request will come, if it comes, in mid-May.] Are people just being conservative?

A. Mostly, they’re probably being conservative. These questions are very novel. Before anybody tries to come to a conclusion, it would make sense to learn a lot more, in terms of having a data-driven analysis. It may well be, after learning more, we’ll be saying it should be blocked.

Q. I’ve heard people say that there’s no problem here, because Google and DoubleClick aren’t direct competitors. [Google's biggest business is in the market for paid-search ads, which are the text ads that show up alongside search results. According to eMarketer, Google held 75.6% of the U.S. paid-search market as of February 2007. Google also posts contextual ads on third-party sites, where the ad is targeted to relate to the content running near the ad space. DoubleClick, on the other hand, is the leader in providing Web services that advertisers and publishers use to post and manage display ads, including rich media and video. Compared to Google's contextual ads, these are typically higher-end ads, running on higher-end sites, touting higher-end brands.]

A. The law is opposed to two companies coming together if it’s going to acquire market power that would enable them to raise prices. So a big part of this question is, are they part of the same market and, if so, will they be in a position to raise prices?

Companies typically defend in a merger analysis by saying either, “No, we’re in two different markets,” or “Yes, we’re in the same market, but we don’t have a significant share of it.”

So the threshold question is: What is the market? To answer that you ask: Are two products substitutable for each other. If you raise the price on product A, will they shift to product B. If so, they’re substitutable, and are in the same market. I think [the argument that display ads, which DoubleClick brokers, and contextual ads, which Google handles, are in different markets] is very unlikely to sway regulators.

The thing that differentiates the two is the way they’re generated. A contextual ad scans the context of a page, and then chooses and serves up an ad related to that context. If it sees that the content is about Ford Motor earnings, it might serve an automobile ad.

With a display ad, they look at it through cookies generated when someone goes to other pages. You may be writing this article about Google, but the reader thirty minutes ago went to a Ford automobile page, so it might serve up an ad for a competing automobile.

Web sites rely on both. Are display ads and contextual ads substitutes for each other? They look the same, and they serve the same purpose.

Q. Do they look the same though? I thought contextual ads were typically much simpler than display ads.

A. Nothing in the technology requires that they be simpler. . . . Are they in the same market? It’s a very objective question. If the price of one goes up, will publishers switch to the other? We think the answer’s yes. If these two companies come together, they’ll have 85% of this market place. They’re the two principal competitors. One has the lion’s share of contextual; the other has the lion’s share of display.

Two other questions then need to be considered. How broadly should the market be defined. The narrowest would be by segment: display is one market, contextual is one market. At the other extreme, there’s [what Google CEO Eric Schmidt was reported as saying at the Web 2.0 Expo conference on April 17, which is that advertising is a trillion dollar business and that a post-acquisition Google would only have about one percent of it.] He wants to include all advertising on the planet. That would be the first time regulators have ever defined a trillion-dollar market, except maybe in the oil industry. Is a Web site publisher going to use newspaper ads [as a substitute for display ads]? I don’t see how that would work. [At the conference, eWeek.com also quoted Schmidt as having said: "This is an emergent business with lots of choices: customers have lots of choices, end users have choices and advertisers have choices. These are people [Microsoft and AT&T] who were involved in acquisition reviews as best I can tell and who lost.” -RP]

The last step, once you define the market and figure out the market shares, is you ask, what are the barriers to entry [by new competitors]? Even if the merged company has 85% of the market, if the barriers to entry are low, the regulators might say, we’re not going to worry [because new entrants to the market will prevent the merged company from raising prices to anticompetitive levels]. This is something the regulators need to study. This is a a market where there are very strong network effects with significant barriers to entry.

Q. What are the network effects here? ["Network effects" were famously a factor in the Justice Department's monopolization suit against Microsoft in the late 1990s. The argument there was that it would have been extremely difficult for a new competitor to enter the market for operating systems when so many thousands of existing applications had already been written to work only on Windows. Few people would want a new operating system, because few applications would exist to run on it.]

A. Everyone [gauges their success in this business] by measuring revenue per something. Revenues per ad impression. Revenues per search. Revenues per click-through. RP-something. What you see today is, Google’s revenue per search or revenue per ad are way higher than its competitors’. They’re double Yahoo’s, and even more compared to Microsoft’s. The reason? It’s how much personal information their sites collect and use. . . . It’s based on how much information you have on users. That’s attractive to advertisers. They keep aggregating [data on] all the searches you do, all the web sites you visit, and use all that data to serve up an ad. That generates more revenue per search. That makes it harder for other people to break into the market. Whereas in the 1990s, people focused on the applications barrier to entry, this is basically the privacy barrier to entry, or the advertising barrier to entry, or something. Within the next six months, I guarantee you a new term will emerge for how difficult it is to enter when you have somebody with economies of scale from owning so much of the personal information on the Internet.

If the kinds of factors I’ve described are real, what you’ll probably see with consolidation is the profitability of the company that serves the ad will continue to go up at the expense of the the Web site publishers on the one hand and the ad agencies on the other. The company in the middle will own all the personal information and derive all benefits. Talk to ad agencies, publishers, content creators. This is why they’re worried.

Well, readers? Do you find Smith’s arguments convincing?

When Google (GOOG) announced its $3.1 billion proposed acquisition of DoubleClick on April 13, recovering monopolists Microsoft (MSFT) and AT&T (T) were the most vociferous complainants urging regulators to scrutinize the deal.

Alluding to the irony, I asked Microsoft general counsel Brad Smith last week if he’d be hiring David Boies, of Boies Schiller & Flexner, to counsel his company on the antitrust issues. It was Boies, of course, who had sliced and very nearly diced Microsoft seven years ago as lead trial attorney for the government in its monopolization case against Microsoft.

“Honestly, it hadn’t occurred to me,” Smith said, but he sounded intrigued, and asked me to have Boies call him if he seemed interested after I spoke to him.

Alas, I’ll be getting no referral fee. By the time I finally got through to Boies today, his partner Donald Flexner had already been retained by long-time client AT&T for the same purpose. Flexner could not immediately be reached for comment.

For now, regulators are doing their initial 30-day inquiry. In mid-May they will decide whether to make a “second request,” which is what would trigger a deep dive analysis that might last six to nine months. During that stage the regulators-who could be either at the Department of Justice or Federal Trade Commission-would typically seek information and submissions from interested parties, like AT&T. Finally, if the regulators ultimately approve the deal, private parties like AT&T have the right to file their own suits to try to block the merger, though you don’t see that tried very often.

We’re quite used to hearing that question posed (and answered “yes”) by champions of Linux and other forms of free and open source software (FOSS). But those people have an obvious axe to grind: users and developers of FOSS fear being sued for patent infringement by big corporations, like Microsoft (MSFT), that have amassed huge software patent portfolios.

Remarkably, however, those very folks with the huge software patent portfolios — Microsoft, the Business Software Alliance, the Software and Information Industry Association, Intel (INTC), Amazon (AMZN), Yahoo (YHOO), Autodesk (ADSK) and others — now seem to be posing that question themselves, although one has to read between the lines a little bit. I’m talking about the message that emerges from the array of briefs those companies and groups have filed in connection with the recently argued U.S. Supreme Court case Microsoft v. AT&T.

The focus of that case is a narrow one. It has to do with a provision of patent law that was enacted two decades ago in order to discourage a pretty obviously unfair practice. (See earlier posting here.) U.S. manufacturers who wanted to make here, but sell abroad, a hardware device that would infringe U.S. patents had been manufacturing all the components here and then shipping them abroad for final assembly–doing an end-run around our patent laws. A law was enacted that forbids that practice. The question posed by the Microsoft v. AT&T case, is whether that law should apply to situations where the only exported “component” in question is software written in the U.S. but copied and reinstalled in computers abroad. Interestingly enough, the near unanimous view in the software industry–judging from the briefs submitted by the parties I’ve listed above–is that it shouldn’t. (The specific facts of the case are these: Microsoft concedes that its Windows operating system infringes a U.S. patent belonging to AT&T (T) relating to coding and decoding human speech. It is willing to pay royalties on copies of Windows sold in the U.S., but contends that it shouldn’t have to pay for copies installed on computers abroad and sold there. AT&T, and the court below, say it should.)

In other words, all these parties with mighty software patent portfolios would rather, on balance, not be allowed to enforce those valuable assets abroad, so long as they could be assured that, in exchange, they also wouldn’t have to worry about being sued for infringing anyone else’s U.S. software patents abroad. That doesn’t sound like a ringing endorsement of the U.S. patent system, at least as it relates to software patents; it sounds like the opposite. (Patent law is supposed to benefit industry by spurring innovation; yet it sounds like the software industry regards it as a net drag on in its industry.)

Emery Simon, counsel to the Business Software Alliance, assures me that none of the software companies in his group agree with my reading of their position. “All of our members believe that intellectual property rights generally, and patents specifically, are essential to promoting their continued development and distribution of innovative products and services,” he writes in an email. “The problem is how the lower courts have interpreted [the statutory provision concerning exportation of components], it is not the fact that the patent law protects software.” He continues: “The way the law has been interpreted is inconsistent with the objective of the law: the purpose of the law is to promote innovation, the effect of the lower court’s decisions is to create disincentives to US-based innovation. So, if the current interpretation of the law stands, US tech companies will have a disincentive to do their development in the US.”

What he’s saying is that the law, as it’s currently being applied, may drive U.S. software makers to move their operations abroad to ensure that they can sell their products abroad without running afoul of the U.S. patent system. Still, it sounds to me like the “disincentive to US-based innovation” he’s complaining about is the burden of having to operate within the U.S. patent system itself. And a patent system is supposed to provide an incentive to innovate, not a disincentive.

I wonder if Simon’s position and mine might be compatible in this sense: Maybe the companies with big software patent portfolios believe that software should be protected by a patent system; they just don’t believe it should be covered by the patent system we happen to have in place in the United States at the moment.

Can others make sense of this situation?

Last week an advocacy group that champions the use of free and open source software, including the Linux operating system, asked the U.S. Supreme Court to invalidate all software patents.

The request was made by the Software Freedom Law Center in an amicus brief submitted in the case known as Microsoft v. AT&T, which is scheduled for argument Feb. 21. It is unlikely that the Court would take the advocacy group up on its invitation, if for no other reason than the Court has only asked the parties to brief narrower questions presented by the case, which focuses on the degree to which a U.S. software patent can be enforced abroad. Still, the center, which aims to provide legal peace of mind to developers and users of open-source software, is putting the lightening-rod issue on the Court’s radar screen and hoping the Court will craft its ruling in a way that tees up the broader issue for future resolution.

One of the greatest threats to the acceptance of open source software by major corporate customers is the so-called FUD factor–the “fear, uncertainty, and doubt” that arises (justifiably or not) from the concern that patented proprietary software code might have found its way into the open source software at some stage, exposing the customer to liability for patent infringement. Because open source software is created through a decentralized process, with hundreds of individual developers making contributions, it is hard to guarantee against such an occurrence. If the SFLC could ever succeed in having the Supreme Court invalidate all software patents in one fell swoop, its mission would largely be complete.

The goal is not as pie-in-the-sky as it might sound. For many years the consensus assumption in the legal community was, indeed, that software, because it is just a set of instructions readable by a compatible machine, could not be patented without impermissibly carving out of the public domain fundamental laws of nature, abstract ideas, or mathematical algorithms, which the Supreme Court has previously declared to be off limits to patenting. That view was gradually reversed by a series of rulings in the 1990s by the U.S. Court of Appeals for the Federal Circuit, a special appellate court set up in the 1980s to handle patent cases, among others. But Daniel Ravicher, the legal director of the Software Freedom Law Center, argues in the group’s brief that these Federal Circuit rulings are inconsistent with the earlier U.S. Supreme Court precedents in the area. He asks that they at long last be examined by the the High Court–and overruled.

The SFLC seeks to ride a legal wave of sorts. The Supreme Court now appears to be cutting back on years of expansive rulings by the Federal Circuit, which many perceive as having inappropriately maximized the rights of patent-holders vis-a-vis accused infringers. Last term, in the eBay v. MercExchange case, the Court struck down one such pro-patent-holder rule that the Federal Circuit had devised, and this term, in the recently argued KSR International v. Teleflex case, the Court is widely expected to pare back another. (For an earlier Legalpad entry on the KSR case, click here.)

The Microsoft v. AT&T dispute concerns a law that was passed in 1984 to plug a loophole that originally had nothing to do with software. The law focused on banning the practice whereby some U.S. manufacturers were effectively doing end runs around other people’s U.S. patents by manufacturing the components of infringing inventions here in the U.S., but then shipping the components overseas for final assembly. The statute deemed such conduct to be infringing, so long as any “component” of the invention was being “supplied” from the U.S.

In this case, Microsoft (MSFT) has admitted that certain software in its Windows operating system violates an AT&T (T) patent relating to the digital coding and decoding of human speech. Though Microsoft concedes it must pay royalties for copies of Windows sold in this country, the question is whether it must also pay AT&T for copies of Windows that are installed on computers that are manufactured and sold abroad. In those situations, Microsoft loads a copy of Windows onto a “golden master disk,” and sends that abroad. There, licensed “replicators” make a first-generation copy of Windows from the golden master disk. Then that first-generation copy is “installed” onto foreign manufactured computers–i.e., it is copied again. So, argues Microsoft, it’s not infringing AT&T’s U.S. patent for two reasons: (1) no molecule of anything that winds up in overseas computers is being “supplied” from the United States; and (2) software is not a “component” of a patented invention within the meaning of the 1984 law. Ravicher hopes to import his contentions onto the second prong of Microsoft’s argument. He would like the Court to say: Right, software can’t be a “component” of a patented invention because it’s not patent-eligible to begin with.

The amicus briefs from the various groups who support either prong of Microsoft’s position were filed on December 15. The most influential brief among them is clearly that of the United States (which represents the views of both the U.S. Patent and Trademark Office and the Justice Department), but the Business Software Alliance, the Software and Information Industry Association, Intel (INTC), Amazon (AMZN), Yahoo! (YHOO), and Autodesk (ADSK) have all weighed in on Microsoft’s side as well. Amicus briefs on AT&T’s side have not yet reached the deadline for filing, so we do not yet know who they will include. The best in-depth discussion (with links) I have seen of the Microsoft v. AT&T case is at the Patently-O blog, where the specific discussion is here.