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After setback, Vonage wins temporary relief

Appeals court blocks a judge's order that would have stopped the Net phone company from taking on new customers.

ALEXANDRIA, Va.--A federal appeals court granted Vonage a temporary reprieve late Friday from an injunction granted earlier in the day that would have prevented the Internet phone provider from signing up new customers.

The U.S. Court of Appeals for the Federal Circuit, which hears patent disputes in Washington, D.C., blocked the injunction from taking effect until the judges were able to consider arguments in the patent case brought by Verizon Communications.

During a Friday morning hearing here that lasted about an hour, U.S. District Judge Claude Hilton ordered Vonage not to accept any new customers while it continues to infringe on Verizon's patents covering some aspects of Internet phone calls.

A copy of the one-page appeals court order(PDF) provided to CNET News.com by Vonage's legal counsel gives Verizon until April 13 to respond to the voice over Internet Protocol company's request to lift the injunction during the appeal process. It was signed by Chief Judge Paul Michel.

Roger Warin, Vonage's attorney, protested Hilton's no-new-customers order during Friday's hearing. Arguing the decision was just as threatening to Vonage as a full injunction, he said "it would be the difference of cutting off oxygen as opposed to a bullet to the head."

He also told Hilton that "in effect, what you are doing is slowly strangling Vonage, because it cannot preserve that customer base" indefinitely. He noted that Vonage's customer turnover rate is 2.5 percent per month.

"It would be the difference of cutting off oxygen as opposed to a bullet to the head."
--Roger Warin, Vonage attorney

Verizon in court filings this week had opposed anything more than a so-called partial stay on the permanent injunction against Vonage. Attorneys for the nation's second-largest telephone company argued that without at least those restrictions, Vonage would continue to pour resources into adding new customers, potentially leaching additional subscribers from Verizon and causing it to lose business.

The judge's order follows a federal jury finding on March 8 that Vonage had infringed three Verizon patents. The New Jersey-based Internet phone provider was ordered to pay $58 million in damages.

Judge Hilton announced two weeks ago that he planned to sign off on an injunction barring Vonage from using the disputed Verizon technologies, but he gave the parties time to convince him otherwise.

Hilton on Friday also ordered Vonage to post an approximately $66 million bond, which includes interest accrued on the damages awarded and other legal costs, while it carries out its appeal.

Financial analysts said the partial injunction, if eventually upheld on appeal, would be a severe blow to Vonage.

"All carriers that have any degree of churn, which is pretty much everyone I know of, must be able to add new subscribers to remain viable as a business," said Albert Lin, an equities analyst with American Technology Research.

But for Vonage, being hamstrung in this way could be particularly devastating, as it faces stiff competition from cable operators, which are also targeting residential phone users with their own VoIP services. Then there are the Internet companies, such as Skype, Google, and Yahoo, that are also offering VoIP services that allow people to make calls to traditional phones as well as cell phones.

Even before the jury found that Vonage was infringing on Verizon's patents, the company was struggling to add new customers. In the fourth quarter of last year, Vonage added 166,000 new subscribers. That was down from 204,591 subscribers in the third quarter and 256,000 in the second quarter of 2006. This drop in new subscriber growth occurred despite the fact that the company spent $365 million on marketing in 2006, a 50 percent increase from the previous year.

The high marketing price tag has translated into hefty losses for the company. During 2006, Vonage lost $286 million on revenue of $607 million.

Vonage's slowing subscriber growth is in stark contrast to cable operators' subscriber growth, which has been setting records.

"The good thing for Vonage is that there are many options for getting VoIP technology as evidenced by the hundreds of other providers in the marketplace. Thus, this is disruptive, but not fatal."
--Albert Lin, analyst, American Technology Research

Despite its losses, Vonage has a strong cash position. The company ended the fourth quarter with almost $500 million in cash, which means that the $58 million in damages it was ordered to pay to Verizon accounts for about 12 percent of its total cash.

Analysts say there is a glimmer of hope that Vonage could still come out of this situation all right.

"The good thing for Vonage is that there are many options for getting VoIP technology as evidenced by the hundreds of other providers in the marketplace," Lin said. "Thus, this is disruptive, but not fatal."

In its original court complaint filed in June 2006, Verizon accused its growing rival of infringing on seven of its patents, but it later scaled back the scope to include only five patents.

The patents Vonage was found to have infringed cover technologies that deal with connection of VoIP calls to the regular phone network, some features for implementing call-waiting and voice mail services, and VoIP calls using Wi-Fi handsets. (The jury found Vonage had not infringed two other patents, which involve billing systems designed to detect fraud.)

Vonage has maintained that it did not infringe on any of the Verizon patents and that its service rests on commercial, off-the-shelf technology.

The company has also said that even if the verdict is upheld, its subscribers will not encounter disruptions because it is developing a technological workaround.

But it's unclear how far along Vonage is in that process. In a recent government filing, the company reported signing a licensing agreement with a VoIP wholesaler that appeared to provide a replacement for two of the Verizon-patented technologies. Vonage said Thursday that the deal actually has nothing to with its patent woes.

The Internet phone provider's remaining options are all uphill battles, said Rebecca Arbogast, an analyst with the firm Stifel Nicolaus. The technical workaround Vonage claims to be preparing, for instance, is not a sure thing, as the judge's broad reading of Verizon's patent claims could imperil any replacement technology as well, she said. Another path could be to work on negotiating a settlement with Verizon to license its patents, but it's not clear that either company is interested in that route.

Verizon "may be more interested in putting (Vonage) out of business," she said. And given the string of legal setbacks for Vonage in this case, she added, "the price tag could be getting so high that Vonage is going to have a hard time making it."

The court could hear Vonage's appeal on the injunction next week, said Susan Pan, a partner who specializes in patent law with the firm Sughrue Mion. She said Vonage likely has a 50-50 chance of winning its case on appeal.

"If you think of a patent as a fence, the lower court has viewed it as covering a large area like an entire acre," she said. "It's possible on appeal that the federal circuit will say that the patent actually only covers two-thirds of that acre. And the other one third could be the area where Vonage is operating, which would mean Vonage isn't infringing."

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