Comparing Legal and Alternative Institutions in Commerce Franklin Allen Jun “QJ” Qian

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II.2 Intellectual Property Rights and Innovations

This is one of the ‘hot-button’ issues in both legal and economic research and practice. Due to space limitations we cannot obviously review all the evidence. We focus on two aspects of the protection of intellectual property rights. First, whether the protection of exclusive rights (through patents, copyrights, trade secrets, trademarks, etc) has a positive impact on the pace of innovation, and second, the advantages and disadvantages of using the law and legal institutions as the basis for disputes related to intellectual property rights.

In most countries and certainly in the U.S., the scope of patentable subject matter has traditionally not included fundamental scientific discoveries. A frequently mentioned rationale for this omission is that many scientists care little for monetary rewards, and would pursue the discoveries in any case. To grant patent awards for purely scientific discoveries would then be socially wasteful. On the other hand, after the patent is applied for and approved and issued, the primary forum for resolving disputes is the (federal) courts, which have exclusive jurisdiction over disputes involving the infringement of patents, as well as over appeals of court decisions.

The background on patents begs the question of what kind of inventions are protected by patents and the relative importance of innovation that are protected by patents and those that are not. In this regard, Table 2 presents the history of some of the major medical breakthroughs during the past 150 years. It is interesting to see that the majority (especially before 1950) of the discoveries were made by university researchers (not affiliated with corporations) and the initial invention was not protected by any patents. In some of the cases the patent holder is not the original inventor or discoverer.

As an example the process of discovering and producing penicillin is illuminating. While widely believed to be discovered by Alexander Fleming (as shown in Table 2), in 1928, several others had discovered its bacteriostatic effects as early as 1875.

The real challenge of the new ‘wonder drug’ was how to produce it in large quantities. This period coincided with WWII, during which penicillin made a significant difference in deaths and amputations caused by infected wounds among Allied forces. Due to the large demand and problems with technologies of mass production, the price soared in the markets and a large amount was reserved for military use. A team of British and American scientists led by Nobel Laureates Howard Florey and Norman Heatley finally made the breakthrough in the early 1940s. Penicillin production was quickly scaled up and made available in quantity to treat Allied soldiers wounded on D-Day. As production rose, the price dropped from being nearly priceless in 1940, to $20 per dose in July 1943, to $0.55 per dose by 1946. Andrew Moyer, a member of the research team, was granted a patent in the U.S. for a method of mass production of penicillin in May of 1948, after the commercial value of the drug had plummeted. Interestingly, other researchers and producers of penicillin had applied for patents in other European countries but the applications were turned down, as it was deemed ‘unethical’ to provide exclusive rights for an invention that can save lives. In fact, the attitude of governments and societies toward using patents and copyrights became increasingly pro-rights holders only after World War II.4

There is an extensive literature in industrial organization in economics examining the relationship between patent/copyright protection and the pace of innovations, and the research yields mixed findings (e.g., see proceedings from OECD 2005 reports on intellectual property rights and competition). While exclusive property rights provide strong incentives for innovations and do lead to more innovations in some industries such as chemicals and pharmaceuticals (and there are significant cross-sectional differences across industries and countries), excessive protection deters competition, another important factor in spurring innovations. In addition, based on changes in patent laws and enforcement regulations, Lerner (2003, 2005) only finds weak or no evidence that strengthening patent rights and enforcement spur the pace of innovations across most developed countries.

China is often singled out as one of the countries that is notoriously bad in protecting intellectual property rights, as copying and imitation via reverse engineering is a prevalent strategy across industries. For example, Chinese car Chery QQ appeared six months before the Chevy Spark which it was a copy of, and the Shanghuan Automobile’s CEO model is remarkably similar to a BMW X5. Legal actions by foreign firms have been nearly useless in preventing these activities. Perhaps a saying in Shanghai best summarizes the social norm toward copyrights protection: “We can copy everything except your mother…” While the protection of intellectual rights in China has been poor, apparently the pace of innovations has been furious at the same time due to the pressure of competition.

One of the main problems with the patent system and using the law and legal system as the basis of protecting intellectual property rights is that it motivates rent-seeking behaviors by interest groups. One of the well-known problems in the patent system is that companies, especially large corporations with abundant resources, come up with numerous nonessential ‘inventions’ to ‘pad’ the one significant (patented) invention or establish a new ‘standard’ in production (e.g., Dewatripont and Legros 2007). This problem is particularly important when the creation of a standard requires the use of many different technologies (in the case of mobile technology, for instance, a handset can require the use of more than a thousand technologies protected by patents.) By jamming the patent system with these extra patents these companies can essentially block or delay innovations by competitors. This is what has led to the FRAND concept – “fair, reasonable and non-discriminatory royalties.”

Another form of rent-seeking behavior is that patent holders, especially those with more resources, seek the best possible legal venue to maximize the likelihood of winning a lawsuit against patent or copyright infringements. This type of behavior runs directly against the principal that the legal system within a democracy should be based on fair procedures and allow equal access to all. The fast rise of Marshall, a small town in eastern Texas, the self-proclaimed Pottery Capital of the World and home to the annual Fire Ant Festival (e.g., New York Times, 9/24/2006), as the center of patent-related litigation is an interesting case study. According to LegalMetric, a legal data and analysis company, the Federal Eastern District of Texas (which also includes the rural towns of Tyler and Texarkana), now handles the largest amount of patent litigation cases (up to one third of all new cases and an even higher fraction of all cases involving a US firm suing foreign firms or individuals) in the country, surpassing courts in Chicago, Manhattan, and even the Central District of California (in Los Angeles), historically home to the largest number of new patent cases.

Some attribute the popularity of the Texas district to the efforts of the locals to streamline the process of patent litigation including adoption of uniform rules. Most observers, however, attribute this phenomenon to one person, T. John Ward, the federal judge in Marshall, Texas. He became interested in patent law while defending Hyundai Electronics against a lawsuit by Texas Instruments; Hyundai lost and Texas Instrument was awarded $25.2 million in 1999. Since Ward joined the Eastern District of Texas, the district has seen a tenfold increases in patent cases since 1999 (14 cases in 1999, and 234 in 2006). Judge Ward has been described as pushing cases through quickly, and his court has been described as a “rocket docket” for its speed. His trial rules include strict timetables and the use of a chess clock to time opening and closing arguments. Each side in a case might receive between 9 and 15 hours for evidence, compared to other courts which it may take a month or more.

There is disagreement as to whether the jurors from the district are “patent friendly.” Judge Ward himself has described the district as historically “plaintiffs oriented,” and the Marshall jury pool as “defenders of property rights” and “friendly to patent owners’ interests.” Some claim that plaintiffs, especially US firms suing foreign firms and individuals over patent infringements, often have an advantage because they hire Marshall lawyers or legal consultants who know the jurors and benefit from that information. Whether the alleged court’s friendliness toward patent holders is true or not, the fact is that plaintiffs (patent holders) have won much more frequently (and have done so in a short period of time no less) in the district than anywhere else in the country.

II.3 Limited Capacity of Legislature

One of the potential problems of using the legal system is that, when there are fundamental changes in an economy so that the law and/or regulation must be revised, the legislature must approve any revisions before corporations and investors can freely implement new techniques in their transactions and interactions (without worrying about breaking the law). However, politicians have limited time and effort that can be devoted to any given area of the law, and hence there is a legislature capacity and a fixed cost in revising the law. The following example illustrates that such limited capacity and fixed costs can single handedly slow down pace of innovations and transactions in practice.

Figure 1 compares payments systems in major developed economies. At the start of the 21st Century the U.S. had a 19th Century payments system, relying mostly on checks and the mail, and significantly lagging behind other developed nations. For example, while countries like Germany, the Netherlands, Sweden and Switzerland have almost completely abandoned checks (and rely instead on electronic payments systems) as a method of payments, about half of all the payments within in the U.S. were still in the form of checks. Checks had to be physically transported from where they were deposited to a central operations center, then to the clearer and then back to the banks they were drawn on. This check-and-clearing process significantly delayed business transactions as compared to electronic methods.

How costly was this backward payment system? Using information from Humphrey et al. (1996) and Bolt et al. (2005), we can conduct the following ‘back-of-the-envelope’ calculations. From cross-country comparisons and analysis, these researchers suggest that there are saving of 1-2% of GDP when a country moves away from paper checks (e.g., the U.S.) and towards electronic-based methods.  From Table 1, the U.S. 2007 GDP was $13,543 billion, which indicates the magnitude of savings from reforming the payment system to be $135billion to $270billion per year. With a 5% discount rate (roughly the risk-free rate in the U.S.), the discounted present value of this savings (assuming perpetuity) is between $2.7 trillion to $5.4 trillion; in other words, the magnitude of the savings is higher than that of the most recent Iraqi war.

Despite years of calls for changes from the banks and businesses, the U.S Congress appeared not in a hurry to solve this seemingly simple yet costly problem. Without the approval of the legislature banks cannot implement any significant changes due to the fear of lawsuits. Then September 11, 2001 acted as a catalyst for change. After the terrorist attack all commercial flights in the U.S. were grounded for several days, completely halting the check clearing process. After the flights resumed the call for change was finally heard by the Congress. The Check Clearing for the 21st Century Act was signed in October 2003, which allows electronic images to be a substitute for the original checks and thus the clearing process is no longer dependent on the mail and transportation system.
II.4 Impact of Patent Protection on Recent Internet-based Innovations

There are recent innovations communications and knowledge industries based on internet technological revolutions that have made fundamental changes to many people’s lives or have the potential to do so. In the knowledge front, SSRN (Social Science Research Network) and JSTOR are great academic inventions that bring new working paper and published articles, in digital and electronic format, to individual researchers worldwide essentially free of charge (based on institutional subscriptions). For the general public, Wikipedia, a multilingual, web-based platform with free content, is quickly becoming the most useful encyclopedia. Written collaboratively by volunteers from around the world, the Wikipedia articles provide links to guide the user to related pages with additional information and a great point to start researching almost any subject (including the materials for this article!). Since its creation in 2001, it has grown rapidly into one of the largest reference websites attracting over 600 million visitors annually by 2008.

While the growth of Wikipedia has met with little resistance from the traditional media companies, it is a totally different situation with Google’s equally ambitious “Print and Library Project.” It has two components, Google Publisher Program, in which a publisher controlling the rights in a book can authorize Google to scan the full text of the book into Google’s search database, and Google Library Project, where some of the largest libraries (Harvard, Oxford, and Stanford Universities, the University of Michigan, and New York Public Library) allow Google to scan materials into a search database. According to the initiatives from Google, for books/print materials in the “public domain” (not subject to copyright) from the libraries, Google will display the full text of the book with the search result; for those that are still covered by copyrights, readers can only see a few sentences of the text around search item. Copyright holders can also exclude selected books from Google Print. The benefits for readers/online users are obvious, and for a lot of authors this project is also a free marketing device.5

Ever since the initial idea of the Project floated around, it was met with disdain from the traditional publications companies. The Association of American Publishers, including firms such as Penguin, McGraw-Hill, Pearson Education, Simon & Schuster and John Wiley & Sons, and the Authors Guild, the nation’s largest organization of book authors, filed suits against Google in the second half of 2005 (despite the objection of many authors whose books were published by the companies). The legal action came after months of talks failed to hammer out an agreement and has held up the implementation of the project indefinitely. Even if Google wins in the U.S. they may be sued again in other countries (e.g., in EU countries) with different and perhaps even more stringent copyright laws. Google’s primary legal defense: Fair use doctrine under the U.S. Copyright Law.

Another example is the Linux operating system, started in 1991 by Linus Torvalds. A Unix-like computer operating system, Linux is one of the most prominent examples of free software and open source development. Typically all underlying source codes can be freely modified, used and redistributed by anyone. Historically, Linux has mainly been used as a server operating system, and has risen to prominence in that area.

How does Linux stack against the Windows system, the most prominent operating system released under a proprietary software license by Microsoft? Not surprisingly, Windows dominates the desktop and personal computer markets with about 90% of market share, as compared to 1% market share by Linux. The distribution techniques used (e.g., through bundling with other softwares such as Internet Explorer) by Microsoft are well known and the firm has been accused of using its monopoly power to take advantage of smaller companies. In the servers market, Windows had a share of 36% (fourth quarter of 2007) while Linux had a share of 12.7%. As of November 2007, Linux powered 85% of the world’s most powerful supercomputers; in February 2008, Linux powered five of the ten most reliable internet hosting companies. Proponents of free software argue that the key strength of Linux is that it respects what they consider to be the users’ essential freedom, the freedom to run, study and change, and to redistribute copies with or without changes free of charges.6

Our final example regards music (and movie) downloads, both legally and illegally, and the status of the music (movie/entertainment) and recording industries. Downloading music first became popular with the file sharing technologies such as peer-to-peer networks, with individuals possibly knowingly or unknowingly violating copyright laws by not obtaining permission or payments. The Recording Industry Association of America (RIAA) claims that this practice is damaging the music (and entertainment) industry, and a series of lawsuits led to many of these networks (with perhaps the best known example of Napster between 1999 and 2001) being shut down. Going after companies such as Napster is one thing, going after millions of people downloading and sharing music on a daily basis is another. However, RIAA and the recording companies are certainly trying.

Recently, the RIAA and industry has taken its crusade against pirating one step further: In its federal case against Jeffrey Howell, a Scottsdale, Arizona man who kept a collection of about 2,000 music recordings on his personal computer, the industry maintains that it is illegal for someone who has legally purchased a CD to transfer that music into his own computer (Washington Post, 12/30/2007). Interestingly, researchers (e.g., Oberholzer-Gee and Strumpf 2007) have found that internet music piracy not only does not hurt legal CD sales, it may even boost sales for some types of music. The researchers, using 1.75 million downloads over 17 weeks in 2002 and comparisons with the sales of 700 albums, found that most illegal downloading is done over peer-to-peer networks by teenagers and college students. These groups are “money poor but time rich,” meaning they would not have purchased the songs they downloaded and hence the industry cannot claim those downloads as lost record sales. On the other hand, illegal downloading may actually help the industry slightly with many “samplers” – an older crowd who downloads a song or two and then, if they like what they hear, go out and buy the music.7 One way or the other, many observers of the industry believe that RIAA’s campaign against its own customers is a classic example of an old media company clinging to a business model whose time is in the past.

There are numerous additional examples of abusing the patent system (e.g., see Bessen and Meurer 2008 for more details). The ordeal Edwin Armstrong (affiliated with Columbia University) had to endure to win his patent rights of inventing FM radio against RCA and other prominent traditional radio companies back in the 1920s and 1930s, and the long (recently resolved) dispute between Research in Motion, maker of the Blackberry handheld device, against NTP, a patent holding company, are a few noted examples.

We end this subsection with a comment on the effectiveness of using lawsuits (by interest groups) to protect copyrights. As in the case of music downloads, the efforts by interest groups seem to be largely ineffective when the public is engaged in the illegal act at low costs, but these efforts become more effective when a single company is leading the implementation of new technologies (e.g., Google’s Print Project). The contrast in these cases however suggests that using the law as the basis for the protection of intellectual property rights can induce rent-seeking behavior by the interest groups that will have the most to lose given the new technologies, and their efforts can become significant barriers to changes and innovations.

II.5 Alternative Mechanisms can work in Complicated Transactions

We provide two examples here to demonstrate that alternative mechanisms operating outside the legal system can deal with complicated transactions. First, the diamond industry has historically operated outside the legal systems (e.g., Bernstein 1992). In fact, the global diamond industry has systematically rejected state-created laws. This is in part due to the fact that legal contracts cannot be enforced since the value of each transaction (a particular diamond) is highly idiosyncratic and most diamond traders do not have access to capital markets, and hence calculated damages based on “what if” contingencies are not applicable. Moreover, it takes too long to get a resolution from courts. In its place, the sophisticated diamond traders (belonging to trading clubs or bourses) who dominate the global industry have developed an elaborate, internal set of rules, complete with distinctive institutions and sanctions, to handle disputes. The arbitration process within the DDC (diamond dealers club) based on the rules is usually straightforward and quick, with ruling often involving parties simply splitting the differences in estimated damages. Typically, the private arbitration system keeps all judgments secret as long as payments are promptly paid. Given the long-term relationship of members and reputation effect, these simple rules work much better in the long run (even though they may not be fair in individual cases) and save costs. In recent years, the World Association of Diamond Bourses (WFDB) has successfully shifted from the traditional relationship-based DDCs to world-wide information technology based regime (database on reports of arbitration from 20 plus member countries, many of which in Asia). In their discussions about the reform rarely does a country’s laws come up.

Another industry that has relied on out-of-court mediations and arbitrations to settle disputes is reinsurance. In the most widely accepted sense, reinsurance is understood to be the practice where an original insurer, for a definite premium, contracts with another insurer or insurers, to carry a part or the whole of a risk assumed by the original insurer. While the earliest reinsurance contract can be traced to the 14th Century Italy (e.g., Kopf 1929), the first use of an arbitration clause in an insurance contract was, by most accounts, the one in the insurance Company of North America in 1793 (e.g., Winn 2004). This system has both parties appointing their own arbitrators and usually has the two party-appointed arbitrators appointing a third arbitrator referred to as an ‘umpire.’ In practice, however, it is the parties and their outside counsel who play a large role in the selection of the umpire. This often results in disagreements, especially in large transactions, which delays the appointment and hence arbitration process.

In recent years the industry has been revising the traditional procedure in order to expedite the process without losing sight of fairness. Industry experts point to other industries where arbitration has been used most successfully. One such example is securities arbitration, where the rules are disseminated by the New York Stock Exchange and the National Association of Securities Dealers and are continually refining and improving (e.g., Kondo 2007). The Dispute Resolution Protocol, which is non-legally binding for members, developed by the Conflict Prevention & Resolution International Industry, reflects these new ideas and changes. Based on best practices from the field, the Protocol, among other things, simplifies and standardizes the process of selecting neutral arbitrators, and has been endorsed by leading companies such as Lloyd’s. This example demonstrates the importance of adapting to changes quickly as a main condition for the long-term viability of a dispute resolution mechanism.

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